MBA795

Strategy Formulation

Steven E. Phelan
Introduction
Course Objectives
Course Assessment
Group Formation
Registration Codes
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Company Registration Code

Company A 9099-SPN-A
Company B 9099-SPN-B
Company C 9099-SPN-C
Company D 9099-SPN-D
Company E 9099-SPN-E
Company F 9099-SPN-F
Company G 9099-SPN-G
Company H 9099-SPN-H
 The Concept of Strategy

OUTLINE

The role of strategy in success

A framework for strategy analysis
The evolution of strategic management
Corporate strategy and business strategy
Strategy making: Design or process?
The role of strategy
 Components of Success
MADONNA
GOALS Single-minded quest for
stardom.
UNDER- Identified emerging trends
STANDING THE in popular culture.
ENVIRONMENT Understood key success
factors in showbiz
RESOURCE Recognized limited raw
APPRAISAL talent. Exploited strengths
in self-promotion, product
development & relationship
management
IMPLEMENT- Commitment and discipline.
ATION Charismatic leadership.
Team building. Attention to
detail.
GIAP & NORTH LANCE ARMSTRONG
VIETNAMESE
Reunification of Winning the Tour de
Vietnam under France
Communist rule.
Intimate knowledge of Diagnosis of the physical,
terrain psychological and
Understanding of U.S. strategic determinants of
political system. individual and team
performance
Recognized economic Systematic development
and military of individual stamina and
weaknesses and core team capabilities
political strengths
Tight control. Long-term Clear delineation of
commitment. Effective individual roles. Alignment
propaganda. of incentives with team
Inspirational leadership. goals. Nurturing esprit de
corp
 What Makes a Successful Strategy?

Successful
Strategy

EFFECTIVE IMPLEMENTATION

Long-term, Profound Objective

simple and understanding of appraisal of
agreed the competitive resources
objectives environment
 What is Strategy?

Distinguishing strategy from tactics:

Strategy is the overall plan for deploying
resources to establish a favorable position.
Tactic is a scheme for a specific maneuver.
(Plan versus strategy?)
Characteristics of strategic decisions:
Important.
Involve a significant commitment of resources.
Not easily reversible.
(Long term)
 The Evolution of Strategic Management

1950s 1960s-early 70s Mid-70s-mid-80s Late 80s 1990s 2000s

DOMINANT Budgetary Corporate Positioning Competitive Strategic

THEME planning & planning advantage innovation
control

MAIN Financial Planning Selecting Focusing on Reconciling

ISSUES control growth &- sectors/markets. sources of size with
diversification Positioning for competitive flexibility &
leadership advantage agility

KEY Capital Forecasting. Industry analysis Resources & Cooperative

CONCEPTS budgeting. Corporate Segmentation capabilities. strategy.
& Financial planning. Experience curve Shareholder Complexity.
TOOLS planning Synergy Portfolio analysis value. Owning
E-commerce. standards.
Knowledge Management

MANAGE-
Coordination Corporate Diversification. Restructuring. Alliances &
MENT & control by planning depts. Global strategies. Reengineering. networks
IMPLIC- Budgeting created. Rise of Matrix structures Refocusing. Self -organiz
ATIONS systems corporate Outsourcing. ation & virtual
planning organization
The Smith Family Case
 The Basic Framework
Strategy: the Link between the Firm
and its Environment

THE FIRM THE

Goals &
INDUSTRY
Values ENVIRONMENT
STRATEGY
STRATEGY
Resources & Competitors
Capabilities Customers
Structure & Suppliers
Systems
SWOT or WOTS-Up
Analysis
 Sources of Superior Profitability

INDUSTRY
ATTRACTIVENESS

Which CORPORATE
RATE OF PROFIT businesses STRATEGY
ABOVE THE should we be
COMPETITIVE in?
LEVEL

How do we
make
money? COMPETITIVE
ADVANTAGE

How should BUSINESS

we compete? STRATEGY
 Strategy Making : Design or Process?

Strategy as Design Strategy as Process

Planning and Many decision makers

rational choice responding to multitude of
external and internal forces

INTENDED EMERGENT
STRATEGY STRATEGY

REALIZED STRATEGY

Mintzbergs Critique of Formal Strategic Planning:

The fallacy of prediction the future is unknown
The fallacy of detachment -- impossible to divorce formulation from
implementation
The fallacy of formalization --inhibits flexibility, spontaneity,
intuition and learning.
Strategy Making Processes within the
Company: Multiple Roles of Strategy

Strategy as Decision Improves the quality

Support of decision making

(Real-Time Strategic Thinking rather than Strategic Planning)

Strategy as Coordination Creates consistency
and Communication and unity

(Focuses Resource Allocation and Rationale)

Improves perform-
Strategy as Target ance by setting
high aspirations
 The Role of Analysis

Strategy analysis improves decision processes,

but doesnt give answers.

Strategy analysis assists us to identify and

understand the main issues.

Strategy analysis helps us to manage complexity

(tells us what to focus on).

Strategy analysis can enhance flexibility and

innovation by supporting learning.
Goals, Values and Performance

OUTLINE

Strategy as a quest for value

What is profit?
The shareholder value approach
The shareholder value and strategy formulation
Mission and values
 Strategy as a Quest for Profit
The stakeholder approach : The firm is a coalition of interest groupsit
seeks to balance their different objectives
INDUCEMENT v. CONTRIBUTION

The shareholder approach : The firm exists to maximize the wealth of

its owners (= max. present value of profits over the life of the firm)

For the purposes of strategy analysis we assume that the primary goal
of the firm is profit maximization.
Rationale:
1) Boards of directors legally obliged to pursue shareholder interest
2) To replace assets firm must earn return on capital > cost of capital
(difficult when competition strong).
3) Firms that do not max. stock-market value will be acquired

Hence: Strategy analysis is concerned with identifying and accessing

the sources of profit available to the firm
From Profit Maximization to Value Maximization

Profit maximization is an ambiguous goal

Total profit vs. Rate of profit
Over what time period?
What measure of profit?
Accounting profit versus economic profit (e.g. Economic Value
Added: Post-tax operating profit less cost of capital)

Maximizing the value of the firm:

Max. net present value of free cash flows: max. V = St Ct
(1 + r)t
Where: V market value of the firm.
Ct free cash flow in time t
r weighted average cost of capital
 The Worlds Most Valuable Companies:
Performance Under Different Profitability Measures

COMPANY MARKET NET RETURN RETURN RETURN RETURN

CAP. INCOME ON ON ON TO
($BN.) ($BN) SALES EQUITY ASSETS SHARE-
(%) (%) (%) HOLDERS
(%)
Exxon Mobil 372 36.1 19.9 34.9 17.8 11.7
General Electric 363 16.4 10.7 22.2 14.7 (1.5)
Microsoft 281 12.3 40.3 30.0 18.8 (0.9)
Citigroup 239 24.6 22.0 21.9 1.5 4.6
BP 233 22.3 9.9 27.9 10.7 10.2
Bank of America 212 16.5 27.0 14.1 1.2 2.4
Royal Dutch Shell 211 25.3 14.7 26.7 11.6 11.8
Wal-Mart 197 11.2 5.5 21.4 8.1 (10.3)
Toyota Motor 197 12.1 10.7 13.0 4.8 (22.1)
Gazprom 196 7.3 28.1 9.8 7.1 n.a.
HSBC 190 15.9 23.0 16.3 1.0 (11.8)
Procter & Gamble 190 8.7 17.3 13.7 6.4 7.2
Shareholder Value Maximization and Strategy Choice

The Value Maximizing Approach to Strategy Formulation:

Identify strategy alternatives
Estimate cash flows associated with each strategy
Estimate cost of capital for each strategy
Select the strategy which generates the highest NPV

Problems:
Estimating cash flows beyond 2-3 years is difficult
Value of firm depends on option value as well as DCF value

Implications for strategy analysis:

Some simple financial guidelines for value maximization
a) On existing assetsmaximize after-tax rate of return
b) On new investmentseek rate of return > cost of capital
Utilize qualitative strategy analysis to evaluate future profit
potential
Valuing Companies and Business Units

If net cash flow growing at constant rate (g)

V = C1
(r-g)

With varying cash flows which can be forecasted

for 4 years:

V = C0 + C1 + C2 + C3 + VH
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )3

where: VH is the horizon value of the firm after 4 years

Real Options
The right but not the obligation to buy an asset
Black Scholes Formula used to value financial options
There is hidden value in real (or strategic) options
Flexibility to speed up or slow down projects
Flexibility to abandon a project
Flexibility to shutdown a project
Flexibility to extend a project into new products or markets
Flexibility to switch designs or plants
In general, more uncertainty and more time before
committing to a decision increases the value of an option
Hence, strategists should seek explore options given time
and uncertainty
 Performance Diagnosis: Disaggregating
Return on Capital Employed

Past performance analysis

(see Ford v. Toyota) COGS/Sales

Margin Depreciation/Sales
(Return on
Sales)
SGA expense/Sales

ROCE Fixed asset turnover

(Sales/PPE)

Inventory Turnover
Asset (Sales/Inventories)
productivity
Creditor Turnover
(Sales/Capital
(Sales/Receivables)
Employed)
Turnover of other items
of working capital
 Linking Value Drivers to Performance Targets
Order Size
Customer Mix
Sales
Sales/Account
Targets
Customer Churn
Rate
cogs/
Margin Deficit Rates
sales
Cost per Delivery
Development Maintenance cost
Shareholder New product
Cost/Sales
value ROCE development time
creation Indirect/Direct
Labor
Inventory Customer
Economic Turnover Complaints
Profit Downtime
Capital Capacity
Turnover Utilization Accounts Payable
Time
Cash Accounts
Turnover Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

Balanced Scorecard
An attempt to link long-term (intangible) value drivers
to financial measures
An attempt to combat a tendency to short-termism by
CEOs
Four areas:
Financial
Customer
Internal
Learning & growth
 Balanced Scorecard for Mobil N. American Marketing & Refining
Strategic Objectives Strategic Measures
F
I
Financially N
F1 Return on Capital Employed * ROCE
F2 Cash Flow * Cash Flow
A
Strong F3 Profitability * Net Margin
N
F4 Lowest Cost * Full cost per gallon delivered to customer
C
F5 Profitable Growth * Volume growth rate Vs. industry
I
F6 Manage risk * Risk index
A
L

CO * Share of segment in key markets

Delight the UM C1 Continually delight the targeted consumer
* Mystery shopper rating
Consumer SE
TR * Dealer/distributor margin on gasoline
Win-Win C2 Improve dealer/distributor profitability
* Dealer/distributor survey
Relationship -

* Non-gasoline revenue and margin per square foot

I1 Marketing
* Dealer/distributor acceptance rate of new programs
1. Innovative products and services
Safe and * Dealer/distributor quality ratings
2. Dealer/distributor quality
Reliable I * ROCE on refinery
I2 Manufacturing
N * Total expenses (per gallon) Vs. competition
1. Lower manufacturing costs
T * Profitability index
Competitive 2. Improve hardware and performance
* Yield index
Supplier E
R I3 Supply, Trading, Logistics
Delivered cost per gallon .Vs. competitors
1. Reducing delivered cost
Good N * Trading margin
2. Trading organization
A * Inventory level compared to plan & to output rate
Neighbor 3. Inventory management
L
* Number of incidents
I4 Improve health, safety, and environmental performance
On Spec * Days away from work
On time I5 Quality
* Quality index

L
E &
Motivated L1 Organization Involvement * Employee survey
A G
and
R R
Prepared L2 Core competencies and skills * Strategic competing (?) availability
N O
I W L3 Access to strategic information * Strategic information availability
N T
G H
 A Comprehensive Value Metrics Framework

Shareholder Intrinsic Financial Value

Value Value Indicators Drivers
Measures: Sources:
Measures: Measures:
Market value of the Market share
Discounted cash Return on Capital
firm Scale economies
flows Growth (of
Market value added Innovation
Real option values revenues & operating
(MVA) Brands
profits)
Return to
Economic profit (EVA)
shareholders
 The Paradox of Value

The companies that are most successful in creating

long term shareholder value are typically those that:
a) Have a missionThey give precedence to goals
other than profitability and shareholder return;
b) Have strong, consistent, ethical values.

Examples:
a) Visionary companies studied by Collins & Porras,
e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP
b) Boeing Focus pre-1996: to build great planes, weak
financial controlsyet high profitability
Focus 1997-2003 : creating shareholder
valueOutcome: loss of market leadership,
declining profitability
(Issue of Corporate Social Responsibility)