The Little Blue Consulting Handbook, 2015 Edition

The Little Blue

Consulting Handbook 2015 Edition

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

Sponsors:

Acknowledgements: Special thanks to the following people for their valuable insights, contributions and support:  Matthew O’Sullivan, President of the Global Consulting Group;  Shishir Pandit, CEO of the Global Consulting Group.

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Contents

Introduction ........................................................................................................5 1. Definitions ......................................................................................................6 1.1 Consulting Jargon ....................................................................................6 1.2 Business Terms ........................................................................................9 2. Industry Analysis ......................................................................................... 31 2.1 Macro Environment ............................................................................. 31 2.1.1 PEST Analysis ................................................................................ 31 2.2 Micro Environment.............................................................................. 37 2.2.1 Business Landscape Survey .......................................................... 37 3. Firm Level Analysis .................................................................................... 52 3.1 Profitability ............................................................................................ 52 3.1.1 Profitability Framework ............................................................... 52 3.2 Competitive Advantage ....................................................................... 58 3.2.1 Value Chain Analysis .................................................................... 58 3.3 Competitive Strategy ............................................................................ 63 3.3.1 Porter’s Generic Strategies ........................................................... 63 3.3.2 Strategy and the Internet .............................................................. 67 3.4 Growth Strategy .................................................................................... 69 3.4.1 Product / Market Expansion Matrix ......................................... 69 3.4.2 GE McKinsey 9 Box Matrix ........................................................ 77 3.4.3 BCG Growth Share Matrix .......................................................... 81 3.5 Marketing Strategy ................................................................................ 87 3.5.1 Four Ps Framework ...................................................................... 87 3.5.2 Product Life Cycle Model ............................................................ 92 3.6 Cost Management ................................................................................. 98 The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 3

3.7 Financial Management ....................................................................... 101 3.7.1 Five C Analysis of Borrower Creditworthiness ...................... 101 3.7.2 Net Present Value........................................................................ 105 3.8 Organisational Cohesiveness ............................................................ 108 3.8.1 McKinsey 7 S Model ................................................................... 108 3.9 Competitive Response ....................................................................... 110 3.10 Corporate Turnaround .................................................................... 112 4. General Concepts and Frameworks ...................................................... 115 4.1 Barriers to Entry ................................................................................. 115 4.2 Cost Benefit Analysis ......................................................................... 119 4.3 Economies of Scale ............................................................................ 122 4.4 Economies of Scope .......................................................................... 126 4.5 Experience Curve ............................................................................... 130 4.6 MECE Framework ............................................................................. 135 4.7 Moral Hazard....................................................................................... 137 4.8 Porter’s Five Forces ........................................................................... 140 4.9 Quantitative Easing ............................................................................ 143 4.10 Rule of 70 ........................................................................................... 144 4.11 SWOT Analysis ................................................................................. 145

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Introduction The Little Blue Book is designed for student consultants and first year management consultants, and aims to provide key concepts and frameworks that can be used to analyse business problems, evaluate situations, and achieve outcomes more quickly and easily than would otherwise be possible. For the sake of clarity, this document is not designed to help you prepare for consulting interviews. If you are looking for such a guidebook, please download “The HUB’s Guide to Consulting Interviews”. The Little Blue Book will be updated from time to time. If you have any comments, suggestions or feedback, please email the Editors at [email protected]. The Little Blue Book is structured in four (4) parts: 1. Definitions of consulting jargon and business terms; 2. Frameworks for understanding the broader macro environment and analysing an industry; 3. Frameworks for examining a firm and firm level strategy; and 4. Concepts and frameworks designed to deepen and broaden your understanding and ability to analyse business situations and which are not covered elsewhere in the Little Blue Book.

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1. Definitions 1.1 Consulting Jargon 10,000 foot view: A high-level overview of the situation. 80/20 rule: A rule of thumb which holds that 80% of a business problem can typically be solved by focusing on 20% of the issues. Add some colour: Make it more interesting/appealing/persuasive. Adding value: Making a contribution. AOB: Stands for “any other business” and might be used in a meeting agenda to block out time for miscellaneous discussion. At the end of the day: A consultant may use this phrase before summarising the main thrust of her argument. B2B: Stands for “business to business” and indicates that a business is aiming to sell to other businesses rather than to end consumers. B2C: Stands for “business to consumer” and indicates that a business is aiming to sell directly to consumers rather than to other businesses. Bandwidth: Capacity to take on additional work commitments. For example, “I don’t have any bandwidth this week”. Big 3: McKinsey, Bain and BCG. Big 4: Deloitte, EY, KPMG and PwC. Boil the ocean: Go overboard; undertake an excessive amount of analysis; fail to follow the 80/20 rule. Buckets: Categories. Buy in: Agreement; support. For example, “we need to get buy in from the client before finalising the report”. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 6

Charge code: A unique code provided for a project which can be used to record work-related expenses. Circle back: Follow up with someone at a later point in time. Close the loop: Completing an item on the agenda or topic of discussion with everyone being in agreement. Core client: A client that has a long-standing relationship with the firm. Deck: PowerPoint slides. Deep dive: To conduct an extensive examination of a particular issue. Deliverable: Work product that a consultant needs to provide to her manager or the client as part of a client engagement. Development opportunity: A professional shortcoming or area for improvement that requires attention. Due diligence: Comprehensive examination of all relevant issues, such as a review of the client’s business or industry. Fact pack: A pack of information that provides the essential facts for a project/industry/company. Granular: Focusing on the finer details, as in “this analysis needs to be more granular.” Hard stop: A stated time after which the person will no longer be available to continue the meeting/discussion. For example, “I have a hard stop at 3 o’clock”. Key: Critical; essential; required; important; central. For example, “the key issues are X, Y, Z.” Let me play this back: Words used before providing a summary of the discussion from the listener’s perspective. This is a helpful technique which can allow a consultant to clarify her understanding of the key The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 7

issues and at the same time sound intelligent by saying something even if the summary adds no additional insights. Low hanging fruit: Targets that are easily achievable, issues that can be quickly resolved, opportunities that can be readily exploited, or problems that are simple to solve. By picking the low hanging fruit first, consultants can demonstrate quick results, which can boost the client’s confidence in the project. Lots of moving parts: Complex. Managing upwards: Providing feedback to more senior employees. MBB: McKinsey, Bain and BCG. MECE: Pronounced “me see”, and stands for “mutually exclusive, collectively exhaustive”. It is a principle for grouping information into distinct categories which, taken together, deal with all available options. For more information, see “4.6 MECE Framework”. On the beach: In between assignments. Time spent on the beach may be spent in training or used for business development. On the same page: See things from the same perspective. Out of the box thinking: Thinking that generates novel ideas which don’t follow neatly from the data. Ping: Contact someone, as in “I will ping you later via email.” PIOUTA: Pulled it out of thin air. Pipeline: Current and upcoming client engagements. Production: A department of the consulting firm (often outsourced) that assists in producing material needed for presentations and meetings. Pushback: Resistance or disagreement, as in “we received some pushback from the client.” The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 8

Right size: Downsize. Sandwich feedback technique: A structure for providing feedback that resembles a sandwich – one positive comment, followed by a piece of feedback, and ending with a positive comment. Scope: Agreed set of deliverables for a client engagement. Scope creep: When the client adds, or attempts to add, additional deliverables which were not agreed in the initial project brief. Sniff test: A common sense check of a particular idea, proposal or analysis. SWAG: Some wild-ass guess. Take the lead: Take responsibility for something, as in: “Why don’t you take the lead on this project.” Takeaways: The key points that should be remembered at the end of a discussion, meeting or presentation. Touch base: To meet at a certain time to talk about the project. Up or out: Many top consulting firms adopt an ‘up or out’ policy. Employees are expected to advance up to the next level of responsibility or they will be counselled out of the firm. Work stream: The tasks that make up a project.

1.2 Business Terms Anchoring: The common tendency for people to rely too heavily on readily available information (the “anchor”) when making decisions involving uncertainty. Anchoring is a cognitive bias relevant in many business contexts. Here are two (2) examples: 1. Price negotiations: A sophisticated buyer in a price negotiation will want the seller to name the first price. This sets an anchor, or a The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 9

maximum price from which the buyer can negotiate downwards. If the seller names an unrealistically high price then the sophisticated buyer will want to emotionally reject the price, which might be done by exclaiming shock, disgust or pretending to walk away. The buyer may still be interested but the purpose of emotionally rejecting the initial offer is to break the anchor so that negotiations can begin afresh. 2. Stock trading: Algorithmic traders can use their knowledge of anchoring to gain a statistical edge in the stock market. Many traders will use a recent high or low price as an anchor to determine whether prices are “too high” or “too low” and an algorithmic trader can use this fact to develop trading systems that allow her to trade with positive expectation over the longer term. For a good book on this subject, get yourself a copy of Way of the Turtle by Curtis M. Faith. Asset (accounting definition): An economic resource that a company uses to operate its business, e.g. cash, inventories, property, plant and equipment. Asset (finance definition): An economic resource that generates cash every month (i.e. your house and your car are probably not assets under this definition). Asset (strategy definition): An economic resource (whether tangible or intangible) that allows an organisation to provide more value to customers (whether real or perceived) for a given cost base. Bandwagon effect: The common tendency for people to believe something because many other people already believe it. The bandwagon effect is relevant in business contexts since it suggests that the probability of a person purchasing a product is proportional to the number of people who have already done so. This helps to explain the existence of fashions, fads and trends.

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Barriers to entry: The costs that must be paid by a new market entrant but not by firms already in the industry. Barriers to entry have the effect of making a market less contestable and so allow existing firms to maintain higher prices than would otherwise be possible. Key barriers to entry might include capital requirements, economies of scale, network effects, product differentiation, proprietary product technology, government policy, access to suppliers, access to distribution channels, and switching costs. For more information, see “4.1 Barriers to Entry”. Black Swan: An event that is unpredictable, has significant consequences, and is (or at least appears to be) retrospectively explainable. The term “Black Swan” was coined by Nassim Nicholas Taleb in his book The Black Swan. Brand: A brand is commonly defined as “a name, mark, logo, symbol or other identifier used to distinguish a product or organisation”. The power of a brand derives not from the particular symbol used but from the stories that people tell about it, and so a brand might more accurately be defined as “what people say about you (your product, or your organisation) when you’re not in the room.” Break-even analysis: Break-even analysis is relevant when trying to decide whether to launch a new product or invest in a project with high fixed costs. Break-even analysis calculates the point at which revenues will equal associated costs. Break-even analysis can be used to calculate the ‘margin of safety’, the amount by which revenues are expected to exceed the break-even point. 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒 =

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡

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𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆ℎ𝑎𝑟𝑒 =

𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑜𝑙𝑢𝑚𝑒

Break-even analysis is a form of supply side analysis that considers costs (variable costs and fixed costs). However, it does not consider how demand may change at different price levels, and so it may make sense to combine break-even analysis with some form of demand side analysis. Bund: The German government’s federal bond, similar to Treasury bonds in the U.S. Bundling: Combining products or services together in order to sell them as a single unit. Bundling can benefit a company by allowing it to increase sales volume and market share. Bundling can also benefit customers by allowing them to purchase the bundle for less than the price of the bundled products if purchased separately. CAGR: Compound annual growth rate. 1

𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (# 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠) 𝐶𝐴𝐺𝑅 = ( ) − 1 𝑆𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

CFA: Stands for “Chartered Financial Analyst”. For more information, visit the CFA Institute. Coase theorem: An economic theorem outlined by Ronald Coase in an article entitled The Problem of Social Cost published in October 1960 in the Journal of Law and Economics. The theorem states that if trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, poorly defined property rights or obstacles to bargaining (e.g. transaction costs, lack of an organised market, or the presence of asymmetric information) tend to prevent Coasian bargaining.

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Comparative advantage: Comparative advantage is an economic theory that explains the existence of gains from trade. David Ricardo developed the classical theory of comparative advantage in 1817 to explain why a country whose workers are more efficient at producing every good compared with workers in other countries will still gain from international trade. In general terms, an individual, firm or country has a comparative advantage in producing a good if it can produce the good at a lower Opportunity cost relative to other individuals, firms or countries. Complimentary goods: Any goods for which an increase in demand for one leads to an increase in demand for the other. Examples of complimentary goods include printers and ink cartridges, DVD players and DVDs, and Microsoft Windows and PCs. Confirmation bias: The common tendency for people to favour information that confirms their existing beliefs. Confirmation bias is relevant in many business contexts. For example, in stock trading confirmation bias can lead a trader to ignore evidence that her trading strategies will lose money leading her to be overconfident. Conglomerate Diversification: A form of diversification where a firm adds new products that are unrelated to existing products and which target new customer segments. Cost benefit analysis: A type of analysis that involves weighing up the total expected costs and benefits of one course of action against one or more other courses of action. For more information, see “4.2 Cost Benefit Analysis”. Credit default swap (CDS): A form of insurance policy which obliges the seller of the CDS to compensate the buyer in the event that the loan defaults. In the event of default, the buyer of the CDS would normally receive money and the seller of the CDS would receive the defaulted loan (and the right to recover amounts outstanding under the loan). The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 13

Cross Rate: The exchange rate between two currencies inferred from each currency’s exchange rate with a third currency. Current Ratio: Otherwise known as the “liquidity ratio”, “cash asset ratio”, “cash ratio” or “working capital ratio”, the current ratio measures a company's ability to repay short term liabilities. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Customer Lifetime Value: Customer lifetime value is a prediction of the entire future value that a company expects to derive from its relationship with a customer. It can be a useful tool for a company that is trying to decide which customer segments to target and how much to spend on customer acquisition. 𝐶𝐿𝑉 = 𝑃𝑟𝑜𝑓𝑖𝑡1 + 𝑃𝑟𝑜𝑓𝑖𝑡2 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)2 + 𝑃𝑟𝑜𝑓𝑖𝑡3 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)3 + ⋯

Debt to Asset Ratio: The debt ratio is the ratio of total debt to total assets, and can be understood as the percentage of a company’s assets that are financed by debt. 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Debt to Equity Ratio: A measure of a company’s financial leverage calculated by dividing total debt by shareholder’s equity. 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Discouraged worker: A person who does not have a job and is available to work but who has stopped actively looking for work. This may happen because the unemployed person:  Becomes discouraged due to previous unsuccessful attempts to obtain work; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 14

 Believes (reasonably or not) that there are no jobs available in their industry or location;  Lacks the skills needed for the jobs which are available, either because they never had the required skills or because their skills have eroded due to a long period of unemployment;  Is discriminated against by prospective employers for some reason beyond their control (e.g. age, race, gender); or  Becomes addicted to Twinkies and day time television. Diseconomies of scale: A situation where the average cost of production increases as output increases. For more information, see “4.3 Economies of Scale”. Disruptive innovation: A term coined by HBS Professor Clayton Christensen to describe the process by which a product or service initially takes root in simple applications at the bottom of a market and then consistently moves ‘up market’, eventually displacing established competitors. Diversification: In the 3.4.1 Product / Market Expansion Matrix, originally explained by Igor Ansoff in his 1957 Harvard Business Review article, diversification is defined as a growth strategy whereby an organisation develops new products for new markets. Diversification is a high risk growth strategy, and a company should look for markets with strong growth and high levels of industry attractiveness (see “4.8 Porter’s Five Forces”). Diversification might involve a company adding new products, which appeal to existing customers (“Horizontal diversification”); it might involve a company acquiring a customer or supplier (“Vertical Integration”); or it might involve a company moving into an entirely new industry (“Conglomerate Diversification”).

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Economic indicator: An economic statistic (e.g. the unemployment rate, GDP, or inflation) which indicates the strength of the economy or the expected future performance of the economy. Economies of scale: A situation where the average cost of producing a unit of output decreases as the quantity of output increases. For more information, see “4.3 Economies of Scale”. Economies of scope: A situation where a firm can produce two or more products at a lower per unit cost than would be possible if it produced only the one. For more information, see “4.4 Economies of Scope”. Elevator pitch: A high-level overview of whatever it is that you are selling and which is designed to just get the conversation started. For more information, please read the articles entitled “The Elevator Pitch” and “12 Tips for Creating an Effective Pitch”. Equity: Assets minus Liabilities. Equity holders are the owners of the business. Expenses: Costs incurred by a business over a specified period of time to generate the revenues earned during that period. For more information, read the article entitled “Understanding Financial Statements 101”. Externality: Costs incurred or benefits gained by third parties resulting from an economic activity. Externalities that confer a benefit are referred to as “positive externalities”, an example of which would be honey bees kept for honey that help to pollinate neighbouring crops. Externalities that impose a cost are referred to as “negative externalities”, an example of which would be a factory that creates air pollution and imposes health and clean-up costs on the surrounding community. Fiscal Policy: Government policy relating to government spending and taxes. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 16

Fisher Effect: The Fisher effect describes the relationship between real interest rates, nominal interest rates and inflation. The Fisher effect states that a change in the nominal interest rate is equal to the real interest rate plus the inflation rate: (1 + 𝑖𝑁𝑜𝑚 ) = (1 + 𝑖𝑅𝑒𝑎𝑙 ) × (1 + 𝑟𝑖𝑛𝑓 )

Fixed cost: A cost that does not vary with the quantity of output produced. It is important to understand that fixed costs are fixed only in the short term. In the long run nearly all costs are variable. For example, in the long run a company could renegotiate supply contracts or move its factories to a lower cost jurisdiction. Forward Contract: A forward contract is a customized contract to buy or sell an asset on a future date at a pre-determined price (the forward price). A forward contract is non-standardized, and so can be used by businesses to manage risk. Futures Contract: A futures contract is a standardized contract to buy or sell an asset on a future date at a pre-determined price (the futures price). A futures contract is standardized and traded on a futures exchange. Settlement may take place through physical delivery of the underlying asset or payment in cash. Greenspan Put: The monetary policy of Alan Greenspan and the U.S. Federal Reserve from the late 1980’s to the mid-2000’s, which involved significantly lowering interest rates in the wake each financial crisis. Homogenous Product: Any good or service for which buyers perceive no difference between the products offered by different suppliers. Examples of homogenous products might include wheat, corn and oil. Horizontal competition: Competition between entities at the same stage of production. See also, “Vertical competition”.

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Horizontal diversification: A form of diversification where a firm adds new products that may be unrelated to existing products but are likely to appeal to existing customers. See also, “Vertical Integration” and “Conglomerate Diversification”. Inflation: The rate at which the overall price level for goods and services is rising. Investment Operation: An operation which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative (Ben Graham, The Intelligent Investor). Joint Production: Production where the production process for two or more different goods is connected. Producing the goods separately would result in increased costs. Joint production may occur naturally, for example a chicken farm produces both chicken wings and chicken breasts. Joint production may also be used because it provides 4.4 Economies of Scope. Leverage (common usage): Make use of. Leverage (investment definition): The use of borrowed capital to partially or fully fund an investment. Leverage is used when an investor expects the return on investment to be greater than the cost of debt, in which case the investor’s return on equity will be greater than the return on investment. In other words, the returns are leveraged. Liability (accounting definition): The debt of a company, a claim that creditors have on the company’s resources. LIBOR: The London Interbank Offered Rate is a benchmark rate quoted by the world’s leading banks as a rate of interest that they would charge financial institutions for short term loans. LIBOR is used extensively in finance as a first step in calculating appropriate rates of interest for a variety of financial products. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 18

Liquidity trap: A situation where interest rates are zero (or near zero) and a central bank is no longer able to stimulate the economy by controlling short term interest rates. In 2008, the US Federal Reserve faced a liquidity trap and employed quantitative easing (i.e. electronically generating money) in an attempt to stimulate the economy. Loss aversion: A commonly observed behavioural tendency whereby people prefer to avoid a loss than to make a commensurate gain. For more information, read the article entitled “Loss Aversion”. Ludic Fallacy: A term coined by Nassim Nicholas Taleb in The Black Swan. The term refers to the misuse of games to model real-life situations. Taleb explains the fallacy as “basing studies of chance on the narrow world of games and dice.” Madoff Scheme: See also “Ponzi Scheme”. Management consulting (Institute of Management Consultants’ definition): The provision to management of objective advice and assistance relating to the strategy, structure, management and operations of an organisation in pursuit of its long-term purposes and objectives. Such assistance may include the identification of options with recommendations; the provision of an additional resource and/or the implementation of solutions. Metcalfe's law: A rule which states that the value of a network is proportional to the square of the number of connected users (or connected devices). Metcalfe’s law explains the network effect which exists for products such as fax machines, telephones, eBay, WhatsApp and Facebook. Monopolistic competition: A situation in which consumers are taught to perceive differences between products. As a result, even though there may be a large number of producers, each producer has a degree of control over price.

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Monopoly: A situation where a market has only one supplier for a particular good or service. The term may also be used where one seller has substantial control of the market. Monopolies are characterised by a lack of competition and a lack of viable substitutes. Monopsony: A situation where a market has only one buyer for a particular good or service. The term may also be used where one buyer has substantial control of the market. See also “Walmart Effect”. Moral Hazard: Any situation in which a person or entity is not fully responsible for the consequences of its actions. As a result, the entity may take greater risks than it would have otherwise because it is not responsible for paying the full cost if things go badly. For more information, see “4.7 Moral Hazard”. Mortgage Securitisation: A process of packaging and selling mortgage debt which involves: 1. Purchasing mortgages from banks or mortgage brokers; 2. Packaging the mortgages into large pools; and 3. Selling “shares” in these mortgage pools to investors. Natural monopoly: An industry where one firm can produce the desired output at a lower social cost than could be achieved by two or more firms (social costs being the sum of private and external costs). Natural monopolies exist because of the existence of economies of scale and examples include railways, water services, and electric utilities. Net Present Value: The NPV of an investment is the present value of the series of expected future cash flows generated by the investment minus the cost of the initial investment. 𝑁𝑃𝑉 =

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 + + ⋯ + + − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =

𝐶𝐹𝑛 × (1 + 𝑔) 𝑟−𝑔

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Where r = discount rate; CFt = expected cash flow in year t; g = long term cash flow growth rate. For more information, see “3.7.2 Net Present Value”. Network effects: The situation whereby a product or service becomes more valuable as more people use it (also known as network externalities). One example is eBay; as more buyers use the online auction site it becomes more valuable to each seller, and as more sellers use the site it becomes more valuable to each buyer. NINJA Loan: Any loan made where the borrower has No Income, No Job, and No Assets. Nominal value: A value expressed in dollar terms. For example, if a Big Mac costs $3 this year and $6 next year, then we would say that the nominal price of a BigMac has doubled. Numéraire: An economic term meaning “the unit of account”. In French, the term means “money”, “coinage” or “face value”. A country’s currency normally acts as the numéraire and is used to measure the worth of other goods and services within the country. In the absence of currency, you could define a “numéraire good” (e.g. salt, copper, gold) to have a fixed price of 1; the worth of other goods and services could then be measured relative to the numéraire good. Oligopoly: A situation where a market is dominated by a small number of suppliers for a particular good or service. Oligopolies are characterised by a lack of competition and a lack of viable substitutes. Each firm in an oligopoly needs to take into account the likely actions and reactions of other firms when developing its strategic plan of action. Operating Cash Flow Ratio: A liquidity ratio that measures how well a company’s current liabilities are covered by cash flow from operations.

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𝑂𝐶𝐹 𝑅𝑎𝑡𝑖𝑜 =

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Opportunity cost: What you give up in order to obtain something; the value of the next best alternative. Option: A derivative financial instrument which grants its owner the right, but not the obligation, to buy or sell an underlying asset at a preestablished price for a specified period of time. Organic growth: Growth that a company can achieve by increasing output and sales. This excludes growth achieved as a result of mergers and acquisitions since this growth is purchased not generated internally. For example, growth that Facebook achieved as a result of its purchase of Instagram or WhatsApp is not organic growth. Outcome bias: The tendency for people to judge a decision based on its outcome rather than the quality of the decision at the time it was made. For example, a person who learns that a friend made a large profit from investing in the stock market may, without any additional evidence, form the view that investing in stocks is a good idea; this person is suffering from outcome bias. Overconfidence bias: A common behavioural trait whereby a person’s confidence in their opinions is invariably higher than the accuracy of those opinions. Pareto efficient: An economic allocation is said to be “Pareto efficient” if no person can be made better off without making at least one person worse off. Pareto efficiency does not imply that an economic allocation is fair or equitable. Perpetuity: A perpetuity is a constant stream of identical cash flows with no end. 𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =

𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 + + +⋯ (1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3

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𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =

𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 𝑟

Where r = discount rate; CFannual = annual cash flow. Ponzi Scheme: Any kind of fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any profits earned. See also, “Madoff Scheme”. Price discrimination: Price discrimination involves setting a different price for the same product for different customer segments. First degree price discrimination involves charging each customer a different price based on their willingness to pay. Second degree price discrimination involves varying the price according to the quantity demanded. Third degree price discrimination involves varying the price by location or customer segment. For example, charging higher prices in expensive suburbs or tourist locations or offering discounted prices for students. Price elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in the price level. Price elasticity of demand is relevant for pricing strategy and for examining customer price sensitivity. 𝐸𝑑 =

%∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %∆𝑃𝑟𝑖𝑐𝑒

If the price elasticity of demand is less than one in absolute value (|𝐸𝑑 | < 1) then demand is said to be “inelastic”. That is, changes in price have a relatively small effect on the quantity demanded. As a result, total revenue will rise if prices are raised. If the price elasticity of demand is greater than one in absolute value (|𝐸𝑑 | > 1) then demand is said to be “elastic”. That is, changes in price have a relatively large effect on the quantity demanded. As a result, total revenue will rise if prices are lowered. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 23

Price maker: A firm that has some control over the price that it charges for a product. For example, a Monopoly or a firm operating within Monopolistic competition. Price taker: A firm that can change production and sales of a product without significantly affecting the market price. Principle-agent problem: The principle-agent problem occurs when a principal employs an agent to perform duties on its behalf. The problem arises where there are conflicts of interest between the principle and the agent (for example, the principle prefers that the agent exert more effort and the agent prefers to exert less effort), the agent is not required to pay the full cost if things go badly (that is, moral hazard issues exist), and the principle cannot directly monitor the agent’s behaviour (that is, there is asymmetric information). An example of where the principle-agent problem arises is in the relationship between management (the agent) and shareholders (the principle). Possible solutions to the principle-agent problem include: 1. Aligning the interests of principle and agent by providing the agent with performance incentives; 2. Reducing the moral hazard issue by promising the agent an ownership stake in the organisation. Product differentiation: The process of distinguishing a good or service in order to create an impression of value in the mind of the customer. Profit Margin: Gross Profit Margin: Gross profit margin measures how much of every dollar of sales revenue remains after subtracting the cost of goods sold. 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

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𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 −

𝐶𝑂𝐺𝑆 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Net Profit Margin: Net profit margin measures how much out of every dollar of sales revenue a company actually keeps. Net profit margin is useful when comparing companies in similar industries. A higher net profit margin indicates a more profitable company that has better control of its costs. 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 −

[𝐶𝑂𝐺𝑆 + 𝐴𝑙𝑙 𝑜𝑡ℎ𝑒𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠] 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Contribution Margin: A cost accounting concept that allows a company to determine the profitability of individual products. 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Equivalently: 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡 𝑃𝑟𝑖𝑐𝑒

Public good: A public good is a good that a person can consume without reducing its availability to others (that is, the good is “nonrival”) and from which no one can be excluded (that is, the good is “non-excludable”). Examples of public goods might include national defence, public television, radio, knowledge, fresh air and sunshine. Pull System of Inventory Control (just in time): The pull system of inventory control involves producing just enough to fill customer orders. An advantage of this system is that there will never be excess The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 25

inventory and so inventory storage costs are minimized. A disadvantage of this system is that supplier bottlenecks or limited operating capacity can lead to ordering backlogs and customer dissatisfaction. Push System of Inventory Control: The push system of inventory control involves forecasting customer demand and producing enough to meet forecast demand. An advantage of this system is that there will typically be enough products on hand to satisfy customer orders. Disadvantages include (a) the difficulty of forecasting demand, and (b) the cost of storing excess inventory if actual demand falls short of expectations. Quantitative easing: A monetary policy tool sometimes employed by central banks to stimulate the economy when conventional monetary policy becomes ineffective. Quantitative easing involves increasing the money supply by purchasing government bonds or other financial assets with newly generated money. For more information, see “4.9 Quantitative Easing”. Quick (Acid Test) Ratio: The quick ratio is more rigorous than the current ratio, and measures whether a company has enough short-term assets to cover short term liabilities without selling inventory. 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =

𝐶𝑎𝑠ℎ + 𝐴⁄𝑅 + 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Real value: A value adjusted for inflation or deflation. For example, if a Big Mac costs $3 this year and $6 next year and inflation is 100%, then the real price of a BigMac has not changed. Recency bias: The common tendency for people to place more weight on recent data or experience compared with earlier data or experience. An example of recency bias is where a salesperson with an acceptable long term sales record becomes discouraged after a few consecutive weeks of unsuccessful sales calls. A few weeks of poor performance can The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 26

count in the sales person’s mind as much as a few months or years of prior success. Recession: Broadly speaking, a recession is a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists sometimes define a recession more formerly as “two consecutive quarters of falling GDP”. Replacement value: An estimate of how much it would cost to build equivalent resources or capabilities from scratch. Return on Investment: ROI is a performance measure that a company can use to evaluate the return from an investment or to compare the returns of a number of different investments. 𝑅𝑂𝐼 =

𝐺𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Revenue: Income generated from trading or, for example, from selling off an asset or piece of the business. Revenue should be recorded when the sale is made as opposed to when the cash is received. For more information, please read the article entitled “Understanding Financial Statements 101”. Rule of 70: The Rule of 70 is a simple rule of thumb that can be used to figure out roughly how long it will take for an investment to double, given an expected growth rate. The rule can be described by the following equation: 𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥) =

70 𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

For more information, see “4.10 Rule of 70”. Spillover: Externalities that result from economic activity and affect people who are not directly involved in the activity. Spillover can be positive or negative. Pollution that leaks out of a manufacturing plant The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 27

and into a local river would have a negative spillover effect on local fishermen. The beauty of the buildings in Oxford would have a positive spillover effect on locals and tourists. Substitute goods: Any goods for which an increase in demand for one leads to a fall in demand for the other. Substitute goods represent a form of indirect competition. Examples of substitute goods might include petroleum and natural gas, or Vegemite and Nutella. Sunk cost: Sunk costs are expenditures that have already been made, and which cannot be recovered. Sunk costs should not be factored into the decision making process when evaluating a potential course of action. Sunk cost fallacy: The common tendency for people to factor amounts of money already spent – the sunk costs – into their decision-making process. This is irrational since sunk costs cannot be recovered, and so are not relevant when making a decision about a future course of action. An example of the sunk cost fallacy would be where a company factors past R&D spending into its future pricing strategy. SWAP Agreement: An agreement to exchange one series of cash flows for another for a set period of time. One of the series of cash flows will normally be more uncertain, such as a floating interest rate, foreign exchange rate, stock price or commodity price. SWAP Agreements are not traded on an exchange, they are customized contracts traded between private parties in the over-the-counter market. Switching costs: Any costs that a customer incurs (for example, time, money, effort) as a result of changing suppliers, brands or products. Switching costs will be affected by various factors including the length of customer contracts, the existence of customer loyalty programs, and the price performance and compatibility of complimentary products.

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Underemployment: A situation where a person’s capacity to work is not fully utilised. This may occur due to (1) over-qualification, (2) involuntary part-time work, or (3) over-staffing. Vanilla: Plain or simple version. Variable cost: A cost that varies with the quantity of output produced. When making decisions in the short run, variable costs are the only costs that should be considered because, in the short term, a company cannot change its fixed costs. Vertical competition: Competition which takes place between firms at different stages of production. Suppliers and customers within the supply chain may be able to exert their bargaining power to compete for a larger share of industry profits. Vertical Integration: A form of diversification in which a firm expands its business to different points in the supply chain. For example, taking over a supplier (backwards vertical integration) or taking over a customer (forwards vertical integration). Backwards vertical integration: A company engages in backwards vertical integration when it purchases one or more suppliers that produce inputs that the company uses to produce final goods or services. For example, a car company might purchase a tire company, a glass company, or an engine manufacturer. Benefits of backwards vertical integration may include (1) creating stable supply, (2) ensuring consistent quality of inputs, and (3) restricting a competitor’s access to essential supplies. Walmart Effect: A situation where a single buyer gains substantial control of a market as the major purchaser of goods or services. See also, “Monopsony”. Wealth: [Note that both of the definitions below use “time” as the relevant yardstick, not “money”.] The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 29

1. Real wealth is discretionary time; money is merely the fuel (attribution: Alan Weiss); 2. A measure of a person’s ability to survive so many number of days forward into the future if they were to stop working today (attribution: Robert Kiyosaki).

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2. Industry Analysis 2.1 Macro Environment 2.1.1 PEST Analysis Understanding the big picture can help reveal hidden opportunities and threats 1. Background In 1967, Harvard Professor Francis Aguilar wrote a book entitled “Scanning the Business Environment” in which he identified four important factors – Economic, Technical, Political, and Social – that a business can use to better understand the big picture. While the ordering of the letters may have changed, the four factors that Aguilar identified half a century ago have not, and they form the basis of PEST Analysis. 2. Relevance If you are thinking about producing a strategic plan, developing a new product, entering a new market, engaging in a joint venture, acquiring a competitor, launching a start-up, or financing a new project then it probably makes sense to understand the big picture issues that could affect the project’s success. Conducting a PEST Analysis can reveal hidden opportunities and threats, and allow you to adapt your approach to achieve a more favourable outcome.

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3. Importance There is something inherently appealing about a four-part model, and its simplicity makes PEST Analysis a convenient and practical tool for understanding the macro environment. Conducting a PEST Analysis can be helpful for three reasons: 1. Understanding the facts: Understanding the big picture can help a business make informed decisions, and avoid making incorrect assumptions based on past experience; 2. Anticipating change: Understanding the macro environment can help a business identify trends and anticipate change, allowing it to take advantage of opportunities and manage potential threats; and 3. Avoiding failure: Understanding the macro environment can help a business (and its investors) to identify projects that are likely to fail due to unfavourable conditions. Knowing which battles not to fight can often be half the battle. 4. PEST Analysis Explained “PEST” is an acronym that stands for “Political, Economic, Social and Technological” – the four factors that a business will want to consider when scanning the macro environment. PEST Analysis is a simple framework that uses these four factors to examine the macro environment in order to understand the potential implications for a business unit, product or project. Insights gained from the analysis can be used to develop a strategic plan of action. PEST Analysis can be used as part of a broader situation analysis.

Figure 1: Situation Analysis The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 32

There is a long list of alternative frameworks that could be used to scan the macro environment. However, they generally complicate the analysis by adding factors that could be dealt with more simply using PEST Analysis. Some of the other variations include: 1. SLEPT: Social, Legal, Economic, Political, and Technological; 2. PESTEL: Political, Economic, Social, Technological, Environmental, and Legal; 3. PESTELI: Political, Economic, Social, Technological, Environmental, Legal, and Industry Analysis; 4. STEEPLED: Social, Technological, Economic, Environmental, Political, Legal, Ethical, and Demographic; 5. PESTLIED: Political, Economic, Social, Technological, Legal, International, Environmental, and Demographic; and 6. LONGPESTLE: Local, National, and Global versions of PESTLE (might be useful for multinational organisations). 5. Conducting a PEST Analysis Conducting a PEST Analysis involves considering issues relating to the four key factors: Political, Economic, Social, and Technological. The four factors will vary in significance depending on the nature of the business. For example, social factors might be relevant for a retail business, but political factors may be more relevant for a munitions dealer. The purpose of a PEST Analysis is to identify potential implications for a specific business unit, product or project, and so it is important to be clear about this purpose before commencing the analysis. Below we outline a range of issues that you might want to consider when conducting a PEST Analysis.

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1. Political Potential political issues include: 1. Laws and regulations that a company may need to comply with (tax, competition, employment, anti-discrimination, consumer protection, environmental, corporate social responsibility, and international law); 2. Property rights, including protection of intellectual property (trademarks, copyrights, patents, registered designs, trade secrets, software and circuit layouts); 3. Industry regulation – How is the industry regulated? Have there been any recent changes? Are there any planned changes? Is there a trend towards regulation or deregulation? 4. Government policy, trade unions, lobby groups, and the electoral cycle. Who holds political power? How might this change at the next election? 5. Rule of law, bureaucracy and corruption; and 6. Political stability, war and conflict. 2. Economic Potential economic issues include: 1. GDP and market growth rates; 2. Inflation, interest rates, and monetary policy; 3. Exchange rates – For companies engaged in cross border trade it may be important to consider exchange rate volatility and the need for a SWAP Agreement; 4. Availability of credit, as well as the liquidity and depth of the credit markets; 5. Labour costs and the unemployment rate. Will it be possible to hire skilled workers? 6. Government support including infrastructure investment, grants, subsidies, and tax breaks; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 34

7. Tax issues including corporate, employee, and value added taxes; 8. Trade restrictions, subsidies, tariffs and quotas; 9. Business cycle, stock market trends, market prices, and seasonality issues; 10. Consumer confidence; and 11. Industry specific factors. 3. Social Potential social issues include: 1. Population growth; 2. Age distribution and life expectancy. Are generational shifts likely to affect customer preferences and market demand? 3. Income distribution, average disposable income, and social mobility; 4. Attitudes towards work; 5. Family size and structure; 6. Health levels, and health consciousness; for example, attitudes towards smoking and drinking; 7. Education levels; 8. Emphasis on safety; 9. Social norms; for example, people tend to take holidays over Christmas and in the summer; 10. Fashions, fads, trends, role models, and influential personalities; 11. Buying patterns and consumer preferences. For example, brand preferences, and attitudes toward product quality, customer service, fair trade, green, and organic products; 12. Ethnic and religious factors; 13. Cultural and sporting events; and 14. Prohibitions, taboos, and ethical issues.

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4. Technological Technological issues relate to the state of technology and its rate of advancement, and may have implications for the competitive intensity of an industry (for example, new technologies can reduce barriers to entry) or may lead to disruptive innovation (for example, Amazon, Airbnb, and Uber). Potential technological issues include: 1. Emerging technologies and trends. For example, 3D printing, collaborative consumption, and wearable technology; 2. Technology level and rate of change in an industry; 3. Technology lifecycle; 4. Location of technology hubs or clusters; university and business partnerships; 5. Supporting infrastructure like high speed internet; 6. R&D spending; 7. Availability of financing for technology and innovative projects; 8. Automation; and 9. Legal frameworks, for example, protection of intellectual property and support for crowd funding. 6. PEST Analysis Template If you would like to download a template that can be used to conduct a PEST Analysis, please click here.

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2.2 Micro Environment 2.2.1 Business Landscape Survey Before taking decisive action, it may be a good idea to assess the lay of the land According to Sun Tzu, the quality of decision “is like the well-timed swoop of a falcon which enables it to strike and destroy its victim.” Much like a circling falcon overhead, a company needs to take a 10,000 foot view of the business landscape before it can take swift and decisive action. The framework outlined in this section provides a structure that consultants and business leaders can follow to help them examine the business situation. 1. Relevance Having a framework to assess the business situation is relevant to any company in the context of making strategic decisions and, what’s more, every important decision that a company makes will in some way be strategic. In the pursuit of growth, should a company enter a new market, develop a new product, launch a start-up, form a joint venture, or acquire a competitor? In the bid to cut costs, should a company reduce headcount, outsource production to a supplier, or utilize lower cost distribution channels? How should the company position itself within its industry? In order to find answers to these key strategic questions, a company and its executives need to develop a clear understanding of the business landscape, and this section provides a structured framework that can be used to guide the exploration process.

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2. Importance Failure to properly assess and understand the business landscape can have billion dollar implications and affect the course of an entire industry. The story that best illustrates this point was IBM’s secret project in 1980 to create the IBM Personal Computer. As part of the project, IBM made three surprising decisions: 1. It allowed Microsoft the right to produce the operating system software and market it separately from the IBM PC; 2. It chose to purchase the microprocessor from Intel; and 3. It opted to make the IBM PC an “open architecture” product, publishing technical guides to the circuit designs and software source code. These three strategic decisions helped to shift market power in the PC industry away from IBM and towards Microsoft and Intel. Although the PC market grew quickly, companies like Compaq, Dell and HP soon reverse engineered the IBM PC and, since IBM had made it an open architecture product, they were able to sell a large number of clones, known as IBM compatibles, which dramatically increased the intensity of competition in the PC industry. Meanwhile, booming PC sales from multiple vendors provided Microsoft and Intel with a lucrative and rapidly growing market for operating system software and microprocessors. Despite the fact that IBM had set the technology standard in the personal computer industry, it failed to capture the lion’s share of industry profits. It helped Microsoft and Intel establish lucrative markets The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 38

for themselves, but was not itself able to compete in these markets due to high barriers to entry including patents, the 4.5 Experience Curve effect and 4.3 Economies of Scale. IBM’s three strategic missteps were a blessing for Microsoft and Intel, which as of 2015 have a combined market cap of over US$555 billion, but are an enduring sore point for IBM, which decided to jettison its PC business to Lenovo in 2005 for a mere US$1.8 billion. The story of the IBM PC is a cautionary tale. Companies that fail to assess the business landscape before taking action may find themselves in an untenable position. 3. Surveying the Business Landscape A popular way to examine the competitive intensity and attractiveness of an industry is to use 4.8 Porter’s Five Forces, a technique which was first outlined by HBS Professor Michael Porter in his 1979 book Competitive Strategy. While Porter’s Five Forces remains a useful reference point, and its core elements are incorporated into the framework outlined in this section, we do not use it directly to assess the business landscape since it fails in one important respect. It does not consider the market power and unique characteristics of the company from whose perspective we are supposed to be analysing the industry. For example, an industry may appear attractive from the perspective of a cash rich tech savvy player like Google but appear quite unattractive from the perspective of other firms. Through their strategies, firms have the ability to change industry structure, and so the business landscape will always need to be assessed relative to the market power of a particular organisation. In order to assess the business landscape, we will examine the three entities whose market power, strategies and actions will, in any industry, The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 39

affect a firm’s profitability: the customer, the competition and the company itself. 3.1 Examining the Customer “There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else.” ~ Sam Walton, founder of Walmart A good first step in assessing the business landscape is to examine the customer, the people whose problems the industry is trying to solve. Below we outline eight (8) factors to consider when examining the customer. 1. Customer Identification In general terms, who is the customer? In trying to identify the customer, remember that the person who makes the purchase decision, the person who pays (the customer), and the end user (the consumer) may all be different people. For example, a doctor may prescribe medicine that will be paid for by an insurance company (the customer) and ultimately used by a patient (the consumer). 2. Customer Segmentation Customer segmentation can make it easier to understand customer needs and preferences, and to understand the size and growth rate of different revenue streams. For example, it may make sense to segment customers by: 1. 2. 3. 4. 5.

Age group; Gender; Income level; Employment status; Distribution channel;

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6. Region; 7. Product preference; 8. Willingness to pay; 9. New versus existing customers; or 10.Large versus small customers. 3. Size How big is the market? How big is each customer segment? How many customers are there and what is the dollar value of those customers? 4. Growth How fast is the market growing? What is the growth rate of each customer segment? 5. Customer Preferences What do customers want? Do different customer segments want different things? Are the needs and preferences of customers changing over time? 6. Willingness to Pay How much is each customer segment willing to pay? How price sensitive is each customer segment? For example, students will normally be very price sensitive, which means that offering student discounts may increase units sold by enough to raise total revenues. 7. Bargaining Power What is the concentration of customers in the market relative to the concentration of firms? If there is a small number of powerful customers who control the market, then it may be necessary to either play by their rules or search for a more favourable market. Examples of this kind of customer include Walmart in the market for homeware products, Amazon in the The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 41

publishing industry, and the U.S. Department of Defence in the market for defence equipment. Do customers face high switching costs? If customers face high switching costs then this will reduce their bargaining power. Switching costs will be affected by various factors including the length of customer contracts, the existence of customer loyalty programs, and the price performance and compatibility of complimentary products. 8. Distribution What is the best way to reach customers? Does each customer segment have a preferred distribution channel? Seven (7) distribution channels that a firm might use to reach customers include: 1. 2. 3. 4. 5. 6. 7.

Network marketing; Mail order; Online store; Factory outlet; Retail store; Supermarket; and Department store.

3.2 Examining the Competition “Competition is not only the basis of protection to the consumer, but is the incentive to progress.” ~ Herbert Hoover, 31st President of the United States In order to understand the business landscape it is also important to understand the competition, and this can be done by examining the Horizontal competition (competition between firms at the same stage of production) and Vertical competition (competition between firms within the supply chain).

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3.2.1 Horizontal Competition Competition can come from firms within an industry who are offering similar solutions to the same group of customers (for example, Pepsi and Coca Cola). Competition can also come from firms in other industries who produce substitutes. Substitutes may have quite different characteristics (for example, petroleum and natural gas) but they represent a form of indirect competition because consumers can use them in place of one another (at least in some circumstances). For example, petroleum and natural gas might both be used to produce heat and energy. Below we outline eleven (11) factors to consider when examining the competition. 1. Competitor Identification Who are the company’s major competitors? Taking Cadbury as an example, some of its major competitors include Lindt, Ferrero, Nestlé, Hershey’s and Mars. What products and services do they offer? 2. Substitutes Who are the company’s indirect competitors? That is, which firms are producing substitutes? To identify indirect competitors, it helps to take a broader view of what the company offers. For example, Cadbury sells chocolate, but more broadly it might be thought of as a snack food company, and so indirect competitors might include companies like Lays, Cheetos and Doritos. 3. Competitor Segmentation Is it possible to segment competitors in a meaningful way? The competition might be grouped by distribution channel, region, product line, or customer segment.

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For example, the FOX Broadcasting Company might segment the competition by region. In America, competitors include PBS, NBC, CBS and ABC. While in Australia, competitors include companies such as Channel 7, 9 and 10 as well as ABC and SBS. 4. Size and Concentration What are the revenues and market shares of major competitors? What is the concentration of competitors in the industry? That is, are there lots of small competitors (a low concentration industry) or a few dominant players (high concentration industry)? Examples of high concentration industries include oil, tobacco and soft drinks. Examples of low concentration industries include wheat and corn. 5. Performance What is the historical performance of the competition? Relevant performance measures might include profit margins, net income, and return on investment. 6. Industry Lifecycle Where is the industry in its lifecycle: early stage, growth, maturity or decline? 7. Industry Drivers What drives the industry: brand, product quality, scale of operations, or technology? 8. Competitive Advantage What is the competition good at? How sustainable are these advantages? What are their weaknesses? How easily can these weaknesses be exploited?

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9. Competitive Strategy What competitive strategy is the competition pursuing? Is the competition producing products that are low cost or differentiated? What customer segments is the competition targeting? What is the competition’s pricing strategy and distribution strategy? What is the competition’s growth strategy? That is, are they seeking growth by focusing on customer retention and increased sales volume, by entering new markets, or by launching new products? 10. Competitive Balance Is the industry balanced in the sense that competitors have clear and sustainable positions within the industry? This may be the case where firms provide customers with different value propositions which appeal to different consumer preferences. On the other hand, the industry may be unbalanced where multiple competitors are trying to become the low cost firm within the industry resulting in aggressive price competition and declining industry profitability. Similarly, the industry may be unbalanced by a distant follower who is making aggressive moves in an attempt to improve its position, for example by introducing low priced unbranded generic products. 11. Barriers to entry The threat posed by potential competitors depends on the level of4.1 Barriers to Entry. Key barriers to entry might include capital requirements, economies of scale, network effects, product differentiation, proprietary product technology, government policy, access to suppliers, access to distribution channels, and switching costs. For more information on barriers to entry, see “4.1 Barriers to Entry”. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 45

3.2.2 Vertical Competition within the Supply Chain Competition includes not just rivalry between firms operating at the same stage of production (horizontal competition) but also the interaction between all firms that have the potential to solve all or part of the end user’s problem, and thereby compete for a share of industry profits. This naturally includes vertical competition from suppliers and customers within the supply chain. An example of supplier bargaining power comes from the PC industry. IBM learned about vertical competition the hard way when it helped Microsoft and Intel gain virtual monopolies over the supply of key components for the IBM PC. Factors that will affect supplier bargaining power include: 1. The number of available suppliers and the strength of competition between them; 2. Whether suppliers produce homogenous or differentiated products; 3. The brand recognition of a supplier and its products; 4. The importance of sales volume to the supplier; 5. The cost to the firm of switching suppliers; 6. The availability of supplier substitutes; and 7. The threat of forward integration by the supplier relative to the threat of backward integration by firms in the industry. An example of customer bargaining power comes from the publishing industry where Amazon has gained substantial bargaining power due to its ability to sell and distribute huge volumes of books to end users. Factors that will affect customer bargaining power include: 1. The number of customers. If there are fewer customers then each customer will have more bargaining power; 2. The volume a customer demands relative to a firm’s total output; 3. The availability of substitutes; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 46

4. The cost to the customer of switching firms; 5. The availability of product comparison information; and 6. The threat of backward integration by the customer relative to the threat of forwards integration by firms in the industry. 3.2.3 Competitive Intensity The intensity of competitive rivalry depends on the pressure exerted by all sources of competition: horizontal competition from direct competitors and substitutes, and vertical competition from firms at different points within the supply chain. Below we outline twelve (12) factors that will influence the strength of competition within an industry: 1. Number of firms: The more firms there are in an industry the stronger will be the competitive rivalry since there will be more firms competing to serve the same number of customers; 2. Market growth: If the market growth rate slows then this will increase competition since firms will need to compete more aggressively to gain new customers; 3. Economies of scale: If firms in the industry have relatively high fixed costs and low variable costs then this will lead to more intense rivalry as firms compete to gain market share; 4. Excess capacity: If the industry experiences cyclical demand then this may result in sporadic industry wide excess capacity leading to bouts of intense price competition; 5. Switching costs: If customers have low switching costs, then this will intensify competition as firms compete to retain existing customers and steal customers from the competition; 6. Product differentiation: If firms in an industry produce homogeneous products, then firms will be forced to compete on price. Firms can achieve product differentiation in various ways including product quality, features, branding and availability;

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7. Instability: Diversity of competition (for example, firms from different countries or cultures) may reduce predictability within a market and lead firms to compete more aggressively; 8. Entry barriers: Low entry barriers will allow more competitors to enter the market resulting in more intense competitive rivalry. For more information on barriers to entry, see “4.1 Barriers to Entry”; 9. Exit barriers: High exit barriers will increase competition because firms that might otherwise exit an industry are forced to stay and compete. A common exit barrier is where a firm has highly specialized equipment that it cannot sell or use for any other purpose; 10. Industry shakeout: Where a growing market induces a large number of firms to enter, a point is likely to be reached where the industry becomes crowded. When market growth slows, a period of intense competition, price wars and company failures is likely to ensue; 11. Substitutes: If the number of substitutes increases, the relative price performance of substitutes improve, the prices of substitutes decrease, or customer willingness to substitute increases, then this will increase the intensity of rivalry within an industry as firms compete to retain customers; and 12. Bargaining power of suppliers and customers: If suppliers and customers have more bargaining power then they will be able to extract a larger share of industry profits. This will reduce the profitability of firms in the industry, which may lead to more intense competition, industry consolidation, vertical integration, and company failures. 3.3 Examining the Company “Know your enemy and know yourself and you can fight a hundred battles without disaster.” ~ Sun Tzu The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 48

In assessing the business landscape, it is not enough simply to understand the customer and the competition, it is also important to understand the firm from whose perspective you are analysing the industry. Below we outline ten (10) factors to consider when examining the company. 1. Performance What is the historical performance of the company? What is its market share? If profits are falling, what is the cause of the issue? 2. Competitive Advantage Identify the company’s resources and capabilities. Consider both tangible assets (property, plant, equipment, inventory and employees) and intangible assets (brand, patents, copyrights and specialised knowledge). How sustainable are the company’s advantages? What are the company’s weaknesses and can they be remedied? 3. Competitive Strategy What is the company’s competitive strategy? Is the company producing products that are low cost or differentiated? Which market segments does the company target? (see “3.3.1 Porter’s Generic Strategies”). What is the company’s pricing strategy, distribution strategy and growth strategy? (see “3.4.1 Product / Market Expansion Matrix”). 4. Products What does the company offer and how does it benefit consumers? Does the product have any downsides or side effects? Is the product differentiated?

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How does the company’s product offering compare with the competition? Are there substitutes available? Do customers face high switching costs? Where does the product fall within its product lifecycle? (see “3.5.2 Product Life Cycle Model”). What is bundled with the product? For example, customer service, warranties and spare parts. Are there opportunities to bundle or unbundle the product in order to increase sales volume? 5. Finances If the company is considering a particular course of action, does it have sufficient funds available to undertake the project? Financing may be secured from various sources including internal cash reserves, bank loans, shareholder loans, bond issues or sale of shares. How many units will the company need to sell in order to cover the cost of the project? Is there sufficient market demand? 6. Cost Structure In order to understand a company’s cost structure, it helps to break each business unit down into the collection of activities that are performed to produce value for customers. The way each activity is performed combined with its economics will determine a firm’s relative cost structure within its industry. Are costs predominantly fixed or variable? How does this compare with the competition? For more information on understanding a company’s cost structure, see “3.6 Cost Management”. 7. Organisational Cohesiveness Understanding a firm’s inner workings is important since competitive strategies can fail if they conflict with a firm’s culture, systems and The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 50

general way of doing business. The organisational aspects of a firm can be examined using the 3.8.1 McKinsey 7 S Model. 8. Marketing What does the company stand for? How do customers perceive the company and its products? How does the company communicate with customers? 9. Distribution Channels What distribution channels does the company use to reach customers (network marketing, mail order, online store, factory outlets, retail stores, supermarkets and/or department stores)? Are there other channels that are more cost effective or which are preferred by customers? 10. Customer Service How does the company interact with customers and support its products post sale? Are employees empowered to solve problems and delight customers? Does the company have a customer loyalty program? 4. Business Landscape Survey Template If you would like to download a template that can be used to conduct a survey of the business landscape, please click here.

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3. Firm Level Analysis 3.1 Profitability 3.1.1 Profitability Framework Understanding profitability issues can help executives, consultants and entrepreneurs to diagnose and respond to falling prices, declining sales volume and rising costs Businesses sometimes experience reduced profitability. This is not necessarily a problem if the decline was expected since a business can be sustained from cash flow, and long term growth can be pursued through capital accumulation, which shows up on the balance sheet not on the profit and loss statement. However, a drop in profits can be concerning if it is unexpected and unexplained. It can limit a business’s ability to achieve organic growth and may mean that its existing business model is no longer viable. 1. Profit

2. Revenue

3. Cost

Price

Units Sold

Variable Costs

Fixed Costs

Pricing Strategy: Competitive, Cost Based, Value Based

Customer segmentation; Market share; New markets; New products

COGS: Raw Materials, Transport, Energy, Labor

SG&A, Rent, R&D, Depreciation, Interest, Labor (fixed contract), Marketing

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1. Profit Profit equals revenue minus cost. By considering the broader economy and comparing a business’s performance numbers with the competition it will be possible to determine whether declining profitability is a company specific or industry wide problem. Assuming the issue is company specific, it will be possible to discover the source of declining profitability by investigating each branch of the profit equation, revenue and cost, and drilling down to explore the company’s current and historical performance figures. Declining profitability may result from falling prices, declining units sold, rising costs or a combination of these factors. 2. Revenue Revenue can come from various sources including advertising and product sales and is normally thought of as being a function of price per unit and units sold. For example, price per widget multiplied by the number of widgets, or cost per click multiplied by the number of clicks. Declining revenue can derive from a fall in prices or a reduction in units sold, and can be examined in four steps. Step 1: Segmentation What are the major revenue streams? It will typically be a good idea to segment units sold, and this might be done by: 1. 2. 3. 4. 5. 6.

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

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Step 2: Examination What percentage of total revenue does each revenue stream represent? Compare current and historical figures to identify how these percentages have changed over time. Step 3: Diagnosis What is the underlying cause of the problem? Step 4: Response Develop a strategic response. 2.1 Diagnosis If faced with declining prices or sales volume, factors to consider include the following. 1. Macro Economy  PEST Analysis: Are there recent or impending changes to the macro environment? This may include changes to political, economic, socio-cultural or technological factors. 2. Customers  Market growth: Has market growth slowed forcing competitors to compete for market share?  Customer needs and preferences: Have customer needs and preferences changed?  Price Discrimination: Is the fall in prices or sales volume attributable to a particular customer segment? Can the company distinguish between customers and charge different prices to different customer segments? This could be done by offering quantity discounts or by distinguishing between people in different groups (e.g. students) or in different locations (e.g. you pay more for popcorn at the cinemas). The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 54

 Distribution Channels: What channels are used to reach customers? Have new or preferred channels become available? Has there been a change in the cost effectiveness of these channels? 3. Competition  Rivalry: Have competitors lowered their prices? How does the company’s product mix, product quality, and cost structure compare to the competition?  Substitutes: Has the availability of substitutes increased or the price performance of substitutes improved?  Barriers to entry: Has it become easier for new competitors to enter the industry? For example, the Internet has enabled new entrants in many established industries including publishing, newspapers, and taxis.  Buyer bargaining power: Has there been an increase in customer bargaining power? For example, Amazon has used its market dominance to drive down the price of books much to the chagrin of book publishers. 4. Company  Market Power: Does the company have market power that might allow it to raise prices (monopoly, product differentiation, proprietary technology, economies of scale, network effects)? For example, De Beers had (and largely still has) a monopoly on the diamond trade which allows it to keep the price of diamonds high.  Products: What products and product mix does the company offer? How does this compare to the competition? Is there something different about the products that might allow the company to raise prices? For example, brand recognition, superior quality, appealing design, unique product features, or strong customer service. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 55

 Value chain analysis: Consider value chain activities such as access to raw materials, operating capacity, inventory handling and distribution. Are there any bottlenecks or capacity limitations? 2.2 Response Declining prices You would be forgiven for thinking that the best way to respond to falling prices is simply to raise them. But unfortunately things are often not that simple since a business’s ability to raise prices can often be constrained. In response to declining prices, there are three pricing strategies to consider: 1. Competitive pricing: How do prices compare with the competition? Is the pricing appropriate given the product’s relative quality and position within the market? How is the competition likely to respond to the firm’s pricing strategy? 2. Cost based pricing: Cost based pricing is a simple pricing strategy that sets price relative to the company’s costs. The price is set by calculating the company’s per unit cost and adding a margin for profit. 3. Value based pricing: Value based pricing involves assessing the customer and setting the price based on the customer’s willingness to pay. For further discussion on pricing strategy, see “3.5.1 Four Ps Framework”. Declining sales volume Faced with falling sales volume, there are four growth strategies that a company might employ: market penetration, market development, product development, and diversification.

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Figure 2: Product/market expansion matrix

For more information on growth strategy, see “3.4.1 Product / Market Expansion Matrix”. 3. Costs The third driver of declining profitability is rising costs. 3.1 Diagnosis If rising costs are driving a decline in profitability, then the cost structure of the business will need to be examined in order to locate the source of the cost blow out. This might be done by segmenting costs into value chain activities: inbound logistics, operations, outbound logistics, sales & marketing, customer service (see “3.2.1 Value Chain Analysis”). Have there been any significant changes in the company’s cost drivers? How do costs compare to the competition? 3.2 Response After determining the source of rising costs, a firm can develop strategies to manage and reduce costs. For more information on cost management, see “3.6 Cost Management”.

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4. Profitability Framework Cheatsheet If you would like to download a one page profitability framework cheatsheet that contains all the essentials of the profitability framework on one page, please click here.

3.2 Competitive Advantage 3.2.1 Value Chain Analysis To understand which activities provide a business with a competitive advantage, either through cost advantage or product differentiation, it is helpful to separate operations into a series of value-generating activities referred to as “the value chain” 1. Background Value Chain Analysis is a concept that was first described and popularised by Michael Porter in his 1985 book, Competitive Advantage. 2. Relevance In order to understand the activities that provide a business with a competitive advantage, either through cost advantage or product differentiation, it is useful to separate the business operation into a series of value-generating activities referred to as “the value chain”. Value Chain Analysis involves identifying all of the important activities in which a business engages and then determining which ones give the company a defensible competitive advantage. By doing this, a company can: 1. Determine which activities are best undertaken internally and which ones are able to be outsourced or eliminated; 2. Identify and compare strengths and weaknesses with the competition; and The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 58

3. Identify synergies between activities. 3. Value Chain Analysis Explained Michael Porter introduced a generic value chain model that comprises a sequence of activities common to a wide range of firms. Porter suggested that the activities of a business could be grouped under two headings: 1. Primary activities: Those that are directly concerned with creating and delivering a product or service; and 2. Support activities: Those that are not directly involved in production, but may increase efficiency or effectiveness.

Figure 3: The Generic Value Chain

The firm’s margin or profit depends on its ability to perform these activities efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of the activities in the value chain. 3.1. Primary activities The primary value chain activities include: 1. Inbound Logistics: Receiving and storing externally sourced materials; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 59

2. Operations: Manufacturing; the way in which inputs are converted into final products; 3. Outbound Logistics: Inventory storage and distribution to customers; 4. Marketing & Sales: Identification of customer needs and preferences, marketing strategy and sales generation; 5. Service: Supporting customers after the product or service has been sold to them. 3.2. Support activities The support value chain activities include: 1. Human resource management: Recruitment, training, development, motivation and compensation of employees; 2. Infrastructure: Includes a broad range of support systems including organisational structure, planning, management, quality control, culture, and finance; 3. Procurement: Sourcing resources and negotiating with suppliers; and 4. Technology development: Managing information, developing and protecting new products and services, developing more efficient processes, and improving quality. 4. Application of the Value Chain Analysis 4.1 Steps to take Value Chain Analysis can be undertaken by following three (3) steps: 1. Break down a company into its key activities under each of the headings in the model; 2. Identify activities that contribute to the firm’s competitive advantage either by giving it a cost advantage or creating product differentiation. At the same time, also identify activities where the business appears to be at a competitive disadvantage; and The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 60

3. Develop strategies around the activities that provide a sustainable competitive advantage. 4.2 Cost advantage A business can achieve a cost advantage over its competitors by understanding the costs associated with each activity and then organising each activity so that it is as efficient as possible. Porter identified ten (10) cost drivers related to each activity in the value chain: 1. 4.3 Economies of Scale; 2. Learning; 3. Capacity utilisation; 4. Linkages among activities; 5. Interrelationships among business units; 6. Degree of vertical integration; 7. Timing of market entry; 8. Firm’s policy on targeting cost or product differentiation; 9. Geographic location; 10. Institutional factors (regulation, union activity, taxes, etc.). A firm can develop a cost advantage by controlling these ten (10) cost drivers better than its competitors. A cost advantage can also be pursued by reconfiguring the value chain. Reconfiguration means introducing structural changes such as a new production process, new distribution channels, or a different sales approach. For example, Qantas structurally redefined its maintenance of aircraft, traditionally conducted by in-house engineers, by outsourcing this function to private overseas contractors. 4.3. Product differentiation A firm can achieve product differentiation by focusing on its core competencies in order to perform them better than its competitors. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 61

Product differentiation can be achieved through any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors, providing high levels of product support services, or designing innovative and aesthetically attractive products. 5. Issues arising from Value Chain Analysis 5.1. Linkages between value generating activities Value chain activities are not isolated from one another. Rather, one value chain activity often affects the cost or performance of other value chain activities. Linkages may exist between primary activities and also between primary and support activities. For example, the design of a product might be changed in order to reduce manufacturing costs. However, if the new product design inadvertently results in increased service costs then the total cost reduction could be less than anticipated. 5.2. Business unit interrelationships Business unit interrelationships can be identified using the Value Chain Analysis. Business unit interrelationships offer opportunities to create synergies among business units. For example, if multiple business units require the same raw material and the procurement process can be coordinated then bulk purchasing may result in cost reductions. Such interrelationships may exist simultaneously in multiple value chain activities. 5.3. Outsourcing Value Chain Analysis can help management decide which activities to outsource. It is rare for a business to undertake all primary and support activities internally. In order to decide which activities to outsource managers must understand the firm’s strengths and weaknesses, both in terms of cost and ability to differentiate. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 62

6. Case Example Below we consider some of the issues that might be relevant for some of Coca Cola’s value chain activities: 1. Procurement: Is it more cost effective to procure inputs locally, regionally or globally? If local procurement is more expensive but better for the environment and local communities, can this be used as a point of differentiation? Are there likely to be political or environmental disturbances that could drive up the cost of key inputs like corn syrup or aluminium? 2. Operations: How much does a bottling plant cost to build and run? How often do factories need to be re-engineered? Would it be more cost effective to outsource bottling? Is bottling strategically important for product differentiation? 3. Logistics: What is the cost of inventory storage? How is Coca Cola distributed to customers? How many cans are lost in transit? 4. Marketing & Sales: Are consumer preferences changing over time? Will people enjoy cherry cola? Are people becoming more health conscious?

3.3 Competitive Strategy 3.3.1 Porter’s Generic Strategies Three strategies to achieve above-average performance: cost leadership, differentiation, and focus In order to understand Porter’s Generic Strategies, it is helpful to take a step back and examine the two things which determine a firm’s profitability in the long run. The first is industry attractiveness, which is determined in any industry by the five competitive forces: the threat of entry by new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry among existing firms. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 63

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

It is the collective strength of these five forces that determine whether firms in an industry will be able to earn attractive rates of return. In industries where the five forces are favourable, such as the soft drink industry, many competitors have earned attractive returns for many decades. However, where one or more of the forces exerts strong pressure on industry profitability, such as in the airline industry, few firms ever do well for long. Understanding industry structure, as determined by the five forces, will inform a firm’s decision to enter or exit an industry, and will also be a key consideration for industry leaders who have the ability to mould industry structure for better or for worse. For example, Coca-Cola is a leader in the soft drink industry and could, if it wanted to, encourage the production and sale of generic unbranded soft drinks. Even if this would increase Coca-Cola’s profits in the short run, it would also threaten the structure of the industry. Generic cola may increase the price sensitivity of buyers, lead to aggressive price competition, and lower barriers to entry by enabling new competitors to enter the market without a large advertising budget.

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In addition to industry attractiveness, the second thing which determines a firm’s profitability in the long run (and this is where Porter’s Generic Strategies comes in) is a firm’s relative position within the industry. That is, can a firm position itself to achieve above average performance within its industry? Or put differently, is it possible for a firm to establish and maintain a competitive advantage? In his 1985 book Competitive Advantage, Michael Porter explains that there are two basic sources of competitive advantage that a firm can possess: cost leadership and differentiation. A firm can also narrow the scope of its activities to compete in niche segments of the market, and so there are actually three generic strategies that a firm can adopt to achieve above-average performance: cost leadership, differentiation, and focus.

Figure 5: Three Generic Strategies

Porter’s generic strategies are based on the idea that in order to achieve a competitive advantage a firm needs to make hard choices. Trying to be all things to all people will put a firm on the fast track to mediocrity, and so a firm needs to decide what kind of competitive advantage to pursue and which market segments it should target. Cost Leadership As the name suggests, a firm that pursues cost leadership aims to be the low cost producer in its industry. While the strategy involves a primary

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focus on cost reduction, the cost leader will also need to produce comparable products in order to maintain prices. If a firm can sustain cost leadership while at the same time charging prices at or near the industry average, then this strategy can allow a firm to achieve above average performance. One danger of the cost leadership strategy is that if there is more than one aspiring cost leader then this can lead to intense competitive rivalry and ultimately destroy industry profitability. If a firm wants to be the cost leader, then its best bet is to get in first in order to deter the competition. Differentiation Differentiation is a strategy in which a firm sets out to provide unique value to buyers. This may be achieved in various ways including producing products with unique features, serving buyers through new or different distribution channels, or by creating perceived differences in the buyer’s mind through clever marketing. While the strategy involves a primary focus on “being different” the differentiator will still need to manage its costs, and will want to reduce costs in any area that does not contribute to differentiation. If a firm is able to charge a price premium that exceeds the cost of sustaining its uniqueness, then the firm will be able to achieve above average returns. Focus The focus strategy involves narrowing the scope of competition in order to serve certain niche segments within the overall market. By serving these target segments well, the focuser may be able to achieve a competitive advantage in its niche even though it does not enjoy a competitive advantage in the market overall.

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Stuck in the Middle While there are three generic strategies for achieving above average performance, a firm that tries to employ all of these strategies without successfully pursuing any of them faces the risk of becoming “stuck in the middle”. As such, it may find itself perpetually outperformed by other firms in the industry that have been willing to make hard strategic choices about how to compete.

3.3.2 Strategy and the Internet There are six strategic principles which are relevant to any company that wants to be profitable online In an article entitled “Strategy and the Internet” published in the March 2001 edition of the Harvard Business Review, Michael Porter outlined six principles that he believes internet companies need to follow if they want to establish and maintain a distinctive strategic position online. While we largely agree with Porter’s six principles, we take issue with his second principle which argues for a focus on profitability through the sale of products and services. Porter’s six strategic principles are instructive, and we outline them below. 1. Stand for something In order for a company to develop unique skills, build the right assets, and establish a strong reputation it is important to define what the company stands for so that the company will have continuity of direction. 2. Focus on profitability Many internet based companies focus on “unique visitors” and “page views” as measures of performance and Porter notes that, at the end of The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 67

the day, sustainable profits will only be possible where goods or services can be provided at a price which exceeds the cost of production. We take issue with this focus on profitability through the sale of goods and services since it misses the key insight that successful internet-based companies are typically in the business of connecting people around a common interest or shared purpose. In other words, the internet is not primarily about selling goods and services, but is instead about creating markets, building communities and connecting people. While it is true that a successful internet-based company may derive some profits from the sale of goods and services, it is also likely to generate a portion of its revenues from advertising, membership fees and commissions. 3. Offer consumers a unique set of benefits Good strategy involves being able to provide a distinct set of benefits to a particular group of consumers. Trying to please every consumer will not give a company a sustainable competitive advantage. 4. Perform core activities differently If a company is able to establish a distinctive value chain by performing key activities differently from its competitors, then this will help the company establish a sustainable competitive advantage. 5. Specialise There is no competitive advantage to being a jack of all trades and a master of none. Porter recommends making trade-offs. By focusing on certain activities, services or products at the expense of others a company can establish a unique strategic position. 6. Ensure that all activities reinforce the company’s strategy All of a company’s activities are interdependent and, as a result, they must be coordinated so as to reinforce the company’s overall strategy. A The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 68

company’s product design, for example, will affect the manufacturing process and the way that products are marketed. By coordinating all of its activities, a company makes it harder for competitors to imitate its strategy.

3.4 Growth Strategy 3.4.1 Product / Market Expansion Matrix A framework to help executives, senior managers and marketers devise strategies for future growth 1. Background The Product/Market Expansion Matrix (or “Ansoff Matrix” as it is sometimes called) was developed by a Russian-American mathematician named Igor Ansoff, and first explained in his 1957 Harvard Business Review article entitled Strategies for Diversification. 2. Relevance The Product/Market Expansion Matrix is particularly useful for strategic planning because it provides a framework to help executives, senior managers and marketers devise strategies for future growth. By aiding clear thinking about growth strategy, the Product/Market Expansion Matrix can help an organisation avoid key risks including: 1. Overlooking available growth strategies; 2. Misunderstanding the implications of pursuing a particular strategy; and 3. Selecting an inappropriate strategy given the firm’s diversification objectives. 3. Product/Market Expansion Matrix Explained The Product/Market Expansion Matrix can help a firm devise a product-market growth strategy by focusing on four growth alternatives: The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 69

1. 2. 3. 4.

Market Penetration; Market Development; Product Development; and Diversification.

Figure 6: Product/market expansion matrix

What is a Product-Market Growth Strategy? A product-market strategy is a description of a firm’s products and target markets. While this may sound straightforward, it can be difficult to clearly delineate a target market since it can be defined very broadly (for example, the transport market) or very narrowly (for example, domestic air transport in America for cost-conscious business travellers). In general, a market should not be defined too broadly (or too narrowly) since a key purpose of market definition is to allow a firm to develop strategy and make decisions. In his 1957 paper, Ansoff defined a product-market strategy as “a joint statement of a product line and the corresponding set of missions which the products are designed to fulfil.” For example, one of Apple’s product missions might be to provide consumers with easy-to-use digital technology, and another mission might be to provide fashion accessories for Yuppies and young people. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 70

The Four Growth Alternatives The four alternative growth strategies are: 1. Market Penetration: A strategy to increase sales without departing from the original product-market strategy. This involves increasing sales to existing customers and finding new customers for existing products. 2. Market Development: A strategy to sell existing products to new markets (normally with some modifications). Ansoff described this as a strategy “to adapt [the] present product line … to new missions.” For example, Boeing might adapt an existing model of passenger aircraft and sell it for cargo transportation. 3. Product Development: A strategy to sell new products, with new or altered features, to existing markets. Ansoff described this as a strategy to develop products with “new and different characteristics such as will improve the performance of the [existing] mission.” For example, Boeing might develop a new aircraft design which offers improved fuel economy. 4. Diversification: A strategy to develop new products for new markets, which can either be related to the current business (e.g. vertical integration or horizontal diversification) or unrelated (e.g. conglomerate diversification). Each of the above strategies represents a different path that a firm can take to pursue growth. However, in practice, a firm will often implement more than one strategy at the same time. As Ansoff noted, “a simultaneous pursuit of market penetration, market development, and product development is usually a sign of a progressive, well-run business and may be essential to survival in the face of economic competition.” 4. Selecting a Strategy A growth strategy can be selected through a three-step process: 1. Setting out all of the available strategies; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 71

2. Applying qualitative criteria to short list the most favourable alternatives; and 3. Applying a return on investment hurdle to narrow the options still further. The discussion below provides a summary of the issues and various situations in which it may make sense for a firm to select a particular growth strategy. 4.1 Market Penetration Market Penetration carries the least implementation risk since a firm is focusing on its existing products and existing markets, and so should be able to leverage its existing resources and capabilities. Pursuing this strategy is likely to make sense if the firm has a strong competitive advantage, or if the overall size of the market is growing or can be induced to grow. 4.2 Market Development Market Development carries more implementation risk than Market Penetration because a firm is expanding into new markets. Companies that have successfully pursued this strategy include CocaCola and McDonalds, and it may make sense where:  The firm’s core competencies relate to its existing products and it has a strong marketing team;  The firm can identify opportunities for market development including chances to reposition the brand, exploit new uses for the product, or expand into new geographical regions;  The firm’s resources are organised to produce particular products and changing the production technology would be costly.

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4.3 Product Development Product Development carries more implementation risk than Market Penetration because the firm is developing new products. Companies that have successfully pursued this strategy include 3M, P&G and Unilever, and it may make sense where:  The firm understands the needs of its customers, and identifies an opportunity to sell new products to satisfy new or changing needs;  The firm operates in a competitive market where continuous product innovation is necessary to prevent product obsolescence or commoditisation;  The firm has large market share and a strong brand;  The firm’s products benefit from network effects or proprietary technology, and new products can gain a significant edge by being first to market;  The firm operates in a market with strong growth potential;  The firm identifies opportunities to commercialise new technology;  The firm has a strong R&D team. 4.4 Diversification Diversification carries the most implementation risk since a firm is simultaneously developing new products and entering new markets, and may need to develop or acquire new resources and capabilities. Diversification can enable a firm to achieve three main objectives: growth, stability, and flexibility. The specific strategies that a firm employs will differ depending on which of these goals a firm is pursuing. There are three primary kinds of diversification that a firm might pursue: 1. Vertical Integration: The firm expands its business to different points in the supply chain; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 73

2. Horizontal Diversification: The firm adds new products that may be unrelated to existing products but are likely to appeal to existing customers. For example, Amazon initially sold only books through its website but has over time added new products such as clothes, jewellery and electronics; 3. Conglomerate Diversification: The firm adds new products that are unrelated to existing products and are likely to appeal to new customer segments. While conglomerate diversification may have little relationship with a firm’s existing business, a firm might adopt this strategy in order to:  Improve profitability by entering a lucrative industry;  Develop resources and capabilities in a potential new growth industry;  Poach top management or key talent;  Compensate for technological obsolescence;  Expand the firm’s revenue base so as to improve its perception in the capital markets and make it easier to borrow money;  Increase strategic flexibility in an uncertain business environment; or  Reduce risk by spreading the firm’s activities across multiple products and markets, and thereby decrease its vulnerability to negative Black Swans and unfavourable events such as economic downturns, increased competitive rivalry, improved supplier or buyer bargaining power, improved price performance of substitutes, or reduced barriers to entry. 5. Implementing a Growth Strategy Below we provide suggestions on how to implement each of the four alternative growth strategies. 5.1 Market Penetration Market Penetration involves increasing sales of existing products to existing markets, and could be pursued in the following ways: The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 74

1. Pricing:  Changing product pricing; for example, if demand is relatively inelastic, then it might be possible to raise prices without a big drop in sales. Alternatively, prices could be lowered to increase sales volume; 2. Product:  Modifying the products or product packaging in order to broaden their appeal;  Bundling products together in order to sell them as a single unit;  Increasing the size of a product in order to increase the amount sold per unit; 3. Place:  Improving distribution channels in order to reach more customers within existing markets;  Targeting a market niche in order to grow sales and build overall market share (this approach may make sense if the firm is small compared to its competitors);  Make products available at times and in locations which correspond with high customer demand (for example, selling ice cream near the beach, selling Christmas trees in December); 4. Promotion:  Increasing advertising to promote the product or reposition the brand;  Offering quantity discounts (e.g. 2 for 1, Buy One Get One Free);  Introducing customer loyalty schemes;  Improving the quality or size of the sales force; 5. Acquisitions:  Acquiring a competitor (this approach may make sense in mature markets where the size of the overall market is not growing); 6. Cost Management: The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 75

 Improving operational efficiency so that increased sales can be achieved without a proportional increase in costs (this might be attained through 4.3 Economies of Scale and product rationalisation). 5.2 Market Development Market Development involves selling existing products to new markets, or new market segments, and could be pursued in the following ways: 1. Product:  Modifying the pricing strategy, products and/or product packaging in order to appeal to different customer segments; 2. Place:  Utilising new distribution channels to reach new market segments, for example building an online store; 3. Promotion:  Marketing products in new locations in order to expand regionally, nationally or internationally;  Advertising through different media in order to reach different customer segments; 4. Acquisitions and Joint Ventures:  Acquiring a competitor or forming a joint venture or strategic alliance in order to gain access to new distribution channels. 5.3 Product Development Product Development involves selling new products to existing markets, and could be pursued in the following ways: 1. Product:  Developing new products through R&D or licensing new technologies;  Extending an existing product by producing different versions; for example, Apple released two versions of the iPhone 5, the iPhone 5C and the iPhone 5S; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 76

 Packaging existing products in new ways; for example, Apple re-released the iPhone 5 in a range of colourful cases and called it the iPhone 5C; 2. Place:  Distributing products manufactured by other firms in order to increase utilization of an existing distribution channel. For example, Amazon not only sells and distributes products through its website but also allows other vendors to do so; 3. Acquisitions and Joint Ventures:  Acquiring a competitor in order to acquire its product line;  Forming a joint venture or strategic alliance with a complementary firm. 5.4 Diversification Diversification involves selling new products to new markets, and can be pursued by simultaneously adopting the strategies suggested above for Market Development and Product Development.

3.4.2 GE McKinsey 9 Box Matrix The GE-McKinsey 9-Box Matrix offers decentralised corporations with multiple business units a systematic approach for investing available cash reserves 1. Background The 9-Box Matrix was developed as part of work that McKinsey did for GE in the early 1970s. At that time, GE had around 150 business units and was faced with the challenge of how to manage such a large number of business units profitably. The 9-Box Matrix was developed as a result of the realisation that it is important to separate the ability of a business to generate cash from the decision about whether to put more cash into the business.

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2. Purpose The 9-Box Matrix offers any decentralised corporation with multiple business units a systematic approach to help it decide where to invest its excess cash reserves. The 9-Box Matrix solves the problem of trying to compare potentially very different business units: one might be capital intensive; another might require high advertising expenditure; a third might have economies of scale. Instead of relying on the projections provided by the manager of each individual business unit, the company can determine whether a business unit is going to do well in the future by considering two factors: 1. Industry attractiveness; and 2. Competitive advantage. [It is worth noting that these are the same factors proposed by Professor Michael Porter in his 1985 book Competitive Advantage.] 3. Using the 9-box Matrix

Figure 7: GE-McKinsey 9-box matrix

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Placing each business unit within the 9-Box Matrix offers a framework for comparison between them. In order to keep things simple, the framework offers three investment strategies: 1. Invest/Grow; 2. Selectivity/Earnings; and 3. Harvest/Divest. Allocating one of these investment strategies to each business unit is the first step. However, it is important to note that two business units that have been given the same strategy will not necessarily be treated in the same way. For example, a strong unit in a weak industry will be in a very different situation from a weak unit in an attractive industry. After placing every business unit into one of the nine boxes, there are at least two questions that need to be asked: 1. If a business unit is in one category, say “selectivity/earnings”, are there any actions that might be taken to improve its position? 2. If a business unit is to receive money, what does it plan to do with that money and does this strategy make sense? It is important that a business unit has a purpose in mind because the best use of money will vary depending on the industry and on the business unit. For example, advertising to enhance the brand might work for one business unit, whereas increasing R&D spending might work for another. 4. Axes of the 9-box Matrix The 9-Box Matrix places “industry attractiveness” along the vertical axis, and “competitive advantage” along the horizontal axis.

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4.1 Industry attractiveness Industry attractiveness refers to industry profitability. That is, how easy will it be for the average firm to generate above average profits over the long run? For a straightforward approach to examining industry attractiveness, see “4.8 Porter’s Five Forces”. 4.2 Competitive advantage A business unit has a competitive advantage when it is able to achieve profits that exceed the industry average. Understanding whether a business unit has a “sustainable competitive advantage” involves examining its relative position within its industry and the resources and capabilities that it possesses which will allow it to maintain and strengthen that position over time. Relevant considerations might include: 1. Does the business unit benefit from economies of scale or network effects? 2. Does the business unit enjoy strong brand recognition? 3. Is the business unit more profitable than its competitors? If so, why so? 5. Available Strategies 5.1 Invest / Grow A business unit will be in the “invest/grow” category if the prospects for the industry as a whole are attractive and the business unit’s position in the industry means that it is likely to do better than most of the other firms in the industry. A business unit in this category should be given increased investment regardless of whether it can generate those funds itself.

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5.2 Selectivity / Earnings Business units in this category are given second priority to those in the “invest/grow” category. As such, the amount of money spent on business units in the “invest/grow” category will determine how much is left over for business units in this category. When allocating money to a business unit in this category, it is important to be selective about where the money is spent and monitor earnings closely. With the right combination of strategies, it may be possible to move a business unit into the “invest/grow” category. However, if a business unit doesn’t improve its performance it may be advisable to reallocate cash to another business unit. 5.3 Harvest / Divest A business unit will be in the “harvest/divest” category if it is in an unattractive industry and its competitive position is weak. There are two potential strategies can be pursued for business units in this category: 1. Harvest: Increase short-term cash flows as far as possible, even at the expense of the business unit’s long term future; or 2. Divest: Sell the business unit or liquidate its assets.

3.4.3 BCG Growth Share Matrix The BCG Growth Share Matrix is a simple conceptual framework for resource allocation within a firm 1. Background In 1968, BCG developed the growth share matrix, which is a simple conceptual framework for resource allocation within a firm. 2. Purpose The BCG matrix is a simple tool that enables management to: The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 81

1. Classify products in a company’s product portfolio into four categories – Stars, Cash Cows, Question Marks, and Dogs; 2. Index a company’s product portfolio according to cash usage and generation; 3. Determine the priority that should be given to different products in a company’s product portfolio; and 4. Develop strategies to tackle various product lines. 3. BCG Growth Share Matrix Explained The idea behind the growth share matrix is that the amount of cash that a product uses is proportional to the rate of growth of that product in the market, and the generation of cash is a function of its market share. Money generated from high-market-share products can be used to develop high-growth products.

Figure 8: BCG Growth Share Matrix

Under the BCG matrix, products are classified into four types: 1. Stars are leaders in high growth markets. Stars grow rapidly and therefore use large amounts of cash. Stars also have a high market share and therefore generate large amounts of cash. Over time, the growth of a product will slow. If a Star maintains a high market The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 82

share, it will eventually become a Cash Cow. If not, it will become a Dog. 2. Cash Cows are highly profitable, and require low investment because they are market leaders in a low-growth market. Growth is slow and therefore cash use is low, and market share is high and therefore cash generation is high. Money generated from cash cows can be used to pay dividends, interest, and overheads, and to develop Stars and Question Marks. 3. Question Marks are low market share high growth products, and almost always require more cash than they can generate. If a Question Mark can improve its market share, it will eventually become a Cash Cow. If not, it will become a Dog. 4. Dogs generate little cash because of their low market share in a low growth market. BCG refers to these products as “cash traps”. Although they may be sold profitably in the market, BCG indicates that, in terms contributing to growth, Dogs are essentially worthless. 4. Available Strategies The BCG matrix offers four alternative strategies: 1. Develop: This strategy is appropriate where a product’s market share needs to be increased in order to strengthen its market position. Short-term earnings and profits are forfeited because it is hoped that the long-term gains will outweigh these short term costs. This strategy is suited to Stars, as well as Question Marks if they are to become Stars. 2. Hold: The objective of this strategy is to maintain the current market share of a product, and is used for Cash Cows so that they will continue to generate large amounts of cash which can be invested in Stars and Question Marks. 3. Harvest: Under this strategy, management attempts to increase short-term cash flows as far as possible (e.g. by increasing prices, The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 83

and cutting costs) even at the expense of the products long-term future. It is a strategy suited to weak Cash Cows or Cash Cows that are in a market with a limited future. Harvesting is also used for Dogs, and for Question Marks that have no possibility of becoming Stars. 4. Divest: The objective of this strategy is to get rid of unprofitable products and products with low market share in low growth markets. Money from divestment can then be used to develop and promote more profitable products. This strategy is typically used for Dogs and for Question Marks that will not become Stars. 5. Criticisms The simplicity of the BCG matrix helped to popularise the tool with management teams around the world. Unfortunately, however, the BCG matrix is not just simple and easy to remember but also simplistic, and using the framework without careful consideration can lead to serious strategic missteps. Below we highlight four (4) key criticisms of the BCG matrix. First of all, the BCG matrix encourages managers to focus primarily on market share at the expense of other factors that may be important for organisational performance. A myopic focus on market share may lead managers to: 1. Engage in aggressive price competition leading to the destruction of industry profits; 2. Focus narrowly on one product or product line, forgetting that markets are fluid and notoriously hard to define. For example, if Apple had defined its market as “PCs and laptops” then it would never have pioneered the iPod, iPhone and iPad; and 3. Ignore other growth alternatives including new product development, new market entry, and diversification.

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The second problem with the BCG matrix is that by classifying a product into one of four types – Star, Cash Cow, Question Mark, or Dog – it is essentially forecasting the product’s potential which can result in a self-fulfilling prophecy. For example, if a product is labelled a Star then it will receive increased investment and management focus, employees working on the product are likely to be more motivated, and the product will therefore be likely to perform much better than it would have otherwise. The third problem with the BCG matrix is that it is often difficult to determine where a product or an industry falls within its life cycle. A technology product with high market share in a low growth market might be labelled as a Cash Cow and assigned a “hold” strategy, and so be given just enough investment to maintain its market share. While this may be an appropriate strategy for a product in a slow moving industry, rapidly changing technology may require significant investment in order to capture new opportunities for growth and innovation. For example, Microsoft, with its a dominant market share for operating system software in the PC industry has been slow to innovate and slow to release software for other devices such as smartphones and tablets. The fourth criticism of the BCG matrix is that it equates high market share with high cash generating ability. It assumes that a product with higher market share will generate more cash; however this may not be the case. In 1970, while outlining the BCG matrix, Bruce Henderson stated that “Margins and cash generated are a function of market share. High margins and high market share go together. This is a matter of common observation, explained by the 4.5 Experience Curve effect.” Henderson’s observation turns out to be an oversimplification of reality (for a full discussion on this point, see “Implications for Strategy”). If a product benefits from 4.3 Economies of Scale and the 4.5 Experience Curve effect, then higher market share will lead to lower unit costs. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 85

However, this does not necessarily mean that the product will generate more cash since the amount of cash that a product generates depends on two factors: 1. The profit margin per unit; and 2. The number of units sold. 1. Profit margin per unit It is common for firms to achieve increased market share by lowering prices, which will lead to lower profit margins unless sufficient cost savings can be found to offset the lower price. This means that a product with higher market share will only generate more cash if the percentage increase in units sold is greater than the percentage decrease in profit margin per unit. This will not always be the case, but admittedly it is likely to occur for the kinds of products that Henderson was talking about, that is, for products which benefit from 4.3 Economies of Scale and the 4.5 Experience Curve effect. 2. Units sold In considering a product’s cash generating potential, companies need to consider not only market share but also market size since units sold is a function of both. For example, a product that has a small market share in a large market may have the potential to generate a large amount of cash. This insight is overlooked by the BCG matrix.

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3.5 Marketing Strategy 3.5.1 Four Ps Framework A useful framework for evaluating the marketing strategy for a product The Four Ps Framework involves examining four aspects relevant to a product’s marketing strategy: 1. 2. 3. 4.

Price; Product; Promotion; and Place.

1. Price The pricing strategy that a firm employs will affect a product’s market share and profitability. Depending on the situation, there are many different pricing strategies that a firm might choose to employ. We can group all of these strategies under three headings: competitive pricing, cost based pricing, and value based pricing. 1.1 Competitive pricing Under this strategy, the price of a product will be affected by the price of competing products, and by the availability of substitutes. How do prices compare with the competition? Is the pricing appropriate given the product’s relative quality and position within the market? A firm might consider the following competitive pricing strategies: 1. Predatory pricing: Aggressive pricing intended to undercut competitors and drive them out of the market. 2. Limit pricing: A low price charged by a monopolist in order to discourage entry into the market by other firms. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 87

3. Penetration pricing: The price is set low in order to gain market share. 1.2 Cost based pricing Under this strategy, the price of a product will be determined by the company’s cost structure and the cost of goods sold. What is the company’s cost structure? What percentage of costs are fixed and variable? A company that has high fixed cost and low variable costs will benefit from economies of scale and may want to lower prices to increase market share. A firm might consider the following cost based pricing strategies: 1. Marginal cost pricing: The price of a product is set equal to the cost of producing one extra unit of output. 2. Target pricing: The price of a product is calculated to produce a particular return on investment. 3. Cost-plus pricing: Arguably the most basic pricing strategy which involves setting price equal to the unit cost of production plus a margin for profit. 1.3 Value based pricing Under this strategy, pricing will be driven by the perceived value of the product in the mind of the customer. Perceived value will depend on various factors include branding, product differentiation, availability, the customer’s price sensitivity and willingness to pay. Are customers price sensitive? If prices are changed, how will this affect sales volume and product perception? Two (2) practical examples of value based pricing include: 1. A company that manufactures t-shirts might produce branded Gucci t-shirts that retail for $80 per shirt, and produce unbranded t-shirts of the same design and quality that retail for $30; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 88

2. A movie theatre might sell adult tickets for $20, and sell the exact same tickets to students for $10. A firm might consider the following value based pricing strategies: 1. Price discrimination: Setting a different price for the same product for different customer segments. See “Price discrimination”. 2. Dynamic pricing: A flexible pricing mechanism, which allows online companies to adjust the price of identical goods to correspond to a customer’s willingness to pay. This is made possible by using data gathered from a customer including where they live, what they buy, and how much they have spent on past purchases. 3. Market-orientated pricing: Setting a price based upon analysis of the target market. 4. Psychological pricing: Pricing designed to have a positive psychological impact. For example, selling a product at $3.95 instead of $4. 5. Skimming: Charging a high price to gain a high profit, at the expense of achieving high sales volume. This strategy is usually employed to recoup the initial investment cost in research and development, commonly used in consumer electronic markets when a new product range is released since early adopters are typically less price sensitive. 6. Premium pricing: Keeping the price of a product artificially high in order to encourage a favourable perception among buyers. 7. Loss leader pricing: A loss leader is a product sold at a low price to stimulate other profitable sales. For example, the 30 cent soft serve cone at McDonalds. 8. Seasonal pricing: Adjusting the price depending on seasonal demand.

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2. Product Is the product a low cost commodity or differentiated? The major sources of product differentiation include: 1. Vertical differentiation: Products can differ in their quality due to differences in reliability, comfort, support services, or other factors. For example, BMW versus Hyundai. 2. Horizontal differentiation: Products can differ in features that cannot be ordered. For example, different flavours of ice-cream. 3. Availability: Products may be available at different times (e.g. seasonal fruits) and locations (e.g. ice-cream sold near the beach). 4. Perception: Products can differ in their brand recognition, which can be influenced through sales, marketing and promotion. How does a product compare with what the competition is offering? Are their viable substitutes? Do customers face high switching costs? Successful product differentiation can lead to Monopolistic competition, a situation where firms retain some control over pricing despite there being multiple competitors. 3. Promotion Promotion is used to enhance the perception of a company or its products in the mind of the customer. A promotion may draw people’s attention to branding, quality, product features, price or availability. What message is the firm trying to communicate? What is the objective? Who is the target customer? What is the right promotion medium, reach (that is, number of people reached through the chosen medium) and frequency of promotion? What is the firm’s marketing budget? How does the firm’s marketing strategy differ from the competition? How might the competition react to the firm’s marketing strategy?

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Understanding the customer’s buying decision process can help a firm decide where and how to influence the customer’s purchase decision. Awareness

Information Search

Evaluation

Purchase

Re-puchase

Figure 9: Customer Buying Decision Process

Promotion can be carried out in various ways including: 1. 2. 3. 4. 5.

Advertising (digital, TV, newspapers, magazines); Direct Sales (door to door, cold calling, warm calling, direct mail); Indirect Sales (word of mouth); Trade Promotions (price discounting, quantity discounting); Public Relations (donating to charity, sponsoring a sports team, celebrity appearances).

4. Place The physical location and availability of a product can be a source of competitive advantage. For example, if there are two ice-cream stores, one next to a popular tourist beach and the other in a quiet suburb, we would reasonably expect that the ice cream store near the beach will be able to charge higher prices and sell more ice-cream. A firm should consider the markets and market segments that it serves. Does the competition serve the same markets and market segments? Which inventory control system should the firm use? Should the firm insource or outsource transportation and logistics? What distribution channels does the firm use? Which channels are most closely aligned with the company’s strategy? What are the economics of available channels? Do these fit with the intended selling price of the product? How much control is the company willing to give up in the delivery of its products? What is the risk that market power shifts to the channel? The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 91

3.5.2 Product Life Cycle Model The Product Life Cycle Model can be used to analyse the maturity stage of products and industries 1. Background The idea of the Product Life Cycle was first developed in 1965 by Theodore Levitt in an article entitled “Exploit the Product Life Cycle” published in the Harvard Business Review on 1 November 1965. 2. Benefits For a business, having a growing and sustainable revenue stream from product sales is important for the stability and success of its operations. The Product Life Cycle model can be used by consultants and managers to analyse the maturity stage of products and industries. Understanding which stage a product is in provides information about expected future sales growth and the kinds of strategies that a firm should implement. 3. Product Life Cycle Model The Product Life Cycle is the name given to the stages through which a product passes over time. The classic Product Life Cycle has four stages: 1. 2. 3. 4.

Introduction; Growth; Maturity; and Decline.

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Figure 10: Product Life Cycle Model

3.1 Introduction At the market introduction stage the size of the market, sales volumes and sales growth are small. A product will also normally be subject to little or no competition. The primary goal in the introduction stage is to establish a market and build consumer demand for the product. There may be substantial costs incurred in getting a product to the market introduction stage. Costs may derive from activities such as thinking of the product idea, developing the technology, determining the product features and quality, establishing sufficient manufacturing capacity, preparing the product branding, ensuring trade mark protection, testing the market, setting up distribution channels, and launching and promoting the product. The market introduction stage is likely to be a period of low or negative profits. As such, it is important that products are carefully monitored to ensure that sales volumes start to grow. If a product fails to become profitable it may need to be abandoned. Factors to consider during the introduction stage include:

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 Product development: Research and development of the basic technology and product concept, determining the product features and quality level.  Pricing: Should penetration pricing or a skimming price strategy be used? A skimming price strategy might be appropriate where there are very few competitors.  Distribution: Distribution might be quite selective until consumer acceptance of the product can be achieved.  Promotion: Marketing efforts are aimed at early adopters, and seek to build product awareness and educate potential consumers about the product. 3.2 Growth If the public gains awareness of a product and consumers come to understand the benefits of the product and accept it then a company can expect a period of rapid sales growth. In the growth stage, a company will try to build brand loyalty and increase market share. Profits are driven by increased sales volume due to growth in market share as well as an increase in the size of the overall market. Profits might also be driven by cost reductions gained from economies of scale, and perhaps more favourable market prices. Competition in the growth stage remains low, although new competitors are expected to enter the market. When competitors enter the market a company might be subject to price competition and increase its marketing expenditure. Factors to consider during the growth stage include:  Product improvement: Product quality might be improved, additional features and support services added, and packaging updated.  Pricing: If consumer demand is high the price might be maintained at a high level.

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 Distribution: Distribution channels might be added as consumer demand increases.  Promotion: Promotion is aimed at a broader audience. A company might spend a lot of resources on promotion during the growth stage in order to build brand loyalty. 3.3 Maturity When a product reaches maturity, sales growth slows and sales volume eventually peaks and stabilises. This is the stage during which the market as a whole makes the most profit. A company’s primary objective at this point is to defend market share while maximising profit. In this stage, prices tend to drop due to increased competition. A company’s fixed costs are low because it is has well established production and distribution. Since brand awareness is strong, marketing expenditure might be reduced, although increased marketing expenditure might be needed to retain market share and fight increasing competition. Expenditure on research and development is likely to be restricted to product modification and improvement, and perhaps research into improved production efficiency and product quality. Factors to consider in a mature product market include:  Product differentiation: Increased competition in the mature product market means that a company must find ways to differentiate its product from that of competitors. Strong branding is one way to do this.  Pricing: Prices may be reduced because of increased competition. Firms in the market should be careful not to start a price war.  Distribution: Distribution intensifies and incentives may be offered to encourage preference to be given over competing products.  Promotion: Promotion will focus on emphasising product differences and creating/maintaining a strong brand.

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3.4 Decline A product enters into decline when sales and profits start to fall. The market for that product shrinks which reduces the amount of profit available to firms in the industry. A decline might occur because the market has become saturated, the product has become obsolete, or customer needs or preferences have changed. A firm might try to stimulate growth by changing its pricing strategy, but ultimately the product will have to be re-designed, or replaced. Highcost and low market share firms will be the first to exit the industry. As product sales decline, a firm has three options: 1. Hold: Maintain production, add new features and find new uses for the product. Reduce the cost of manufacturing (e.g. move manufacturing to a low cost jurisdiction). Consider whether there are new markets in which the product might be sold. 2. Harvest: Continue to offer the product, but reduce marketing expenditure perhaps by targeting a smaller niche segment of the market. 3. Divest: Discontinue production, and liquidate the remaining inventory or sell the product to another firm. Factors to consider during a declining market include:  Product consolidation: The number of products may be reduced, and surviving products rejuvenated.  Price: Prices may be lowered to liquidate inventory, or maintained for continued products.  Distribution: Distribution becomes more selective. Channels that are no longer profitable are phased out.  Promotion: Expenditure on promotion is reduced.

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4. Criticisms The Product Life Cycle is useful for monitoring sales results over time and comparing them to products with a similar life cycle. However, the Product Life Cycle model is by no means a perfect tool. Products often do not follow a defined life cycle, not all products go through each stage, and it is not always easy to tell which stage a product is in at any point in time. Consequently, the life cycle concept is not well-suited for forecasting product sales. The length of each stage will vary depending on the product and the marketing strategies employed. A Product Life Cycle may be as short as a few months for a fad or as long as a century or more for a product like petrol cars. In many markets the product life cycle is longer than the planning cycle of the organisations involved. Major products often hold their position for several decades or more, indeed, Coca-Cola was introduced in 1886 and is still the leading brand of cola. The Product Life Cycle is only one of many considerations that a company needs to bear in mind. The product life cycle of many modern products is shrinking, while the operating life for many of these products is lengthening. For example, the operating life of durable goods like household appliances has increased substantially. As a result, a company that produces these products must take their market life and service life into account when planning. Some critics have argued that a Product Life Cycle can become selffulfilling. For example, if sales peak and then fall a manager may conclude that a product is in decline and cut back on marketing, thus precipitating a further drop in sales.

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3.6 Cost Management 1. Cost Structure In order to understand a company’s costs, it will help to break each business unit down into the collection of activities that are performed to produce value for customers. This is an application of Value Chain Analysis (see “3.2.1 Value Chain Analysis”). The way each activity is performed combined with its economics will determine a firm’s relative cost structure within its industry. In examining a firm’s cost structure, relevant considerations include: 1. What are the business’s fixed costs? For example, Sales General & Admin, overheads, rent and interest expenses, depreciation, capital costs, R&D, and wages under fixed employment contracts. 2. What are the business’s variable costs? For example, raw materials, shipping, energy, sales commissions and performance bonuses. 3. What are the main cost drivers? 4. How have costs changed over time? 5. How does the firm’s cost structure compare to the competition? A company that has more fixed costs relative to variable costs is said to have more operating leverage, and will experience a greater percentage change in profits for a given percentage change in sales. Firms with high operating leverage tend to be in industries that require large economies of scale, such as the software industry. Operating leverage is a form of risk since a company with high operating leverage will require high sales volumes in order to ensure profitability. 2. Cost Reduction When developing a cost reduction strategy, three questions to consider include: 1. How long will it take to reduce major cost drivers? 2. Are the activities strategically important? The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 98

3. To what extent do the activities contribute to operational performance?

Figure 11: Cost reduction decision matrix

A company will want to eliminate or outsource costly activities that have low strategic importance. If the activity has a low contribution to operational performance it should probably be eliminated, and if it has a high contribution to operational performance it can be outsourced. A company will want to retain control of activities that have high strategic importance. This can be done by continuing with business as usual, finding ways to increase efficiency, or forming a strategic alliance with more capable firms. Twelve (12) common cost reduction techniques include: Procurement 1. Consolidate procurement or renegotiate supply contracts; HR Management 2. Reduce labour costs through decreasing salaries, training, overtime, benefits and healthcare, introducing employee stock ownership, and ‘right sizing’;

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Technology Development 3. Use IT and digital technology to reduce communication and organisational costs; 4. Employ more advanced production technology; Operations 5. Improve the utilisation rate of plant, property and equipment; 6. Outsource manufacturing to a lower cost jurisdiction (for example, China or India); 7. Relocate the centre of operations to a lower cost city, region or country; Logistics 8. Partner with distribution companies (for example, FedEx); Finance 9. Reduce working capital including inventory and accounts receivable; 10.Refinance outstanding debt; 11.Buy futures contracts to hedge against changes in commodity prices and foreign exchange rates; 12.Divest non-core assets.

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3.7 Financial Management 3.7.1 Five C Analysis of Borrower Creditworthiness When a company is trying to borrow money, executives, entrepreneurs and consultants need to be aware of the five criteria that lenders typically care about It is important to understand what lenders look for when they assess a company’s creditworthiness because companies often need to borrow money for various purposes: increasing working capital, refinancing existing debt, paying operating expenditures, conducting research and development, undertaking new product development, expanding into new markets, or pursuing M&A activity. There are five criteria that most lenders use to assess a borrower’s creditworthiness: 1. 2. 3. 4.

Capacity to generate sufficient cash flows to service the loan; Collateral to secure the loan in case the borrower defaults; Capital that shareholders have invested in the business; Conditions prevailing in the borrower’s industry and the broader economy; and 5. Character and track record of the borrower and the borrower’s management. It is important to bear in mind that lenders don’t give equal weight to each criterion and will use all five criteria to create an overall impression of a company’s creditworthiness. Lenders are typically cautious and weakness in one of the five criteria may offset strength in all of the others. For example, if a company is in a cyclical industry (e.g. construction, auto, or aviation) the company may find it difficult to borrow money during an economic downturn even if the company shows strength in all of the other criteria. Similarly, if a company’s The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 101

management has a bad reputation and poor track record then the company may find it difficult to borrow money even if it has a strong financial statement. Taken together, these five criteria indicate a borrower’s ability and willingness to repay its debts. As such, if you a company aiming to raise finance, or are advising such a company, it is important to ensure that the company can satisfy prospective lenders on each of the five criteria. Below we consider each of the five criteria in more detail. 1. Capacity Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness. The borrower must be able to satisfy the lender that it has the ability to repay the loan. To satisfy itself of the borrower’s capacity, the lender will consider various factors including: 1. Profitability: What are the revenues and expenses of the borrower? 2. Cash flows: How much cash flow does the business generate? The lender is interested not only in cash flows from operations, but also cash flows from investing and financing activities. What are the timing of cash flows with regard to repayment? 3. Payment history: What is borrower’s payment history and track record of loan repayment? 4. Debt levels: How much debt does the borrower have? How much debt can the borrower reasonably afford to repay? 5. Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry? 6. Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will typically evaluate before lending money: for example, Debt to Equity Ratio, Debt to Asset Ratio, Current Ratio, Quick (Acid Test) Ratio, and Operating Cash Flow Ratio. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 102

2. Collateral While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment. Collateral represents the assets that are provided to the lender to secure a loan. In the event that the borrower defaults, the collateral may be seized by the lender to repay the loan. A borrower will usually need to provide a lender with suitable collateral. To do this, the borrower normally pledges hard assets like real estate, office equipment or manufacturing equipment. However, accounts receivable and inventory might also be pledged as collateral. Service businesses and small companies may find it difficult to provide lenders with the collateral they require because they have fewer hard assets to pledge. If the borrower doesn’t have the necessary collateral, the lender may require personal guarantees from the borrower’s directors or from a third party such as the borrower’s parent company. 3. Capital Capital is the money that shareholders have personally invested in the business. Capital represents the money that shareholders have at risk if the business fails. Lenders are more likely to lend money to a borrower if shareholders have invested a large amount of their own money in the business. If the business runs into financial difficulty, then the capital of the business provides a cushion for repayment of the loan. If shareholders have a large amount of capital invested in the business, this indicates they have confidence in the venture and that they will do all that they can to ensure the borrower does not default on the loan.

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4. Conditions Conditions refer to two factors that the lender will take into account. Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally that could affect the borrower’s ability to repay the loan. For example, during recessions and periods of tight credit it becomes more difficult for small businesses to repay loans and more difficult for lenders to find money to lend. Thus, during these periods a small business will find it difficult to borrow money and must present lenders with a flawless loan application. In considering the overall economic climate a lender may consider various questions including: 1. What is the current business climate? 2. What are the trends for the borrower’s industry? How does the borrower fit within them? 3. What is the short and long-term growth potential for the industry? 4. Where does the industry fall within its life cycle? Is it an emerging or mature industry? 5. Are there any economic or political hot potatoes that could negatively impact the borrower’s growth? Secondly, conditions refer to the intended purpose of the loan. The borrower’s reasons for seeking the loan should be spelt out in detail in the loan application. Will the money be used to buy new equipment for expansion? Will the money be used to replenish working capital to prepare for a seasonal inventory build-up? 5. Character Character refers to the general impression that the borrower forms about the prospective lender. The lender will form a subjective judgement as to whether the borrower is sufficiently trustworthy to repay the loan. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 104

Lenders want to place their money with companies that have impeccable credentials. Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include: 1. What is the character of each member of the management team? 2. What reputation do management have in the industry and the community? 3. What educational background and level of experience does management have? 4. What is management’s track record? 5. What is the overall consumer perception of the borrower? 6. Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions? 7. Does the borrower have a track record of fulfilling its obligations in a timely manner? 8. What is the borrower’s payment history and track record of loan repayment? 9. Are there any legal actions pending against the borrower? If so, what is the reason for these legal actions?

3.7.2 Net Present Value NPV is a simple tool that executives and consultants can use to determine whether an investment should be undertaken. The NPV of an investment is the present value of the series of expected cash flows generated by the investment minus the cost of the initial investment The net present value (NPV) of an investment is the present value of the series of expected cash flows generated by the investment minus the cost of the initial investment, and can be written as follows: 𝑁𝑃𝑉 =

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 + + ⋯ + + − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =

𝐶𝐹𝑛 × (1 + 𝑔) 𝑟−𝑔

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Where r = discount rate; CFt = expected cash flow in period t; g = long term cash flow growth rate. NPV is a simple tool used to assess whether an investment should be undertaken. As a general rule, assuming you have selected an appropriate discount rate, only investments that yield a positive NPV should be considered for investment. 1. The Discount Rate The rate used to discount future cash flows to their present value is an important variable in the net present value calculation. The choice of discount rate will depend on the situation. 1.1 Cost of capital One option is to use a firm’s weighted average cost of capital. However, there are two potential problems with using the cost of capital for the discount rate. Firstly, it may not be possible to know what the cost of capital will be in the future. Secondly, the cost of capital does not take into account opportunity costs. A positive NPV calculation tells us that the investment is profitable, but does not tell us whether the investment should be undertaken because there may be even more profitable investment opportunities. 1.2 Opportunity Cost A second option is to use a discount rate that reflects the opportunity cost of capital. The opportunity cost of capital is the rate which the capital needed for the project could return if invested in an alternative venture. Obviously, where there is more than one alternative investment opportunity, the opportunity cost of capital is the expected rate of return of the most profitable alternative.

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2. Potential Issues 2.1 Negative future cash flows One potential problem with NPV is that if the future cash flows are negative (for example, a mining project might have large clean-up costs towards the end of a project) then a high discount rate is not too cautious but too optimistic. A way to avoid this problem is to explicitly calculate the cost of financing losses after the initial investment. 2.2 Adjusting for risk Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project that does not necessarily mean that this is a valid way to adjust a net present value calculation. One reason for this is that where a risky investment results in losses, a higher discount rate in the NPV calculation will reduce the impact of such losses below their true financial cost. 2.3 Negative NPV The general rule is that only those investments that yield a positive NPV should be considered for investment. However, this will only be true if we have selected an appropriate discount rate. For example, if the appropriate discount rate is 15% but we used a higher discount rate to calculate NPV, then obtaining a negative NPV does not mean that the project should be rejected.

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3.8 Organisational Cohesiveness 3.8.1 McKinsey 7 S Model The 7 S Model can help executives and consultants understand the inner workings of an organisation, and can provide a guide for organisational change 1. Background Developed around 1978, the 7 S model first appeared in a book called The Art of Japanese Management by Richard Pascale and Anthony Athos, and also featured in In Search of Excellence by Tom Peters and Robert Waterman. McKinsey has adopted the 7 S model as one of its basic analysis tools. 2. Relevance The 7 S model is a useful diagnostic tool for understanding the inner workings of an organisation. It can be used to identify an organisation’s strengths and sources of competitive advantage, and also to identify the reasons why an organisation is not performing effectively. As such, the 7 S model can be a useful analysis tool for mangers, consultants, business analysts and potential investors. The 7 S model can provide a guide for organisational change. The framework maps a group of interrelated factors, all of which influence an organisation’s ability to change. The interconnectedness among each of the seven factors suggests that significant progress in one area will be difficult without working on the others. The implication is that, if management wants to successfully establish change within an organisation, they must work on all of the factors, and not just one or two.

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

Figure 12: McKinsey 7 S Model

The seven (7) factors considered by the 7 S Model include: 1. Shared values refer to the values that are widely practiced within an organisation and which form its core guiding principles. Shared values may include things like the purpose of the organisation and its long term vision for the future. For example, the core guiding principle at McKinsey is ‘professionalism’. 2. Strategy refers to the plans that a company has for gaining a sustainable competitive advantage (e.g., low cost or differentiated products; new product development and entering new markets).

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3. Skills refers to the competencies of the organisation, the skills and experience of staff, management practices, and the ability to innovate. 4. Structure refers to the way in which an organisation’s people and business units relate to each other. This includes organizational structure, communication channels, and chain of command. 5. Staffing refers to the recruitment, selection, training, development, and management of talent. 6. Style refers to the work culture, the leadership style of upper management and the way things are done in the course of day-today operations. 7. Systems refers to the organisation’s processes and procedures for things like budgeting, communication, recruitment, compensation, and performance reviews.

3.9 Competitive Response A competitor’s recent or impending actions may call for a competitive response. When placed in this kind of situation, a company should first examine the business situation to see what kind of response might be appropriate. Have customer needs and preferences changed? What actions have the competition taken or threatened to take? Are they offering new or different products? Have they changed their pricing strategy? Are they using new raw materials or distribution channels? Have they gained market share or entered new markets? Have they changed their cost structure or increased their operating efficiency? Potential competitive responses might include:  Product innovation: Redesign, repackage or improve existing products; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 110

 Product development: Introduce new products;  Pricing: Change the pricing strategy. See “3.5.1 Four Ps Framework”;  Marketing: Increase brand recognition and improve customer loyalty;  Customer service: Improve customer service and introduce customer loyalty programs;  New market entry: Enter new markets. This might be achieved by launching a start-up, acquiring a competitor, or forming joint ventures;  Control suppliers and channels: Monopolize key suppliers and distribution channels through acquisition or by entering into long term contracts;  Mimic: Observe the competition and mimic their behaviour;  Attack: Seek to undermine the competition by poaching key employees, entering one of its other markets, launching a patent lawsuit, or attacking it in the media. Case Example A situation might unfold in which CanadaCo, the largest discount retailer in Canada by market share, is forced to respond to a competitive threat from USCo, the largest discount retailer in the United States, which has decided to expand into Canada by purchasing CanadaCo’s competition. The question is, how should the CEO of CanadaCo respond? In the CanadaCo example, it would be important to test the hypothesis that USCo has a cost advantage due to economies of scale in the US market. A cost advantage would allow USCo to provide lower prices to Canadian consumers and, as a result, USCo’s entry into the Canadian market might be expected to reduce CanadaCo’s market share.

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Once the business situation and the relative strengths and positions of USCo and CanadaCo are fully understood, it will then be possible to formulate a competitive response. CandaCo could opt to do nothing, or respond in one or more of the following ways: 1. 2. 3. 4.

Change its pricing strategy; Hire top executives away from USCo; Acquire or merge with a competing company; Rouse customer loyalty through rewards programs and customer service; 5. Mimic USCo’s behaviour by entering the US market; or 6. Market CanadaCo’s products in order to build brand recognition.

3.10 Corporate Turnaround When faced with the challenge of turning around and restructuring a company, it is important to ask a variety of questions to determine the source of the problem. What is the state of the economy? What have been the prevailing trends in the industry? Are competitors facing the same problems? Are there issues with the company’s finances? Is the company publicly traded or privately held? Below we outline eight (8) actions that a company might pursue as part of a turnaround: 1. Examine and understand the company, its finances and operations; 2. Talk to key stakeholder including suppliers, distributors and customers; 3. Review the company’s culture, management team and existing talent; The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 112

4. Review the company’s products and services; 5. Secure sufficient funding to give the company the time and resources needed to pursue a turnaround strategy; 6. Establish and prioritize short term and long term goals; 7. Prepare a business plan; 8. Prioritize small successes in order to build positive momentum. Case Example Take RadioShack as an example, which filed for bankruptcy protection in February 2015. Assuming a turnaround is possible, what strategy should be followed to save the company? Looking at the stock price of RadioShack over the past fifty years, it is apparent that the dotcom boom represented the height of success for the company. RadioShack had developed a reputation as the ultimate shopping destination for budding innovators and engineers. But unfortunately the company failed to modernize, doing little to transform itself into a destination for mobile buyers. By comparison, rivals Amazon and Wal-Mart have continuously adapted and maintain a significant competitive advantage in pricing these products due to scale. In a competitive landscape fraught with declining sales of consumer electronics and falling margins, RadioShack has fallen into a precarious situation. As of 15 January 2015, RadioShack closed 175 underperforming brick and mortar stores and may close further stores as part of restructuring plans. This should present the company with the opportunity to reinvent product offerings and create a new culture. A strategy that RadioShack might consider is to return to its roots as a place of innovation by offering specialty and niche products that are unavailable through the company’s major rivals. Shifting the product The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 113

focus would need to be accompanied by a shift in employee training, encouraging hiring practices that target inventive individuals that can appropriately engage with the new desired consumer base. Rather than attempt to compete with pre-existing rivals, RadioShack should carve out a new niche in the consumer electronics market that celebrates the pioneers and the mavericks.

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4. General Concepts and Frameworks This section contains concepts and frameworks designed to deepen and broaden your understanding and ability to analyse business situations.

4.1 Barriers to Entry Barriers to entry represent the costs that must be paid by a new market entrant but not by firms already in the industry. Barriers to entry reduce the threat posed by potential competitors by making a market less contestable, and allow existing firms to maintain higher prices than would otherwise be possible. Below we outline eight (8) examples of barriers to entry: 1. Economies of Scale The existence of economies of scale in an industry creates a barrier to entry. Since existing firms are already producing they are often in a better position to exploit economies of scale than a new entrant and, as such, can often undercut on price. A new entrant is forced either to accept the cost disadvantage or enter the industry on a large scale (which increases the likely financial loss if they are later forced to exit the industry). 2. Network Effects If existing products or services in the industry benefit from Network effects then it may be difficult for new firms to enter the industry. 3. Product Differentiation If there is a high level of product differentiation in the industry then this creates a barrier to entry since new entrants will not be able to compete merely on price, but will need to provide a unique value proposition. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 115

Sources of product differentiation include: 3.1 Branding: If existing firms and products have strong brand recognition then this will deter new entrants. If customers perceive existing products as unique or high quality then a new entrant will need to spend money to educate customers about the unique qualities and benefits of its products. This will increase the cost of gaining market share and deter entry into the market. 3.2 Customer service: If existing firms have strong customer relationships formed through customer service and customer loyalty programs then it may be difficult for new entrants to gain market share. 3.3 Product differences: Existing products in the industry may be different due to differing design, quality, benefits, features, or availability. 4. Capital Requirements High start-up costs: High fixed start-up costs will deter new firms from entering an industry. Examples of capital intensive industries with high fixed costs include the automotive and telecommunications industries. High sunk costs: If a large portion of the start-up costs cannot be recovered (that is, they are Sunk costs) then a new entrant risks having to absorb the loss if it decides to exit the industry. Examples of sunk costs include:  Specialised assets: Highly specialised technology or equipment that cannot be used for other purposes and which cannot be sold (or can only be sold at a steep discount); and  Industry specific expenditure: Industry specific expenditure, such as marketing or R&D, which cannot be used to benefit the firm’s operations in other industries.

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5. Intangible Assets Proprietary product technology: The existence of proprietary product technology represents a barrier to entry. If an existing product is protected by patent then it will not be possible for a new entrant to use the patented technology without permission from the patent owner. Specialised knowledge: Incumbents may possess specialised knowledge, skills or qualifications which are difficult or costly to acquire, for example, legal or medical certifications. 6. Access to Suppliers and Buyers Access to raw materials: If a new entrant cannot gain access to raw materials then this represents a barrier to entry. If existing firms have exclusive long term contracts with suppliers, or existing firms own key suppliers, then this will make it difficult for a new entrant to obtain the raw materials it needs to operate effectively in the industry. Access to distribution channels: If a new entrant cannot gain access to distribution channels then this represents a barrier to entry. If there are a limited number of wholesale or retail distribution channels, or existing firms have exclusive long term contracts with distributors then this will make it difficult for a new entrant to reach the customer. For example, McDonalds often has stores in the best locations which makes it more difficult for new restaurants to compete with it. Switching costs: If customers face high switching costs, then it will be more difficult for a new entrant to gain market share. Switching costs will be affected by various factors including the length of customer contracts, the existence of customer loyalty programs, and the price performance and compatibility of complimentary products.

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7. Government Policy 7.1 Government Regulation The government may limit or restrict entry into a market by requiring market participants to obtain a licence or other government approval in order to carry on business; examples include taxi licenses, safety standard compliance certificates, mining permits, and investment approvals. In extreme cases, the government may make competition illegal by establishing a statutory monopoly. For example, AT&T had a statutory monopoly in the telecommunications industry in the United States until the early 1980s. 7.2 Tariffs and Subsidies Government regulations that subsidise or tax the activity of all industry participants do not represent a barrier to entry. For example, tariffs, quotas or subsidies that apply equally to incumbents and new entrants are not barriers to entry. That being said, tariffs and quotas may pose barriers to entry where they protect the market share of existing firms or prevent new firms from gaining access to the market. Similarly, subsidies may pose a barrier to entry where they operate solely or predominantly for the benefit of incumbents. 8. Competitive Response A potential entrant’s expectations about how existing firms will respond to market entry by a new player will affect their entry decision. If a potential entrant reasonably expects, or irrationally fears, that existing firms will compete aggressively then this may deter entry. Expectations of a strong competitive response from incumbents will be higher where: The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 118

1. Industry growth is slow, which means the industry will not be able to absorb new entrants without the profitability of incumbents being hurt; 2. Incumbents have a lot of fighting potential including large cash balance, strong cash flow, unused credit facilities, or clout with government, distribution channels and customers; and 3. Incumbents are likely to cut prices due to industry wide excess capacity or a desire to retain market share.

4.2 Cost Benefit Analysis The cost benefit analysis is a basic analysis framework that involves weighing up the costs and benefits of one course of action against one or more other courses of action. 1. Relevance The cost benefit analysis is one of the most straightforward ways to compare one course of action against another. Business leaders need to constantly evaluate options, and consultants are paid to provide recommendations to help executives make these decisions. 2. Cost Benefit Analysis Explained The cost-benefit analysis is one of the most basic analysis frameworks that can be used to examine a business problem, and involves weighing up the expected costs and benefits of one course of action against another. Understanding the relative benefits and costs of the available options can make it easier to select a course of action and identify whether further information is required.

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3. Case Example Consider the following situation. Your client is a mining company and presents the following problem, “We currently own and operate a gold mine, Mine A, and we are trying to decide whether to expand Mine A or build a second mine, Mine B. Which project should we undertake?” In this problem there are three possible options: 1. Expand Mine A; 2. Build Mine B; or 3. Do nothing. To make a recommendation, it is necessary to consider the benefits and costs of each potential course of action. In this example, the benefits are the expected revenues from pursuing each option (revenue=quantity x price), and might be estimated using a discounted cash flow model. Costs derive from various sources, and there are four types of cost that should be considered: 1. 2. 3. 4.

Sunk costs; Fixed costs; Variable costs; and Opportunity costs.

1. Sunk Costs Sunk cost are expenditures that have already been made and which cannot be recovered. As a result, they should not be factored into the decision-making process. For example, in our mining example the original cost of building Mine A is a sunk cost. The money was spent in the past, it cannot be recovered, and so it should not affect the current decision.

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2. Fixed Costs Fixed costs are costs that do not vary with the quantity of output produced. In our mining example, fixed costs might include things like rent, wages, land taxes, utilities and overheads. It is important to remember that fixed costs are fixed only in the short term. For example, wages may be a fixed cost in the short term if the company cannot vary the number of employees due to contractual obligations. In the long run, however, these contracts could be renegotiated. In the long run, nearly all costs are variable, even things like rent, because a company can always move its operations to new premises or to a lower cost jurisdiction. 3. Variable Costs Variable costs are costs that vary with the quantity of output produced. In our mining example, the main variable costs would be the cost of extracting ore from the ground, and the cost of transportation. When making decisions in the short run, variable costs are the only costs that should be considered because a company will not be able to change its fixed costs. 4. Opportunity costs The opportunity cost of pursuing a course of action is what must be given up in order to pursue it. In our mining example, failing to consider opportunity costs could lead to the wrong decision being made. For example, if expanding Mine A is expected to produce a $1 million profit and building Mine B is expected to produce a $2 million profit, which project should the company pursue? The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 121

Building Mine B appears favourable, but the company also needs to consider the opportunity cost. If ‘business as usual’ is expected to produce an even greater profit, then the opportunity cost of pursuing either project exceeds the expected payoffs, and so the company should not take action.

4.3 Economies of Scale Economies of scale exist where the average cost of producing one unit of output decreases as the quantity of output increases. 1. Relevance There are many instances when, for a firm to make a sensible decision or for a government to engage in sound policy making, an understanding of economies of scale is helpful. 1.1 Barriers to entry The existence of economies of scale in an industry creates a barrier to entry (for more information, see “4.1 Barriers to Entry”). This is relevant for firms that benefit from economies of scale and want to deter new entrants from entering their industry. This might be done by investing in excess capacity, which can be used to compete aggressively in response new entrants. 1.2 Natural monopoly An industry is a natural monopoly if one firm can produce the desired output at a lower social cost than two or more firms. That is, a natural monopoly exhibits economies of scale in social costs. Examples of industries that are natural monopolies include railways, water, electricity, telecommunications, and postal services. Since it is always more efficient for one firm to expand than for a new firm to be established, the dominant firm in a natural monopoly often

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has significant market power. As a result, it will make sense for these firms to be highly regulated or publicly-owned. 1.3 Free trade Economies of scale provide a justification for free trade policies since a firm may require more customers than are present in the domestic market in order to fully benefit from economies of scale. For example, it is unlikely that Airbus, based in Toulouse, would be able to operate profitably if it could only sell aeroplanes within France. 2. Importance In the early 20th century, by using assembly lines to mass produce the Model T Ford, Henry Ford became one of the richest and best-known men in the entire world. Economies of scale provide a company with two key benefits: 1. Increased market share: Lower per unit costs can allow a company to reduce prices and increase market share. Economies of scale allow larger companies to be more competitive and to undercut smaller firms. 2. Higher profit margins: If a company is able to maintain prices, then lowering the average cost per unit will result in higher profit margins. 3. Economies of Scale Explained Economies of scale may result from the increased output of an individual firm (internal economies of scale) or from the growth of the industry as a whole (external economies of scale).

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Figure 13: Economies of scale exist where the average cost of producing one unit of output decreases as the quantity of output increases

3.1 Internal economies of scale Internal economies of scale are the cost savings that accrue to a firm as its output increases. A firm will benefit from internal economies of scale where it has high fixed costs and low variable costs since it will be able to spread fixed costs over more units of output as production increases. Below we list seven (7) potential sources for internal economies of scale: 1. Lower input costs: A larger firm may have more bargaining power with suppliers that it can use to negotiate lower prices for raw materials by bulk buying or entering long term contracts. 2. Efficient technology: As output increases it may become economical for a firm to invest in more advanced production technology leading to lower average costs. 3. Research and development: Research and development is a large fixed cost for many firms. As a company increases output, R&D can be spread over more units of output. 4. Access to finance: A large company will typically find it easier to borrow money, to access a broader range of financial instruments, and may be able to borrow at lower interest rates.

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5. Marketing: Many marketing costs are fixed costs, and so as output increases a firm can spread this cost over a larger number of units thereby reducing the average marketing cost per unit. 6. Specialisation of labour: In a larger company, employees are able to become more specialised in the tasks that they perform. For example, different managers might specialise in operations, marketing, human resources and finance. Specialist managers are likely to be more effective and efficient since they are likely to have a higher level of experience as well as role specific training and qualifications. 7. Learning by doing: Workers will improve their productivity by regularly repeating the same tasks (see “4.5 Experience Curve”). 3.2 External economies of scale External economies of scale arise when firms benefit from the way in which the industry is organised. Below we list three (3) potential sources of external economies of scale: 1. Improved transport and communication links: As an industry becomes established in a particular location, the government is likely to provide better transport and communication links to the region. This benefits firms as they will be able to reduce related expenses. Improved transport will also allow firms to attract more customers, and recruit from a broader pool of employees. 2. Industry specific training and education: As an industry becomes more dominant, universities will offer more courses tailored for a career in that industry. For example, the rise of the IT industry led to a proliferation of IT courses. Firms benefit from being able to recruit from a larger pool of appropriately skilled employees. 3. Growth of support industries: If a network of suppliers and other support industries grows alongside the main industry then firms will be able to purchase higher quality inputs at lower cost.

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4. Diseconomies of scale ‘Diseconomies of scale’ exist where the average cost of production increases as output increases. As a firm grows it is likely to become more complex to manage and run. Diseconomies may result from increasing bureaucracy, problems with motivating a larger work force, greater barriers to innovation and entrepreneurial activity, and increased agency costs (see “Principle-agent problem”).

4.4 Economies of Scope Economies of scope exist where a firm can produce two products at a lower per unit cost than would be possible if it produced only the one. Economies of scope is an idea that was first explored by John Panzar and Robert Willig in an article published in 1977 in the Quarterly Journal of Economics entitled “Economies of Scale in Multi-Output Production”. 1. Relevance The title of Panzar and Willig’s landmark article may not sound very interesting, but it does make one thing clear; economies of scope and 4.3 Economies of Scale are closely related concepts. 4.3 Economies of Scale is a fairly well known concept relevant to big producers like Intel, Microsoft, Boeing and Toyota. In contrast, economies of scope is a lesser known concept particularly relevant to small and medium sized enterprises (SMEs) that may not have access to large markets or the ability to produce at scale. SMEs are important because they represent the overwhelming majority of global business activity, and are the world’s main source of job The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 126

creation and economic growth. For example, SMEs account for around 99% of businesses in Europe (Economist Intelligence Unit 2011). 2. Importance Economies of scope provide firms with two key benefits: 1. Lower average costs: If a company diversifies its product offering it may be able to lower the average cost of production. For example, McDonalds offers a range of different products (burgers, fries, sundaes, salads, etc.). As a result, it can achieve lower per unit costs by spreading overheads across a broader range of products. Lower per unit costs allow a company to enjoy higher profit margin on each unit sold, or lower the price it charges customers in order to increase market share. 2. Diversified revenue streams: By producing multiple products, a firm can diversify its sources of revenue, which reduces the risk associated with product failure. 3. Economies of Scope Explained Economies of scope exist where a firm can produce two products at a lower average per unit cost than would be possible if it produced only one of those products. Economies of scope have been found to exist in a range of industries including banking, publishing, distribution, and telecommunications. Economies of scope and 4.3 Economies of Scale are related concepts. The distinction is that ‘4.3 Economies of Scale’ refers to the situation where the average per unit cost of production decreases as output increases, whereas ‘economies of scope’ refers to the situation where the average per unit cost of production decreases as the number of different products increases.

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Figure 14: Economies of scope exist where the average cost of producing one unit of output decreases as the number of different products increases.

3.1 Sources of Economies of Scope Below we outline seven (7) potential sources of economies of scope: 1. Common inputs: Using more of the same inputs will increase a firm’s bargaining power with suppliers. For example, Kleenex manufactures a range of products which use the same raw materials: tissues, napkins, paper towels, facial tissues, incontinence products and Huggies nappies. 2. Joint production facilities: Plant and equipment can be more fully utilised. For example, a dairy manufacturer may be able to use its existing dairy production facilities to produce a range of different dairy based products: milk, butter, cheese and yoghurt. 3. Shared overhead costs: Overheads can be shared across multiple products. For example, McDonalds can produce hamburgers, French fries and salads at a lower average per unit cost than would be possible if it produced only one of these goods. Each product shares overhead costs such as food storage, preparation facilities, restaurant space, toilets, car parks and play equipment. 4. Marketing: Marketing and advertising costs can be shared across products. For example, Proctor & Gamble produces hundreds of The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 128

products from Gillette razors to Old Spice aftershave, and can therefore afford to hire expensive designers and marketing experts and spread the cost across a broad range of products. 5. Sales: Selling products is easier when it is possible to provide customers with a range of options … “Would you like fries with that?” 6. Distribution: Shipping a range of products is more efficient than shipping a single product. For example, Amazon sells an extremely broad range of products, which enables it to negotiate favourable deals with freight companies. 7. Diversified revenue streams: A firm that sells multiple products will have lower revenue risk because it is less dependent on any one product to sustain sales. More stable cash flows are attractive for three reasons: a. They can be used to negotiate more favourable credit terms with banks. b. A strong cash position can also be used to extend credit to customers and thereby increase sales. c. More stable cash flows can allow a firm to be more innovative with new product launches because the failure of any one product will have less impact on total revenues. 4. Diseconomies of scope A firm that offers too many products may begin to incur an increase in average per unit costs with each additional product offered. Reasons for diseconomies of scope may include: 1. 2. 3. 4.

Diluted competitive focus; Lack of management expertise; Higher raw material costs due to bottlenecks or shortages; and Increased overhead costs.

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4.5 Experience Curve The Experience Curve captures the predictable and persistent relationship between increasing production experience and declining costs 1. Background The Learning Curve, the concept which predates the Experience Curve, was first described by German psychologist Hermann Ebbinghaus in 1885 as part of his studies into human memory. In 1936, T.P. Wright described the effect of learning on production costs in the aircraft industry showing that required labour time dropped by 10 to 15 percent with every doubling of production experience. In 1966, Bruce Henderson and the Boston Consulting Group conducted research for a major semiconductor manufacturer, in which they introduced the concept of the Experience Curve and revealed that unit production costs fell by 20 to 30 percent every time production experience doubled. How did BCG’s “Experience Curve” differ from the earlier concept of the “Learning Curve”? Well, in essence the two concepts capture the same big idea: performance improves with experience in a predictable and persistent manner. In his 1968 article, Bruce Henderson attempted to distinguish the two concepts by explaining that the Learning Curve relates only to labour and production inputs, whereas the Experience Curve focuses on total costs. In other words, the Experience Curve is intended to be a more comprehensive measure of how costs decline with production experience.

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2. The Experience Curve The Experience Curve captures the relationship between a firm’s unit production costs and production experience. Research has shown that a firm’s costs typically fall by a predictable amount for every doubling of production experience.

Source: Wikipedia

Unit production costs tend to decline at a consistent rate as a firm gains production experience, however the rate typically varies from firm to firm and from one industry to another. The interesting thing about the Experience Curve is not that a firm’s performance improves with experience, we would expect as much, but instead that performance tends to improve with experience at a predictable rate. This is surprising. What might explain the Experience Curve effect? 3. The Experience Curve Effect In his 1968 article, Bruce Henderson noted that: “… reductions in costs as volume increases are not necessarily automatic. They depend crucially on a competent management that seeks ways to force costs down as volume expands. Production costs are most likely to decline under this internal pressure. Yet in the long-run the average combined cost of all The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 131

elements should decline under the pressure for the company to remain as profitable as possible. To this extent the [Experience Curve] relationship is [one] of normal potential rather than one of certainty …” While falling costs may not occur with certainty, the Experience Curve effect has proved to be pervasive and has been shown to exist for different firms and across a broad range of different industry sectors. It must be the case then that declining costs are the result of certain innate human and organisational factors rather than from a specific cause, such as the brilliance of a rock star management team or the well power pointed recommendations of a top consulting firm. If top executives and consultants are not the key source of persistent organisational learning, then what is? There does not appear to be a definitive answer to this question, however seven (7) factors that are likely to contribute to the Experience Curve effect include: 1. Optimised Procurement: As a firm gains production experience it will learn more about its suppliers, which will allow it to optimise its procurement practices. Increased production may also give a firm more bargaining power with suppliers; 2. Labour efficiency: As employees gain production experience they will develop skills, learn shortcuts, and find ways to produce more with less; 3. Standardisation: Over time processes and product parts are likely to become standardised allowing for more streamlined production; 4. Specialisation: As production volume increases a firm is likely to hire more employees, allowing each of them to specialise in a narrower range of tasks and thereby perform more efficiently; 5. Product Refinement: A firm may engage in significant R&D and marketing prior to and during the initial product launch. As it learns more about the product and its customers it will be able to The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 132

refine the product, which may allow the firm to reduce ongoing R&D and marketing costs; 6. Automation: Increased production volume may make it feasible for a firm to adopt more automated and advanced production technology and IT systems; and 7. Capacity Utilisation: If a firm has incurred large set up costs, then increasing production will allow it to spread these fixed costs across a larger number of units. 4. Implications for Strategy The Experience Curve effect shows that a firm’s production costs decline in a predictable way as it gains production experience. What are the implications of the Experience Curve effect for corporate strategy? In 1968, in light of BCG’s research, Bruce Henderson took the view that a firm should price its products as low as would be necessary to dominate their market segment, or else it should probably stop selling them. The same year BCG also developed the growth share matrix, a framework which recommends allocating resources within a firm towards products that are, or are likely to become, market leaders. The clear and resounding message from Henderson and BCG was “dominate the market or don’t bother”. The thinking behind this simple and rather clear-cut view was that a company with market share leadership would be able to gain production experience more quickly than its rivals and so would be able to achieve a self-sustaining cost advantage. As it turns out though, pursuing market share leadership will not always be the best approach as there are four (4) countervailing factors that may neutralise the benefits of market share leadership.

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Firstly, market share may not confer a cost advantage since firms can learn not just from production experience but also from books, courses, formal training, conferences, reverse engineering, talking to suppliers, hiring consultants, and by poaching staff from the competition. Secondly, if multiple firms pursue market share leadership at the same time then this may create intense competitive rivalry leading to a decline in industry profitability. Thirdly, new entrants can often avoid going head to head with the market share leader by creating more advanced products or by using more efficient production technology. This can allow new players to leap frog the competition and force existing firms to play catch up by investing heavily in R&D, forming strategic alliances or acquiring the new players before they are able to dominate the market. Fourthly, even if market share leadership does confer a cost advantage there are other ways to compete effectively. Firms can also gain a competitive advantage by creating differentiated products or by targeting a niche market segment (see “3.3.1 Porter’s Generic Strategies”). So, where does this leave us? Well, a firm that aims to be the cost leader within its industry will probably want to pursue market share leadership since the Experience Curve effect and 4.3 Economies of Scale are two significant factors that will allow it to reduce costs. However, a firm that aims to compete by providing differentiated products or by targeting a market niche may find the pursuit of market share leadership to be incompatible with its chosen strategy. A firm that provides unique or targeted products will generally be able to charge higher prices and this will naturally limit potential sales volume. If it makes its products more generic or more widely available in an attempt to gain market share, then this may reduce the uniqueness of its products and require the firm to lower prices. A firm that tries to make The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 134

its products both differentiated and ubiquitous runs the risk of failing to achieve either strategy. In short, market share leadership is likely to be appropriate for firms that are competing on the basis of cost leadership. It is unlikely to be the correct strategy in every situation.

4.6 MECE Framework MECE (pronounced “me see”) stands for “mutually exclusive and collectively exhaustive” and is one of the hallmarks of problem solving at McKinsey (The McKinsey Way by Ethan M. Rasiel). 1. Benefit of the MECE Framework The MECE framework can aid clear thinking about a business problem by: 1. Helping to avoid double counting – categories of information are grouped so that there are no overlaps; and 2. Helping to avoid overlooking information – all categories of information taken together should cover all possible options. 2. MECE MECE is a framework used to organise information which is: 1. Mutually exclusive: Information is grouped into categories that are separate and distinct; and 2. Collectively exhaustive: All categories taken together should deal with all possible options without leaving any gaps. 3. MECE Tree Diagram The MECE tree diagram is a way of graphically organising information into categories which are mutually exclusive and collectively exhaustive. The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 135

The diagram as a whole represents the problem at hand; each branch stemming from the starting node of the tree represents a major issue that needs to be considered; each branch stemming from one of these major issues represents a sub-issue that needs to be considered; and so on. A major issues list should not contain more than five issues, with three being the ideal number (see Rule of Three). If you are not able to categorise a problem in five major issues then consider creating a category of “other issues”. The MECE framework can be applied to a wide variety of business problems, for example, Coca-Cola might ask the question “what is the source of declining global profitability”? To answer this question, CocaCola might use a MECE tree diagram to help it identify the source of the issue.

Figure 15: MECE Tree Diagram

4. Resources For more information on the MECE framework, please see Barbara Minto’s book Pyramid Principle.

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4.7 Moral Hazard “Moral hazard is when they take your money and then are not responsible for what they do with it.” ~ Gordon Gekko Moral Hazard refers to any situation where a person is not fully responsible for the consequences of their actions. As a result, they may take greater risks than they would have otherwise. 1. Relevance The 2008 financial crisis caused the largest recession since the great depression. According to the US Department of the Treasury as many as 8.8 million jobs were lost and $19.2 trillion in household wealth was wiped out (US Treasury Report). At the heart of the great recession was a concept known as “moral hazard”. 2. What is Moral Hazard? Moral Hazard is a concept that is often misunderstood by politicians, journalists and economists. And so we turn to Hollywood for clarity. Gordon Gekko in the movie Wall Street captured the nature of Moral Hazard very concisely when he explained that “moral hazard is when they take your money and then are not responsible for what they do with it.” Gekko may well have borrowed his definition from Paul Krugman, Professor of Economics at Princeton University, who described Moral Hazard as “… any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”

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It is worth noting that “Moral Hazard” is an economic concept and does not necessarily imply immorality or unscrupulous dealing. Below we outline six (6) examples of where Moral Hazard shows up in practice. 1. Insurance: The provision of insurance is the most common example of where Moral Hazard tends to arise. For example, if you have comprehensive private health insurance you are more likely to visit the doctor. You may also engage in more risk taking behaviour, like bungy jumping or sky diving, because you are not responsible for paying the medical bill if things go wrong. Malcolm Gladwell provides an amusing example of “Universal Pepsi Insurance”: “Moral hazard” is the term economists use to describe the fact that insurance can change the behaviour of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you’ll drink more Pepsi than you would have otherwise. 2. Mortgage Securitisation: Mortgage securitisation is another example of where Moral Hazard shows up. The US government, motivated by a desire to expand home ownership, for many years actively encouraged bankers to make loans to people with poor credit ratings. Fannie Mae and Freddie Mac, two large government sponsored enterprises, carried out this policy through a process known as “mortgage securitisation”. Moral Hazard occurred because the banks and mortgage brokers who originated the loans were able to on-sell the loans to Fannie Mae and Freddie Mac, and so were not on the hook if lenders The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 138

ultimately defaulted. As a result, they had an incentive to make as many loans as possible, even to people with extremely poor credit ratings. 3. The Greenspan Put: The Greenspan Put is another example of where Moral Hazard comes into play. Since the late 1980’s the Federal Reserve followed a policy of significantly lowering interest rates in the wake each financial crisis (often referred to as the Greenspan Put). Lowering interest rates has the effect of increasing the amount of money available in the economy which prevents the economy from deteriorating further and stops asset prices from falling. As a result, investors were encouraged to take excessive risks because they knew that the Fed would lower interest rates if a financial crisis ensued. 4. Bank Bailouts: The provision of bank bailouts by government is another example of where Moral Hazard occurs. In 2008, in the wake of the sub-prime mortgage crisis, the US government created a US$700 billion Troubled Asset Relief Program (known as TARP) to buy financial assets from banks and other financial institutions. The bailout was intended to stabilise financial markets, make sure that credit markets remained liquid and prevent a repeat of the great depression. A worthy goal, however a big problem with TARP was that it created a large Moral Hazard. If banks come to know that government will bail them out during periods of financial instability, then they have an incentive to take excessive risks in the future. 5. Private Equity: Private equity vehicles are another example of where Moral Hazard can show up. Assume, for example, that investors give a private equity firm $100 million to invest. If the fund makes a profit of $20 million then the fund managers might take fees of 20%, or $4 million. On the other The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 139

hand, if the fund loses $20 million then the investors lose money but the fund managers are not required to cover the cost. Since the managers do not have to pay for the cost of their investment decisions if things go badly they have a strong incentive to take excessive risks. 6. The Limited Liability Company: The limited liability company presents an often overlooked example of where Moral Hazard takes place. Companies often link executive remuneration with the company’s performance on the stock market. The reason for doing this is to align the interests of executives with the interests of shareholders, in an attempt to reduce the Principle-agent problem. If the company performs well and its stock price rises then shareholders are happy and executives are paid a bonus (which might be in the form of cash or shares). However, if the company performs poorly then shareholders lose, while executives still receive their base salary and are not required to compensate shareholders. Since executives are not responsible for paying the full cost if things go badly, they have an incentive to take excessive risks in order to boost the company’s short term stock price in order to secure their bonuses.

4.8 Porter’s Five Forces The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry 1. Background Harvard Business School Professor Michael Porter, in his 1979 book Competitive Strategy, developed the Porter’s Five Forces.

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The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry (attractiveness in this context refers to the overall industry profitability). The framework can be used in the context of deciding whether to enter a new market. In determining the competitive intensity of an industry, Porter’s Five Forces include three forces from Horizontal competition (1, 2 and 3), and two forces from Vertical competition (4 and 5): 1. Existing competition: How strong is the rivalry among existing firms? 2. Barriers to entry: What is the threat posed by new entrants? 3. Substitutes: What is the threat posed by substitutes? 4. Supplier bargaining power: How much bargaining power do suppliers have? 5. Customer bargaining power: How much bargaining power do customers have?

Figure 16: Porter’s Five Forces

1. Existing Competition Factors contributing to increased competitive rivalry among exiting competitors include:  Increased number of firms, The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 141

     

Slower market growth rate, Low product differentiation, Low switching costs, Industry wide excess capacity, High fixed costs / economies of scale, High exit barriers.

For more information on the factors that will influence the strength of competition within an industry, see “3.2.3 Competitive Intensity”. 2. Barriers to entry The threat posed by new players entering the market will depend on the level of barriers to entry. High barriers to entry will reduce the rate of entry by new firms, and allow firms already in the industry to charge higher prices than would otherwise by possible. Barriers to entry might include capital requirements, economies of scale, network effects, product differentiation, proprietary product technology, government policy, access to suppliers, access to distribution channels, and switching costs. For more information on barriers to entry, see “4.1 Barriers to Entry”. 3. Substitutes Substitutes represent a form of indirect competition because consumers can use substitute products in place of one another (at least in some circumstances). For example, natural gas is a substitute for petroleum. The threat posed by substitutes will depend on various factors, including: 1. Switching costs: The cost to customers of switching to a substitute product or service; 2. Buyer propensity to substitute; 3. Relative price-performance of substitutes; and The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 142

4. Perceived level of product differentiation. 4. Supplier Bargaining Power Suppliers provide inputs to firms in an industry, for example, labour and raw materials. The ability of suppliers to extract a share of industry profits depends on the level of supplier bargaining power. For more information on the factors that will affect supplier bargaining power, see “3.2.2 Vertical Competition within the Supply Chain”. 5. Customer Bargaining Power Customers are the purchasers of goods or services produced by firms in the industry. The ability of customers to extract a share of industry profits depends on the level of customer bargaining power. For more information on the factors that will affect customer bargaining, see “3.2.2 Vertical Competition within the Supply Chain”.

4.9 Quantitative Easing Quantitative easing is a monetary policy tool sometimes employed by central banks to stimulate the economy when conventional monetary policy becomes ineffective. Normally, the central bank carries out expansionary monetary policy by lowering short-term interest rates through the purchase of short-term government securities. However, when the short-term interest rate gets close to zero it becomes impossible to lower the short-term interest rate further and so this policy tool can no longer be used to stimulate the economy (this is known as the liquidity trap). When faced with the liquidity trap, the central bank can shift the focus of monetary policy away from interest rates and towards increasing the money supply (that is, quantitative easing). To increase the money supply, the central bank creates new money electronically and uses it to buy financial assets from financial institutions. This leads to an increase The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 143

in the excess reserves held by these financial institutions, and the central bank hopes that banks will use these funds to increase lending and stimulate the economy. If the central bank increases the money supply too quickly, then this is likely to lead to price inflation since there will be more money chasing the same number of goods and services.

4.10 Rule of 70 The Rule of 70 is a simple rule of thumb that can be used to figure out roughly how long it will take for an investment to double, given an expected growth rate The Rule of 70 is a simple rule of thumb that can be used to figure out roughly how long it will take for an amount to double, given an expected growth rate. The rule can be described by the following equation: 𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥 ) =

70 𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

If the world’s GDP is growing at 4% per year then global GDP will double in about 17 years. 𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝐺𝐷𝑃 =

70 = 17.5 ≈ 17 4

If your company’s revenue is growing at 10% per month then revenues will double in about 7 months. 𝑀𝑜𝑛𝑡ℎ𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 =

70 =7 10

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4.11 SWOT Analysis SWOT Analysis is a strategic planning tool used to evaluate the strengths, weaknesses, opportunities, and threats involved in a business venture 1. Background Albert Humphrey is credited with inventing the SWOT analysis technique. 2. SWOT Analysis SWOT analysis is a strategic planning tool used to evaluate the Strengths, Weaknesses, Opportunities, and Threats involved in a business venture. It involves specifying the objective of the business venture and identifying the internal and external environmental factors that are expected to help or hinder the achievement of that objective. After a business clearly identifies the objective, SWOT analysis involves: 1. Examining the strengths and weaknesses of the business (internal factors); and 2. Considering the opportunities presented and threats posed by business conditions, for example, the strength of the competition (external factors). By identifying its strengths, a company will be better able to think of appropriate strategies to take advantage of new opportunities. By identifying weaknesses and threats, a company will be better able to identify changes that need to be made to improve performance and protect the value of its current operations. 3. Criticisms SWOT analysis has two clear weaknesses. Firstly, using SWOT analysis may persuade companies to write lists of Pros and Cons, rather than think about what needs to be done to achieve objectives. Secondly, there The Little Blue Book will give you an edge in your consulting career, so don’t share it with your friends. Tom Spencer © 2015 145

is a risk that the resulting lists will be used uncritically and without clear prioritisation. For example, weak opportunities might be used to balance strong threats. 4. Case example To help understand SWOT analysis, consider the strategy of a hypothetical soft drinks manufacturer called “Coca-Cola”. Coke is currently the market leader in the manufacture and sale of sugary carbonated drinks and has a strong brand image. Sugary carbonated drinks are currently an extremely profitable line of business. The company’s goal is to develop strategies to achieve sustained profit growth in future. 1. Strengths Coke’s strengths are its resources and capabilities that provide it with a competitive advantage in the market place, and help it to achieve its strategic objective. Coke’s strengths might include: 1. 2. 3. 4. 5.

Strong product brand names, Large number of successful drink brands, Good reputation among customers, Low cost manufacturing, and A large and efficient distribution network.

2. Weaknesses Weaknesses include the attributes of Coke’s business that may prevent it from achieving its strategic objective. Coke’s weaknesses might include: 1. Limited range of healthy beverage options, and 2. Large manufacturing capacity makes it difficult to change production lines in order to respond to changes in the market.

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3. Opportunities Changing business conditions may reveal new opportunities for profit and growth. Coke’s opportunities might include: 1. New markets into which Coke could expand, and 2. The absence of a dominant global manufacturer of healthy beverages may leave a gap in the market. 4. Threats Changing business conditions may present certain threats. Coke’s threats might include: 1. Shifting consumer preferences away from Coke’s core products, and 2. New government regulations that prevent the acquisition of large competing soft drink companies. 5. Proposed strategy Based on the foregoing analysis, the main opportunity for Coca-Cola might be the rising popularity of healthy beverages, such as water and fruit juice. The main threat may be the dominance of Coca-Cola and the increasing number of anti-trust regulations that prevent Coke from acquiring competing manufacturers. A possible strategy could therefore be to find small manufacturers of healthy beverages with quality products. Purchasing these small companies will not raise competition concerns. Coke might use its strong brand name, manufacturing capacity and distribution networks to obtain strong market penetration for the newly acquired beverages.

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