Managers, consultants, and entrepreneurs must make strategic choices that directly impact firm performance. These decisions range from which industries to compete in to which capabilities a firm should invest in. However, as the introduction of cutting-edge technologies exponentially reduces industry lifecycles, these choices become even more complex and uncertain. This course, Strategic Management, focuses on how managers can use analysis to make insightful strategic decisions about overall firm direction in this fast moving environment.
The design of this course reflects a three-pronged pedagogical approach to helping you learn the foundations of strategy.
First, we introduce you to the basic theories of strategic management – theories and mechanisms are important because they allow you to abstract from any particular situation and understand underlying causal relationships (like why is this firm profitable?)
Second we teach you strategic frameworks and tools that allow you to apply those theories.
Frameworks and tools help you take the basic theory and understand how to analyze a company’s situation, diagnose its problems, and offer sound solutions.
Third, we provide ample opportunities (much of it with your team) –through cases and
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experiential learning – to apply theses theories and frameworks. It’s the hands on part where you actually have to apply what you’ve learned. It’s a powerful tri-partite pedagogy that’s designed to make you a better strategist.
Porter suggests that a competitive advantage is based on carving out a unique position in the industry and taking advantage of or actively establishing barriers to imitation, so that other competitors cannot erode that advantage.
In contrast, Zenger argues that strategy is based on having unique resources that your competitors do not possess. He explains that firms can use these unique resources to create a theory of the firm that can be used to apply these resources across different contexts.
So, which side did you feel would create the most value?
The answer is that they are both equally valuable, as Zenger focuses on finding new opportunities that can be well-served by the firm’s unique resources, and Porter focuses on creating a position within that new industry and developing further barriers to imitation.
If we think back to the idea of creative destruction and renewal from Schumpeter, we can see that Porter is particularly applicable when a company is on an industry curve, while Zenger is most valuable when the company is looking to jump to the next industry curve.
Instead of a SWOT analysis, which yields imprecise and potentially biased analyses, we introduced a strategic framework in this course that allows for a deeper dive into analyzing a firm and its environment.
Key takeaways
TOPIC: Introduction – Strategic Analysis in the Digital Age | CASE: Zoom
1. Strategy is both about a strategic theory based on firm resources as well as strategic positioning in the industry a) So, Porter and Zenger!
b) But, Porter during stability and Zenger during environmental shifts
2. Strategic analysis
a) Allows us to get behind the numbers
b) SWOT Analysis is imprecise and subjective – other analyses offer greater precision, especially in time of rapid environmental shifts
c) Strategic framework allows us to explore more precise analytical tools throughout the course
INSTITUTIONAL VOIDS
Includes political institutions such as the national structure of policymaking, regulation and adjudication; economic institutions such as the structure of the national factor markets and the terms of access to international factors of production; and sociocultural institutions such as informal norms. Institutional voids must be considered with FDI, that is If you are planning to invest in a foreign country.
To do an institutional void analysis, evaluate each of the components and then weigh the need to address those voids with the costs associated with them. When the ability to “fill” the voids exceeds the costs, then FDI is more likely.
COMPETITOR ANALYSIS
When you are selecting your own dimensions for your own analysis - It’s up to you to choose the right dimensions. Here you’ll want to focus on those dimensions which are especially salient competitive dimensions.
The first step in a competitor analysis is to determine the boundaries of the industry. This is a difficult part of the analysis. Essentially who is in and who is out? This is tricky because you want to make sure that you don’t’ miss peripheral players who could be more central in in the future. On the other hand, you don’t want to waste resources pursuing everyone if they don’t compete.
There are a few ways to establish the boundaries:
1. Consider the nature of PRODUCT DIFFERENTIATION – HUNDAI COMPETE PORCHE?
2. Understand GEOGRAPHICAL DISTINCTIONS
3. Understand whether CLOSE SUBSTITUTES exist (Cable operators and DirecTV)
4. Or how the industry is evolving
What are some ways you can clearly identify competitors?
CROSS PRICE ELASTICITY = GOLD STANDARD
Extent to which the price of another product, of a competitor’s product, affects demand for your product. Percentage change in price of other product vs. percentage change in demand of our product. So, if the price of another product drops, our demand goes up a lot, they’re pretty close substitutes. On the other hand, if when the price of another product changes, demand for our product is not affected at all, we’re not substitutes.
In strategy, we also do a strategic group analysis, which is a map.
The goal with a strategic groups analysis is to Identify distinct clusters of firms with similar strategic positions It’s a “Segmentation” of competitors, where the axes are key dimensions of competition. When you are selecting your own dimensions for your own analysis - It’s up to you to choose the right dimensions. Here you’ll want to focus on those dimensions which are especially salient competitive dimensions. What do players compete on in the particular industry you’re analyzing.
Environmental (PESTLE) analysis
Political-Gov’t Pressure Technological changes
MacroEconomic Impact
Socio-Cultural Influences Other Environmental trends
Key Questions for Five Forces Analysis
Threat of entry:
How much competitive pressure is applied by potential new entrants? How much are prices constrained by the risk that new entrants will enter and steal business?
Threat of substitution:
How much competitive pressure is applied by substitute industries? How likely is it that consumers in this industry will switch to products from another industry?
CONSEQUENCES FOR PROFITS AT FOCAL FIRM
Threat of new entrants:
NEW ENTRANTS WILL INCREASE SUPPLY – PUSH PRICES AND THEREFORE PROFITS
DOWN
Threat of substitutes:
CLOSE SUBSTITUTES THAT CUSTOMER COULD SWITCH TO WILL LIMITE A FOCAL FIRMS PRICING POWER AS WELL
Key Questions for Five Forces Analysis (Cont.)
Internal Rivalry:
§ How much competition is there among the set of direct competitors? That is, how much downward pressure do direct competitors put on a firm’s prices?
Supplier of Power:
§ Can suppliers negotiate to capture the profits created on the value chain?
Buyer of Power:
§ Can buyers negotiate to capture the profits created on the value chain?
CONSEQUENCES FOR PROFITS AT FOCAL FIRM
Rivalry
LOTS OF RIVALRY (COMP) PUSH PROFITS DOWN
Supplier power:
SUPPLIERS CAN CHARGE HIGH PRICES – PUSH PROFITS DOWN
Buyer power:
CUSTOMER HAVE BARGAINING POWER – PUSH PROFITS DOWN
What to look for in assessing rivalry
Key Issue: Where does the industry sit on continuum between monopoly and perfect competition? That is, how much downward pressure do direct competitors put on a firm’s prices? Or put differently, if a firm tries to maintain a price above cost, how much business will it lose to direct competitors.
Key questions:
Are the incentives to “fight” are high? Is tacit coordination feasible?
Look for: Look for:
• Many competitors (e.g. CR4<50%) • Structural factors
• Slow market growth (especially if • Few competitors capacity not constrained) (concentration)
• Substantial excess capacity (demand is • A few dominant competitors cyclical) • Similar competitors
• No opportunities to differentiate • Facilitating devices
• High exit costs • Threat of price wars (tit-for-tat)
• Rapid obsolescence • Best-price clauses
• Long history of trust
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RIVALRY INTENSITY GREATER (INCENTIVES TO FIGHT ARE GREATER) WHEN:
MANY COMPETITORS
--Look for a concentration ratio (CR4) < 50%. CR4 is sum of market share of top 4 players.
SLOW MARKET GROWTH (especially if NOT capacity constrained) --COMPETING FOR SAME CUSTOMERS.
--EXAMPLE: PC MAKERS LOOKING TO INT’L MARKETS BECAUSE US MARKETS SLOWED --Calculate CAGR, compare forward and backward looking CAGRs, compare to industry averages or to GDP growth
NO OPPORTUNITIES TO DIFFERENTIATE
--Coke and Pepsi, but you’ve been doing it for 75 years and have spent a tremendous amount of money marketing that and cementing that brand image and loyalty in consumers minds, reducing incentives to fight. -Look for strategic groups
HIGH EXIT COSTS
--Have to worry about cleanup, terminating contracts with suppliers, exec compensation
TONS OF EXCESS CAPACITY
--Think about the airline industry. Flights are already scheduled. They’ve already paid to buy or lease the planes. They’ve already paid for their landing slots. A huge amount of fixed
costs they can’t get back, even if they – even if they don’t have any passengers flying. On the other hand, the marginal cost of flying a passenger is pretty low.
RAPID OBSOLESENCE
--Inventory is perishable (like plane seats or consumer electronics)
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SUPPLIER POWER GREATER WHEN:
MORE THREAT WHEN CONCENTRATED
--CAN’T PLAY THEM OFF (IN PC INDUSTRY MS AND INTEL CAN CHARGE HIGH PRICES)
MORE THREAT WHEN FIRMS HAVE FEW ALTERNATIVES.
--IT MEANS THEY ARE DEPEPNDENT. So, again, if I have lots of other things I can buy, if I’m not dependent on one firm or one industry, that’s going to give me more power and it’s going to reduce the relative power of suppliers.
•Substitutes – Dual sourcing
•Low switching – NOT IT consultants
•Supplier cannot forward integrate
IF SUPPLIERS CAN EASILY DISCRIMINATE
--If they know how much I’m willing to pay for a given input, then I will have more power, rather than the supplier.
•Price info widely available – online exchanges; Low search costs.
•Price discrimination
FIRST DEGREE OR PERFECT PRICE DISCRIMINATION – Where you can
actually figure out exactly what each individual consumer’s willingness to pay is and charge it to them.
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SECOND DEGREE OR SORTING - A way for getting consumers to sort themselves into different groups.
THIRD DEGREE – Price based on (identification of) observable characteristics.
BUYER POWER IS GREATER WHEN:
BUYERS ARE CONCENTRATED (MONOPSONY is when buyers are concentrated but suppliers are not and stands in contrast to perfect competition, monopolies, or mutual dependence)
--Look for CR4<50% or significantly more concentrated than the incumbent industry
--Each buyer accounts for a small fraction of sales
BUYERS HAVE MANY INCUMBENTS TO CHOOSE FROM
--Especially true if incumbent products are undifferentiated
--If switching costs are close to zero (e.g., PCs)
--Buyers can backward integrate (e.g., retailers into mobile phone sellers)
IF THE INCUMBENT CANNOT SEGMENT BUYERS
--Harder to extract each buyers’ WTP and consumer surplus
NOTE: PRICE WAR MORE LIKELY
--A price war is more likely If there are only a couple of major buyers for the products in an industry. (cellular carriers – a lot of power over the mobile device manufacturers). --Individual buyers may capture profits by negotiating for lower prices. This is not the overall price sensitivity of consumers. That’s part of rivalry. This is the power of an individual buyer or group of buyers to demand deals.
The analyst should address the following questions:
1. Are deals negotiated individually?
2. Does the product make up a large portion of the buyer’s total costs? If so, he’ll bargain aggressively.
3. Does the buyer purchase a large portion of the firm’s total output?
4. Has the firm has made relationship specific investments in serving the buyer?
5. Could the buyer potentially “backward integrate” to produce the product itself?
6. Does the buyer have multiple firms/products to choose from?
THREAT OF NEW ENTRANTS IS HIGH WHEN:
SUNK COSTS ARE LOW
--Not high per se, but asset specific investments that cannot be recovered --Electricity plant vs. Walmart – Big box store is redeplyoable. Coal plant is not.
INCUMBENTS HAVE NO COMPETITIVE ADVANTAGE
Here you are looking for some capabilities that provide a unique WTP of consumers or a cost advantage.
NEW ENTRANTS FACE DO NOT FACE RETALIATION FROM INCUMBENTS
Here you are looking for an incumbents ability to retaliate against a new entrant. That is, they are able to fight a price war to keep them out.
MINIMUM EFFICIENT SCALE – BOTTOM OF COST CURVE
--Costs decline over some range of output.
--Fixed costs get amortized, or operating costs might also go down for a variety of reasons.
--MES, Minimum Efficient Scale: The point at which you reach the bottom of this cost curve is called Minimum Efficient Scale. Typically costs will start to go back up after that (because or coordination problems, overtime, etc.)
THREAT OF SUBSTITUES IS HIGH WHEN:
SWITCHING COSTS ARE LOW– ONE TIME CUSTOMER INCURS WHEN SWITCHING
--Switching costs are one-time costs, that consumers incur when switching to a new product or service.
--Switching costs may be economic, but they may also be emotional.
CROSS-PRICE ELASTICITY OF DEMAND IS HIGH
Shows the percentage change in the quantity demanded of good (2) in response to a change in the price of good (1).
e = % Change in Q2 / % change in P1
where Q2 iis the change in quantity demanded of product 2, when the price of product 1 (P1) increases
For true substitutes, this number will be between 0 and 1. Read as the cross-price elasticity of demand for product 2 with respect to product 1.
Key Takeaways
TOPIC: Environmental Analyses | CASE: Siemens
§ Institutional analysis: use institutional analysis to identify key institutional voids for FDI
§ Political/social system, openness/restrictions, product markets, labor markets, capital markets
§ PESTLE: Use PESTLE framework to asses major environmental pressures on industry
§ Political-Gov’t pressures, Macroeconomic impact, Socio-cultural influences, Technological change, Legal issues, Other environmental trends
§ Competitor analysis: Use strategic group/map analysis to identify distinct clusters of firms with similar strategic positions, define the industry, collect data on competitors
§ Industry structure (Five Forces): Use five forces to assess the overall attractiveness (profit potential) of the industry from the incumbents perspective
§ Rivalry, Threat of new entrants, Threat of substitutes, Buyer power, Supplier power
§ Value-added: Understand which step of the value chain brings in the greatest value
When you want to assess a firm’s resources and capabilities . . .use the VRI test
Apply the following tests to determine if candidate resources/capabilities can provide sustained economic profits (aka ex-post limits to competition): Value: Assess whether they add value to firm
§ Does the resource/capability create greater WTP or a greater cost advantage than the competition, for at least some customers?
§ Does the resource/capability support the firm’s current or desired strategy and industry trends?
The third part of a firm analysis, involves assessing it’s resources and capabilities. The goal is to understand whether they can support the activities critical to the firm’s value chain and positioning. And whether those resources and capabilities can provide the firm with a sustainable competitive advantage.
That is, do they promise the potential for sustained economic profits over time.
This approach to strategy, by the way, is called the Resource based view or RBV. It was developed by Jay Barney among others including the authors of your reading for this week, Cynthia Montgomery.
First, they need to be valuable. That is they must provide for a higher WTP or lower costs.
When you want to assess a firm’s resources and capabilities . . .use the VRI test (Cont.) Rarity: Assess whether the resource/capability is scarce?
§ Do rivals have or are they developing the resource or capability? Inimitability: Assess whether the resource/capability can be imitated?
§ Are there isolating mechanisms?
§ Is there something preventing competitors from duplicating the resource or capability?
Second they must be rare. If the resource is widely shared (say the resource is a commodity), then it cannot provide advantage. So some sort of contract manufacturing of personal computers for example, or input such as wood, silicon or sugar.
Third, it must be inimitable. That is, it cannot be easily duplicated by a competitor. Typically you look for isolating mechanisms or something that serves as a barrier to duplication. You can think of things like economies of scale or learning.
While value and rarity are fairly straightforward to understand, I think the inimitability criteria warrants closer examination. Inimitability depends on two factors: 1) Characteristics of the firm or its resources that “isolate” specific resources or sets of resources; 2) Features of the market or technology
Let’s consider which of these isolating mechanisms are especially effective in an industry facing digital transformation.
1) Given that the benefit of many resources and capabilities may be losing their inherent value (for example cheap mfg is available to all, as is online channels of distribution), it may be those tacit resources that can be especially important since firms cannot easily copy them.
2) Patents are still important in some industries such as pharmaceuticals, but with the speed of change increasing the advantage that a patent provides is only shortterm. Plus, not all software code – on which some capabilities are build – is patentable and must meet stringent criteria.
3) Resources which take time to build. Frankly, companies just don’t have as much time to scale.
4) Truly one of a kind resources will always be valuable
5) Complementary capabilities. As we saw with Siemens, these complementary assets can be especially important in a digital transformation. The focal innovation will only have an impact if it is paired with sufficient complementary activities so as to support them.
6) We are seeing more and more complexity in business models. Take Amazon or Google. No longer are firms creating value by just developing, manufacturing and distributing goods in house. They are creating complex ecosystems of partners and complementors.
Let’s re-evaluate the features of the market or technology under conditions of digital disruption. Which resources are likely more effective in creating a barrier?
1) Clearly traditional barriers such as economies of scale are less important, especially in a digital environment which is characterized by scale-free resources (like software).
2) Switching costs are declining as information is becoming more readily available.
3) Network effects are likely becoming the most important for creating inimitability. Facebook, Snapchat and ridesharing services benefit from many users – both because it creates communities, but also because it creates opportunities for the collection of information.
EXAMPLE:
=aXb
Y = 60000 (avg unit cost) a = 325000 (first unit cost) X= 12000 (cumulative production)
Ln(Y) = ln(a) + b ln(X)
Ln(60000) = ln(325000) + b ln(12000)
11=12.69+b(9.39)
B=-.1798
Learning curve = 2^(-.1798) = 88.3%
The Learning Curve:
Firms often reduce costs as they accrue production experience or know-how
The Advantage:
Because I entered the market early, I have an edge over new competitors in cumulative production experience
This means that my firm can produce the product at a lower unit cost than my rivals
So, I can underprice them in bidding for new business
This advantage strengthens through time:
With lower prices, I can increase my cumulative volume even more, while my competitors remain stalled
I move even further ahead of them on the learning curve, thereby expanding my present cost advantage
Firms can either be the pioneer of a technology or they can be a follower. Which is a better strategy? Which yield better overall performance?
Innovator (first-mover) strategy
First movers face highest risk
Appropriate for new entrants and those with capabilities (e.g., learning) and innovation strategies (breadth) to match
Advantage is sustainable but must keep innovating
Follower (second-mover) strategy
Less risky (but can miss the boat)
Appropriate for large incumbents
Success requires leveraging complementary capabilities
Firms can be great in one activity and do that better than anyone (e.g., some firms may be particularly good at branding or product development). Alternatively, firms can gain their advantage from how their activities fit together into a cohesive whole (e.g., WalMart).
A key point of this slide is to get you to think about linkages among value chain activities. Firms need to build expertise in individual elements of the value chain, but they also need to exploit linkages. Linkages are more important in some situations than others. For example, ZARA needed to exploit linkages to achieve speed and flexibility. New entrants like ASOS can take advantage of a much more well-developed e-commerce ecosystem, and concentrate only on the upstream activities in the value chain (i.e. design, sourcing & manufacturing, distribution).
Each firm needs to understand the source of its own competitive advantage and the value chain should be configured to reinforce and further develop that advantage.
The purpose of creating a value chain is to break down the firm’s unique activities and analyze them individually as well as understand how they fit together, to assess the firm’s generic strategy or lack thereof. Thus, this is a tool that looks at generic strategy from the perspective of inside the firm.
Value chain analysis can help illustrate how a firm’s activities support one another. However, it can also highlight situations in which activities might conflict with one another in a way that is hurting the firm.
When mapping out the firm’s value chain, start with their unique activities (if any) involved in delivering the product or service (key linkages). Then examine their unique activities (if any) that indirectly support delivery of the product or service (HR, R&D, etc.). Be as specific as you can in terms of what makes up each activity. If you are very vague about how the firm organizes each activity, then it will be difficult to spot potential problems (or strengths upon which the firm can build).
The main value in this analysis is the conclusions and implications that come from it. You are not done with a value chain analysis when you have mapped out the firm’s value chain, you have just started! The next, and most important, step is to determine what conclusions you can draw from the value chain regarding the firm’s activities. Which activities are cost driving or cost saving? Which activities support
differentiation? Based on these activities, does the firm have a generic strategy?, If not,
what might the firm do differently to further support or develop a particular generic strategy?
In Porter’s version of strategy, firms organize their activities in the value chain to support a low cost or differentiation strategy.
A value chain with activities and linkages that reduce firm cost support a low-cost strategy.
A value chain with activities and linkages that increase quality or add features that customers are more willing to pay for, support a differentiation strategy.
Low-cost strategy lowers the focal firm’s cost.
Differentiation strategy raises customer’s willingness to pay.
-Compare prices and volume of sales
-Prices might be higher, but if not selling then customers not willing to pay
-Compare features or quality
-May have more
features or higher quality but if customers not willing to pay for it then no differentiation advantage
This tools highlights the two basic competitive strategies that firms can adopt, as well as the consequences for trying to do both. A value chain supporting a differentiation strategy will create higher margin, but lower quantity sold. A value chain supporting a low cost strategy will create lower margin but high quantity sold. However, both are profitable. A value chain that mixes low cost and differentiation activities creates a product or service that is neither cheap enough for price sensitive customers nor differentiated enough for customers who may be willing to pay more. As a result, the firm is “stuck in the bucket” because neither customer wants the product or service.
A value chain with tight linkages provides a sustainable competitive advantage in a stable environment because competitors have difficulty imitating it.
A value chain with tight linkages leads to difficulty adapting to a new environment because if you change one activity, it has an impact on multiple activities.
Flexibility matters in changing industry environment. In addition to a loosely linked value chain, it can arise from generic inputs and flexible labor.
Key Takeaways
TOPIC: Firm Analysis (I): Value Chain| CASE: ZARA
§ Value chain allows for assessment of firm’s generic strategy from inside the firm
1. Identify principal links in the value chain for the industry
2. List key activities in the links for a specific firm
3. Identify linkages between the activities for the firm
4. Identify which elements or linkages in the firm increase or decrease differentiation and/or cost & recommend changes
§ A tightly linked value chain prevents imitation, but prevents flexibility to jump to next industry curve (new trade-off in digital age)
§ Generic strategies
§ Low-cost: Lowering costs doing something more cost-effective or more efficient than competitors that lowers costs from supplier or costs of developing or delivering the cost or service
§ Differentiation: Doing something different or better than competitors that increases customer willingness to pay
§ Porter’s bucket
§ Tradeoff between low-cost and differentiation - straddling is unprofitable
§ When efficiency frontier is pushed out (e.g. disruption), low cost and differentiation strategies can coexist but dual advantage does not last long
As discussed in the section value chain, Porter’s bucket occurs when a firm straddles low cost and differentiation strategies in a mature industry. However, Blue Ocean strategy allows firms to disrupt mature industries, breaking the tradeoff between low cost and differentiation.
When the industry has been disrupted (is immature) Porter’s bucket does not apply, because the productivity frontier has been pushed out and it takes a while for the firms to find best practices and move to the productivity frontier. Thus, gains in efficiency can produce a temporary competitive advantage, allowing firms to pursue both a low cost and a differentiation strategy. However, once an industry matures, the firms are already out on the productivity frontier, so it is not possible to get advantage from increases in efficiency, so firms have to choose either a low cost or a differentiation strategy.
Red ocean versus Blue ocean
Red Ocean Blue Ocean
Compete in existing markets Create uncontested markets
Focus on beating the competition Focus on making the competition irrelevant
Exploit existing demand Create & capture new demand
Make a value/cost trade-off Break the value-cost trade-off
Align the firm activities to achieve Align the firm activities to achieve either low cost or differentiation differentiation & low cost
Kim and Mauborgne created the concept of blue ocean strategy to allow for the disruption of current industries through the creation of new industries. Red ocean is the typical competition discussed in strategy: focus on sustainable competitive advantage, choosing a generic strategy and applying Porter (building barriers to imitation of your company’s position or your advantage based on activities and their linkages. Blue ocean strategy is about creating the next industry curve: applying Zenger to determine what capabilities you have and which you need, create a new offering that addresses customer or noncustomer pain points in traditional industry.
The first step in blue ocean strategy is create a buyer’s utility map to understand the customers’ and non-customers’ pain points. First lay out the steps in the customer ownership for the product or service. Then, list the characteristics that customers care about for that particular product or service. Finally, evaluate the offerings in the current industry or the focal firm offerings using this criteria. This analysis will help to uncover how the customers and non-customers are being underserved in the current industry or by the focal firm. When an industry has a lot of pain points, it is ripe for disruption.
Using the pain points uncovered in the BUM analysis, the focal firm can decide if there are product, service or industry characteristics that can be reduced (the product or service provides a solution when there is no pain), eliminated (no one is having pain from these elements no matter what the product or service characteristics), raise (the current product or service does not adequately address all the customers’ pain), and create (the product or service does not currently address the pain at all).
The 4-Action framework allows us to tie blue ocean strategy to Porter’s generic strategies. Eliminating and/or reducing industry, product or service factors supports a low cost strategy. Raising and/or creating industry, product or service factors supports a differentiation strategy. Doing both allows for a mixed strategy of low cost and differentiation, which is profitable while the industry is immature.
Once the pain points are uncovered, firms usually do market research to understand how their customers and non-customers rank different characteristics of the firm’s product or service and that of their competitors. By laying out the different combinations of characteristics on the value curve, the firm can potentially spot “open territory” and evaluate whether a subset of customers or a group of non-customers would value a product or service with that particular bundle of characteristics.
This is done using the following 3 steps:
1. Identify key elements of product & service content
2. Rate the offering level of each key element for focal firm & competition
3. Look for white space in the value curve to guide what to change & where to find
innovations
While white space is one place to find innovation, there are 4 key sources of value curve innovation that is less likely to be found.
1. Other industries: By adding new characteristics that address previously unaddressed pain points, focal firms can create new industries (think of the progression of digital music offerings from iTunes to Apple Music).
2. Segments within industries: Unidentified or underserved customer segments may not care about the same characteristics or have the same pain as the current target customers. Analyzing the characteristics of the people who respond above or below the median or mean in the market research data may give insight to these new segments (think of the customers seeking organic products but not desiring the traditional health food store experience).
3. Complementary services: By offering a complementary service in a different way that still addresses what the customers care about, the focal firm can potentially create a blue ocean (think of Uber)
4. New functional or emotional appeals: By offering a product or service that appeals to at least a subset of customers based on emotional or functional needs, the focal firm can provide a new industry that may disrupt the traditional industry.
Critique of value curves
§ If everyone conducts market research to build their value curves:
§ Everyone uses roughly the same characteristics
§ Everyone creates roughly the same value curve Everyone spots roughly the same opportunities So, can this tool drive innovation?
§ The only way that the focal firm could create a new industry by raising or lowering characteristics is to find the opportunity first or implement it better due to key inimitable resources or capabilities
§ There is much more power to create unique innovation in adding or eliminating characteristics, as this requires much more abstract thought.
§ Innovation from analogy supports this abstract thought
Breaking the frame of the focal firm’s industry allows for more creative thought. Using another industry as an analogy and applying it to the focal firm’s industry allows for the generation of unique combinations of characteristics that are not readily apparent by looking for white space on the value curve.
Avoid superficial analogies
§ Most analogies are applied superficially, leading to business failure (think Uber of X businesses)
§ Avoid superficial analogies by:
§ Recognize the analogy & identify its purpose
§ Understand the source and context of the analogy
§ Assess similarity between the context, product or service of the analogy and the industry in which it is applied
§ Translate the analogy, decide if it is appropriate for this industry and/or adapt or discard it
Barriers to imitation for sustain competitive advantage
§ Cognitive barriers
§ When traditional competitors cannot understand the blue ocean firm’s competitive advantage or source of competitive advantage
§ When traditional competitors cannot understand that the firm is a threat to their industry
§ Brand barrier
§ When the blue ocean firm’s product or service is incompatible with the traditional competitors’ brands
§ When the blue ocean firm’s product or service is synonymous with the new industry
§ Economic barrier
§ When switching to the blue ocean firm’s product or service will cannibalize the traditional competitors’ main revenue streams and replaces it with a significantly decreased revenue stream
§ Alignment barrier
§ When the blue ocean firm’s product or service has both a low cost and differentiation advantage, traditional firms, who offer either a low cost or differentiation product or service in the traditional industry, cannot imitate the blue ocean firm because their value chain supports low cost or differentiation, not both
§ If they continue to offer their traditional product along with the low cost-differentiated blue ocean product, they will fall into Porter’s bucket
Key Takeaways
TOPIC: Firm Analysis (III): Value Curve| CASE: Salesforce
§ Value curve allows for assessment of firm’s generic strategy/strategies from outside the firm (focusing on customer value proposition)
1. Identify characteristics that customers care about and list from most to least important
2. Rank each company on these criteria
3. Use 4-action framework to determine if characteristics can be reduced, eliminated, raised or added to create a unique position in the market
4. Data for this exercise is collected through market research
§ Generic strategies
§ Low cost: Lowering costs through: Reducing or eliminating product or service characteristics that reduces focal firm costs
§ Differentiation: Raising or adding product or service characteristics that increase customer willingness to pay
§ Value curve allows firms to do both, breaking Porter’s bucket
§ Limitations of the value curve for innovation
§ However, if all firms are collecting similar data, then the seemingly unique positions in the market are likely to be identified by all competitors (particularly reducing or raising factors)
§ Thus, if firms focus on adding characteristics, they can be more innovative
§ Characteristics from outside the industry can be added using innovation by analogy, which increases unique innovation Analogies are often applied superficially so these businesses often fail (e.g. Uber of X)
§ Need to dig into analogy to recognize why it worked
§ Understand the industry context and capabilities of competitors in original industry
§ Assess similarity with industry in which you want to apply the analogy
§ Adapt the analogy to the new context or realize that it is not appropriate
§ As cognitive, brand, economic and alignment barriers fall, competitive advantage is no longer sustainable.
There are several types of diversification.
If >95% of revenues come from a single line of business, this is essentially a single business. Birkenstock (shoes), Coke (from beverages and syrups) and Facebook (from advertising)
If between 70 and 90% of revenues come from a single line of business, you have a dominant business, which shares competencies. Examples are Harley Davidson motorocycles which also drives revenue though parts and swag.
Related diversifiers also come in several variants. With related-constrained diversifiers, businesses share competencies. Disney is the perfect example here – using that creative story-telling engine. With related-linked diversifiers, a subset of the businesses share competencies. GE and Siemens have competencies in manufacturing and industrial processes which can help across multiple businesses such as oil and gas infrastructure, jet engines, diagnostic equipment manufacturing, locomotives.
Finally, unrelated diversifiers are the true conglomerates or holding companies like Hanwha a Korean chaebol or Birshire Hathaway. Which has railroads and See’s candies, Duracell and even Fruit of the Loom.
This is the GE/McKinsey matrix and its used by firms to help GE’s corporate office think through which businesses they should divest, build and hold. It was developed by McKinsey and Company for General Electric to help them make resource allocation decisions across its many businesses. It’s useful in that it considers both the industry structure that a business unit is in, as well as the units resource-based advantage.
To use the framework, place the firm’s business units on the 2x2 based on the answer to two questions:
1) How attractive is the industry?
2) Does the business unit have the capabilities to compete effectively in their segment?
GE/McKinsey Matrix allows highly diversified firms to:
Compare very different businesses
Assess which businesses are worth investing in; which businesses are worth divesting
Key questions:
How attractive is the industry?
Does the business unit have the capabilities to compete effectively? With investment, can the business be moved out of its current position into a better position?
The matrix does not allow firms to:
Identify how to improve the business (i.e. whether to invest in R&D, promotion, distribution, etc.)
Incorporate dynamics
Assess synergies
Structured approach to looking for synergy opportunities (and guiding valuation) Is also easy to explain and is useful for selling the story to the markets
CONSOLIDATION
This can be on large or small scale, but is usually seen in older industries with excess capacity. Achieving this type of synergy involves reduction in headcount/capital invested by merging assets (e.g., factories)
Emphasizing shared services; back office stuff primarily . . . finance, HR, treasury, legal, accounting, R&D
Sharing tangible assets such as a store location
Where are you going to find this in the financial statements. Typically the value drives affected are SGA, Capex, Cost of Goods sold.
COMBINATION
The second synergy operator is combination. Here he idea is to pool similar resources to achieve scale. Synergies largely come from EOS – larger scale production or volume discounts in upstream procurement. It also comes through sharing tangible assets such as distribution centers.
Another feature of this type of synergy operator is that it reduces competitive intensity through mutual forebearance. That is, it reduces rivalry through multipoint competition Reduces incentives to fight (e.g., airline mergers). This seems a bit counterintuitive at the start. So let’s take an example of airlines. The idea is that when you go head-to-head with a competitor in multiple markets, you tend to see LESS price competition. The reason? If a price war DOES break out it is like to be severe. American Airlines can hit British Airways with LAX flights, but BA can hit back at AA with flights to south Asia. So companies shy away from this race to the bottom.
You will find these synergies again in SGA, COGS, and CapEx, but you may also see increases in revenue.
CO-SPECIALIZATION
The third type of synergy operator is Co-specialization. Co-specialization is the idea of making different resources work better when they are put together.
Linking different parts of two value chains to increase capabilities. Upstream product development and downstream marketing and distribution.
Cross-selling of products. You’ve got your imaging sales team out there already – they are selling CT scanners, why not MRIs, US and the software to go with them.
Sharing brands across businesses Virgin was very good at this. Airways, books, hotels, telecom
Some other benefits of this type of diversification move:
Subsidization: Limit competition by subsidizing a price war
Vertical foreclosure: Pre-empt rivals seeking similar assets. Raise rivals’ costs. Exert power through backward/forward integration
The primary value driver in these cases is revenue. Top line growth.
CO-CREATION
The final synergy operator is Co-creation. This is the idea of creating something new by pooling resources.
This includes joint R&D efforts to generate new IP, joint product development work or creation ”solutions” from product/service combinations.
In many cases, this is used as a mechanism for a differentiation strategy and clearly the impact is to top line revenue.
FINANCIAL SYNERGIES
I want to take a moment to discuss financial synergies through diversification, which does not fall in any of the four categories I discussed. They are a separate set of rationale and not all are really worth pursuing and so worth discussing.
The first is risk reduction, stabilization of cash flows, altering the cost of capital, or seasonality. However, this outcome should not be pursued independently of one of the other sources of synergy. For example, with a diversifying acquisition designed to stabilize of cash flows, the acquirers seeks to balance the firms’ portfolio so when one sector is down, others will compensate. However, this is not optimal because portfolio diversification should be done at the level of the investor, not at the level of the firm. Firms should be doing what they do best and avoid pure counter-cyclical moves.
The second is unique information. Here the idea is that a firm has some “unique source” of information that investors and other potential acquirers do not see in the target firm. While this is possible, it is not highly if you have an reasonably efficient capital market.
There are occasions where firms diversify in order to benefit from tax savings. An example was the proposed merger between US Pfizer and Ireland’s Allergan. This $160B merger which was eventually scrapped would have allowed New York-based
Pfizer to cut its tax bill by an estimated $1 billion annually by putting their headquarters in Ireland, where tax rates are lower.
Here the primary value drivers affect include revenue, cost of capital and taxes.
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So what’s behind all these disasters and the reason that transaction fail to generate value so often is because of complexity: READ
Over the past 20years, the average premium paid is 40-50% (Laamanen, 2007)
In any given deal: Since integration is always costly, deciding carefully on appropriate integration level
To determine the appropriate level, go back to the type of synergy you expect to realize and consider the impact of your PMI choices. Ultimately, you are seeking to
collaborate (where needed) with minimal disruption elsewhere
The extent of integration between the units of different organizations depends on . . . . Organization design choices about the new organizational structure and geography of the new unit. The former can be broker down into incentives, information channels and processes. These formal elements are important because they will, in turn, shape the emergence of social networks and shared cultural elements.
PMI FRAMEWORK
Here is the PMI framework informed by a variety of work done on organization design of acquisitions. Structure refers to the formal structure (reporting lines). Incentives are compensation (cash, equity), information channels are about how information flows from the new unit to the acquirer. Processes refer to the routines and activities for things like R&D, manufacturing, distribution, sales – activities along the value chain. And Co-location refers to where the new unit will be geographically located. Each of these can range from low levels of integration (where the target is left to be independent) to complete integration of the new unit – often re-location and disbanding much of the target into the acquirer.
Although the firm’s value chain often contains all the activities to bring the product or service from inception to market (including aftermarket support), it does not have to conduct all those activities in-house. Instead, firms often face the make (vertical integration) or buy (outsourcing) decision for links along their value chain. Thus, one of the most difficult decisions that managers make is whether to conduct a particular activity along their firm’s value chain in-house or whether to outsource it. For example, if we return to the Comcast case from the residential, broadcast networks often own studios that created content.
Key focus of Ttransaction Cost Economics (TCE) is to determine whether an activity should be vertically integrated (inside the firm or make) or outsourced (buy). This example shows the same exchange (money for content) between firms (when actual money changes hands) or between divisions within a firm (when a transfer price is set and money moves from one division’s books to another). This same exchange can be organized as an outsourced activity or a vertically integrated activity.
In addition to weighing cost savings for the value chain activity, the firm should also be concerned about whether the activity is core and the costs that arise from the transaction itself.
Estimate the cost advantage or disadvantage from outsourcing versus in-house production using both in-house data and supplier data. Consider how supplier power (now and in the future depending on environmental trends) may impact outsourcing costs.
Assess whether this activity is a core activity in the value chain. A value chain analysis will reveal if the activity is core to the firm, as it will show whether this activity is the basis for a low cost or differentiation advantage or even a key linkage supporting a generic str
Transaction costs are frictions between firms and business units within firms while negotiating or completing the exchange.
Transaction costs are always higher between firms. Governance costs are always higher within firms.
Thus, when the characteristics of the transaction are likely to lead to high transaction costs, it is better to do the activity in-house or vertically integrate.
(High transaction costs between firms + low governance costs from outsourcing > lower transaction costs between divisions within a firm + high governance cost within the firm)
Conversely, when the characteristics of the transaction are unlikely to lead to high transaction costs, it is better to outsource the activity.
(Low transaction costs between firms + low governance costs from outsourcing < lower transaction costs between divisions within a firm + high governance cost within the firm)
Everyone is boundedly rational, but not everyone is opportunistic (we just can’t tell who is and isn’t in the initial exchange).
Bounded rationality and opportunism: Transaction costs arise in exchanges, leading to contracting issues – this is the world in which we live!
Transaction costs (i)
Protection & enforcement costs: Arise from ensuring exchange partners do what they are supposed to do
Requirement specification/design costs oArise from safeguarding the exchange by detailing
requirements & consequences
oInclude drafting lengthy contracts with detailed safeguards
against infringing
Control costs oArise from monitoring & enforcing exchange oInclude monitoring suppliers, resolving price disputes, &
haggling about product quality
Transaction costs (ii)
Cooperation costs: Arise from clearly defining exchange & supporting partner’s ability to work together to successfully meet requirements
§ Coordination costs oArise from aligning actions so people know how best to work together oInclude designing protracted contracts containing miniscule details of
process and project requirements, appointing coordinator roles, & fixing mistakes from misunderstandings
§ Knowledge transfer costs oArise from passing information back & forth
oInclude gathering information from other party to understand how to
combine both production processes to create a new product
Williamson recognized the tradeoff between protection against transaction costs and the cost of governance and suggested that even though vertical integration is more effective at addressing TCs, you only want to use that more costly solution when you need it.
Thus, the main prediction of the TCE is that when TCs are low, you want to use outsourcing, because the TCs under outsourcing + governance costs of outsourcing are less than the TCs under VI + the governance costs of VI. In contrast, when TCs are high, you want to use vertical integration, because the TCs under VI + the governance costs of VI are < the TCs under outsourcing (which cannot address them) + the governance costs of outsourcing.
Vertical integration costs:
• Composed of governance costs rather than transaction costs
• Strong protection against transaction costs (so very low under vertical integration)
• Remain constant because the focal firm will have to put a governance structure in place no matter the level of exchange characteristics that drive transaction costs
Outsourcing costs
• Primarily composed of transaction costs rather than governance costs
• No protection against transaction costs
• Transaction costs under outsourcing increases as potential transaction costs rise in the exchange
Once the transaction relative transaction costs have been estimated, they are added to the activity costs and an overall cost determination of outsourcing versus inhouse is made.
Crowdsourcing can be used with activities that are not core, even thought they create large transaction costs, due to the fact that it significantly reduces the cost of the activity.
Key Takeaways
TOPIC: Portfolio Analysis (III): Transaction cost analysis | CASE: LEGO
§ TCE informs the decision of which activities along the value chain to conduct in-house and which to outsource
§ 2 behavioral assumptions in TCE are opportunism and bounded rationality
§ “Make or Buy” decision should be based on 3 criteria:
§ Cost advantage vs. disadvantage of vertically integrating the activity
(conducting it in-house) versus outsourcing
§ Core activity or not
§ High or low transaction cost
§ Crowdsourcing can create high transaction costs but significantly lower activity costs
In this section, we will
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When an incumbent firm fails to recognize that a new technology will disrupt their industry because the disruptive technology is initially performing below the technological limit of the traditional technology. However, when the technological limit is reached and then exceeded by the disruptive technology, the incumbent firm has not made the necessary investments in R&D early enough to be able to catch up with the disruptive firms. This phenomenon was demonstrated in the Back Bay simulation debrief by showing performance overshoot due to continued investment in traditional technology R&D while lack of early investment in the novel technology resulted in underperformance.
Biggest Challenges: Managers’ Decisions
Internal fit and core rigidities
§ Firm develops VRIN resources
§ Firm further investments in VRIN & complementary resources
§ Tightly integrated activities increase advantage sustainability
§ But are also harder to change, so firms don’t respond to new opportunities and threats
Regularities in search behavior
§ “If it ain’t broke, don’t fix it” = Status quo bias
§ Firms are generally biased against search for distant solutions
§ Results in minor tweaking not innovative changes
Small sample effects
§ Generalizing successes is challenging with little data
§ Managers typically over sample success and under sample failure
Identify where in the industry lifecycle a particular technology falls
Understand key success factors for that particular stage of the lifecycle
Challenge & success factors by stage
Introduction Growth Maturity
Challenge Challenge Challenge
• Product • Scaling up • Competition based on innovation (on Success Factors cost efficiency and small scale) • Sales capabilities reliability
Success Factors and access to Success Factors
• R&D investment distribution • Focus on drivers of
• Standardization • Facing challenges costs & process
• Already of organizing a • innovationLess focus on R&D, identifying firm capital investment, new • Small investments marketing technologies for in new • R&D investments next industry technologies fully in new
curve to prepare for next technologies to
industry curve prepare to jump to next industry curve
Decline
Challenge
• Can lead to price competition
Success Factors
• Industry consolidation
• Price-based
competition forces continued cost focus
• Strategic business exit and migration to new platform
• Profitably harvesting industry
• Jumping to new industry curve