STRATEGIC MANAGEMENT

PART 1

Contents:
• Understanding strategy
• Purpose of strategic management
• Distinguishing strategic problem from tactical problem
• Formulation of a strategic plan

A) Understanding strategy:

In understanding strategy two broad views are used, viz., strategic fit concept and strategic
stretch concept. Both are discussed in the following paragraphs. But before discussing those two concepts,
we need to discuss two factors on which these two concepts lean heavily i.e concept of external and internal
environment.

External environment lets one know the industry in which the firm is operating. It takes into
account the product and factor markets. Profitability of the firm essentially depends on these two markets.
Equilibrium conditions in these two markets determines the profitability. Strategic management monitors the
factors which influence the equilibrium.

Internal environment deals with the status of the resource base of the firm on the basis of
which the firm competes in the market. This concept is encapsulated in the concept of SWOT analysis. SW-
refers to internal environment whereas OT-Refers to the external environment. The essence is that strength
and weaknesses is matched with opportunities and threat to develop strategy. Now which environment is
more important? It is in this regard that the two broad views or schools of thought differ. Strategic fit
concepts or the classical school lays the importance on the external environment whereas the strategic
stretch concept emphasizes on the internal environment of the firm. Let’s discuss both of them one by one---

1. Strategic Fit concept:

Michael Porter and other eminent classical strategy Gurus have the dominant figure in
shaping this framework of business strategy. According to them, the central thrust of the strategy is to gain a
sustainable competitive advantage over the competitors which results in the superior profitability of the firm.
In their opinion, the difference in profitability among the firms operating in the industry can be attributed to
the external environment and not to the internal resource base. This happens due to mobility of factors which
wipes out the heterogeneity of the resource base in the long run. Then the higher profitability is attributed to
the higher adaptive capacity of the firm in adapting to changing external environment. So monitor the
environment, find opportunities and modify the resource base. So according to this view, strategy is a set of
action plans which is used to monitor the external environment of the firm in order to adapt the firm
according to the changes of the environment aiming at gaining a sustainable competitive advantage.

2. Strategic Stretch concept:

This concept evolved out of the quest for success of Japanese firm in 1970s when they
entered the U.S market. It was attributed to the factor that not the adaptive capacity but to the quality of the
resource base that makes the difference in commercial success. So, the purpose of strategic management is
to improve the quality of the resource base. The notion of core competencies is closely related to the so-
called resource based view of the firm., which is most recent model to understand the mechanism for
achieving competitive advantage. It represents a major departure from a strategic approach based on market
driven considerations. But how the firm decides which resource base to use to gain positive economic
profit? The criteria are as follows---
 i) Is it easily available?

It means that the resources are traded in the market or not. For example, the raw
material or resources should not be easily available to the competitors.

ii) Inimitability:

The resource should be such that it cannot be easily copied by the competitors and
hard to copy. There are certain features of resources which makes it hard to copy:

• Physical uniqueness:

It refers to acquiring assets which are not available to any other competitor.
For example: Service centres of Maruti.

• Path Dependency:

A resource base is developed expending lot over a long period of time, which
if the competitor wants to copy or develop has to spend the same time and
amount i.e will have to follow the same path. This is called path dependency.
For example: Corporate image, Goodwill etc.

• Causal ambiguity:

It means developing excellence in multi areas of which few can be copied but not
the all. It isdeveloping the sum total attribute of characteristics which are unique.

• Scale deterrence:

It means coming out with a mammoth size plant then taking down the cost
which cannot be copied by the competitors.

iii) Durability:

Every asset depreciates with use. But to gain sustainable competitive advantage, firm
need to have assets which don’t depreciate with use such as non-physical asset. For
example: Brand name of TATA.

iv) Appropriability:

Resources create value. Receiver of the values varies. As a manager, it is the duty to
take care that the value created by firm remains within the firm. A strategy that is both
unique and sustainable generates a significant economic value. The issue of
appropriability addresses the question of who will capture the resulting economic rent.
Sometimes, the owners of the business unit do not appropriate the totality of the value
created because of the gap that might exist between ownership and control. Non
owners might control complementary and specialized factors that might divert the
cash proceeds away from the business. This type of dissipation of value is called
holdup. A notorious example of holdup in recent business history has taken place in
the personal computer industry, where Microsoft and Intel have captured
manufacturing firms the meager 20 percent remaining.
 The second threat for the appropriability of the economic value is referred to as slack.
It measures the extent to which the economic value realized by the business unit is
significantly lower than what potentially could have been created. Slack is often the
result of the inefficiencies or unwarranted benefits that prevent the accumulation of
economic results in the business. While holdup produces a different distribution of the
total wealth created, slack reduces the size of this wealth.

v) Substitutability:

If it can be substituted by anything else, then it can’t be the source of competitive

advantage.

vi) Superiority:

Whether it is of superior value than the competiting firm or not.

vii) Opportunism and timing:

One other condition that is necessary to obtain competitive advantage occurs prior to
establishing superior resource position. It is necessary that the cost incurred in
acquiring the resources are lower than the value created by them. In other words, the
cost implicit in implementing the strategy of business unit should not offset the value
generated by it. This condition is what we aspire to capture under this requirement of
opportunism and timing in order to secure competitive advantage.

B) Purpose of strategic management:

The primary concern of strategic management is to help the firm gain a sustainable
competitive advantage in the market place. Competitive advantage is a competitive
superiority in attracting customers. It helps the firm to gain a continuous positive economic
profit. Now economic profit is defined as ---

Economic profit= Profit after tax (PAT) --- Cost of equity capital

It is considered as a measure of competitive advantage because it considers the productivity

of all the factor. On economic profit there is no claimant. Thus it is called free cash which can
be invested in future to meet company’s non-financial goal. The cost of equity capital is
calculated using the capital asset pricing model developed by William Sharpe.

Knowledge of strategic management helps a manager in the following ways—

i) Defining the boundary of the firm:

The boundary of the firm has three aspects--- corporate, horizontal and vertical
boundary.

• Corporate boundary:

It is not possible for a single firm to rule over the market. Thus instead of
looking at all areas , the firm must decide what are the business areas it wants
to look for and compete. This defines the corporate boundary of the firm.
 • Horizontal boundary:

As a manager, a person divides the business of the firm into different product
markets. Now based on resources the firm decides on which segments it wants
to compete. This is called the horizontal boundary of the firm.

• Vertical boundary:

Vertical boundary means whether the firm only produces the finished product,
or produces both the raw material, end products and distributes its end product
also.

These all determines the market place the firm is going to compete.

ii) Industry analysis:

Knowledge of strategic management helps the manager in analyzing the industry the
firm is operating in. It has been found empirically that the kind of industry the firm
operates in, determines its profitability, at least to the extent of 20-30%. So at every
point of time, the manager has to think that whether the firm should enter the industry
in particular or exit.

iii) Positioning in the market place:

Positioning means how the firm wants to present itself in the market. There are three
ways to it---

• Cost leadership strategy—It means that the firm endeavors to keep the cost of
production and distribution less than any other firm in the industry.
• Product differentiation—It means that the firm differentiates its product by features
as per the customer requirements.
• Focus strategy—It postulates to concentrate at the niche market instead of looking at
all the market.

iv) Internal organization of the firm:

It means the administrative system which the firm can use to narrow down the goal
incongruence between the goal of the firm and goal of individuals. These are—

• Management control system (MCS)

• Management communication and information system(MCIS)
• Organisational structure (OS)
• Executive compensation system(ECS)

C) Distinguishing strategic problem from tactical problem:

All organizational problem can be categorized as—strategic problem and tactical problem.
There are three characteristics based on which we can distinguish these two problems--- Range, Scope and
End orientation. Let’s discuss each one of them one by one—
 a) Range:
When an organizational problem is solved it creates effects across the organization.
The duration of the effect is called range. The longer the range, more difficult to
reverse it. Strategic problem has a longer effect thus a longer range and tactical
problem has a shorter range.

b) Scope:
Scope of a problem denotes the area of an organization it encompasses and feels the
effect of the problem. Strategic problem has a larger scope than a tactical problem.

c) End orientation:

In order to solve some problem, the end which is going to be achieved through
solving the problem is given and in some cases has to be identified while solving the
problem.

In strategic problem, the end result is not given, rather has ti be identified before
embarking on the problem. In case of tactical problem, the end result is given, e.g.
minimize the total transportations cost.

D) Formulation of a strategic plan:

The steps involved in developing a strategic plan can be plotted as follows:

Developing mission statement  Analysis of internal environment  Analysis of external environment 

Developing broad strategies  Developing long term program  Developing short term program 
Implementation.
 A strategy project may be conducted in five phase s

Phase I Phase II Phase III Phase IV Phase V

Situational Dev elopment Implemen-

Project Context of and assess- Specif ication tation
Initialization Strategy ment of stra- of chosen plan
Design tegic options strategy

• Infor mati on • Market segmentation • Definition of strategic • Description of chosen • Design of

collection and • Market attracti veness goals options in detail and implementati on plan
issue anal ysis • Differenziati on definition of related • Timeframe and
• Competition anal ysis
• Selection of team • Organizational, HR strategic goals milestones
• Synergy potential
members related and fi nanci al • Business plan • Priorities
• Market position
• Wor k pl an consequences • Detailed outline of • Responsi bilities
• Cost- and revenue consequences for
• Time pl anni ng • Development of • Resources
position organization and
strategic options • Project c ontrolling
• Corporate strategy / HRM
• Risk / attractiveness
business portfolio assessment of the
• Strength and weak-
options
nesses / cor e
competences • Choosing of options

TOO
L- B
OX

MA BE S trategy Consulting January 2007 ©Prof. Friedrich Bock

page 22

Strategic issues at different level:

Corporate strategy deals with

basic values and overall vision
portfolio of activities (Strategic Business Units - SBU’s)
mission of each strategic business unit
overall allocation of resources
Business strategy deals with
competitive positioning of the business unit
choice of segments
trade-offs, specific strengths
action towards customers

Functional strategy deals with

development of functional strengths and resources
as required by businesses and the corporation
PART B

DEFINING THE BOUNDARY OF THE FIRM

Contents:
• Vision of a firm
• Developing the mission statement---- Process and contents

A) Vision of a firm:
A vision gives direction for the desired future scope and position of a company:
■It deals with the future.
■It is ambitious.
■It is expressed in simple terms - understandable at all levels of the company.
■It does not deal with details, but is concrete.
■It does not deal with solutions.
■It opens space for creative forward thinking, based on an (emotionally appealing) “picture”
■It is not a secret plan but an open declaration.
■A vision serves to create a common mind set throughout the organization.
■It helps to mobilize people.
■It creates momentum and initiative: “Am I doing enough to increase the fit of my business with the
corporate vision?”

B) Mission of a firm:

Mission of a firm is the expression of its strategic intent. Strategic intent is the fundamental
ends a firm wants to pursue. Mission statement also reveals the self-concept of the firm. Thus, the mission of
the business is a qualitative statement of overall business position that summarizes the key points with
regard to products, markets, geographic locations and unique competencies. A mission statement abstracts
the important points to guide the development of business. Besides others there are two pieces of
information that must be contained in the mission statement---Clear definition of current and future business
scope and second the unique competencies that distinguish the firm from others in the same industry.
Following is the detailed description of the contents of the mission statement---

i) Core values:
It is the beliefs which guide the behaviour of the firm. This is to be encoded in the
mission statement so that the employees understand that it has to be followed at any cost.

ii) Core purpose:

It is the fundamental end for which an organization exists. It is the very reason of the
existence of the firm in the market.

iii) BHAG—It represents Big Hairy Audacious Goal. This implies, that the mission statement
should be organized in such a manner that it fires up the competitive zeal of the employees. In their
celebrated article, Garry Hamel and C.K.Pralhad state that rather than trimming ambitions to match
available resources, managers should instead leverage resources to reach seemingly unattainable goals. This
challenge is at the heart of a proper mission statement.

iv) Vivid description of future:

A mission statement is grossly incomplete without the clear definition of the
expected future business scope. This has got two dimensions---business and ethical. Business dimensions
includes-------
 • Scope of the firm: the description of current and future market scope, product scope, geographical
reach scope and customer scope.
• Positioning strategy: This explains on what basis the firm wants to compete and how the firm wants
itself to be known in the market. There are two ways to create value for money for shareholders—
cost leadership strategy and product differentiation strategy.

The image of the firm will depend on this positioning strategy.

• Responsibilities to the stakeholders: Here the firm has to spell out how it wants to treat its different
stakeholders.

Factors influencing the development of mission statement:

Following factors play a crucial role in developing and shaping the mission statement
are as follows:

• Organisational power structure

• Corporate culture
• Personal values of CEO
• Societal value

i) Organisational power structure:

In every organization there are two groups of people viz. Internal stakeholders and External
stakeholders which competes with each other. An organization is a dynamic powerstructure.
The group which wins decides the shape of the mission statement. One author has found out
several power structure which works toward the development of the mission statement----

a) Continuous Chain or Simple mass output system: Here external stakeholders are
the people who decides the mission statement. For example: Stock exchange and Post
office.

b) Closed system: Here the external stakeholders are fragmented and internal
stakeholders are more powerful and there is no clear goal of the firm to follow.

c) Command type system: This is the typical power structure in an organization set up
by an entrepreneur or organization passing through severe crisis. Here the
entrepreneur decides the mission statement. No value system is adhered to.

d) Missionary power configuration: This is the type of organization which works for a
voluntary cause. Here the mission statement is driven by ideology.

e) Professional power configuration: This is the organizational power structure

typically found out in consulting firms like TCS, IBM, Mckinsey etc where some
outstanding professional determine the mission statement.

f) Conflictive power configuration: Here the entire organization is divided into power
groups which fight with each other and the group that wins determines the mission
statement.

ii) Corporate culture:

 Corporate culture is the sum total of beliefs, values, norms, which regulate the behaviour of
an employee in the organization. Since mission gets implemented by the employees, it’s very
much imperative that the organizational culture is taken into account with due importance
while framing the mission statement.

iii) Personal Values of CEO:

Personal values of CEO, who is ultimately held responsible for the company’s growth,
determines the mission statement and also his risk taking ability influences the mission
statement.

iv) Societal values:

Any firm is a social entity. Societal values is the timeless principle which has evolved in
society over very long period of time and the firm must obey it and comply with it.

Advantages of Mission statement:

Developing an mission statement serves several important purpose, such as…….

a) It gives the guidelines as to how to treat different stakeholders: It is embedded in the

mission statement, and of course in its development, which stakeholder is more important and
how to satisfy them. So, in other words, mission statement sets a priority amongst the
stakeholder, to be served by the organization. It also determines the right of every stakeholder
on the economic value created by the stakeholders.

b) Mission statement helps to avoid strategic opportunism:

c) Mission statement is a tool for communication. It conveys the expectations of the firm
from its employees.
PART C

ANALYSIS OF INTERNAL RESOURCE BASE AND ENVIRONMENT

Contents:

• Value chain analysis

• Strategic group concept
• Benchmarking

A) Value chain analysis:

(Describe the value chain of a firm and its significance in strategic planning—2005,[4])

This very concept was propagated by Michael Porter as a tool of analyzing the firm’s internal
environment and resource base. It is an analytical tool that describes all activities that make
up the economic performance and capabilities of the firm, used to analyze and examine
activities that create value for a given firm. A firm can be conceived of an aggregation of
discrete activities and the competitive edge arises based on how a firm performs these
activities better than its competitors. The cluster of these activities is called the value chain.

The value chain classifies each firm’s activities into two broad categories: Primary activities
and Secondary activities or support activities. The following figure represents the value chain
of a firm:

S
u MARGIN
FIRM INFRASTRUCTURE
p
p
o HUMAN RESOURCE MANAGEMENT
r
t
a
c TECHNOLOGY DEVELOPMENT
t
i
v PROCUREMENT
i
.

Marketing
Inbound Outbound and
Operations Service
Logistics logistics sales MARGIN

<-----------------PRIMARY ACTIVITIES---------------------->

Primary activities: The sequence of activities through which raw materials are transformed
into benefits enjoyed by the customer is called primary activities.These activities relate
directly to the actual creation, development, manufacture, distribution, sales and servicing of
 the product or the service to a customer. Five major activities are involved in this sequence:
inbound logistics, operations, outbound logistics, marketing and sales and service. Working
together, these activities determine the key operational tasks surrounding the product or
services.

• Inbound logistics: As the word implies, inbound logistics deal with the handling of
raw materials and inventory received from the firm’s suppliers. Detail activities
include Receiving, storing, materials handling, warehousing, inventory control,
vehicles scheduling and returns to suppliers.
• Operations: Operations are the activities and procedures that transform raw materials,
components and other inputs into finished end products. Detail activities include
machining, packaging, assembly, equipment maintenance, testing, printing, facility
operations.
• Outbound logistics: Outbound logistics refers to the transfer of finished product to the
distribution channel members. The focus of outbound logistics is on managing the
flow and distribution of products to the firm’s immediate customers such as
wholesalers and retailers. Activities and procedures associated with outbound logistics
include inventory control, warehousing, order processing, delivery schedule
maintenance etc.
• Marketing and sales: Marketing and sales include advertising, promotion, product mix
pricing, specifying distribution channel members, maintaining channel relations etc in
order to induce and facilitate buyers to purchase the product.
• Service: Customer service is a central value adding activity that a firm can seek to
improve over time. It includes installation, repair, training, parts supply and product
adjustment in order to maintain or enhance the value of the product after sales.

Secondary or support activities:

The remaining activities of the value chain are undertaken to support primary
activities. They are therefore referred to as the secondary or support activities.
Support activities help the firm improve co-ordinations across and achieve efficiency
within the firm’s primary value adding activities. Support activities are located across
the first four rows of the diagram. This includes, procurement, technology
development, human resource management and firm level infrastructure.

• Procurement: Securing inputs (such as raw materials, supplies, and other consumable
items and assets) for primary activities.
• Technology development: Methods of performing primary activities are improved
(Such as know-how, procedures, technological inputs needed)
• Human resource management: Employees who will carry out the primary activities
are recruited, trained, motivated and supervised.
• Firm infrastructure: Activities such as accounting, finance, legal affairs, and
regulatory compliance are carried out to provide ancillary support for primary
activities.

How value chain analysis matters in strategic planning:

As already stated, the competitive edge arises based on how better the firm performs
the activities involved in the value chain compared to its competitor. For this purpose,
each activity is broken up in sun activities for comparison with the competitors, and
three basic questions are tried to be answered?
 i) How can the firm keep the benefits provided to the customers intact keeping the cost
constant?
ii) How can the firm increase the benefits provided to the customers keeping the cost
constant?
iii) How can the firm increase the benefits provided to the customer while lowering the cost?

For creating competitive advantage through the value chain analysis while answering these
questions, Porter has suggested the following measures----

• Reconfigure the value chain differently from those of the competitors.

• Perform the activities more efficiently than the competitors.
• Outsource the non-core activities:
While outsourcing the following points are needed to be judged
judiciously---
i) There might be a risk of non-performance by the supplier, To avoid this,
ways of keeping alternative suppliers, Tapered integration and part
outsourcing can be adopted.
ii) There might be a risk of disproportionate value appropriation
iii) There can be a high risk of elimination by suppliers.

• Internal integration of value chain activities:

Internal integration of value chain activity gives the following benefits…
i) Improvement of quality
ii) Shorten new product development cycle.
iii) By integrating the firm with its external suppliers and buyers it can
reduce inventory holding costs, enhance the ability to customize the product
and become more responsive to customers’ demand.

The point to be noted that throughout the whole analysis every measures are to be taken on the basis
of comparison with suppliers.

B) Strategic group concept:

Strategic group is a group of firms within an industry which face the same environmental forces,
have same resources and follow similar strategy in response to the environmental forces. To carry on
the value chain analysis it is very important that the firm identifies the strategic group to which it
belongs. Porter suggests the following dimensions to identify differences in firm strategies within an
industry: i)specialization, ii) brand identification, iii) a push versus pull marketing strategy, iv)
vertical integration, v)channel selection, vi) product quality, vii) technological leadership, viii) cost
position, ix)service, x) price policy, xi) financial and operating leverage, xii) relationship with parent
company, xiii) relationships with home and host government. We should try to locate in the same
group all firms with comparable characteristics and following a similar competitive strategy.

Essentially the concept of strategic grouping is a very pragmatic approach aimed at cataloguing firms
within an industry in accordance with the way they have chosen to seek competitive advantage. This
segmentation is useful when one faces a high diversity of competitive positions in a fairly complex
and heterogeneous industry. Typical examples of this situation are global industries with a wide
variety of players, some being totally international and some purely local.

A useful tool that can guide the separation of strategic group in an industry is the so called strategic
mapping. This is a two dimensional display that helps to explain the different strategies of the firm.
These two dimensions should not be interdependent because otherwise the map would show an
inherent correlation. Most important, managers must choose those dimensions that are most salient
and relevant to their own particular industry.
 Though according to Porter, move from one strategic group to another is very difficult, because
every strategic group creates its own image in the market place, the following points should be kept
in mind:

• Strategic groups can shift over time as the needs of the customers or different
technologies evolve in the marketplace. Therefore managers should not assume that
membership in a particular strategic group permanently locks the firm into a fixed
strategy. With sufficient resources and focus, firms can enter or exit strategic groups over
time.
• Entire strategic groups and the firms that compose them can emerge and disappear over
time. Thus as the environment changes, the competitive conditions that define a strategic
group may work against the entire collection of the firms, resulting in the groups long
term decline if competitive conditions intensify.
• In recent years one of the more enduring trends that have defined a growing number of
industries is the hastening pace of consolidation. Competitors are now seeking to buy or
merge with their rivals to limit the effects of fierce price wars that negatively impact
profitability. Thus consolidation within and among industries can also markedly redefine
the underlying stability and membership of strategic group.

C) Benchmarking:

It is the process of continuously measuring and comparing the business processes against
comparable process of the leading organization to obtain the information that will help the
organization to identify and implement improvement programs. The essence of
benchmarking is to contrast the firm’s performance against some challenging yardsticks. It is
a multistep process in which the firm doing the benchmarking seeks to learn and incorporate
process refinements, even if the model firm is different from its own. The steps in
benchmarking (compared to induatry) are as follows:

Step1: The firm identifies those processes within its own organization that need improvement or
attention,

Step 2: Managers try to locate other firms that are particularly distinctive or excellent in performing
or managing those processes.

Step 3: The benchmarking firm contacts the managers of the model firm to learn from their
experiences, problems and solutions.

Step 4: The bench marking firm tries to duplicate the successful practices or processes that seem to
performance and better quality.

Benefits of Benchmarking:

The benefits of benchmarking are as follows:

• It sparks the creativity of internal people.

• The firm can be the frontrunner of implementing practices which was never conceived
of in the industry. For example: The “BARCODE” invented by the American
agricultural food products association.
• Targeting the best, so the firm keeps itself ahead of the other competitors.
Types of Bench marking:

There are four types of benchmarking:

1. Historical benchmarking: It refers to evaluating the firm’s current performance with the
firm’s past performance. The problem here is that the past performance may not be
impressive. Secondly, There can be an illusion of big performance. Thirdly, It may encourage
more of a bad thing. For example, if rejection rate is high, SQC is put in place and as a result
rejection goes down, But this is not a progress. The question is why should rejection happen
at all? Fourthly, Competitor performance is not considered in this way.

2. Industry Bench marking: It refers to evaluating one own performance with industry data.
The major problem here is—getting stuck in the middle. Second, unequal bases of
comparison, like comparing apple with orange.

3. Functional benchmarking: It refers to finding one activity and finding out the best practice
in that in any strategic group or in any industry and upgrade the process to that.
PART C

ANALYSIS OF EXTERNAL ENVIRONMENT

Analysis of external environment of a firm is necessary while formulating strategy because-----

i) It affects the business potential of the firm and therefore its profitability.
ii) It influences resource allocation among businesses in a multibusiness firm.

When we consider the external environment of the firm, we get two layers:

i) Operating environment.
ii) Remote environment or macro environment.

We will discuss the model used to analyze those environment one by one:

i) Macro environment:

Macro environment includes all those environmental forces and conditions that have an
impact on every firm and organization within the economy. The main differences between
operating environment and remote environment are -----

a) Forces consisting of macro environment affects all the firm directly or indirectly
across the industry.
b) The environmental forces comprising the external macro environment are given A
firm cannot do anything or do very little to influence it.

For analyzing the macro environment we use two models, PEST (Political, Economic, Social,
Technological) and STEEP (Social, Technological, Economic, Ecological, Political)

However without adhering to any particular model, we will describe the general
environments included in macro environment and their effect on strategy decisions.

• Economic environment:

The variables included in this environment are GNP,GDP, Distribution of GDP and
GNP, Inflation, Balance of payments(BOP), Size of external debt. Let’s discuss them
one by one..

i) GDP and GNP:

GDP includes the market value of the goods and services produced within the
country by domestic and foreign factors of production whereas GNP includes
the value of goods and services newly produced by domestic factors of
production at home and abroad. When a firm is multinational, GDP and GNP
gives the level of wealth in aparticular country and thus the economic vigour
of the country.

ii) Distribution of GDP and GNP:

How GDP and GNP is distributed across various industry and area is also
important because it denotes which industry and which location are important.
 iii) Inflation:

Inflation also poses a big problem because it increases the price of factors of
production and thus to survive the firm has to change the price very often.
Inflation also affects the firm in the following way….

Inflation…> Rise in bank interest rate….> Rise in prime lending rate….>

Investment slows down for being costly…>Slow economic growth rate.

iv) Balance of payments:

BOP also influences the economic environment. Adverse BOP affects in the
following way….

Adverse BOP

Import restriction
Interest rate hike

Foreign companys can’t

Business loans get less
remit dividend in foreign
attractive
currency
Cost of foreign
raw material goes
up
Slow economic
growth

v) Size of external debt:

Size of external debt is also very crucial because this affects in the following
way……
High external debt…..>Import restriction…….>Foreign currency gets dearer.

• Social environment:
 Analyzing the social environment is also very important in formulating
appropriate competitive strategy. The main variables included in this
environment are as follows…..

i) Demographics:
Demographics is the statistical variables used to define a population. It
influences the firm by dominating the nature of demand, size of working
population etc.

ii) Social stratification:

Social stratification means how the society is divided in different castes,
tribes, starta etc. This is very important in case of market segmentation and
targeting and desigining the product offering according to that.

iii) Importance of work and result.

iv) Employment as a profession---How people view the work under someone.

v) Trust on people--- How much is the mutual trust among people.

vi) Individualism versus collectivism

vii) Consumer buying process—whether it is simple or complex.

viii) Educational level—If it high then tendency to white collar jobs increases.

Analyzing social environment is particularly essential because it helps to solve the following
problem…

1. Mobility of labour. 2. How much important is material reward. 3. How to meet the social
needs in the firm.

• Political and legal environment:

The variables included in this environment which influence the strategic

decision are---

i) Number of political parties and their ideologies.

ii) Form of legal system (Common law, civil law and theocratic law)
iii) Laws related to business issues. (Health and safety, employment practice,
environmental practice, laws related to export import, group treaties and international
business forums)

• Technological environment:

Status of fundamental research, development research and technology are the

main variables here. It is important to analyze because it depicts the scope of
innovation and infrastructural facilities that a firm can avail.

• Ecological environment:
 The main variable included here are the----

1. Status of natural wealth 2. Flora and fauna 3. Laws relating to utilization and
exploitation of ecological resources. This is very much important because it
determines to which extent and how a firm can use the natural environment of a
country to its own benefits.

ii) Analyzing the operating environment—Porter’s five forces model:

Operating environment of a firm refers to the industry to which a firm belongs.

According to Michael E. Porter an industry can be defined as “The group of firms
producing products that are close substitute to each other”. The intensity of
competition in an industry is neither a matter of coincidence or bad luck, rather
competition in an industry is rooted in its underlying economic structure and goes
well beyond the behaviour of the current competitors. According to Porter, the state of
competition in an industry depends on five basic competitive forces (which is
presented in the diagram below). It is imperative to analyze this forces in order to
formulate competitive strategy because the collective strength of those forces
determines the ultimate profit potential in the industry, where profit potential is
measured in terms of long run return on invested capital. Also knowledge of these
underlying sources of competitive pressure highlights the critical strengths and
weaknesses of the company, animates its positioning in its industry, clarifies the areas
where strategic changes may greatest payoffs and highlights the areas where industry
trends promise to hold the greatest significance as either opportunities or threats.
Following is a diagrammatic representations of the basic five forces underlying the
competitiveness of the industry:

POTENTIAL ENTRANTS

Threat of new entrants

INDUSTRY COMPETITORS

SUPPLIERS BUYERS

Bargaining power of Rivalry among existing firms Bargaining power of

suppliers buyers

Threat of substitute product or

services

SUBSTITUTES

Let’s now discuss each of these forces one by one------

1. THREAT OF NEW ENTRANTS:

New entrants to an industry bring new capacity, thy desire to gain market share and
often substantial resources. Prices can be bid down or incumbent’s costs inflated as a
result, reducing profitability. The threat of entry into an industry depends on A) the
barriers to entry that are present, coupled with B) reaction from existing competitors
that the entrant can expect. These are discussed below:

A. Barriers to entry:
There are major seven sources of barriers to entry which are as follows:

i) Economies of scale:
Economies of scale refer to declines in unit costs of a product (or operation or
function that goes into producing a product) as the absolute volume per period
increases. Economies of scale deter entry by forcing the entrant to come in at
large scale and risk strong reaction from existing firms or come in at a small
scale and accept a cost disadvantage, both undesirable options.

ii) Product differentiation:

Product differentiation means that established firms have identification and

customers loyalties, which stem from past advertising, customer service,
product differences, or simply being first in the industry. Differentiation
creates barrier to entry by forcing entrants to spend heavily to overcome
customer loyalties. This effort usually involves start up losses and often takes
an extended period of time. Such investments in building a brand name are
particularly risky since they have no salvage value if entry fails.

iii) Capital requirements:

The need to invest large financial resources in order to compete creates barrier
to entry, particularly if the capital is required for risky or unrecoverable up-
front advertising or research and development.

iv) Switching costs:

A barrier to entry is created by the presence of switching costs, that is, one
time costs facing the buyer who witches over from one supplier’s product to
another’s.

v) Access to distribution channel:

A barrier to entry can be created by the new entrants’ need to secure r its
product. To the extent that logical distribution channels for the product have
already been served by established firms, the new firm must persuade the
channels to accept its product through price breaks, cooperative advertising
allowances and the like, which reduce profits.

vi) Cost disadvantages independent of scale:

 Established firms may have cost advantages not replicable by potential
entrants no matter what their size and attained economies of scale. The most
critical advantages are the factors such as the following:

a) Proprietary product technology or patent

b) Favourable access to raw materials
c) Favourable locations.
d) Government subsidies
e) Learning or experience curve effect.

B) Expected retaliation ( Contrived deterrence)

The potential entrant’s expectations about the reaction of existing competitors also
influence the threat of entry. If existing competitors are expected to respond forcefully
to make the entrant’s stay in the industry an unpleasant one, then the entry may well
be deterred.

2. INTENSITY OF RIVALRY AMONG EXISTING COMPETITORS:

Rivalry occurs because one or more competitors either feels the pressure or
sees the opportunity to improve position. Intense rivalry is the result of a
number of interacting structural forces:

i) Numerous or equally balanced competitors:

When firms are numerous, the likelihood of mavericks is great and some firms
may habitually believe they can make moves without being noticed. Even
when there are relatively few firms, if they are relatively balanced in terms of
size and perceived resources, it creates instability because they may be prone
to fight each other and have the resources for sustained and vigorous
retaliation.

ii) Slow industry growth:

Slow industry growth turns competition into a market share game for firms
seeking expansion. Market share competition is a great deal more volatile than
is the situation in which rapid industry growth insures that firms can improve
results just by keeping up with the industry and where all their financial and
managerial resources may be consumed by expanding with the industry.

iii) High fixed or storage costs:

High fixed costs create strong pressures for all firms to fill capacity which
often lead to rapidly escalating price cutting when excess capacity is present.

iv) Lack of differentiation or switching costs:

Where the product or service is perceived as a commodity or near commodity,

price and service competition result.

v) Capacity augmented in large increments:

 Where economies of scale dictate that capacity must be added in large
increments, capacity additions can be chronically disruptive to the industry
supply/ demand balance particularly where there is a risk of bunching capacity
additions.

vi) Diverse competitors:

Competitors diverse in strategies, origins, personalities, and relationships to

their parent companies have differing goals and differing strategies for how to
compete and may continually run head on to each other in the process.

vii) High strategic stakes:

choice by the buyer is largely based on price and service, and pressure for
intenseRivalry in an industry becomes even more volatile if a number of firms
have high stakes in achieving success there.

viii) High exit barriers:

Exit barriers are economic, strategic and emotional factors that keep
companies competing in business even though they may be earning low or
even negative returns on investment. The major sources of exit barriers are
specialized assets, fixed cost of exit, strategic interrelationships, emotional
barriers and government and social reactions.

3. THREAT OF THE BUYERS:

Buyers compete with industry by forcing down the price, bargaining for higher
quality or more services and playing competitors against each other-all at the expense
of industry profitability. A buyer group is powerful if the following circumstances
hold true:

i) It is concentrated or purchases large volumes relative to seller sales:

If a large portion of sales is purchased by a given buyer this raises the importance of
the buyer’s business in results. Large volume buyers are particularly potent forces if
heavy fixed costs characterize the industry.

ii) The products it purchases from the industry represents a significant fraction of the
buyer’s cost or purchases:

Here buyers are prone to expend the resources necessary to shop for a favourable
price and purchases selectively. When the product sold by the industry in question is a
small fraction of buyer’s cost, buyers are usually much less price sensitive.

iii) The product it purchases from the industry are standard or undifferentiated:

Buyers, sure that they can always find alternative supplies, may play one company
against another.

iv) It faces few switching costs:

 Switching costs lock the buyer to particular sellers. Conversely the buyer’s power is
enhanced if the seller faces switching costs.

v) It earns low profits:

Low profits create great incentive to lower purchasing costs. Highly profitable buyers,
however, are generally less price sensitive and may take a long term view toward
preserving the health of their suppliers.

vi) Buyers pose a credible threat of backward integration:

If buyers either are partially integrated or pose a credible threat of backward

integration, they are in a position to demand bargaining concessions.

vii) The industry’s product is unimportant to the quality of the buyer’s product or services:

When the quality of the buyer’s product is very much affected by the industry’s
product, buyers are less price sensitive. For example: medical equipment.

viii) The buyer has full information:

Where the buyer has full information about demand, actual prices, and even supplier
costs, this usually yields the buyer greater bargaining leverage than when information
is poor.

4. THREAT OF THE SUPPLIERS: (Bargaining power of the suppliers)

Suppliers can exert bargaining power over participants in an industry by threatening

to raise prices or reduce the quality of purchased goods and services. Powerful
suppliers can thereby squeeze profitability out of an industry unable to recover cost
increases in its own prices. A supplier group is powerful if the following apply:

i) It is dominated by a few companies and is more concentrated than the industry it sells
to:

Suppliers selling to more fragmented buyers will usually be able to exert considerable
influence in prices, quality and terms.

ii) It is not obliged to contend with other substitute products for sale to the industry:

The power of even large, powerful suppliers can be checked if they compete with
substitutes.

iii) The industry is not an important customer of the supplier group:

When suppliers sell to a number of industries and a particular industry does not
represent a significant fractions of sales, suppliers are much more prone to exert
powers. If the industry is an important customer, suppliers fortunes will be tied up to
the industry and they will want to protect it through reasonable pricing and assistance
in activities like R&D and lobbying.

iv) The suppliers’ product is an important input to the buyer’s business:

 Such an input is important to the success of the buyer’s manufacturing process or
product quality. This raises the supplier power. This is particularly true when the input
is not storable, thus enabling the buyer to build up stocks of inventory.

v) The supplier group’s products are differentiated or it has built up switching costs:

Differentiation or switching costs facing the buyers cut off their options to play one
supplier against another. If the supplier faces the switching costs the effect is the
reverse.

vi) The supplier group poses a credible threat of forward integration:

This provides a check against the industry’s ability to improve the terms on which it
purchases.

5. THREAT OF SUBSTITUTES:

It becomes high when----

i) Existing products have a lower price performance ratio than the new product.

ii) Number of substitutes are very high

iii) Switching costs for the buyers are very low.

The point to be noted here, that here we have to take into account the indirect
substitutes such as product for product (Fax vs. E-mail), Substitution of needs,
Generic substitutes and doing away with the product itself (Tobacco).
 PART E

FORMULATING THE STRATEGIES AND POSITIONING THE FIRM IN THE MARKET

Contents:

A) Three generic strategies—Cost leadership, Differentiation, Focus.

Having analysed the operating environment through Porter’s five forces model, a
firm needs to decide on the strategies it will adopt. For deciding on the strategies a firm needs to consider
its goal. A firm’s goal is to gain competitive advantage which is measured by positive economic profit,
which is in turn measured by economic value. Now,

Economic value(EV)= B – C

Where, B= Perceived utility of a firm’s product. It is measured by the maximum willingness to pay.
This i.e. maximum willingness to pay is measured by auctioning the new product.

C= Opportunity cost of input resources that are used up to produce and distribute the
product.

Now to gain competitive advantage a firm must have……

(B-C) > (B` -- C`)

where B` and C` are same as B and C but for competitors. Now as the gap between (B-C) and (B`--C`)
increases, organization has more liberty. Now we can write,

B-C = (B-P)+(P-C)

(B-P) is the consumer surplus and (P-C) is the producers’ surplus. Given this the firm’s aim is to give
more to consumer at a lesser cost i.e to maximize the gap between (B-C).

Now having the aim as mentioned above, M.E.Porter suggests three generic strategies---

i) Product differentiation strategy.

ii) Cost leadership strategy.
iii) Focus strategy.

Porter’s proposition is to focus on either B or C., because the first two set of strategies are mutually
exclusive. Cost leadership strategy focuses on C and product differentiation strategy focuses on B.
Now we will discuss these three strategies one by one—

1. COST LEADERSHIP STRATEGY:

It aims at achieving lowest economic costs with benefits same as the competitors or bit less.
Result is (B-C) greater than equal to (B`-C`). Let’s discuss the sources of cost leadership---

A. Sources of cost leadership strategy:

The sources of cost leadership strategy are as follows:

 i) Economies of scale in production:
Economies of scale refer to declines in unit costs of a product (or operation or
function that goes into producing a product) as the absolute volume per period
increases. Now if we plot the U shaped average cost curve, we get to see---

AC

AC

Economies of scale Diseconomies of scale

MES Production

The volume of production at which average cost is minimum is called the “minimum
efficient scale”. The sources of economies of scale are as follows:

• Volume of production
• Specialized equipment.
• Employee specialization
• Cost of the plant (The rule states that if a plant increases by double in size, the cost
will increase by 2α where α = 0.66 to 0.80
• Lower fixed cost.
 ii) Learning curve effect:

Learning curve effect states that direct labour cost of production goes down by a
certain percentage each time accumulated volume of production gets doubled. For example: if it takes 10
hours to produce 1st unit and 9 hrs to produce second unit, so learning curve effect is 9/10X100=90%. So for
the fourth unit the time will be 9 X 0.9=8.1 hrs. But getting the time amount for the third unit is not possible
in this way. So it is expressed as mathematical relationship which is depicted by the following diagram---
[ The mathematical relationship is given by the equation y=ax-β where….
x= no of units produced
a= time taken to produce first unit
y= Average time to produce y unit
β= The coefficient related to learning curve.

Direct
labour
cost

y=ax-β

Production

Graphical representation of Learning curve effect

The implication is that the existing producer has the accumulated experience in production for which
the cost of production will be lower than a new entrant who does not have any experience.

Example: Following are the data given:

Time to produce first unit= 45 minutes

Time to produce second unit=27 minutes

Estimate the learning curve coefficients and average and total time to produce 6 units.
Solution: Here average time to produce two units (y)= (45+27)/2 minutes= 36 minutes

-β
So in the equation, y=ax , putting a=45, x=2, y=36, we get
-β
36=45 (2)
Solving we get, β = 0.3219
Now we want to find out the average and total time to produce 6 units, which are as follows:

Average time(y)= 45(6)-0.3219 minutes

Total time={45(6)-0.3219}X 6 minutes.

This learning curve effect was found first in aircraft manufacturing industry during world war II and
applicable in case of direct labour cost. Bruce Henderson, founder of Boston consulting group, this
effect is not only applicable to labour cost but also to all value added costs. Value added costs are
defined as the difference between the total cost of the product and cost of raw materials. He has
given a new name to it, called “Experience curve effect”.

iii) Access to low cost factors of production:

Achieving a low overall cost position often requires a high relative market share or other
advantages, such as favorable access to raw materials. High market share in turn allow
economies in purchasing which lower costs even further.

iv) Cost advantages independent of scale:

Established firms may have cost advantages not replicable by potential entrants no matter what
their size and attained economies of scale. The most critical advantages are the factors such as
the following:

a) Proprietary product technology or patent

b) Favourable access to raw materials
c) Favourable locations.
d) Government subsidies
e) Learning or experience curve effect.

B. Specific functional strategy under cost leadership generic strategy:

Following are the different strategies under cost leadership----

i) Economies of scale:

This implies producing larger volume in automated structure. This helps reducing the
costs thus contributing to the competitive advantage.

ii) Automate parts of manual process:

Automating different parts of a manual process helps reducing costs which helps
make process less expensive. This can also be done by employing high skilled
workers.

iii) Redefine product:

 This strategy tells to redefine the product in such a way that cost advantage is far
better than benefit disadvantage. For example: Indian postal service and DHL.

Other initiatives that are required to achieve the cost leadership strategy are---

• Construction of efficient scale activities.

• Vogorous pursuit of cost reductions from experience.
• Tight costs and overhead control.
• Avoidance of marginal customer accounts.
• Cost minimization in areas like R&D, service, sales force, advertising and so
on.

C. Commonly required skills and resources and common organisational structure to implement
cost leadership strategy:

i) Commonly required skills and Resources:

• Substantial capital investment and access to capital.

• Process engineering skills.
• Intense supervision of labour.
• Product designed for ease in manufacture.
• Low cost distribution system.

ii) Common organizational requirements:

• Tight cost control.

• Frequent, detailed control reports.
• Structured organization and responsibilities.
• Incentives based on meeting strict quantitative targets.

D. Risks of Cost leadership strategy:

Cost leadership imposes severe burdens on the firm to keep up its position, which means
reinvesting in modern equipment, ruthlessly scrapping obsolete assets, avoiding product line
proliferation and being alert for technological improvements. Cost declines with cumulative volume
are by no means automatic, nor is reaping all available economies of scale achievable without
significant attention.

Cost leadership is vulnerable to the same risks as on relying on scale or experience as entry
barriers. Some of the risks are----

• Technological change that nullifies past investment or learning.

• Low cost learning by industry newcomers or followers. Through imitation or through
their ability to invest in state of the art facilities.
• Inability to see required product or marketing change because of the attention placed
on cost.
 • Inflation in costs that narrow the firm’s ability to maintain enough of price differential
to offset competitors brand images or other approaches to differentiation.

The classic example of the risks of cost leadership is the Ford motor company of the 1920s. Ford had
achieved unchallenged cost leadership through limitation of models and varieties, aggressive
backward integration, highly automated facilities, and aggressive pursuit of lower costs through
learning. Learning was facilitated by the lack of model changes. Yet as incomes rose and many
buyers had already purchased a car and were considering their second, the market began to place
more of a premium on styling, model changes, comfort and closed rather than open cars. Customers
were willing to pay a price premium to get such features. General Motors stood ready to capitalized
on this development with a full line of models. Ford faced enormous costs of strategic readjustment
given the rigidity created by heavy investments in costs minimization of an obsolete model.

2. PRODUCT DIFFERENTIATION STRATEGY:

This generic strategy implies generating more perceived value of the product (B) than its
competitors at the same costs of the competitor or bit higher, such that (B-C) greater than
equal to (B`- C`). The essence of this strategy is creating something that is perceived industry
wide as being unique.

A. Approaches to differentiation:
A firm can differentiate along several dimensions such as---

• Design or brand image (Titan)

• Technology (Sony, Philips)
• Features (Nokia)
• Customer service (Maruti)
• Dealer network (Philips, Hero –Honda)

B. Specific strategies under product differentiation strategy:

The different specific strategies under product differentiation generic strategy are as
follows:

i) Product features:

Increase of product features implies increase of the perceived value of the

product (B) which in turn involves increase in costs which forces the price to
go up. But the firm has to ensure that increase in the perceived value of the
product is greater than the increase in the cost, thus creating a positive
economic value.

ii) Timing:

Timing of introduction of the new product is also very crucial to gain

competitive advantage. Because the first entrant always has an advantage of
locking in the customers and creating switching costs.
 iii) Location:

Competitive advantage is also determined by the location of factories,

warehouses, after sales service points. All these affects the early availability
which helps to gain competitive advantage.

iv) Reputation:

Reputation of company, brand also helps to increase the perceived value of the
product, contributing to the competitive advantage. For example, recent
marketing of VOLTAS air conditioner as a “TATA PRODUCT”.

v) Cross functional features:

Incorporating cross functional features in the product also contributes towards

the competitive advantage by increasing the perceived value of the product.
Example: Camera and video recording features in mobile phone.

vi) Linkage with other firms:

Here we have to remember that horizontal integration is not same as the

horizontal marketing. Two firms coming together to produce a product, to
market a product etc, contributes to the competitive advantage by enhancing
the perceived value of the product.

C. Commonly required skills and resources and common organizational requirements for
product differentiation strategy:

i) Commonly required skills and resources:

• Strong marketing abilities.
• Product engineering.
• Creative flair.
• Strong capabilities in basic research.
• Corporate reputation for quality or technological leadership.
• Long tradition in the industry or unique combination of skills drawn from
other businesses.
• Strong cooperation from channels.

ii) Common organizational requirements:

• Strong coordination among functions in R&D, product development and

marketing.
• Subjective measurement and incentives instead of quantitative measures.
• Amenities to attract highly skilled labour, scientists and creative people.

D. Risks of product differentiation strategy:

Differentiation involves a series of risks such as

• The cost differential between low cost competitors and the differentiated firm
becomes too great for differentiation to hold brand loyalty. Buyers thus
 sacrifice some of the features, services, or image possessed by the
differentiated firm for large costs savings.
• Buyers need for the differentiating factor falls. This can occur as buyers
become more sophisticated.
• Imitation narrows perceived differentiation, a common occurrence as
industries mature.

E. Successful implementation of product differentiation strategy:

This will depend on several factors which are depicted below in the diagram….

High quality Annual customer

service survey

Timely
distribution of
products through
distribution Successful Economic profit ROI
channel implementation

Dollar
investment of
the product in A string of new
No of patents
warehouse products

The factors in the first box after the circle in each direction is called the critical success factors and the
following box is the measurement criteria of that critical success factors. Now all these factors are given
weight to be measured.

3. FOCUS STRATEGY:
This strategy postulates selecting or focusing on a particular market, buyer group,
segment of the product line, geographical market etc, then reconfigure the value chain to satisfy the needs of
the customers. This is practiced by organizations with limited resources or with a very risky product.
Although the low cost and differentiation strategies are aimed at achieving their objectives industrywide, the
entire focus strategy is built around serving a particular target very well and each functional policy is
developed with this in mind. The strategy rests on the premise that the firm is thus able to serve its narrow
strategic target more efficiently and effectively than competitors who are competing more broadly. As a
result, the firm achieves either differentiation from better meeting the needs of the particular target or lower
costs in serving the target or both. Even though the focus strategy doesnot achieve low cost or differentiation
from the perspective of the market as a whole, it does achieve one or both of these positions vis-à-vis its
narrow market target. Here to achieve competitive advantage the firm has to do two things…
 i) Create economic value:
(Discussed earlier)

ii) Capture economic value:

This concept is related with price elasticity of demand. Depending upon that, two
strategies are adopted…

a) Margin strategy:

This strategy tells to increase the profitability by concentrating on the increase

of unit product margin.

b) Share strategy:

This strategy concentrates on increasing the market share resulting in the sales volume as well as
profit.

Now we shall compare this strategy with cost leadership and product differentiation strategy..

Price Elasticity of demand Cost Leadership Differentiation

Ep>1 Small fall in price=>Large Small increase in price=>Large
increase in sales => Share strategyfall in sales=> Share strategy i.e.
i.e. decrease price marginally thanmaintain price parity with the
competitors and exploit benefit competitors and exploit benefit of
from increasing market share. higher market share by giving
more perceived value.
Ep< 1 Big fall in price=>Little increase Margin strategy: Provide more
in sales=> Margin strategy i.e. benefit at higher price.
maintain price parity and lower
cost drives the higher profit
margin.

4. Selection of cost leadership and differentiation strategy:

i) Cost leadership strategy is ideal for commodity market where consumers are price sensitive.
When it is a search product, then also cost leadership strategy is adopted.

ii) Product differentiation strategy is adopted in case of experience product, non commodity and
non-price sensitive product.

5. How to implement the generic strategies:

There are four levers to implement this strategy. They are as following:

i) Management communication and information system. (MCIS)

ii) Management control system. (MCS)
iii) Organisation structure (OS)
iv) Executive compensation system (ECS)

Now let’s take a look at the comparison of these levers under two generic strategies:

Levers Cost leadership strategy Product differentiation strategy

ORGANISATION 1. Few layers in organization 1. Cross divisional/cross
structure. functional product development
STRUCTURE 2.Simple, U type reporting team.
(OS) relationships. 2. Semi permanent organization
3. Small corporate staff structure to exploit new business
4. Focus on narrow range of opportunities.
business. 3. Isolated pockets of intensive
creative efforts.
MANAGEMENT 1. Tight cost control. 1. Broad decision making guide
2. Quantitative cost goal. lines.
CONTROL SYSTEMS 3. Close supervision of raw 2. Managerial freedom within
(MCS) materials, labour, inventory and guidelines.
overhead. 3. Policy of experimentation.
4. A cost leadership philosophy.
EXECUTIVE 1. Reward for cost reduction. 1. Reward for taking risk.
2. Incentive for all employees 2. Reward for creative flair.
COMPENSATION involved in cost reduction. 3. Multidimensional performance
SYSTEM (ECS) measurement system.
MANAGEMENT 1. Strategic plan (Vision, Mission etc.)
2. Budget
COMMUNICATION 3. Company newsletter.
AND INFORMATION 4. Theme of the year.
SYSTEM. (MCIS)
 PART F
FUNCTIONAL STRATEGIES

Contents:

1. Economies of scope
2. Strategic gap analysis and Growth strategies (Ansoff growth strategies)
3. Different growth form- strategic alliance, joint venture,Diversification, Merger and acquisition.

1. ECONOMIES OF SCOPE:

Economies of scope implies “ When more than one item is produced at a plant, it is cheaper than
producing the items separately in different plants” S, if we produce X and Y, an the cost function
of X and Y are Q(X) and Q(Y) and if the cost function for producing the items jointly in one plant
is Q(X,Y) then..

Q(X,Y)<Q(X,0) + Q(0,Y)

Economies of scope can be observed in other functions other than production such as purchase,
distribution etc. But for economies of scope, the products X and Y has to be related, preferably to
the core competency of the organization.

2. STRATEGIC GAP ANALYSIS AND ANSOFF GROWTH STRATEGIES:

So far we have discussed the generic strategies and what are the sources of the. Basically generic
strategies set a broad guiding principles as to how would the firm operate in the market place. But
to tackle competitors under different market conditions requires different set of strategies which
helps the firm to grow in the market. These are called growth strategies. In deciding upon the
growth strategies two steps are involved: i) Strategic gap analysis ii) Deciding on the particular
growth strategies. We will discuss tham one by one:

i) Strategic gap analysis:

Gap analysis is basically done to measure the gap between the current situation and future expected
situation. It reveals the gap that has to be fulfilled in futures on different fonts.

Gap analysis is a very useful tool for helping marketing managers to decide upon marketing
strategies and tactics. Again, the simple tools are the most effective. There's a straightforward
structure to follow. The first step is to decide upon how you are going to judge the gap over
time. For example, by market share, by profit, by sales and so on.
This will help you to write SMART objectives. Then you simply ask two questions - where are we
now? and where do we want to be? The difference between the two is the GAP - this is how you
are going to get there. Take a look at the diagram below. The lower line is where you'll be if you
do nothing. The upper line is where you want to be.
What is Gap Analysis?
Your next step is to close the gap. Firstly decide whether you view from a strategic or an
operational/tactical perspective. If you are writing strategy, you will go on to write tactics - see the
lesson on marketing plans. The diagram below uses Ansoff's matrix to bridge the gap using
strategies:
Strategic Gap Analysis.

ii) Deciding on particular growth strategies---Ansoff Groqth Matrix:

The Product/Market Grid of Ansoff is a model that has proven to be very useful in business unit strategy processes to determine
business growth opportunities. The Product/Market Grid has two dimensions: products and markets.

Over these 2 dimensions, four growth strategies can be formed.

(Please refer to next page)

FOUR GROWTH STRATEGIES IN THE PRODUCT/MARKET GRID
1. Market Penetration. Sell more of the same products or services in current markets. These
strategies normally try to change incidental clients to regular clients, and regular client into
heavy clients. Typical systems are volume discounts, bonus cards and Customer Relationship
Management. Strategy is often to achieve economies of scale through more efficient
manufacturing, more efficient distribution, more purchasing power, overhead sharing. Main
target is …..i) Increase the amount and frequency of use.
2. Market Development. Sell more of the same products or services in new markets. These
strategies often try to lure clients away from competitors or introduce existing products in
foreign markets or introduce new brand names in a market. New markets can be geographic or
functional, such as when we sell the same product for another purpose. Small modifications may
be necessary. Beware of cultural differences. The main target is…..i) Convert the non-users to
users and ii) Expand geographically.
3. Product Development. Sell new products or services in current markets. These strategies often
try to sell other products to (regular) clients. These can be accessories, add-ons, or completely
new products. Cross-selling. Often, existing communication channels are used.
4. Diversification. Sell new products or services in new markets. These strategies are the most
risky type of strategies. Often there is a credibility focus in the communication to explain why
the company enters new markets with new products. On the other hand diversification strategies
also can decrease risk, because a large corporation can spread certain risks if it operates on more
than one market. Diversification can be done in four ways:
o Horizontal diversification. This occurs when the company acquires or develops new
products that could appeal to its current customer groups even though those new
products may be technologically unrelated to the existing product lines.
o Vertical diversification. The company moves into the business of its suppliers or into
the business of its customers.
o Concentric diversification. This results in new product lines or services that have
technological and/or marketing synergies with existing product lines, even though the
products may appeal to a new customer group.
o Conglomerate diversification. This occurs when there is neither technological nor
marketing synergy and this requires reaching new customer groups. Sometimes used by
large companies seeking ways to balance a cyclical portfolio with a non-cyclical one.
 Now while adopting these strategies a firm can decide to perform in all the segments of the value
chain or decide to outsource some of them depending on the margin being contributed by the activity.Here
comes the question of transactions. Whether the firm will depend on internal transactions or external market
transactions to accomplish the growth objective Here comes the question of vertical integration, strategic
alliance, tapered integration, Franchisee, Joint venture. We will discuss them one by one….

A) VERTICAL INTEGRATION:

Vertical integration gives the stages at which the firm operates in the value chain. According to Porter
“vertical integration is the combination of technologically distinct production, distribution, selling and/or
other economic processes within the confines of a single firm. As such it represents a decision by the firm to
utilize internal or administrative transactions rather than market transactions to accomplish its economic
purpose. For example, a firm with its own sales force instead could have contracted, through the market, an
independent selling organization to supply the selling services it requires.

When a firm owns and controls the customers subject to the moves closer to the end users of
product/service, it is said to be forwardly vertically integrated. In other words when the firms owns and
controls the downstream activities in a value chain i.e. outbound logistics, marketing/sales and service it is
said to be forward vertical integration.

When a firm owns and controls the input resources subject to it moves closer to the raw materials resources
the firm is said to move closer to the backward vertical integration. In other words when the firms owns and
controls the upstream activities of its value chain i.e the inbound logistics and raw material resources it is
said the backward vertical interagration.

Now, we will discuss the when and why of vertical integration:

• When to go in for vertical integration:

The firm should go in for vertical integration when the following situations are there..

i) When there are low no of suppliers and distributors.

ii) When the value of an investment in a transaction is much higher than its value in
alternate channel.
iii) Uncertainty and complexity of contract.

• Benefits of (sources of competitive advantage) vertical integration:

The benefits of vertical integration depend, first of all, on the volume of products or
services the firm purchases from or sells to the adjacent stage relative to the size of efficient
production facility in that stage. Following are the benefits of vertical integration:

A) Economies of integration:

If the volume of the throughput is sufficient to reap available economies of scale, the most
commonly cited benefit of vertical integration is the achievement of the economies, or cost
savings, in joint production, sales, purchasing, control and other areas. Following economies
can be achieved:
 i) Economies of combined operation:

By putting technologically distinct operations together, the firm can sometimes gain
efficiencies. In manufacturing, this move, for example, can reduce the number of
steps in the production process, reduce handling costs, and utilize the slack capacity
which arises from indivisibilities in one stage.

ii) Economies of Internal control and coordination:

The costs of scheduling, coordinating operations and responding to emergencies may

be lower if the firm is integrated. Adjacent location of the integrated units facilitates
coordination and control.

iii) Economies of information:

Integrated operations may reduce the need for collecting some types of information
about the market, or more likely, may reduce the overall costs of gaining information.
The fixed costs of monitoring the market and predicting supply, demand and prices
can be spread over all parts of the integrated firm, whereas they would have to be
borne by each entity in an uninegrated firm.

iv) Economies of avoiding the market:

By integrating, the firm can potentially save on some of the selling, price shopping,
negotiating, and transactions costs of the market transactions.

v) Economies of stable relationships:

Both upstream and downstream stages, knowing that their purchasing and selling
relationship is stable, may be able to develop more efficient, specialized procedures
for dealing with each other that would not be feasible with an independent supplier or
customer---where both the buyer and the seller in the transaction face the competitive
risk of being dropped or squeezed by the other party.

B) Tap into technology:

Another important benefit of vertical integration is a tap into technology. In some

circumstances it can provide close familiarity with technology in upstream and
downstream businesses that is crucial to the succees of the base business, a form of
economy of information so important as to deserve separate treatment.

C) Assured supply and demand:

Vertical integration assures the firm that it will receive available supplies in tight
periods or that or that it will have an outlet for its products in periods of low overall
demand to the extent that the downstream unit can absorb the output of the upstream
unit.

D) Enhanced ability to differentiate:

Vertical integration can improve the ability of the firm to differentiate itself from
others by offering a wider slice of value added under the control of the management.
This aspect, for example,allow better control of channels of distribution in order to
offer superior service or provide opportunities for differentiation through in house
manufacture of proprietary components.
E) Offset bargaining power and input cost distortion:

If a firm dealing with suppliers or customers who weild significant bargaining power
and reap returns on investment in excess of the opportunity cost of capital, it pays for
the firm to integrate even if there are no other savings from integration. Offsetting
bargaining power through integration may not only lower costs of supply (by
backward integration) or raise price realization (by forward integration) but also allow
the firm to operate more efficiently by eliminating otherwise valueless practices used
to cope with the powerful suppliers or customers.

F) Elevate entry or mobility barriers:

If vertical integration achieve any of these benefits, it can raise mobility barriers. The
benefits give the integrated firm, in the form of higher prices, lower costs or lower
risks.

G) Enter a higher return business:

A firm may sometimes increase its overall return on investment by vertically

integrating. If the stages of production into which integration is being contemplated
has a structure that offers a return on investment greater than the opportunity cost of
capital for th firm, then it is possible to integrate even if there is no economies of
integration per se.

H) Defend against foreclosure:

Even if there are no positive benefits of integration, it may be necessary to defend

against foreclosure of access to suppliers or customers if competitors are integrated.

• Costs or disadvantages of vertical integration:

The strategic costs of vertical integration basically involve entry cost,flexibility,

balance, ability to manage the integrated firm, and the use of internal organizational
versus market incentives.

A) Cost of overcoming mobility barriers:

Vertical integration obviously requires the firm to overcome the mobility barriers to
compete in the upstream or downstream business. Integration is after all a special case
(though a common one) of the general strategic option of entry into a new business.

B) Increased operating leverage:

Vertical integration increases the proportion of a firm’s costs that are fixed. If the
market, for example, all the costs of that input on the spot market, for example, all
the costs of that input would be variable.

C) Elevate and entry and mobility barriers:

Vertical integration implies that the fortunes of a business unit are at least partly tied
to the ability of its in-house supplier or customer (who might be its distribution
channel) to compete successfully. Vertical integration raises costs of changeover to
another supplier or customer relative to contracting with independent entities.
 D) Higher overall exit barriers:

Integration that further increases the specialization of assets, strategic

interrelationships, or emotional ties to a business may raise overall exit barriers.

E) Capital investment requirements:

Vertical integration consumes capital resources, which have an opportunity cost

within the firm, whereas dealing with an independent entity uses investment capital or
outsiders. Vertical integration must yield a return higher than the to the firm’s
opportunity cost of capital.

F) Foreclosure of access to suppliers or consumer research and/or know how:

By integrating the firm may cut itself off from the flow of technology from its
suppliers and customers. Integration usually means that a company must accept
responsibility for developing its own technological capability rather than
piggybackying on others.

G) Maintaining balance:

The productive capacities of the upstream and downstream units in the firm must be
held in balance or potential problem arise. The stage of the vertical chain with excess
capacity (or excess demand) must sell some of its output(or purchase some of its
inputs) on the open market or sacrifice the market position.

H) Dulled incentives:

Vertical integration means that buying and selling will occur through a captive
relationships. The incentives for the upstream business to perform may be dulled
because it sells in-house instead of competing for the business.

I) Differing managerial requirements:

Business can be different in structure, technology, and management despite having a

vertical relationship. Since vertically linked business transact business with each
other,however, there is a subtle tendency to view them as similar business from a
managerial point of view.

• Particular benefits in forward vertical integration:

i)Improve ability to differentiate the product:

Forward integration can often allow the firm to differentiate its product more
successfully because the firm can control more elements of the production
process or the way the product is sold. For example: forward integration in
retailing sometimes allow the firm to control the salespersons and other
elements of the retailing selling function that help to differentiate the product.
 ii) Access to distribution channels:

Forward integration solves the problem of access to distribution channels and

removes any bargaining power the channels have.

iii) Better access to market information:

In a vertical chain the underlying demand for the product (and the decision
maker who actually makes the choices among competing brands) often are
located in a forward stage. This stage determines both the size and the
composition of demand of the upstream stages of production. This is called the
demand leading stage. Forward integration into demand leading stage can
provide the firm with critical market information, that allows the entire
vertical chain to function more effectively.

iv) Higher price realization:

In some cases forward integration can allow the firm to realize the higher
overall prices by making it possible to set different prices for different
customers for essentially the same product. If the firm integrates into
businesses that should be charged with lower price because its demand is more
elastic, it may realize higher prices on sales to other customers. However other
firms selling the product must also be integrated, or the firm’s product must be
differentiated so that customers will not accept competitor’s products as
perfect substitutes.

• Particular benefits with backward vertical integration:

As with forward integration, there are some particular issues that must be
examined in considering backward vertical integration :

i) Proprietary knowledge:

By producing needs internally, the firm can avoid sharing proprietary data
with its suppliers, who need it to manufacture component parts or raw
materials. Often the exact specifications for component parts reveal the key
characteristics of the final product’s design or manufacture to the supplier.

ii) Differentiation:

Backward integration can allow the firm to enhance differentiation ,though the
circumstances are somewhat different than those of forward integration. BY
gaining control over the production of key inputs, the firm actually may be
able to differentiate its product better or say credibly that it can.

• Tapered integration:

Tapered integration is partial integration backward forward, the firm

purchasing the rest of its needs on the open market. It requires that the firm be
able more than support an efficiently sized in-house operation and still have
additional requirements which are met through the market place.
 * Benefits of Tapered integration:

1. It allows a firm to increase its sales without substantial financial outlay.

2. It can use the internal cost data for negotiation with independent suppliers
and customers. Similarly, it can use the market data to increase the efficiency
of the inhouse production facility.

3. It helps the firm to protect itself against the holdup problem created by the
external suppliers.
4. Tapered integration results in less elevation in fixed costs than full
integration.
5. The degree of taper can be adjusted to reflect the degree of risk in the
market. Independent suppliers can be utilized to bear the risk of the
fluctuations, while in house suppliers maintain steady production rates.

* Disadvantages of tapered integration:

1. Due to shared production it may happen both the external production facility and
outside supplier may fail to achieve economies of production.

2. Shared production may create problem of co ordination between internal supply

and external supply in terms of product specification and delivery.

3. By mistake the firm may use the cost data of an inefficient internal production
system for negotiation with external suppliers.

4. It may happen that managers may like to retain an inefficient internal production
system due to emotional bondage.

B) STRATEGIC ALLIANCE:

It takes place when two or more firms agree to collaborate a project, share information or
share production resources. Strategic alliance may be horizontal and vertical. When the
two firms operate in the same stage of the value chain or belong to the same industry, we
get horizontal strategic alliance. When two firms belong to the different stages of value
chain we get vertical strategic alliance.

• Types of strategic alliance:

Strategic alliances fall into four categories:

i) Product or service alliances:

One company licenses another to produce its product, or two companies jointly
market their complementary products or a new product.

ii) Promotional alliances:

One company agrees to carry a promotion for another company’s product or service.

iii) Logistics alliance:

One company offers logistical services for another company’s product.

iv) Pricing alliances:

One or more companies join in a special pricing collaboration. It is common for hotel
and rental car companies to offer mutual price discounts.
 • When strategic alliance is good:

1. To avoid barriers to entry. Some government insists that a foreign company can do
business in that country provided it takes a local national company as partner.

2. To reduce risk when the transaction involves transaction specific investment in

order to avoid cheating by one party. It is required that both the parties are involved in
that transaction specific investment.

3. To undertake a project that is too big for either party either due to indivisibility of
upfront cost or due to presence of experience curve effects.

• Conditions for successful strategic alliance:

1. Goal compatibility: Both parties must have the same goal.

2. Synergy: There must be a case that this transaction will create more positive
economic value.

3. Value adding: Both must bring some value to the alliance and both must agree on a
fair appropriation of value.

4. Balancing contribution: It is required that one party doesn’t dominate the other to
have the alliance long live.
C) JOINT VENTURE:

When two or firms joins hand to form a third independent company, it’s a joint venture. The new
company is not under the corporate governance of any of the parent company. For example, in
India, AVIVA life insurance is a joint venture between Dabur India and Aviva group of U.K.

D) FRANCHISING:

Franchising is a contract between a franchiser and franchisee. Franchiser develops a brand, owns
it and has developed a system to make or sell a good or service. A franchisee is a party which
gives the right to use the brand name and the system developed by the franchiser for a fee. It’s
basically a quasi vertical integration.

E) DIVERSIFICATION:

When a firm operates in multiple businesses we call it the firm has diversified. Technically
speaking, “ No single business’s revenue is more than 70% of the group’s revenue and all the
businesses are under the same corporate governance.

• Reasons for diversification:

The reasons for a company to diversify are as follows:

i) Operational efficiency of scope:

Opeartional efficiency of scope is generated through diversification in the following

way…..
 * Shared activities and cost reduction
* Shared activities and revenue enhancement
* Core competency.

The collective learning in an organization about how to co ordinate diverse production skill
and integrate multiple things or technologies. It is basically intangible in nature and refers to
managerial and technical know-how, experience and wisdom.

Example: a) Birla 3M company: It has developed core competencies in substrates, adhesive

coatings production and now produces Post and notes, magnetic tapes, photographic film,
press sensitive notes and coated adhesives all of which relate to the core competencies thus
enjoying the economies of scope.

b) Honda motor company: It has developed core competency in the production of engine and
power transmission chain which now it leverages in producing motor cycle, automobiles,
power tillers, lawn mowers.

ii) Financial economies of scope:

This is realized through…..

* Internal market for capital.

* Risk reduction
* Tax advantage

When a diversified firm has got individual businesses whose cash flows are perfectly
and negatively corerelated, the standard deviation of cash flows for the diversifies
firm will always be the lower than the sum of S.Ds of cash flows of individual
businesses. Also the debt capacity of the firm goes up because revenue go up. Also
under tax law the profit from some business can be set off against losses other
businesses within the same group. As a result the overall tax liability goes down.

iii) Anti-competitive economies scope:

This is realized through two ways:

First. Suppose there are two companies, A and B, which operate in more than two
businesses, business 1 and business2, but B is stronger in business1 and A is stronger
in business2. Now if B wants to create a price war with A in business1, than A can
retaliate by creating price war in business 2. So sometimes companies acquire firm or
form a tacit collusion with competitor to prevent this kind of price war.

Second, Expanding market power. Sometimes a near monopolist firm acquire a firm
in a loosing business based on the profit it earns in the existing business, I initiates
predatory pricing in the newly acquired business to drive out competitor to create a
monopolistic situation after sometime to reap profit in future.

iv) Employees and stakeholders incentives for diversification:

It realizes this through the following ways:

* Diversify human capital.

* Maximizing managerial compensation.
* Diversifying the stake of non employees stakeholders.
[ N.B: Related diversification: It helps to create more economic value as compared to that in case of
unrelated diversification]

• Conditions for diversification:

1. Structural attractiveness of the market i.e. some industries are inherently more profitable
than others. Thus diversification, if any, should be only attractive industries.

2. Cost of entry: If cost of entry is higher than the scope for generation of positive
economic value, do not venture into it. The best method is to identify an undervalued firm
and try to acquire it. But in today age, when information is very difficult to identify an
undervalued organization without others noticing it.

3. Structural linkage between new and existing firm i.e. linked in terms of any part of the
value chain.

• Management of diversified company:

A diversified firm is characterized by varied products, markets, geographical areas,

technology etc. Thus it is very difficult to get people competent to handle all such
organization. The organizational structure of a typical diversified company consists of
three layers as follows:

Corporate Headquarter

Division 3
Division 1 Division 2

SBU 1 SBU 2 SBU 2

SBU 1 SBU 2 SBU3

SBU 1 SBU2 SBU 3

First level is the corporate headquarters which plans at strategic level.

Second level consists of the divisions which handles the related businesses.
Third level consists of Strategic business units (SBUs).

When the businesses are thinly related, the corporate office is small, then divisions vanishes and the
SBUs comes directly under corporate supervision.
 When the businesses are related i.e. there is a chance of deriving economies of scope due to presence of
certain common activities in the value chain, a division has to be put up to co ordinate activities of
related SBUs.

Activities of corporate head quarters: (Mainly strategic)

i) Monitor the performance of divisions/SBU.

ii) Allocation of financial resources.
iii) Allocation of human talent.
iv) Makes further investment/divestment decisions.

Activities of the division: (Strategic + Tactical)

i) Co ordination of manufacturing, marketing and production development activities.

Activities of SBUs:

Before discussing the function of SBUs let’s understand the concept of SBU.

• Concept of SBU:

It has got the following features:

a) It must serve an external market. It should not be for internal purpose.

b) It must have a set of external set of competitors which it is trying to compete with
or surpass.

c) The SBU manager must be the boss of the destiny of the SBU. Complete freedom
regarding choice of suppliers and choice of time and position of the market.

d) The performance of an SBU can be measured in terms of its financial status i.e. it
should be a true profit and loss centre.

F) CONGLOMERATE:

Group of unrelated business is called conglomerate. The above definition of SBU is only
applicable to a conglomerate. But if the SBUs are related a cost linkage approach has to be
taken for defining SBUs. Identify the companies sharing the resources and club them together
under a division or as SBUs.

G) MERGER AND ACQUISITION:

Motives for and forms of merger: same as diversification. This a means of acquiring business. The word
“merger” is replaced by “amalgamation” in Indian context. The companies merging together is called
amalgamating companies and the new company is called the amalgamated company. This is divided nto two
groups:

i) Absorption: The company being absorbed looses its legal entity and its assets gets transferred to
to absorbing company.

ii) Consolidation: When two or more companies merge together where only one company retains
its legal identity and others loose their identity it is called consolidation.
 Example: Hindustan computer Ltd, Hindustan investment Ltd, Hindustan software company ltd
and Hindustan retrographics ltd merge together to form Hindustan computer ltd (HCL).

In consolidation shareholders holding not less than 90% share value of the amalgamating
company must become shareholders of the newly amalgamated company.

Types of merger: There are three types of merger:

a) Horizontal merger: Amalgamating companies compete with each other.

b) Vertical merger: Amalgamating companies operate at the different stages of

production and distribution of a product or service.

c) Conglomerate merger: Amalgamating companies operate in unrelated products.

Legalities of Merger: In amalgamation, the management of amalgamating companies operate together. In

acquisition it involves management control of one company by another company. After acquisition both the
company retains their legal entity. According to Sec.372 of companies act of India,1956,i) acquiring
company must hold not less than 10% of the paid-up equity shares of the acquired company. Ii) This
acquisition must be approved in the AGM of the acquiring company.

When an acquisition is hostile in nature, it is called takeover.

Financial aspects of merger: When an amalgamation takes place, the acquiring company pays cash or
shares of acquiring company to the members of the acquired company. This is called purchase consideration.
The financial logic of merger to be successful is that, if A acquires B, NPV(A+B)> NPV(A)+ NPV(B). In
accounting concept,

Economic advantage (EA)= NPV(A+B) – [NPV(A) + NPV (B)]

Cost of margin= (Cash to be paid)- NPV(B)

Net economic advantage= EA- cost of margin.

However while calculating the value of NPV(A+B), we follow three methods---

i) Supra normal growth ii) Above normal growth iii) Normal growth.

In this way, the whole planning horizon, i.e. the economic life merger is divided into three levels.

Value of each firm is calculated separately by market capitalisaion.

Problem: Let P acquires Q. Following information is available is available:

i) P has 12 lakh shares @ Rs.50 each

ii) Q has 5 lakh shares @ Rs.60 each
iii) NPV(P+Q)=25 core
iv) Cash to be paid to Q = 4.5 core.

Find out Economic advantage, net economic advantage, cost of margin.

Solution: Economic advantage= NPV(P+Q) – [ NPV(P)+ NPV(Q)]

= 25,00,00,000 – [ (150X12,00,000)+(60X5,00,000)]
= 25,00,00,000-21,00,00,000 = 4,00,00,000
Cost of margin = {Cash to be paid to Q – NPV(Q)}
= (4,50,00,000-3,00,00,000)
= Rs. 1,50,00,000

Net economic advantage= Economic advantage – cost of margin

= 4,00,00,0000 – 1,50,00,000
= Rs. 2,50,00,000

Now if shares had been paid instead of cash, then no.of shares to be issued= 4,50,00,000/150
= 3,00,000

Total no of shareholders of the new company= 12,00,000+3,00,000=15,00,000

Share value of the new company= {NPV(P+Q)/ 15,00,000}= Rs.166.67.

 PART F
PORTFOLIO MANAGEMENT MODELS

Contents:
1. BCG matrix
2. GE-Mackinsey matrix
3. ADL matrix.

Portfolio management models are used, in case of a diversified company, to judge the
performance of the different businesses or SBUs and to allocate resources among different SBUs and to
decide on strategy to be adopted on them. Different models are used for this purpose using different criteria
and dimensions. The main ones are : BCG matrix, GE-Mackinsey matrix and Arthur D Little matrix(ADL).
All these models were developed during the chairman ship of Fred Borch of G.E. At that point of time, G.E
had 60 unrelated businesses and was facing tremendous pressure from the Japanese and European firms. The
models were developed by BCG, Mckinsey and Arthur D.Little separately for the reconstruction of G.E.

All these models are known as strategic fit models. According to this concept, the source of
competitive advantage lies in the external environment and the firm’s ability to adapt itself to the
environment. Thus for formulation of strategy the external environment is more important than the resource
base. Thus these two dimensional models are easy to visualize and understand. One dimensions of these
models shows the structural attractiveness of the industry while the other dimension refers to the relative
competitive position of the firm within the industry. These models can be applied not only at the business
level but also at the product market level within the business. The common features of these models are that
all of them provide certain prescriptions about managing the strategic business units. These three generic
decisions are invest, withdraw/divest, hold.

• Assumptions underlying the models:

1. the market has been defined properly to account for the important shared
experience and other interdependences with other markets. This is often a subtle problem requiring a great
deal of analysis.

2. The structure of the industry and within the industry are such that relative market
share is a good proxy for competitive position and relative costs. This is often not true.

3. Market growth is a good proxy for required cash investment. Yet profits(and cash
flows) depend on a lot of other things.

1.BOSTON CONSULTING GROUP’S GROWTH/SHARE MATRIX: ( BCG MATRIX)

The growth share matrix is based on the use of industry growth and relative market share as
proxies of 1) The competitive position of a firm’s business unit in industry and 2) The resulting net cash
flow required to operate in the business unit. This formula reflects the underlying assumptions that the
experience curve is operating and that the firm with largest relative market share will thereby the lowest cost
producer.

[ N.B: Causes for using relative market share instead of absolute market share:

BCG has used relative market share to show the position of the firm compared to its competitors.
They have used relative market share deliberately because in some market if any company holds even a tiny
percentage of the market it will be the market leader. This type of market is called fragmented market. A
market is fragmented when no firm in the market clearly holds absolute majority market share. ]
These premises lead to a portfolio chart shown like in the following diagram----

HIGH STAR PROBLEM CHILD

Moderate + or – cash flow Large negative cash flow

Growth
* ?
10%

CASH COW DOGS

Large positive cash flow Modest + or – cash flow

LOW

1.0
HIGH LOW
Relative market share

Construction of BCG matrix: i) How to calculate relative market share:

Suppose we are calculating the relative market share of the firm at the
beginning of 2007, then the formula for the calculation of relative market share will be-----

R.M.S= Sales of the firm for 2006/ Sales of the leading competitor.

Suppose there are three firms in the market having sales 20 million, 10 million, 5 million. Then if calculate
R.M.S for the first firm then the leading competitor will be the firm having sales of 10 million, but if we
calculate the R.M.S for the firm having sales of 5 million then the leading competitor will be the firm having
sales of 20 million. Relative share of 1% is denoted by a vertical line. BCG believes that combination of
these two dimensions gives the higher profitability of the firm because they believed in economies of scale
which has accumulated experience in production resulting in lower unit cost of production and higher
profitability.

Now high relative market share and higher profitability is not related directly and interlinked through some
intervening variable. Thus if we plot the relative in a graph the resulting graph will be curvilinear in nature
the most generic equation of which can be y=abx. If we take log at the both side we get,

log y= log a + b log x

So here we get the linear relation. So BCG has used the semilogarithmic scale to plot relative market share
on x axis.

ii) How to calculate market growth rate:

Market growth rate is defined by the following formula:

M.G.R= {sales2006 – sales 2005}/ sales 2005

BCG has arbitrarily assumed that a growth rate above 10% means market is in the embryonic or
growth stage. If it is less than 10% it is in maturity or decline stage. This 10% mark is denoted by
a horizontal line.

iii) How to plot SBUs in BCG matrix:

Now for every company we will get a point on the grid which will denote its market growth rate
and relative market share. After getting the points, we have to draw a circle against each point
where the diameter of the circle will be directly proportional to the sales value of the firm.

Feature and strategic implication of different quadrant:

i) STAR: High cash inflow due to high market share and high growth rate. But high cash outflow due to
sustaining the high growth rate. So the result will be marginally +ve or –ve profit. So it requires heavy
support from corporate management to sustain the growth. The strategy is to INVEST.

ii) CASH COW: In this case, the relative market share is very high so cash inflow is very high because of
very high past investment made when it was in the growth stage. But now growth has come down, so now
the only requirement is to sustain the dominant position. So in sum it is generating cash more than the
requirement. The strategic option is to HARVEST.

iii) PROBLEM CHILD: It is a high growth market and there is lot of opportunity. But due to some reason,
relative market share is low. To convert a problem child to a star performer, investment requirement will be
very high because internal cash flow is not adequate due to low relative market share. But if there are no of
problem child, then we have to divide it into two groups, one we will sell off and other we will invest in.

iv) DOGS: It is in a low market share and very low growth rate. So whatever cash it is generating, is getting
consumed to retain its own position in the market. So there is no prospect in future. So the strategic option is
to DIVEST( Sell off at whatever price is available) or HARVEST ( Not very sure whether the market will
die or not or not getting the price it should get. So let it be there, but trip its cash flow by not expanding. Let
it have its own economic demise.)

Constraints of BCG matrix:

i) It sees the different businesses in the conglomerate as completely unrelated. So that at any point of time
any company can be divested without affecting the group’s performance. It’s not practicable at all point of
time.

ii) It assumes capital allocation through internal route is efficient than external market capital allocation. But
according to BCG, it has to be cash neutral to achieve a high growth.

iii) Many people object the name it gives.

iv) Relationship between high accumulated production experience and high profitability is not justified.
Because the amount of investment it requires to achieve high sales is very costly to the profitability of the
market.

v) This is called transactional model. This gives the picture of the last year. Decision taken on which may
not be right.

2. GE-MCKINSEY’S COMPANY POSITION/INDUSTRY ATTRACTIVENESS MATRIX:

Another technique is the three by three matrix variously attributed to General electric, Mckinsey and
company and Shell. One representative variation of this technique is shown in the following figure:

The two axes in this approach are the attractiveness of the industry and the strength or competitive position,
of the business unit. Where a particular business unit fall along this axes is determined by an analysis of that
particular unit and its industry, using the following criteria:

A) For business strength:

i) Size ii) Growth iii) Share iv) Position v) Profitability vi) Margins vii) Technological positions
viii) Strengths/weaknesses ix) Image x) Pollution xi) people.

B) Industry attractiveness:

i) Size ii) Market growth/pricing iii) Market diversity iv) Competitive structure v) Industry
profitability vi) technical role vii) Social viii) Environmental ix) Legal x) Human.

Depending on where a unit falls in the matrix, its broad strategic mandate is either to invest capital to build
position, to hold by balancing cash generation and selective cash use or to harvest or divest. Expected shifts
in industry attractiveness or company positions lead to the need to reassess the strategy.

3. ARTHUR D.LITTLE’S LIFE CYCLE MATRIX:

Refer to SKB notes.