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The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 1 The Little Blue Consulting Handbook 2015 Edition

The Little Blue Consulting Handbook, 2015 Edition

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The Little Blue Book is designed for student consultants and first year management consultants, and aims to provide key concepts and frameworks that can be used to analyse business problems, evaluate situations, and achieve outcomes more quickly and easily than would otherwise be possible.This book gives us an edge in your consulting career.

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Page 1: The Little Blue Consulting Handbook, 2015 Edition

The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 1

The Little Blue

Consulting

Handbook

2015 Edition

Page 2: The Little Blue Consulting Handbook, 2015 Edition

The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 2

Sponsors:

Acknowledgements:

Special thanks to the following people for their valuable insights,

contributions and support:

Matthew O’Sullivan, President of the Global Consulting Group;

Shishir Pandit, CEO of the Global Consulting Group.

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The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 3

Contents

Introduction ........................................................................................................ 5

1. Definitions ...................................................................................................... 6

1.1 Consulting Jargon .................................................................................... 6

1.2 Business Terms ........................................................................................ 9

2. Industry Analysis ......................................................................................... 31

2.1 Macro Environment ............................................................................. 31

2.1.1 PEST Analysis ................................................................................ 31

2.2 Micro Environment .............................................................................. 37

2.2.1 Business Landscape Survey .......................................................... 37

3. Firm Level Analysis .................................................................................... 52

3.1 Profitability ............................................................................................ 52

3.1.1 Profitability Framework ............................................................... 52

3.2 Competitive Advantage ....................................................................... 58

3.2.1 Value Chain Analysis .................................................................... 58

3.3 Competitive Strategy ............................................................................ 63

3.3.1 Porter’s Generic Strategies ........................................................... 63

3.3.2 Strategy and the Internet .............................................................. 67

3.4 Growth Strategy .................................................................................... 69

3.4.1 Product / Market Expansion Matrix ......................................... 69

3.4.2 GE McKinsey 9 Box Matrix ........................................................ 77

3.4.3 BCG Growth Share Matrix .......................................................... 81

3.5 Marketing Strategy ................................................................................ 87

3.5.1 Four Ps Framework ...................................................................... 87

3.5.2 Product Life Cycle Model ............................................................ 92

3.6 Cost Management ................................................................................. 98

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3.7 Financial Management ....................................................................... 101

3.7.1 Five C Analysis of Borrower Creditworthiness ...................... 101

3.7.2 Net Present Value ........................................................................ 105

3.8 Organisational Cohesiveness ............................................................ 108

3.8.1 McKinsey 7 S Model ................................................................... 108

3.9 Competitive Response ....................................................................... 110

3.10 Corporate Turnaround .................................................................... 112

4. General Concepts and Frameworks ...................................................... 115

4.1 Barriers to Entry ................................................................................. 115

4.2 Cost Benefit Analysis ......................................................................... 119

4.3 Economies of Scale ............................................................................ 122

4.4 Economies of Scope .......................................................................... 126

4.5 Experience Curve ............................................................................... 130

4.6 MECE Framework ............................................................................. 135

4.7 Moral Hazard....................................................................................... 137

4.8 Porter’s Five Forces ........................................................................... 140

4.9 Quantitative Easing ............................................................................ 143

4.10 Rule of 70 ........................................................................................... 144

4.11 SWOT Analysis ................................................................................. 145

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Introduction The Little Blue Book is designed for student consultants and first year

management consultants, and aims to provide key concepts and

frameworks that can be used to analyse business problems, evaluate

situations, and achieve outcomes more quickly and easily than would

otherwise be possible.

For the sake of clarity, this document is not designed to help you prepare

for consulting interviews. If you are looking for such a guidebook,

please download “The HUB’s Guide to Consulting Interviews”.

The Little Blue Book will be updated from time to time. If you have any

comments, suggestions or feedback, please email the Editors at

[email protected].

The Little Blue Book is structured in four (4) parts:

1. Definitions of consulting jargon and business terms;

2. Frameworks for understanding the broader macro environment

and analysing an industry;

3. Frameworks for examining a firm and firm level strategy; and

4. Concepts and frameworks designed to deepen and broaden your

understanding and ability to analyse business situations and which

are not covered elsewhere in the Little Blue Book.

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1. Definitions

1.1 Consulting Jargon 10,000 foot view: A high-level overview of the situation.

80/20 rule: A rule of thumb which holds that 80% of a business

problem can typically be solved by focusing on 20% of the issues.

Add some colour: Make it more interesting/appealing/persuasive.

Adding value: Making a contribution.

AOB: Stands for “any other business” and might be used in a meeting

agenda to block out time for miscellaneous discussion.

At the end of the day: A consultant may use this phrase before

summarising the main thrust of her argument.

B2B: Stands for “business to business” and indicates that a business is

aiming to sell to other businesses rather than to end consumers.

B2C: Stands for “business to consumer” and indicates that a business is

aiming to sell directly to consumers rather than to other businesses.

Bandwidth: Capacity to take on additional work commitments. For

example, “I don’t have any bandwidth this week”.

Big 3: McKinsey, Bain and BCG.

Big 4: Deloitte, EY, KPMG and PwC.

Boil the ocean: Go overboard; undertake an excessive amount of

analysis; fail to follow the 80/20 rule.

Buckets: Categories.

Buy in: Agreement; support. For example, “we need to get buy in from

the client before finalising the report”.

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Charge code: A unique code provided for a project which can be used

to record work-related expenses.

Circle back: Follow up with someone at a later point in time.

Close the loop: Completing an item on the agenda or topic of

discussion with everyone being in agreement.

Core client: A client that has a long-standing relationship with the firm.

Deck: PowerPoint slides.

Deep dive: To conduct an extensive examination of a particular issue.

Deliverable: Work product that a consultant needs to provide to her

manager or the client as part of a client engagement.

Development opportunity: A professional shortcoming or area for

improvement that requires attention.

Due diligence: Comprehensive examination of all relevant issues, such

as a review of the client’s business or industry.

Fact pack: A pack of information that provides the essential facts for a

project/industry/company.

Granular: Focusing on the finer details, as in “this analysis needs to be

more granular.”

Hard stop: A stated time after which the person will no longer be

available to continue the meeting/discussion. For example, “I have a

hard stop at 3 o’clock”.

Key: Critical; essential; required; important; central. For example, “the

key issues are X, Y, Z.”

Let me play this back: Words used before providing a summary of the

discussion from the listener’s perspective. This is a helpful technique

which can allow a consultant to clarify her understanding of the key

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issues and at the same time sound intelligent by saying something even if

the summary adds no additional insights.

Low hanging fruit: Targets that are easily achievable, issues that can be

quickly resolved, opportunities that can be readily exploited, or problems

that are simple to solve. By picking the low hanging fruit first,

consultants can demonstrate quick results, which can boost the client’s

confidence in the project.

Lots of moving parts: Complex.

Managing upwards: Providing feedback to more senior employees.

MBB: McKinsey, Bain and BCG.

MECE: Pronounced “me see”, and stands for “mutually exclusive,

collectively exhaustive”. It is a principle for grouping information into

distinct categories which, taken together, deal with all available options.

For more information, see “4.6 MECE Framework”.

On the beach: In between assignments. Time spent on the beach may

be spent in training or used for business development.

On the same page: See things from the same perspective.

Out of the box thinking: Thinking that generates novel ideas which

don’t follow neatly from the data.

Ping: Contact someone, as in “I will ping you later via email.”

PIOUTA: Pulled it out of thin air.

Pipeline: Current and upcoming client engagements.

Production: A department of the consulting firm (often outsourced)

that assists in producing material needed for presentations and meetings.

Pushback: Resistance or disagreement, as in “we received some

pushback from the client.”

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Right size: Downsize.

Sandwich feedback technique: A structure for providing feedback

that resembles a sandwich – one positive comment, followed by a piece

of feedback, and ending with a positive comment.

Scope: Agreed set of deliverables for a client engagement.

Scope creep: When the client adds, or attempts to add, additional

deliverables which were not agreed in the initial project brief.

Sniff test: A common sense check of a particular idea, proposal or

analysis.

SWAG: Some wild-ass guess.

Take the lead: Take responsibility for something, as in: “Why don’t you

take the lead on this project.”

Takeaways: The key points that should be remembered at the end of a

discussion, meeting or presentation.

Touch base: To meet at a certain time to talk about the project.

Up or out: Many top consulting firms adopt an ‘up or out’ policy.

Employees are expected to advance up to the next level of responsibility

or they will be counselled out of the firm.

Work stream: The tasks that make up a project.

1.2 Business Terms Anchoring: The common tendency for people to rely too heavily on

readily available information (the “anchor”) when making decisions

involving uncertainty. Anchoring is a cognitive bias relevant in many

business contexts. Here are two (2) examples:

1. Price negotiations: A sophisticated buyer in a price negotiation will

want the seller to name the first price. This sets an anchor, or a

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maximum price from which the buyer can negotiate downwards.

If the seller names an unrealistically high price then the

sophisticated buyer will want to emotionally reject the price, which

might be done by exclaiming shock, disgust or pretending to walk

away. The buyer may still be interested but the purpose of

emotionally rejecting the initial offer is to break the anchor so that

negotiations can begin afresh.

2. Stock trading: Algorithmic traders can use their knowledge of

anchoring to gain a statistical edge in the stock market. Many

traders will use a recent high or low price as an anchor to

determine whether prices are “too high” or “too low” and an

algorithmic trader can use this fact to develop trading systems that

allow her to trade with positive expectation over the longer term.

For a good book on this subject, get yourself a copy of Way of the

Turtle by Curtis M. Faith.

Asset (accounting definition): An economic resource that a company

uses to operate its business, e.g. cash, inventories, property, plant and

equipment.

Asset (finance definition): An economic resource that generates cash

every month (i.e. your house and your car are probably not assets under

this definition).

Asset (strategy definition): An economic resource (whether tangible

or intangible) that allows an organisation to provide more value to

customers (whether real or perceived) for a given cost base.

Bandwagon effect: The common tendency for people to believe

something because many other people already believe it. The

bandwagon effect is relevant in business contexts since it suggests that

the probability of a person purchasing a product is proportional to the

number of people who have already done so. This helps to explain the

existence of fashions, fads and trends.

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Barriers to entry: The costs that must be paid by a new market entrant

but not by firms already in the industry. Barriers to entry have the effect

of making a market less contestable and so allow existing firms to

maintain higher prices than would otherwise be possible.

Key barriers to entry might include capital requirements, economies of

scale, network effects, product differentiation, proprietary product

technology, government policy, access to suppliers, access to

distribution channels, and switching costs.

For more information, see “4.1 Barriers to Entry”.

Black Swan: An event that is unpredictable, has significant

consequences, and is (or at least appears to be) retrospectively

explainable. The term “Black Swan” was coined by Nassim Nicholas

Taleb in his book The Black Swan.

Brand: A brand is commonly defined as “a name, mark, logo, symbol or

other identifier used to distinguish a product or organisation”. The

power of a brand derives not from the particular symbol used but from

the stories that people tell about it, and so a brand might more

accurately be defined as “what people say about you (your product, or

your organisation) when you’re not in the room.”

Break-even analysis: Break-even analysis is relevant when trying to

decide whether to launch a new product or invest in a project with high

fixed costs.

Break-even analysis calculates the point at which revenues will equal

associated costs. Break-even analysis can be used to calculate the ‘margin

of safety’, the amount by which revenues are expected to exceed the

break-even point.

𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠

𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡

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𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆ℎ𝑎𝑟𝑒 = 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑜𝑙𝑢𝑚𝑒

Break-even analysis is a form of supply side analysis that considers costs

(variable costs and fixed costs). However, it does not consider how

demand may change at different price levels, and so it may make sense

to combine break-even analysis with some form of demand side analysis.

Bund: The German government’s federal bond, similar to Treasury

bonds in the U.S.

Bundling: Combining products or services together in order to sell

them as a single unit. Bundling can benefit a company by allowing it to

increase sales volume and market share. Bundling can also benefit

customers by allowing them to purchase the bundle for less than the

price of the bundled products if purchased separately.

CAGR: Compound annual growth rate.

𝐶𝐴𝐺𝑅 = (𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

𝑆𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒)

(1

# 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠)

− 1

CFA: Stands for “Chartered Financial Analyst”. For more information,

visit the CFA Institute.

Coase theorem: An economic theorem outlined by Ronald Coase in an

article entitled The Problem of Social Cost published in October 1960 in

the Journal of Law and Economics. The theorem states that if trade in

an externality is possible and there are no transaction costs, bargaining

will lead to an efficient outcome regardless of the initial allocation of

property rights. In practice, poorly defined property rights or obstacles

to bargaining (e.g. transaction costs, lack of an organised market, or the

presence of asymmetric information) tend to prevent Coasian

bargaining.

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Comparative advantage: Comparative advantage is an economic

theory that explains the existence of gains from trade.

David Ricardo developed the classical theory of comparative advantage

in 1817 to explain why a country whose workers are more efficient at

producing every good compared with workers in other countries will still

gain from international trade.

In general terms, an individual, firm or country has a comparative

advantage in producing a good if it can produce the good at a lower

Opportunity cost relative to other individuals, firms or countries.

Complimentary goods: Any goods for which an increase in demand

for one leads to an increase in demand for the other. Examples of

complimentary goods include printers and ink cartridges, DVD players

and DVDs, and Microsoft Windows and PCs.

Confirmation bias: The common tendency for people to favour

information that confirms their existing beliefs. Confirmation bias is

relevant in many business contexts. For example, in stock trading

confirmation bias can lead a trader to ignore evidence that her trading

strategies will lose money leading her to be overconfident.

Conglomerate Diversification: A form of diversification where a firm

adds new products that are unrelated to existing products and which

target new customer segments.

Cost benefit analysis: A type of analysis that involves weighing up the

total expected costs and benefits of one course of action against one or

more other courses of action. For more information, see “4.2 Cost

Benefit Analysis”.

Credit default swap (CDS): A form of insurance policy which obliges

the seller of the CDS to compensate the buyer in the event that the loan

defaults. In the event of default, the buyer of the CDS would normally

receive money and the seller of the CDS would receive the defaulted

loan (and the right to recover amounts outstanding under the loan).

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Cross Rate: The exchange rate between two currencies inferred from

each currency’s exchange rate with a third currency.

Current Ratio: Otherwise known as the “liquidity ratio”, “cash asset

ratio”, “cash ratio” or “working capital ratio”, the current ratio measures

a company's ability to repay short term liabilities.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Customer Lifetime Value: Customer lifetime value is a prediction of

the entire future value that a company expects to derive from its

relationship with a customer. It can be a useful tool for a company that

is trying to decide which customer segments to target and how much to

spend on customer acquisition.

𝐶𝐿𝑉 = 𝑃𝑟𝑜𝑓𝑖𝑡1 + 𝑃𝑟𝑜𝑓𝑖𝑡2 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)2 + 𝑃𝑟𝑜𝑓𝑖𝑡3 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)3 + ⋯

Debt to Asset Ratio: The debt ratio is the ratio of total debt to total

assets, and can be understood as the percentage of a company’s assets

that are financed by debt.

𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Debt to Equity Ratio: A measure of a company’s financial leverage

calculated by dividing total debt by shareholder’s equity.

𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟′𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Discouraged worker: A person who does not have a job and is

available to work but who has stopped actively looking for work. This

may happen because the unemployed person:

Becomes discouraged due to previous unsuccessful attempts to

obtain work;

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Believes (reasonably or not) that there are no jobs available in their

industry or location;

Lacks the skills needed for the jobs which are available, either

because they never had the required skills or because their skills

have eroded due to a long period of unemployment;

Is discriminated against by prospective employers for some reason

beyond their control (e.g. age, race, gender); or

Becomes addicted to Twinkies and day time television.

Diseconomies of scale: A situation where the average cost of

production increases as output increases. For more information, see “4.3

Economies of Scale”.

Disruptive innovation: A term coined by HBS Professor Clayton

Christensen to describe the process by which a product or service

initially takes root in simple applications at the bottom of a market and

then consistently moves ‘up market’, eventually displacing established

competitors.

Diversification: In the 3.4.1 Product / Market Expansion Matrix,

originally explained by Igor Ansoff in his 1957 Harvard Business Review

article, diversification is defined as a growth strategy whereby an

organisation develops new products for new markets.

Diversification is a high risk growth strategy, and a company should look

for markets with strong growth and high levels of industry attractiveness

(see “4.8 Porter’s Five Forces”).

Diversification might involve a company adding new products, which

appeal to existing customers (“Horizontal diversification”); it might

involve a company acquiring a customer or supplier (“Vertical

Integration”); or it might involve a company moving into an entirely

new industry (“Conglomerate Diversification”).

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Economic indicator: An economic statistic (e.g. the unemployment

rate, GDP, or inflation) which indicates the strength of the economy or

the expected future performance of the economy.

Economies of scale: A situation where the average cost of producing a

unit of output decreases as the quantity of output increases. For more

information, see “4.3 Economies of Scale”.

Economies of scope: A situation where a firm can produce two or

more products at a lower per unit cost than would be possible if it

produced only the one. For more information, see “4.4 Economies of

Scope”.

Elevator pitch: A high-level overview of whatever it is that you are

selling and which is designed to just get the conversation started. For

more information, please read the articles entitled “The Elevator Pitch”

and “12 Tips for Creating an Effective Pitch”.

Equity: Assets minus Liabilities. Equity holders are the owners of the

business.

Expenses: Costs incurred by a business over a specified period of time

to generate the revenues earned during that period. For more

information, read the article entitled “Understanding Financial

Statements 101”.

Externality: Costs incurred or benefits gained by third parties resulting

from an economic activity. Externalities that confer a benefit are

referred to as “positive externalities”, an example of which would be

honey bees kept for honey that help to pollinate neighbouring crops.

Externalities that impose a cost are referred to as “negative

externalities”, an example of which would be a factory that creates air

pollution and imposes health and clean-up costs on the surrounding

community.

Fiscal Policy: Government policy relating to government spending and

taxes.

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Fisher Effect: The Fisher effect describes the relationship between real

interest rates, nominal interest rates and inflation. The Fisher effect

states that a change in the nominal interest rate is equal to the real

interest rate plus the inflation rate:

(1 + 𝑖𝑁𝑜𝑚) = (1 + 𝑖𝑅𝑒𝑎𝑙) × (1 + 𝑟𝑖𝑛𝑓)

Fixed cost: A cost that does not vary with the quantity of output

produced. It is important to understand that fixed costs are fixed only

in the short term. In the long run nearly all costs are variable. For

example, in the long run a company could renegotiate supply contracts

or move its factories to a lower cost jurisdiction.

Forward Contract: A forward contract is a customized contract to buy

or sell an asset on a future date at a pre-determined price (the forward

price). A forward contract is non-standardized, and so can be used by

businesses to manage risk.

Futures Contract: A futures contract is a standardized contract to buy

or sell an asset on a future date at a pre-determined price (the futures

price). A futures contract is standardized and traded on a futures

exchange. Settlement may take place through physical delivery of the

underlying asset or payment in cash.

Greenspan Put: The monetary policy of Alan Greenspan and the U.S.

Federal Reserve from the late 1980’s to the mid-2000’s, which involved

significantly lowering interest rates in the wake each financial crisis.

Homogenous Product: Any good or service for which buyers perceive

no difference between the products offered by different suppliers.

Examples of homogenous products might include wheat, corn and oil.

Horizontal competition: Competition between entities at the same

stage of production. See also, “Vertical competition”.

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Horizontal diversification: A form of diversification where a firm adds

new products that may be unrelated to existing products but are likely to

appeal to existing customers. See also, “Vertical Integration” and

“Conglomerate Diversification”.

Inflation: The rate at which the overall price level for goods and

services is rising.

Investment Operation: An operation which, upon thorough analysis,

promises safety of principal and an adequate return. Operations not

meeting these requirements are speculative (Ben Graham, The

Intelligent Investor).

Joint Production: Production where the production process for two or

more different goods is connected. Producing the goods separately

would result in increased costs. Joint production may occur naturally, for

example a chicken farm produces both chicken wings and chicken

breasts. Joint production may also be used because it provides 4.4

Economies of Scope.

Leverage (common usage): Make use of.

Leverage (investment definition): The use of borrowed capital to

partially or fully fund an investment. Leverage is used when an investor

expects the return on investment to be greater than the cost of debt, in

which case the investor’s return on equity will be greater than the return

on investment. In other words, the returns are leveraged.

Liability (accounting definition): The debt of a company, a claim that

creditors have on the company’s resources.

LIBOR: The London Interbank Offered Rate is a benchmark rate

quoted by the world’s leading banks as a rate of interest that they would

charge financial institutions for short term loans. LIBOR is used

extensively in finance as a first step in calculating appropriate rates of

interest for a variety of financial products.

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Liquidity trap: A situation where interest rates are zero (or near zero)

and a central bank is no longer able to stimulate the economy by

controlling short term interest rates. In 2008, the US Federal Reserve

faced a liquidity trap and employed quantitative easing (i.e. electronically

generating money) in an attempt to stimulate the economy.

Loss aversion: A commonly observed behavioural tendency whereby

people prefer to avoid a loss than to make a commensurate gain. For

more information, read the article entitled “Loss Aversion”.

Ludic Fallacy: A term coined by Nassim Nicholas Taleb in The Black

Swan. The term refers to the misuse of games to model real-life

situations. Taleb explains the fallacy as “basing studies of chance on the

narrow world of games and dice.”

Madoff Scheme: See also “Ponzi Scheme”.

Management consulting (Institute of Management Consultants’

definition): The provision to management of objective advice and

assistance relating to the strategy, structure, management and operations

of an organisation in pursuit of its long-term purposes and objectives.

Such assistance may include the identification of options with

recommendations; the provision of an additional resource and/or the

implementation of solutions.

Metcalfe's law: A rule which states that the value of a network is

proportional to the square of the number of connected users (or

connected devices). Metcalfe’s law explains the network effect which

exists for products such as fax machines, telephones, eBay, WhatsApp

and Facebook.

Monopolistic competition: A situation in which consumers are taught

to perceive differences between products. As a result, even though there

may be a large number of producers, each producer has a degree of

control over price.

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Monopoly: A situation where a market has only one supplier for a

particular good or service. The term may also be used where one seller

has substantial control of the market. Monopolies are characterised by a

lack of competition and a lack of viable substitutes.

Monopsony: A situation where a market has only one buyer for a

particular good or service. The term may also be used where one buyer

has substantial control of the market. See also “Walmart Effect”.

Moral Hazard: Any situation in which a person or entity is not fully

responsible for the consequences of its actions. As a result, the entity

may take greater risks than it would have otherwise because it is not

responsible for paying the full cost if things go badly. For more

information, see “4.7 Moral Hazard”.

Mortgage Securitisation: A process of packaging and selling mortgage

debt which involves:

1. Purchasing mortgages from banks or mortgage brokers;

2. Packaging the mortgages into large pools; and

3. Selling “shares” in these mortgage pools to investors.

Natural monopoly: An industry where one firm can produce the

desired output at a lower social cost than could be achieved by two or

more firms (social costs being the sum of private and external costs).

Natural monopolies exist because of the existence of economies of scale

and examples include railways, water services, and electric utilities.

Net Present Value: The NPV of an investment is the present value of

the series of expected future cash flows generated by the investment

minus the cost of the initial investment.

𝑁𝑃𝑉 = 𝐶𝐹1

(1 + 𝑟)1+

𝐶𝐹2

(1 + 𝑟)2+ ⋯ +

𝐶𝐹𝑛

(1 + 𝑟)𝑛+

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒

(1 + 𝑟)𝑛− 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝐶𝐹𝑛 × (1 + 𝑔)

𝑟 − 𝑔

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Where r = discount rate; CFt = expected cash flow in year t; g = long

term cash flow growth rate.

For more information, see “3.7.2 Net Present Value”.

Network effects: The situation whereby a product or service becomes

more valuable as more people use it (also known as network

externalities). One example is eBay; as more buyers use the online

auction site it becomes more valuable to each seller, and as more sellers

use the site it becomes more valuable to each buyer.

NINJA Loan: Any loan made where the borrower has No Income, No

Job, and No Assets.

Nominal value: A value expressed in dollar terms. For example, if a Big

Mac costs $3 this year and $6 next year, then we would say that the

nominal price of a BigMac has doubled.

Numéraire: An economic term meaning “the unit of account”. In

French, the term means “money”, “coinage” or “face value”. A

country’s currency normally acts as the numéraire and is used to measure

the worth of other goods and services within the country. In the absence

of currency, you could define a “numéraire good” (e.g. salt, copper,

gold) to have a fixed price of 1; the worth of other goods and services

could then be measured relative to the numéraire good.

Oligopoly: A situation where a market is dominated by a small number

of suppliers for a particular good or service. Oligopolies are

characterised by a lack of competition and a lack of viable substitutes.

Each firm in an oligopoly needs to take into account the likely actions

and reactions of other firms when developing its strategic plan of action.

Operating Cash Flow Ratio: A liquidity ratio that measures how well a

company’s current liabilities are covered by cash flow from operations.

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𝑂𝐶𝐹 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Opportunity cost: What you give up in order to obtain something; the

value of the next best alternative.

Option: A derivative financial instrument which grants its owner the

right, but not the obligation, to buy or sell an underlying asset at a pre-

established price for a specified period of time.

Organic growth: Growth that a company can achieve by increasing

output and sales. This excludes growth achieved as a result of mergers

and acquisitions since this growth is purchased not generated internally.

For example, growth that Facebook achieved as a result of its purchase

of Instagram or WhatsApp is not organic growth.

Outcome bias: The tendency for people to judge a decision based on

its outcome rather than the quality of the decision at the time it was

made. For example, a person who learns that a friend made a large profit

from investing in the stock market may, without any additional evidence,

form the view that investing in stocks is a good idea; this person is

suffering from outcome bias.

Overconfidence bias: A common behavioural trait whereby a person’s

confidence in their opinions is invariably higher than the accuracy of

those opinions.

Pareto efficient: An economic allocation is said to be “Pareto efficient”

if no person can be made better off without making at least one person

worse off. Pareto efficiency does not imply that an economic allocation

is fair or equitable.

Perpetuity: A perpetuity is a constant stream of identical cash flows

with no end.

𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙

(1 + 𝑟)1+

𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙

(1 + 𝑟)2+

𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙

(1 + 𝑟)3+ ⋯

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𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙

𝑟

Where r = discount rate; CFannual = annual cash flow.

Ponzi Scheme: Any kind of fraudulent investment operation that pays

returns to investors from their own money or money paid by subsequent

investors rather than from any profits earned. See also, “Madoff

Scheme”.

Price discrimination: Price discrimination involves setting a different

price for the same product for different customer segments. First degree

price discrimination involves charging each customer a different price

based on their willingness to pay. Second degree price discrimination

involves varying the price according to the quantity demanded. Third

degree price discrimination involves varying the price by location or

customer segment. For example, charging higher prices in expensive

suburbs or tourist locations or offering discounted prices for students.

Price elasticity of demand: A measure of the responsiveness of the

quantity demanded to changes in the price level. Price elasticity of

demand is relevant for pricing strategy and for examining customer price

sensitivity.

𝐸𝑑 =%∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑

%∆𝑃𝑟𝑖𝑐𝑒

If the price elasticity of demand is less than one in absolute value

(|𝐸𝑑| < 1) then demand is said to be “inelastic”. That is, changes in

price have a relatively small effect on the quantity demanded. As a result,

total revenue will rise if prices are raised.

If the price elasticity of demand is greater than one in absolute value

(|𝐸𝑑| > 1) then demand is said to be “elastic”. That is, changes in price

have a relatively large effect on the quantity demanded. As a result, total

revenue will rise if prices are lowered.

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Price maker: A firm that has some control over the price that it charges

for a product. For example, a Monopoly or a firm operating within

Monopolistic competition.

Price taker: A firm that can change production and sales of a product

without significantly affecting the market price.

Principle-agent problem: The principle-agent problem occurs when a

principal employs an agent to perform duties on its behalf.

The problem arises where there are conflicts of interest between the

principle and the agent (for example, the principle prefers that the agent

exert more effort and the agent prefers to exert less effort), the agent is

not required to pay the full cost if things go badly (that is, moral hazard

issues exist), and the principle cannot directly monitor the agent’s

behaviour (that is, there is asymmetric information).

An example of where the principle-agent problem arises is in the

relationship between management (the agent) and shareholders (the

principle).

Possible solutions to the principle-agent problem include:

1. Aligning the interests of principle and agent by providing the agent

with performance incentives;

2. Reducing the moral hazard issue by promising the agent an

ownership stake in the organisation.

Product differentiation: The process of distinguishing a good or

service in order to create an impression of value in the mind of the

customer.

Profit Margin:

Gross Profit Margin: Gross profit margin measures how much of every

dollar of sales revenue remains after subtracting the cost of goods sold.

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

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𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 − 𝐶𝑂𝐺𝑆

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Net Profit Margin: Net profit margin measures how much out of every

dollar of sales revenue a company actually keeps. Net profit margin is

useful when comparing companies in similar industries. A higher net

profit margin indicates a more profitable company that has better

control of its costs.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 − [𝐶𝑂𝐺𝑆 + 𝐴𝑙𝑙 𝑜𝑡ℎ𝑒𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠]

𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Contribution Margin: A cost accounting concept that allows a company

to determine the profitability of individual products.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠

𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Equivalently:

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡

𝑃𝑟𝑖𝑐𝑒

Public good: A public good is a good that a person can consume

without reducing its availability to others (that is, the good is “non-

rival”) and from which no one can be excluded (that is, the good is

“non-excludable”). Examples of public goods might include national

defence, public television, radio, knowledge, fresh air and sunshine.

Pull System of Inventory Control (just in time): The pull system of

inventory control involves producing just enough to fill customer

orders. An advantage of this system is that there will never be excess

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inventory and so inventory storage costs are minimized. A disadvantage

of this system is that supplier bottlenecks or limited operating capacity

can lead to ordering backlogs and customer dissatisfaction.

Push System of Inventory Control: The push system of inventory

control involves forecasting customer demand and producing enough to

meet forecast demand. An advantage of this system is that there will

typically be enough products on hand to satisfy customer orders.

Disadvantages include (a) the difficulty of forecasting demand, and (b)

the cost of storing excess inventory if actual demand falls short of

expectations.

Quantitative easing: A monetary policy tool sometimes employed by

central banks to stimulate the economy when conventional monetary

policy becomes ineffective. Quantitative easing involves increasing the

money supply by purchasing government bonds or other financial assets

with newly generated money. For more information, see “4.9

Quantitative Easing”.

Quick (Acid Test) Ratio: The quick ratio is more rigorous than the

current ratio, and measures whether a company has enough short-term

assets to cover short term liabilities without selling inventory.

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑎𝑠ℎ + 𝐴 𝑅⁄ + 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Real value: A value adjusted for inflation or deflation. For example, if a

Big Mac costs $3 this year and $6 next year and inflation is 100%, then

the real price of a BigMac has not changed.

Recency bias: The common tendency for people to place more weight

on recent data or experience compared with earlier data or experience.

An example of recency bias is where a salesperson with an acceptable

long term sales record becomes discouraged after a few consecutive

weeks of unsuccessful sales calls. A few weeks of poor performance can

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count in the sales person’s mind as much as a few months or years of

prior success.

Recession: Broadly speaking, a recession is a period of slow or negative

economic growth, usually accompanied by rising unemployment.

Economists sometimes define a recession more formerly as “two

consecutive quarters of falling GDP”.

Replacement value: An estimate of how much it would cost to build

equivalent resources or capabilities from scratch.

Return on Investment: ROI is a performance measure that a company

can use to evaluate the return from an investment or to compare the

returns of a number of different investments.

𝑅𝑂𝐼 = 𝐺𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Revenue: Income generated from trading or, for example, from selling

off an asset or piece of the business. Revenue should be recorded when

the sale is made as opposed to when the cash is received. For more

information, please read the article entitled “Understanding Financial

Statements 101”.

Rule of 70: The Rule of 70 is a simple rule of thumb that can be used to

figure out roughly how long it will take for an investment to double,

given an expected growth rate. The rule can be described by the

following equation:

𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥) = 70

𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

For more information, see “4.10 Rule of 70”.

Spillover: Externalities that result from economic activity and affect

people who are not directly involved in the activity. Spillover can be

positive or negative. Pollution that leaks out of a manufacturing plant

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and into a local river would have a negative spillover effect on local

fishermen. The beauty of the buildings in Oxford would have a positive

spillover effect on locals and tourists.

Substitute goods: Any goods for which an increase in demand for one

leads to a fall in demand for the other. Substitute goods represent a

form of indirect competition. Examples of substitute goods might

include petroleum and natural gas, or Vegemite and Nutella.

Sunk cost: Sunk costs are expenditures that have already been made,

and which cannot be recovered. Sunk costs should not be factored into

the decision making process when evaluating a potential course of

action.

Sunk cost fallacy: The common tendency for people to factor amounts

of money already spent – the sunk costs – into their decision-making

process. This is irrational since sunk costs cannot be recovered, and so

are not relevant when making a decision about a future course of action.

An example of the sunk cost fallacy would be where a company factors

past R&D spending into its future pricing strategy.

SWAP Agreement: An agreement to exchange one series of cash flows

for another for a set period of time. One of the series of cash flows will

normally be more uncertain, such as a floating interest rate, foreign

exchange rate, stock price or commodity price. SWAP Agreements are

not traded on an exchange, they are customized contracts traded

between private parties in the over-the-counter market.

Switching costs: Any costs that a customer incurs (for example, time,

money, effort) as a result of changing suppliers, brands or products.

Switching costs will be affected by various factors including the length

of customer contracts, the existence of customer loyalty programs, and

the price performance and compatibility of complimentary products.

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Underemployment: A situation where a person’s capacity to work is

not fully utilised. This may occur due to (1) over-qualification, (2)

involuntary part-time work, or (3) over-staffing.

Vanilla: Plain or simple version.

Variable cost: A cost that varies with the quantity of output produced.

When making decisions in the short run, variable costs are the only costs

that should be considered because, in the short term, a company cannot

change its fixed costs.

Vertical competition: Competition which takes place between firms at

different stages of production. Suppliers and customers within the

supply chain may be able to exert their bargaining power to compete for

a larger share of industry profits.

Vertical Integration: A form of diversification in which a firm expands

its business to different points in the supply chain. For example, taking

over a supplier (backwards vertical integration) or taking over a

customer (forwards vertical integration).

Backwards vertical integration: A company engages in

backwards vertical integration when it purchases one or more

suppliers that produce inputs that the company uses to produce

final goods or services. For example, a car company might

purchase a tire company, a glass company, or an engine

manufacturer. Benefits of backwards vertical integration may

include (1) creating stable supply, (2) ensuring consistent quality of

inputs, and (3) restricting a competitor’s access to essential

supplies.

Walmart Effect: A situation where a single buyer gains substantial

control of a market as the major purchaser of goods or services. See

also, “Monopsony”.

Wealth: [Note that both of the definitions below use “time” as the

relevant yardstick, not “money”.]

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1. Real wealth is discretionary time; money is merely the fuel

(attribution: Alan Weiss);

2. A measure of a person’s ability to survive so many number of days

forward into the future if they were to stop working today

(attribution: Robert Kiyosaki).

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2. Industry Analysis

2.1 Macro Environment

2.1.1 PEST Analysis

Understanding the big picture can help reveal hidden

opportunities and threats

1. Background

In 1967, Harvard Professor

Francis Aguilar wrote a

book entitled “Scanning the

Business Environment” in

which he identified four

important factors –

Economic, Technical, Political, and Social – that a business can use to

better understand the big picture.

While the ordering of the letters may have changed, the four factors that

Aguilar identified half a century ago have not, and they form the basis of

PEST Analysis.

2. Relevance

If you are thinking about producing a strategic plan, developing a new

product, entering a new market, engaging in a joint venture, acquiring a

competitor, launching a start-up, or financing a new project then it

probably makes sense to understand the big picture issues that could

affect the project’s success.

Conducting a PEST Analysis can reveal hidden opportunities and

threats, and allow you to adapt your approach to achieve a more

favourable outcome.

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3. Importance

There is something inherently appealing about a four-part model, and its

simplicity makes PEST Analysis a convenient and practical tool for

understanding the macro environment.

Conducting a PEST Analysis can be helpful for three reasons:

1. Understanding the facts: Understanding the big picture can help a

business make informed decisions, and avoid making incorrect

assumptions based on past experience;

2. Anticipating change: Understanding the macro environment can

help a business identify trends and anticipate change, allowing it to

take advantage of opportunities and manage potential threats; and

3. Avoiding failure: Understanding the macro environment can help a

business (and its investors) to identify projects that are likely to fail

due to unfavourable conditions. Knowing which battles not to fight

can often be half the battle.

4. PEST Analysis Explained

“PEST” is an acronym that stands for “Political, Economic, Social and

Technological” – the four factors that a business will want to consider

when scanning the macro environment.

PEST Analysis is a simple framework that uses these four factors to

examine the macro environment in order to understand the potential

implications for a business unit, product or project. Insights gained from

the analysis can be used to develop a strategic plan of action.

PEST Analysis can be used as part of a broader situation analysis.

Figure 1: Situation Analysis

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There is a long list of alternative frameworks that could be used to scan

the macro environment. However, they generally complicate the analysis

by adding factors that could be dealt with more simply using PEST

Analysis. Some of the other variations include:

1. SLEPT: Social, Legal, Economic, Political, and Technological;

2. PESTEL: Political, Economic, Social, Technological,

Environmental, and Legal;

3. PESTELI: Political, Economic, Social, Technological,

Environmental, Legal, and Industry Analysis;

4. STEEPLED: Social, Technological, Economic, Environmental,

Political, Legal, Ethical, and Demographic;

5. PESTLIED: Political, Economic, Social, Technological, Legal,

International, Environmental, and Demographic; and

6. LONGPESTLE: Local, National, and Global versions of PESTLE

(might be useful for multinational organisations).

5. Conducting a PEST Analysis

Conducting a PEST Analysis involves considering issues relating to the

four key factors: Political, Economic, Social, and Technological.

The four factors will vary in significance depending on the nature of the

business. For example, social factors might be relevant for a retail

business, but political factors may be more relevant for a munitions

dealer.

The purpose of a PEST Analysis is to identify potential implications for

a specific business unit, product or project, and so it is important to be

clear about this purpose before commencing the analysis.

Below we outline a range of issues that you might want to consider

when conducting a PEST Analysis.

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1. Political

Potential political issues include:

1. Laws and regulations that a company may need to comply with

(tax, competition, employment, anti-discrimination, consumer

protection, environmental, corporate social responsibility, and

international law);

2. Property rights, including protection of intellectual property

(trademarks, copyrights, patents, registered designs, trade secrets,

software and circuit layouts);

3. Industry regulation – How is the industry regulated? Have there

been any recent changes? Are there any planned changes? Is there

a trend towards regulation or deregulation?

4. Government policy, trade unions, lobby groups, and the electoral

cycle. Who holds political power? How might this change at the

next election?

5. Rule of law, bureaucracy and corruption; and

6. Political stability, war and conflict.

2. Economic

Potential economic issues include:

1. GDP and market growth rates;

2. Inflation, interest rates, and monetary policy;

3. Exchange rates – For companies engaged in cross border trade it

may be important to consider exchange rate volatility and the

need for a SWAP Agreement;

4. Availability of credit, as well as the liquidity and depth of the

credit markets;

5. Labour costs and the unemployment rate. Will it be possible to

hire skilled workers?

6. Government support including infrastructure investment, grants,

subsidies, and tax breaks;

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7. Tax issues including corporate, employee, and value added taxes;

8. Trade restrictions, subsidies, tariffs and quotas;

9. Business cycle, stock market trends, market prices, and

seasonality issues;

10. Consumer confidence; and

11. Industry specific factors.

3. Social

Potential social issues include:

1. Population growth;

2. Age distribution and life expectancy. Are generational shifts likely

to affect customer preferences and market demand?

3. Income distribution, average disposable income, and social

mobility;

4. Attitudes towards work;

5. Family size and structure;

6. Health levels, and health consciousness; for example, attitudes

towards smoking and drinking;

7. Education levels;

8. Emphasis on safety;

9. Social norms; for example, people tend to take holidays over

Christmas and in the summer;

10. Fashions, fads, trends, role models, and influential personalities;

11. Buying patterns and consumer preferences. For example, brand

preferences, and attitudes toward product quality, customer

service, fair trade, green, and organic products;

12. Ethnic and religious factors;

13. Cultural and sporting events; and

14. Prohibitions, taboos, and ethical issues.

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4. Technological

Technological issues relate to the state of technology and its rate of

advancement, and may have implications for the competitive intensity of

an industry (for example, new technologies can reduce barriers to entry)

or may lead to disruptive innovation (for example, Amazon, Airbnb, and

Uber).

Potential technological issues include:

1. Emerging technologies and trends. For example, 3D printing,

collaborative consumption, and wearable technology;

2. Technology level and rate of change in an industry;

3. Technology lifecycle;

4. Location of technology hubs or clusters; university and business

partnerships;

5. Supporting infrastructure like high speed internet;

6. R&D spending;

7. Availability of financing for technology and innovative projects;

8. Automation; and

9. Legal frameworks, for example, protection of intellectual property

and support for crowd funding.

6. PEST Analysis Template

If you would like to download a template that can be used to conduct a

PEST Analysis, please click here.

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2.2 Micro Environment

2.2.1 Business Landscape Survey

Before taking decisive action, it may be a good idea to assess the

lay of the land

According to Sun Tzu, the quality of decision “is like the well-timed

swoop of a falcon which enables it to strike and destroy its victim.”

Much like a circling falcon overhead, a company needs to take a 10,000

foot view of the business landscape before it can take swift and decisive

action.

The framework outlined in this section provides a structure that

consultants and business leaders can follow to help them examine the

business situation.

1. Relevance

Having a framework to assess the business situation is relevant to any

company in the context of making strategic decisions and, what’s more,

every important decision that a company makes will in some way be

strategic.

In the pursuit of growth, should a company enter a new market, develop

a new product, launch a start-up, form a joint venture, or acquire a

competitor? In the bid to cut costs, should a company reduce

headcount, outsource production to a supplier, or utilize lower cost

distribution channels? How should the company position itself within its

industry?

In order to find answers to these key strategic questions, a company and

its executives need to develop a clear understanding of the business

landscape, and this section provides a structured framework that can be

used to guide the exploration process.

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2. Importance

Failure to properly assess and understand the

business landscape can have billion dollar

implications and affect the course of an entire

industry.

The story that best illustrates this point was

IBM’s secret project in 1980 to create the

IBM Personal Computer.

As part of the project, IBM made three

surprising decisions:

1. It allowed Microsoft the right to produce the operating system

software and market it separately from the IBM PC;

2. It chose to purchase the microprocessor from Intel; and

3. It opted to make the IBM PC an “open architecture” product,

publishing technical guides to the circuit designs and software

source code.

These three strategic decisions helped to shift market power in the PC

industry away from IBM and towards Microsoft and Intel.

Although the PC market grew quickly, companies like Compaq, Dell and

HP soon reverse engineered the IBM PC and, since IBM had made it an

open architecture product, they were able to sell a large number of

clones, known as IBM compatibles, which dramatically increased the

intensity of competition in the PC industry. Meanwhile, booming PC

sales from multiple vendors provided Microsoft and Intel with a

lucrative and rapidly growing market for operating system software and

microprocessors.

Despite the fact that IBM had set the technology standard in the

personal computer industry, it failed to capture the lion’s share of

industry profits. It helped Microsoft and Intel establish lucrative markets

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for themselves, but was not itself able to compete in these markets due

to high barriers to entry including patents, the 4.5 Experience Curve

effect and 4.3 Economies of Scale.

IBM’s three strategic missteps were a blessing for Microsoft and Intel,

which as of 2015 have a combined market cap of over US$555 billion,

but are an enduring sore point for IBM, which decided to jettison its PC

business to Lenovo in 2005 for a mere US$1.8 billion.

The story of the IBM PC is a cautionary tale. Companies that fail to

assess the business landscape before taking action may find themselves

in an untenable position.

3. Surveying the Business Landscape

A popular way to examine the competitive intensity and attractiveness of

an industry is to use 4.8 Porter’s Five Forces, a technique which was first

outlined by HBS Professor Michael Porter in his 1979 book Competitive

Strategy.

While Porter’s Five Forces remains a useful reference point, and its core

elements are incorporated into the framework outlined in this section,

we do not use it directly to assess the business landscape since it fails in

one important respect. It does not consider the market power and

unique characteristics of the company from whose perspective we are

supposed to be analysing the industry. For example, an industry may

appear attractive from the perspective of a cash rich tech savvy player

like Google but appear quite unattractive from the perspective of other

firms.

Through their strategies, firms have the ability to change industry

structure, and so the business landscape will always need to be assessed

relative to the market power of a particular organisation.

In order to assess the business landscape, we will examine the three

entities whose market power, strategies and actions will, in any industry,

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affect a firm’s profitability: the customer, the competition and the

company itself.

3.1 Examining the Customer

“There is only one boss. The customer. And he can fire everybody in the

company from the chairman on down, simply by spending his money somewhere

else.”

~ Sam Walton, founder of Walmart

A good first step in assessing the business landscape is to examine the

customer, the people whose problems the industry is trying to solve.

Below we outline eight (8) factors to consider when examining the

customer.

1. Customer Identification

In general terms, who is the customer?

In trying to identify the customer, remember that the person who makes

the purchase decision, the person who pays (the customer), and the end

user (the consumer) may all be different people. For example, a doctor

may prescribe medicine that will be paid for by an insurance company

(the customer) and ultimately used by a patient (the consumer).

2. Customer Segmentation

Customer segmentation can make it easier to understand customer

needs and preferences, and to understand the size and growth rate of

different revenue streams. For example, it may make sense to segment

customers by:

1. Age group;

2. Gender;

3. Income level;

4. Employment status;

5. Distribution channel;

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6. Region;

7. Product preference;

8. Willingness to pay;

9. New versus existing customers; or

10. Large versus small customers.

3. Size

How big is the market? How big is each customer segment? How many

customers are there and what is the dollar value of those customers?

4. Growth

How fast is the market growing? What is the growth rate of each

customer segment?

5. Customer Preferences

What do customers want? Do different customer segments want

different things? Are the needs and preferences of customers changing

over time?

6. Willingness to Pay

How much is each customer segment willing to pay?

How price sensitive is each customer segment? For example, students

will normally be very price sensitive, which means that offering student

discounts may increase units sold by enough to raise total revenues.

7. Bargaining Power

What is the concentration of customers in the market relative to the

concentration of firms?

If there is a small number of powerful customers who control the

market, then it may be necessary to either play by their rules or search

for a more favourable market. Examples of this kind of customer

include Walmart in the market for homeware products, Amazon in the

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publishing industry, and the U.S. Department of Defence in the market

for defence equipment.

Do customers face high switching costs? If customers face high

switching costs then this will reduce their bargaining power. Switching

costs will be affected by various factors including the length of customer

contracts, the existence of customer loyalty programs, and the price

performance and compatibility of complimentary products.

8. Distribution

What is the best way to reach customers? Does each customer segment

have a preferred distribution channel?

Seven (7) distribution channels that a firm might use to reach customers

include:

1. Network marketing;

2. Mail order;

3. Online store;

4. Factory outlet;

5. Retail store;

6. Supermarket; and

7. Department store.

3.2 Examining the Competition

“Competition is not only the basis of protection to the consumer, but is the

incentive to progress.”

~ Herbert Hoover, 31st President of the United States

In order to understand the business landscape it is also important to

understand the competition, and this can be done by examining the

Horizontal competition (competition between firms at the same stage of

production) and Vertical competition (competition between firms within

the supply chain).

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3.2.1 Horizontal Competition

Competition can come from firms within an industry who are offering

similar solutions to the same group of customers (for example, Pepsi

and Coca Cola).

Competition can also come from firms in other industries who produce

substitutes. Substitutes may have quite different characteristics (for

example, petroleum and natural gas) but they represent a form of

indirect competition because consumers can use them in place of one

another (at least in some circumstances). For example, petroleum and

natural gas might both be used to produce heat and energy.

Below we outline eleven (11) factors to consider when examining the

competition.

1. Competitor Identification

Who are the company’s major competitors? Taking Cadbury as an

example, some of its major competitors include Lindt, Ferrero, Nestlé,

Hershey’s and Mars. What products and services do they offer?

2. Substitutes

Who are the company’s indirect competitors? That is, which firms are

producing substitutes?

To identify indirect competitors, it helps to take a broader view of what

the company offers. For example, Cadbury sells chocolate, but more

broadly it might be thought of as a snack food company, and so indirect

competitors might include companies like Lays, Cheetos and Doritos.

3. Competitor Segmentation

Is it possible to segment competitors in a meaningful way? The

competition might be grouped by distribution channel, region, product

line, or customer segment.

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For example, the FOX Broadcasting Company might segment the

competition by region. In America, competitors include PBS, NBC, CBS

and ABC. While in Australia, competitors include companies such as

Channel 7, 9 and 10 as well as ABC and SBS.

4. Size and Concentration

What are the revenues and market shares of major competitors?

What is the concentration of competitors in the industry? That is, are

there lots of small competitors (a low concentration industry) or a few

dominant players (high concentration industry)? Examples of high

concentration industries include oil, tobacco and soft drinks. Examples

of low concentration industries include wheat and corn.

5. Performance

What is the historical performance of the competition? Relevant

performance measures might include profit margins, net income, and

return on investment.

6. Industry Lifecycle

Where is the industry in its lifecycle: early stage, growth, maturity or

decline?

7. Industry Drivers

What drives the industry: brand, product quality, scale of operations, or

technology?

8. Competitive Advantage

What is the competition good at? How sustainable are these advantages?

What are their weaknesses? How easily can these weaknesses be

exploited?

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9. Competitive Strategy

What competitive strategy is the competition pursuing? Is the

competition producing products that are low cost or differentiated?

What customer segments is the competition targeting?

What is the competition’s pricing strategy and distribution strategy?

What is the competition’s growth strategy? That is, are they seeking

growth by focusing on customer retention and increased sales volume,

by entering new markets, or by launching new products?

10. Competitive Balance

Is the industry balanced in the sense that competitors have clear and

sustainable positions within the industry? This may be the case where

firms provide customers with different value propositions which appeal

to different consumer preferences.

On the other hand, the industry may be unbalanced where multiple

competitors are trying to become the low cost firm within the industry

resulting in aggressive price competition and declining industry

profitability. Similarly, the industry may be unbalanced by a distant

follower who is making aggressive moves in an attempt to improve its

position, for example by introducing low priced unbranded generic

products.

11. Barriers to entry

The threat posed by potential competitors depends on the level of4.1

Barriers to Entry.

Key barriers to entry might include capital requirements, economies of

scale, network effects, product differentiation, proprietary product

technology, government policy, access to suppliers, access to

distribution channels, and switching costs.

For more information on barriers to entry, see “4.1 Barriers to Entry”.

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3.2.2 Vertical Competition within the Supply Chain

Competition includes not just rivalry between firms operating at the

same stage of production (horizontal competition) but also the

interaction between all firms that have the potential to solve all or part

of the end user’s problem, and thereby compete for a share of industry

profits. This naturally includes vertical competition from suppliers and

customers within the supply chain.

An example of supplier bargaining power comes from the PC industry.

IBM learned about vertical competition the hard way when it helped

Microsoft and Intel gain virtual monopolies over the supply of key

components for the IBM PC.

Factors that will affect supplier bargaining power include:

1. The number of available suppliers and the strength of competition

between them;

2. Whether suppliers produce homogenous or differentiated

products;

3. The brand recognition of a supplier and its products;

4. The importance of sales volume to the supplier;

5. The cost to the firm of switching suppliers;

6. The availability of supplier substitutes; and

7. The threat of forward integration by the supplier relative to the

threat of backward integration by firms in the industry.

An example of customer bargaining power comes from the publishing

industry where Amazon has gained substantial bargaining power due to

its ability to sell and distribute huge volumes of books to end users.

Factors that will affect customer bargaining power include:

1. The number of customers. If there are fewer customers then each

customer will have more bargaining power;

2. The volume a customer demands relative to a firm’s total output;

3. The availability of substitutes;

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4. The cost to the customer of switching firms;

5. The availability of product comparison information; and

6. The threat of backward integration by the customer relative to the

threat of forwards integration by firms in the industry.

3.2.3 Competitive Intensity

The intensity of competitive rivalry depends on the pressure exerted by

all sources of competition: horizontal competition from direct

competitors and substitutes, and vertical competition from firms at

different points within the supply chain.

Below we outline twelve (12) factors that will influence the strength of

competition within an industry:

1. Number of firms: The more firms there are in an industry the

stronger will be the competitive rivalry since there will be more

firms competing to serve the same number of customers;

2. Market growth: If the market growth rate slows then this will

increase competition since firms will need to compete more

aggressively to gain new customers;

3. Economies of scale: If firms in the industry have relatively high

fixed costs and low variable costs then this will lead to more

intense rivalry as firms compete to gain market share;

4. Excess capacity: If the industry experiences cyclical demand then

this may result in sporadic industry wide excess capacity leading

to bouts of intense price competition;

5. Switching costs: If customers have low switching costs, then this

will intensify competition as firms compete to retain existing

customers and steal customers from the competition;

6. Product differentiation: If firms in an industry produce

homogeneous products, then firms will be forced to compete on

price. Firms can achieve product differentiation in various ways

including product quality, features, branding and availability;

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7. Instability: Diversity of competition (for example, firms from

different countries or cultures) may reduce predictability within a

market and lead firms to compete more aggressively;

8. Entry barriers: Low entry barriers will allow more competitors to

enter the market resulting in more intense competitive rivalry. For

more information on barriers to entry, see “4.1 Barriers to

Entry”;

9. Exit barriers: High exit barriers will increase competition because

firms that might otherwise exit an industry are forced to stay and

compete. A common exit barrier is where a firm has highly

specialized equipment that it cannot sell or use for any other

purpose;

10. Industry shakeout: Where a growing market induces a large

number of firms to enter, a point is likely to be reached where the

industry becomes crowded. When market growth slows, a period

of intense competition, price wars and company failures is likely

to ensue;

11. Substitutes: If the number of substitutes increases, the relative

price performance of substitutes improve, the prices of

substitutes decrease, or customer willingness to substitute

increases, then this will increase the intensity of rivalry within an

industry as firms compete to retain customers; and

12. Bargaining power of suppliers and customers: If suppliers and

customers have more bargaining power then they will be able to

extract a larger share of industry profits. This will reduce the

profitability of firms in the industry, which may lead to more

intense competition, industry consolidation, vertical integration,

and company failures.

3.3 Examining the Company

“Know your enemy and know yourself and you can fight a hundred battles

without disaster.”

~ Sun Tzu

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In assessing the business landscape, it is not enough simply to

understand the customer and the competition, it is also important to

understand the firm from whose perspective you are analysing the

industry.

Below we outline ten (10) factors to consider when examining the

company.

1. Performance

What is the historical performance of the company? What is its market

share? If profits are falling, what is the cause of the issue?

2. Competitive Advantage

Identify the company’s resources and capabilities. Consider both

tangible assets (property, plant, equipment, inventory and employees)

and intangible assets (brand, patents, copyrights and specialised

knowledge).

How sustainable are the company’s advantages? What are the

company’s weaknesses and can they be remedied?

3. Competitive Strategy

What is the company’s competitive strategy? Is the company producing

products that are low cost or differentiated? Which market segments

does the company target? (see “3.3.1 Porter’s Generic Strategies”).

What is the company’s pricing strategy, distribution strategy and growth

strategy? (see “3.4.1 Product / Market Expansion Matrix”).

4. Products

What does the company offer and how does it benefit consumers? Does

the product have any downsides or side effects?

Is the product differentiated?

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How does the company’s product offering compare with the

competition? Are there substitutes available? Do customers face high

switching costs?

Where does the product fall within its product lifecycle? (see “3.5.2

Product Life Cycle Model”).

What is bundled with the product? For example, customer service,

warranties and spare parts. Are there opportunities to bundle or

unbundle the product in order to increase sales volume?

5. Finances

If the company is considering a particular course of action, does it have

sufficient funds available to undertake the project? Financing may be

secured from various sources including internal cash reserves, bank

loans, shareholder loans, bond issues or sale of shares.

How many units will the company need to sell in order to cover the cost

of the project? Is there sufficient market demand?

6. Cost Structure

In order to understand a company’s cost structure, it helps to break each

business unit down into the collection of activities that are performed to

produce value for customers. The way each activity is performed

combined with its economics will determine a firm’s relative cost

structure within its industry.

Are costs predominantly fixed or variable? How does this compare with

the competition?

For more information on understanding a company’s cost structure, see

“3.6 Cost Management”.

7. Organisational Cohesiveness

Understanding a firm’s inner workings is important since competitive

strategies can fail if they conflict with a firm’s culture, systems and

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general way of doing business. The organisational aspects of a firm can

be examined using the 3.8.1 McKinsey 7 S Model.

8. Marketing

What does the company stand for? How do customers perceive the

company and its products? How does the company communicate with

customers?

9. Distribution Channels

What distribution channels does the company use to reach customers

(network marketing, mail order, online store, factory outlets, retail

stores, supermarkets and/or department stores)? Are there other

channels that are more cost effective or which are preferred by

customers?

10. Customer Service

How does the company interact with customers and support its

products post sale? Are employees empowered to solve problems and

delight customers? Does the company have a customer loyalty program?

4. Business Landscape Survey Template

If you would like to download a template that can be used to conduct a

survey of the business landscape, please click here.

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3. Firm Level Analysis

3.1 Profitability

3.1.1 Profitability Framework

Understanding profitability issues can help executives, consultants

and entrepreneurs to diagnose and respond to falling prices,

declining sales volume and rising costs

Businesses sometimes experience reduced profitability.

This is not necessarily a problem if the decline was expected since a

business can be sustained from cash flow, and long term growth can be

pursued through capital accumulation, which shows up on the balance

sheet not on the profit and loss statement.

However, a drop in profits can be concerning if it is unexpected and

unexplained. It can limit a business’s ability to achieve organic growth

and may mean that its existing business model is no longer viable.

1. Profit

2. Revenue

Price

Pricing Strategy: Competitive, Cost Based, Value Based

Units Sold

Customer segmentation;

Market share; New markets; New

products

3. Cost

Variable Costs

COGS: Raw Materials,

Transport, Energy, Labor

Fixed Costs

SG&A, Rent, R&D, Depreciation,

Interest, Labor (fixed contract),

Marketing

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1. Profit

Profit equals revenue minus cost.

By considering the broader economy and comparing a business’s

performance numbers with the competition it will be possible to

determine whether declining profitability is a company specific or

industry wide problem.

Assuming the issue is company specific, it will be possible to discover

the source of declining profitability by investigating each branch of the

profit equation, revenue and cost, and drilling down to explore the

company’s current and historical performance figures.

Declining profitability may result from falling prices, declining units

sold, rising costs or a combination of these factors.

2. Revenue

Revenue can come from various sources including advertising and

product sales and is normally thought of as being a function of price per

unit and units sold. For example, price per widget multiplied by the

number of widgets, or cost per click multiplied by the number of clicks.

Declining revenue can derive from a fall in prices or a reduction in units

sold, and can be examined in four steps.

Step 1: Segmentation

What are the major revenue streams? It will typically be a good idea to

segment units sold, and this might be done by:

1. Product;

2. Product line;

3. Distribution channel;

4. Region;

5. Customer type (new/old, big/small); or

6. Industry vertical.

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Step 2: Examination

What percentage of total revenue does each revenue stream represent?

Compare current and historical figures to identify how these percentages

have changed over time.

Step 3: Diagnosis

What is the underlying cause of the problem?

Step 4: Response

Develop a strategic response.

2.1 Diagnosis

If faced with declining prices or sales volume, factors to consider include

the following.

1. Macro Economy

PEST Analysis: Are there recent or impending changes to the

macro environment? This may include changes to political,

economic, socio-cultural or technological factors.

2. Customers

Market growth: Has market growth slowed forcing competitors to

compete for market share?

Customer needs and preferences: Have customer needs and

preferences changed?

Price Discrimination: Is the fall in prices or sales volume

attributable to a particular customer segment? Can the company

distinguish between customers and charge different prices to

different customer segments? This could be done by offering

quantity discounts or by distinguishing between people in different

groups (e.g. students) or in different locations (e.g. you pay more

for popcorn at the cinemas).

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Distribution Channels: What channels are used to reach

customers? Have new or preferred channels become available?

Has there been a change in the cost effectiveness of these

channels?

3. Competition

Rivalry: Have competitors lowered their prices? How does the

company’s product mix, product quality, and cost structure

compare to the competition?

Substitutes: Has the availability of substitutes increased or the price

performance of substitutes improved?

Barriers to entry: Has it become easier for new competitors to

enter the industry? For example, the Internet has enabled new

entrants in many established industries including publishing,

newspapers, and taxis.

Buyer bargaining power: Has there been an increase in customer

bargaining power? For example, Amazon has used its market

dominance to drive down the price of books much to the chagrin

of book publishers.

4. Company

Market Power: Does the company have market power that might

allow it to raise prices (monopoly, product differentiation,

proprietary technology, economies of scale, network effects)? For

example, De Beers had (and largely still has) a monopoly on the

diamond trade which allows it to keep the price of diamonds high.

Products: What products and product mix does the company

offer? How does this compare to the competition? Is there

something different about the products that might allow the

company to raise prices? For example, brand recognition, superior

quality, appealing design, unique product features, or strong

customer service.

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Value chain analysis: Consider value chain activities such as access

to raw materials, operating capacity, inventory handling and

distribution. Are there any bottlenecks or capacity limitations?

2.2 Response

Declining prices

You would be forgiven for thinking that the best way to respond to

falling prices is simply to raise them. But unfortunately things are often

not that simple since a business’s ability to raise prices can often be

constrained.

In response to declining prices, there are three pricing strategies to

consider:

1. Competitive pricing: How do prices compare with the

competition? Is the pricing appropriate given the product’s relative

quality and position within the market? How is the competition

likely to respond to the firm’s pricing strategy?

2. Cost based pricing: Cost based pricing is a simple pricing strategy

that sets price relative to the company’s costs. The price is set by

calculating the company’s per unit cost and adding a margin for

profit.

3. Value based pricing: Value based pricing involves assessing the

customer and setting the price based on the customer’s willingness

to pay.

For further discussion on pricing strategy, see “3.5.1 Four Ps

Framework”.

Declining sales volume

Faced with falling sales volume, there are four growth strategies that a

company might employ: market penetration, market development,

product development, and diversification.

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Figure 2: Product/market expansion matrix

For more information on growth strategy, see “3.4.1 Product / Market

Expansion Matrix”.

3. Costs

The third driver of declining profitability is rising costs.

3.1 Diagnosis

If rising costs are driving a decline in profitability, then the cost structure

of the business will need to be examined in order to locate the source of

the cost blow out. This might be done by segmenting costs into value

chain activities: inbound logistics, operations, outbound logistics, sales &

marketing, customer service (see “3.2.1 Value Chain Analysis”).

Have there been any significant changes in the company’s cost drivers?

How do costs compare to the competition?

3.2 Response

After determining the source of rising costs, a firm can develop

strategies to manage and reduce costs. For more information on cost

management, see “3.6 Cost Management”.

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4. Profitability Framework Cheatsheet

If you would like to download a one page profitability framework

cheatsheet that contains all the essentials of the profitability framework

on one page, please click here.

3.2 Competitive Advantage

3.2.1 Value Chain Analysis

To understand which activities provide a business with a

competitive advantage, either through cost advantage or product

differentiation, it is helpful to separate operations into a series of

value-generating activities referred to as “the value chain”

1. Background

Value Chain Analysis is a concept that was first described and

popularised by Michael Porter in his 1985 book, Competitive

Advantage.

2. Relevance

In order to understand the activities that provide a business with a

competitive advantage, either through cost advantage or product

differentiation, it is useful to separate the business operation into a series

of value-generating activities referred to as “the value chain”.

Value Chain Analysis involves identifying all of the important activities

in which a business engages and then determining which ones give the

company a defensible competitive advantage. By doing this, a company

can:

1. Determine which activities are best undertaken internally and

which ones are able to be outsourced or eliminated;

2. Identify and compare strengths and weaknesses with the

competition; and

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3. Identify synergies between activities.

3. Value Chain Analysis Explained

Michael Porter introduced a generic value chain model that comprises a

sequence of activities common to a wide range of firms. Porter

suggested that the activities of a business could be grouped under two

headings:

1. Primary activities: Those that are directly concerned with

creating and delivering a product or service; and

2. Support activities: Those that are not directly involved in

production, but may increase efficiency or effectiveness.

Figure 3: The Generic Value Chain

The firm’s margin or profit depends on its ability to perform these

activities efficiently, so that the amount that the customer is willing to

pay for the products exceeds the cost of the activities in the value chain.

3.1. Primary activities

The primary value chain activities include:

1. Inbound Logistics: Receiving and storing externally sourced

materials;

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2. Operations: Manufacturing; the way in which inputs are converted

into final products;

3. Outbound Logistics: Inventory storage and distribution to

customers;

4. Marketing & Sales: Identification of customer needs and

preferences, marketing strategy and sales generation;

5. Service: Supporting customers after the product or service has

been sold to them.

3.2. Support activities

The support value chain activities include:

1. Human resource management: Recruitment, training,

development, motivation and compensation of employees;

2. Infrastructure: Includes a broad range of support systems

including organisational structure, planning, management, quality

control, culture, and finance;

3. Procurement: Sourcing resources and negotiating with suppliers;

and

4. Technology development: Managing information, developing and

protecting new products and services, developing more efficient

processes, and improving quality.

4. Application of the Value Chain Analysis

4.1 Steps to take

Value Chain Analysis can be undertaken by following three (3) steps:

1. Break down a company into its key activities under each of the

headings in the model;

2. Identify activities that contribute to the firm’s competitive

advantage either by giving it a cost advantage or creating product

differentiation. At the same time, also identify activities where the

business appears to be at a competitive disadvantage; and

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3. Develop strategies around the activities that provide a sustainable

competitive advantage.

4.2 Cost advantage

A business can achieve a cost advantage over its competitors by

understanding the costs associated with each activity and then organising

each activity so that it is as efficient as possible.

Porter identified ten (10) cost drivers related to each activity in the value

chain:

1. 4.3 Economies of Scale;

2. Learning;

3. Capacity utilisation;

4. Linkages among activities;

5. Interrelationships among business units;

6. Degree of vertical integration;

7. Timing of market entry;

8. Firm’s policy on targeting cost or product differentiation;

9. Geographic location;

10. Institutional factors (regulation, union activity, taxes, etc.).

A firm can develop a cost advantage by controlling these ten (10) cost

drivers better than its competitors.

A cost advantage can also be pursued by reconfiguring the value chain.

Reconfiguration means introducing structural changes such as a new

production process, new distribution channels, or a different sales

approach. For example, Qantas structurally redefined its maintenance of

aircraft, traditionally conducted by in-house engineers, by outsourcing

this function to private overseas contractors.

4.3. Product differentiation

A firm can achieve product differentiation by focusing on its core

competencies in order to perform them better than its competitors.

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Product differentiation can be achieved through any part of the value

chain. For example, procurement of inputs that are unique and not

widely available to competitors, providing high levels of product support

services, or designing innovative and aesthetically attractive products.

5. Issues arising from Value Chain Analysis

5.1. Linkages between value generating activities

Value chain activities are not isolated from one another. Rather, one

value chain activity often affects the cost or performance of other value

chain activities. Linkages may exist between primary activities and also

between primary and support activities.

For example, the design of a product might be changed in order to

reduce manufacturing costs. However, if the new product design

inadvertently results in increased service costs then the total cost

reduction could be less than anticipated.

5.2. Business unit interrelationships

Business unit interrelationships can be identified using the Value Chain

Analysis.

Business unit interrelationships offer opportunities to create synergies

among business units. For example, if multiple business units require the

same raw material and the procurement process can be coordinated then

bulk purchasing may result in cost reductions. Such interrelationships

may exist simultaneously in multiple value chain activities.

5.3. Outsourcing

Value Chain Analysis can help management decide which activities to

outsource. It is rare for a business to undertake all primary and support

activities internally. In order to decide which activities to outsource

managers must understand the firm’s strengths and weaknesses, both in

terms of cost and ability to differentiate.

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6. Case Example

Below we consider some of the issues that might be relevant for some of

Coca Cola’s value chain activities:

1. Procurement: Is it more cost effective to procure inputs locally,

regionally or globally? If local procurement is more expensive but

better for the environment and local communities, can this be used

as a point of differentiation? Are there likely to be political or

environmental disturbances that could drive up the cost of key

inputs like corn syrup or aluminium?

2. Operations: How much does a bottling plant cost to build and

run? How often do factories need to be re-engineered? Would it

be more cost effective to outsource bottling? Is bottling

strategically important for product differentiation?

3. Logistics: What is the cost of inventory storage? How is Coca

Cola distributed to customers? How many cans are lost in transit?

4. Marketing & Sales: Are consumer preferences changing over

time? Will people enjoy cherry cola? Are people becoming more

health conscious?

3.3 Competitive Strategy

3.3.1 Porter’s Generic Strategies

Three strategies to achieve above-average performance: cost

leadership, differentiation, and focus

In order to understand Porter’s Generic Strategies, it is helpful to take a

step back and examine the two things which determine a firm’s

profitability in the long run.

The first is industry attractiveness, which is determined in any industry

by the five competitive forces: the threat of entry by new competitors,

the threat of substitutes, the bargaining power of buyers, the bargaining

power of suppliers, and the rivalry among existing firms.

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Figure 4: Porter’s Five Competitive Forces that Determine Industry

Profitability

It is the collective strength of these five forces that determine whether

firms in an industry will be able to earn attractive rates of return. In

industries where the five forces are favourable, such as the soft drink

industry, many competitors have earned attractive returns for many

decades. However, where one or more of the forces exerts strong

pressure on industry profitability, such as in the airline industry, few

firms ever do well for long.

Understanding industry structure, as determined by the five forces, will

inform a firm’s decision to enter or exit an industry, and will also be a

key consideration for industry leaders who have the ability to mould

industry structure for better or for worse. For example, Coca-Cola is a

leader in the soft drink industry and could, if it wanted to, encourage the

production and sale of generic unbranded soft drinks. Even if this would

increase Coca-Cola’s profits in the short run, it would also threaten the

structure of the industry. Generic cola may increase the price sensitivity

of buyers, lead to aggressive price competition, and lower barriers to

entry by enabling new competitors to enter the market without a large

advertising budget.

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In addition to industry attractiveness, the second thing which determines

a firm’s profitability in the long run (and this is where Porter’s Generic

Strategies comes in) is a firm’s relative position within the industry. That

is, can a firm position itself to achieve above average performance

within its industry? Or put differently, is it possible for a firm to

establish and maintain a competitive advantage?

In his 1985 book Competitive Advantage, Michael Porter explains that

there are two basic sources of competitive advantage that a firm can

possess: cost leadership and differentiation. A firm can also narrow the

scope of its activities to compete in niche segments of the market, and

so there are actually three generic strategies that a firm can adopt to

achieve above-average performance: cost leadership, differentiation, and

focus.

Figure 5: Three Generic Strategies

Porter’s generic strategies are based on the idea that in order to achieve a

competitive advantage a firm needs to make hard choices. Trying to be

all things to all people will put a firm on the fast track to mediocrity, and

so a firm needs to decide what kind of competitive advantage to pursue

and which market segments it should target.

Cost Leadership

As the name suggests, a firm that pursues cost leadership aims to be the

low cost producer in its industry. While the strategy involves a primary

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focus on cost reduction, the cost leader will also need to produce

comparable products in order to maintain prices.

If a firm can sustain cost leadership while at the same time charging

prices at or near the industry average, then this strategy can allow a firm

to achieve above average performance.

One danger of the cost leadership strategy is that if there is more than

one aspiring cost leader then this can lead to intense competitive rivalry

and ultimately destroy industry profitability. If a firm wants to be the

cost leader, then its best bet is to get in first in order to deter the

competition.

Differentiation

Differentiation is a strategy in which a firm sets out to provide unique

value to buyers. This may be achieved in various ways including

producing products with unique features, serving buyers through new or

different distribution channels, or by creating perceived differences in

the buyer’s mind through clever marketing.

While the strategy involves a primary focus on “being different” the

differentiator will still need to manage its costs, and will want to reduce

costs in any area that does not contribute to differentiation. If a firm is

able to charge a price premium that exceeds the cost of sustaining its

uniqueness, then the firm will be able to achieve above average returns.

Focus

The focus strategy involves narrowing the scope of competition in order

to serve certain niche segments within the overall market. By serving

these target segments well, the focuser may be able to achieve a

competitive advantage in its niche even though it does not enjoy a

competitive advantage in the market overall.

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Stuck in the Middle

While there are three generic strategies for achieving above average

performance, a firm that tries to employ all of these strategies without

successfully pursuing any of them faces the risk of becoming “stuck in

the middle”. As such, it may find itself perpetually outperformed by

other firms in the industry that have been willing to make hard strategic

choices about how to compete.

3.3.2 Strategy and the Internet

There are six strategic principles which are relevant to any

company that wants to be profitable online

In an article entitled “Strategy and the Internet” published in the March

2001 edition of the Harvard Business Review, Michael Porter outlined

six principles that he believes internet companies need to follow if they

want to establish and maintain a distinctive strategic position online.

While we largely agree with Porter’s six principles, we take issue with his

second principle which argues for a focus on profitability through the

sale of products and services.

Porter’s six strategic principles are instructive, and we outline them

below.

1. Stand for something

In order for a company to develop unique skills, build the right assets,

and establish a strong reputation it is important to define what the

company stands for so that the company will have continuity of

direction.

2. Focus on profitability

Many internet based companies focus on “unique visitors” and “page

views” as measures of performance and Porter notes that, at the end of

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the day, sustainable profits will only be possible where goods or services

can be provided at a price which exceeds the cost of production.

We take issue with this focus on profitability through the sale of goods

and services since it misses the key insight that successful internet-based

companies are typically in the business of connecting people around a

common interest or shared purpose. In other words, the internet is not

primarily about selling goods and services, but is instead about creating

markets, building communities and connecting people. While it is true

that a successful internet-based company may derive some profits from

the sale of goods and services, it is also likely to generate a portion of its

revenues from advertising, membership fees and commissions.

3. Offer consumers a unique set of benefits

Good strategy involves being able to provide a distinct set of benefits to

a particular group of consumers. Trying to please every consumer will

not give a company a sustainable competitive advantage.

4. Perform core activities differently

If a company is able to establish a distinctive value chain by performing

key activities differently from its competitors, then this will help the

company establish a sustainable competitive advantage.

5. Specialise

There is no competitive advantage to being a jack of all trades and a

master of none. Porter recommends making trade-offs. By focusing on

certain activities, services or products at the expense of others a

company can establish a unique strategic position.

6. Ensure that all activities reinforce the company’s

strategy

All of a company’s activities are interdependent and, as a result, they

must be coordinated so as to reinforce the company’s overall strategy. A

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company’s product design, for example, will affect the manufacturing

process and the way that products are marketed. By coordinating all of

its activities, a company makes it harder for competitors to imitate its

strategy.

3.4 Growth Strategy

3.4.1 Product / Market Expansion Matrix

A framework to help executives, senior managers and marketers

devise strategies for future growth

1. Background

The Product/Market Expansion Matrix (or “Ansoff Matrix” as it is

sometimes called) was developed by a Russian-American mathematician

named Igor Ansoff, and first explained in his 1957 Harvard Business

Review article entitled Strategies for Diversification.

2. Relevance

The Product/Market Expansion Matrix is particularly useful for strategic

planning because it provides a framework to help executives, senior

managers and marketers devise strategies for future growth.

By aiding clear thinking about growth strategy, the Product/Market

Expansion Matrix can help an organisation avoid key risks including:

1. Overlooking available growth strategies;

2. Misunderstanding the implications of pursuing a particular

strategy; and

3. Selecting an inappropriate strategy given the firm’s diversification

objectives.

3. Product/Market Expansion Matrix Explained

The Product/Market Expansion Matrix can help a firm devise a

product-market growth strategy by focusing on four growth alternatives:

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1. Market Penetration;

2. Market Development;

3. Product Development; and

4. Diversification.

Figure 6: Product/market expansion matrix

What is a Product-Market Growth Strategy?

A product-market strategy is a description of a firm’s products and

target markets. While this may sound straightforward, it can be difficult

to clearly delineate a target market since it can be defined very broadly

(for example, the transport market) or very narrowly (for example,

domestic air transport in America for cost-conscious business travellers).

In general, a market should not be defined too broadly (or too narrowly)

since a key purpose of market definition is to allow a firm to develop

strategy and make decisions.

In his 1957 paper, Ansoff defined a product-market strategy as “a joint

statement of a product line and the corresponding set of missions which

the products are designed to fulfil.” For example, one of Apple’s

product missions might be to provide consumers with easy-to-use digital

technology, and another mission might be to provide fashion accessories

for Yuppies and young people.

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The Four Growth Alternatives

The four alternative growth strategies are:

1. Market Penetration: A strategy to increase sales without departing

from the original product-market strategy. This involves increasing

sales to existing customers and finding new customers for existing

products.

2. Market Development: A strategy to sell existing products to new

markets (normally with some modifications). Ansoff described this

as a strategy “to adapt [the] present product line … to new

missions.” For example, Boeing might adapt an existing model of

passenger aircraft and sell it for cargo transportation.

3. Product Development: A strategy to sell new products, with new

or altered features, to existing markets. Ansoff described this as a

strategy to develop products with “new and different

characteristics such as will improve the performance of the

[existing] mission.” For example, Boeing might develop a new

aircraft design which offers improved fuel economy.

4. Diversification: A strategy to develop new products for new

markets, which can either be related to the current business (e.g.

vertical integration or horizontal diversification) or unrelated (e.g.

conglomerate diversification).

Each of the above strategies represents a different path that a firm can

take to pursue growth. However, in practice, a firm will often implement

more than one strategy at the same time. As Ansoff noted, “a

simultaneous pursuit of market penetration, market development, and

product development is usually a sign of a progressive, well-run business

and may be essential to survival in the face of economic competition.”

4. Selecting a Strategy

A growth strategy can be selected through a three-step process:

1. Setting out all of the available strategies;

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2. Applying qualitative criteria to short list the most favourable

alternatives; and

3. Applying a return on investment hurdle to narrow the options still

further.

The discussion below provides a summary of the issues and various

situations in which it may make sense for a firm to select a particular

growth strategy.

4.1 Market Penetration

Market Penetration carries the least implementation risk since a firm is

focusing on its existing products and existing markets, and so should be

able to leverage its existing resources and capabilities.

Pursuing this strategy is likely to make sense if the firm has a strong

competitive advantage, or if the overall size of the market is growing or

can be induced to grow.

4.2 Market Development

Market Development carries more implementation risk than Market

Penetration because a firm is expanding into new markets.

Companies that have successfully pursued this strategy include Coca-

Cola and McDonalds, and it may make sense where:

The firm’s core competencies relate to its existing products and it

has a strong marketing team;

The firm can identify opportunities for market development

including chances to reposition the brand, exploit new uses for the

product, or expand into new geographical regions;

The firm’s resources are organised to produce particular products

and changing the production technology would be costly.

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4.3 Product Development

Product Development carries more implementation risk than Market

Penetration because the firm is developing new products.

Companies that have successfully pursued this strategy include 3M,

P&G and Unilever, and it may make sense where:

The firm understands the needs of its customers, and identifies an

opportunity to sell new products to satisfy new or changing needs;

The firm operates in a competitive market where continuous

product innovation is necessary to prevent product obsolescence

or commoditisation;

The firm has large market share and a strong brand;

The firm’s products benefit from network effects or proprietary

technology, and new products can gain a significant edge by being

first to market;

The firm operates in a market with strong growth potential;

The firm identifies opportunities to commercialise new

technology;

The firm has a strong R&D team.

4.4 Diversification

Diversification carries the most implementation risk since a firm is

simultaneously developing new products and entering new markets, and

may need to develop or acquire new resources and capabilities.

Diversification can enable a firm to achieve three main objectives:

growth, stability, and flexibility. The specific strategies that a firm

employs will differ depending on which of these goals a firm is pursuing.

There are three primary kinds of diversification that a firm might pursue:

1. Vertical Integration: The firm expands its business to different

points in the supply chain;

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2. Horizontal Diversification: The firm adds new products that may

be unrelated to existing products but are likely to appeal to existing

customers. For example, Amazon initially sold only books through

its website but has over time added new products such as clothes,

jewellery and electronics;

3. Conglomerate Diversification: The firm adds new products that

are unrelated to existing products and are likely to appeal to new

customer segments. While conglomerate diversification may have

little relationship with a firm’s existing business, a firm might

adopt this strategy in order to:

Improve profitability by entering a lucrative industry;

Develop resources and capabilities in a potential new growth

industry;

Poach top management or key talent;

Compensate for technological obsolescence;

Expand the firm’s revenue base so as to improve its perception

in the capital markets and make it easier to borrow money;

Increase strategic flexibility in an uncertain business

environment; or

Reduce risk by spreading the firm’s activities across multiple

products and markets, and thereby decrease its vulnerability to

negative Black Swans and unfavourable events such as

economic downturns, increased competitive rivalry, improved

supplier or buyer bargaining power, improved price

performance of substitutes, or reduced barriers to entry.

5. Implementing a Growth Strategy

Below we provide suggestions on how to implement each of the four

alternative growth strategies.

5.1 Market Penetration

Market Penetration involves increasing sales of existing products to

existing markets, and could be pursued in the following ways:

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1. Pricing:

Changing product pricing; for example, if demand is relatively

inelastic, then it might be possible to raise prices without a big

drop in sales. Alternatively, prices could be lowered to increase

sales volume;

2. Product:

Modifying the products or product packaging in order to

broaden their appeal;

Bundling products together in order to sell them as a single

unit;

Increasing the size of a product in order to increase the amount

sold per unit;

3. Place:

Improving distribution channels in order to reach more

customers within existing markets;

Targeting a market niche in order to grow sales and build

overall market share (this approach may make sense if the firm

is small compared to its competitors);

Make products available at times and in locations which

correspond with high customer demand (for example, selling

ice cream near the beach, selling Christmas trees in December);

4. Promotion:

Increasing advertising to promote the product or reposition the

brand;

Offering quantity discounts (e.g. 2 for 1, Buy One Get One

Free);

Introducing customer loyalty schemes;

Improving the quality or size of the sales force;

5. Acquisitions:

Acquiring a competitor (this approach may make sense in

mature markets where the size of the overall market is not

growing);

6. Cost Management:

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Improving operational efficiency so that increased sales can be

achieved without a proportional increase in costs (this might be

attained through 4.3 Economies of Scale and product

rationalisation).

5.2 Market Development

Market Development involves selling existing products to new markets,

or new market segments, and could be pursued in the following ways:

1. Product:

Modifying the pricing strategy, products and/or product

packaging in order to appeal to different customer segments;

2. Place:

Utilising new distribution channels to reach new market

segments, for example building an online store;

3. Promotion:

Marketing products in new locations in order to expand

regionally, nationally or internationally;

Advertising through different media in order to reach different

customer segments;

4. Acquisitions and Joint Ventures:

Acquiring a competitor or forming a joint venture or strategic

alliance in order to gain access to new distribution channels.

5.3 Product Development

Product Development involves selling new products to existing markets,

and could be pursued in the following ways:

1. Product:

Developing new products through R&D or licensing new

technologies;

Extending an existing product by producing different versions;

for example, Apple released two versions of the iPhone 5, the

iPhone 5C and the iPhone 5S;

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Packaging existing products in new ways; for example, Apple

re-released the iPhone 5 in a range of colourful cases and called

it the iPhone 5C;

2. Place:

Distributing products manufactured by other firms in order to

increase utilization of an existing distribution channel. For

example, Amazon not only sells and distributes products

through its website but also allows other vendors to do so;

3. Acquisitions and Joint Ventures:

Acquiring a competitor in order to acquire its product line;

Forming a joint venture or strategic alliance with a

complementary firm.

5.4 Diversification

Diversification involves selling new products to new markets, and can be

pursued by simultaneously adopting the strategies suggested above for

Market Development and Product Development.

3.4.2 GE McKinsey 9 Box Matrix

The GE-McKinsey 9-Box Matrix offers decentralised corporations

with multiple business units a systematic approach for investing

available cash reserves

1. Background

The 9-Box Matrix was developed as part of work that McKinsey did for

GE in the early 1970s. At that time, GE had around 150 business units

and was faced with the challenge of how to manage such a large number

of business units profitably.

The 9-Box Matrix was developed as a result of the realisation that it is

important to separate the ability of a business to generate cash from the

decision about whether to put more cash into the business.

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2. Purpose

The 9-Box Matrix offers any decentralised corporation with multiple

business units a systematic approach to help it decide where to invest its

excess cash reserves.

The 9-Box Matrix solves the problem of trying to compare potentially

very different business units: one might be capital intensive; another

might require high advertising expenditure; a third might have

economies of scale.

Instead of relying on the projections provided by the manager of each

individual business unit, the company can determine whether a business

unit is going to do well in the future by considering two factors:

1. Industry attractiveness; and

2. Competitive advantage.

[It is worth noting that these are the same factors proposed by Professor

Michael Porter in his 1985 book Competitive Advantage.]

3. Using the 9-box Matrix

Figure 7: GE-McKinsey 9-box matrix

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Placing each business unit within the 9-Box Matrix offers a framework

for comparison between them.

In order to keep things simple, the framework offers three investment

strategies:

1. Invest/Grow;

2. Selectivity/Earnings; and

3. Harvest/Divest.

Allocating one of these investment strategies to each business unit is the

first step. However, it is important to note that two business units that

have been given the same strategy will not necessarily be treated in the

same way. For example, a strong unit in a weak industry will be in a very

different situation from a weak unit in an attractive industry.

After placing every business unit into one of the nine boxes, there are at

least two questions that need to be asked:

1. If a business unit is in one category, say “selectivity/earnings”, are

there any actions that might be taken to improve its position?

2. If a business unit is to receive money, what does it plan to do with

that money and does this strategy make sense? It is important that

a business unit has a purpose in mind because the best use of

money will vary depending on the industry and on the business

unit. For example, advertising to enhance the brand might work

for one business unit, whereas increasing R&D spending might

work for another.

4. Axes of the 9-box Matrix

The 9-Box Matrix places “industry attractiveness” along the vertical axis,

and “competitive advantage” along the horizontal axis.

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4.1 Industry attractiveness

Industry attractiveness refers to industry profitability. That is, how easy

will it be for the average firm to generate above average profits over the

long run? For a straightforward approach to examining industry

attractiveness, see “4.8 Porter’s Five Forces”.

4.2 Competitive advantage

A business unit has a competitive advantage when it is able to achieve

profits that exceed the industry average.

Understanding whether a business unit has a “sustainable competitive

advantage” involves examining its relative position within its industry

and the resources and capabilities that it possesses which will allow it to

maintain and strengthen that position over time.

Relevant considerations might include:

1. Does the business unit benefit from economies of scale or

network effects?

2. Does the business unit enjoy strong brand recognition?

3. Is the business unit more profitable than its competitors? If so,

why so?

5. Available Strategies

5.1 Invest / Grow

A business unit will be in the “invest/grow” category if the prospects

for the industry as a whole are attractive and the business unit’s position

in the industry means that it is likely to do better than most of the other

firms in the industry.

A business unit in this category should be given increased investment

regardless of whether it can generate those funds itself.

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5.2 Selectivity / Earnings

Business units in this category are given second priority to those in the

“invest/grow” category. As such, the amount of money spent on

business units in the “invest/grow” category will determine how much is

left over for business units in this category.

When allocating money to a business unit in this category, it is important

to be selective about where the money is spent and monitor earnings

closely. With the right combination of strategies, it may be possible to

move a business unit into the “invest/grow” category. However, if a

business unit doesn’t improve its performance it may be advisable to

reallocate cash to another business unit.

5.3 Harvest / Divest

A business unit will be in the “harvest/divest” category if it is in an

unattractive industry and its competitive position is weak.

There are two potential strategies can be pursued for business units in

this category:

1. Harvest: Increase short-term cash flows as far as possible, even at

the expense of the business unit’s long term future; or

2. Divest: Sell the business unit or liquidate its assets.

3.4.3 BCG Growth Share Matrix

The BCG Growth Share Matrix is a simple conceptual framework

for resource allocation within a firm

1. Background

In 1968, BCG developed the growth share matrix, which is a simple

conceptual framework for resource allocation within a firm.

2. Purpose

The BCG matrix is a simple tool that enables management to:

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1. Classify products in a company’s product portfolio into four

categories – Stars, Cash Cows, Question Marks, and Dogs;

2. Index a company’s product portfolio according to cash usage and

generation;

3. Determine the priority that should be given to different products

in a company’s product portfolio; and

4. Develop strategies to tackle various product lines.

3. BCG Growth Share Matrix Explained

The idea behind the growth share matrix is that the amount of cash that

a product uses is proportional to the rate of growth of that product in

the market, and the generation of cash is a function of its market share.

Money generated from high-market-share products can be used to

develop high-growth products.

Figure 8: BCG Growth Share Matrix

Under the BCG matrix, products are classified into four types:

1. Stars are leaders in high growth markets. Stars grow rapidly and

therefore use large amounts of cash. Stars also have a high market

share and therefore generate large amounts of cash. Over time, the

growth of a product will slow. If a Star maintains a high market

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share, it will eventually become a Cash Cow. If not, it will become

a Dog.

2. Cash Cows are highly profitable, and require low investment

because they are market leaders in a low-growth market. Growth is

slow and therefore cash use is low, and market share is high and

therefore cash generation is high. Money generated from cash

cows can be used to pay dividends, interest, and overheads, and to

develop Stars and Question Marks.

3. Question Marks are low market share high growth products, and

almost always require more cash than they can generate. If a

Question Mark can improve its market share, it will eventually

become a Cash Cow. If not, it will become a Dog.

4. Dogs generate little cash because of their low market share in a

low growth market. BCG refers to these products as “cash traps”.

Although they may be sold profitably in the market, BCG indicates

that, in terms contributing to growth, Dogs are essentially

worthless.

4. Available Strategies

The BCG matrix offers four alternative strategies:

1. Develop: This strategy is appropriate where a product’s market

share needs to be increased in order to strengthen its market

position. Short-term earnings and profits are forfeited because it is

hoped that the long-term gains will outweigh these short term

costs. This strategy is suited to Stars, as well as Question Marks if

they are to become Stars.

2. Hold: The objective of this strategy is to maintain the current

market share of a product, and is used for Cash Cows so that they

will continue to generate large amounts of cash which can be

invested in Stars and Question Marks.

3. Harvest: Under this strategy, management attempts to increase

short-term cash flows as far as possible (e.g. by increasing prices,

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and cutting costs) even at the expense of the products long-term

future. It is a strategy suited to weak Cash Cows or Cash Cows

that are in a market with a limited future. Harvesting is also used

for Dogs, and for Question Marks that have no possibility of

becoming Stars.

4. Divest: The objective of this strategy is to get rid of unprofitable

products and products with low market share in low growth

markets. Money from divestment can then be used to develop and

promote more profitable products. This strategy is typically used

for Dogs and for Question Marks that will not become Stars.

5. Criticisms

The simplicity of the BCG matrix helped to popularise the tool with

management teams around the world. Unfortunately, however, the BCG

matrix is not just simple and easy to remember but also simplistic, and

using the framework without careful consideration can lead to serious

strategic missteps.

Below we highlight four (4) key criticisms of the BCG matrix.

First of all, the BCG matrix encourages managers to focus primarily on

market share at the expense of other factors that may be important for

organisational performance. A myopic focus on market share may lead

managers to:

1. Engage in aggressive price competition leading to the destruction

of industry profits;

2. Focus narrowly on one product or product line, forgetting that

markets are fluid and notoriously hard to define. For example, if

Apple had defined its market as “PCs and laptops” then it would

never have pioneered the iPod, iPhone and iPad; and

3. Ignore other growth alternatives including new product

development, new market entry, and diversification.

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The second problem with the BCG matrix is that by classifying a

product into one of four types – Star, Cash Cow, Question Mark, or

Dog – it is essentially forecasting the product’s potential which can

result in a self-fulfilling prophecy. For example, if a product is labelled a

Star then it will receive increased investment and management focus,

employees working on the product are likely to be more motivated, and

the product will therefore be likely to perform much better than it would

have otherwise.

The third problem with the BCG matrix is that it is often difficult to

determine where a product or an industry falls within its life cycle. A

technology product with high market share in a low growth market

might be labelled as a Cash Cow and assigned a “hold” strategy, and so

be given just enough investment to maintain its market share. While this

may be an appropriate strategy for a product in a slow moving industry,

rapidly changing technology may require significant investment in order

to capture new opportunities for growth and innovation. For example,

Microsoft, with its a dominant market share for operating system

software in the PC industry has been slow to innovate and slow to

release software for other devices such as smartphones and tablets.

The fourth criticism of the BCG matrix is that it equates high market

share with high cash generating ability. It assumes that a product with

higher market share will generate more cash; however this may not be

the case.

In 1970, while outlining the BCG matrix, Bruce Henderson stated that

“Margins and cash generated are a function of market share. High

margins and high market share go together. This is a matter of common

observation, explained by the 4.5 Experience Curve effect.”

Henderson’s observation turns out to be an oversimplification of reality

(for a full discussion on this point, see “Implications for Strategy”). If a

product benefits from 4.3 Economies of Scale and the 4.5 Experience

Curve effect, then higher market share will lead to lower unit costs.

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However, this does not necessarily mean that the product will generate

more cash since the amount of cash that a product generates depends on

two factors:

1. The profit margin per unit; and

2. The number of units sold.

1. Profit margin per unit

It is common for firms to achieve increased market share by lowering

prices, which will lead to lower profit margins unless sufficient cost

savings can be found to offset the lower price. This means that a

product with higher market share will only generate more cash if the

percentage increase in units sold is greater than the percentage decrease

in profit margin per unit. This will not always be the case, but

admittedly it is likely to occur for the kinds of products that Henderson

was talking about, that is, for products which benefit from 4.3

Economies of Scale and the 4.5 Experience Curve effect.

2. Units sold

In considering a product’s cash generating potential, companies need to

consider not only market share but also market size since units sold is a

function of both. For example, a product that has a small market share

in a large market may have the potential to generate a large amount of

cash. This insight is overlooked by the BCG matrix.

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3.5 Marketing Strategy

3.5.1 Four Ps Framework

A useful framework for evaluating the marketing strategy for a

product

The Four Ps Framework involves examining four aspects relevant to a

product’s marketing strategy:

1. Price;

2. Product;

3. Promotion; and

4. Place.

1. Price

The pricing strategy that a firm employs will affect a product’s market

share and profitability.

Depending on the situation, there are many different pricing strategies

that a firm might choose to employ. We can group all of these strategies

under three headings: competitive pricing, cost based pricing, and value

based pricing.

1.1 Competitive pricing

Under this strategy, the price of a product will be affected by the price

of competing products, and by the availability of substitutes.

How do prices compare with the competition? Is the pricing appropriate

given the product’s relative quality and position within the market?

A firm might consider the following competitive pricing strategies:

1. Predatory pricing: Aggressive pricing intended to undercut

competitors and drive them out of the market.

2. Limit pricing: A low price charged by a monopolist in order to

discourage entry into the market by other firms.

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3. Penetration pricing: The price is set low in order to gain market

share.

1.2 Cost based pricing

Under this strategy, the price of a product will be determined by the

company’s cost structure and the cost of goods sold.

What is the company’s cost structure? What percentage of costs are

fixed and variable? A company that has high fixed cost and low variable

costs will benefit from economies of scale and may want to lower prices

to increase market share.

A firm might consider the following cost based pricing strategies:

1. Marginal cost pricing: The price of a product is set equal to the

cost of producing one extra unit of output.

2. Target pricing: The price of a product is calculated to produce a

particular return on investment.

3. Cost-plus pricing: Arguably the most basic pricing strategy which

involves setting price equal to the unit cost of production plus a

margin for profit.

1.3 Value based pricing

Under this strategy, pricing will be driven by the perceived value of the

product in the mind of the customer. Perceived value will depend on

various factors include branding, product differentiation, availability, the

customer’s price sensitivity and willingness to pay.

Are customers price sensitive? If prices are changed, how will this affect

sales volume and product perception?

Two (2) practical examples of value based pricing include:

1. A company that manufactures t-shirts might produce branded

Gucci t-shirts that retail for $80 per shirt, and produce unbranded

t-shirts of the same design and quality that retail for $30;

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2. A movie theatre might sell adult tickets for $20, and sell the exact

same tickets to students for $10.

A firm might consider the following value based pricing strategies:

1. Price discrimination: Setting a different price for the same product

for different customer segments. See “Price discrimination”.

2. Dynamic pricing: A flexible pricing mechanism, which allows

online companies to adjust the price of identical goods to

correspond to a customer’s willingness to pay. This is made

possible by using data gathered from a customer including where

they live, what they buy, and how much they have spent on past

purchases.

3. Market-orientated pricing: Setting a price based upon analysis of

the target market.

4. Psychological pricing: Pricing designed to have a positive

psychological impact. For example, selling a product at $3.95

instead of $4.

5. Skimming: Charging a high price to gain a high profit, at the

expense of achieving high sales volume. This strategy is usually

employed to recoup the initial investment cost in research and

development, commonly used in consumer electronic markets

when a new product range is released since early adopters are

typically less price sensitive.

6. Premium pricing: Keeping the price of a product artificially high in

order to encourage a favourable perception among buyers.

7. Loss leader pricing: A loss leader is a product sold at a low price to

stimulate other profitable sales. For example, the 30 cent soft serve

cone at McDonalds.

8. Seasonal pricing: Adjusting the price depending on seasonal

demand.

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2. Product

Is the product a low cost commodity or differentiated? The major

sources of product differentiation include:

1. Vertical differentiation: Products can differ in their quality due to

differences in reliability, comfort, support services, or other

factors. For example, BMW versus Hyundai.

2. Horizontal differentiation: Products can differ in features that

cannot be ordered. For example, different flavours of ice-cream.

3. Availability: Products may be available at different times (e.g.

seasonal fruits) and locations (e.g. ice-cream sold near the beach).

4. Perception: Products can differ in their brand recognition, which

can be influenced through sales, marketing and promotion.

How does a product compare with what the competition is offering?

Are their viable substitutes? Do customers face high switching costs?

Successful product differentiation can lead to Monopolistic competition,

a situation where firms retain some control over pricing despite there

being multiple competitors.

3. Promotion

Promotion is used to enhance the perception of a company or its

products in the mind of the customer. A promotion may draw people’s

attention to branding, quality, product features, price or availability.

What message is the firm trying to communicate? What is the objective?

Who is the target customer? What is the right promotion medium, reach

(that is, number of people reached through the chosen medium) and

frequency of promotion? What is the firm’s marketing budget?

How does the firm’s marketing strategy differ from the competition?

How might the competition react to the firm’s marketing strategy?

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Understanding the customer’s buying decision process can help a firm

decide where and how to influence the customer’s purchase decision.

Figure 9: Customer Buying Decision Process

Promotion can be carried out in various ways including:

1. Advertising (digital, TV, newspapers, magazines);

2. Direct Sales (door to door, cold calling, warm calling, direct mail);

3. Indirect Sales (word of mouth);

4. Trade Promotions (price discounting, quantity discounting);

5. Public Relations (donating to charity, sponsoring a sports team,

celebrity appearances).

4. Place

The physical location and availability of a product can be a source of

competitive advantage. For example, if there are two ice-cream stores,

one next to a popular tourist beach and the other in a quiet suburb, we

would reasonably expect that the ice cream store near the beach will be

able to charge higher prices and sell more ice-cream.

A firm should consider the markets and market segments that it serves.

Does the competition serve the same markets and market segments?

Which inventory control system should the firm use? Should the firm

insource or outsource transportation and logistics?

What distribution channels does the firm use? Which channels are most

closely aligned with the company’s strategy? What are the economics of

available channels? Do these fit with the intended selling price of the

product? How much control is the company willing to give up in the

delivery of its products? What is the risk that market power shifts to the

channel?

Awareness Information

Search Evaluation Purchase Re-puchase

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3.5.2 Product Life Cycle Model

The Product Life Cycle Model can be used to analyse the maturity

stage of products and industries

1. Background

The idea of the Product Life Cycle was first developed in 1965 by

Theodore Levitt in an article entitled “Exploit the Product Life Cycle”

published in the Harvard Business Review on 1 November 1965.

2. Benefits

For a business, having a growing and sustainable revenue stream from

product sales is important for the stability and success of its operations.

The Product Life Cycle model can be used by consultants and managers

to analyse the maturity stage of products and industries. Understanding

which stage a product is in provides information about expected future

sales growth and the kinds of strategies that a firm should implement.

3. Product Life Cycle Model

The Product Life Cycle is the name given to the stages through which a

product passes over time. The classic Product Life Cycle has four stages:

1. Introduction;

2. Growth;

3. Maturity; and

4. Decline.

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Figure 10: Product Life Cycle Model

3.1 Introduction

At the market introduction stage the size of the market, sales volumes

and sales growth are small. A product will also normally be subject to

little or no competition. The primary goal in the introduction stage is to

establish a market and build consumer demand for the product.

There may be substantial costs incurred in getting a product to the

market introduction stage. Costs may derive from activities such as

thinking of the product idea, developing the technology, determining the

product features and quality, establishing sufficient manufacturing

capacity, preparing the product branding, ensuring trade mark

protection, testing the market, setting up distribution channels, and

launching and promoting the product.

The market introduction stage is likely to be a period of low or negative

profits. As such, it is important that products are carefully monitored to

ensure that sales volumes start to grow. If a product fails to become

profitable it may need to be abandoned.

Factors to consider during the introduction stage include:

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Product development: Research and development of the basic

technology and product concept, determining the product features

and quality level.

Pricing: Should penetration pricing or a skimming price strategy be

used? A skimming price strategy might be appropriate where there

are very few competitors.

Distribution: Distribution might be quite selective until consumer

acceptance of the product can be achieved.

Promotion: Marketing efforts are aimed at early adopters, and seek

to build product awareness and educate potential consumers about

the product.

3.2 Growth

If the public gains awareness of a product and consumers come to

understand the benefits of the product and accept it then a company can

expect a period of rapid sales growth. In the growth stage, a company

will try to build brand loyalty and increase market share.

Profits are driven by increased sales volume due to growth in market

share as well as an increase in the size of the overall market. Profits

might also be driven by cost reductions gained from economies of scale,

and perhaps more favourable market prices. Competition in the growth

stage remains low, although new competitors are expected to enter the

market. When competitors enter the market a company might be subject

to price competition and increase its marketing expenditure.

Factors to consider during the growth stage include:

Product improvement: Product quality might be improved,

additional features and support services added, and packaging

updated.

Pricing: If consumer demand is high the price might be maintained

at a high level.

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Distribution: Distribution channels might be added as consumer

demand increases.

Promotion: Promotion is aimed at a broader audience. A company

might spend a lot of resources on promotion during the growth

stage in order to build brand loyalty.

3.3 Maturity

When a product reaches maturity, sales growth slows and sales volume

eventually peaks and stabilises. This is the stage during which the market

as a whole makes the most profit. A company’s primary objective at this

point is to defend market share while maximising profit.

In this stage, prices tend to drop due to increased competition. A

company’s fixed costs are low because it is has well established

production and distribution. Since brand awareness is strong, marketing

expenditure might be reduced, although increased marketing

expenditure might be needed to retain market share and fight increasing

competition. Expenditure on research and development is likely to be

restricted to product modification and improvement, and perhaps

research into improved production efficiency and product quality.

Factors to consider in a mature product market include:

Product differentiation: Increased competition in the mature

product market means that a company must find ways to

differentiate its product from that of competitors. Strong branding

is one way to do this.

Pricing: Prices may be reduced because of increased competition.

Firms in the market should be careful not to start a price war.

Distribution: Distribution intensifies and incentives may be offered

to encourage preference to be given over competing products.

Promotion: Promotion will focus on emphasising product

differences and creating/maintaining a strong brand.

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3.4 Decline

A product enters into decline when sales and profits start to fall. The

market for that product shrinks which reduces the amount of profit

available to firms in the industry. A decline might occur because the

market has become saturated, the product has become obsolete, or

customer needs or preferences have changed.

A firm might try to stimulate growth by changing its pricing strategy, but

ultimately the product will have to be re-designed, or replaced. High-

cost and low market share firms will be the first to exit the industry.

As product sales decline, a firm has three options:

1. Hold: Maintain production, add new features and find new uses

for the product. Reduce the cost of manufacturing (e.g. move

manufacturing to a low cost jurisdiction). Consider whether there

are new markets in which the product might be sold.

2. Harvest: Continue to offer the product, but reduce marketing

expenditure perhaps by targeting a smaller niche segment of the

market.

3. Divest: Discontinue production, and liquidate the remaining

inventory or sell the product to another firm.

Factors to consider during a declining market include:

Product consolidation: The number of products may be reduced,

and surviving products rejuvenated.

Price: Prices may be lowered to liquidate inventory, or maintained

for continued products.

Distribution: Distribution becomes more selective. Channels that

are no longer profitable are phased out.

Promotion: Expenditure on promotion is reduced.

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4. Criticisms

The Product Life Cycle is useful for monitoring sales results over time

and comparing them to products with a similar life cycle. However, the

Product Life Cycle model is by no means a perfect tool. Products often

do not follow a defined life cycle, not all products go through each stage,

and it is not always easy to tell which stage a product is in at any point in

time. Consequently, the life cycle concept is not well-suited for

forecasting product sales.

The length of each stage will vary depending on the product and the

marketing strategies employed. A Product Life Cycle may be as short as

a few months for a fad or as long as a century or more for a product like

petrol cars. In many markets the product life cycle is longer than the

planning cycle of the organisations involved. Major products often hold

their position for several decades or more, indeed, Coca-Cola was

introduced in 1886 and is still the leading brand of cola.

The Product Life Cycle is only one of many considerations that a

company needs to bear in mind. The product life cycle of many modern

products is shrinking, while the operating life for many of these

products is lengthening. For example, the operating life of durable goods

like household appliances has increased substantially. As a result, a

company that produces these products must take their market life and

service life into account when planning.

Some critics have argued that a Product Life Cycle can become self-

fulfilling. For example, if sales peak and then fall a manager may

conclude that a product is in decline and cut back on marketing, thus

precipitating a further drop in sales.

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3.6 Cost Management 1. Cost Structure

In order to understand a company’s costs, it will help to break each

business unit down into the collection of activities that are performed to

produce value for customers. This is an application of Value Chain

Analysis (see “3.2.1 Value Chain Analysis”). The way each activity is

performed combined with its economics will determine a firm’s relative

cost structure within its industry.

In examining a firm’s cost structure, relevant considerations include:

1. What are the business’s fixed costs? For example, Sales General &

Admin, overheads, rent and interest expenses, depreciation, capital

costs, R&D, and wages under fixed employment contracts.

2. What are the business’s variable costs? For example, raw materials,

shipping, energy, sales commissions and performance bonuses.

3. What are the main cost drivers?

4. How have costs changed over time?

5. How does the firm’s cost structure compare to the competition?

A company that has more fixed costs relative to variable costs is said to

have more operating leverage, and will experience a greater percentage

change in profits for a given percentage change in sales. Firms with high

operating leverage tend to be in industries that require large economies

of scale, such as the software industry. Operating leverage is a form of

risk since a company with high operating leverage will require high sales

volumes in order to ensure profitability.

2. Cost Reduction

When developing a cost reduction strategy, three questions to consider

include:

1. How long will it take to reduce major cost drivers?

2. Are the activities strategically important?

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3. To what extent do the activities contribute to operational

performance?

Figure 11: Cost reduction decision matrix

A company will want to eliminate or outsource costly activities that have

low strategic importance. If the activity has a low contribution to

operational performance it should probably be eliminated, and if it has a

high contribution to operational performance it can be outsourced.

A company will want to retain control of activities that have high

strategic importance. This can be done by continuing with business as

usual, finding ways to increase efficiency, or forming a strategic alliance

with more capable firms.

Twelve (12) common cost reduction techniques include:

Procurement

1. Consolidate procurement or renegotiate supply contracts;

HR Management

2. Reduce labour costs through decreasing salaries, training, overtime,

benefits and healthcare, introducing employee stock ownership,

and ‘right sizing’;

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Technology Development

3. Use IT and digital technology to reduce communication and

organisational costs;

4. Employ more advanced production technology;

Operations

5. Improve the utilisation rate of plant, property and equipment;

6. Outsource manufacturing to a lower cost jurisdiction (for example,

China or India);

7. Relocate the centre of operations to a lower cost city, region or

country;

Logistics

8. Partner with distribution companies (for example, FedEx);

Finance

9. Reduce working capital including inventory and accounts

receivable;

10. Refinance outstanding debt;

11. Buy futures contracts to hedge against changes in commodity

prices and foreign exchange rates;

12. Divest non-core assets.

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3.7 Financial Management

3.7.1 Five C Analysis of Borrower

Creditworthiness

When a company is trying to borrow money, executives,

entrepreneurs and consultants need to be aware of the five criteria

that lenders typically care about

It is important to understand what lenders look for when they assess a

company’s creditworthiness because companies often need to borrow

money for various purposes: increasing working capital, refinancing

existing debt, paying operating expenditures, conducting research and

development, undertaking new product development, expanding into

new markets, or pursuing M&A activity.

There are five criteria that most lenders use to assess a borrower’s

creditworthiness:

1. Capacity to generate sufficient cash flows to service the loan;

2. Collateral to secure the loan in case the borrower defaults;

3. Capital that shareholders have invested in the business;

4. Conditions prevailing in the borrower’s industry and the broader

economy; and

5. Character and track record of the borrower and the borrower’s

management.

It is important to bear in mind that lenders don’t give equal weight to

each criterion and will use all five criteria to create an overall impression

of a company’s creditworthiness. Lenders are typically cautious and

weakness in one of the five criteria may offset strength in all of the

others. For example, if a company is in a cyclical industry (e.g.

construction, auto, or aviation) the company may find it difficult to

borrow money during an economic downturn even if the company

shows strength in all of the other criteria. Similarly, if a company’s

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management has a bad reputation and poor track record then the

company may find it difficult to borrow money even if it has a strong

financial statement.

Taken together, these five criteria indicate a borrower’s ability and

willingness to repay its debts. As such, if you a company aiming to raise

finance, or are advising such a company, it is important to ensure that

the company can satisfy prospective lenders on each of the five criteria.

Below we consider each of the five criteria in more detail.

1. Capacity

Capacity to repay a loan is the most important criterion used to assess a

borrower’s creditworthiness. The borrower must be able to satisfy the

lender that it has the ability to repay the loan. To satisfy itself of the

borrower’s capacity, the lender will consider various factors including:

1. Profitability: What are the revenues and expenses of the

borrower?

2. Cash flows: How much cash flow does the business generate?

The lender is interested not only in cash flows from operations,

but also cash flows from investing and financing activities. What

are the timing of cash flows with regard to repayment?

3. Payment history: What is borrower’s payment history and track

record of loan repayment?

4. Debt levels: How much debt does the borrower have? How much

debt can the borrower reasonably afford to repay?

5. Industry evaluation: What is the normal debt/liquidity level for

companies in the borrower’s industry?

6. Financial ratios: There are a number of financial ratios, such as

debt and liquidity ratios, that lenders will typically evaluate before

lending money: for example, Debt to Equity Ratio, Debt to Asset

Ratio, Current Ratio, Quick (Acid Test) Ratio, and Operating Cash

Flow Ratio.

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2. Collateral

While cash flows are the primary source for the repayment of a loan,

collateral provides lenders with a secondary source of repayment.

Collateral represents the assets that are provided to the lender to secure

a loan. In the event that the borrower defaults, the collateral may be

seized by the lender to repay the loan.

A borrower will usually need to provide a lender with suitable collateral.

To do this, the borrower normally pledges hard assets like real estate,

office equipment or manufacturing equipment. However, accounts

receivable and inventory might also be pledged as collateral.

Service businesses and small companies may find it difficult to provide

lenders with the collateral they require because they have fewer hard

assets to pledge.

If the borrower doesn’t have the necessary collateral, the lender may

require personal guarantees from the borrower’s directors or from a

third party such as the borrower’s parent company.

3. Capital

Capital is the money that shareholders have personally invested in the

business. Capital represents the money that shareholders have at risk if

the business fails.

Lenders are more likely to lend money to a borrower if shareholders

have invested a large amount of their own money in the business. If the

business runs into financial difficulty, then the capital of the business

provides a cushion for repayment of the loan. If shareholders have a

large amount of capital invested in the business, this indicates they have

confidence in the venture and that they will do all that they can to

ensure the borrower does not default on the loan.

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4. Conditions

Conditions refer to two factors that the lender will take into account.

Firstly, conditions refer to the overall economic climate, both within the

borrower’s industry and in the economy generally that could affect the

borrower’s ability to repay the loan. For example, during recessions and

periods of tight credit it becomes more difficult for small businesses to

repay loans and more difficult for lenders to find money to lend. Thus,

during these periods a small business will find it difficult to borrow

money and must present lenders with a flawless loan application.

In considering the overall economic climate a lender may consider

various questions including:

1. What is the current business climate?

2. What are the trends for the borrower’s industry? How does the

borrower fit within them?

3. What is the short and long-term growth potential for the industry?

4. Where does the industry fall within its life cycle? Is it an emerging

or mature industry?

5. Are there any economic or political hot potatoes that could

negatively impact the borrower’s growth?

Secondly, conditions refer to the intended purpose of the loan. The

borrower’s reasons for seeking the loan should be spelt out in detail in

the loan application. Will the money be used to buy new equipment for

expansion? Will the money be used to replenish working capital to

prepare for a seasonal inventory build-up?

5. Character

Character refers to the general impression that the borrower forms

about the prospective lender. The lender will form a subjective

judgement as to whether the borrower is sufficiently trustworthy to

repay the loan.

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Lenders want to place their money with companies that have impeccable

credentials. Relevant factors that a lender may consider in deciding

whether the borrower is sufficiently trustworthy include:

1. What is the character of each member of the management team?

2. What reputation do management have in the industry and the

community?

3. What educational background and level of experience does

management have?

4. What is management’s track record?

5. What is the overall consumer perception of the borrower?

6. Is the borrower progressive about its waste disposal, quality of life

for its employees, and charitable contributions?

7. Does the borrower have a track record of fulfilling its obligations

in a timely manner?

8. What is the borrower’s payment history and track record of loan

repayment?

9. Are there any legal actions pending against the borrower? If so,

what is the reason for these legal actions?

3.7.2 Net Present Value

NPV is a simple tool that executives and consultants can use to

determine whether an investment should be undertaken. The NPV

of an investment is the present value of the series of expected cash

flows generated by the investment minus the cost of the initial

investment

The net present value (NPV) of an investment is the present value of the

series of expected cash flows generated by the investment minus the

cost of the initial investment, and can be written as follows:

𝑁𝑃𝑉 = 𝐶𝐹1

(1 + 𝑟)1+

𝐶𝐹2

(1 + 𝑟)2+ ⋯ +

𝐶𝐹𝑛

(1 + 𝑟)𝑛+

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒

(1 + 𝑟)𝑛− 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝐶𝐹𝑛 × (1 + 𝑔)

𝑟 − 𝑔

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Where r = discount rate; CFt = expected cash flow in period t; g = long

term cash flow growth rate.

NPV is a simple tool used to assess whether an investment should be

undertaken. As a general rule, assuming you have selected an appropriate

discount rate, only investments that yield a positive NPV should be

considered for investment.

1. The Discount Rate

The rate used to discount future cash flows to their present value is an

important variable in the net present value calculation. The choice of

discount rate will depend on the situation.

1.1 Cost of capital

One option is to use a firm’s weighted average cost of capital.

However, there are two potential problems with using the cost of capital

for the discount rate. Firstly, it may not be possible to know what the

cost of capital will be in the future. Secondly, the cost of capital does not

take into account opportunity costs. A positive NPV calculation tells us

that the investment is profitable, but does not tell us whether the

investment should be undertaken because there may be even more

profitable investment opportunities.

1.2 Opportunity Cost

A second option is to use a discount rate that reflects the opportunity

cost of capital. The opportunity cost of capital is the rate which the

capital needed for the project could return if invested in an alternative

venture. Obviously, where there is more than one alternative investment

opportunity, the opportunity cost of capital is the expected rate of return

of the most profitable alternative.

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2. Potential Issues

2.1 Negative future cash flows

One potential problem with NPV is that if the future cash flows are

negative (for example, a mining project might have large clean-up costs

towards the end of a project) then a high discount rate is not too

cautious but too optimistic. A way to avoid this problem is to explicitly

calculate the cost of financing losses after the initial investment.

2.2 Adjusting for risk

Another common pitfall is to adjust for risk by adding a premium to the

discount rate. Whilst a bank might charge a higher rate of interest for a

risky project that does not necessarily mean that this is a valid way to

adjust a net present value calculation. One reason for this is that where a

risky investment results in losses, a higher discount rate in the NPV

calculation will reduce the impact of such losses below their true

financial cost.

2.3 Negative NPV

The general rule is that only those investments that yield a positive NPV

should be considered for investment. However, this will only be true if

we have selected an appropriate discount rate. For example, if the

appropriate discount rate is 15% but we used a higher discount rate to

calculate NPV, then obtaining a negative NPV does not mean that the

project should be rejected.

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3.8 Organisational Cohesiveness

3.8.1 McKinsey 7 S Model

The 7 S Model can help executives and consultants understand the

inner workings of an organisation, and can provide a guide for

organisational change

1. Background

Developed around 1978, the 7 S model first appeared in a book called

The Art of Japanese Management by Richard Pascale and Anthony

Athos, and also featured in In Search of Excellence by Tom Peters and

Robert Waterman.

McKinsey has adopted the 7 S model as one of its basic analysis tools.

2. Relevance

The 7 S model is a useful diagnostic tool for understanding the inner

workings of an organisation. It can be used to identify an organisation’s

strengths and sources of competitive advantage, and also to identify the

reasons why an organisation is not performing effectively. As such, the 7

S model can be a useful analysis tool for mangers, consultants, business

analysts and potential investors.

The 7 S model can provide a guide for organisational change. The

framework maps a group of interrelated factors, all of which influence

an organisation’s ability to change. The interconnectedness among each

of the seven factors suggests that significant progress in one area will be

difficult without working on the others. The implication is that, if

management wants to successfully establish change within an

organisation, they must work on all of the factors, and not just one or

two.

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3. McKinsey 7 S Model

The 7 S model describes seven factors which together determine the way

in which an organisation operates. The seven factors are interrelated

and, as such, form a system that might be thought to preserve an

organisation’s competitive advantage. The logic is that competitors may

be able to copy any one of the factors, but will find it very difficult to

copy the complex web of interrelationships between them.

Figure 12: McKinsey 7 S Model

The seven (7) factors considered by the 7 S Model include:

1. Shared values refer to the values that are widely practiced within

an organisation and which form its core guiding principles. Shared

values may include things like the purpose of the organisation and

its long term vision for the future. For example, the core guiding

principle at McKinsey is ‘professionalism’.

2. Strategy refers to the plans that a company has for gaining a

sustainable competitive advantage (e.g., low cost or differentiated

products; new product development and entering new markets).

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3. Skills refers to the competencies of the organisation, the skills and

experience of staff, management practices, and the ability to

innovate.

4. Structure refers to the way in which an organisation’s people and

business units relate to each other. This includes organizational

structure, communication channels, and chain of command.

5. Staffing refers to the recruitment, selection, training,

development, and management of talent.

6. Style refers to the work culture, the leadership style of upper

management and the way things are done in the course of day-to-

day operations.

7. Systems refers to the organisation’s processes and procedures for

things like budgeting, communication, recruitment, compensation,

and performance reviews.

3.9 Competitive Response A competitor’s recent or impending actions may call for a competitive

response.

When placed in this kind of situation, a company should first examine

the business situation to see what kind of response might be

appropriate.

Have customer needs and preferences changed?

What actions have the competition taken or threatened to take? Are they

offering new or different products? Have they changed their pricing

strategy? Are they using new raw materials or distribution channels?

Have they gained market share or entered new markets? Have they

changed their cost structure or increased their operating efficiency?

Potential competitive responses might include:

Product innovation: Redesign, repackage or improve existing

products;

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Product development: Introduce new products;

Pricing: Change the pricing strategy. See “3.5.1 Four Ps

Framework”;

Marketing: Increase brand recognition and improve customer

loyalty;

Customer service: Improve customer service and introduce

customer loyalty programs;

New market entry: Enter new markets. This might be achieved

by launching a start-up, acquiring a competitor, or forming joint

ventures;

Control suppliers and channels: Monopolize key suppliers and

distribution channels through acquisition or by entering into long

term contracts;

Mimic: Observe the competition and mimic their behaviour;

Attack: Seek to undermine the competition by poaching key

employees, entering one of its other markets, launching a patent

lawsuit, or attacking it in the media.

Case Example

A situation might unfold in which CanadaCo, the largest discount

retailer in Canada by market share, is forced to respond to a competitive

threat from USCo, the largest discount retailer in the United States,

which has decided to expand into Canada by purchasing CanadaCo’s

competition. The question is, how should the CEO of CanadaCo

respond?

In the CanadaCo example, it would be important to test the hypothesis

that USCo has a cost advantage due to economies of scale in the US

market. A cost advantage would allow USCo to provide lower prices to

Canadian consumers and, as a result, USCo’s entry into the Canadian

market might be expected to reduce CanadaCo’s market share.

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Once the business situation and the relative strengths and positions of

USCo and CanadaCo are fully understood, it will then be possible to

formulate a competitive response.

CandaCo could opt to do nothing, or respond in one or more of the

following ways:

1. Change its pricing strategy;

2. Hire top executives away from USCo;

3. Acquire or merge with a competing company;

4. Rouse customer loyalty through rewards programs and customer

service;

5. Mimic USCo’s behaviour by entering the US market; or

6. Market CanadaCo’s products in order to build brand recognition.

3.10 Corporate Turnaround When faced with the challenge of turning around and restructuring a

company, it is important to ask a variety of questions to determine the

source of the problem.

What is the state of the economy?

What have been the prevailing trends in the industry? Are competitors

facing the same problems?

Are there issues with the company’s finances? Is the company publicly

traded or privately held?

Below we outline eight (8) actions that a company might pursue as part

of a turnaround:

1. Examine and understand the company, its finances and operations;

2. Talk to key stakeholder including suppliers, distributors and

customers;

3. Review the company’s culture, management team and existing

talent;

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4. Review the company’s products and services;

5. Secure sufficient funding to give the company the time and

resources needed to pursue a turnaround strategy;

6. Establish and prioritize short term and long term goals;

7. Prepare a business plan;

8. Prioritize small successes in order to build positive momentum.

Case Example

Take RadioShack as an example, which filed for bankruptcy protection

in February 2015. Assuming a turnaround is possible, what strategy

should be followed to save the company?

Looking at the stock price of RadioShack over the past fifty years, it is

apparent that the dotcom boom represented the height of success for

the company. RadioShack had developed a reputation as the ultimate

shopping destination for budding innovators and engineers. But

unfortunately the company failed to modernize, doing little to transform

itself into a destination for mobile buyers.

By comparison, rivals Amazon and Wal-Mart have continuously adapted

and maintain a significant competitive advantage in pricing these

products due to scale.

In a competitive landscape fraught with declining sales of consumer

electronics and falling margins, RadioShack has fallen into a precarious

situation.

As of 15 January 2015, RadioShack closed 175 underperforming brick

and mortar stores and may close further stores as part of restructuring

plans. This should present the company with the opportunity to reinvent

product offerings and create a new culture.

A strategy that RadioShack might consider is to return to its roots as a

place of innovation by offering specialty and niche products that are

unavailable through the company’s major rivals. Shifting the product

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focus would need to be accompanied by a shift in employee training,

encouraging hiring practices that target inventive individuals that can

appropriately engage with the new desired consumer base.

Rather than attempt to compete with pre-existing rivals, RadioShack

should carve out a new niche in the consumer electronics market that

celebrates the pioneers and the mavericks.

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4. General Concepts and

Frameworks This section contains concepts and frameworks designed to deepen and

broaden your understanding and ability to analyse business situations.

4.1 Barriers to Entry Barriers to entry represent the costs that must be paid by a new market

entrant but not by firms already in the industry. Barriers to entry reduce

the threat posed by potential competitors by making a market less

contestable, and allow existing firms to maintain higher prices than

would otherwise be possible.

Below we outline eight (8) examples of barriers to entry:

1. Economies of Scale

The existence of economies of scale in an industry creates a barrier to

entry. Since existing firms are already producing they are often in a

better position to exploit economies of scale than a new entrant and, as

such, can often undercut on price. A new entrant is forced either to

accept the cost disadvantage or enter the industry on a large scale (which

increases the likely financial loss if they are later forced to exit the

industry).

2. Network Effects

If existing products or services in the industry benefit from Network

effects then it may be difficult for new firms to enter the industry.

3. Product Differentiation

If there is a high level of product differentiation in the industry then this

creates a barrier to entry since new entrants will not be able to compete

merely on price, but will need to provide a unique value proposition.

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Sources of product differentiation include:

3.1 Branding: If existing firms and products have strong brand

recognition then this will deter new entrants. If customers perceive

existing products as unique or high quality then a new entrant will need

to spend money to educate customers about the unique qualities and

benefits of its products. This will increase the cost of gaining market

share and deter entry into the market.

3.2 Customer service: If existing firms have strong customer

relationships formed through customer service and customer loyalty

programs then it may be difficult for new entrants to gain market share.

3.3 Product differences: Existing products in the industry may be

different due to differing design, quality, benefits, features, or

availability.

4. Capital Requirements

High start-up costs: High fixed start-up costs will deter new firms from

entering an industry. Examples of capital intensive industries with high

fixed costs include the automotive and telecommunications industries.

High sunk costs: If a large portion of the start-up costs cannot be

recovered (that is, they are Sunk costs) then a new entrant risks having

to absorb the loss if it decides to exit the industry. Examples of sunk

costs include:

Specialised assets: Highly specialised technology or equipment that

cannot be used for other purposes and which cannot be sold (or

can only be sold at a steep discount); and

Industry specific expenditure: Industry specific expenditure, such

as marketing or R&D, which cannot be used to benefit the firm’s

operations in other industries.

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5. Intangible Assets

Proprietary product technology: The existence of proprietary product

technology represents a barrier to entry. If an existing product is

protected by patent then it will not be possible for a new entrant to use

the patented technology without permission from the patent owner.

Specialised knowledge: Incumbents may possess specialised knowledge,

skills or qualifications which are difficult or costly to acquire, for

example, legal or medical certifications.

6. Access to Suppliers and Buyers

Access to raw materials: If a new entrant cannot gain access to raw

materials then this represents a barrier to entry. If existing firms have

exclusive long term contracts with suppliers, or existing firms own key

suppliers, then this will make it difficult for a new entrant to obtain the

raw materials it needs to operate effectively in the industry.

Access to distribution channels: If a new entrant cannot gain access to

distribution channels then this represents a barrier to entry. If there are a

limited number of wholesale or retail distribution channels, or existing

firms have exclusive long term contracts with distributors then this will

make it difficult for a new entrant to reach the customer. For example,

McDonalds often has stores in the best locations which makes it more

difficult for new restaurants to compete with it.

Switching costs: If customers face high switching costs, then it will be

more difficult for a new entrant to gain market share. Switching costs

will be affected by various factors including the length of customer

contracts, the existence of customer loyalty programs, and the price

performance and compatibility of complimentary products.

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7. Government Policy

7.1 Government Regulation

The government may limit or restrict entry into a market by requiring

market participants to obtain a licence or other government approval in

order to carry on business; examples include taxi licenses, safety

standard compliance certificates, mining permits, and investment

approvals.

In extreme cases, the government may make competition illegal by

establishing a statutory monopoly. For example, AT&T had a statutory

monopoly in the telecommunications industry in the United States until

the early 1980s.

7.2 Tariffs and Subsidies

Government regulations that subsidise or tax the activity of all industry

participants do not represent a barrier to entry. For example, tariffs,

quotas or subsidies that apply equally to incumbents and new entrants

are not barriers to entry.

That being said, tariffs and quotas may pose barriers to entry where they

protect the market share of existing firms or prevent new firms from

gaining access to the market. Similarly, subsidies may pose a barrier to

entry where they operate solely or predominantly for the benefit of

incumbents.

8. Competitive Response

A potential entrant’s expectations about how existing firms will respond

to market entry by a new player will affect their entry decision. If a

potential entrant reasonably expects, or irrationally fears, that existing

firms will compete aggressively then this may deter entry.

Expectations of a strong competitive response from incumbents will be

higher where:

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1. Industry growth is slow, which means the industry will not be able

to absorb new entrants without the profitability of incumbents

being hurt;

2. Incumbents have a lot of fighting potential including large cash

balance, strong cash flow, unused credit facilities, or clout with

government, distribution channels and customers; and

3. Incumbents are likely to cut prices due to industry wide excess

capacity or a desire to retain market share.

4.2 Cost Benefit Analysis The cost benefit analysis is a basic analysis framework that involves

weighing up the costs and benefits of one course of action against one

or more other courses of action.

1. Relevance

The cost benefit analysis is one of the most straightforward ways to

compare one course of action against another. Business leaders need to

constantly evaluate options, and consultants are paid to provide

recommendations to help executives make these decisions.

2. Cost Benefit Analysis Explained

The cost-benefit analysis is one of the most basic analysis frameworks

that can be used to examine a business problem, and involves weighing

up the expected costs and benefits of one course of action against

another.

Understanding the relative benefits and costs of the available options

can make it easier to select a course of action and identify whether

further information is required.

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3. Case Example

Consider the following situation. Your client is a mining company and

presents the following problem, “We currently own and operate a gold

mine, Mine A, and we are trying to decide whether to expand Mine A or

build a second mine, Mine B. Which project should we undertake?”

In this problem there are three possible options:

1. Expand Mine A;

2. Build Mine B; or

3. Do nothing.

To make a recommendation, it is necessary to consider the benefits and

costs of each potential course of action.

In this example, the benefits are the expected revenues from pursuing

each option (revenue=quantity x price), and might be estimated using a

discounted cash flow model.

Costs derive from various sources, and there are four types of cost that

should be considered:

1. Sunk costs;

2. Fixed costs;

3. Variable costs; and

4. Opportunity costs.

1. Sunk Costs

Sunk cost are expenditures that have already been made and which

cannot be recovered. As a result, they should not be factored into the

decision-making process.

For example, in our mining example the original cost of building Mine A

is a sunk cost. The money was spent in the past, it cannot be recovered,

and so it should not affect the current decision.

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2. Fixed Costs

Fixed costs are costs that do not vary with the quantity of output

produced.

In our mining example, fixed costs might include things like rent, wages,

land taxes, utilities and overheads.

It is important to remember that fixed costs are fixed only in the short

term. For example, wages may be a fixed cost in the short term if the

company cannot vary the number of employees due to contractual

obligations. In the long run, however, these contracts could be

renegotiated. In the long run, nearly all costs are variable, even things

like rent, because a company can always move its operations to new

premises or to a lower cost jurisdiction.

3. Variable Costs

Variable costs are costs that vary with the quantity of output produced.

In our mining example, the main variable costs would be the cost of

extracting ore from the ground, and the cost of transportation.

When making decisions in the short run, variable costs are the only costs

that should be considered because a company will not be able to change

its fixed costs.

4. Opportunity costs

The opportunity cost of pursuing a course of action is what must be

given up in order to pursue it.

In our mining example, failing to consider opportunity costs could lead

to the wrong decision being made.

For example, if expanding Mine A is expected to produce a $1 million

profit and building Mine B is expected to produce a $2 million profit,

which project should the company pursue?

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Building Mine B appears favourable, but the company also needs to

consider the opportunity cost. If ‘business as usual’ is expected to

produce an even greater profit, then the opportunity cost of pursuing

either project exceeds the expected payoffs, and so the company should

not take action.

4.3 Economies of Scale Economies of scale exist where the average cost of producing one unit

of output decreases as the quantity of output increases.

1. Relevance

There are many instances when, for a firm to make a sensible decision or

for a government to engage in sound policy making, an understanding of

economies of scale is helpful.

1.1 Barriers to entry

The existence of economies of scale in an industry creates a barrier to

entry (for more information, see “4.1 Barriers to Entry”). This is

relevant for firms that benefit from economies of scale and want to

deter new entrants from entering their industry. This might be done by

investing in excess capacity, which can be used to compete aggressively

in response new entrants.

1.2 Natural monopoly

An industry is a natural monopoly if one firm can produce the desired

output at a lower social cost than two or more firms. That is, a natural

monopoly exhibits economies of scale in social costs. Examples of

industries that are natural monopolies include railways, water, electricity,

telecommunications, and postal services.

Since it is always more efficient for one firm to expand than for a new

firm to be established, the dominant firm in a natural monopoly often

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has significant market power. As a result, it will make sense for these

firms to be highly regulated or publicly-owned.

1.3 Free trade

Economies of scale provide a justification for free trade policies since a

firm may require more customers than are present in the domestic

market in order to fully benefit from economies of scale. For example,

it is unlikely that Airbus, based in Toulouse, would be able to operate

profitably if it could only sell aeroplanes within France.

2. Importance

In the early 20th century, by using assembly lines to mass produce the

Model T Ford, Henry Ford became one of the richest and best-known

men in the entire world.

Economies of scale provide a company with two key benefits:

1. Increased market share: Lower per unit costs can allow a

company to reduce prices and increase market share. Economies

of scale allow larger companies to be more competitive and to

undercut smaller firms.

2. Higher profit margins: If a company is able to maintain prices,

then lowering the average cost per unit will result in higher profit

margins.

3. Economies of Scale Explained

Economies of scale may result from the increased output of an

individual firm (internal economies of scale) or from the growth of the

industry as a whole (external economies of scale).

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Figure 13: Economies of scale exist where the average cost of

producing one unit of output decreases as the quantity of output increases

3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as

its output increases. A firm will benefit from internal economies of scale

where it has high fixed costs and low variable costs since it will be able

to spread fixed costs over more units of output as production increases.

Below we list seven (7) potential sources for internal economies of scale:

1. Lower input costs: A larger firm may have more bargaining power

with suppliers that it can use to negotiate lower prices for raw

materials by bulk buying or entering long term contracts.

2. Efficient technology: As output increases it may become

economical for a firm to invest in more advanced production

technology leading to lower average costs.

3. Research and development: Research and development is a large

fixed cost for many firms. As a company increases output, R&D

can be spread over more units of output.

4. Access to finance: A large company will typically find it easier to

borrow money, to access a broader range of financial instruments,

and may be able to borrow at lower interest rates.

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5. Marketing: Many marketing costs are fixed costs, and so as output

increases a firm can spread this cost over a larger number of units

thereby reducing the average marketing cost per unit.

6. Specialisation of labour: In a larger company, employees are able

to become more specialised in the tasks that they perform. For

example, different managers might specialise in operations,

marketing, human resources and finance. Specialist managers are

likely to be more effective and efficient since they are likely to have

a higher level of experience as well as role specific training and

qualifications.

7. Learning by doing: Workers will improve their productivity by

regularly repeating the same tasks (see “4.5 Experience Curve”).

3.2 External economies of scale

External economies of scale arise when firms benefit from the way in

which the industry is organised.

Below we list three (3) potential sources of external economies of scale:

1. Improved transport and communication links: As an industry

becomes established in a particular location, the government is

likely to provide better transport and communication links to the

region. This benefits firms as they will be able to reduce related

expenses. Improved transport will also allow firms to attract more

customers, and recruit from a broader pool of employees.

2. Industry specific training and education: As an industry becomes

more dominant, universities will offer more courses tailored for a

career in that industry. For example, the rise of the IT industry led

to a proliferation of IT courses. Firms benefit from being able to

recruit from a larger pool of appropriately skilled employees.

3. Growth of support industries: If a network of suppliers and other

support industries grows alongside the main industry then firms

will be able to purchase higher quality inputs at lower cost.

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4. Diseconomies of scale

‘Diseconomies of scale’ exist where the average cost of production

increases as output increases. As a firm grows it is likely to become more

complex to manage and run. Diseconomies may result from increasing

bureaucracy, problems with motivating a larger work force, greater

barriers to innovation and entrepreneurial activity, and increased agency

costs (see “Principle-agent problem”).

4.4 Economies of Scope Economies of scope exist where a firm can

produce two products at a lower per unit cost

than would be possible if it produced only the

one.

Economies of scope is an idea that was first

explored by John Panzar and Robert Willig in an

article published in 1977 in the Quarterly Journal

of Economics entitled “Economies of Scale in

Multi-Output Production”.

1. Relevance

The title of Panzar and Willig’s landmark article may not sound very

interesting, but it does make one thing clear; economies of scope and 4.3

Economies of Scale are closely related concepts.

4.3 Economies of Scale is a fairly well known concept relevant to big

producers like Intel, Microsoft, Boeing and Toyota.

In contrast, economies of scope is a lesser known concept particularly

relevant to small and medium sized enterprises (SMEs) that may not

have access to large markets or the ability to produce at scale.

SMEs are important because they represent the overwhelming majority

of global business activity, and are the world’s main source of job

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creation and economic growth. For example, SMEs account for around

99% of businesses in Europe (Economist Intelligence Unit 2011).

2. Importance

Economies of scope provide firms with two key benefits:

1. Lower average costs: If a company diversifies its product

offering it may be able to lower the average cost of production.

For example, McDonalds offers a range of different products

(burgers, fries, sundaes, salads, etc.). As a result, it can achieve

lower per unit costs by spreading overheads across a broader range

of products. Lower per unit costs allow a company to enjoy higher

profit margin on each unit sold, or lower the price it charges

customers in order to increase market share.

2. Diversified revenue streams: By producing multiple products, a

firm can diversify its sources of revenue, which reduces the risk

associated with product failure.

3. Economies of Scope Explained

Economies of scope exist where a firm can produce two products at a

lower average per unit cost than would be possible if it produced only

one of those products. Economies of scope have been found to exist in

a range of industries including banking, publishing, distribution, and

telecommunications.

Economies of scope and 4.3 Economies of Scale are related concepts.

The distinction is that ‘4.3 Economies of Scale’ refers to the situation

where the average per unit cost of production decreases as output

increases, whereas ‘economies of scope’ refers to the situation where the

average per unit cost of production decreases as the number of different

products increases.

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Figure 14: Economies of scope exist where the average cost of producing

one unit of output decreases as the number of different products increases.

3.1 Sources of Economies of Scope

Below we outline seven (7) potential sources of economies of scope:

1. Common inputs: Using more of the same inputs will increase a

firm’s bargaining power with suppliers. For example, Kleenex

manufactures a range of products which use the same raw

materials: tissues, napkins, paper towels, facial tissues, incontinence

products and Huggies nappies.

2. Joint production facilities: Plant and equipment can be more fully

utilised. For example, a dairy manufacturer may be able to use its

existing dairy production facilities to produce a range of different

dairy based products: milk, butter, cheese and yoghurt.

3. Shared overhead costs: Overheads can be shared across multiple

products. For example, McDonalds can produce hamburgers,

French fries and salads at a lower average per unit cost than would

be possible if it produced only one of these goods. Each product

shares overhead costs such as food storage, preparation facilities,

restaurant space, toilets, car parks and play equipment.

4. Marketing: Marketing and advertising costs can be shared across

products. For example, Proctor & Gamble produces hundreds of

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products from Gillette razors to Old Spice aftershave, and can

therefore afford to hire expensive designers and marketing experts

and spread the cost across a broad range of products.

5. Sales: Selling products is easier when it is possible to provide

customers with a range of options … “Would you like fries with

that?”

6. Distribution: Shipping a range of products is more efficient than

shipping a single product. For example, Amazon sells an extremely

broad range of products, which enables it to negotiate favourable

deals with freight companies.

7. Diversified revenue streams: A firm that sells multiple products

will have lower revenue risk because it is less dependent on any

one product to sustain sales. More stable cash flows are attractive

for three reasons:

a. They can be used to negotiate more favourable credit terms

with banks.

b. A strong cash position can also be used to extend credit to

customers and thereby increase sales.

c. More stable cash flows can allow a firm to be more innovative

with new product launches because the failure of any one

product will have less impact on total revenues.

4. Diseconomies of scope

A firm that offers too many products may begin to incur an increase in

average per unit costs with each additional product offered. Reasons for

diseconomies of scope may include:

1. Diluted competitive focus;

2. Lack of management expertise;

3. Higher raw material costs due to bottlenecks or shortages; and

4. Increased overhead costs.

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4.5 Experience Curve The Experience Curve captures the predictable and persistent

relationship between increasing production experience and

declining costs

1. Background

The Learning Curve, the concept which predates the Experience Curve,

was first described by German psychologist Hermann Ebbinghaus in

1885 as part of his studies into human memory.

In 1936, T.P. Wright described the effect of learning on production

costs in the aircraft industry showing that required labour time dropped

by 10 to 15 percent with every doubling of production experience.

In 1966, Bruce Henderson and the Boston Consulting Group conducted

research for a major semiconductor manufacturer, in which they

introduced the concept of the Experience Curve and revealed that unit

production costs fell by 20 to 30 percent every time production

experience doubled.

How did BCG’s “Experience Curve” differ from the earlier concept of

the “Learning Curve”?

Well, in essence the two concepts capture the same big idea:

performance improves with experience in a predictable and persistent

manner.

In his 1968 article, Bruce Henderson attempted to distinguish the two

concepts by explaining that the Learning Curve relates only to labour

and production inputs, whereas the Experience Curve focuses on total

costs. In other words, the Experience Curve is intended to be a more

comprehensive measure of how costs decline with production

experience.

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2. The Experience Curve

The Experience Curve captures the relationship between a firm’s unit

production costs and production experience. Research has shown that a

firm’s costs typically fall by a predictable amount for every doubling of

production experience.

Source: Wikipedia

Unit production costs tend to decline at a consistent rate as a firm gains

production experience, however the rate typically varies from firm to

firm and from one industry to another.

The interesting thing about the Experience Curve is not that a firm’s

performance improves with experience, we would expect as much, but

instead that performance tends to improve with experience at a

predictable rate.

This is surprising. What might explain the Experience Curve effect?

3. The Experience Curve Effect

In his 1968 article, Bruce Henderson noted that:

“… reductions in costs as volume increases are not necessarily

automatic. They depend crucially on a competent management

that seeks ways to force costs down as volume expands.

Production costs are most likely to decline under this internal

pressure. Yet in the long-run the average combined cost of all

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elements should decline under the pressure for the company to

remain as profitable as possible. To this extent the [Experience

Curve] relationship is [one] of normal potential rather than one of

certainty …”

While falling costs may not occur with certainty, the Experience Curve

effect has proved to be pervasive and has been shown to exist for

different firms and across a broad range of different industry sectors. It

must be the case then that declining costs are the result of certain innate

human and organisational factors rather than from a specific cause, such

as the brilliance of a rock star management team or the well power

pointed recommendations of a top consulting firm.

If top executives and consultants are not the key source of persistent

organisational learning, then what is?

There does not appear to be a definitive answer to this question,

however seven (7) factors that are likely to contribute to the Experience

Curve effect include:

1. Optimised Procurement: As a firm gains production experience

it will learn more about its suppliers, which will allow it to optimise

its procurement practices. Increased production may also give a

firm more bargaining power with suppliers;

2. Labour efficiency: As employees gain production experience they

will develop skills, learn shortcuts, and find ways to produce more

with less;

3. Standardisation: Over time processes and product parts are likely

to become standardised allowing for more streamlined production;

4. Specialisation: As production volume increases a firm is likely to

hire more employees, allowing each of them to specialise in a

narrower range of tasks and thereby perform more efficiently;

5. Product Refinement: A firm may engage in significant R&D and

marketing prior to and during the initial product launch. As it

learns more about the product and its customers it will be able to

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refine the product, which may allow the firm to reduce ongoing

R&D and marketing costs;

6. Automation: Increased production volume may make it feasible

for a firm to adopt more automated and advanced production

technology and IT systems; and

7. Capacity Utilisation: If a firm has incurred large set up costs,

then increasing production will allow it to spread these fixed costs

across a larger number of units.

4. Implications for Strategy

The Experience Curve effect shows that a firm’s production costs

decline in a predictable way as it gains production experience.

What are the implications of the Experience Curve effect for corporate

strategy?

In 1968, in light of BCG’s research, Bruce Henderson took the view that

a firm should price its products as low as would be necessary to

dominate their market segment, or else it should probably stop selling

them. The same year BCG also developed the growth share matrix, a

framework which recommends allocating resources within a firm

towards products that are, or are likely to become, market leaders.

The clear and resounding message from Henderson and BCG was

“dominate the market or don’t bother”.

The thinking behind this simple and rather clear-cut view was that a

company with market share leadership would be able to gain production

experience more quickly than its rivals and so would be able to achieve a

self-sustaining cost advantage.

As it turns out though, pursuing market share leadership will not always

be the best approach as there are four (4) countervailing factors that may

neutralise the benefits of market share leadership.

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Firstly, market share may not confer a cost advantage since firms can

learn not just from production experience but also from books, courses,

formal training, conferences, reverse engineering, talking to suppliers,

hiring consultants, and by poaching staff from the competition.

Secondly, if multiple firms pursue market share leadership at the same

time then this may create intense competitive rivalry leading to a decline

in industry profitability.

Thirdly, new entrants can often avoid going head to head with the

market share leader by creating more advanced products or by using

more efficient production technology. This can allow new players to leap

frog the competition and force existing firms to play catch up by

investing heavily in R&D, forming strategic alliances or acquiring the

new players before they are able to dominate the market.

Fourthly, even if market share leadership does confer a cost advantage

there are other ways to compete effectively. Firms can also gain a

competitive advantage by creating differentiated products or by targeting

a niche market segment (see “3.3.1 Porter’s Generic Strategies”).

So, where does this leave us?

Well, a firm that aims to be the cost leader within its industry will

probably want to pursue market share leadership since the Experience

Curve effect and 4.3 Economies of Scale are two significant factors that

will allow it to reduce costs.

However, a firm that aims to compete by providing differentiated

products or by targeting a market niche may find the pursuit of market

share leadership to be incompatible with its chosen strategy. A firm that

provides unique or targeted products will generally be able to charge

higher prices and this will naturally limit potential sales volume. If it

makes its products more generic or more widely available in an attempt

to gain market share, then this may reduce the uniqueness of its

products and require the firm to lower prices. A firm that tries to make

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its products both differentiated and ubiquitous runs the risk of failing to

achieve either strategy.

In short, market share leadership is likely to be appropriate for firms that

are competing on the basis of cost leadership. It is unlikely to be the

correct strategy in every situation.

4.6 MECE Framework MECE (pronounced “me see”) stands for

“mutually exclusive and collectively

exhaustive” and is one of the hallmarks of

problem solving at McKinsey (The

McKinsey Way by Ethan M. Rasiel).

1. Benefit of the MECE Framework

The MECE framework can aid clear thinking about a business problem

by:

1. Helping to avoid double counting – categories of information are

grouped so that there are no overlaps; and

2. Helping to avoid overlooking information – all categories of

information taken together should cover all possible options.

2. MECE

MECE is a framework used to organise information which is:

1. Mutually exclusive: Information is grouped into categories that

are separate and distinct; and

2. Collectively exhaustive: All categories taken together should deal

with all possible options without leaving any gaps.

3. MECE Tree Diagram

The MECE tree diagram is a way of graphically organising information

into categories which are mutually exclusive and collectively exhaustive.

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The diagram as a whole represents the problem at hand; each branch

stemming from the starting node of the tree represents a major issue

that needs to be considered; each branch stemming from one of these

major issues represents a sub-issue that needs to be considered; and so

on.

A major issues list should not contain more than five issues, with three

being the ideal number (see Rule of Three). If you are not able to

categorise a problem in five major issues then consider creating a

category of “other issues”.

The MECE framework can be applied to a wide variety of business

problems, for example, Coca-Cola might ask the question “what is the

source of declining global profitability”? To answer this question, Coca-

Cola might use a MECE tree diagram to help it identify the source of

the issue.

Figure 15: MECE Tree Diagram

4. Resources

For more information on the MECE framework, please see Barbara

Minto’s book Pyramid Principle.

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4.7 Moral Hazard “Moral hazard is when they take your money and then are

not responsible for what they do with it.”

~ Gordon Gekko

Moral Hazard refers to any situation where a person

is not fully responsible for the consequences of

their actions. As a result, they may take greater risks

than they would have otherwise.

1. Relevance

The 2008 financial crisis caused the largest recession since the great

depression. According to the US Department of the Treasury as many

as 8.8 million jobs were lost and $19.2 trillion in household wealth was

wiped out (US Treasury Report).

At the heart of the great recession was a concept known as “moral

hazard”.

2. What is Moral Hazard?

Moral Hazard is a concept that is often misunderstood by politicians,

journalists and economists. And so we turn to Hollywood for clarity.

Gordon Gekko in the movie Wall Street captured the nature of Moral

Hazard very concisely when he explained that “moral hazard is when

they take your money and then are not responsible for what they do

with it.”

Gekko may well have borrowed his definition from Paul Krugman,

Professor of Economics at Princeton University, who described Moral

Hazard as “… any situation in which one person makes the decision

about how much risk to take, while someone else bears the cost if things

go badly.”

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It is worth noting that “Moral Hazard” is an economic concept and does

not necessarily imply immorality or unscrupulous dealing.

Below we outline six (6) examples of where Moral Hazard shows up in

practice.

1. Insurance: The provision of insurance is the most common

example of where Moral Hazard tends to arise.

For example, if you have comprehensive private health insurance

you are more likely to visit the doctor. You may also engage in

more risk taking behaviour, like bungy jumping or sky diving,

because you are not responsible for paying the medical bill if

things go wrong.

Malcolm Gladwell provides an amusing example of “Universal

Pepsi Insurance”:

“Moral hazard” is the term economists use to describe the

fact that insurance can change the behaviour of the person

being insured. If your office gives you and your co-workers

all the free Pepsi you want—if your employer, in effect,

offers universal Pepsi insurance—you’ll drink more Pepsi

than you would have otherwise.

2. Mortgage Securitisation: Mortgage securitisation is another

example of where Moral Hazard shows up.

The US government, motivated by a desire to expand home

ownership, for many years actively encouraged bankers to make

loans to people with poor credit ratings. Fannie Mae and Freddie

Mac, two large government sponsored enterprises, carried out this

policy through a process known as “mortgage securitisation”.

Moral Hazard occurred because the banks and mortgage brokers

who originated the loans were able to on-sell the loans to Fannie

Mae and Freddie Mac, and so were not on the hook if lenders

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ultimately defaulted. As a result, they had an incentive to make as

many loans as possible, even to people with extremely poor credit

ratings.

3. The Greenspan Put: The Greenspan Put is another example of

where Moral Hazard comes into play.

Since the late 1980’s the Federal Reserve followed a policy of

significantly lowering interest rates in the wake each financial crisis

(often referred to as the Greenspan Put). Lowering interest rates

has the effect of increasing the amount of money available in the

economy which prevents the economy from deteriorating further

and stops asset prices from falling. As a result, investors were

encouraged to take excessive risks because they knew that the Fed

would lower interest rates if a financial crisis ensued.

4. Bank Bailouts: The provision of bank bailouts by government is

another example of where Moral Hazard occurs.

In 2008, in the wake of the sub-prime mortgage crisis, the US

government created a US$700 billion Troubled Asset Relief

Program (known as TARP) to buy financial assets from banks and

other financial institutions. The bailout was intended to stabilise

financial markets, make sure that credit markets remained liquid

and prevent a repeat of the great depression. A worthy goal,

however a big problem with TARP was that it created a large

Moral Hazard. If banks come to know that government will bail

them out during periods of financial instability, then they have an

incentive to take excessive risks in the future.

5. Private Equity: Private equity vehicles are another example of

where Moral Hazard can show up.

Assume, for example, that investors give a private equity firm $100

million to invest. If the fund makes a profit of $20 million then the

fund managers might take fees of 20%, or $4 million. On the other

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hand, if the fund loses $20 million then the investors lose money

but the fund managers are not required to cover the cost. Since the

managers do not have to pay for the cost of their investment

decisions if things go badly they have a strong incentive to take

excessive risks.

6. The Limited Liability Company: The limited liability company

presents an often overlooked example of where Moral Hazard

takes place.

Companies often link executive remuneration with the company’s

performance on the stock market. The reason for doing this is to

align the interests of executives with the interests of shareholders,

in an attempt to reduce the Principle-agent problem.

If the company performs well and its stock price rises then

shareholders are happy and executives are paid a bonus (which

might be in the form of cash or shares). However, if the company

performs poorly then shareholders lose, while executives still

receive their base salary and are not required to compensate

shareholders. Since executives are not responsible for paying the

full cost if things go badly, they have an incentive to take excessive

risks in order to boost the company’s short term stock price in

order to secure their bonuses.

4.8 Porter’s Five Forces The Porter’s Five Forces framework is used to determine the

competitive intensity and attractiveness of an industry

1. Background

Harvard Business School Professor Michael Porter, in his 1979 book

Competitive Strategy, developed the Porter’s Five Forces.

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The Porter’s Five Forces framework is used to determine the

competitive intensity and attractiveness of an industry (attractiveness in

this context refers to the overall industry profitability).

The framework can be used in the context of deciding whether to enter

a new market.

In determining the competitive intensity of an industry, Porter’s Five

Forces include three forces from Horizontal competition (1, 2 and 3),

and two forces from Vertical competition (4 and 5):

1. Existing competition: How strong is the rivalry among existing

firms?

2. Barriers to entry: What is the threat posed by new entrants?

3. Substitutes: What is the threat posed by substitutes?

4. Supplier bargaining power: How much bargaining power do

suppliers have?

5. Customer bargaining power: How much bargaining power do

customers have?

Figure 16: Porter’s Five Forces

1. Existing Competition

Factors contributing to increased competitive rivalry among exiting

competitors include:

Increased number of firms,

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Slower market growth rate,

Low product differentiation,

Low switching costs,

Industry wide excess capacity,

High fixed costs / economies of scale,

High exit barriers.

For more information on the factors that will influence the strength of

competition within an industry, see “3.2.3 Competitive Intensity”.

2. Barriers to entry

The threat posed by new players entering the market will depend on the

level of barriers to entry. High barriers to entry will reduce the rate of

entry by new firms, and allow firms already in the industry to charge

higher prices than would otherwise by possible.

Barriers to entry might include capital requirements, economies of scale,

network effects, product differentiation, proprietary product technology,

government policy, access to suppliers, access to distribution channels,

and switching costs.

For more information on barriers to entry, see “4.1 Barriers to Entry”.

3. Substitutes

Substitutes represent a form of indirect competition because consumers

can use substitute products in place of one another (at least in some

circumstances). For example, natural gas is a substitute for petroleum.

The threat posed by substitutes will depend on various factors,

including:

1. Switching costs: The cost to customers of switching to a substitute

product or service;

2. Buyer propensity to substitute;

3. Relative price-performance of substitutes; and

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4. Perceived level of product differentiation.

4. Supplier Bargaining Power

Suppliers provide inputs to firms in an industry, for example, labour and

raw materials. The ability of suppliers to extract a share of industry

profits depends on the level of supplier bargaining power.

For more information on the factors that will affect supplier bargaining

power, see “3.2.2 Vertical Competition within the Supply Chain”.

5. Customer Bargaining Power

Customers are the purchasers of goods or services produced by firms in

the industry. The ability of customers to extract a share of industry

profits depends on the level of customer bargaining power.

For more information on the factors that will affect customer

bargaining, see “3.2.2 Vertical Competition within the Supply Chain”.

4.9 Quantitative Easing Quantitative easing is a monetary policy tool sometimes employed by

central banks to stimulate the economy when conventional monetary

policy becomes ineffective.

Normally, the central bank carries out expansionary monetary policy by

lowering short-term interest rates through the purchase of short-term

government securities. However, when the short-term interest rate gets

close to zero it becomes impossible to lower the short-term interest rate

further and so this policy tool can no longer be used to stimulate the

economy (this is known as the liquidity trap).

When faced with the liquidity trap, the central bank can shift the focus

of monetary policy away from interest rates and towards increasing the

money supply (that is, quantitative easing). To increase the money

supply, the central bank creates new money electronically and uses it to

buy financial assets from financial institutions. This leads to an increase

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in the excess reserves held by these financial institutions, and the central

bank hopes that banks will use these funds to increase lending and

stimulate the economy.

If the central bank increases the money supply too quickly, then this is

likely to lead to price inflation since there will be more money chasing

the same number of goods and services.

4.10 Rule of 70 The Rule of 70 is a simple rule of thumb that can be used to figure

out roughly how long it will take for an investment to double,

given an expected growth rate

The Rule of 70 is a simple rule of thumb that can be used to figure out

roughly how long it will take for an amount to double, given an expected

growth rate.

The rule can be described by the following equation:

𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥) = 70

𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

If the world’s GDP is growing at 4% per year then global GDP will

double in about 17 years.

𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝐺𝐷𝑃 = 70

4= 17.5 ≈ 17

If your company’s revenue is growing at 10% per month then revenues

will double in about 7 months.

𝑀𝑜𝑛𝑡ℎ𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 70

10= 7

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4.11 SWOT Analysis SWOT Analysis is a strategic planning tool used to evaluate the

strengths, weaknesses, opportunities, and threats involved in a

business venture

1. Background

Albert Humphrey is credited with inventing the SWOT analysis

technique.

2. SWOT Analysis

SWOT analysis is a strategic planning tool used to evaluate the

Strengths, Weaknesses, Opportunities, and Threats involved in a

business venture. It involves specifying the objective of the business

venture and identifying the internal and external environmental factors

that are expected to help or hinder the achievement of that objective.

After a business clearly identifies the objective, SWOT analysis involves:

1. Examining the strengths and weaknesses of the business (internal

factors); and

2. Considering the opportunities presented and threats posed by

business conditions, for example, the strength of the competition

(external factors).

By identifying its strengths, a company will be better able to think of

appropriate strategies to take advantage of new opportunities. By

identifying weaknesses and threats, a company will be better able to

identify changes that need to be made to improve performance and

protect the value of its current operations.

3. Criticisms

SWOT analysis has two clear weaknesses. Firstly, using SWOT analysis

may persuade companies to write lists of Pros and Cons, rather than

think about what needs to be done to achieve objectives. Secondly, there

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is a risk that the resulting lists will be used uncritically and without clear

prioritisation. For example, weak opportunities might be used to balance

strong threats.

4. Case example

To help understand SWOT analysis, consider the strategy of a

hypothetical soft drinks manufacturer called “Coca-Cola”. Coke is

currently the market leader in the manufacture and sale of sugary

carbonated drinks and has a strong brand image. Sugary carbonated

drinks are currently an extremely profitable line of business. The

company’s goal is to develop strategies to achieve sustained profit

growth in future.

1. Strengths

Coke’s strengths are its resources and capabilities that provide it with a

competitive advantage in the market place, and help it to achieve its

strategic objective. Coke’s strengths might include:

1. Strong product brand names,

2. Large number of successful drink brands,

3. Good reputation among customers,

4. Low cost manufacturing, and

5. A large and efficient distribution network.

2. Weaknesses

Weaknesses include the attributes of Coke’s business that may prevent it

from achieving its strategic objective. Coke’s weaknesses might include:

1. Limited range of healthy beverage options, and

2. Large manufacturing capacity makes it difficult to change

production lines in order to respond to changes in the market.

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3. Opportunities

Changing business conditions may reveal new opportunities for profit

and growth. Coke’s opportunities might include:

1. New markets into which Coke could expand, and

2. The absence of a dominant global manufacturer of healthy

beverages may leave a gap in the market.

4. Threats

Changing business conditions may present certain threats. Coke’s threats

might include:

1. Shifting consumer preferences away from Coke’s core products,

and

2. New government regulations that prevent the acquisition of large

competing soft drink companies.

5. Proposed strategy

Based on the foregoing analysis, the main opportunity for Coca-Cola

might be the rising popularity of healthy beverages, such as water and

fruit juice. The main threat may be the dominance of Coca-Cola and the

increasing number of anti-trust regulations that prevent Coke from

acquiring competing manufacturers. A possible strategy could therefore

be to find small manufacturers of healthy beverages with quality

products. Purchasing these small companies will not raise competition

concerns. Coke might use its strong brand name, manufacturing capacity

and distribution networks to obtain strong market penetration for the

newly acquired beverages.