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Consulting
Handbook
2015 Edition
The Little Blue Book will give you an edge in your consulting career, so dont share it with your friends.
Tom Spencer 2015
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Sponsors:
Acknowledgements:
Special thanks to the following people for their valuable insights,
contributions and support:
Matthew OSullivan, President of the Global Consulting Group;
Shishir Pandit, CEO of the Global Consulting Group.
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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 Porters 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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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 HUBs 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
editors@spencertom.com.
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 dont 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 clients 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 oclock.
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 listeners 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 clients
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
dont 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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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 youre 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.
=
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(# )
= (
)
1
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Cross Rate: The exchange rate between two currencies inferred from
each currencys 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.
=
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 companys assets
that are financed by debt.
=
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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 + ) = (1 + ) (1 + )
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 1980s to the mid-2000s, 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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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). Metcalfes 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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1
2
+
+
+
+
(1 + )1 (1 + )2
(1 + )
(1 + )
(1 + )
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+
+
+
(1 + )1 (1 + )2 (1 + )3
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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 agents
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.
=
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= 1
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.
=
= 1
[ + ]
Equivalently:
=
+ +
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:
() =
70
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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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 projects 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.
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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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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. 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
IBMs 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 lions 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.
IBMs 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 Porters Five Forces, a technique which was first
outlined by HBS Professor Michael Porter in his 1979 book Competitive
Strategy.
While Porters 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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Age group;
Gender;
Income level;
Employment status;
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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Network marketing;
Mail order;
Online store;
Factory outlet;
Retail store;
Supermarket; and
Department store.
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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 competitions pricing strategy and distribution strategy?
What is the competitions 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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2. Revenue
3. Cost
Price
Units Sold
Variable Costs
Fixed Costs
Pricing Strategy:
Competitive, Cost
Based, Value Based
Customer
segmentation;
Market share; New
markets; New
products
COGS: Raw
Materials,
Transport, Energy,
Labor
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1. Profit
Profit equals revenue minus cost.
By considering the broader economy and comparing a businesss
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
companys 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.
2.
3.
4.
5.
6.
Product;
Product line;
Distribution channel;
Region;
Customer type (new/old, big/small); or
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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6. Case Example
Below we consider some of the issues that might be relevant for some of
Coca Colas 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?
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Porters 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 buyers 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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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 companys
strategy
All of a companys activities are interdependent and, as a result, they
must be coordinated so as to reinforce the companys overall strategy. A
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1.
2.
3.
4.
Market Penetration;
Market Development;
Product Development; and
Diversification.
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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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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
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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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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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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 products 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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Price;
Product;
Promotion; and
Place.
1. Price
The pricing strategy that a firm employs will affect a products 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 products 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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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 customers 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 peoples
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 firms marketing budget?
How does the firms marketing strategy differ from the competition?
How might the competition react to the firms marketing strategy?
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Information
Search
Evaluation
Purchase
Re-puchase
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 companys 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?
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Introduction;
Growth;
Maturity; and
Decline.
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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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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. Highcost 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 selffulfilling. 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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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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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 borrowers 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
borrowers creditworthiness. The borrower must be able to satisfy the
lender that it has the ability to repay the loan. To satisfy itself of the
borrowers 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 borrowers 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 borrowers 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 doesnt have the necessary collateral, the lender may
require personal guarantees from the borrowers directors or from a
third party such as the borrowers 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
borrowers industry and in the economy generally that could affect the
borrowers 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 borrowers 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 borrowers growth?
Secondly, conditions refer to the intended purpose of the loan. The
borrowers 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 managements 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 borrowers 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?
1
2
+
+
+
+
(1 + )1 (1 + )2
(1 + )
(1 + )
=
(1 + )
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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. 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
organisations 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.
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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.
2.
3.
4.
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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 entrants 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.
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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.
2.
3.
4.
Sunk costs;
Fixed costs;
Variable costs; and
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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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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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).
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.
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Source: Wikipedia
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 firms 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 BCGs 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 dont 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 Porters 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. Resources
For more information on the MECE framework, please see Barbara
Mintos book Pyramid Principle.
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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 companys
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 companys short term stock price in
order to secure their bonuses.
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1. Existing Competition
Factors contributing to increased competitive rivalry among exiting
competitors include:
Increased number of firms,
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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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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:
( ) =
70
If the worlds GDP is growing at 4% per year then global GDP will
double in about 17 years.
=
70
= 17.5 17
4
70
=7
10
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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
companys goal is to develop strategies to achieve sustained profit
growth in future.
1. Strengths
Cokes 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. Cokes strengths might include:
1.
2.
3.
4.
5.
2. Weaknesses
Weaknesses include the attributes of Cokes business that may prevent it
from achieving its strategic objective. Cokes 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. Cokes 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. Cokes threats
might include:
1. Shifting consumer preferences away from Cokes 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.
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