MBA795Strategy Formulation

Steven E. PhelanSteven E. Phelan

IntroductionCourse ObjectivesCourse AssessmentGroup Formation

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Company   Registration Code Company A   9099-SPN-A Company B   9099-SPN-B Company C   9099-SPN-C Company D   9099-SPN-D Company E   9099-SPN-E Company F   9099-SPN-F Company G   9099-SPN-G Company H   9099-SPN-H

The Concept of StrategyThe Concept of Strategy

The role of strategy in successA framework for strategy analysis

The evolution of strategic management

Corporate strategy and business strategy

Strategy making: Design or process?

The role of strategy

OUTLINEOUTLINE

Components of SuccessComponents of Success

MADONNA GIAP & NORTH VIETNAMESE

LANCE ARMSTRONG

GOALS Single-minded quest for stardom.

Reunification of Vietnam under Communist rule.

Winning the Tour de France

UNDER-STANDING THE ENVIRONMENT

Identified emerging trends in popular culture. Understood key success factors in showbiz

Intimate knowledge of terrain

Understanding of U.S. political system.

Diagnosis of the physical, psychological and strategic determinants of individual and team performance

RESOURCE APPRAISAL

Recognized limited raw talent. Exploited strengths in self-promotion, product development & relationship management

Recognized economic and military weaknesses and core political strengths

Systematic development of individual stamina and team capabilities

IMPLEMENT- ATION

Commitment and discipline. Charismatic leadership. Team building. Attention to detail.

Tight control. Long-term commitment. Effective propaganda. Inspirational leadership.

Clear delineation of individual roles. Alignment of incentives with team goals. Nurturing esprit de corp

Successful

Strategy

Long-term, simple and

agreed objectives

Profound understanding of the competitive

environment

Objective appraisal of resources

What Makes a Successful Strategy?What Makes a Successful Strategy?

EFFECTIVE IMPLEMENTATION

What is Strategy?What is Strategy?

Distinguishing strategy from tactics:Strategy is the overall plan for deploying

resources to establish a favorable position.Tactic is a scheme for a specific maneuver.(Plan versus strategy?)

Characteristics of strategic decisions:Important.Involve a significant commitment of resources.Not easily reversible.(Long term)

The Evolution of Strategic ManagementThe Evolution of Strategic Management

DOMINANTTHEME

1950s 1960s-early 70s Mid-70s-mid-80s Late 80s –1990s 2000s

Budgetary Corporate Positioning Competitive Strategicplanning & planning advantage innovationcontrol Financial Planning Selecting Focusing on Reconcilingcontrol growth &- sectors/markets. sources of size with

diversification Positioning for competitive flexibility &leadership advantage agility

Capital Forecasting. Industry analysis Resources & Cooperativebudgeting. Corporate Segmentation capabilities. strategy.Financial planning. Experience curve Shareholder Complexity. planning Synergy Portfolio analysis value. Owning

E-commerce. standards. — Knowledge Management—

Coordination Corporate Diversification. Restructuring. Alliances && control by planning depts. Global strategies. Reengineering. networksBudgeting created. Rise of Matrix structures Refocusing. Self -organizsystems corporate Outsourcing. ation & virtual

planning organization

MAINISSUES

KEY CONCEPTS

&TOOLS

MANAGE-MENT

IMPLIC-ATIONS

The Basic FrameworkStrategy: the Link between the Firm and its Environment

The Basic FrameworkStrategy: the Link between the Firm and its Environment

THE FIRM

• Goals & Values

• Resources & Capabilities

• Structure & Systems

THE FIRM

• Goals & Values

• Resources & Capabilities

• Structure & Systems

THE INDUSTRYENVIRONMENT

• Competitors

• Customers

• Suppliers

THE INDUSTRYENVIRONMENT

• Competitors

• Customers

• Suppliers

STRATEGYSTRATEGYSTRATEGY

SWOT or WOTS-UpAnalysis

Sources of Superior Profitability

RATE OF PROFIT ABOVE THE

COMPETITIVE LEVEL

How do we make

money?

INDUSTRY

ATTRACTIVENESS

Which businesses

should we be in?

COMPETITIVE ADVANTAGE

How should we compete?

CORPORATE STRATEGY

BUSINESS STRATEGY

Strategy Making : Design or Process?Strategy Making : Design or Process?

Strategy as Design

Planning andrational choice

INTENDEDSTRATEGY

Many decision makersresponding to multitude ofexternal and internal forces

REALIZED STRATEGY

EMERGENT STRATEGY

Strategy as Process

Mintzberg’s Critique of Formal Strategic Planning:•The fallacy of prediction – the future is unknown•The fallacy of detachment -- impossible to divorce formulation from implementation•The fallacy of formalization --inhibits flexibility, spontaneity, intuition and learning.

Mintzberg’s Critique of Formal Strategic Planning:•The fallacy of prediction – the future is unknown•The fallacy of detachment -- impossible to divorce formulation from implementation•The fallacy of formalization --inhibits flexibility, spontaneity, intuition and learning.

Strategy Making Processes within the Company: Multiple Roles of Strategy

Strategy Making Processes within the Company: Multiple Roles of Strategy

Strategy as DecisionSupport

Strategy as Coordinationand Communication

Strategy as Target

Improves the qualityof decision making

Creates consistencyand unity

Improves perform- ance by setting high aspirations

(Real-Time Strategic Thinking rather than Strategic Planning)

(Focuses Resource Allocation and Rationale)

The Role of AnalysisThe Role of Analysis

Strategy analysis improves decision processes, but doesn’t give answers.

Strategy analysis assists us to identify and understand the main issues.

Strategy analysis helps us to manage complexity (tells us what to focus on).

Strategy analysis can enhance flexibility and innovation by supporting learning.

Goals, Values and PerformanceGoals, Values and Performance

Strategy as a quest for value

What is profit?

The shareholder value approach

The shareholder value and strategy formulation

Mission and values

OUTLINE

Strategy as a Quest for ProfitStrategy as a Quest for Profit• The stakeholder approach : The firm is a coalition of interest

groups—it seeks to balance their different objectives• INDUCEMENT v. CONTRIBUTION

The shareholder approach : The firm exists to maximize the wealth of its owners (= max. present value of profits over the life of the firm)

For the purposes of strategy analysis we assume that the primary goal of the firm is profit maximization.

Rationale:1) Boards of directors legally obliged to pursue shareholder interest2) To replace assets firm must earn return on capital > cost of capital (difficult when competition strong).3) Firms that do not max. stock-market value will be acquired

Hence: Strategy analysis is concerned with identifying and accessing the sources of profit available to the firm

From Profit Maximization to Value MaximizationFrom Profit Maximization to Value Maximization

Profit maximization is an ambiguous goal Total profit vs. Rate of profit Over what time period? What measure of profit? Accounting profit versus economic profit (e.g. Economic

Value Added: Post-tax operating profit less cost of capital)

Maximizing the value of the firm:

Max. net present value of free cash flows: max. V = t Ct

(1 + r)t Where: V market value of the firm.

Ct free cash flow in time t

r weighted average cost of capital

The World’s Most Valuable Companies: Performance Under Different Profitability Measures

The World’s Most Valuable Companies: Performance Under Different Profitability Measures

COMPANY MARKET CAP.

($BN.)

NET INCOME ($BN)

RETURN ON

SALES (%)

RETURN ON

EQUITY (%)

RETURN ON

ASSETS (%)

RETURN TO

SHARE-HOLDERS

(%)

Exxon Mobil 372 36.1 19.9 34.9 17.8 11.7

General Electric 363 16.4 10.7 22.2 14.7 (1.5)

Microsoft 281 12.3 40.3 30.0 18.8 (0.9)

Citigroup 239 24.6 22.0 21.9 1.5 4.6

BP 233 22.3 9.9 27.9 10.7 10.2

Bank of America 212 16.5 27.0 14.1 1.2 2.4

Royal Dutch Shell 211 25.3 14.7 26.7 11.6 11.8

Wal-Mart 197 11.2 5.5 21.4 8.1 (10.3)

Toyota Motor 197 12.1 10.7 13.0 4.8 (22.1)

Gazprom 196 7.3 28.1 9.8 7.1 n.a.

HSBC 190 15.9 23.0 16.3 1.0 (11.8)

Procter & Gamble 190 8.7 17.3 13.7 6.4 7.2

Shareholder Value Maximization and Strategy ChoiceShareholder Value Maximization and Strategy Choice

The Value Maximizing Approach to Strategy Formulation: Identify strategy alternatives Estimate cash flows associated with each strategy Estimate cost of capital for each strategy Select the strategy which generates the highest NPV

Problems:

• Estimating cash flows beyond 2-3 years is difficult

• Value of firm depends on option value as well as DCF value

Implications for strategy analysis: • Some simple financial guidelines for value maximization

a) On existing assets—maximize after-tax rate of returnb) On new investment—seek rate of return > cost of capital

• Utilize qualitative strategy analysis to evaluate future profit potential

Valuing Companies and Business UnitsValuing Companies and Business Units

If net cash flow growing at constant rate (g)

V = C1

( r - g )

With varying cash flows which can be forecasted for 4 years:

V = C0 + C1 + C2 + C3 + VH

(1 + r ) (1 + r )2 (1 + r )3 (1 + r )3

where: VH is the horizon value of the firm after 4 years

Real OptionsThe right but not the obligation to buy an assetBlack Scholes Formula used to value financial optionsThere is hidden value in real (or strategic) options

Flexibility to speed up or slow down projectsFlexibility to abandon a projectFlexibility to shutdown a projectFlexibility to extend a project into new products or

marketsFlexibility to switch designs or plants

In general, more uncertainty and more time before committing to a decision increases the value of an option

Hence, strategists should seek explore options given time and uncertainty

ROCE

Margin(Return on

Sales)

Asset productivity(Sales/Capital

Employed)

COGS/Sales

Depreciation/Sales

SGA expense/Sales

Fixed asset turnover(Sales/PPE)

Inventory Turnover(Sales/Inventories)

Creditor Turnover(Sales/Receivables)

Turnover of other items of working capital

Performance Diagnosis: DisaggregatingReturn on Capital Employed

Performance Diagnosis: DisaggregatingReturn on Capital Employed

Past performance analysis(see Ford v. Toyota)

Shareholdervalue

creation

Shareholdervalue

creation ROCEROCE

Economic Profit

Economic Profit

MarginMargin

CapitalTurnover

CapitalTurnover

Sales Targets

Sales Targets

cogs/sales

cogs/sales

DevelopmentCost/Sales

DevelopmentCost/Sales

InventoryTurnover

InventoryTurnover

CapacityUtilization

CapacityUtilization

CashTurnover

CashTurnover

Order SizeCustomer MixSales/Account

Customer ChurnRate

Deficit Rates

Cost per DeliveryMaintenance cost

New productdevelopment time

Indirect/DirectLabor

Customer Complaints

Downtime

Accounts PayableTime

Accounts Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

Linking Value Drivers to Performance TargetsLinking Value Drivers to Performance Targets

Balanced ScorecardAn attempt to link long-term (intangible)

value drivers to financial measuresAn attempt to combat a tendency to short-

termism by CEOsFour areas:

FinancialCustomerInternalLearning & growth

FINANCIAL

F1 Return on Capital EmployedF2 Cash FlowF3 ProfitabilityF4 Lowest CostF5 Profitable GrowthF6 Manage risk

F1 Return on Capital EmployedF2 Cash FlowF3 ProfitabilityF4 Lowest CostF5 Profitable GrowthF6 Manage risk

Strategic Objectives

Financially

Strong* ROCE* Cash Flow* Net Margin* Full cost per gallon delivered to customer * Volume growth rate Vs. industry* Risk index

* ROCE* Cash Flow* Net Margin* Full cost per gallon delivered to customer * Volume growth rate Vs. industry* Risk index

Strategic Measures

C OU MS ET R-

C1 Continually delight the targeted consumer

C2 Improve dealer/distributor profitability

C1 Continually delight the targeted consumer

C2 Improve dealer/distributor profitability

* Share of segment in key markets* Mystery shopper rating

* Dealer/distributor margin on gasoline* Dealer/distributor survey

* Share of segment in key markets* Mystery shopper rating

* Dealer/distributor margin on gasoline* Dealer/distributor survey

Delight the Consumer

Win-Win Relationship

I1 Marketing 1. Innovative products and services 2. Dealer/distributor quality

I2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance

I3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management

I4 Improve health, safety, and environmental performance I5 Quality

I1 Marketing 1. Innovative products and services 2. Dealer/distributor quality

I2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance

I3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management

I4 Improve health, safety, and environmental performance I5 Quality

INTERNAL

* Non-gasoline revenue and margin per square foot* Dealer/distributor acceptance rate of new programs* Dealer/distributor quality ratings

* ROCE on refinery* Total expenses (per gallon) Vs. competition* Profitability index* Yield index

Delivered cost per gallon .Vs. competitors* Trading margin* Inventory level compared to plan & to output rate

* Number of incidents* Days away from work

* Quality index

* Non-gasoline revenue and margin per square foot* Dealer/distributor acceptance rate of new programs* Dealer/distributor quality ratings

* ROCE on refinery* Total expenses (per gallon) Vs. competition* Profitability index* Yield index

Delivered cost per gallon .Vs. competitors* Trading margin* Inventory level compared to plan & to output rate

* Number of incidents* Days away from work

* Quality index

L E & A GR RN O I WN TG H

L1 Organization Involvement

L2 Core competencies and skills

L3 Access to strategic information

L1 Organization Involvement

L2 Core competencies and skills

L3 Access to strategic information

* Employee survey

* Strategic competing (?) availability

* Strategic information availability

* Employee survey

* Strategic competing (?) availability

* Strategic information availability

Safe and Reliable

Competitive Supplier

Good Neighbor

On SpecOn time

Motivated and

Prepared

Shareholder ValueMeasures:• Market value of the firm•Market value added (MVA)•Return to shareholders

Intrinsic ValueMeasures:• Discounted cash flows•Real option values

Financial IndicatorsMeasures:• Return on Capital • Growth (of revenues & operating profits)•Economic profit (EVA)

Value DriversSources:• Market share• Scale economies• Innovation• Brands

A Comprehensive Value Metrics FrameworkA Comprehensive Value Metrics Framework

The Paradox of ValueThe Paradox of Value

The companies that are most successful in creating long term shareholder value are typically those that:

a) Have a mission—They give precedence to goals other than profitability and shareholder return;

b) Have strong, consistent, ethical values.

Examples: a) “Visionary” companies studied by Collins & Porras,

e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP

b) Boeing — Focus pre-1996: “to build great planes,” weak financial controls—yet high profitability

— Focus 1997-2003 : “creating shareholder value”—Outcome: loss of market leadership, declining profitability

(Issue of Corporate Social Responsibility)