Strategy Overview

Table of Contents

 

Strategy.......................................................................................................................................... 2


Is this an Attractive COMPANY? And Internal Alignment..................................................... 3

    STEP A. What is the strategic position of the company in the marketplace?............ 3

    STEP B. What is the combo of choices/practices (the “model” or “design”) to deliver superior economic value to the position?................................................................................................................................................. 4

    STEP C. What are the sources of uniqueness and sustainability that will protect the position and model from being copied?................................................................................................................................................. 4

 

Is this an Attractive INDUSTRY? And External Alignment.................................................... 6

    STEP A. Perform an analysis of underlying “structural” features of the industry...... 6

    STEP B. Refine and improve the above analysis by determining how industry attractiveness is being shaped by how the game is being played and strategies........................................................................................... 7

 

Dynamic Analysis and Dynamic Consistency........................................................................ 9

 

Quantitative Analysis of Profitability, CA, CP (in the Course).............................................. 9

    STEP A. A rough attempt at approximating excess economic profits......................... 9

    STEP B. A rough attempt at figuring out whether economic profits are due to competitive advantage      11

    STEP C. A rough attempt at figuring out whether economic profits are due to an attractive industry context       11

 

Corporate Strategy (and Business Strategy)........................................................................ 12

 

Designing a Strategy Statement.............................................................................................. 12

 

Additional Readings for After the Course.............................................................................. 13

 


 

Strategy 

·      The business function that integrates and guides planning across *all* other functional areas[1]

o   Ideally should provide the minimum sufficient guidance that allows functional managers to assure they take decisions in alignment with the strategy

 

·      Two big problems to solve—both follow similar principles:

1.    Designing a new company, or

2.    Analyzing an existing company

·      To improve or refine the strategy

·      To assess future prospects

·      To provide guidance to any number of particular decisions

 

·      Necessary conditions for good strategy:

o   Internal alignment” – the many interdependent decisions/practices in the business design should work together in a complementary, reinforcing way?

o   External alignment” – the business design explicitly ‘solves’ the problems and takes advantage of opportunities in the external environment

o   Dynamically alignment” – internal and external alignment managed not just for today, but for tomorrow (taking decisions today in anticipation of later opportunities and challenges)

 

·      The following notes largely follow the three preceding points

 

 


 

 

Is this an Attractive COMPANY? And Internal Alignment 

·      Strategy is always preoccupied with “fit” or “internal consistency” – the tens of thousands of decisions taken / practices implemented in a company should be taken in a coherent manner to maximize performance[2]

·      If a company can:

A.    Sustain a unique value-creating position in the economy,

B.    Implement a successful model -- set or combination of choices/practices -- to successfully deliver value to the position, and

C.   If it can somehow remain unique and defend the model or position from being copied

…then it can have a competitive advantage relative to other companies in the industry, and make excess profits (these are three necessary conditions for attaining CA)

·      NB. These three conditions map directly 1:1 to the “5-Elements”, see below

 

STEP A. What is the strategic position of the company in the marketplace?

·      What is the intended value creation?

·      (Elements i and ii in the 5 elements)

·      Phrased in many different ways in industry and various books.[3]

·      Scope of your economic activity (element-i in 5 elements)

§  Often there are several salient dimensions: Product, customers, vertical scope and activities, geography

§  It is often the case that the scope we have analyzed has been so obvious, we have jumped straight to value proposition; it is good to explicitly write down the scope to be complete.

·      Value proposition you are bringing to that scope of activities, for buyers (element-ii in 5 elements)

§  What is the value you are trying to create (relative to buyer preferences, relative to what other suppliers – competitors, substitutes – provide)

§  Value curve is terrific tool here – focus on big important issues, don’t get caught in unnecessary detail

 

STEP B. What is the combo of choices/practices (the “model” or “design”) to deliver superior economic value to the position?

·      How will value be delivered to the position

·      (Element-iii in 5 elements)

·      Phrased in many different ways in industry and various books.[4]

·      This question does NOT worry about whether the combo/model is particularly unique, let alone whether it is sustainable (see following question). The central concern in this step is to identify the particular choices/practices that deliver the promised position / value prop in a most economical manner – whether unique or not.

·      The model or combo of choices typically implies “hard choices” and tradeoffs—to excel at certain things and to be less excellent at other things. There are inherent tradeoffs in most business activities.

·      While you can use a variety of ways/frameworks/tools to generate describe key choices (diagrams with arrows, pictures of the value chain), the basic challenge here is:

§  Identify key practices/choices

§  Explain how they fit together, and thus

§  Explain how they deliver on the position

·      Where the model is not unique it is a “template” business (this does not mean that it is not profitable, but profits are not going to come from competitive advantage)[5]

 

STEP C. What are the sources of uniqueness and sustainability that will protect the position and model from being copied?[6]

·      How do you sustain uniqueness and thus capture value

·      (Element-iv or/and element-v in 5 elements)

·      The things you have that allow you to “pin down” or protect the position from being copied.

·      In principle, you need just ONE source of uniqueness/sustainability/defensibility; practically speaking, you will in all likelihood manage a portfolio of multiple (imperfect) sources of uniqueness

·      Sources of uniqueness are bound to evolve, grow, or erode--and become more or less important over time (see Dynamics)

·      Phrased in many different ways in industry and various books.[7]

·      Sources of uniqueness come in two forms:

§  Resource/asset-based advantages (element-iv in 5 elements); OR

·      What makes a competitor fundamentally different from another, because it has different assets it can draw upon

·      E.g., Scarce factors, IP, organizational capabilities

§  Position/scale-based advantages (element-v in 5 elements)

·      Even if competitors are not fundamentally different (have same assets) they might still be different and have relative advantages based solely on the “state of play” and their “positions on the game board”

·      E.g., Scale, incumbency/first-move, “strategic agility” (having no position or advantages can at least make you nimble and not beholden to any choices)


 

 


 

Is this an Attractive INDUSTRY? And External Alignment 

·      Key questions:

·      Beyond the attractiveness of the company – how attractive is the industry[8] more generally? How much does this account for excess economic profits?

·      What are the “rules of the game” -- opportunities and challenges – that the company design should externally align to

 

·      Even a firm without competitive advantage might still make excess profits if actors in the industry all “play nice”[9]

 

STEP A. Perform an analysis of underlying “structural” features of the industry

·      Analyzing attractiveness of an industry usefully begins by describing “structural features” of an industry in order to assess:

§  (i) the competitive intensity of the industry (from monopolistic to fully competitive), based on the structure and rivalry of the industry itself, the threat of more distant substitutes and possible entrants; and

§  the (ii) relative bargaining power of industry players, relative to other actors in the wider environment (upstream suppliers, downstream suppliers, etc.)

·      This approach might be phrased in many different ways in industry and various books.[10]

·      We do precisely this same thing, with two important exceptions/additions. The first exception is minor:

§  We do not assume the structure of the industry (i.e., whether it has five, six or however many distinct set of actors and who they are). Rather you are asked to assess who are the key sets of actors for yourself. [11]

·      Therefore, as a first step to analyzing the attractiveness and “rules of the game” of an industry you are asked to think through following issues:

§  Who the relevant groups of players interacting in the industry

§  What are industry characteristics shaping competitive intensity and bargaining power – and thus the overall tug-of-war to capture profits

·      e.g., Even in a relatively traditional industry as Transdigm, we found it useful to draw a sketch of the true industry structure and the multiple relationships among players (rather than artificially forcing it to conform to a particular framework) to clarify major players, competition and bargaining power

·      e.g., In our Apple discussion, the industry is quite complex and difficult to draw on the board. (See slides). But sketching out the structure of the industry and annotating the structural factors in the industry that determine competitive intensity and bargaining power gives a clear view of where profits will start to pool in the industry the inherent attractiveness of being the platform supplier

 

STEP B. Refine and improve the above analysis by determining how industry attractiveness is being shaped by how the game is being played and strategies

·      The second exception to old-style analysis is we consider not only that structure shapes strategy and conduct, but that structure and attractiveness is itself shaped by how the game is being played

§  For example, in the simulation – under identical starting conditions -- we saw VERY different outcomes, based on the strategies, patterns of choices and commitments made by different sets of competitors

§  E.g., in Nutrasweet-Holland, we saw that the way the game was played altered, investments, commitments – and ultimately shaped the industry structure and attractiveness of the industry (beyond anything that might be said about any one company’s competitive advantage)

·      Here are questions you can ask to try to refine your baseline structural analysis:

§  Within the existing competitive equilibrium, what are the strategies of key players? How much of the industry attractiveness is being shaped by those choices (rather than “immutable” structural features of the industry)

§  Can those strategies be changed (or perhaps the entire pattern of strategies – the competitive equilibrium – be changed to another)

·      E.g., Ryannair aligned better to industry structure by repositioning  away from Aer Lingus’s routes

·      E.g., Recall in the simulation discussion that Ben F mentioned his team simply repositioned to niche, once Joe/Akash/David/Amy started playing decimating the competitive landscape with scale and pricing

·      E.g., The energy drink business is now somewhat “well behaved” as it has aligned around a traditional stable relationship between Pepsi/Rockstar and Coke/Monster, and a RedBull that is reluctant to aggressively change its position or compete very aggressively… any takeover by Rockstar or Monster by aggressive investors to capture profits could (ironically) reduce profits by changing the current equilibrium (despite underlying structural conditions of cost, preferences, etc. not changing)

·      E.g., Industry attractiveness is aspartame was entirely driven by the terrible equilibrium the two players constructed for themselves – despite what would otherwise be unbelievable attractive structural conditions

·      E.g., Any structural analysis of used cars would have told you that selling cars is not necessarily an attractive business. However, by discerning the problems that needed to be solved in the industry, Carmax has begun to succeed at an unprecedented scale

§  Where there is any ambiguity, it can often be helpful to turn to quantitative analysis to more precisely understand incentives of players to play different strategies

·      E.g., analysis of fixed and marginal costs to determine how low prices could potentially be set; profits/losses when playing certain strategies, etc.

o   Ex: quantitative analysis of likely pricing scenarios and incentives to pursue different strategies in Ryannair, Boeing-Airbus, Nutrasweet-Holland, etc.

 

 


  

Dynamic Analysis and Dynamic Consistency

 

Under construction

 


 


Quantitative Analysis of Profitability, CA, CP (in the Course

 

·      In broadest brushstrokes, a company might earn excess profits (returns above competitive economic levels) for a couple reasons.

·      First, it might be truly unique and be an inherently attractive company.

·      Second, it might operate in an attractive industry, as when competition “plays nice”.

·      Or, it might be some mix of these things.

 

·      Why bother with these approximations?

·      This is just a way to tell whether your analysis of the attractiveness of the company and the industry is correct or not. Your analysis (as above) should be reconcilable with observable performance.

 

STEP A. A rough attempt at approximating excess economic profits

·      Approximation of excess economic profits of the focal company
= Operating income, minus opportunity cost of capital (“OpInc – CoC”)

 

·      What question are we trying to answer with this?

§  Does this company in fact make excess returns?

§  Is there evidence that my analysis of the design of the business and the attractiveness of the industry is correct?

·      Why operating income (including D&A, not including interest or tax)?

§  Operating income before taxes (including and D&A) gives a sense of the actual true income generated with the asset

§  Including D&A provides (an extremely rough), nets out important costs

§  (To emphasize, we want to include net income, including D&A, but excluding tax and interest. We exclude tax, as it takes us steps away from the true economics of the business. We exclude interest, and instead net out total opportunity costs of capital – which may be larger than the observable interest charges – see OppCoC, below)

·      Why “opportunity cost of capital”?

§  The cost of the capital/assets employed is the return we could have sought if we redirected those resources elsewhere

§  On a per-year basis, the opportunity cost of capital/assets is their value, times the WACC; what you would have to pay to financiers for using this capital is the same as the competitive return of these assets some other use

§  You could just refer to this approximation as the “annual interest payments” or something like that, but the true concept is what you would get with all assets in some alternative use.

§  So excess returns should be the returns that EXCEED this opportunity cost of capital

·      What are some limitations with this metric as an indication of economic profits?

§  Accounting data is always problematic

§  It is backwards looking

§  It is subject to fluctuations and does not capture the full NPV of the future

·      Ex: Walmart calculations are quite well-behaved given the stability of the business

·      Ex: When we looked at Carmax, they have a positively trending stock price, but as a growth company it is not surprising (and even not bad!) that we approximate current year economic profits to be zero

·      Is this a most useful financial ratio and best predictor of shareholder returns?

§  NO. This is approximating an economic concept in order for you to assess strategic fundamentals. There are far more direct metrics indicative of financial returns.

§  OpInc-CoC provides an approximation of excess economic profits—an economic concept we will never truly observe. To the extent we can get close to this unobserved value and assess whether there are excess profits, we can better assess whether the fundamentals of the company and the industry (see above) are truly attractive.

§  Strong fundamentals should be strongly positively correlated with other financial metrics (In most cases we looked at, stock market returns were closely correlated with OpInc-CoC, albeit slightly lagged)

§  But, NO – OpInc-CoC disregards hugely important factors that influence true income – like tax! Further it looks for total economic opportunity costs which might often be ignored by accountants and sharedholders. So it is a better indicator of the underlying economics than it is the purely financial picture

·      Ex: When calculating the valuation / price of Pixar to Disney and other cases, we focused on after tax income as a basis for roughing out a valuation of the company – NOT this theoretical concept of economic excess returns

 

 

STEP B. A rough attempt at figuring out whether economic profits are due to competitive advantage

·      Approximation of excess economic profits of the focal company -
Approximation of excess economic profits of a benchmark

·      What question are we trying to answer with this?

§  Is this company’s success attributable to it being somehow special and more productive than other companies (in serving its position)? Or, is this perhaps more of a general characteristic of the industry?

§  Is there evidence that my analysis of the design of the business is correct?

·      What is a relevant benchmark?

§  Traditional Strategy textbooks and practice have tended to compare a company’s profits to those of the industry average. This is nice in that it is simple and there is no question about what it represents. This is a nice practical comparison.

§  We have tried to take one step further to ask how well “the next best company” trying to do the same thing as the focal company would perform.

§  And so, we have tried to make adjustments to get closer to an apples-to-apples comparison

·      (e.g., what are the economics of Walmart, in relation to those of Aldi? What are the economics of Airborne relative to Fedex)

·      What are some limitations with this metric as an indication of economic profits?

§  All of the limitations of using OpInc-CoC as an approximation (see above)

§  Possible subjectivity in choosing relevant benchmark

§  Possible subjectivity in making adjustments in making “apples-to-apples” comparison

·      The most powerful use of this metric

§  Is there any quantitative evidence—at all—of an competitive advantage, that this company is truly somehow special and more productive than peer companies in serving its position?

§  If your benchmark indeed was in an identical position, with the identical combination of choices and with the identical sources of uniqueness, the benchmark would--by definition—perform as well as the focal company. So what precisely is different?

 

STEP C. A rough attempt at figuring out whether economic profits are due to an attractive industry context

·      The earlier statistics approximate total excess profits, and the share of excess profits that can be attributed to the company having some competitive advantage. Here, we are interested in what is “left over”:

§  i.e.,

total excess economic profits of the focal company -
excess economic profits of the focal company from company attractiveness (i.e., competitive advantage) =

excess economic profits of the focal company that are attributable to the industry attractiveness

·      What question are we trying to answer with this?

§  Is this company’s economic profitability simply attributable to the company being in a good (or bad) industry—rather than necessarily somehow being special and unusually productive?

·      Following earlier logic, it necessarily follows (by construction) that our approximation of industry attractiveness must necessarily be as follow:

 

§  Approx of total excess economic profits of the focal company -

Approx of excess economic profits of the focal company from company attractiveness (i.e., competitive advantage)


= Approximation of excess economic profits of the benchmark
…where, as above in Step B, the benchmark is some other close company
(this is necessarily true from the math – it takes some reflection to see the intuition)

 

·      Why is this referred to as “Common Performance”?

§  This is just another word used at HBS for “industry attractiveness” in terms of the underlying economics

 



Corporate Strategy (and Business Strategy)

 

Under construction


 

Designing a Strategy Statement


Additional Readings for After the Course 

 

 

Under construction

 



[1] Footnotes are optional. Feel free not to read them. The main text is all that is needed to attack a strategy problem.

[2] Endless frameworks are used in books and in industry to address this problem Porter’s “activity system”, “business model” mapping, 3Cs, Mck’s 7S, value-loop diagrams, and many more.

[3] The simplest way to describe one’s position is as “low cost” or “differentiated”, as in Porter’s “generic strategies”. However, we want to strive for more precision here. For example, low cost models are often quite a bit different from one another, as in the case of say low-cost grocers. “Disruption theory” talks about the “the job to be done”. Using a “value curve” to articular position (see below) as we have done in class should build on each and all of these ideas.

[4] Endless frameworks are used in industry to address this problem Porter’s “activity system”, “business model” mapping, 3Cs, Mck’s 7S, value-loop diagrams, and many more.

[5]  For example, Allied and Benson do similar things, but collude. Banks and many financial services companies are not terribly unique or innovative, but they are successful in not competing too hard with one another. Coke and Pepsi compete aggressively—but in every dimension other than price. Holland Sweetener was even following the template of Nutrasweet, while being much less efficient.

[6] A subtle point: Most people in industry refer to these sources of uniqueness (resources, assets, scale and the like) themselves as “sources of competitive advantage.” This makes sense in that they are indeed things that set apart a company. At HBS we instead define these sources of uniqueness as a necessary but not sufficient condition for competitive advantage, in that you still need to exploit these sources of uniqueness with a well chosen position and finely honed model or set of choices—in order to truly REALIZE excess profits.

[7] Most books (particularly Strategy texts and “guru” airport books) discuss “capabilities”, “competencies (associated with culture, organizational knowledge, routines, etc.) without going into IP or other scarce factors, let along positional sources of advantage. An exception is “Strategic Management” by Saloner, Shepard, and Podolny.

 

[8] There is a large academic literature on this question. For example, about 20% of variation of accounting profits of business units of publicly traded corporations in the US is wholly explained simply by what industry you are in. (This is about 40% of total variation in profits that can be explained by econometric models when accounting for industry, time period, corporate entity.)

[9] This point is mostly ignored in standard Strategy textbooks today. However, it is not only a common occurrence it is even the standard assumption of oligopoly models in economics. Many large profitable businesses are full of “template” profitable oligopolists – see banking and financial services.

[10] This is used in classical “Structure Conduct Performance” approach in 20th Century Inudstrial Economics tradition, which was turned into the Five-Forces in the classical Porter model. This idea of describing the underlying structure of an industry to assess attractiveness is also echoed in McKinsey’s “SCP” framework and a number of others.

[11] For those of you with a background in using Five-Forces, if you prefer, you can simply start out by drawing 5-Forces and ask “what’s missing? What is not quite correct? What more precise detail might be nice to include? This is because the Five Forces is simply a list of the 5 sets of actors that are relevant in a simplest possible value chain.

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