Product Market Expansion Matrix

Product Market Expansion Matrix

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The product-market expansion matrix may prove useful in the consulting case interview and is relevant when considering growth strategies. It might be used on a standalone basis or as part of a larger profitability framework.

Product Market Expansion Matrix

There are four ways that a company can pursue growth:

  1. Market penetration: A strategy to increase sales to existing customers and increase market share. Market penetration can be pursued through a combination of initiatives relating to pricing, product, placement and promotion (see “Four P’s Framework”).
  2. Market development: A strategy to sell existing products to new markets which might include new regions, customer segments, or distribution channels.
  3. Product development: A strategy to sell new products to existing customers to increase share-of-wallet.
  4. Diversification: A strategy to develop new products for new markets. This is the highest risk option, and so it will make sense to look for markets with strong market growth and high levels of industry attractiveness (see “Porter’s Five Forces”).

[For more information on consulting interviews, please download “The HUB’s Guide to Consulting Interviews“.]

Outsourcing Matrix

Outsoucing Decision Matrix

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The outsourcing matrix may prove useful in the consulting case interview, either as a standalone framework or as part of a larger profitability framework.

With the view to reducing costs, there are three questions that a firm would do well to consider:

  1. How long will it take to reduce major cost drivers?
  2. Are the activities strategically important?
  3. To what extent do the activities contribute to operational performance?

Outsourcing Matrix

A company will want to eliminate or outsource costly activities that have low strategic importance. If the activity has a low contribution to operational performance it can be eliminated, and if it has a high contribution to operational performance it should be outsourced.

A company will want to retain control of activities that have high strategic importance. This can be done by pursuing business as usual or by forming a strategic alliance or increasing efficiency.

Common cost reduction techniques include:

1. Procurement

  • Consolidate procurement or renegotiate supply contracts.

2. HR Management

  • Reduce labour costs through decreasing salaries, training, overtime, benefits and healthcare, introducing employee stock ownership, and right sizing.

3. Technology Development

  • Use IT and digital technology to reduce communication and organisational costs.
  • Employ more advanced production technology.

4. Logistics

  • Partner with distribution companies (e.g. FedEx).

5. Operations

  • Outsource manufacturing to a lower cost jurisdiction (e.g. China/India/other).
  • Improve the utilisation rate of plant, property and equipment.
  • Relocate headquarters to lower cost city, region or country.

6. Finance

  • Reduce working capital including inventory and accounts receivable.
  • Refinance outstanding debt.
  • Divest non-core assets.

[For more information on consulting interviews, please download “The HUB’s Guide to Consulting Interviews“.]

McKinsey 7 S Model

McKinsey 7 S Framework 2

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While you may not directly use the 7 S Model in the consulting case interview, it will give you a deeper understanding of how to examine the inner workings of an organisation, identify strengths and sources of competitive advantage, as well as weaknesses and reasons why an organisation may not be operating effectively.

The 7 S Model can also provide a guide for organisational change.

McKinsey 7 S Model

The seven (7) factors considered by the 7 S Model include:

  1. Shared values refer to the values that are widely practiced within an organisation and form the company’s core guiding principles.
  2. Strategy refers to the plans that a company has for gaining a competitive advantage (e.g. low cost; product differentiation; new product development; entering new markets).
  3. Skills refer to the competencies of the organisation, its staff and management.
  4. Structure refers to the way in which an organisation’s people and business units relate to each other. This includes organizational structure, communication channels, and chain of command.
  5. Staffing refers to recruitment, selection, training, development, and management of talent.
  6. Style refers to the work culture, leadership style of upper management and the way things are done.
  7. Systems refers to the organisation’s processes and procedures for things like budgeting, communication, recruitment, compensation, and performance reviews.

[For more information on the consulting interview, download “The HUB’s Guide to the Consulting Interview“.]

BCG Growth/Share Matrix

Cash Cow

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While it may not be a core framework for solving consulting case questions, the BCG Growth Share Matrix can help to broaden your understanding of how a company might want to allocate cash between products and business units.

The framework is based on the idea that the amount of cash a product uses is proportional to the rate of growth of that product in the market, and the generation of cash is a function of market share.

To be successful, the story goes, a company should have a portfolio of products with different growth rates and different market shares. Money generated from high-market-share products can then be used to develop high-growth products.

BCG Matrix

Under the BCG matrix, products are classified into four types:

  1. Stars are leaders in high growth markets. Stars grow rapidly and therefore use large amounts of cash. Stars also have a high market share and therefore generate large amounts of cash.
  2. Cash Cows are highly profitable and require low investment because they are market leaders in a low-growth market.
  3. Question Marks are low market share high growth products, and almost always require more cash than they can generate.
  4. Dogs are low market share low growth products. BCG refers to these products as “cash traps”. They require little cash but also generate little cash.

[For more information on consulting interviews, please download “The HUB’s Guide to Consulting Interviews“.]

Value Chain Analysis

Value Chain Analysis 2

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Value Chain Analysis is another tool that may prove useful during the consulting case interview. It can be used to analyse the cost structure of a company as part of a declining profitability case, or to analyse the supply chain as part of an operations case.

Value Chain

To understand which activities provide a company with a competitive advantage, either through cost advantage or product differentiation, it is helpful to separate operations into a series of value-generating activities referred to as “the value chain”.

Value Chain Analysis involves identifying all of the important activities in which a company engages and then determining which ones give the company a competitive advantage. By doing this, a company can:

  1. Determine which activities are best undertaken internally and which ones are able to be outsourced or eliminated;
  2. Identify and compare strengths and weaknesses with the competition; and
  3. Identify synergies between activities.

The primary value chain activities include:

  1. Inbound Logistics: Receiving and storing raw materials;
  2. Operations: Manufacturing products and services; the way in which inputs are converted into final products;
  3. Outbound Logistics: Inventory storage and distribution to customers;
  4. Marketing & Sales: Identification of customer needs and preferences, marketing and sales generation;
  5. Service: Interacting with and supporting customers.

[For more information on consulting interviews, please download “The HUB’s Guide to Consulting Interviews“.]

Porter’s Five Forces

Porter's Five Forces 2

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The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry, and is relevant in the context of entering a new market, M&A, or starting a new business.

The intensity of competition will depend on the strength of the five competitive forces, however the significance of the forces will vary by industry.

1. Existing competition

How strong is the rivalry among existing firms?

Factors contributing to competitive rivalry include:

  • Increased number of firms;
  • Slower market growth;
  • Low product differentiation;
  • Low switching costs;
  • Industry wide excess capacity;
  • High fixed costs; and
  • High exit barriers.

2. Substitutes

What is the price performance of substitutes? Do customers have high switching costs?

3. Barriers to entry

What is the threat posed by new entrants?

Barriers to entry might include capital requirements, economies of scale, network effects, government policy, switching costs, access to suppliers, access to distribution channels, product differentiation, and proprietary product technology.

4. Supplier bargaining power

How much bargaining power do suppliers have?

5. Customer bargaining power

How much bargaining power do customers have?

[For more information on the consulting interview, download “The HUB’s Guide to the Consulting Interview“.]

Profitability Framework

The profitability framework is probably the most important framework for solving consulting case questions

Profitability Framework

Profit equals revenue minus cost.

1. Revenue

Revenue is normally thought of as being a function of price per unit and units sold.

Declining revenue can derive from a fall in prices or a reduction in units sold, and can be examined in four steps.

Step 1: Segmentation

What are the major revenue streams? It will typically be a good idea to segment units sold, and this might be done by:

  1. Product;
  2. Product line;
  3. Distribution channel;
  4. Region;
  5. Customer type (new/old, big/small); or
  6. Industry vertical.

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.

1.1 Diagnosis

If faced with declining prices or volume, factors to consider include the following.

1. Macro Economy

  • PEST Analysis: Political upheaval; Economic decline; Socio-cultural factors; Technology. Have there been any recent or impending changes?

2. Customers

  • Market growth: Has market growth slowed forcing competitors to compete over market share?
  • Customer needs and preferences: Have customer needs and preferences changed?
  • Distribution Channels: What channels are used to reach customers? Has there been a change in the cost effectiveness of these channels?
  • Price Discrimination: Can the company distinguish between customers and charge different prices to different customer segments?

3. Competition

  • Rivalry: Have competitors lowered their prices? How does the company’s product mix, product quality, and cost structure compare to the competition?
  • Substitutes: Has the price performance of substitutes improved?
  • Barriers to entry: Has it become easier for new competitors to enter the industry?
  • Buyer bargaining power: Has there been an increase in customer bargaining power?

4. Company

  • Market Power: Does the company have market power (product differentiation, proprietary technology, economies of scale, network effects)?
  • Products: What products and product mix does the company offer? How do these compare to the competition? Is there something different about the products that might allow the company to raise prices?
  • Value chain analysis: Consider value chain activities: access to raw materials; operating capacity; inventory handling and distribution.

1.2 Response

Declining prices

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

  1. Competitive pricing: How do prices compare with the competition? Is the pricing appropriate given the product’s quality and relative position within the market? How is the competition likely to respond to the firm’s pricing strategy?
  2. Cost based pricing: What is the company’s cost structure? What percentage of costs are fixed and variable? A company that has high fixed cost and low variable costs will benefit from economies of scale and so may want to lower prices to increase market share.
  3. Value based pricing: Is the product a commodity or differentiated? Do different customer segments have a different willingness to pay? Are customers price sensitive (see “Price elasticity of demand”)? If prices are changed, how will this affect sales volume and product perception?

Declining sales volume

Faced with falling sales volume, there are four growth strategies that a business might choose to employ: market penetration, market development, product development, and diversification.

Product Market Expansion Matrix

  1. Market penetration: A strategy to increase sales to existing customers and increase market share. Market penetration can be pursued through a combination of initiatives relating to pricing, product, placement and promotion (see “Four P’s Analysis”).
  2. Market development: A strategy to sell existing products to new markets which might include new regions, customer segments, or distribution channels.
  3. Product development: A strategy to sell new products to existing customers to increase share-of-wallet.
  4. Diversification: A strategy to develop new products for new markets. This is the highest risk option. Look for markets with strong market growth and high levels of industry attractiveness (see “Porter’s Five Forces”).

2. Costs

The third driver of declining profitability (after prices and volume) is rising costs.

2.1 Diagnosis

Examine the cost structure of the business to locate the source of rising costs. This might be done by segmenting costs into value chain activities: inbound logistics, operations, outbound logistics, sales & marketing, customer service.

Consider also fixed costs and variable costs. Have there been any significant changes in the company’s cost drivers? How do costs compare to the competition?

2.2 Response

In responding to rising costs, there are three questions that a firm should consider:

  1. How long will it take to reduce major cost drivers?
  2. Are the activities strategically important?
  3. To what extent do the activities contribute to operational performance?

Outsourcing Matrix

A company will want to eliminate or outsource costly activities that have low strategic importance. If the activity has a low contribution to operational performance it should be eliminated, and if it has a high contribution to operational performance it should be outsourced.

A company will want to retain control of activities that have high strategic importance. This can be done by forming a strategic alliance or increasing efficiency.

If a company wants to increase efficiency, then it will need to find ways to reduce costs.

Common cost reduction techniques include:

1. Procurement

  • Consolidate procurement or renegotiate supply contracts.

2. HR Management

  • Reduce labour costs through decreasing salaries, training, overtime, benefits and healthcare, introducing employee stock ownership, and right sizing.

3. Technology Development

  • Use IT and digital technology to reduce communication and organisational costs.
  • Employ more advanced production technology.

4. Logistics

  • Partner with distribution companies (e.g. FedEx).

5. Operations

  • Outsource manufacturing to a lower cost jurisdiction (e.g. China/India/other).
  • Improve the utilisation rate of plant, property and equipment.
  • Relocate headquarters to lower cost city, region or country.

6. Finance

  • Reduce working capital including inventory and accounts receivable.
  • Refinance outstanding debt.
  • Divest non-core assets.

[For more information on the consulting interview, download “The HUB’s Guide to the Consulting Interview“.]

Surveying the Business Landscape

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

Business Landscape

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According to Sun Tzu, the quality of decision “is like the well-timed swoop of a falcon which enables it to strike and destroy its victim.”

And much like a circling falcon overhead, a company needs to take a 10,000 foot view of the business landscape before it can take swift and decisive action.

The framework outlined in this post provides a framework that business leaders can follow to examine the business situation.

1. Relevance

Having a framework to assess the business situation is relevant to any company in the context of making strategic decisions and, what’s more, every important decision that a company makes will in some way be strategic.

In the pursuit of growth, should a company enter a new market, develop a new product, launch a start-up, form a joint venture, or acquire a competitor? In a bid to cut costs, should a company reduce headcount, outsource production to a supplier, or utilize lower cost distribution channels? How should the company position itself within its industry?

In order to find answers to these key strategic questions, a company and its executives need to develop a clear understanding of the business landscape, and to do this it will help to have a simple framework to structure the exploration process.

2. Importance

Failure to properly assess and understand the business landscape can have billion dollar implications and affect the course of an entire industry.

Welcome IBM SeriouslyThe story that best illustrates this point was IBM’s secret project in 1980 to create the IBM Personal Computer.

As part of the project, IBM made three surprising decisions:

  1. It allowed Microsoft the right to produce the operating system software and market it separately from the IBM PC;
  2. It chose to purchase the microprocessor from Intel; and
  3. It opted to make the IBM PC an “open architecture” product, publishing technical guides to the circuit designs and software source code.

These three strategic decisions helped to shift market power in the PC industry away from IBM and towards Microsoft and Intel.

Although the PC market grew quickly, companies like Compaq, Dell and HP soon reverse engineered the IBM PC and, since IBM had made it an open architecture product, they were able to sell a large number of clones, known as IBM compatibles, which 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 software and chips.

Despite the fact that IBM set the technology standard in the personal computer industry, it failed to capture the lion’s share of industry profits. It helped Microsoft and Intel establish lucrative markets for themselves, but was not itself able to compete in these markets due to high barriers to entry including technology patents, the Experience Curve effect and economies of scale.

IBM’s three strategic missteps were a blessing for Microsoft and Intel, which now 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 $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 Porter’s Five Forces, a technique which was first outlined by HBS Professor Michael Porter in his 1979 book Competitive Strategy.

While the Porter’s five forces remains a useful reference point, and we incorporate its core elements into our framework, there is a bit of a problem with using it directly to assess the business landscape.

The key issue is that Porter’s Five Forces doesn’t consider the market power and unique characteristics of the company from whose perspective we are supposed to be analyzing the industry. For example, an industry may appear attractive from the perspective of a cash rich tech savy player like Google but appear quite unattractive to pretty much everyone else.

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, have the capacity to affect a firm’s profitability: the customer, the competition and the company itself.

3.1 Understanding the Customer

“There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else.” ~ Sam Walton, founder of Walmart

A good first step in assessing the business landscape is to examine the customer, the people whose problems the industry is trying to solve.

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

1. Identifying the customer

In general terms, who is the customer?

In trying to identify the customer, remember that the person who makes the purchase decision, the person who pays (the customer), and the end user (the consumer) may all be different people. For example, a doctor may prescribe medicine that will be used by a patient (the consumer) and paid for by an insurance company (the customer).

2. Placing customers into meaningful buckets

Dividing customers into meaningful groups can make it easier to understand their specific needs and preferences.

For example, it may make sense to group customers by:

  1. Age group
  2. Gender
  3. Income level
  4. Employment status
  5. Distribution channel
  6. Region
  7. Product preference
  8. New versus existing customers
  9. 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. Industry Life Cycle

Where is the industry in its life cycle: early stage, growth, maturity or decline?

6. Customer Preferences

What do customers want? Do different customer segments want different things? Are the needs and preferences of customers changing over time?

7. 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 price sensitive, which means that offering student discounts can often increase quantity sold by enough to boost total revenues.

8. Concentration

What is the concentration of customers in the market relative to the concentration of firms? Is there a small handful of customers who are so large that they cannot be ignored?

If the market is dominated by a small number of large and powerful customers then it may be necessary to either play by their rules or search for a more favorable market (see Walmart Effect).

9. Recent and impending changes

Have there been any recent changes in the industry? Are there any impending changes? For example, M&A activity, new entrants, new substitutes, new technology, or changes in government policy.

10. Industry Drivers

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

11. Distribution

What is the best way to reach customers (mail order, online store, factory outlet, retail store, supermarket, department store or network marketing)?

Does each customer segment have a preferred distribution channel? For example, younger customers may prefer purchasing online whereas older customers may prefer bricks and mortar retail outlets.

3.2 Understanding the Competition

“Competition is not only the basis of protection to the consumer, but is the incentive to progress.” ~ Herbert Hoover, 31st President of the United States

In order to understand the business landscape it is also important to understand the competition, and this can be done by examining horizontal competition (competition between firms at the same stage of production) and vertical competition (competition from within the supply chain).

3.2.1 Horizontal Competition

Competition can come from firms within the industry who are offering similar solutions to the same group of customers (e.g. Pepsi and Coca Cola).

Competition can also come from firms in other industries who produce substitutes. Substitutes may have quite different characteristics (for example, petroleum and natural gas) but they represent a form of indirect competition because consumers can use them in place of one another (at least in some circumstances). For example, petroleum and natural gas might both be used to produce heat and energy.

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

1. Identifying direct competitors

Who are the company’s major competitors? Taking Cadbury as an example, some of its major competitors might include Lindt, Ferrero, Nestlé, Hershey’s and Mars. What products and services do they offer?

2. Substitutes

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

To identify these, it helps to take a broader view of what the company offers. For example, Cadbury sells chocolate, but more broadly it might be thought of as a snack food company, and so indirect competitors might include companies like Lays, Cheetos and Doritos.

3. Placing the competition into meaningful buckets

Is it possible to group competitors in a meaningful way? The competition might be categorized by distribution channel, region, product line, or customer segment. For example, the FOX Broadcasting Company might segment the competition by region. In America, some of its major competitors include PBS, NBC, CBS and ABC. While in Australia, competitors include Channel 7, 9 and 10 as well as ABC and SBS.

4. Size and Concentration

What is the sales volume and market share of major competitors?

What is the concentration of competitors in the industry? That is, are there lots of small competitors (a low concentration industry) or a few dominant players (high concentration industry)? Examples of high concentration industries include oil, tobacco and soft drinks. Examples of low concentration industries include wheat and corn.

5. Performance

What is the historical performance of the competition? Relevant indicators of performance might include profit margins, net income, and return on investment.

6. Competitive Advantage

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

What are their weaknesses? How easily might these weaknesses be exploited?

7. Competitive Strategy

What competitive strategy is the competition pursuing? Do they produce products that are low cost or differentiated? Which market segments do they target?

What is the competition’s pricing strategy, distribution strategy and growth strategy? (see Product/Market Expansion Matrix).

8. Competitive Balance

Is the industry balanced in the sense that competitors have clear and sustainable positions within the industry? This might be the case where firms have taken efforts to differentiate themselves by providing customers with different value propositions which appeal to different consumer preferences.

On the one 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 the destruction of 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.

9. Competitive Response

How will the competition respond to the company’s actions?

10. Barriers to entry

The threat posed by potential competition depends on the level of barriers to entry. Barriers to entry make it more difficult for potential competitors to enter, and allow existing firms to maintain higher prices than would otherwise be possible.

3.2.2 Vertical Competition

Competition includes not just other firms operating at the same stage of production but any entities that have the potential to solve all or part of the end user’s problem, and thereby compete for a share of industry profits. This naturally includes vertical competition from suppliers and customers within the supply chain.

It is important and somewhat interesting to realise that suppliers and customers can represent a form of competition. Customers and suppliers within the supply chain that have more bargaining power will be able to extract a larger share of industry profits.

IBM learned about supplier bargaining power the hard way when it helped Microsoft and Intel gain virtual monopolies over the supply of key components for the personal computer.

Factors that will affect the bargaining power of suppliers (e.g. Microsoft and Intel) include:

  1. The number of available suppliers and the strength of competition between them;
  2. Whether suppliers produce homogenous or differentiated products;
  3. The brand recognition of a supplier and its products;
  4. The importance of sales volume to the supplier;
  5. The cost to the firm of switching suppliers;
  6. The availability of substitutes; and
  7. The threat of forward integration by the supplier relative to the threat of backward integration by firms in the industry.

Amazon.com has gained substantial customer bargaining power in the publishing industry due to the huge volume of books that it is able to sell and distribute.

Factors that will affect the bargaining power of customers (e.g. Amazon) include:

  1. The number of customers;
  2. The volume a customer demands relative to a firm’s total output;
  3. The availability of substitutes;
  4. The cost to the customer of switching products or firms;
  5. The availability of product comparison information; and
  6. The threat of backward integration by the customer relative to the threat of forwards integration by firms in the industry.

3.2.3 Competitive Intensity

Below we outline twelve (12) factors that will influence the strength of competition within an industry:

  1. Number of firms: The more firms there are in an industry the stronger will be the competitive rivalry since there will be more firms competing to serve the same number of customers;
  2. Market growth: If the market growth rate slows then this will increase competition since firms will need to compete more aggressively to gain new customers;
  3. Economies of scale: If firms in the industry have relatively high fixed costs and low variable costs then this will lead to more intense rivalry as firms compete to gain market share;
  4. Excess capacity: If the industry experiences cyclical demand then this may result in sporadic industry wide excess capacity leading to bouts of intense price competition;
  5. Switching costs: If customers have low switching costs, then this will intensify competition as firms compete to retain existing customers and steal customers from the competition;
  6. Product differentiation: If firms in an industry produce homogeneous products, then firms will be forced to compete on price. Firms can achieve product differentiation in various ways including improving product quality, features, branding and availability;
  7. Instability: Diversity of competition (for example, firms from different countries or cultures) may reduce predictability within a market and lead firms to compete more aggressively;
  8. Entry barriers: Low entry barriers will allow more competitors to enter the market resulting in more intense competitive rivalry (see ‘Barriers to entry‘);
  9. Exit barriers: High exit barriers will increase competition because firms that might otherwise exit an industry are forced to stay and compete. A common exit barrier is where a firm has highly specialized equipment that it cannot sell or use for any other purpose;
  10. Industry shakeout: Where a growing market induces a large number of firms to enter, a point is likely to be reached where the industry becomes crowded. When market growth slows, a period of intense competition, price wars and company failures is likely to ensue;
  11. Substitutes: If the number of substitutes increases, the relative price performance of substitutes improve, the prices of substitutes decrease, or customer willingness to substitute increases, then this will increase the intensity of rivalry within an industry as firms compete more intensely to retain customers; and
  12. Bargaining power of suppliers and customers: If suppliers and customers have more bargaining power then they will be able to extract a larger share of industry profits. This will reduce the profitability of firms in the industry, which may result in more intense competition, industry consolidation, vertical integration, and company failures.

3.3 Understanding the Company

“Know your enemy and know yourself and you can fight a hundred battles without disaster.” ~ Sun Tzu

In assessing the business landscape, it is not enough simply to understand the customer and the competition, it is also important to understand the organisation from whose perspective we are analyzing the industry.

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

1. Performance

What is the historical performance of the company? How does this compare to the competition? If profits have declined, what is the source of the decrease? Is it a cause for concern? (see the Profitability Framework).

2. Competitive Advantage

What are the company’s capabilities and key strengths? How sustainable are these advantages? What are its weaknesses and can these be remedied?

3. Competitive Strategy

What is the company’s competitive strategy? Does the company focus on reducing costs or on differentiating itself in a way that customers value? Which market segments does the company target? (see Porter’s Generic Strategies).

4. Products

What does the company offer and how does this benefit customers?

Is the product a commodity or differentiated?

How does the company’s offering compare with the competition?

Where does the product fall within its product lifecycle? (see Product Life Cycle Model)

What is bundled with the product, for example, customer service, warranty insurance or more hard disk space? Are there opportunities to bundle or unbundle the product in order to increase sales?

5. Finances

If the company is considering a certain course of action, does it have sufficient funds available to undertake the project? Financing may be sourced from internal cash reserves, bank loans, shareholder loans, bond issues or sale of shares.

How many units will need to be sold in order to recover the total project cost? Is there sufficient market demand?

6. Cost Structure

It may be obvious from a company’s profit and loss statement whether it is a high cost or a low cost operator, however aggregate figures can often hide important details.

In order to understand a company’s cost structure, it will help to break each business unit down into the collection of activities that are performed to design, produce, market, deliver and support its product. The way each activity is performed combined with its economics will determine a firm’s relative cost structure within its industry. This technique for examining a company’s cost structure is an application of Value Chain Analysis.

7. Organisational Cohesiveness

Understanding a firm’s inner workings is important since competitive strategies can fail if they conflict with a firm’s culture, systems and general way of doing business. The organisational aspects of a firm can be examined using the Seven S Framework.

8. Marketing

How do the company communicate with customers, and how do customers perceive the company and its products?

9. Distribution Channels

What distribution channels does the company use to reach customers? Are there other distribution channels that are more cost effective or which are preferred by customers?

10. Customer Service

Are employees empowered to solve problems and delight individual customers?

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Profitability Framework

The profitability framework can help executives, consultants and entrepreneurs to diagnose and respond to falling prices, declining sales volume, or rising costs

Profit Framework

(Source: Flickr)

BUSINESSES sometimes experience reduced profitability.

This is not necessarily a problem if the decline was expected because a business is sustained from cashflow, not profit, and long term growth can be pursued through capital appreciation, which shows up on the balance sheet and not on the profit and loss statement.

However, a drop in profits can be concerning if it is unexpected and unexplained. It can limit a business’s ability to achieve organic growth and may mean that its existing business model is no longer sustainable.

In order to remedy the situation, the executive team will need to find out what is happening and why, and will sometimes engage management consultants to help them understand and respond to the problem more quickly and effectively.

1. Profit

Profit equals revenue minus cost. (yep, so far so good)

Profit Framework

By investigating each branch of the profit equation, revenue and cost, and drilling down to explore a business’s current and historical performance figures (e.g. revenue, price per unit, units sold, product mix, segment mix, and gross margins) you will be able to discover the source of declining profitability. It may result from a falling price per unit, declining units sold, rising costs, or a combination of the three.

If you realise that a branch or sub-branch of the profitability framework is not the problem, then you can simply come back up a level and examine the remaining branches.

By comparing the business’s performance numbers with the competition you can also determine whether the problem is company specific or industry wide.

2. Revenue

Revenue can come from various sources including advertising and product sales, but 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 (CPC) multiplied by the number of clicks of a website ad.

Declining revenue can derive from a fall in prices or a reduction in units sold, and can be looked at in four stages:

1. Segment: The total revenue number is likely to hide important details, and so you may want to segment units sold into its component parts. There are lots of ways to do this, including by:

  • Product
  • Product line
  • Distribution channel
  • Region
  • Customer type (new/old, big/small)
  • Industry vertical

2. Examine: Compare current and historical numbers in order to find the trend and identify the source of the problem. For example, you might discover that the price of widgets in America has fallen.

3. Diagnose: Once you know what is happening, you also need to figure out why. For example, did a new low cost competitor like Walmart enter the market?

4. Respond: Once you fully understand the source of the problem, you can then develop a strategic response.

2.1 Falling Prices

If you discover that declining revenue results from falling prices, there could be a number of explanations.

Diagnosing falling prices

Although you may know that prices have fallen, you might not know why this has happened in the context of the marketplace, and you need to figure this out before you can devise a plan of action.

In examining the business situation, you will want to consider the customer, the product, the competition, and the company itself.

If falling prices turn out to be an industry wide problem, then you can explore the competitive dynamics of the industry and may discover that the issue results from:

  1. Increased competition (for example, entry into the market of a new low cost competitor like easyJet),
  2. Increase in the number of substitutes,
  3. Reduced barriers to entry (for example, the Internet has enabled new entrants in the markets for book stores, newspapers, and taxis),
  4. Increased buyer bargaining power (for example, Amazon has used its market dominance to drive down the price of books much to the chargrin of book publishers), or
  5. Decreased supplier bargaining power (for example, excess supply of American shale gas forces all suppliers to lower prices).

Responding to falling prices

You would be forgiven for thinking that the best way to respond to falling prices is simply to raise them. But unfortunately things are not that simple. A business’s ability to raise prices can often be constrained.

Before responding to falling prices, a business should consider the following issues:

  1. Market Power: Does the business have market power as a monopoly or oligopoly producer? For example, De Beers had (and largely still has) a monopoly on the diamond trade which allows it to keep the price of diamonds high.
  2. Competitor Pricing: Have competitors changed their prices? How does the business’s product mix, product quality, and cost structure compare to the competition?
  3. Customer Price Sensitivity (or “price elasticity of demand”): A business has to think not only about its competitors but also about its customers, who will normally respond to higher prices by demanding less. If customers are very price sensitive (e.g. students) then higher prices may result in lower revenues.
  4. Price Discrimination: Can the business distinguish between customers and charge different prices for the same product? 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).
  5. Product Differentiation: Is there something different about the product that might allow the business to raise prices? For example, a trusted brand, appealing design, unique product features, or strong customer service.

2.2 Declining Sales Volume

If prices are not the issue, then declining profitability may have been caused by declining sales volume.

Diagnosing declining sales volume

Declining sales can result from:

1. External factors (see Porter’s Five Forces and PEST Analysis):

  • Increased value for money of substitute goods due to lower prices or improved quality
  • Reduced value for money of complementary goods due to higher prices or reduced quality
  • Increased competition
  • Reduced barriers to entry
  • Shrinking market size
  • Political upheaval
  • Shrinking size of the regional, national or global economy
  • Changes in consumer demographics or consumer preferences
  • Introduction of new disruptive technologies

2. Internal factors (see Value Chain Analysis):

  • Supply chain bottlenecks
  • Limited operating capacity
  • Restricted access to distribution channels

Responding to declining sales volume

Faced with falling sales, there are a number of ways that a business can respond, for example:

  1. Market penetration: increase market share or grow the size of the market by using various marketing strategies focused around pricing, product differentiation, promotion, and product placement (see Four P’s Marketing Framework),
  2. Market expansion: expand into new markets in order to sell existing products to new customers,
  3. Product development: develop new products for existing customers, or
  4. Diversification: develop new products to be sold in new markets.

Ansoff Matrix 4

3. Costs

The third driver of declining profitability is rising costs.

Diagnosing rising costs

If your examination reveals that rising costs are the problem, then you will need to inspect the cost structure of the business in order to locate the source of the cost blow out.

A few questions that you may want to ask:

  1. Does it make sense to segment costs using the value chain? For example, raw materials, procurement, operations, distribution, customer service.
  2. What are the business’s fixed costs? For example, Sales General & Admin, overheads, rent and interest expenses, depreciation, capital costs, R&D, and wages under fixed employment contracts.
  3. What are the business’s variable costs? For example, raw materials, shipping, energy, and wages based on commission or performance bonuses.
  4. What are the main cost drivers?
  5. How have costs changed over time?
  6. How does the business’s cost structure compare with the competition?

Responding to rising costs

After determining the source of rising costs, you then need to figure out how to respond.

Here are three questions to think about:

  1. How long will it take to reduce major cost drivers?
  2. Are the activities strategically important?
  3. To what extent do the activities contribute to operational performance?

Outsourcing Decision Matrix

The method that you employ to reduce costs will depend on the situation.

You may want to consider the following common cost reduction techniques:

  • Improve the utilisation rate of plant, property and equipment (PP&E)
  • Consolidate procurement across business units
  • Outsource manufacturing to China/India/other
  • Relocate operations to lower cost cities, regions or jurisdictions
  • Partner with distribution companies (e.g. FedEx)
  • Use IT and digital channels to reduce communication and organisational costs
  • Eliminate costly activities that have low contribution to operational performance and low strategic importance

4. Profitability Framework Cheatsheet

As a bonus for aspiring consultants (and perhaps also as a refresher for practicing consultants and business leaders), we have prepared a one page profitability framework cheatsheet to help you understand and use the framework.

You can download it here.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

PEST Analysis

Understanding the big picture can help reveal hidden opportunities and threats

PEST Analysis

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 47 years 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 new venture, or financing a project then it probably makes sense to understand the big picture issues that could affect your success.

Conducting a PEST Analysis can reveal hidden opportunities and threats, and allow you to adapt your approach to achieve a more favourable result.

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. Seeing Clearly: Understanding the big picture can help a business make informed decisions, and avoid making incorrect assumptions based on past experience with other projects.
  2. Anticipating Change: Understanding the macro environment can help a business anticipate change, take advantage of opportunities and manage potential threats.
  3. Rejecting Projects: Understanding the macro environment can help a business (and its financiers) identify projects that are likely to fail due to unfavourable conditions. Knowing which battles not to fight can be half the battle.

4. PEST Analysis Explained

“PEST” is an acronym that stands for “Political, Economic, Social and Technological” – four important factors for a business to consider when scanning the macro environment.

PEST Analysis is a simple framework that uses these four factors to examine the macro environment and identify potential implications for a business unit, product or project. Insights gained from the analysis can then be used to develop a strategic plan of action.

PEST Analysis is often used as part of a broader situation analysis.

PEST Analysis

There is a long list of alternative frameworks that you could use to scan the macro environment. However, they generally complicate the analysis by adding factors that could have been dealt with more simply using PEST Analysis.

That being said, feel free to use any framework that best suits your purpose. Some of the other variations include:

  • SLEPT: Social, Legal, Economic, Political, and Technological
  • PESTEL: Political, Economic, Social, Technological, Environmental, and Legal
  • PESTELI: Political, Economic, Social, Technological, Environmental, Legal, and Industry Analysis
  • STEEPLED: Social, Technological, Economic, Environmental, Political, Legal, Ethical, and Demographic
  • PESTLIED: Political, Economic, Social, Technological, Legal, International, Environmental, Demographic
  • LONGPESTLE: Local, National, and Global versions of PESTLE (might be useful for multinational organisations)

5. Conducting a PEST Analysis

Conducting a PEST Analysis involves considering issues relating to the four key factors: Political, Economic, Social, and Technological.

The four factors will vary in significance depending on the nature of the business. For example, social factors might be quite relevant for a retail business, but political factors will be more relevant for a global munitions dealer.

The purpose of a PEST Analysis is to identify potential implications for a specific business unit, product or project. Make sure you are clear on the central purpose of your analysis before commencing.

Insights gained from the analysis can then be used to develop a strategic plan of action.

Below we set out a list of issues that you might want to consider when conducting a PEST Analysis.

5.1 Political

Potential political issues include:

  • Laws and regulations that a company may need to comply with (tax, competition, consumer protection, employment law, environmental regulations, anti-discrimination, corporate social responsibility, international law)
  • Property rights, including protection of intellectual property (trade marks, copyright, patents, registered designs, trade secrets, software and circuit layouts)
  • Industry regulation. How is the industry regulated? Are there planned changes? Is there a trend towards regulation or deregulation?
  • Government policy, trade unions, lobby groups, and the electoral cycle. Who holds the power? How might this change at the next election?
  • Rule of law, bureaucracy and corruption
  • Political stability, war and conflict

5.2 Economic

Potential economic issues include:

  • GDP, and economic growth rates
  • Inflation, interest rates, and monetary policy
  • Exchange rates (consider exchange rate volatility and the need for a swap agreement)
  • Availability of credit (consider also the liquidity and depth of the credit markets)
  • Labour costs and the unemployment rate. Will it be affordable/easy to hire skilled workers?
  • Government support (e.g. infrastructure investment, grants, subsidies, tax breaks)
  • Tax issues (corporate, employee, and value added taxes)
  • Trade restrictions (tariffs and quotas)
  • Business cycle, stock market trends, market prices, and seasonality issues
  • Consumer confidence
  • Industry specific factors

5.3 Social

Potential social issues include:

  • Population growth
  • Age distribution and life expectancy. Are generational shifts in attitude likely to affect what you’re doing?
  • Income distribution, average disposable income, and social mobility
  • Attitudes towards work
  • Family size and structure
  • Health levels, and health consciousness (e.g. attitudes towards smoking)
  • Education levels
  • Emphasis on safety
  • Social norms (e.g. people tend to take holidays in summer)
  • Fashions, fads, trends, role models, and influential personalities
  • Buying patterns and consumer preferences (e.g. brand preferences, and attitudes toward product quality, customer service, fair trade, green, and organic)
  • Ethnic and religious factors
  • Cultural and sporting events
  • Prohibitions, taboos, and ethical issues

5.4 Technological

Technological issues relate to the state of technology and the rate of innovation and may have implications for the competitive intensity of an industry (e.g. new technologies can reduce barriers to entry), and may result in disruptive innovation (e.g. online education).

Potential technological issues include:

  • Emerging technologies and trends (e.g. 3D printing, collaborative consumption, and wearable technology)
  • Technology level and rate of change in an industry
  • Technology lifecycle
  • Location of technology hubs or clusters; university and business partnerships
  • Supporting infrastructure (e.g. high speed internet)
  • R&D spending
  • Availability of financing (investment and grant funding)
  • Automation
  • Legal frameworks, for example, protection of intellectual property (patents, registered designs, software and circuit layouts), and support for crowd funding

6. Template

Please download our PEST Analysis Template.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

MECE Framework

MECE stands for “mutually exclusive” and “collectively exhaustive”

MECE

1. Background

MECE stands for “mutually exclusive and collectively exhaustive” and is one of the hallmarks of problem solving at McKinsey (The McKinsey Way by Ethan M. Rasiel).

2. Benefit of the MECE framework

You can use the MECE framework to help you think clearly about a business problem.  The framework aids clear thinking in two ways:

  1. No overlap: categories of information should be grouped so that there are no overlaps, which helps to avoid double counting; and
  2. No gaps: all categories of information taken together should cover all possible options, which helps to avoid overlooking information.

3. MECE explained

MECE is a framework used to organise information which is:

  1. Mutually exclusive: information should be grouped into categories so that each category is separate and distinct without any overlap; and
  2. Collectively exhaustive: all categories taken together should deal with all possible options without leaving any gaps.

4. MECE tree diagram

The MECE tree diagram is a way of graphically organising information into categories which are mutually exclusive and collectively exhaustive. The diagram as a whole represents the problem at hand; each branch stemming from the starting node of the tree represents a major issue that needs to be considered; each branch stemming from one of these major issues represents a sub-issue that needs to be considered; and so on.

A major issues list should not contain more than five issues, with three being the ideal number (see Rule of Three). If you are not able to categorise a problem in 5 major issues there is always the option of creating a category of “other issues”.

The MECE framework can be applied to a lot of different business problems, for example, “what is the source of Coca-Cola’s declining global profitability?”.  Coca-Cola could tackle this business problem by using a MECE tree diagram to help it locate the source of declining profitability.

MECE tree diagram v2

5. Resources

Victor Cheng, former McKinsey consultant and creator of CaseInterview.com, indicates that:

The definitive book on this subject is the Pyramid Principle by Barbara Minto. It’s a book that describes an approach to communicating complex ideas in easy to understand ways. It is based on the MECE Principles and was a book often referred to and used while I was at McKinsey.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Set SMART Goals

Whether your goals are personal or professional, setting SMART goals is the first step to actually achieving them

Set SMART Goals

“A goal properly set is halfway reached.”
~ Zig Ziglar

1. Background

ALTHOUGH its origins are unclear, SMART goal setting appears to have been first used by Peter Drucker in his 1954 book “The Practice of Management”.

2. Relevance

Where ever you are right now, you most likely have bright dreams for the future. You may want to publish a book, get your dream job in consulting, boost company profits by 50%, or take a much deserved luxury holiday to the Maldives. The future is a bright beacon of hope where your imagination is the limit and anything is possible; but how do you get there?

3. Importance

The only way to make your dreams for the future become a reality is to set clear goals and to achieve them: each day, each month and each year. Whether your goals are personal or professional, setting SMART goals is the first step to actually achieving them.

4. SMART Goals

Your goals should be SMART:

Specific
Measureable
Achievable
Relevant, and
Time-Bound.

4.1 Specific

Your goal should be specific. Goals must be clearly defined and describe what will happen in as much detail as possible. Clearly defined goals are helpful because they allow you to focus on taking action rather than trying to define and understand the goal. For example, a goal to “increase company profits” could be replaced by a more specific goal to “increase profits in each division of the company by at least 5% with 12 months.” Vague goals are no good because it is not be possible to measure progress or to know whether the goal has been achieved.

If your goal is specific, you should be able to answer the following questions:

  • What is the goal? Write the goal down so that you have a record and use action words like “build, organise, complete, create, coordinate, make, develop, plan”. What actions will need to be taken to achieve the goal?
  • Who is involved? Who is responsible for each action that will need to be taken? It may help to write in the active voice, for example “John will organise the web-design…” and not “the web-design will be organised…”
  • Where will this all happen?
  • When will the goal be achieved?
  • How high are you aiming? Be specific. For example, are you aiming for 7% profit growth, or is 4% okay?

4.2 Measurable

Your goal should be measurable so that you can track your progress, hold people accountable for their performance, and so that you know when the goal has been achieved. Make sure that you have established criteria for measuring progress toward the goal. Measuring your progress is important because it will help you stay motivated and on track. If you are behind schedule this would be good to know because it gives you the opportunity to re-double your efforts and make up for lost time.

To determine if your goal is measurable, ask questions such as:

  • How much?
  • How many?
  • How will we know when the goal has been achieved?

4.3 Achievable

Your goal should be achievable with the resources available. Your resources include assets such as cash, real property, equipment, intellectual property, the skills of the people involved, and the time available. If your goal is not achievable with the resources available then you will need to create a sub-goal “get more resources!” and achieve that sub-goal before returning to the primary goal.

Your goal can be ambitious but should also be realistic. If you set the goal too high or too low then the goal will not be meaningful and people will lose motivation.
To determine whether the goal is achievable, ask questions such as:

  • Can we get it done in the proposed timeframe?
  • Do we understand our limitations and constraints?
  • Can we do this with the resources available?
  • Has anyone else done this successfully?
  • Is this possible?

4.4 Relevant

Your goal should be relevant in the sense that it should be consistent with your core values and broader mission. Achieving your goal should move you forwards, not bump you sideways or push you backwards. If your goal is relevant and you are willing to make it a priority then this will help you take ownership of the goal and increase your chances of success.

To determine whether the goal is relevant, ask questions such as:

  • Why is the goal important?
  • Have we achieved similar goals in the past?
  • If the goal is achieved, how will we benefit?
  • Is this a priority?

4.5 Time-Bound

You should set a date by which the goal will be achieved. Setting an end point for the goal will allow you to determine whether you are making good progress. In order to meet a fixed deadline you will need to focus your efforts and work efficiently, there is no time to waste. Go. Hurry.

To determine whether the goal is time-bound, ask questions such as:

  • When will the goal be achieved?
  • Is there a deadline?

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

GE-McKinsey 9-Box Matrix

The GE-McKinsey 9-Box Matrix offers any decentralised corporation with multiple business units a systematic approach to help it decide where to invest its cash

GE-McKinsey 9-box matrix

IN SEPTEMBER 2008, the McKinsey Quarterly published an interactive audio presentation on the GE-McKinsey 9-Box Matrix

An outline of this framework is provided below, but I highly recommend watching the original presentation.

1. Background

The 9-Box Matrix follows in the footsteps of Boston Consulting Group’s growth share matrix which was introduced in 1968.

The 9-Box Matrix was developed as part of work that McKinsey did for GE in the early 1970s. At that time, GE had around 150 business units and was faced with the challenge of how to manage such a large number of business units profitably.

The 9-Box Matrix was developed as a result of the realisation that it is important to separate the ability of a business to generate cash from the decision about whether to put more cash into the business.

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 cash.

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. attractiveness of the industry; and
  2. the business unit’s competitive strength within that industry.

3. Using the matrix

GE-McKinsey 9-box matrix

(Source: McKinsey Quarterly)

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 only three investment strategies:

  1. Invest/Grow;
  2. Selectivity/Earnings; and
  3. Harvest/Divest.

Allocating one of these investment strategies to each business unit is a necessary 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 is in a very different situation than a weak unit in a highly attractive industry.

After placing a business unit into one of the nine boxes, there are at least two questions that are worth asking:

  1. If a business unit is in one category, say “selectivity/earnings”, is there anything that can be done to change its position? That is, would it be possible to move a business unit from the “selectivity/earnings” category and into the “invest/grow” category by making any kind of strategic investments?
  2. If a business unit is to receive money, what should it do with that money? It is important that money is given with 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 investing to increase research and development might work for another.

4. Axes of the matrix

The 9-Box Matrix places “industry attractiveness” along the vertical or y-axis, and “competitive advantage” (otherwise known as competitive position, or competitive strength of the business) along the horizontal or x-axis.

4.1 Industry attractiveness

Industry attractiveness refers to whether the industry is going to do well in the future. Are most players in the industry likely to do well? How easy will it be for the average company in the industry to make profits over the long run?

There are a number of different factors that affect industry attractiveness and those factors will vary in importance from industry to industry, for example: long run growth rate of the industry, current profitability, etc.

The Structure Conduct Performance model or, its more popular simplified version, the Porters Five Forces model both provide a formal approach to look at industry attractiveness.

4.2 Competitive advantage

According to Coyle, the first formal definition of “sustainable competitive advantage” was not determined until the mid-eighties.

In the early days of the 9-Box Matrix, analysts used proxies for sustainable competitive advantage:

  • Is the business unit’s market share growing? Maybe we can infer from this something about its competitive advantage.
  • How strong is the business unit’s brand equity? That is, how much of a price premium can it charge?
  • Is the company more profitable than its competitors?

A business has a competitive advantage when it is able to achieve profits that exceed the industry average. Competitive advantage may be established by offering consumers greater value by way of:

  • lower prices;
  • differentiated goods or services that justify higher prices; or
  • establishing a market niche and achieving a narrow, rather than an industry wide, competitive advantage.

5. Available strategies

5.1 Invest / Grow

A business unit will be in the “invest/grow” category if the prospects for the industry as a whole are attractive and the business unit’s position in the industry means that it is likely to do better than most of the other firms in the industry.

A business unit in this category should be given as much money as it needs regardless of whether it can generate those funds itself.

5.2 Selectivity / Earnings

Business units in this category are given second priority to those in the “invest/grow” category. So, the amount of money spent on business units in the “invest/grow” category will determine how much money is left over for business units in this category.

When allocating money to a business unit in this category, it is important to be selective about where the money is spent and monitor earnings closely. With the right combination of strategies, it may be possible to move the business unit into the “invest/grow” category.

In this part of the matrix it is a good idea to be careful. If the business unit doesn’t improve then it may be best to invest money elsewhere.

5.3 Harvest / Divest

A business unit will be in the “harvest/divest” category if it is in an unattractive industry and its competitive position is weak.

There are two suggested strategies:

  1. sell the business unit (divest); or
  2. increase short-term cash flows as far as possible, even at the expense of the business unit’s long term future (harvest).

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Product Life Cycle Model

The Product Life Cycle Model can be used to analyse the maturity stage of products and industries

Product life cycle

1. Background

THE idea of the Product Life Cycle was first developed in 1965 by Theodore Levitt in an article entitled “Exploit the Product Life Cycle” published in the Harvard Business Review on 1 November 1965.

2. Benefit of the Product Life Cycle model

For a business, having a growing and sustainable revenue stream from product sales is important for the stability and success of its operations. The Product Life Cycle model can be used by consultants and managers to analyse the maturity stage of products and industries. Understanding which stage a product is in provides information about expected future sales growth, and the kinds of strategies that should be implemented.

3. Product Life Cycle model

product_life_cycle_2

The “Product Life Cycle” is the name given to the stages through which a product passes over time. The classic Product Life Cycle has four stages:

  1. Introduction,
  2. Growth,
  3. Maturity, and
  4. Decline.

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. Substantial research and development costs may have been incurred, for example, thinking of the product idea, developing the technology, determining the product features and quality level, establishing sufficient manufacturing capacity, preparing the product branding, ensuring trade mark protection, etc. Marketing costs may be high in order to test the market, launch and promote the product, develop a market for the product, and set up distribution channels.

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.

Some of the considerations in the introduction stage include:

  • Product development: research and development of the basic technology and product concept, determining the product features and quality level.
  • Pricing: should penetration pricing or a skimming price strategy be used? A skimming price strategy might be appropriate where there are very few competitors.
  • Distribution: distribution might be quite selective until consumer acceptance of the product can be achieved.
  • Promotion: marketing efforts are aimed at early adopters, and seek to build product awareness and to educate potential consumers about the product.

3.2 Growth

If the public gains awareness of a product and consumers come to understand the benefits of the product and accept it then a company can expect a period of rapid sales growth, enter the “Growth Stage”. In the Growth Stage, a company will try to build brand loyalty and increase market share.

Profits are driven by increased sales volume (due to growth in market share as well as an increase in the size of the overall market). Profits might also be driven by cost reductions gained from economies of scale, and perhaps more favourable market prices. Competition in the Growth Stage remains low, although new competitors are expected to enter the market. When competitors enter the market a company might be subject to price competition and increase its marketing expenditure.

Some of the considerations in the Growth Stage include:

  • Product improvement: product quality might be improved, additional features and support services added, and packaging updated.
  • Pricing: if consumer demand is high the price might be maintained at a high level.
  • Distribution: distribution channels might be added as consumer demand increases.
  • Promotion: promotion is aimed at a broader audience. A company might spend a lot of resources on promotion during the Growth Stage to build brand loyalty.

3.3 Maturity

When a product reaches maturity, sales growth slows and sales volume eventually peaks and stabilises. This is the stage during which the market as a whole makes the most profit. A company’s primary objective at this point is to defend market share while maximising profit.

In this stage, prices tend to drop due to increased competition. A company’s fixed costs are low because it is has well established production and distribution. Since brand awareness is strong, marketing expenditure might be reduced, although increased marketing expenditure might be needed to retain market share and fight increasing competition. Expenditure on research and development is likely to be restricted to product modification and improvement, and perhaps research into improved production efficiency and product quality.

Some considerations for the mature product market include:

  • Product differentiation: increased competition in the mature product market means that a company must find ways to differentiate its product from that of competitors. Strong branding is one way to do this.
  • Pricing: prices may be reduced because of increased competition. Firms in the market should be careful not to start a price war.
  • Distribution: distribution intensifies and incentives may be offered to encourage preference to be given over competing products.
  • Promotion: promotion will focus on emphasising product differences and creating/maintaining a strong brand.

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 the firms in the industry. A decline might occur because the market has become saturated, the product has become obsolete, or customer tastes have changed.

A company might try to stimulate growth by changing their pricing strategy, but ultimately the product will have to be re-designed, or replaced. High-cost and low market share firms will be forced to exit the industry.

As sales decline, a company has three strategy options:

  • Hold: maintain production and 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.
  • Harvest: continue to offer the product, reduce marketing expenditure, and sell possibly to a loyal niche segment of the market.
  • Divest: Discontinue production, and liquidate the remaining inventory or sell the product to another firm.

Some considerations for 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 for products subject to the Harvest and Divest strategies.

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 one time. Consequently, the life cycle concept is not well-suited for the forecasting of 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 must 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 the Product Life Cycle may become self-fulfilling. For example, if sales peak and then decline a manager may conclude that a product is on the decline and cut back on marketing, thus precipitating a further decline.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Five C Analysis of Borrower Creditworthiness

When a company is trying to borrow money, executives, entrepreneurs and consultants should be aware that there are five criteria that most lenders care about

5 C Analysis of Borrower Creditworthiness

(Source: Flickr)

What are lenders looking for?

IT IS important to understand what lenders look for when they lend money because companies often need to borrow money for various reasons: increase cash reserves, refinance existing debt, pay regular operating expenditures, research and development, capital expenditure, product development, expansion into new markets, strategic acquisitions, etc.

There are five criteria that most lenders use to assess a borrower’s creditworthiness:

  1. capacity to generate sufficient cash flows to service the loan;
  2. collateral to secure the loan in case the borrower defaults;
  3. capital that shareholders have invested in the business;
  4. conditions prevailing in the borrower’s industry and broader economy; and
  5. character and track record of the borrower and the borrower’s management.

It is important to keep in mind that lenders don’t give equal weight to each criterion and will use all five criteria to create an overall impression of a company’s creditworthiness. Lenders are typically cautious and weakness in one of the five criteria may offset strength in all of the others. For example, if a company is in a cyclical industry (e.g. construction, auto, or aviation) the company may find it difficult to borrow money during an economic downturn even if the company shows strength in all of the other criteria. Similarly, if a company’s management has a bad reputation and poor track record then the company may find it difficult to borrow money even if it has strong financial statements.

Taken together, these five criteria indicate a borrower’s ability and willingness to repay its debts. As such, if you are advising a company in relation to raising finance, you must ensure that each of the five criteria is fully addressed in your loan request.

Let’s consider each of the five criteria in a little more detail:

1. Capacity

Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness. The borrower must be able to satisfy the lender that it has the ability to repay the loan. To satisfy itself of the borrower’s capacity, the lender will consider various factors including:

  1. Profitability: What are the revenues and expenses of the borrower?
  2. Cash flows: How much cash flow does the business generate? The lender is interested not only in cash flows from operations, but also cash flows from investing and financing activities. What are the timing of cash flows with regard to repayment?
  3. Payment history: What is borrower’s payment history and track record of loan repayment?
  4. Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
  5. Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
  6. Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt to equity ratio, debt to asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.

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 fails to repay the loan, the collateral may be seized by the lender to repay the loan.

The borrower must usually provide the lender with suitable collateral. To do this, the borrower normally pledges hard assets like real estate, office equipment or manufacturing equipment. However, accounts receivable and inventory might also be pledged as collateral.

Service businesses and small companies may find it difficult to provide lenders with the collateral they require because they have fewer hard assets to pledge. If the borrower doesn’t have the necessary collateral, the lender may require personal guarantees from the borrower’s directors or from a third party such as the borrower’s parent company.

3. Capital

Capital is the money that shareholders have personally invested in the business. Capital represents the money that shareholders have at risk should the business fail.

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 business venture and that they will do all that they can to ensure the borrower does not default on the loan.

4. Conditions

Conditions refer to two factors that the lender will take into account. Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. For example, during recessions and periods of tight credit it becomes more difficult for small businesses to repay loans and more difficult for lenders to find money to lend. Thus, during these periods a small business will find it difficult to borrow money and must present lenders with a flawless loan application.

In considering the overall economic climate a lender may consider various questions including:

  1. What is the current business climate?
  2. What are the trends for the borrower’s industry? How does the borrower fit within them?
  3. What is the short and long-term growth potential in the industry?
  4. How is the market characterised? Is it an emerging or mature market?
  5. Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?

Secondly, conditions refer to the intended purpose of the loan. The borrower’s reasons for seeking the loan should be spelt out in detail in the loan application. Will the money be used to buy new equipment for expansion? Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?

5. Character

Character refers to the general impression that the borrower makes on the prospective lender. The lender will form a subjective judgement as to whether the borrower is sufficiently trustworthy to repay the loan.

Lenders want to put their money with companies that have impeccable credentials. Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:

  1. What is the character of each member of the management team?
  2. What reputation do management have in the industry and the community?
  3. What educational background and level of experience does management have?
  4. What is management’s track record?
  5. What is the overall consumer perception of the borrower?
  6. Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
  7. Does the borrower have a track record of fulfilling its obligations in a timely manner?
  8. What is the borrower’s payment history and track record of loan repayment?
  9. Are there any legal actions pending against the borrower? If so, what is the reason for these legal actions?

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Value Chain Analysis

To understand which activities provide a business with a competitive advantage, it is helpful to separate operations into a series of value-generating activities referred to as the “value chain”

Value Chain Analysis

(Source: Flickr)

1. Background

VALUE Chain Analysis is a concept that was first described and popularised by Michael Porter in his 1985 book, Competitive Advantage.

2. Relevance of Value Chain Analysis

In order to understand the activities that provide a business with a competitive advantage, it is useful to separate the business operation into a series of value-generating activities referred to as the value chain.

Value Chain Analysis involves identifying all of the important activities in which a business engages and then determining which ones give the company a defensible competitive advantage. By doing this, we can identify which activities are best undertaken by the company itself and which ones are able to be outsourced.

3. Value Chain Analysis explained

Michael Porter introduced a generic value chain model that comprises a sequence of activities common to a wide range of firms. Porter suggested that the activities of a business could be grouped under two headings:

  1. Primary activities: those that are directly concerned with creating and delivering a product; and
  2. Support activities: those that are not directly involved in production, but may increase effectiveness or efficiency.

The firm’s margin or profit depends on its ability to perform these activities efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of the activities in the value chain.

3.1. Primary activities

The primary activities in Porter’s model include:

  1. Inbound Logistics: Receiving and storing externally sourced materials.
  2. Operations: Manufacturing products and services – the way in which inputs are converted into final products.
  3. Outbound Logistics: Getting finished goods and services to consumers.
  4. Marketing & Sales: Identification of customer needs and the generation of sales.
  5. Service: Supporting customers after the product or service has been sold to them.

3.2. Support activities

The support activities in Porter’s model include:

  1. Human resource management: Recruitment, training, development, motivation and compensation of employees.
  2. Infrastructure: Includes a broad range of support systems including organisational structure, planning, management, quality control, culture, and finance.
  3. Procurement: Sourcing resources and negotiating with suppliers.
  4. Technology development: Managing information, developing and protecting new products and services, developing more efficient processes, and improving quality.

4. Application of the Value Chain Analysis

4.1. Steps to take

Value Chain Analysis can be broken down into a three sequential steps:

  1. Break down a company into its key activities under each of the headings in the model;
  2. Identify activities that contribute to the firm’s competitive advantage either by giving it a cost advantage or creating product differentiation. Also identify activities where the business appears to be at a competitive disadvantage; and
  3. Develop strategies around the activities that provide a sustainable competitive advantage.

4.2. Cost advantage

A business can achieve a cost advantage over its competitors by firstly understanding the costs that are associated with each activity and then organising each activity to be as efficient as possible.

Porter identified 10 cost drivers related to each activity in the value chain:

  1. Economies of scale
  2. Learning
  3. Capacity utilisation
  4. Linkages among activities
  5. Interrelationships among business units
  6. Degree of vertical integration
  7. Timing of market entry
  8. Firm’s policy on targeting cost or product differentiation
  9. Geographic location
  10. Institutional factors (regulation, union activity, taxes, etc.)

A firm can develop a cost advantage by controlling these 10 cost drivers better than its competitors.

A cost advantage can also be pursued by reconfiguring the value chain. Reconfiguration means introducing structural changes such as a new production process, new distribution channels, or a different sales approach. For example, Qantas structurally redefined its maintenance of aircraft, which was traditionally conducted by inhouse engineers, by outsourcing this function to private overseas contractors.

4.3. Product differentiation

Product differentiation can be achieved by a business by focusing on its core competencies in order to perform them better than its competitors.

Product differentiation can be achieved through any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors, providing high levels of product support services, or designing innovative and aesthetically attractive products are all ways of creating product differentiation.

5. Issues arising from the Value Chain Analysis

5.1. Linkages between Value Chain activities

Value Chain activities are not isolated from one another. Rather, one value chain activity often affects the cost or performance of other ones. Linkages may exist between primary activities and also between primary and support activities.

Consider the case in which the design of a product is changed in order to reduce manufacturing costs. Suppose that the new product design inadvertantly results in increased service costs; the cost reduction could be less than anticipated and even worse, there could be a net cost increase.

5.2. Business unit interrelationships

Business unit interrelationships can be identified using the Value Chain Analysis.

Business unit interrelationships offer opportunities to create synergies among business units. For example, if multiple business units require the same raw material and the procurement process can be coordinated then bulk purchasing may result in cost reductions. Such interrelationships may exist simultaneously in multiple value chain activities.

5.3. Outsourcing

Value Chain Analysis assists management decide which activities should be outsourced. It is rare for a business to undertake all primary and support activities internally. In order to decide which activities to outsource managers must understand the firm’s strengths and weaknesses, both in terms of cost and ability to differentiate.

6. Case example

For example, Coca-cola might have the following value chain elements:

  1. Research and development (Will cherry taste good with cola?)
  2. Manufacturing (How much does the bottling plant cost to build and run? How often do factories need to be re-engineered?)
  3. Cost of goods sold (How much does it cost to manufacture cola? Is there a frost in Florida that will drive up the cost of cherries?)
  4. Packaging and shipping (How much does that new design of packaging cost? Are many cans of cola lost in transit? What are the fixed costs of shipping?)

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Four P’s Marketing Framework

A useful framework for evaluating the marketing strategy for a product

Four P Marketing

THE Four P’s consists of:

  1. price ;
  2. product ;
  3. position/place; and
  4. promotion .

1. Price

The pricing strategy employed by a firm for a particular good or service will have a significant effect on profit.

There are many different pricing strategies that can be employed in different combinations, including:

  1. Price differentiation – setting a different price for the same product in different segments of the market. First degree price discrimination involves charging each customer a different price. To do this, the seller must be able to observe each customers willingness to pay, this is very difficult to do in practice. Second degree price discrimination involves varying the price according to quantity sold. Third degree price discrimination involves varying the price by location or market segment. For example, charging discounted prices for students.
  2. Dynamic pricing – a form of first degree price discrimination, dynamic pricing is a flexible pricing mechanism that allows online companies to adjust the price of identical goods to correspond to a customer’s willingness to pay. This is made possible by using data gathered from a customer including where they live, what they buy, and how much they have spent on past purchases.
  3. Predatory pricing – aggressive pricing intended to undercut competitors and drive them out of the market.
  4. Limit pricing – a low price charged by a monopolist in order to discourage entry into the market by other firms.
  5. Using a loss leader – 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.
  6. Penetration pricing – the price is set low in order to gain market share.
  7. Marginal cost pricing – the practice of setting the price of a product equal to the cost of producing one extra unit of output.
  8. Market-orientated pricing – setting a price based upon analysis of the targeted market.
  9. Psychological pricing – pricing designed to have a positive psychological impact. For example, selling a product at $3.95 instead of $4.
  10. 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 electronic markets when a new product range is released.
  11. Premium pricing – involves keeping the price of a good or service artificially high in order to encourage a favorable perception among buyers.
  12. Target pricing – a method of pricing whereby the selling price of a product is calculated to produce a particular rate of return on investment.
  13. Seasonal pricing – adjusting the price depending on seasonal demand.
  14. Cost-plus pricing – a very basic pricing strategy where a firm sets price equal to unit cost of production plus a margin for profit.

2. Product

Product differentiation is a source of competitive advantage. Product differentiation is the process of describing the differences between a good or service in order to demonstrate the unique aspects of the good or service and create an impression of value in the mind of the consumer.

The major sources of product differentiation include:

  1. Vertical differentiation –where products differ in their quality. For example, BMW and Hyundai.
  2. Horizontal differentiation – where products differ in features that cannot be ordered. For example, different flavours of ice-cream.
  3. Availability – where products are available at different times (e.g. seasonal fruits) and locations (e.g. location of an ice-cream store near the beach). See section 3, “Position/Place”.
  4. Perception – branding, sales, and promotion can be used to distinguish a product in the market. See section 4, “Promotion”.

Successful product differentiation leads to monopolistic competition. In a monopolistically competitive market consumers perceive that there are non-price differences between products. As a result, even though there are a large number of producers, each producer has a degree of control over price.

3. Position/Place

The physical location of a good or service can be a source of competitive advantage. For example, imagine we have two ice-cream stores. One ice-cream store (Store A) opens next to a popular tourist beach, and one ice-cream store opens in the backstreets of a quiet suburb (Store B). We expect that Store A will be able to charge a higher price and sell more ice-cream than Store B, other things being equal.

4. Promotion

Promotion is used to enhance the perception of a good or service in the minds of consumers. A promotion will draw peoples attention to any features of a product that people might find attractive including its quality, specialised features, availability, brand name, or image.

Promotion can be carried out in various ways including:

  1. advertising (developing brand awareness);
  2. publicity (sponsoring a sports team);
  3. public relations (donating to charity);
  4. celebrity appearances;
  5. door to door sales;
  6. price discounting (see section 1, “Price”); and
  7. quantity discounting (two for one offers, bundling).

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

McKinsey 7 S Framework

The 7 S Framework can help executives and consultants to understand the inner workings of an organisation, and it provides a guide for organisational change

McKinsey 7 S Framework(Source: Flickr)

1. Background

DEVELOPED around 1978, the 7 S framework first appeared in a book called The Art of Japanese Management by Richard Pascale and Anthony Athos, and also featured in In Search of Excellence by Thomas Peters and Robert Waterman.

McKinsey has adopted the 7 S model as one of its basic analysis tools.

2. Benefits of the 7 S Framework

The 7 S framework is a useful diagnostic tool for understanding the inner workings of an organisation. It can be used to identify an organisations strengths and sources of competitive advantage, or to identify the reasons why an organisation is not operating effectively. As such, the 7 S framework is an important analysis framework for mangers, consultants, business analysts and potential investors to understand.

The 7 S framework provides a guide for organisational change. The framework maps a group of interrelated factors, all of which influence an organisation’s ability to change. The interconnectedness among each of the seven factors suggest that significant progress in one area will be difficult without working on the others. The implication of this is that, if management wants to successfully establish change within an organisation, they must work on all of the factors, and not just one or two.

3. McKinsey’s 7 S framwork explained

The 7 S framework describes seven factors which together determine the way in which an organisation operates. The seven factors are interrelated and, as such, form a system that might be thought to preserve an organisation’s competitive advantage. The logic is that competitors may be able to copy any one of the factors, but will find it very difficult to copy the complex web of interrelationships between them.

McKinsey 7 S model

  1. Shared values (also called Superordinate Goals) refer to what an organisation stands for and believes in. This includes things like the long term vision of the organisations, its charitable ideals, or its core guiding principles. For example, the core guiding principle at McKinsey is professionalism.
  2. Staff refers to the number and type of people employed by the organisation.
  3. Skills refers to the learned capabilities of staff within the organisation.
  4. Style refers to the way things are done within the organisation, that is, the work culture.
  5. Strategy refers to the plans an organisation has for the allocation of its resources to achieve specific goals.
  6. Structure refers to the way in which an organisation’s business units relate to each other. For example, a company may use a centralised system where all key decisions are made at the head office.
  7. Systems are the practices and procedures that an organisation uses to get things done, e.g. financial systems, information systems, recruitment and performance review systems, etc.

As a consultant, you will need to ask targeted questions to identify an organisation’s strengths and weaknesses for each of the above factors.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

NPV: Net Present Value

The NPV of an investment is the present value of the series of cash flows generated by the investment minus the cost of the initial investment

Net Present Value

(Source: Flickr)

1. Net Present Value (NPV) explained

THE net present value (NPV) of an investment is the present value of the series of cash flows generated by the investment minus the cost of the initial investment. Each cash inflow/outflow is discounted back to its present value and then summed together:

NPV

Where t is the time of the cash flow; r is the discount rate (see below for further explanation); Ct is the net cash flow (cash inflow minus cash outflow) at time t; and Co is the cost of the initial investment made at time zero.

NPV is used to analyse the profitability of an investment. As a general rule, assuming you have selected an appropriate discount rate, only those investments that yield a positive NPV should be considered for investment.

2. The discount rate

The rate used to discount future cash flows to their present value is an important variable in the net present value calculation. To some extent, the selection of the discount rate depends on the use to which the NPV calculation will be put.

2.1 Option 1 – cost of capital:

One option that is often used is to use a firm’s weighted average cost of capital.

There are two problems with using the cost of capital for the discount rate. Firstly, it may not be possible to know what the cost of capital will be in the future. One solution to this problem is to use a variable discount rate that increases over time to reflect the yield curve premium for long-term debt. A yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity and is usually upward sloping asymptotically. There are two common explanations for why the yield curve is upward sloping. Firstly, it might be that rising interest rates are expected in the future and investors who are willing to lock their money in now therefore need to receive a higher rate of interest. Secondly, even if interest rates are not expected to rise, longer maturities involve greater risks to an investor and so, to compensate for these inherent uncertainties about the future, a risk premium should be paid.

The second problem with using the cost of capital for the discount rate is that it does not take into account opportunity costs. A positive NPV calculation would tell us that the investment is profitable, but would not tell us whether the investment should be undertaken because there may be more profitable investment opportunities.

2.2 Option 2 – opportunity cost:

A second option is to use a discount rate that reflects the opportunity cost of capital. The opportunity cost of capital is the rate which the capital needed for the project could return if invested in an alternative venture. Obviously, where there is more than one alternative investment opportunity, the opportunity cost of capital is the expected rate of return of the most profitable alternative.

For example, assume that a firm has two investment options, investing in Project A (its existing line of business) or Project B (a new line of business). Based on past experience, the firm knows that it can obtain a 15% return from investing in Project A. This means that the opportunity cost of capital for investing in Project B is 15%. Thus, an NPV calculation for Project B will use a discount rate of 15%.

3. Common pitfalls

3.1 Negative future cash flows:

One potential problem with NPV is that if, for example, 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 cautious but too optimistic. A way to avoid this problem is to explicitly calculate the cost of financing any losses after the initial investment.

3.2 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.

3.3 Dealing with 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, in the example in section 2.2, if we used a discount rate higher than 15% in the NPV calculation for Project B then obtaining a negative NPV calculation does not necessarily mean that we should reject Project B. Unless we have intellionally chosen a higher discount rate to adjust for the risk of the project, the negative NPV result does give us any useful information.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Porter’s Five Forces Analysis

The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry

Porter's Five Forces

HARVARD Business School professor Michael Porter, in his 1979 book Competitive Strategy, developed the Porter’s Five Forces.

The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry. Attractiveness in this context refers to the overall industry profitability. You can use this framework when introducing a new product, expanding into a new market, divesting a product line, acquiring a new business, or assessing the cause of declining sales or profitability.

In determining the competitive intensity of an industry, Porter’s Five Forces include three forces from ‘horizontal’ competition (1, 2 and 3), and two forces from ‘vertical’ competition (4 and 5):

  1. Existing competition: How strong is the rivalry posed by the present competition?
  2. Barriers to entry: What is the threat posed by new players entering the market?
  3. Substitutes: What is the threat posed by substitute products and services?
  4. Supplier bargaining power: How much bargaining power do suppliers have?
  5. Customer bargaining power: How much bargaining power do customers have?

Porter's Five Forces

1. Competition: How strong is the rivalry posed by the present competition?

The intensity of competition in an industry is affected by various factors, including:

  1. The number of firms in the industry, the more firms the stronger the competition because there are more firms competing for the same customers;
  2. Slow market growth leads to increased competition because there is only a small number of new customers entering the market each year, firms must compete to win existing customers;
  3. Where firms have economies of scale, that is they have relatively high fixed costs and low variable costs, the more they produce the lower their per unit costs become. This results in more intense rivalry between firms as they compete to gain market share;
  4. Where customers have low switching costs, this intensifies competition as firms compete to retain their current customers and steal customers from other firms;
  5. Low levels of product differentiation between firms leads to increased competition. Where a firm has a strong brand name or a highly differentiated product, this reduces the intensity of competition;
  6. Diversity of competition (for example, firms from different countries and cultures) reduces the predictability and stability in the market.  Uncertainty in the market leads firms to compete more agressively, thereby driving down firm profits in the industry;
  7. High exit barriers increase competition because firms that might otherwise exit the industry are forced to stay and compete. A common exit barrier is where a firm has highly specialised equipment that it cannot sell or use for any other purpose; and
  8. An industry shakeout will result in a short period of intense competition. Where a growing market induces a large number of new firms to enter the market, a point is reached where the industry becomes crowded with competitors. When the market growth rate slows and the market becomes overcrowded, a period of intense competition, price wars and company failures ensues.

2. Barriers to entry: What is the threat posed by new players entering the market?

In theory, any firm should be able to enter a market, however, in reality industries often possess characteristics that prevent new players from entering the market (barriers to entry).  Barriers to entry reduce the rate of entry of new firms, thus maintaining the level of profits for those firms already in the industry.

Barriers to entry may exist for various reasons, including:

  1. high capital costs of setting up a business in a particular industry;
  2. where an industry requires highly specialised equipment, potential entrants may be reluctant to commit to acquiring specialised assets that cannot be sold or converted into other uses if the venture fails;
  3. lack of the proprietary technology or patents that are needed to become a player in the industry;
  4. extensive scale and branding of existing competitors may prevent potential entrants from gaining market share and hence deter entry into the market;
  5. government regulations: Government may regulate to prevent new firms from entering an industry. It might do this because of the existence of a natural monopoly. A natural monopoly is an industry where one firm is able to produce the desired output at a lower social cost than could be achieved by two or more firms (social costs being the sum of private and external costs). Natural monopolies exist because of the existence of economies of scale, and examples include railways, water services, and electricity; and
  6. Individual firms may have economies of scale. The existence of such economies of scale creates a barrier to entry because an existing firm can produce at a much lower cost per unit than a new firm.

3. Substitutes: What is the threat posed by substitute products and services?

Economics defines substitute goods as goods for which an increase in demand for one leads to a fall in demand for the other. In the Porter’s Five Forces framework, a reference to a substitute good refers to a good in another industry. For example, natural gas is a substitute for petroleum.

Good A and good B are substitutes if they can be used in place of one another (at least in some circumstances). The existence of close substitutes constrains the ability of a firm to raise prices and, as the number of substitutes increase, the quantity demanded will become more and more sensitive to changes in the price level (i.e. price elasticity of demand for the product increases).

The threat posed by substitute goods is affected by various factors, including:

  1. the cost to customers of switching to a substitute product or service (switching costs). For example, the cost of switching between the Windows operating system and Apple operating system might be prohibitive because computer programs and accessories are built to work with one operating system or the other;
  2. buyer propensity to substitute;
  3. relative price-performance of substitutes; and
  4. perceived level of product differentiation.

4. Supplier bargaining power: How much bargaining power do suppliers have?

Suppliers are providers of the inputs to the industry, for example, labour and raw materials. Factors that will effect the bargaining power of a supplier include:

  1. The number of possible suppliers and the strength of competition between suppliers;
  2. Whether suppliers produce homogenous or differentiated products;
  3. The importance of sales volume to the supplier;
  4. The cost to the firm of changing suppliers (switching cost);
  5. The presence of substitute inputs; and
  6. Vertical integration of the supplier or threat to become vertically integrated. Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers. For example, a car manufacturer may also own a tyre manufacturer.

5. Customer bargaining power: How much bargaining power do customers have?

Customers are the purchasers of the goods or services produced by the company.  Factors that will effect the bargaining power of a customer include:

  1. The volume of goods or services purchased. If the customer purchases a significant proportion of output, then they will have a significant amount of bargaining power;
  2. The number of customers. The fewer customers there are, the more bargaining power they will have to negotiate price. For example, in America the market for defence equipment is a monopsony, a market in which there are many suppliers and only one buyer. As such, the Department of Defence has strong bargaining power to negotiate the terms of supply contracts;
  3. Brand name strength. A product that has a stronger brand name will be able to be sold for a higher price in the market;
  4. Products differentiation. A firm that produces a product or service that is unique in some way will have more bargaining power and will be able to charge a higher price in the market; and
  5. The availability of substitutes.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

SWOT Analysis

SWOT Analysis is a strategic planning tool used to evaluate the strengths, weaknesses, opportunities, and threats involved a business venture

SWOT Analysis

1. SWOT Analysis Explained

ALBERT Humphrey is credited with inventing the SWOT analysis technique.

SWOT analysis is a strategic planning tool used to evaluate the strengths (S), weaknesses (W), opportunities (O), and threats (T) involved a business venture. It involves specifying the objective of the business venture and identifying the internal and external environmental factors that are expected to help or hinder the achievement of that objective.

After a business clearly identifies an objective that it wants to achieve, SWOT analysis involves:

  1. examining the strengths and weaknesses of the business (internal factors); and
  2. considering the opportunities presented and threats posed by business conditions, for example, the strength of the competition (external factors).

By identifying its strengths, a company will be better able to think of strategies to take advantage of new opportunities. By identifying current weaknesses and threats, a company will be able to identify changes that need to be made to improve and protect the value of its current operations.

2. Criticisms

SWOT analysis has two clear weaknesses. Firstly, using SWOT may tend to persuade companies to write lists of Pros and Cons, rather than think about what needs to be done to achieve objectives. Secondly, there is the risk that the resulting lists will be used uncritically and without clear prioritisation. For example, weak opportunities may appear to balance strong threats.

3. Case example: drinks manufacturer

Let’s use SWOT analysis to consider the strategy of a hypothetical prominent soft drinks manufacturer called Coca-Cola. Coke is currently the market leader in the manufacture and sale of sugary carbonated drinks and has a strong brand image. Sugary carbonated drinks are currently an extremely profitable line of business. The company’s goal is to develop strategies to achieve sustained profit growth into the future.

3.1 Strengths

A firm’s strengths are its resources and capabilities that provide the firm with a competitive advantage in the market place, and help the firm achieve its strategic objective. Coke’s strengths might include:

  • strong product brand names,
  • large number of successful drink brands,
  • good reputation among customers,
  • low cost manufacturing, and
  • a large and efficient distribution network.

3.2 Weaknesses

Weaknesses include the attributes of a business that may prevent the business from achieving its strategic objective. Coke’s weaknesses might include:

  • lack of a large number of healthy beverage options, and
  • large manufacturing capacity makes it difficult to change production lines in order to respond to changes in the market.

3.3 Opportunities

Changing business conditions may reveal certain new opportunities for profit and growth. Coke’s opportunities might include:

  • new countries and markets that Coke might expand into, and
  • a lack of any strong global fruit juice or other healthy beverage manufacturer leaves a gap in the market.

3.4 Threats

Changing business conditions may present certain threats. Coke’s threats might include:

  • shifting consumer preferences away from Coke’s core products, and
  • new government competition regulations that prevent the acquisition of large competing soft drink companies.

3.5 Proposed strategy

The main opportunity for Coca-Cola is the rising popularity of healthy beverage alternatives, such as water and fruit juice. The dominance of Coca-Cola and the increasing number of competition regulations that prevent Coke’s acquisition of competing drink manufacturers presents a threat to Coke’s objective to obtain profit and growth. A proposed strategy may therefore be to find small healthy beverage manufacturers 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 its newly acquired healthy beverages.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Cost Benefit Analysis

The cost benefit analysis is a basic analysis framework that involves weighing up the costs and benefits of one course of action against another

Cost Benefit Analysis

IN YOUR consulting case interview you will most likely be required to make a recommendation on a hypothetical business problem. Understanding how to use the cost benefit analysis could come in handy.

The cost benefit analysis

One of the most basic analysis frameworks you can use to solve a business problem is the “cost-benefit analysis”. This method is fairly self-explanatory. It involves weighing up the total expected costs and benefits of one course of action against another. Having done this, you will be able to formulate a more well-thought-out solution to the business problem.

For example, consider the following business problem (Project Gold Mine). Your client says to you, “Currently we run a single gold mine (Mine A) and are trying to decide whether we should expand Mine A or build a second mine (Mine B). Which project should we undertake?” In this problem there are three possible recommendations: (1) expand Mine A, (2) build Mine B, or (3) do nothing (i.e. maintain the status quo). To make a recommendation, you will need to consider the benefits and costs of each course of action.

Evaluating the benefits

In considering the benefits, you will mainly want to think about revenue (Revenue=quantity x price); more on this in a later post.

Counting the cost

As far as I’m aware, there are four types of costs that you need to pay attention to: sunk costs, fixed costs, variable costs, and opportunity costs. I will consider them in turn.

1. Sunk costs

Sunk costs are expenditures that have already been made and cannot be recovered. As such, sunk costs should not be factored into your decision-making process. For example, in Project Gold Mine the original cost of building Mine A is a sunk cost. This money has already been spent and cannot be recovered, it is therefore a sunk cost, and should not be factored into the decision-making process.

2. Fixed costs

Fixed costs are costs that do not vary with the quantity of output produced. In the Project Gold Mine example, fixed costs might include things like rent, land taxes, utilities and other overheads.

It is important to understand that fixed costs are fixed only in the short term. In the short term, the cost of labour may be a fixed cost if the mining company cannot vary the number of employees due to contract obligations. In the long run, these contracts can be renegotiated. In the long run, nearly all costs are variable, even things like rent, because the mining company could move its operations overseas to a country where operating costs are lower.

3. Variable costs

Variable costs are costs that vary with the quantity of output produced. In the Project Gold Mine example, the main variable costs would be the cost of extracting the 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, in the short term, a company cannot change its fixed costs.

4. Opportunity costs

The opportunity cost of an item is what must be given up to obtain that item.

In the Project Gold Mine example, failing to consider opportunity costs could lead to the wrong decision being made. Consider the following hypothetical:

If the mining company expands Mine A the profit is $1 million, and if it builds Mine B the profit is $2 million. Which project should it undertake? Building Mine B is the more profitable of the two projects; however, the company also needs to consider the opportunity cost of building Mine B. In this hypothetical example, the profit obtained from not undertaking either project is $3 million. So, although building Mine B is the most profitable project, doing nothing is even more profitable.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]