MODULE 2

Analyze your firm’s external fit

Introduction to Strategy Audit and Evaluating External Fit

Three types of fit to evaluate a strategy

Content: Positioning,

Activities, Capabilities …

Process: Incentives, Org

structure …

Internal

External

Industry,

Competition,

Regulation …

Dynamic fit

Competitor reactions,

Technological change,

Demand changes …

The elements of a strategy Strategy = Distinctive array of interdependent choices that

address

• A desired outcome

• Where to compete (market positioning)

Product

Customers

Geography

• Value proposition

• Source of CA (strategic positioning)

• High-level (cost vs. differentiation)

• Detailed level (activities, resources, capabilities)

Strategy Audit

Industry

Background

Firm

Positioning

Activities,

Resources,

Capabilities

Drivers of profitability

By how much is profitability of a firm driven by: – Industry effects?

– Positioning effects?

– Corporate effects?

Average Return on Invested Capital in U.S. Industries, 1992–2006

0

5

10

15

20

25

30

35

40

45

0% 5% 10% 15% 20% 25% 30% 35% 40%

Nu

mb

er

of

Ind

us

trie

s

ROIC

10th percentile

7.0%

25th percentile

10.9%

Median

14.3%

75th percentile

18.6%

90th percentile

25.3%

or lower

ROIC = EBIT/(Average invested capital – excess cash)

or higher

Source: Porter, 1996)

Source: “The Five Competitive Forces That Shape Strategy” Porter, Harvard Business Review, 2008

5.9%

5.9%

10.4%

10.5%

11.7%

12.6%

13.4%

13.4%

13.7%

13.8%

13.9%

15.0%

15.4%

15.6%

16.0%

16.5%

17.0%

17.6%

19.0%

19.2%

19.5%

19.5%

21.0%

21.3%

26.4%

27.3%

28.6%

31.7%

37.6%

37.6%

40.9%

Catalog, Mail-Order Houses

Airlines

Hotels

Knitting Mills

Soft Drink Bottling

Oil and Gas Machinery

Book Publishing

Laboratory Equipment

Engines and Turbines

Bakery Products

Wine and Brandy

Mobile Homes

Cookies and Crackers

Iron and Steel Foundaries

Grocery Stores

Drug Stores

Household Furniture

Child Day Care Services

Malt Beverages

Household Appliances

Men's and Boys' Clothing

Tires

Medical Instruments

Semiconductors

Distilled Spirits

Advertising Agencies

Perfums, Cosmetics, Toiletries

Pharmaceuticals

Soft Drinks

Prepackaged Software

Security Brokers and Dealers

Source: “The Five Competitive Forces That Shape Strategy” Porter, Harvard Business Review, 2008

Average ROIC, 1992–2006

Note: Return on Equity = Net Income / Year End Shareholders’ Equity

8.7%

22.3%

20.5%

14.0%

12.3%

7.2%7.0%

3.0%

-1.6%

Positioning

Arkansas

Best Pfizer

Ave

rag

e R

etu

rn o

n E

qu

ity,

1

98

2–

1993

Hunt Roadway Carolina

Freight Consolidated

Freightway

Arnold Yellow Central

Freight

Builders

Transport

18.3%19.3%

23.6%23.8%

28.9%

33.6%

22.2%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Merck Schering-

Plough

Eli Lilly

Marion

Merrell Dow Bristol-Meyers Upjohn

Pharmaceuticals Trucking

Industry Average 10.4%

Industry Average 24.2%

Value creation

Strategy Audit

Industry

Background

Firm

Positioning

Activities,

Resources,

Capabilities

Value creation and appropriation

Utility (in money)

[Willingness to pay]

Price

Cost

Supplier’s cost

Value

created

Buyer’s share

Firm’s share

Supplier’s share

Value appropriation

Industry analysis

Value appropriation—Industry Analysis: 5 Forces

Who wants to appropriate value?

– Buyers => lower price

– Suppliers => increase cost

Who else limits the amount you can appropriate? – Current competitors => lower price

– New competitors => lower price

– Substitution => lower price

– Complementors => lower WTP, or higher cost

What other factors determine profitability in your industry? – Regulation?

Supply

chain

Drivers of appropriation threats

Customer Power – Price sensitivity (volume; importance to their cost)

– Switching costs/customer lock-in (technical; brand)

– Ability to backward integrate

– For instance, shipping managers buying trucking services.

Supplier Power – How important are our sales to them?

– Switching costs for you

– Ability to forward integrate

For instance, Intel

Drivers of appropriation threats (2)

Barriers to Entry (new entry & substitutes) – Scale-based benefits; Experience, learning effects

– Capital requirements

– Value of reputation, brand

– Access to distribution

– For instance, pharma detailing to doctors vs. TL trucking.

Rivalry (existing competitors) – Number of effective competitors

– Market growth

– Degree of differentiation

– Strategic stakes

– Patents

For instance, full-service US domestic airlines

Value proposition

Strategy Audit

Industry

Background

Firm

Positioning

Activities,

Resources,

Capabilities

The elements of a strategy

Strategy = distinctive array of choices that address

– A desired outcome

– Where to compete (market positioning)

• Product

• Customers

• Geography

– Value proposition

– Source of CA (strategic positioning)

High-level (cost vs. differentiation)

Detailed level (activities, resources, capabilities)

Value Proposition

Customers care about (WTP – Price), not just one or the other

One can create value by increasing the customer’s willingness to pay or by

decreasing cost (iPod vs. Southwest)

What factors drive willingness to pay?

What factors drive cost?

Willingness to pay

Price

Cost

Value

created

Value

appropriated by

customer

How to assess WTP

Engineering estimate: – WTP = Current price + (non-price) cost savings – switching costs

Focus groups: – Assess indifference point between $ and the product

Quantitative analysis: – Survey of potential customers: give various options of features and prices and customers

make (hypothetical) choices; from this one can estimate elasticities

– E.g., refrigerator: $1 annual savings from energy consumption = $2.45 higher WTP

Auctions

Competitive advantage

What is the size of your competitive advantage?

CA = (WTP – Cost)you – (WTP – Cost)strongest competitor

Or

CA = (WTP – WTPcompetitor) + (Costcompetitor – Costyou)

Why is Porsche still around?

The role of nationality in buying cars

Cup holders

Implications

CA = (WTP – Cost)you – (WTP – Cost)strongest competitor

To appropriate value, you need to create more value than your competitors

You need to create some asymmetry in WTP and/or in Cost

Being different, i.e., doing different things, is what is at the heart of strategy.

Positioning

Strategic Positioning

Relative Cost Position

WTP

Low

High

High Low

Productivity Frontier

(State of Best Practice)

Source: “What Is Strategy?” Porter, Harvard Business Review, 1996

Strategic Positioning in the Airline Industry

Cost

WTP

SQ

US SWA

BA

LOW

LOW

HIGH

HIGH

Differentiation and Cost Drivers

WTP drivers

Brand

Technological performance

After-sale services, etc.

WTP(a, b, c, ..)

WTP = “a*a + b*b + g*c + …“

Different segments differ in their weights

Cost drivers

Production costs

Logistical costs

Transportation costs

Service costs

WTP drivers for airlines

Worst in

industry Average

Best in

industry

1 2 3 4 5

Drivers of WTP:

Number of flights/Coverage

Point-to-point

On-time arrival/departure

Bags arrive

Meals

Lounges

Quality of frequent flier program

Friendly service; quality of seats

Market positioning

The elements of a strategy

Strategy = distinctive array of choices that address – A desired outcome

– Where to compete (market positioning)

• Product

• Customers

• Geography

– Value proposition

– Source of CA (strategic positioning)

High-level (cost vs. differentiation)

Detailed level (activities, resources, capabilities)

Market Positioning

Identify the two, three dimensions on which firms differentiate themselves in

the market

Plot your position vs. those of your competitors

Provides an idea of where in the market space strategic convergence is likely

to happen and where there might be opportunities

Market Positioning in US Fast Food

High

Price

High

Quality

Low

Price

Low

Quality

Strategy Audit Summary

Strategy Audit Summary

What is the condition of the industry today?

Where is the industry going?

What are the WTP and cost drivers for different segments?

Where are we positioned? Where are our competitors positioned?

Where are our competitors moving?

How strong are our capabilities vs. competitors vs. world-class?

What are our key activities? Are they OE or SP?

How are we using corporate? How are we leveraging other divisions?

Strategy Audit

Industry

Background

Firm

Positioning

Activities,

Resources,

Capabilities

Strategic

Initiatives

• Industry

Analysis

• Scenarios

• Drivers of Cost

and WTP

• Strategic

Positioning

• Value Chain

• Activity System

Tools

Analyze the Structure of Your Industry Assignment

Industry Attractiveness

Highly

Unattractive

Mildly

Unattractive

Neutral Mildly

Attractive

Highly

Attractive

Threat of Value

Appropriation

by Customers

Size of key customers:

Price sensitivity:

Switching costs (technical):

Switching costs (brand):

Ability to backward integrate:

High

Customer

Power

Large

High

Low

Low

Easy

Low

Customer

Power

Small

Low

High

High

Difficult

Threat of Value

Appropriation

by Suppliers

Size of key suppliers:

Price sensitivity:

Your switching costs (technical):

Your switching costs (brand):

Ability to forward integrate:

High

Supplier

Power

Large

High

High

High

Easy

Low

Supplier

Power

Small

Low

Low

Low

Difficulty

Rivalry among

competitors

Number of effective competitors:

Market growth:

Degree of differentiation:

Strategic stakes:

Patents protect profits:

High Rivalry

Large

Slow

Little

High

No

Low Rivalry

Small

Fast

High

Low

Yes

Industry Attractiveness

Highly

Unattractive

Mildly

Unattractive

Neutral Mildly

Attractive

Highly

Attractive

Barriers to

Entry

Scale-based benefits:

Experience, learning effects:

Capital requirements:

Value of reputation, brand:

Access to distribution:

Low Entry

Barriers

Little

Little

Small

Unimportant

Unimportant

High Entry

Barriers

Large

Large

Large

Important

Important

Substitutes

Availability of close substitutes

for product or services:

Many

substitutes

Few

substitutes

Regulatory

Factors

Impact of regulatory

Changes:

Negative Positive

Industry Attractiveness

Highly

Unattractive

Mildly

Unattractive

Neutral Mildly

Attractive

Highly

Attractive

Complementors Other firms have exclusive

relationships with

complementors vs. we

have these relationships:

Negative Positive

Other Factors Negative Positive

Other Factors Negative Positive

Industry Attractiveness

Current Future

Factors: Un-

attractive Neutral Attractive Un-

attractive Neutral Attractive

Power of Customers

(make this industry…)

Power of Suppliers

Rivalry among

Competitors

Barriers to Entry

Availability of Substitutes

Regulatory Factors

Growth Rates

(make this industry…)

Understanding the Industry

Make a mark in each row for “the average firm” and for “your firm.”

Understanding the Industry

The two most significant factors affecting industry attractiveness are:

1.

2.

The two factors most likely to change significantly are:

1.

2.

The factors for which our firm is much better/much worse positioned (if any):

1.

2.

Evaluate the Positioning of your Organization Assignment

Differentiation

Make a mark in each row for “your firm” and 2–3 competitors.

Worst in

industry Average

Best in

industry

1 2 3 4 5

Drivers of WTP:

(fill in relevant dimension)

Cost

Make a mark in each row for “your firm” and 2–3 competitors.

Worst in

industry Average

Best in

industry

1 2 3 4 5

Cost drivers:

Strategic Positioning— Now and Future

1) Where are we located?

2) Where are our competitors currently located?

3) Where do we believe our competitors are moving toward?

4) Where do we see ourselves going?

high low

relative cost position

high

low

WTP