THE PROFIT-IMPACT OF MARKET STRATEGY MODEL

In this section you are expected to learn the following: (i) How the PIMS model was developed (ii) Identify the 30 major variables shown to be significant, (iii) To examine the linkages between quality, market share and profitability, (iv) To examine the impact of relative perceived quality on profitability (v) To examine the impact of investment intensity on profitability, (vi) To examine the impact of the stage of product development on profitability, The PIMS model is a major attempt to provide a quantified view of business strategy. The PIMS model uses 30 variables to explain the comparative performance of firms. In this note we will only consider three of the many insights offered by the PIMS researchers. The three chosen areas are: the effects of quality, capital intensity and the impact of market evolution on profitability. 6.1 HOW THE PIMS MODEL WORKS The PIMS model is designed to enable firms to make quantitative evaluations of their SBU's strategic and budgetary plans. The model is based on some 30 strategic variables stored in an extensive computer based model & database. The variables are organised in the form of a series of regression equations. This enables users to make predictions about the outcome of a series of structural changes as well as about changes in conditions affecting the SBU. The 'database' enables firms to evaluate the effects of their strategies that they can contrast with a series of 'norms for their industrial segments'. The initial system was developed by General Electric (USA) and was subsequently, transferred to Harvard Business School in 1972. It was then set up in 1975 as the 'Strategic Planning Institute'. By 1986 some 2,600 businesses had used this service. We will examine two main aspects of the PIMS model. How it: a) Affects evaluations of the relative performance of Strategic Business Units compared with industrial norms for their market segments. (b) Is used to evaluate the industrial and combined impacts of Quality Positioning and Market Share on the level of profits generated. 6. 11 Some Important Linkages There are six major principles that explain the linkages between strategy and performance. 1. In the end, the most important single factor affecting a business units performance is the quality of its products and services, relative to those of competitors. (a) The short run effect of superior quality increases profits via premium prices. PIMS showed that businesses in the top third on relative quality sold their products or services, on average, at a price 5-6% higher than competitors in the bottom third of the industry. (b) ln the longer term superior and/or improving 'relative' quality is the most effect way to grow a business. This works in two ways; it helps the market to grow, and it helps the firm to gain an increased share of that market. Even if there are initial costs associated with improving quality, these are usually offset by improvements in the scale of production. The linkages between relative quality, market share and profitability are shown below in Figure 6.1.

Figure 6.1 The primary linkages among relative quality, market share and profitability

2 Market share and profitability are strongly related The study showed that business units with very large market shares, say over 50% of the market, enjoy rates of return more than three times greater than their small share SBUs (those under 10% of their markets). PIMS estimate that every additional 10 points of market share roughly equals about 3.5% increase in profits. Fig 6.2 Market share and RoI

The principal cause of the increased profit is scale economies. These lower costs compared with smaller competitors. 3. High investment intensity acts as a powerful drag on profitability This is concerned with the situation where businesses have a high investment intensity per value of sales, or per pound () added value, or per employee. Capital intensity occurs in two forms: 1. Fixed assets or 2. Working capital Figure 6.3 below shows that both ROI and ROS decline as the ratio of investment to capacity increases. As can be seen from the table below, the ROI can be helped by high investment compared with low investment firms.

Fig 6.3 Investment intensity and profitability

It is worth considering the way in which many firms are attempting to escape from their past difficulties. As you will recognise in many instances the chosen escape route is to invest heavily in major new buildings, equipment and rules and procedures. As firms increase capacity etc. they often unintentionally produce this higher level of capital intensity. 4. Many so called 'dog' and 'question mark businesses generate cash, while many 'cash cows' are dry. One of the guiding issues in Portfolio models is the cash-flow position. The PIMS model shows that the situation about cash flow is far more complex and variable than would be understood if only the Portfolio model is used. Fig 6.4 Percentage of businesses generating positive cash flows

5. Vertical integration is a profitable strategy for some kinds of businesses, but not for others. This is one of many contingent relationships between strategy and performance. Whether in fact vertical integration does or does not help profitability is dependent on the costs of its achievement and on a number of other factors. As will be seen from the figure below, the rate of ROI changes between 'relative market share' and 'vertical integration'. It will be seen that there is a small 'U' shaped relationship with the scale of vertical integration. One problem of vertical integration is that it is indirectly linked to other factors usually linked with higher capital intensity small businesses often have difficulty in achieving minimum efficient scale at the several stages of vertical integration The relationship between Vertical Integration, Market Share and Profitability is shown below as Figure 6.5

Fig 6.5 Vertical integration, market share & profitability

6. Most of the strategic factors that boost ROI also contribute to long term value Concerned about the over emphasis on short-term approaches, the PIMS workers have taken a seven year average This has been applied to over 600 businesses in the PIMS database. 6.12 The Major Findings The PIMS researchers claim to have identified the major factors resulting in a successful strategy. You should recall that success in these terms means achieving a high level of profit, relative to the industry in which the corporation SBU operates. The major determinants of ROI are: - investment intensity - relative market share - market growth - stage of product life cycle - marketing expenses/sales ratio High ROI companies had the following characteristics: - low investment intensity - high market share - high relative product quality - high capacity utilisation - low. relative unit direct costs - high operating efficiency: actual/expected employment productivity In the long run, the most important single factor affecting an SBU's performance was the quality of its products and services. In the short run superior quality yields increased profits through the ability to charge premium prices, whilst in the longer run, superior and/or improving relative quality was the most effective way for an SBU to grow. Table 6.1 The major influences in the PIMS model

In other words, growth and relating market share are just two, albeit important factors that influence cash flow, but there are many others! PIMS findings show that SBUs with strong initial competitive positions are more likely to enhance their value than those SBUs with weaker positions. Strongly positioned units improved their overall value by an average of 14%. Those with average profit potential at the beginning of the five year period stayed about even, while the weakest group lost overall value by an average of just over 20%. 6.13 The Use of PIMS The PIMS model is not simply used to find universal relations; it is also used to answer more particular questions: what rate of ROI or C/F is normal on par in a given type of SBU under given market conditions and pursuing a given strategy? How will ROI and other measures of performance change in a specific SBU given a specific change of strategy? What are promising directions to explore in improving the performance of a given SBU? 6.2 PIMS IS A GENERAL MANAGEMENT TOOL The PIMS research data can be used as a 'General Management tool. There are four common areas of application: helps to forecast profits, helps to make effective allocation of capital, manpower and other scarce resources. helps to assess SBU managers' performance - actual vs expected. helps to appraise new business opportunities.

6.21 Help Forecast Profits It is important that managers, who are in charge of businesses, whether single SBUs or large corporations, have a reasonable understanding of the future levels of profit (and cash flow). The PIMS model enables manager to make reliable forecasts of their units/divisions profitability and cash flows. 6.22 Capital Allocations All businesses use capital. At most stages in a business's life it will be consuming some capital. Some of this capital will be in the form of investment in buildings and plant. Other uses of capital are to enable day-to-day workings to proceed. Clearly, firms want a good return on this capital. That is the value of the future float, of income (profits) must exceed by a given amount the cost of the capital. If a firm gets this decision right, the value of its shares will rise. This is because those who purchase shares do so on the expectation of a stream of future earnings in real terms, exceeding the price they paid for them. NB There are also some sales of shares where the purchasers are buying them because of take-over etc. The theory behind most takeovers is that the new owners will be able to achieve a better stream of income than the present owners will. This new, high value stream of income can be from a combination of selling off some of the assets for cash, and from making better use of the existing assets. NNB Many shares are brought and sold at least as much for their expected future price as for the profits to be paid as dividend. Thus in evaluating a share portfolio the differences in the value of the shares may he much greater than the dividends paid. I have gone into the above deviation because the managers in a large corporation need to be aware of the threats of such takeovers. That is their policy on investing capital must take into account the state of the firm's shares. If they do not invest, then the value of the shares will slide down as the firm faces the market with older and older products and uses increasingly outdated technologies. If it makes foolish nvestments, it will waste capital and shares will slide i downwards. What these managers must do is make investments that are:(a) the right amount (b) will produce effective results

6.23 Assets Actual v Expected SBU Performance The PIMS model can be used at the corporate level to evaluate how well a SBU has performed. This can be done by comparing the actual results with those of the norms in the data base. Such comparisons could be set at whatever level the corporate managers required. Thus the norms might be set against the average for the situation, or it could be against a higher standard: i.e. 90%. The latter would be used to see how the SBU compared with the top 10% of firms in its industry given its resources, market position etc. 6.24 Appraise New Business Opportunities Just as the performance of an existing SBU can be compared against a series of norms, so the same data can be used to indicate the likely profit potential in a new business situation. The strategists can consider a variety of strategies and come to a conclusion as to which one was best and whether it met the firm's criteria for investment. PIMS is a major improvement on the GE matrix - it replaces the subjective even arbitrary weights and scores, and further it predicts future profits explicitly - not possible with the matrix. Also, as most of the strategic variables are included in the PIMS model, then failure to achieve par results must be due to non strategic variables - management! However, there may be other reasons for deviations from par: transitory events such as strikes, unusual weather, unanticipated moves by competitors, technological problems or breakthroughs or economic cycle effects that create an environment that is different from that encountered normally. lagged effects of prior strategic moves such as major investments to improve productivity or build market share the impact of synergy or shared resources with other business units in the portfolio. NB over 30% of the PIMS sample has deviations from par more than (+ or -) 15%. As time passes large deviations tend to shrink and move back towards par. 6.3 PIMS AND QUALITY Buzzell and Gale describe quality as king: see chapter 6 of their textbook. We will see in this section that quality on its own is significant. However, when it is linked with high market share it becomes an overwhelming competitive force. 6.31 What is 'Relative Perceived Quality'? Quality is a very difficult area of performance. One of the problems we face is knowing what the other person means when discussing quality. Galvin (1988) identified eight meanings of quality. His eight definitions are: 1. Performance 5. Reliability 2. Durability 6. Aesthetics 3. Features 7. Conformance 4. Serviceability 8. Perceived Quality

The costs of achieving good quality in each of these areas will differ and thus may impact differently on prices and market share. Example 1 A superior performance product may go into a Niche market at a much higher price. Example 2 A different product is produced with an emphasis on conformance. In this instance, there may well be an eventual impact on market share. As we discuss the idea of quality with someone else we must understand very clearly what it is they mean. Otherwise we might be tempted to try and improve already acceptable dimensions of our quality performance and leave undone vital areas requiring attention. Buzzell & Gale define quality in the context of the customer. They argue that quality has to be viewed externally by the customer - and from their perspective. They point out that this may not be the same thing as having low scrap rates and/or meeting the specification. They extend this argument so that the customer is making comparisons about your quality compared with that of other producers: thus relative perceived quality.. The method used to assess RPQ is given in appendix B. It will be seen that the method used has many similarities to the technique of Quality Function Deployment. 6.32 How Does Quality Affect Profitability? High levels of RPQ offer a firm a number of routes to achieving higher profits. These reduce to two main directs: Gain a larger market share Make wider profit margins on the existing market share

An overview of these routes is shown in Figure 6.6 below. This shows the effects of both RPQ and conformance quality. Figure 6.6 Quality drives profitability & growth

Examining the figure we see that a high RPQ can be used to drive up the customer's perception of 'Relative Value'. Further, this helps drive up the relative market share. This increase in market share comes as a result of customers moving towards those products which they consider offer them the best value for money. With the increase in demand, the firm begins to obtain a number of cost benefits from scale and learning. Consequently their profit levels start to increase. NB This theme is continued in week 7 Alternatively, a firm might not wish to become noticeably larger. This can often be a wise choice. Its owners/managers might believe that they would be incapable of running a a much larger firm. They may recognise that one or more of the following limitations applies: insufficient capital to expand managerial skills insufficient current knowledge and capabilities are orientated to smaller scale businesses etc. From their perspective the answer might be to charge higher prices - this restricts demand to the level of their capacity. The firm can then enjoy higher profits. However, this situation would not remain static. So far we have used models in a static manner. It is now necessary to bring in the essential dimension of change. There are three ways in which changes occurs to our value map: We change what we do Customers change in what they want Competitors change in what they do Our own changes can obviously be favourable or unfavourable. They can also be intentional or accidental. Assume first that we study carefully what the customers want and carefully modify what we make (or how we make it) so that it becomes more satisfying to the customer: we add value. Assume next that we do not fully understand the customers needs, yet we still make changes either to the product or how we make it. Such changes may have been driven by accountants wishing to cut costs, or engineers wanting to make it easier to produce. Their changes could reduce the RPQ. Next let us assume, quite reasonably, that customers tastes and preferences change over time. It is possible that such changes could either make our product less desirable or (less frequently) more desirable. Understanding that this is likely to occur, over time, should make firms constantly monitor their customers to identify such shifts in preferences. Firstly we must recognise that competition is about other firms changing, every bit as much as it is about our changing. We need to constantly monitor what our rivals are doing. This will tell us whether they are static, attempting to emulate what we are doing or whether they are seeking to leapfrog our position or even change the basis agenda upon which the current market is based.

6.33 The Combined Effects of Quality & Market Share on Profitability Although quality on its own affects profitability, it is only when we study its effects in combination with market share, that we realise its full potential. An immediate picture of this effect can be seen in Figure 6.7. Fig 6.7 Quality & market share both drive profitability

This shows that at the extremities of low market share/low RPQ compared with high market share and high RPQ, profitability moves from an average of 7% to 38%. If either tactic is adopted on its own profitability rises but only to 20 or 21%. This gives the SBU the same result as if it were in the middle position on either dimension. In week 7 we explicitly address the question of how should a firm plan its development from a low/low position to a high/high position. Should it initially improve its quality and hold prices down to attract more volume, or should it offer low prices and buy its way into a larger share? Clearly, there are intermediate positions which entail movements on both axis. Hopefully, if the other parts of the module have had their proper impact you will think about answering this question in terms of the firms environmental circumstances, its own resources and competencies and finally (but not least) take into account the likely actions of its rivals. While either quality or market share o its own help boost the ROI, combining then together has the effect of n accelerating the level of profitability a stage further. The PIMS writers tend to promote the view that firms should first improve their RPQ, which will then give the increased market share (assuming no or only small price rises). 6.34 Quality, Value & Growth Customers want 'good value' for their money (VFM). Not everyone requires a 'Rolls-Royce' version of a product. They may be perfectly satisfied with a lower specification and they may recognise that the high specification version is not feasible for them. What they do want, however, is to be confident that they have a product that meets their needs and is at a price which is attractive, for that specification. In other words they require value. The firm could use its increased profits in two ways: make high dividends or re-invest in R & D to create the next generation of advanced products. Before leaving this section, we must return to an earlier theme: some markets are more attractive than others. If the firm has increased its profits, it is making its industry more attractive. Other firms might look at these profits and conclude they could make 'that kind of product'. They may also see an opportunity for making them in greater volume and at lower costs. The point about this is that firms should not limit their strategic thinking to questions of what can we do and what do our customers want'? They must always consider what other firms might do in the circumstances we should create if we followed that course of action. Figure 6.8 below shows the 'value map'. It gives three value positions and five product/service positions. The three value positions are the starting point. They represent the basic quality positions that a firm might adopt. While this describes the 'product position' it is only when we add information about price, that we can make a judgment about value. The map shows that whatever the 'product position' adopted, it is price relative to that position which makes the product/service better or worse value. A premium product might be excellent, but the price difference asked for it may be too much relative to the item offered. (There are some exceptions where customers want to pay outrageous prices just to show off, but there are very few instances when this occurs). At the other end of the scale some people move away from economy versions of the product because they are not even worth the low price asked. This can occur with some non-fashion clothes, cheap washing up liquid etc.

Figure 6.8 The Value map

6.35 Quality & Differentiation The topic of differentiation has already been discussed (Week 5). We can now turn to those situations where quality in terms of RPQ interacts with the level of market differentiation. Market differentiation in PIMS terms occurs when one product is clearly distinguishable from others in terms of a specific characteristic. In this instance we can see each firm has an advantage in one of the product's features. This would result in customers choosing different products depending on the extent they meet their particular needs i.e. firms requiring fuel economy as their first priority would be likely to prefer the Navistor product. If a firm has a higher weighted attraction and wins on many criteria, it has a strongly differentiated product. If, however, its superiority is on one dimension only, it is acting as a niche product. Figure 6.9 shows the impact on profitability of the alternative positions. N.B. The niche product tends to be on the left-hand side because it is differentiated in only a single characteristic. Figure 6.9 How differentiation & quality drive profitability

6.4 PIMS AND CAPITAL INTENSITY You will hopefully recall that the purpose of a strategy is to ensure a high ongoing profit. Firms want to achieve a high rate of return on their level of investment. We need to consider the effects on this RoI, of high levels of expenditure per pound of sales income. Firms with a high ratio of investment to sales are said to be 'capital intensive'. In general, a high level of capital intensity reduces the ROI achieved. We need to understand why? We also need to know what, if anything, can be done to improve the level of ROI when high levels of expenditure are necessary. This issue is particularly important for manufacturing engineers. The nature of much of what they do can lead to the adoption of high levels of capital expenditure. If this reduces their firms profitability it will be a serious problem. In a sense this problem is counter intuitive. Most managers and engineers would intuitively expect that high levels of' capital expenditure would save more money than was being invested. Thus they expect profits to rise. Too often they do not! High investment intensity acts as a powerful break on profitability whether in the form of either fixed assets or working capital. The suggestion of "re-industrialising" US and UK plant to match the Japanese could well reduce profitability further.

Problems: 1. the use of such a large number of factors leads to certain statistical problems as the factors relate to each other multi-collinearity: PIMS have attempted to cluster the variables into relatively independent groupings which makes it easier to evaluate the impact of a group of variables, but difficult to asses the impact of a single factor within the group. data has been collected in very different environments - the early 1970s were highly inflationary - must have had an impact on the cash flow relationships. some of the data has been cleaned up! simultaneous relationships about the direction of influence e.g. between RMS and ROI. input problems: susceptibility to differences in accounting contentions, the exercise of judgment, lack of time to ensure accuracy etc.

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3. 4. 5.

Limitations: PIMS is helpful in defining strategic improvements that need to be made - but not how such improvements are to be achieved. Consider such factors as relative share, investment intensity etc - to what extent can they be directly controlled by management - at least in the short term? To increase market share functional programmes must be designed - no help from PIMS. Nor does the model take explicit account of future changes in the market - nor can it be used directly to explore the changing fit between a company's skills and resources and the changing environment (GE matrix, ADL more useful). That is the model is good at assessing today's strategy in todays market and can assess the adaptation of a strategy in todays market, but not in a changing market. Nor does the model provide competitive insight into individual competitors. Comparisons are only made in terms of the average three competitors - not possible to assess either the impact of an individual competitor's strategic moves over time, or the overall balance in terms of strong and weak positions in a competitors portfolio (G/S matrix more useful?). Mounting evidence that differences between industries are sufficient and persistent to justify the use of separate models for each industry,: that is relationships among strategic variables did not change if the business was a leader or a follower, a market pioneer or a late entrant, etc. 6.41 What is Capital Intensity? the rate of investment to sale. Firms which have a high investment to sales ratio normally achieve significantly lower levels of profit than do their less capital intensive counterparts. The critical ratios are below 20% and up to 80%. Thus, firms with ratios of 20% or below achieve on average a 30% ROI, while those with 80% and above achieve a ROI of 10%. This information comes from Buzzell & Gales textbook on PIMS. Frankly it is confusing. No firm that I am aware of would spend 80% of its sales on investment in a year. The logical interpretation is that the investment figures refers to the SBUs cumulative investment. Most of this investment will be in the form of facilities or WIP. Both fixed capital and working capital have negative effects on a plants level of ROI. Figure 6.10 shows both the individual changes in working capital and fixed capital and their combined effect on ROI. The figure shows that a combination of low fixed and working capital produce on average, the highest rate of ROI (41%). Conversely, if these aspects of capital are both high, profitability declines to 7%. As can be seen from this figure, the decline in profitability from either form of capital intensity is very similar.

Figure 6.10 Fixed & working capital intensity hurts RoI

6.42 Controlling the Level of Capital Intensity This question is of particular importance to engineers: manufacturing engineers in particular. Some simple guide lines are as follows: 1. Be cautious about expensive forms of automation. Many proposals to automate are based on the assumption that there will be large savings from the reduction in direct labour. This is often only partly true. Frequently there are other off setting employment costs in the form of expensive indirect staff etc. There may also be marginally less reductions in the number of indirect employees. The higher the level of capital i tensity, the more important it is to achieve a high level of facilities n utilisation. The critical issue is how to maintain good utilisation without entering into a price war with other firms which similarly want high utilisation to cover their costs. Manufacturing engineers can play vital roles in raising the effective level of capacity utilisation. They can improve yield levels, throughput times, introduce better scheduling systems, train and motivate the workforce etc. Most of all they can stretch the processes rated capacity to levels unimagined by their initial designers. The use of sensible capacity expansion/contraction policies is also important. Buying large machines is often attractive in terms of economies of scale, but they lack the potential for discrete changes in output levels at minimum costs. The use of multiple smaller equipment should be compared with the purchase of fewer larger machines. The difference is often noticeable and surprisingly often in favour of the more flexible route of several smaller machines. A characteristic of excellent manufacturers is that their engineers and managers actively seek innovative processing capabilities. They learn to develop lower cost solutions for their processing needs as a consequence of their superior understanding of what is needed by the customer and how to provide it. Controlling the levels of WIP is another major aspect of efficient use of capital. This goes beyond Production Panning and Control Systems into the whole area of plant layout and facilities design. Other methods of influencing the investment in WIP include product design, component standardisation, product range strategies etc.

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3.

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6.

It is recommended that you examine the fuller argument about the potentially adverse impact of capital intensity on achieving levels of ROI.

Table 6.2 Capital intensity after-tax profitability for selected companies

6.5 MARKET EVOLUTION This section of the notes will be quite brief because the topic of market evolution will be developed in detail in weeks 8 & 9. At that moment we will limit ourselves to considering two of the stages in market evolution. The remaining stages will be only briefly discussed. Market evolution is about the way in which an industry goes through its life cycle. That is how it changes, over time, from an infant industry, to a declining industry. Mostly, an industry experiences the following stages: infancy, growth, maturity and decline. A few industries appear to cut out one or more of these stages. Thus, some infant industries die off very quickly. A few industries seem to reach maturity and continue for a long period without evidence of reaching the decline stage. (Here we must distinguish between decline in demand arising from general recessions, and decline in demand from a lowering of the market's interest in a particular type of product). When we consider market evolution we should divide our view of the managers involved into three groupings: (i) managers that help bring about market evolution (ii) managers that react successfully to changes in market evolution (iii) managers that fail to deal successfully with changes in market evolution. However, first we need to understand how the PIMS researchers have attempted to gauge the stages of 'evolution'. They have used three measures: (a) Age: when the product/services were first marketed (b) Growth rate (c) Managerial assignment to one of the four stages

A summary of these three measures and the number of SBUs involved within them is given below in Table 6.3. The PIMS workers have divided the maturity' stage into three sub-groups. These are Growth Maturity, Stable Maturity and Declining Maturity. As will be seen, growth markets attract a higher proportion of new entrants to the industry. and they exit the industry. Table 6.3 Market evolution & selected characteristics

What surprises most people is how many SBUs enter industries at the later stages of their lives. What the PIMS figures do not tell us is the number of firms entering the markets. The data given refers to the percentage of markets with new entrants or with competitors exiting them. This does not show whether the numbers in either instance were large or small. The Table shows a number of important patterns that arise from the effects of the evolution in the product life cycle. These are: 1. The number of new entrants to an industry is highest in the growth phase. Yet, it remains higher than might be expected even when reaching the decline phase. New product sales make up a much higher proportion of sales in the growth phase. This is confirmed by the figures for the use of new technologies. Differentiation is slowly dissipated over the life cycle. At the same time a higher proportion of firms face competition from rivals with a range of similar products. The impact on profitability and cash flow are significant. It shows an almost consistent decline in product evolution. There is a general pattern of lowering the spending on product-based R & D.

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Questions 1. Which organisation developed the original version of the PIMS research, and who subsequently took over this work? and when? 2. Construct a Quality value map for any group of products that you are familiar with. 3. Identify the stages in a products life cycle. How does the stage affect the choice of strategy? 4. Identify five distinct sets of variables that form part of the PIMS model. 5. Why might capital intensity harm a firms ROI? Give three examples of areas where manufacturing engineers/ managers could improve the productive use of capital. 6. What is the value map? How can a firm use the value map to help evaluate the dynamic changes in the market?