CH-1-2 Strategic Leadership: Managing the Strategy-Making Process for Competitive Advantage – Strategic Management: Theory: An Integrated Approach : Book Guide

This Document Contains Chapters 1 to 2 Chapter 1 Strategic Leadership: Managing the Strategy-Making Process for Competitive Advantage Synopsis of Chapter This chapter is an introductory chapter. Its purpose is to define critical concepts and introduce the main components of the strategic leadership and management process. This chapter serves to establish the context within which subsequent chapters fit. Chapter 1 begins with a discussion of the concept of strategy. The strategies an organization pursues have a major impact upon its performance relative to its peers. The firm’s top managers have direct responsibility for choosing strategies that will lead to superior performance and provide competitive advantage. Next, the chapter equates superior performance with profitability, for profit-seeking enterprises. Sustained competitive advantage occurs when a firm is able to maintain above average profitability over an extended period of time. Strategic management is just as crucial to nonprofits as it is to profit-seeking businesses. Much of this book is about identifying and describing the strategies that managers can pursue to achieve superior performance and provide their company with a competitive advantage. The book will provide a thorough understanding of the business model analytical techniques and skills necessary to identify and implement strategies successfully. A discussion of strategic managers and the strategy-making process follows. Strategic managers are the linchpin in the strategy-making. Strategy-making is the process by which managers formulate and implement a set of strategies for a company, the aim of which is to attain competitive advantage. It examines the types of strategic managers, their roles and their responsibilities at three main levels within an organization—corporate, business, and functional. This chapter also gives an overview of the formal strategic management process. The process consists of two phases. The first phase, formulation, includes the establishment of corporate mission, values, and goals; analysis of the external environment; analysis of the internal environment; and selection of an appropriate functional-, business-, global, or corporate-level strategy. The second phase, implementation, consists of the actions taken to carry out the chosen strategy such as appropriate governance and ethics, designing an organizational structure, designing an organization culture, and designing organization controls. The traditional concept of the strategic planning process is one that is rational and deterministic, and orchestrated by senior managers. However, strategies may also emerge through other mechanisms. The next section of this chapter presents a discussion of strategic planning in practice. Formal planning helps companies make better strategic decisions, and the use of decision aids can help managers make better forecasts. However, formal strategic planning systems do not always produce the desired results. The next section of the chapter stresses the importance of strategic decision-making by providing an understanding of how cognitive biases impact strategic decision making along with techniques for improving decision making. The final section of the chapter addresses key characteristics of good strategic leadership that will lead organizations to high performance. By the end of this chapter, students will understand how strategic leaders can manage the strategy-making process, formulating and implementing strategies that enable a company to achieve a competitive advantage and superior performance. Moreover, they will have an appreciation for how the strategy-making process can go wrong, and what managers can do to make this process more effective. Learning Objectives 1. Explain what is meant by “competitive advantage.” 2. Discuss the strategic role of managers at different levels within an organization. 3. Identify the primary steps in a strategic planning process. 4. Discuss the common pitfalls of planning, and how those pitfalls can be avoided. 5. Outline the cognitive biases that might lead to poor strategic decisions, and explain how these biases can be overcome. 6. Discuss the role strategic leaders play in the strategy-making process. Opening Case Wal-Mart The opening case examines Wal-Mart’s persistently superior profitability, which reflects a competitive advantage that is based upon a number of strategies. Wal-Mart’s competitive advantage was based on a business model of targeting small southern towns as well as the urban and suburban locations. Wal-Mart grew quickly by pricing its products lower than those of local retailers, often putting them out of business. The company was also an innovator in information systems, logistics, and human resource practices. These strategies resulted in higher productivity and lower costs as compared to rivals, which enabled the company to earn a high profit while charging low prices. Wal-Mart led the way among U.S. retailers in developing and implementing sophisticated product tracking systems using bar-code technology and checkout scanners. This information technology enabled Wal-Mart to track what was selling and adjust its inventory accordingly so that the products found in each store matched local demand, thereby avoiding overstocking. With regard to human resources, Sam Walton believed that employees should be respected and rewarded for helping to improve the profitability of the company. By the time the 1990s came along, Wal-Mart was already the largest seller of general merchandise in the United States. But, rivals Target and Costco have continued to improve their performance, and Costco in particular is now snapping at Wal-Mart’s heals. Teaching Note: This Opening Case provides an excellent opportunity to discuss many of the concepts that will be introduced in Chapter 1. For example, Wal-Mart developed a business model that was unique and revolutionary at the time. The model allowed the firm to keep costs low and capture a greater portion of the profits. Because the model was unique and led to improved effectiveness and efficiency, the firm achieved a sustained competitive advantage. The business model was developed by Sam Walton and provides an example of effective strategic leadership and vision. This case may be used to point out to students that every firm, no matter how successful, is vulnerable to competitive attack. Figure 1.1: Profitability of Wal-Mart and Competitors, 2003-2012 Lecture Outline I. Overview This book argues that the strategies that a company’s managers pursue have a major impact on the company’s performance relative to that of its competitors. A strategy is a set of related actions that managers take to increase their company performance. This book identifies and describes the strategies that managers can pursue to achieve superior performance and provide their companies with a competitive advantage. One of its aims is to give the students a thorough understanding of the analytical techniques and skills necessary to identify and implement strategies successfully. Strategic leadership is about how to most effectively manage a company’s strategy-making process to create competitive advantage. The strategy-making process is the process by which managers select and then implement a set of strategies that aim to achieve a competitive advantage. Strategy formulation is the task of selecting strategies, whereas strategy implementation is the task of putting strategies into action, which includes designing, delivering, and supporting products; improving the efficiency and effectiveness of operations; and designing a company’s organization structure, control systems, and culture. II. Strategic Leadership, Competitive Advantage, and Superior Performance Strategic leadership is concerned with managing the strategy-making process to increase the performance of a company, thereby increasing the value of the enterprise to its owners, its shareholders. To increase shareholder value, managers must pursue strategies that increase the profitability of the company and ensure that profits grow (Figure 1.2). To do this, a company must be able to outperform its rivals; it must have a competitive advantage. Figure 1.2: Determinants of Shareholder Value A. Superior Performance: Maximizing shareholder value is the ultimate goal of profit making companies for two reasons: • Shareholders provide a company with the risk capital that enables managers to buy the resources needed to produce and sell goods and services. Risk capital is capital that cannot be recovered if a company fails and goes bankrupt. • Shareholders are the legal owners of a corporation, and their shares therefore, represent a claim on the profits generated by a company. Thus, mangers have an obligation to invest those profits in ways that maximize shareholder value. Shareholder value means the returns that shareholders earn from purchasing shares in a company. These returns come from two sources: • Capital appreciation in the value of a company’s shares • Dividend payments One way of measuring the profitability of a company is by the return that it makes on the capital invested in the enterprise. The return on invested capital (ROIC) that a company earns is defined as its net profit over the capital invested in the firm (profit/capital invested). Net profit means net income after tax. Capital means the sum of money invested in the company—that is, stockholders’ equity plus debt owed to creditors. So defined, profitability is the result of how efficiently and effectively managers use the capital at their disposal to produce goods and services that satisfy customer needs. The profit growth of a company can be measured by the increase in net profit over time. A company can grow its profits if it sells products in markets that are growing rapidly, gains market share from rivals, increases the amount it sells to existing customers, expands overseas, or diversifies profitably into new lines of business. Together, profitability and profit growth are the principal drivers of shareholder value. To both boost profitability and grow profits over time, managers must formulate and implement strategies that give their company a competitive advantage over rivals. What shareholders want to see, and what managers must try to deliver through strategic leadership, is profitable growth—that is, high profitability and sustainable profit growth. B. Competitive Advantage and a Company’s Business Model To maximize shareholder value, managers must formulate and implement strategies that enable their company to outperform rivals—that give it a competitive advantage. A company is said to have a competitive advantage over its rivals when its profitability is greater than the average profitability and profit growth of other companies competing for the same set of customers. The higher its profitability relative to rivals, the greater its competitive advantage will be. A company has a sustained competitive advantage when its strategies enable it to maintain above-average profitability for a number of years. A business model is managers’ conception of how the set of strategies their company pursues should work together as a congruent whole, enabling the company to gain a competitive advantage and achieve superior profitability and profit growth. In essence, a business model is a kind of mental model, or gestalt, of how the various strategies and capital investments a company makes should fit together to generate above-average profitability and profit growth. III. Industry Differences in Performance It is important to recognize that in addition to its business model and associated strategies, a company’s performance is also determined by the characteristics of the industry in which it competes. Different industries are characterized by different competitive conditions. In some industries, demand is growing rapidly, and in others it is contracting. Some industries might be beset by excess capacity and persistent price wars, others by strong demand and rising prices. Figure 1.3 shows the average profitability, measured by ROIC, among companies in several different industries between 2002 and 2011. Figure 1.3: Return on Invested Capital (ROIC) in Selected Industries, 2002-2011 A. Performance in Nonprofit Enterprises Nonprofit enterprises such as government agencies, universities, and charities are not in “business” to make profits. Nevertheless, they are expected to use their resources efficiently and operate effectively, and their managers set goals to measure their performance. The managers of nonprofits need to map out strategies to attain these goals. They also need to understand that nonprofits compete with each other for scarce resources, just as businesses do. IV. Strategic Managers In most companies, there are two primary types of managers: • General managers, who bear responsibility for the overall performance of the company or for one of its major self-contained subunits or divisions. The overriding concern of general managers is the success of the whole company or the divisions under their direction; they are responsible for deciding how to create a competitive advantage and achieve high profitability with the resources and capital they have at their disposal. • Functional managers, who are responsible for supervising a particular function, that is, a task, activity, or operation, such as accounting, marketing, etc. Figure 1.4 shows the organization of a multidivisional company, that is, a company that competes in several different businesses and has created a separate self-contained division to manage each. There are three main levels of management—corporate, business, and functional. Figure 1.4: Levels of Strategic Management A. Corporate-Level Managers The corporate level of management consists of the chief executive officer (CEO), other senior executives, and corporate staff. The CEO is the principal general manager. In consultation with other senior executives, the role of corporate-level managers is to oversee the development of strategies for the whole organization. This role includes defining the goals of the organization, determining what businesses it should be in, allocating resources among the different businesses, formulating and implementing strategies that span individual businesses, and providing leadership for the entire organization. Corporate-level managers also provide a link between the people who oversee the strategic development of a firm and those who own it (the shareholders). Corporate-level managers, and particularly the CEO, can be viewed as the agents of shareholders. B. Business-Level Managers A business unit is a self-contained division (with its own functions—e.g., finance, purchasing, etc.) that provides a product or service for a particular market. The principal general manager at the business level, or the business-level manager, is the head of the division. The strategic role of these managers is to translate the general statements of direction and intent that come from the corporate level into concrete strategies for individual businesses. C. Functional-Level Managers Functional-level managers are responsible for the specific business functions or operations (human resources, purchasing, product development, customer service, etc.) that constitute a company or one of its divisions. Thus, a functional manager’s sphere of responsibility is generally confined to one organizational activity, whereas general managers oversee the operation of an entire company or division. V. The Strategy-Making Process B. A Model of the Strategic Planning Process The formal strategic planning process has five main steps: • Select the corporate mission and major corporate goals. • Analyze the organization’s external competitive environment to identify opportunities and threats. • Analyze the organization’s internal operating environment to identify the organization’s strengths and weaknesses. • Select strategies that build on the organization’s strengths and correct its weaknesses in order to take advantage of external opportunities and counter external threats. These strategies should be consistent with the mission and major goals of the organization. • Implement the strategies. The task of analyzing the organization’s external and internal environments and then selecting appropriate strategies constitutes strategy formulation. In contrast, strategy implementation involves putting the strategies (or plan) into action. This includes taking actions consistent with the selected strategies of the company at the corporate, business, and functional levels; allocating roles and responsibilities among managers (typically through the design of organization structure); allocating resources (including capital and money); setting short-term objectives; and designing the organization’s control and reward systems. These steps are illustrated in Figure 1.5. Figure 1.5: Main Components of the Strategic Planning Process Each step in Figure 1.5 constitutes a sequential step in the strategic planning process. At step 1, each round, or cycle, of the planning process begins with a statement of the corporate mission and major corporate goals. The mission statement, then, is followed by the foundation of strategic thinking: external analysis, internal analysis, and strategic choice. The strategy-making process ends with the design of the organizational structure and the culture and control systems necessary to implement the organization’s chosen strategy. Some organizations go through a new cycle of the strategic planning process every year. This does not necessarily mean that managers choose a new strategy each year. In many instances, the result is simply to modify and reaffirm a strategy and structure already in place. The strategic plans generated by the planning process generally project over a period of 1 to 5 years, and the plan is updated, or rolled forward, every year. In most organizations, the results of the annual strategic planning process are used as input into the budgetary process for the coming year so that strategic planning is used to shape resource allocation within the organization. B. Mission Statement The first component of the strategic management process is crafting the organization’s mission statement, which provides the framework—or context—within which strategies are formulated. A mission statement has four main components: • A statement of the raison d’être of a company or organization—its reason for existence—which is normally referred to as the mission • A statement of some desired future state, usually referred to as the vision • A statement of the key values that the organization is committed to • A statement of major goals 1. Mission A company’s mission describes what the company does. According to the late Peter Drucker, an important first step in the process of formulating a mission is to come up with a definition of the organization’s business. Essentially, the definition answers these questions—“What is our business? What will it be? What should it be?” The responses to these questions guide the formulation of the mission. To answer the question, “What is our business?” a company should define its business in terms of three dimensions—who is being satisfied (what customer groups), what is being satisfied (what customer needs), and how customers’ needs are being satisfied (by what skills, knowledge, or distinctive competencies)? Figure 1.6 illustrates these dimensions. Figure 1.6: Defining the Business This approach stresses the need for a customer-oriented rather than a product-oriented business definition. 2. Vision The vision of a company defines a desired future state; it articulates, often in bold terms, what the company would like to achieve. 3. Values The values of a company state how managers and employees should conduct themselves, how they should do business, and what kind of organization they should build to help a company achieve its mission. Insofar as they help drive and shape behavior within a company, values are commonly seen as the bedrock of a company’s organizational culture—the set of values, norms, and standards that control how employees work to achieve an organization’s mission and goals. In one study of organizational values, researchers identified a set of values associated with high-performing organizations that help companies achieve superior financial performance through their impact on employee behavior. These values include respect for the interests of key organizational stakeholders—individuals or groups that have an interest, claim, or stake in the company, in what it does, and in how well it performs. They include stockholders, bondholders, employees, customers, the communities in which the company does business, and the general public. VI. Major Goals A goal is a precise and measurable desired future state that a company attempts to realize. The purpose of goals is to specify with precision what must be done if the company is to attain its mission or vision. Well-constructed goals have four main characteristics: • They are precise and measurable. • They address crucial issues. • They are challenging but realistic. • They specify a time period in which the goals should be achieved, when that is appropriate. Well-constructed goals also provide a means by which the performance of managers can be evaluated. The primary goal of most corporations is to maximize shareholder returns, and doing this requires both high profitability and sustained profit growth. Thus, most companies operate with goals for profitability and profit growth. A. External Analysis The essential purpose of external analysis is to identify strategic opportunities and threats within the organization’s operating environment that will affect how it pursues its mission. Three interrelated environments should be examined when undertaking an external analysis—the industry environment in which the company operates, the country or national environment, and the wider socioeconomic or macroenvironment. 1.1 Strategy in Action: Strategic Analysis at Time Inc. In the mid-2000s, Time Inc. recognized that it needed to change its strategy. Its traditional publications were losing readers. External analysis showed that younger readers were turning to the web for information of the type provided by Time’s publications. Internally, Time treated web publication as a separate and less desirable outlet for its content. The Managing Editor of People, Martha Nelson, was the first to see the advantages of a web presence. She merged the two newsrooms and emphasized the need for original content on the web. She stressed the importance of driving traffic to the web and earning advertising revenues. The People model became the template for the other magazines published by Time. Ann Moore, the CEO, neutralized the cultural weakness that hindered online efforts in the past at Time and redirected resources to Web publishing. Web partnerships that merged news channels, magazines, and websites resulted in top online websites. This Web-centric publishing created a focus on energy, resources, and investments toward brands having the ability to obtain digital form audiences. Teaching Note: This insert provides an example of how a large, mainstream firm can experience the strategy-making process. An external analysis revealed the need for change, an internal analysis revealed the weaknesses of the firm; the strategic options were identified and implemented. Ultimately, the strategic options were expanded throughout the firm and continued to evolve. B. Internal analysis Internal analysis focuses on reviewing the resources, capabilities, and competencies of a company. The goal is to identify the strengths and weaknesses of the company. C. SWOT Analysis and the Business Model The comparison of strengths, weaknesses, opportunities, and threats is normally referred to as a SWOT analysis. The central purpose is to identify the strategies to exploit external opportunities, counter threats, build on and protect company strengths, and eradicate weaknesses. The goal of a SWOT analysis is to create, affirm, or fine-tune a company-specific business model that will best align, fit, or match a company’s resources and capabilities to the demands of the environment in which it operates. Managers compare and contrast the various alternative possible strategies against each other and then identify the set of strategies that will create and sustain competitive advantage. These strategies can be divided into four main categories: • Functional-level strategies, directed at improving the effectiveness of operations within a company, such as manufacturing, marketing, etc. • Business-level strategies, which encompass the business’s overall competitive theme, the way it positions itself in the marketplace to gain a competitive advantage, and the different positioning strategies that can be used in different industry settings—for example, cost leadership, differentiation, etc. • Global strategies, which address how to expand operations outside the home country to grow and prosper in a world where competitive advantage is determined at a global level. • Corporate-level strategies, which answer the primary questions—What business or businesses should we be in to maximize the long-run profitability and profit growth of the organization, and how should we enter and increase our presence in these businesses to gain competitive advantage? The strategies identified through a SWOT analysis should be congruent with each other. Thus, functional-level strategies should be consistent with, or support, the company’s business-level strategies and global strategies. D. Strategy Implementation Strategy implementation involves taking actions at the functional, business, and corporate levels to execute a strategic plan. Implementation can include, for example, putting quality improvement programs into place, changing the way a product is designed, positioning the product differently in the marketplace, segmenting the marketing and offering different versions of the product to different consumer groups, implementing price increases or decreases, etc. Strategy implementation entails designing the best organization structure and the best culture and control systems to put a chosen strategy into action. In addition, senior managers need to put a governance system in place to make sure that all within the organization act in a manner that is not only consistent with maximizing profitability and profit growth, but also legal and ethical. E. The Feedback Loop The feedback loop indicates that strategic planning is ongoing—it never ends. Once a strategy has been implemented, its execution must be monitored to determine the extent to which strategic goals and objectives are actually being achieved, and to what degree competitive advantage is being created and sustained. Top managers can then decide whether to reaffirm the existing business model and the existing strategies and goals, or suggest changes for the future. IVII. Strategy as an Emergent Process The planning model suggests that a company’s strategies are the result of a plan, that the strategic planning process is rational and highly structured, and that top management orchestrates the process. Several scholars have criticized the formal planning model for three main reasons: • The unpredictability of the real world • The role that lower-level managers can play in the strategic management process • The fact that many successful strategies are often the result of serendipity, not rational strategizing A. Strategy Making in an Unpredictable World Critics of formal planning systems argue that we live in a world in which uncertainty, complexity, and ambiguity dominate, and in which small chance events can have a large and unpredictable impact on outcomes. In such circumstances, they claim, even the most carefully thought-out strategic plans are prone to being rendered useless by rapid and unforeseen change. In an unpredictable world, being able to respond quickly to changing circumstances, and to alter the strategies of the organization accordingly, is paramount. B. Autonomous Action: Strategy Making by Lower-Level Managers Another criticism leveled at the rational planning model of strategy is that too much importance is attached to the role of top management, particularly the CEO. An alternative view is that individual managers deep within an organization can—and often do—exert a profound influence over the strategic direction of the firm. Autonomous action may be particularly important in helping established companies deal with the uncertainty created by the arrival of a radical new technology that changes the dominant paradigm in an industry. 1.2 Strategy in Action: Starbucks’ Music Business Starbucks sells music in addition to its coffee and food offerings. Music sales came about, not through a formal planning process, but due to an emergent situation. The company’s journey into music started in the late 1980s when Tim Jones, the manager of one Starbucks in Seattle’s University Village, started to bring his own tapes of music compilations into the store to play. Soon Jones was getting requests for copies from customers. Jones told this to Starbucks’ CEO, Howard Schultz, and suggested that Starbucks start to sell music compilations. At first, Schultz was skeptical, but after repeated lobbying efforts by Jones, he eventually took up the suggestion. Today Starbucks’ music business represents a small but healthy part of its overall product portfolio. Teaching Note: The key point here is that strategy is not only a rational and deterministic planning process. It can come about by autonomous action on the part of lower-level managers. 1.3 Strategy in Action: A Strategic Shift at Charles Schwab Charles Schwab had been a successful discount stockbroker company for over twenty years. Its business was handled through branches and a telephone system as well as proprietary software. Then E*Trade came on the scene. E*Trade used the web of online trading; it had no branches, no brokers, no telephone system, thus having a very low cost structure. A software specialist at Schwab, William Pearson, realized the power of the web but couldn’t get the attention of his superiors. Eventually he approached Anne Hennegar, a former Schwab manager who now worked as a consultant to the company. Hennegar suggested that Pearson meet with Tom Seip, an executive vice president at Schwab who was known for his ability to think outside the box. Hennegar approached Seip on Pearson’s behalf, and Seip responded positively, asking her to set up a meeting. Hennegar and Pearson arrived, expecting to meet only Seip, but to their surprise, in walked Charles Schwab, his chief operating officer, David Pottruck, and the vice presidents in charge of strategic planning and electronic brokerage. As the group watched Pearson’s demo, which detailed how a Web-based system would look and work, they became increasingly excited. A year later, Schwab launched its own Web-based offering, eSchwab, which enabled Schwab clients to execute stock trades for a low flat-rate commission. eSchwab went on to become the core of the company’s offering, enabling it to stave off competition from deep discount brokers like E*Trade. Teaching Note: An interesting discussion could be generated from this case by asking students to consider what kind of organization culture, policies, structure, leadership, and so on would be necessary to encourage and accept employees’ creativity and autonomy. William Pearson was able to overcome the inertia of the system at Charles Schwab. Others may not be so fortunate. Classroom discussion can also be enlivened and humor introduced if you describe, or ask students to describe, other innovations that were not pursued, to disastrous results. For example, when a Harvard MBA student wrote a paper proposing a profit-making delivery service, he hoped his professor would help him find venture financing, but instead received a D on the assignment. The professor believed that no firm would ever be able to deliver packages more efficiently or cheaply than the government-subsidized U.S. Postal Service. The student went on to become the founder of Federal Express. C. Serendipity and Strategy Business history is replete with examples of accidental events that help to push companies in new and profitable directions. These examples suggest that many successful strategies are not the result of well-thought-out plans, but of serendipity—stumbling across good things unexpectedly. Serendipitous discoveries and events can open all sorts of profitable avenues for a company. But some companies have missed profitable opportunities because serendipitous discoveries or events were inconsistent with their prior (planned) conception of what their strategy should be. D. Intended and Emergent Strategies Henry Mintzberg’s model of strategy development provides an encompassing view of what strategy actually is. According to this model, a company’s realized strategy is the product of whatever planned strategies are actually put into action (the company’s deliberate strategies) and any unplanned, or emergent, strategies (Figure 1.7). In Mintzberg’s view, many planned strategies are not implemented because of unpredicted changes in the environment (they are unrealized). Emergent strategies are the unplanned responses to unforeseen circumstances. They arise from autonomous action by individual managers deep within the organization, from serendipitous discoveries or events, or from an unplanned strategic shift by top-level managers in response to changed circumstances. Figure 1.7: Emergent and Deliberate Strategies Mintzberg maintains that emergent strategies are often successful and may be more appropriate than intended strategies. Successful strategies can often emerge within an organization without prior planning, and in response to unforeseen circumstances. As Mintzberg has noted, strategies can take root wherever people have the capacity to learn and the resources to support that capacity. In practice, the strategies of most organizations are likely a combination of the intended and the emergent. The message for management is that it needs to recognize the process of emergence and to intervene when appropriate, relinquishing bad emergent strategies and nurturing potentially good ones. To make such decisions, managers must be able to judge the worth of emergent strategies. They must be able to think strategically. Although emergent strategies arise from within the organization without prior planning, top management must still evaluate emergent strategies. VII. Strategic Planning in Practice Despite criticism, research suggests that formal planning systems do help managers make better strategic decisions. For strategic planning to work, it is important that top-level managers plan not only within the context of the current competitive environment but also within the context of the future competitive environment. A. Scenario Planning Scenario planning involves formulating plans that are based upon “what-if” scenarios about the future. In the typical scenario-planning exercise, some scenarios are optimistic and some are pessimistic. Teams of managers are asked to develop specific strategies to cope with each scenario. A set of indicators is chosen as signposts to track trends and identify the probability that any particular scenario is coming to pass. The idea is to allow managers to understand the dynamic and complex nature of their environment, to think through problems in a strategic fashion, and to generate a range of strategic options that might be pursued under different circumstances. The great virtue of the scenario approach to planning is that it can push managers to think outside the box, to anticipate what they might need to do in different situations. It can remind managers that the world is complex and unpredictable, and to place a premium on flexibility, rather than on inflexible plans based on assumptions about the future. As a result of scenario planning, organizations might pursue one dominant strategy related to the scenario that is judged to be most likely, but they make some investments that will pay off if other scenarios come to the fore (Figure 1.8). Figure 1.8 Scenario Planning B. Decentralized Planning A mistake that some companies have made in constructing their strategic planning process has been to treat planning exclusively as a top-management responsibility. This “ivory tower” approach can result in strategic plans formulated in a vacuum by top managers who have little understanding or appreciation of current operating realities. The ivory tower concept of planning can also lead to tensions between corporate-, business-, and functional-level managers. Correcting the ivory tower approach to planning requires recognizing that successful strategic planning encompasses managers at all levels of the corporation. Much of the best planning can and should be done by business and functional managers who are closest to the facts; in other words, planning should be decentralized. Corporate-level planners should take on roles as facilitators who help business and functional managers do the planning by setting the broad strategic goals of the organization and providing the resources necessary to identify the strategies that might be required to attain those goals. IX. Strategic Decision Making Even the best-designed strategic planning systems will fail to produce the desired results if managers do not effectively use the information at their disposal. One important way in which managers can make better use of their knowledge and information is to understand how common cognitive biases can result in poor decision making. A. Cognitive Biases and Strategic Decision Making Humans are not supercomputers, and it is difficult for us to absorb and process large amounts of information effectively. As a result, when we make decisions, we tend to fall back on certain rules of thumb, or heuristics, that help us to make sense out of a complex and uncertain world. However, sometimes these rules lead to severe and systematic errors in the decision-making process. Systematic errors are those that appear time and time again. They seem to arise from a series of cognitive biases in the way that humans process information and reach decisions. The following are some of the cognitive biases that exist and that people are prone to: • The prior hypothesis bias refers to the fact that decision makers who have strong prior beliefs about the relationship between two variables tend to make decisions on the basis of these beliefs, even when presented with evidence that their beliefs are incorrect. o Moreover, they tend to seek and use information that is consistent with their prior beliefs while ignoring information that contradicts these beliefs. • Another well-known cognitive bias, escalating commitment occurs when decision makers having already committed significant resources to a project, commit even more resources if they receive feedback that the project is failing. o This may be an irrational response; a more logical response would be to abandon the project and move on, rather than escalate commitment. • A third bias, reasoning by analogy involves the use of simple analogies to make sense out of complex problems. o The problem with this heuristic is that the analogy may not be valid. • A fourth bias, representativeness is rooted in the tendency to generalize from a small sample or even a single vivid anecdote. o This violates the statistical law of large numbers, which says that it is inappropriate to generalize from a small sample, let alone from a single case. • A fifth cognitive bias is referred to as the illusion of control, or the tendency to overestimate one’s ability to control events. o General or top-level managers seem to be particularly prone to this bias—having risen to the top of an organization, they tend to be overconfident about their ability to succeed. • The availability error is yet another common bias. o The availability error arises from our predisposition to estimate the probability of an outcome based on how easy the outcome is to imagine. B. Techniques for Improving Decision Making The existence of cognitive biases raises a question—How can critical information affect the decision-making mechanism so that a company’s strategic decisions are realistic and based on thorough evaluations? Two techniques known to enhance strategic thinking and counteract cognitive biases are: • Devil’s advocacy—this requires the generation of a plan, and a critical analysis of that plan. One member of the decision-making group acts as the devil’s advocate, emphasizing all the reasons that might make the proposal unacceptable. o In this way, decision makers can become aware of the possible perils of recommended courses of action. • Dialectic inquiry—this is more complex because it requires the generation of a plan (a thesis) and a counter-plan (an antithesis) that reflect plausible but conflicting courses of action. Strategic managers listen to a debate between advocates of the plan and counterplan and then decide which plan will lead to higher performance. o The purpose of the debate is to reveal problems with definitions, recommended courses of action, and assumptions of both plans. As a result of this exercise, strategic managers are able form a new and more encompassing conceptualization of the problem, which then becomes the final plan (a synthesis). Another technique for countering cognitive biases is the outside view, which has been championed by Nobel Prize winner Daniel Kahneman and his associates. The outside view requires planners to identify a reference class of analogous past strategic initiatives, determine whether those initiatives succeeded or failed, and evaluate the project at hand against those prior initiatives. X. Strategic Leadership One of the key strategic roles of both general and functional managers is to use all their knowledge, energy, and enthusiasm to provide strategic leadership for their subordinates and develop a high-performing organization. Several authors have identified a few characteristics of good strategic leaders that do lead to high performance: • Vision, eloquence, and consistency • Articulation of a business model • Commitment • Being well informed • Willingness to delegate and empower • Astute use of power • Emotional intelligence A. Vision, Eloquence, and Consistency One of the key tasks of leadership is to give an organization a sense of direction. Strong leaders seem to have a clear and compelling vision of where the organization should go, are eloquent enough communicate this vision to others within the organization in terms that energize people, and consistently articulate their vision until it becomes part of the organization’s culture. B. Articulation of the Business Model Another key characteristic of good strategic leaders is their ability to identify and articulate the business model the company will use to attain its vision. A business model is managers’ conception of how the various strategies that the company pursues fit together into a congruent whole. Although individual strategies can take root in many different places in an organization, and although their identification is not the exclusive preserve of top management, only strategic leaders have the perspective required to make sure that the various strategies fit together into a congruent whole and form a valid and compelling business model. C. Commitment Strong leaders demonstrate their commitment to the visions and business models by actions and words, and they often lead by example. D. Being Well Informed Effective strategic leaders develop a network of formal and informal sources who keep them well informed about what is going on within the company. Using informal and unconventional ways to gather information is wise because formal channels can be captured by special interests within the organization or by gatekeepers—managers who may misrepresent the true state of affairs to the leader. E. Willingness to Delegate and Empower High-performance leaders are skilled at delegation. They recognize that unless they learn how to delegate effectively, they can quickly become overloaded with responsibilities. They also recognize that empowering subordinates to make decisions is a good motivational tool and often results in decisions being made by those who must implement them. F. The Astute Use of Power In a now-classic article on leadership, Edward Wrapp noted that effective leaders tend to be very astute in their use of power. He argued that strategic leaders must often play the power game with skill and attempt to build consensus for their ideas rather than use their authority to force ideas through; they must act as members of a coalition or its democratic leaders rather than as dictators. G. Emotional Intelligence Emotional intelligence is a term that Daniel Goleman coined to describe a bundle of psychological attributes that many strong and effective leaders exhibit: • Self-awareness—the ability to understand one’s own moods, emotions, and drives, as well as their effect on others. • Self-regulation—the ability to control or redirect disruptive impulses or moods, that is, to think before acting. • Motivation—a passion for work that goes beyond money or status and a propensity to pursue goals with energy and persistence. • Empathy—the ability to understand the feelings and viewpoints of subordinates and to take those into account when making decisions. • Social skills—friendliness with a purpose. According to Goleman, leaders who possess these attributes—who exhibit a high degree of emotional intelligence—tend to be more effective than those who lack these attributes. Their self-awareness and self-regulation help to elicit the trust and confidence of subordinates. In Goleman’s view, people respect leaders who, because they are self-aware, recognize their own limitations and, because they are self-regulating, consider decisions carefully. Goleman also argues that self-aware and self-regulating individuals tend to be more self-confident and therefore better able to cope with ambiguity and more open to change. A strong motivation exhibited in a passion for work can also be infectious, helping to persuade others to join together in pursuit of a common goal or organizational mission. Teaching Note: Ethical Dilemma This question should solicit an interesting discussion of various viewpoints regarding whether to aim toward accomplishing a large bonus and promotion or keep with the mission statement and maintain the importance of acting with integrity at all times. The instructor should explain, in such a dilemma that while satisfying the goals is important, employees should not lower lending standards and should not lend money to people whose ability to meet their mortgage payments is questionable. Answers to Discussion Questions 1. What do we mean by strategy? How is a business model different from a strategy? Strategy is an action a company takes to attain superior performance. Strategy also involves both thinking and doing. From Mintzberg’s definition of strategy as a pattern in a stream of decisions or actions, strategy is more than what a company intends to do; it is also what it actually does. That is to say, a company’s strategy is the product of (a) that part of its intended strategy that is actually realized and (b) its emergent strategy. A business model is managers’ conception of how the various strategies that the company pursues fit together into a congruent whole. 2. What do you think are the sources of sustained superior profitability? Sustained superior profitability results when a company is able to increase profits, either by increasing revenues or decreasing expenses or both, and when that ability is difficult or impossible for competitors to imitate. Sustained superior profitability is most likely to occur when the advantages are intangible, such as management insight, disciplined cost cutting by employees, or a culture that nourishes creativity. Intangible resources are much more difficult to imitate than tangible ones, and thus provide a sustainable advantage. However, no firm can sustain an advantage forever. The advantage itself will tend to weaken over time and competitors will learn to imitate that advantage or develop other advantages of their own that will counteract the power of the original advantage. 3. What are the strengths of formal strategic planning? What are its weaknesses? A formal strategic planning process results in a systematic review of all the external and internal factors that might have a bearing on the ability of the company to meet its strategic objectives. Formally identifying strengths, weaknesses, opportunities, and threats is a good way of alerting strategic managers to what needs to be done if the firm is to fulfill its strategic mission. However, like any rational process, strategic planning is limited by the fallibility of human decision makers. In particular, strategic managers may fall victim to the phenomenon of groupthink and to their own cognitive biases. Thus, supposedly rational decisions can turn out to be anything but rational. This hazard can be minimized, however, if the organization uses decision-making techniques such as devil’s advocacy or dialectic inquiry. In addition, in a complex and uncertain world characterized by rapid change, strategic plans can become outdated as soon as they are made. In such circumstances, the company’s plan can become a policy straitjacket, committing it to a course of action that is no longer appropriate. Change is something that cannot be insured against. Consequently, flexible, open-ended plans are perhaps the best way of giving the company room to maneuver in response to change. Moreover, consistent vision and strategic intent are probably more important than detailed strategic plans. The strategies that a company adopts might need to change with the times, but the vision can be more enduring. 4. To what extent do you think that cognitive biases may have contributed to the global financial crisis that gripped financial markets in 2008–2009? Explain your answer. Cognitive biases prevent rational action and prevent leaders from being mentally prepared for trouble. Behavioral economists such as the Nobel prize-winner, Daniel Kahneman, have documented cognitive biases in markets, such as over-optimism, over-pessimism, deal frenzy, failure to ignore sunk costs, and so on. Hence, the CEOs end up making poor acquisition decisions, often paying far too much for the companies they acquire. Subsequently, servicing the debt taken on to finance such an acquisition makes it all but impossible to make money from the acquisition. 5. Discuss the accuracy of the following statement: Formal strategic planning systems are irrelevant for firms competing in high-technology industries where the pace of change is so rapid that plans are routinely made obsolete by unforeseen events. Formal strategic planning systems are not at their best in situations with rapid and unpredictable change. Formal systems are time-consuming, and may not be able to provide answers quickly enough when time is very short. Also, formal systems depend upon detailed estimates and forecasts, which are very difficult to do well when conditions are chaotic. Nevertheless, formal systems may still be useful in some ways, even in these challenging environments. For example, formal systems are often associated with detailed and directive plans, but they may also be used to prepare flexible, open-ended plans that are more appropriate for rapidly changing environments. Also, the activities of formal planning—gathering data, preparing forecasts, generating and considering multiple alternatives, and so on—are themselves good preparation for making strategic choices, and thus could be useful in any type of environment. 6. Pick the current or a past president of the United States and evaluate his performance against the leadership characteristics discussed in the text. On the basis of this comparison, do you think that the president was/is a good strategic leader? Why? Students’ answers will vary. Answering this question calls for students to rate the president according to the six main characteristics of good strategic leaders discussed in the text. There is no right answer to this question. Students’ political biases will undoubtedly color the answers they give. It is the exercise itself that is important. Only with the passage of time will a more objective judgment of a president’s leadership skills be possible. Let’s evaluate Abraham Lincoln. He demonstrated exceptional vision and resilience during the Civil War, striving to preserve the Union and abolish slavery. His communication skills were evident in speeches like the Gettysburg Address. Lincoln’s integrity and empathy helped him navigate the nation’s most challenging period. Based on these traits, he was indeed a good strategic leader. Practicing Strategic Management Small-Group Exercise: Designing A Planning System The students are asked to break up into groups of three to five students and discuss the following scenario. They are asked to appoint one group member as a spokesperson who will communicate the group’s findings to the class when called on to do so by the instructor. You are a group of senior managers working for a fast-growing computer software company. Your product allows users to play interactive role-playing games over the Internet. In the past 3 years, your company has gone from being a start-up enterprise with 10 employees and no revenues to a company with 250 employees and revenues of $60 million. It has been growing so rapidly that you have not had time to create a strategic plan, but now members of the board of directors are telling you that they want to see a plan, and they want the plan to drive decision making and resource allocation at the company. They want you to design a planning process that will have the following attributes: 1. It will be democratic, involving as many key employees as possible in the process. 2. It will help to build a sense of shared vision within the company about how to continue to grow rapidly. 3. It will lead to the generation of three to five key strategies for the company. 4. It will drive the formulation of detailed action plans, and these plans will be subsequently linked to the company’s annual operating budget. Design a planning process to present to your board of directors. Think carefully about who should be included in this process. Be sure to outline the strengths and weaknesses of the approach you choose, and be prepared to justify why your approach might be superior to alternative approaches. Teaching Note: This is an excellent exercise to get students involved. In addition, it is an excellent exercise to break the ice and to make the students feel comfortable with one another and with the instructor. This is an interactive exercise, and students should be asked to present their findings to the rest of the class. The students should think carefully about who should be included in this process and to outline the strengths and weaknesses of their proposed approach. Several groups will be asked to present. Each group will then be asked to justify the advantages of their approach relative to that of other groups. If time permits, an open discussion involving all groups at the end of the class can be used to come up with some kind of synthesis. From this classroom discussion, students should emerge with two important conclusions. First, there is no single “best” way to plan. Different companies and different situations require different processes. Second, every approach to planning involves some tradeoffs. The key to choosing an appropriate process is understanding the tradeoffs and choosing the process that is best for the firm’s specific needs. Strategy Sign-On Article File 1 This exercise asks students to find an example of a company that has recently changed its strategy. They should identify whether this change was the outcome of a formal planning process or whether it was an emergent response to unforeseen events occurring in the company’s environment. Teaching Note: Students will come away from this task with an appreciation for the ways in which formal planning and emergent strategies interact and influence each other. For example, a firm without any formal planning may be reacting to events as they occur, but this is unlikely to occur in ways that achieve a focused strategy. On the other hand, firms that engage in some formal planning are better prepared to react to unforeseen events with a coherent and realistic strategy. However, if formal planning is carried to an extreme and adherence to plans is strictly enforced, emergent responses may be discouraged and inflexibility may present problems. Strategic Management Project Module 1 To give students practical insight into the strategic management process, this book provides a series of strategic modules; one is at the end of every chapter. Each module asks students to collect and analyze information relating to the material discussed in that chapter. By completing these strategic modules, students will gain a clearer idea of the overall strategic management process. The first step in this project is to pick a company to study. The book recommends that students focus on the same company throughout the book. Remember also that the book will be asking students for information about the corporate and international strategies of their company as well as its structure. The book strongly recommends that students pick a company for which such information is likely to be available. There are two approaches that can be used to select a company to study, and the students’ instructor will tell them which one to follow. The first approach is to pick a well-known company that has a lot of information written about it. For example, large publicly held companies such as IBM, Microsoft, and Southwest Airlines are routinely covered in the business and financial press. By going to the library at their university, students should be able to track down a great deal of information on such companies. Many libraries now have comprehensive Web-based electronic data search facilities such as ABI/Inform, the Wall Street Journal Index, Predicasts F&S Index, and the LexisNexis databases. These enable students to identify any article that has been written in the business press on the company of their choice within the past few years. A number of non-electronic data sources are also available and useful. For example, Predicasts F&S publishes an annual list of articles relating to major companies that appeared in the national and international business press. S&P Industry Surveys is also a great source for basic industry data, and Value Line Ratings and Reports contain good summaries of a firm’s financial position and future prospects. Students should collect full financial information on the company that they pick. This information can be accessed from Web-based electronic databases such as the EDGAR database, which archives all forms that publicly quoted companies have to file with the Securities and Exchange Commission (SEC); for example, 10-K filings can be accessed from the SEC’s EDGAR database. Most SEC forms for public companies can now be accessed from Internet-based financial sites, such as Yahoo!’s finance site (www.finance.yahoo.com). A second approach is to choose a smaller company in the city or town to study. Although small companies are not routinely covered in the national business press, they may be covered in the local press. More important, this approach can work well if the management of the company will agree to talk to the students at length about the strategy and structure of the company. If students happen to know somebody in such a company or if they have worked there at some point, this approach can be very worthwhile. However, the book does not recommend this approach unless students can get a substantial amount of guaranteed access to the company of their choice. If in doubt, students should ask their instructor before making a decision. The primary goal is to make sure that students have access to enough interesting information to complete a detailed and comprehensive analysis. Students assignment for Module 1 is to choose a company to study and to obtain enough information about it to carry out the following instructions and answer the questions: 1. Give a short account of the history of the company, and trace the evolution of its strategy. Try to determine whether the strategic evolution of your company is the product of intended strategies, emergent strategies, or some combination of the two. 2. Identify the mission and major goals of the company. 3. Do a preliminary analysis of the internal strengths and weaknesses of the company and the opportunities and threats that it faces in its environment. On the basis of this analysis, identify the strategies that you think the company should pursue. (You will need to perform a much more detailed analysis later in the book.) 4. Who is the CEO of the company? Evaluate the CEO’s leadership capabilities. Whichever approach the students use, the instructor should point out to students that some sources are biased, and that they should think carefully about the source of the information as they interpret it. For example, company founders may be overly optimistic about their firm’s performance. Corporate web sites should be treated as advertisements because few will report any negative information. Some respected publications have biases towards liberal or conservative reporting—consider the difference between the New York Times and the Wall Street Journal. Other publications tend to present a more balanced view. In order to reduce biases in their data, students should consult several different sources. Once students have chosen a company for this project, they should obtain information about its history, trace the evolution of its strategy, and try to determine whether the strategic evolution of the company is the product of intended strategies, emergent strategies, or some combination of the two. They should identify its mission and major goals, perform a preliminary analysis of its internal strengths and weaknesses, and the opportunities and threats that it faces in its environment for the purpose of identifying the strategies they think the company should pursue. They should also obtain information about the firm’s CEO and evaluate their leadership capabilities. The information they obtain in this first chapter is of an introductory nature. They will perform a full-blown SWOT analysis in later chapters. For this chapter, the purpose of this assignment is to acquaint themselves with several data sources, and to develop an understanding of the firm that can be used as a foundation for further exploration in future assignments. Closing Case General Electric’s Ecomagination Strategy Back in 2004, GE’s top-management team was going through its annual strategic planning review when the management team came to a sudden realization: six of the company’s core businesses were deeply involved in environmental and energy-related projects. What was particularly striking was that GE had initiated almost all of these projects in response to requests from its customers. They initiated a data-gathering effort. They made an effort to educate themselves on the science behind energy and environmental issues, including greenhouse gas emissions. At the same time, GE talked to government officials and regulators to try and get a sense for where public policy might be going. This external review led to the conclusion that energy prices would likely increase going forward, driven by rising energy consumption in developing nations and creating demand for energy-efficient products. The team also saw tighter environmental controls, including caps on greenhouse gas emissions, as all but inevitable. What emerged from these efforts was a realization that GE could build strong businesses by helping its customers to improve their energy efficiency and environmental performance. Thus was born GE’s ecomagination strategy. First rolled out in 2005, the ecomagination strategy cut across businesses. The corporate goals were broken into subgoals and handed down to the relevant businesses. Performance against goals was reviewed on a regular basis, and the compensation of executives was tied to their ability to meet the goals. The effort soon started to bear fruit. These included a new generation of energy-efficient appliances, more-efficient fluorescent and LED lights, a new jet engine that burned 10% less fuel, a hybrid locomotive that burned 3% less fuel and put out 40% lower emissions than its immediate predecessor, lightweight plastics to replace the steel in cars, and technologies for turning coal into gas in order to drive electric turbines, while stripping most of the carbon dioxide (CO2) from the turbine exhaust. By the end of its first 5-year plan, GE had met or exceeded most of its original goals, despite the global financial crisis that hit in 2008. Not only did GE sell more than $20 billion worth of eco-products in 2010, according to management, these products were also among the most profitable in GE’s portfolio. Teaching Note: This case illustrates a number of concepts from the chapter, including many successful strategic ideas, the evolution of strategy over time, and the impact of environmental and internal forces on strategic decision-making and strategic success. It also emphasizes the importance of strategic leadership and a thorough analysis when formulating strategies. Answers to Case Discussion Questions 1. Where did the original impetus for GE’s ecomagination strategy come from? What does this tell you about strategy making? GE’s ecomagination strategy originally came up when the top-management team realized that six of the company’s core businesses were deeply involved in environmental and energy-related projects, all in response to requests from its customers. So, an effort was made to educate themselves about the science behind environmental issues. This shows that strategy making should value the company’s customers’ response and should believe in building strong businesses by meeting the customers changing needs. 2. To what extent did GE follow a classic SWOT model when formulating its ecomagination strategy? While formulating its ecomagination strategy GE followed the classic SWOT analysis to a great extent. GE realized that it had strength and opportunities because customers knew the brand and were loyal to it. Moreover, it realized that there was not much of a threat because there was no other company to give it strong competition. 3. GE’s CEO Jeff Immelt often states that “green is green.” What does he mean by this? Is the ecomagination strategy in the best interests of GE’s stockholders? Immelt’s statement emphasizes the fact that the company can make money and improve the environment at the same time by developing new technology. The strategy also considers the best interests of its stockholders. 4. By most reports, GE’s ecomagination strategy has been successfully implemented. Why do you think this is the case? What did GE do correctly? What are the key lessons here? The strategy has been successful as the company had set some goals that were successfully handled by the company’s promising young leaders who headed the program. These corporate goals were broken into subgoals and handed down to the relevant businesses. Performance against goals was reviewed on a regular basis, and the compensation of executives was tied to their ability to meet these goals. 5. If GE had not pursued an ecomagination strategy, where do you think it would be today? Where might it be 10 years from now? Students’ answers may vary. Some of them may say that with the growing concern that customers these days have about environment and energy efficiency, GE would have lost its customers if it had not pursued an ecomagination strategy. Without the Ecomagination strategy, GE might have struggled to stay competitive in the rapidly evolving clean energy market. Today, it could be facing significant regulatory and market pressures due to a lack of sustainable innovations. In 10 years, GE might lag behind competitors who embraced green technologies, potentially losing market share and facing financial instability12. CHAPTER 2 External Analysis: The Identification of Opportunities and Threats Synopsis of Chapter The purpose of this chapter is to familiarize students with the forces that shape competition in a company’s external environment and to discuss techniques for identifying strategic opportunities and threats. The central theme is that if a company is to survive and prosper, its management must understand the implications environmental forces have for strategic opportunities and threats. This chapter first defines industry, sector, market segments, and changes in industry boundaries. The next section offers a detailed look at the forces that shape competition in a company’s industry environment, using Porter’s Five Forces Model as an overall framework. In addition, a sixth force—complementors—is introduced and discussed. The chapter continues, exploring the concepts of strategic groups and mobility barriers. The competitive changes that take place during the evolution of an industry are examined. Next the chapter considers some of the limitations inherent in the five forces, strategic group, and industry life-cycle models. These limitations do not render the models useless, but managers need to be aware of them as they employ these models. Finally, the chapter provides a review of the significance that changes in the macroenvironment have for strategic opportunities and threats. Learning Objectives 1. Review the primary technique used to analyze competition in an industry environment: the Five Forces model. 2. Explore the concept of strategic groups and illustrate the implications for industry analysis. 3. Discuss how industries evolve over time, with reference to the industry life-cycle model. 4. Show how trends in the macroenvironment can shape the nature of competition in an industry. Opening Case The Market for Large Commercial Jet Aircraft Just two companies, Boeing and Airbus, have long dominated the market for large commercial jet air- craft. In early 2012, Boeing planes accounted for 50% of the world’s fleet of commercial jet aircraft, and Airbus planes accounted for 31%. The reminder of the global market was split between several smaller players, including Embraer of Brazil and Bombardier of Canada, both of which had a 7% share. The overall market is large and growing. Demand for new aircraft is driven primarily by demand for air travel, which has grown at 5% per annum compounded since 1980. Looking forward, Boeing predicts that between 2011 and 2031 the world economy will grow at 3.2% per annum, and airline traffic will continue to grow at 5% per annum as more and more people from the world’s emerging economies take to the air for business and pleasure trips. Clearly, the scale of future demand creates an enormous profit opportunity for the two main incumbents, Boeing and Airbus. with five producers rather than two in the market, it seems likely that competition will become more intense in the narrow-bodied segment of the industry, which could well drive prices and profits down for the big two incumbent producers. Teaching Note: This case illustrates how two companies, Boeing and Airbus, have dominated the market, the new entrants, and their future in the market. The case also talks about the scale of future demands and the profit opportunities. A class discussion could include the following questions: • Are the two main incumbents, Boeing and Airbus, set to dominate the market? • What are the opportunities for the new entrants? • Suggest more ways in which the new entrants could compete with Boeing and Airbus. Lecture Outline VI. Overview Strategy formulation begins with an analysis of the forces that shape competition within the industry in which a company is based. The goal is to understand the opportunities and threats confronting the firm, and to use this understanding to identify strategies that will enable the company to outperform its rivals. Opportunities arise when a company can take advantage of conditions in its industry environment to formulate and implement strategies that enable it to become more profitable. Threats arise when conditions in the external environment endanger the integrity and profitability of the company’s business. VII. Defining an Industry An industry can be defined as a group of companies offering products or services that are close substitutes for each other—that is, products or services that satisfy the same basic customer needs. A competitor’s closest competitor’s—its rivals—are those that serve the same basic consumer needs. External analysis begins by identifying the industry within which a company competes. To do this, managers must start by looking at the basic customer needs their company is serving—that is, they must take a customer-oriented view of their business rather than a product-oriented view. A. Industry and Sector A distinction can be made between an industry and a sector. A sector is a group of closely related industries. For example, the computer sector comprises several related industries—the computer component industries, the computer hardware industries, and the computer software industry (Figure 2.1). Figure 2.1: The Computer Sector: Industries and Segments A. Industry and Market Segments It is also important to recognize the difference between an industry and the market segments within that industry. Market segments are distinct groups of customers within a market than can be differentiated from each other on the basis of their individual attributes and specific demands. B. Changing Industry Boundaries Industry boundaries may change over time as customer needs evolve, or as emerging new technologies enable companies in unrelated industries to satisfy established customer needs in new ways. Industry competitive analysis begins by focusing upon the overall industry in which a firm competes before market segments or sector-level issues are considered. VIII. Competitive Forces Model Once boundaries of an industry have been identified, managers face the task of analyzing competitive forces within the industry environment in order to identify opportunities and threats. Michael E. Porter’s well-known framework, the Five Forces model, helps managers with this analysis. An extension of his model, shown in Figure 2.2, focuses on six forces that shape competition within an industry: • The risk of entry by potential competitors • The intensity of rivalry among established companies within an industry • The bargaining power of buyers • The bargaining power of suppliers • The closeness of substitutes to an industry’s products • The power of complement providers (Porter did not recognize this sixth force) Figure 2.2: Competitive Forces As each of these forces grows stronger, it limits the ability of established companies to raise prices and earn greater profits. Within this framework, a strong competitive force can be regarded as a threat because it depresses profits. A. Risk of Entry by Potential Competitors Potential competitors are companies that are not currently competing in an industry, but have the capability to do so if they choose. Established companies already operating in an industry often attempt to discourage potential competitors from entering the industry because as more companies enter, it becomes more difficult for established companies to protect their share of the market and generate profits. A high risk of entry by potential competitors represents a threat to the profitability of established companies. If the risk of new entry is low, established companies can take advantage of this opportunity, raise prices, and earn greater returns. The risk of entry by potential competitors is a function of the height of the barriers to entry, that is, factors that make it costly for companies to enter an industry. The greater the costs potential competitors must bear to enter an industry, the greater the barriers to entry, and the weaker this competitive force. High entry barriers may keep potential competitors out of an industry even when industry profits are high. Important barriers to entry include economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation. 1. Economies of scale Economies of scale arise when unit costs fall as a firm expands its output. Sources of economies include: • Cost reductions gained through mass-producing a standardized output • Discounts on bulk purchases of raw material inputs and component parts • The advantages gained by spreading fixed production costs over a large production volume • The cost savings associated with distributing marketing and advertising costs over a large volume of output 2. Brand Loyalty Brand loyalty exists when consumers have a preference for the products of established companies. A company can create brand loyalty by continuously advertising its brand-name products and company name, patent protection of its products, product innovation achieved through company research and development programs, an emphasis on high quality products, and exceptional after-sales service. Significant brand loyalty makes it difficult for new entrants to take market share away from established companies. 3. Absolute Cost Advantages Sometimes established companies have an absolute cost advantage relative to potential entrants, meaning that entrants cannot expect to match the established companies’ lower cost structure. Absolute cost advantages arise from three main sources: • Superior production operations and processes due to accumulated experience, patents, or trade secrets • Control of particular inputs required for production, such as labor, materials, equipment, or management skills that are limited in their supply • Access to cheaper funds because existing companies represent lower risks than new entrants 4. Customer Switching Costs Switching Costs arise when a customer invests time, energy, and money switching from the products offered by one established company to the products offered by a new entrant. When switching costs are high, customers can be locked in to the product offerings of established companies, even if new entrants offer better products. 5. Government Regulations Historically, government regulation has constituted a major entry barrier for many industries. The competitive forces model predicts that falling entry barriers due to government deregulation will result in significant new entry, an increase in the intensity of industry competition, and lower industry profit rates. If established companies have built brand loyalty for their products, have an absolute cost advantage over potential competitors, have significant scale economies, are the beneficiaries of high switching costs, or enjoy regulatory protection, the risk of entry by potential competitors is greatly diminished; it is a weak competitive force. Consequently, established companies can charge higher prices, and industry profits are therefore higher. 2.1 Strategy in Action: Circumventing Entry Barriers into the Soft Drink Industry The soft drink industry has long been dominated by two companies, Coca-Cola and PepsiCo. Both companies have historically spent large sums of money on advertising and promotion, which has created significant brand loyalty and made it very difficult for prospective new competitors to enter the industry and take market share away from these two giants. When new competitors do try and enter, both companies have shown themselves capable of responding by cutting prices, forcing the new entrant to curtail expansion plans. However, in the early 1990s the Cott Corporation, then a small Canadian bottling company, worked out a strategy for entering the soft drink market. The company used a deal with RC Cola to enter the cola segment of the soft drink market. Cott next introduced a private label brand for a Canadian retailer. Both of these offerings took share from Coke and Pepsi. Cott then decided to try and convince other retailers to carry private label cola. Cott spent almost nothing on advertising and promotion. These cost savings were passed onto retailers in the form of lower prices. For their part, the retailers found that they could significantly undercut the price of Coke and Pepsi colas, and still make better profit margins on private label brands than on branded colas. Despite the savings, many retailers were leery of offending Coke and Pepsi and declined to offer a private label. Cott was able to establish a relationship with Walmart as it was entering the grocery market. The “President’s Label” became very popular. Cott soon added other flavors to its offering, such as a lemon lime soda that would compete with Seven Up and Sprite. Moreover, pressured by Walmart, by the late 1990s other U.S. grocers also started to introduce private label sodas, often turning to Cott to supply their needs. By 2010, Cott had grown to become a $1.8 billion company, capturing over 6% of the U.S. soda market up from almost nothing a decade earlier, and held onto a 15% share of sodas in grocery stores, its core channel. The losers in this process were Coca-Cola and Pepsi Cola, who were now facing the steady erosion of their brand loyalty and market share as consumers increasingly came to recognize the high quality and low price of private label sodas. Teaching Note: As this case illustrates, entry barriers can be effective in discouraging new entrants; however, they can be circumvented. Cott was able to enter a much closed industry through a combination of its own efforts and the changes brought to the industry environment by the advent of Walmart. You can use this case in a classroom discussion to identify entry barriers in other industries. Another approach is to ask students to consider the lessons that other industries might learn from Cott. What did Cott do to lower entry barriers, and how could those tactics be used in another context? B. Rivalry Among Established Companies The second competitive force is the intensity of rivalry among established companies within an industry. Rivalry refers to the competitive struggle between companies within an industry to gain market share from each other. Four factors have a major impact on the intensity of rivalry among established companies within an industry: • Industry competitive structure • Demand conditions • Cost conditions • The height of exit barriers in the industry 1. Industry Competitive Structure The competitive structure of an industry refers to the number and size distribution of companies in it, something that strategic managers determine at the beginning of an industry analysis. Industry structures vary, and different structures have different implications for the intensity of rivalry. A fragmented industry consists of a large number of small or medium-sized companies. A consolidated industry is dominated by a small number of large companies (an oligopoly) or, in extreme cases, by just one company (a monopoly), and companies often are in a position to determine industry prices. Low-entry barriers and commodity-type products that are difficult to differentiate characterize many fragmented industries. This combination tends to result in boom-and-bust cycles as industry profits rapidly raise and fall. Low-entry barriers imply that new entrants will flood the market, hoping to profit from the boom that occurs when demand is strong and profits are high. Often the flood of new entrants into a booming, fragmented industry creates excess capacity, and companies start to cut prices in order to use their spare capacity. The difficulty companies face when trying to differentiate their products from those of competitors can exacerbate this tendency. The result is a price war, which depresses industry profits, forces some companies out of business, and deters potential new entrants. A fragmented industry structure, then, constitutes a threat rather than an opportunity. Economic boom times in fragmented industries are often relatively short-lived because the ease of new entry can soon result in excess capacity, which in turn leads to intense price competition and the failure of less efficient enterprises. In consolidated industries, companies are interdependent because one company’s competitive actions (changes in price, quality, etc.) directly affect the market share of its rivals, and thus their profitability. When one company makes a move, this generally “forces” a response from its rivals, and the consequence of such competitive interdependence can be a dangerous competitive spiral. Companies in consolidated industries sometimes seek to reduce this threat by following the prices set by the dominant company in the industry. However, companies must be careful, for explicit face-to-face price-fixing agreements are illegal. 2.2 Strategy in Action: Price Wars in the Breakfast Cereal Industry The breakfast cereal industry in the U.S. was one of the most profitable and desirable competitive environments, with steadily rising demand, brand loyalty, and close relationships with buyers (grocery retailers). Best of all, the industry was dominated by just three competitors, Kellogg’s, General Mills, and Kraft Foods. Kellogg’s, controlled 40% of the market share and was a price leader. It raised prices a bit each year, and the smaller companies followed suit. Then the industry structure changed. Huge discounters began to promote cheaper private brands and bagels or muffins replaced cereal as the preferred breakfast food. Under pressure, the big manufacturers began a price war, ending the tacit price collusion that had kept the industry stable and profitable. Although profit margins were slashed in half, the big three continued to lose market share to private brands. What was once a desirable industry is now exactly like most others—competitive, unstable, and far less profitable. Teaching Note: This case illustrates the sad outcomes that result when industry competitors react to increased pressure by breaking off tacit price collusion. You should be sure to emphasize to students the difference between tacit price collusion, which is indirect and therefore legal, and price fixing, which is overt and therefore illegal. The message here is that a well-run industry, with sustained high profitability and stability for all competitors, fell victim to powerful external forces. An interesting discussion question would be to ask students, “Is there any action the big three competitors can take now to undo the damage and recover their profitability?” If students suggest any action that they believe will restore the situation, ask them how the other competitors would be likely to react. For example, if students suggest a one-sided price increase, ask them if competitors would be likely to follow suit. Students may be surprised to realize how difficult it is to “put the genie back in the bottle”; once trust is destroyed, an industry may never be able to recreate stability and prosperity. 2. Industry Demand The level of industry demand is another determinant of the intensity of rivalry among established companies. Growing demand tends to reduce rivalry because all companies can sell more without taking market share away from other companies. Demand declines when customers exit the marketplace, or when each customer purchases less. 2. Cost Conditions The cost structure of firms in an industry is a third determinant of rivalry. In industries where fixed costs are high, profitability tends to be highly leveraged to sales volume, and the desire to grow volume can spark intense rivalry. In situations where demand is not growing fast enough and too many companies are simultaneously engaged in the same actions, the result can be intense rivalry and lower profits. 3. Exit Barriers Exit Barriers are economic, strategic, and emotional factors that prevent companies from leaving an industry. If exit barriers are high, companies become locked into an unprofitable industry where overall demand is static or declining. The result is often excess productive capacity, leading to even more intense rivalry and price competition as companies cut prices attempting to obtain the customer orders needed to use their idle capacity and cover their fixed costs. Common exit barriers include the following: • Investments in assets such as specific machines, equipment, or operating facilities that are of little or no value in alternative uses, or cannot be later sold. • High fixed costs of exit, such as severance pay, health benefits, or pensions that must be paid to workers who are being made laid off when a company ceases to operate. • Emotional attachments to an industry, such as when a company’s owners or employees are unwilling to exit from an industry for sentimental reasons or because of pride. • Economic dependence on the industry because a company relies on a single industry for its entire revenue and all profits. • The need to maintain an expensive collection of assets at or above a minimum level in order to participate effectively in the industry. • Bankruptcy regulations, particularly in the United States, where bankruptcy provisions allow insolvent enterprises to continue operating and to reorganize under this protection. These regulations can keep unprofitable assets in the industry, result in persistent excess capacity, and lengthen the time required to bring industry supply in line with demand. C. The Bargaining Power of Buyers The third competitive force is the bargaining power of buyers. An industry’s buyers may be the individual customers who consume its products (end-users) or the companies that distribute an industry’s products to end-users, such as retailers and wholesalers. The bargaining power of buyers refers to the ability of buyers to bargain down prices charged by companies in the industry, or to raise the costs of companies in the industry by demanding better product quality and service. Powerful buyers, therefore, should be viewed as a threat. Buyers are most powerful in the following circumstances: • When the buyers have choice of who to buy from. • When the buyers purchase in large quantities. In such circumstances, buyers can use their purchasing power as leverage to bargain for price reductions. • When the supply industry depends upon buyers for a large percentage of its total orders. • When switching costs are low and buyers can pit the supplying companies against each other to force down prices. • When it is economically feasible for buyers to purchase an input from several companies at once so that buyers can pit one company in the industry against another. • When buyers can threaten to enter the industry and independently produce the product, thus supplying their own needs, also a tactic for forcing down industry prices. D. The Bargaining Power of Suppliers The fourth competitive force is the bargaining power of suppliers—the organizations that provide inputs into the industry, such as materials, services, and labor (which may be individuals, organizations such as labor unions, or companies that supply contract labor). The bargaining power of suppliers refers to the ability of suppliers to raise input prices, or to raise the costs of the industry in other ways—for example, by providing poor-quality inputs or poor service. Powerful suppliers squeeze profits out of an industry by raising the costs of companies in the industry. Thus, powerful suppliers are a threat. As with buyers, the ability of suppliers to make demands on a company depends on their power relative to that of the company. Suppliers are most powerful in these situations: • The product that suppliers sell has few substitutes and is vital to the companies in an industry. • The profitability of suppliers is not significantly affected by the purchases of companies in a particular industry, in other words, when the industry is not an important customer to the supplier. • Companies in an industry would experience significant switching costs if they moved to the product of a different supplier because a particular supplier’s products are unique or different. • Suppliers can threaten to enter their customers’ industry and use their inputs to produce products that would compete directly with those of companies already in the industry. • Companies in the industry cannot threaten to enter their suppliers’ industry and make their own inputs as a tactic for lowering the price of inputs. Focus On: Wal-Mart Wal-Mart’s Bargaining Power over Suppliers When Wal-Mart and other discount retailers began in the 1960s, they were small operations with little purchasing power. The cost savings generated by not having to pay profits to wholesalers were passed on to consumers in the form of lower prices, which helped Wal-Mart continue growing. Because 8% of all retail sales in the United States are made in a Wal-Mart store, the company has enormous bargaining power over its suppliers. Suppliers of nationally branded products, such as P&G, are no longer in a position to demand high prices. Instead, Wal-Mart is now so important to P&G that it is able to demand deep discounts from P&G. Since the early 1990s, Wal-Mart has provided suppliers with real-time information on store sales through the use of individual stock-keeping units (SKUs). These have allowed suppliers to optimize their own production processes, matching output to Wal-Mart’s demands and avoiding under- or overproduction and the need to store inventory. The efficiencies that manufacturers gain from such information are passed on to Wal-Mart in the form of lower prices, which then passes on those cost savings to consumers. Teaching Note: This case describes the bargaining power of Wal-Mart over its suppliers. It provides a good opportunity to quiz the students on the pros and cons of having a bargaining power over an organization’s suppliers. E. Substitute Products The final force in Porter’s model is the threat of substitute products—the products of different businesses or industries that can satisfy similar customer needs. The existence of close substitutes is a strong competitive threat because this limits the price that companies in one industry can charge for their product, which also limits industry profitability. F. Complementors Complementors are companies that sell products that add value to (complement) the products of companies in an industry because, when used together, the use of the combined products better satisfies customer demands When the number of complementors is increasing and producing attractive complementary products, demand increases and profits in the industry can broaden opportunities for creating value. Conversely, if complementors are weak, and are not producing attractive complementary products, they can become a threat, slowing industry growth and limiting profitability. It’s also possible for complementors to gain so much power that they are able to extract profit out of the industry they are providing complements to. Complementors this strong can be a competitive threat. G. Summary: Why Industry Analysis Matters The analysis of forces in the industry environment using the competitive forces framework is a powerful tool that helps managers to think strategically. It is important to recognize that one competitive force often affects others, and all forces need to be considered when performing industry analysis. Industry analysis inevitably leads managers to think systematically about strategic choices. An analysis of industry opportunities and threats leads directly to a change in strategy by companies within the industry. This is the crucial point—analyzing the industry environment in order to identify opportunities and threats leads logically to a discussion of what strategies should be adopted to exploit opportunities and counter threats. IX. Strategic Groups within Industries Companies in an industry often differ significantly from one another with regard to the way they strategically position their products in the market. Factors such as the distribution channels they use, the market segments they serve, the quality of their products, technological leadership, customer service, pricing policy, advertising policy, and promotions affect product position. Figure 2.3: Strategic Groups in the Commercial Aerospace Industry Normally, the basic differences between the strategies that companies in different strategic groups use can be captured by a relatively small number of factors. A. Implications of Strategic Groups The concept of strategic groups has a number of implications for the identification of opportunities and threats within an industry: • Because all companies in a strategic group are pursuing a similar strategy, customers tend to view the products of such enterprises as direct substitutes for each other. Thus, a company’s closest competitors are those in its strategic group. • Different strategic groups can have different relationships to each of the competitive forces; thus, each strategic group may face a difference set of opportunities and threats. B. The Role of Mobility Barriers Some strategic groups are more desirable than others because competitive forces open up greater opportunities and present fewer threats for those groups. Managers, after analyzing their industry, might identify a strategic group where competitive forces are weaker and higher profits can be made. Sensing an opportunity, they might contemplate changing their strategy and move to compete in that strategic group. However, taking advantage of this opportunity may be difficult because of mobility barriers between strategic groups. Mobility barriers are within-industry factors that inhibit movement of companies between strategic groups. They include the barriers to entry into a group and the barriers to exit from a company’s existing group. Managers should be aware that companies based in another strategic group within their industry might ultimately become their direct competitors if they can overcome mobility barriers. X. Industry Life-Cycle Analysis Changes that take place in an industry over time are an important determinant of the strength of the competitive forces in the industry( and of the nature of opportunities and threats). The similarities and differences between companies in an industry often become more pronounced over time, and its strategic group structure frequently changes. The strength and nature of each of the competitive forces also change as an industry evolves, particularly the two forces of risk of entry by potential competitors and rivalry among existing firms. A useful tool for analyzing the effects that industry evolution has on competitive forces is the industry life-cycle model. This model identifies five sequential stages in the evolution of an industry that lead to five distinct kinds of industry environment—embryonic, growth, shakeout, mature, and decline (Figure 2.4). Figure 2.4: Stages in the Industry Life Cycle A. Embryonic Industries An embryonic industry refers to an industry just beginning to develop. Growth at this stage is slow because of factors such as buyers’ unfamiliarity with the industry’s product, high prices due to the inability of companies to reap any significant scale economies, and poorly developed distribution channels. Barriers to entry tend to be based on access to key technological knowhow, rather than cost economies or brand loyalty. Rivalry in embryonic industries is based not so much on price as on educating customers, opening up distribution channels, and perfecting the design of the product. B. Growth Industries Once demand for the industry’s product begins to increase, the industry develops the characteristics of a growth industry. In a growth industry, first-time demand is expanding rapidly as many new customers enter the market. Typically, an industry grows when customers become familiar with the product, prices fall because scale economies have been attained, and distribution channels develop. High growth usually means that new entrants can be absorbed into an industry without a marked increase in the intensity of rivalry. Thus, rivalry tends to be relatively low. Rapid growth in demand enables companies to expand their revenues and profits without taking market share away from competitors. C. Industry Shakeout Explosive growth cannot be maintained indefinitely. Sooner or later, the rate of growth slows, and the industry enters the shakeout stage. In the shakeout stage, demand approaches saturation levels—more and more of the demand is limited to replacement because fewer potential first-time buyers remain. As an industry enters the shakeout stage, rivalry between companies can become intense. Typically, companies that have become accustomed to rapid growth continue to add capacity at rates consistent with past growth. However, demand is no longer growing at historic rates, and the consequence is the emergence of excess productive capacity. This condition is illustrated in Figure 2.5, where the solid curve indicates the growth in demand over time and the broken curve indicates the growth in productive capacity over time. Figure 2.5: Growth in Demand and Capacity D. Mature Industries The shakeout stage ends when the industry enters its mature stage—the market is totally saturated, demand is limited to replacement demand, growth is low or zero. Typically, the growth that remains comes from population expansion, bringing new customers into the market or increasing replacement demand. As an industry enters maturity, barriers to entry increase, and the threat of entry from potential competitors decreases. As growth slows during the shakeout, companies can no longer maintain historic growth rates merely by holding on to their market share. As a result of the shakeout, most industries in the maturity stage consolidate and become oligopolies. In mature industries, companies tend to recognize their interdependence and try to avoid price wars. E. Declining Industries Eventually, most industries enter a stage of decline—growth becomes negative for a variety of reasons, including technological substitution, social changes, demographics, and international competition. Within a declining industry, the degree of rivalry among established companies usually increases. Depending on the speed of the decline and the height of exit barriers, competitive pressures can become as fierce as in the shakeout stage. F. Summary A third task of industry analysis is to identify the opportunities and threats that are characteristic of different kinds of industry environments in order to develop effective strategies. Managers have to tailor their strategies to changing industry conditions. XI. Limitations of Models for Industry Analysis The competitive forces, strategic groups, and life-cycle models provide useful ways of thinking about and analyzing the nature of competition within an industry to identify opportunities and threats. However, each has its limitations, and managers must be aware of their shortcomings. A. Life-Cycle Issues It is important to remember that the industry life-cycle model is a generalization. In practice, industry life-cycles do not always follow the pattern illustrated in Figure 2.4. In some cases, growth is so rapid that the embryonic stage is skipped altogether. In others, industries fail to get past the embryonic stage. Industry growth can be revitalized after long periods of decline through innovation or social change. The time span of these stages can also vary significantly from industry to industry. Some industries can stay in maturity almost indefinitely if their products are viewed as basic necessities, as is the case for the car industry. Other industries skip the mature stage and go straight into decline, as in the case of the vacuum tube industry. B. Innovation and Change Over any reasonable length of time, in many industries competition can be viewed as a process driven by innovation. Innovation is frequently the major factor in industry evolution and causes a company’s movement through the industry life-cycle. Innovation is attractive because companies that pioneer new products, processes, or strategies can often earn enormous profits. Successful innovation can transform the nature of industry competition. In recent decades, one frequent consequence of innovation has been to lower the fixed costs of production, thereby reducing barriers to entry and allowing new, and smaller, enterprises to compete with large established organizations. Michael Porter, talks of innovations as “unfreezing” and “reshaping” industry structure. He argues that after a period of turbulence triggered by innovation, the structure of an industry once more settles down into a fairly stable pattern, and the five forces and strategic group concepts can once more be applied. This view of the evolution of industry structure is often referred to as “punctuated equilibrium.” The punctuated equilibrium view holds that long periods of equilibrium (refreezing), when an industry’s structure is stable, are punctuated by periods of rapid change (unfreezing), when industry structure is revolutionized by innovation. Figure 2.6 shows what punctuated equilibrium might look like for one key dimension of industry structure: competitive structure. During a period of rapid change when industry structure is being revolutionized by innovation, value typically migrates to business models based on new positioning strategies. Figure 2.6: Punctuated Equilibrium and Competitive Structure C. Company Differences Another criticism of industry models is that they overemphasize the importance of industry structure as a determinant of company performance, and underemphasize the importance of variations or differences among companies within an industry or a strategic group. Research by Richard Rumelt and his associates, for example, suggests that industry structure explains only about 10% of the variance in profit rates across companies. This implies that individual company differences explain much of the remainder. Other studies have estimated the explained variance at about 20%, which is still not a large figure. These studies suggest that a company’s individual resources and capabilities may be more important determinants of its profitability than the industry or strategic group of which the company is a member. Although the findings do not invalidate the competitive forces and strategic group models, they do imply that the models are imperfect predictors of enterprise profitability. A company will not be profitable just because it is based in an attractive industry or strategic group. XII. The Macroenvironment Just as the decisions and actions of strategic managers can often change an industry’s competitive structure, so too can changing conditions or forces in the wider macroenvironment , that is, the broader economic, technological, demographic, social, and political context in which companies and industries is embedded (Figure 2.7). Changes in the forces within the macroenvironment can have a direct impact on any or all of the forces in Porter’s model, thereby altering the relative strength of these forces as well as the attractiveness of an industry. Figure 2.7: The Role of the Macroenvironment A. Macroeconomic Forces The four most important macroeconomic forces are the growth rate of the economy, interest rates, currency exchange rates, and inflation (or deflation) rates. • Economic growth, because it leads to an expansion in customer expenditures, tends to ease competitive pressures within an industry. This gives companies the opportunity to expand their operations and earn higher profits. • Interest rates can determine the demand for a company’s products. Interest rates are important whenever customers routinely borrow money to finance their purchase of these products. • Currency exchange rates define the comparative value of different national currencies. Movement in currency exchange rates has a direct impact on the competitiveness of a company’s products in the global marketplace. • Price inflation can destabilize the economy, producing slower economic growth, higher interest rates, and volatile currency movements. If inflation continues to increase, investment planning will become hazardous. o Price deflation also has a destabilizing effect on economic activity. If prices fall, the real price of fixed payments goes up. This is damaging for companies and individuals with a high level of debt who must make regular fixed payments on that debt. In a deflationary environment, the increase in the real value of debt consumes more household and corporate cash flows, leaving less for other purchases and depressing the overall level of economic activity. B. Global Forces Over the last half-century there have been enormous changes in the world’s economic system. The important points to note are that barriers to international trade and investment have tumbled, and more and more countries have enjoyed sustained economic growth. Falling barriers to international trade and investment have made it much easier to enter foreign nations. By the same token, however, falling barriers to international trade and investment have made it easier for foreign enterprises to enter the domestic markets of many companies (by lowering barriers to entry), thereby increasing the intensity of competition and lowering profitability. Because of these changes, many formerly isolated domestic markets have now become part of a much larger, more competitive global marketplace, creating both threats and opportunities for companies. C. Technological Forces Over the last few decades the pace of technological change has accelerated.. This has unleashed a process that has been called a “perennial gale of creative destruction.” Technological change can make established products obsolete overnight, and simultaneously create a host of new product possibilities. Thus technological change is both creative and destructive—both an opportunity and a threat. The impacts of technological change can affect the height of barriers to entry and therefore radically reshape industry structure. D. Demographic Forces Demographic forces are outcomes of changes in the characteristics of a population, such as age, gender, ethnic origin, race, sexual orientation, and social class. Like the other forces in the general environment, demographic forces present managers with opportunities and threats and can have major implications for organizations. E. Social Forces Social forces refer to the way in which changing social mores and values affect an industry. Like the other macroenvironmental factors, social change creates opportunities and threats. F. Political and Legal Forces Political and legal forces are outcomes of changes in laws and regulations, and significantly affect managers and companies. Political processes shape a society’s laws, which constrain the operations of organizations and managers and thus create both opportunities and threats. Teaching Note: Ethical Dilemma While discussion could enter into whether or not moral objections should influence analysis and recommendations, the real question should focus on whether or not casinos will be a complement to the industry. Will casinos bring value to the customers? Will casinos generate demand for the hotel industry? Answers to Discussion Questions 1. Under what environmental conditions are price wars most likely to occur in an industry? What are the implications of price wars for a company? How should a company try to deal with the threat of a price war? Price wars are most likely to occur when the following conditions are present in an industry: • The product is a commodity • Exit barriers are substantial • Excess capacity exists • The industry is consolidated • Demand is declining A price war constitutes a strong threat. It is difficult for companies that market commodity-type products to build brand loyalty; therefore, competition tends to focus on price. High exit barriers make it hard for companies to eliminate excess capacity through plant closings. In turn, the persistence of excess capacity leads to price cuts, as companies strive to generate enough demand to utilize their ideal capacity and cover fixed costs. In a consolidated industry, interdependence implies that one company’s price cuts will elicit a response from its rivals, producing a downward spiral of prices. And it is declining demand that produces excess capacity and sparks off a price war in the first place. If all these conditions are present a severe price war is likely. Survival depends on a company’s ability to reduce operating costs and build brand loyalty so that it can retain its customers and still make profits when those of its competitors have dried up. Furthermore, the risk of a damaging price war can be reduced if the company can successfully enter into tacit price agreements with its competitors and if it can stress nonprice factors when competing. As demand declines, however, tacit price agreements can be difficult to maintain. Finally, if excess capacity is the major reason for a price war, capacity reduction agreements between competitors, or mergers between competitors followed by the elimination of excess capacity, may be suitable strategies for attacking this problem. 2. Discuss the competitive forces model with reference to what you know about the global market for commercial jet aircraft (see the Opening Case). What does the model tell you about the level of competition in this industry? Potential competitors: Recent high profitability and an enormous surge in demand for new aircraft is driven primarily by demand for air travel worldwide and there is room for new entrants. Barriers to entry is that Embraer and Bombardier are focused primarily on regional market, and the market for aircraft with more than 100 seats has been totally dominated by Boeing and Airbus. Rivalry among established companies: Rivalry between Boeing, Airbus and the three new entrants is minimal. All three are building narrow-bodied jets with a seat capacity between 100 and 190. Boeing’s 737 and the Airbus A320 currently dominate the narrow-bodied segment. The Commercial Aircraft Corporation of China (Comac) is building a 170- to 190-seat narrow-bodied jet, scheduled for introduction in 2016. Bargaining power of buyers: Consumers have little power in the large commercial jet aircraft industry. However, when substitutes are available they are able bargain down prices as was done historically in the industry. Bargaining power of suppliers: Suppliers in the large commercial jet aircraft have little power. Suppliers are also threatened by potential and existing substitutes. 3. Identify a growth industry, a mature industry, and a declining industry. For each industry, identify the following: (a) the number and size distribution of companies; (b) the nature of barriers to entry; (c) the height of barriers to entry; and (d) the extent of product differentiation. What do these factors tell you about the nature of competition in each industry? What are the implications for the company in terms of opportunities and threats? Students’ answers will vary depending on the companies they select. For example, growth industries might include the personal computer industry, the computer software industry, and the nursing home industry. Mature industries include the auto industry, the airline industry, and the beer industry. Declining industries include the tobacco industry, the sugar industry, and the steel industry. Growth industries tend to have many firms and are relatively fragmented. Barriers to entry may center on access to technological know-how, but overall, are low. Product differentiation also tends to be relatively low. Mature and declining industries have fewer firms and are more consolidated than growth industries. In addition, they have much higher barriers to entry, in the form of cost economies and brand loyalties. Product differentiation in mature and declining industries becomes much greater as an industry approaches maturity. These changes reveal that the nature of competition in an industry also changes as the industry moves from growth through maturity and into decline. Specifically, a growth industry is characterized by relatively benign competitive pressures. Mature industries are characterized by an emphasis on nonprice competition as a means of avoiding damaging price wars, although price wars may break out from time to time. Competition in a declining industry depends on the speed of decline and the height of exit barriers. The faster the decline and the higher the exit barriers, the more intense is the competition within a declining industry. 4. Assess the impact of macroenvironmental factors on the likely level of enrollment at your university over the next decade. What are the implications of these factors for the job security and salary level of your professors? The most significant macroenvironmental factor on the likely level of enrollment at an university is to be found in the demographic environment. In the 1980s and early 1990s, many universities experienced a decline in enrollments due to the declining birthrate in the 1960s and 1970s. Starting in the late 1990s, however, enrollments had risen as a result of the “baby boomlet” that occurred when the children of the Baby Boomers entered their late teen years. Rising enrollments led to increased demand for higher education. Universities are now able to increase their admission standards and smaller, regional schools are absorbing some of the excess demand. In addition, the economic downturn has led to an increase in older students returning to school for degrees, especially in business and other professions. On the negative side, legislative spending is lower, because state tax revenues are less. Universities are thus stuck in the position of trying to increase offerings while also reducing costs. Many colleges are responding by hiring more faculty but paying less, which they can accomplish by increasing the number of temporary, adjunct, or graduate student faculty members. Practicing Strategic Management Small-Group Exercise: Competing With Microsoft The students are asked to break into groups of three to five people, and discuss the following scenario. They are asked to appoint one group member as a spokesperson who will communicate their findings to the class. You are a group of managers and software engineers at a small start-up. You have developed a revolutionary new operating system for personal computers that offers distinct advantages over Microsoft’s Windows operating system: it takes up less memory space on the hard drive of a personal computer; it takes full advantage of the power of the personal computer’s microprocessor, and in theory can run software applications much faster than Windows; it is much easier to install and use than Windows; and it responds to voice instructions with an accuracy of 99.9%, in addition to input from a keyboard or mouse. The operating system is the only product offering that your company has produced. They are then asked to complete the following exercise: 1. Analyze the competitive structure of the market for personal computer operating systems. On the basis of this analysis, identify what factors might inhibit adoption of your operating system by customers. 2. Can you think of a strategy that your company might pursue, either alone or in conjunction with other enterprises, in order to “beat Microsoft”? What will it take to execute that strategy successfully? Teaching Note: This case will serve as a powerful illustration to students that even the best product will not succeed in a severely hostile environment. Although some of the five forces are favorable in this case—low power of buyers and lack of substitutes—others are extremely negative, such as the very high barriers to entry and the intense rivalry. However, the most important factor is the lack of complementors. Students will discover that, even though the innovative operating system is superior to Microsoft’s Windows, without complementing software (e.g. word processing, spreadsheet, etc.), the new operating system will have no chance to succeed. Software developers will have no incentive to write for this new operating system, and without sufficient software, the product will fail to gain a foothold in the industry. Thus, the strategic goal of the start-up should be to create an as large as possible installed base of computers using its operating system. The start-up can either decide to give the operating system away for free or sell it for a nominal fee to original equipment manufacturers like Compaq in the hope that software developers will start writing software for this new operating system. On the other hand, given that Microsoft has all the necessary complementary assets in house, it might be wiser for the start-up to cooperate with Microsoft. Strategy Sign On Article File 2 Students should find an example of an industry that has become more competitive in recent years. They should identify the reasons for the increase in competitive pressure. Teaching Note: Completion of this exercise will help students to see that the intensity of competition is increasing in most industries. They should have no trouble identifying industries with increasing competition. Reasons for the increased competition are many. First, many of the factors mentioned in Porter’s model are changing across many industries in ways that will increase competition. For example, the U.S. and many other national governments are reducing industry regulation, lowering barriers to entry and opening up industries that were formerly monopolistic to competition. International regulation is also decreasing, raising competitive intensity for multinational firms. Another change is the consolidation that resulted from the merger-and-acquisition fever of the 1980s and 1990s. Higher consolidation has led to increased competition. Higher consolidation in the buyer and supplier industries, such as the increased power of giant discount retailers, has also put competitive pressure on many firms. Second, industries, especially in developing countries, are starting to mature, which tends to increase competitive intensity. Strategic Management Project: Module 2 This module requires students to analyze the industry environment in which their companies are based using the information they have already gathered. Teaching Note: Because this is the first module of the strategic management project that requires the gathering of a great deal of information, you should ensure that students are able to access sufficient data to perform a detailed analysis of their firm’s external opportunities and threats. Students may tend to rush through this section of the strategic management project because it appears to be a fairly mechanical exercise in information gathering. However, students should be encouraged to do a thorough and careful job in this section for three reasons. First, this analysis, along with the analysis of strengths and weaknesses that will be performed in Chapter 3, serves as the foundation for all of the remaining sections of the project. A poor job in this section will make it very difficult to do well in future assignments. Second, a hurried project may not aid students in understanding the concepts of the chapter in detail. For example, there are five major components to Porter’s model, and each consists of several sub-components, each of which must be analyzed individually in order to provide an accurate overall assessment. Third, you can point out to students that this section is not merely a mechanical exercise, but also involves higher-level analytical skills. The students must gather data, and they must interpret that data. In particular, deciding whether a specific fact conveys more of a threat or more of an opportunity can be challenging and requires some careful thought. What threatens one industry may benefit another. For example, the aging population has constituted a threat for baby food manufacturers, but it has proven to be a boon for the home nursing care industry. It is also important in this section that students use as many different analytical tools as possible, including Porter’s five forces and complementors, strategic groups, and macroenvironmental analysis. You should emphasize to students that each of these tools provides a different type of insight such as the dynamics of the industry, stage of the life cycle in the industry, global expansion initiatives, and national context to a firm’s managers, and that use of every available tool will provide the most well-rounded and realistic picture of the industry. Closing Case The United States Airline Industry The U.S. airline industry has long struggled to make a profit. Analysts point to a number of factors that have made the industry a difficult place in which to do business. Over the years, larger carriers such as United, Delta, and American have been hurt by low-cost budget carriers entering the industry, including Southwest Airlines, Jet Blue, AirTran Airways, and Virgin America. These new entrants have used nonunion labor, often fly just one type of aircraft (which reduces maintenance costs), have focused on the most lucrative routes, typically fly point-to-point (unlike the incumbents, which have historically routed passengers through hubs), and compete by offering very low fares. New entrants have helped to create a situation of excess capacity in the industry, and have taken share from the incumbent air- lines, which often have a much higher cost structure (primarily due to higher labor costs). The incumbents have had little choice but to respond to fare cuts, and the result has been a protracted industry price war. To complicate matters, the rise of Internet travel sites such as Expedia, Travelocity, and Orbitz has made it much easier for consumers to comparison shop, and has helped to keep fares low. Beginning in 2001, higher oil prices also complicated matters. Fuel costs accounted for 32% of total revenues in 2011 (labor costs accounted for 26%; together they are the two biggest variable expense items). Many airlines went bankrupt in the 2000s, including Delta, Northwest, United, and US Airways. The larger airlines continued to fly, however, as they reorganized under Chapter 11 bankruptcy laws, and excess capacity persisted in the industry. The late 2000s and early 2010s were characterized by a wave of mergers in the industry. In 2008, Delta and Northwest merged. In 2010, United and Continental merged, and Southwest Airlines announced plans to acquire AirTran. In late 2012, American Airlines put itself under Chapter 11 bankruptcy protection. US Airways subsequently pushed for a merger agreement with American Airlines, which was under negotiation in early 2013. Teaching Note: This case introduces many of the themes of Chapter 2, including the impact that competitive forces have on industry behavior and profitability, concepts about market segmentation and strategic groups, and the changing nature of competition over an industry’s life cycle. One of the most important lessons of this chapter and this case, and one that may be somewhat surprising to students, is the very strong influence that external environments can have on firm performance. Much of what is discussed in the popular business literature focuses on the achievements or shortcomings of individual managers and other forces internal to the firm. But it is worthwhile to remind students that external forces can have just as much impact and can even cause the demise of industries with competent managers. Answers to Case Discussion Questions 1. Conduct a competitive forces analysis of the U.S. airline industry. What does this analysis tell you about the causes of low profitability in this industry? Students’ answers may vary. However, some of them may include the following points: • Potential competitors: Recent high profitability and an enormous surge in demand for new aircraft is driven primarily by demand for air travel. • Rivalry among established companies: The rivalry in U.S airline industry is heavy. Over the years, larger carriers such as United, Delta, and American have been hurt by low-cost budget carriers entering the industry, including Southwest Air- lines, Jet Blue, AirTran Airways, and Virgin America. These new entrants have used nonunion labor, often fly just one type of aircraft (which reduces maintenance costs), have focused on the most lucrative routes, typically fly point-to-point (unlike the incumbents, which have historically routed passengers through hubs), and compete by offering very low fares. The incumbents have had little choice but to respond to fare cuts, and the result has been a protracted industry price war. • Bargaining power of buyers: Consumers have little power in the U.S airline industry. However, when substitutes are available they are able to bargain down prices as was done historically in the industry. • Bargaining power of suppliers: Suppliers in the U.S airline industry have little power. Suppliers are also threatened by potential and existing competitors. 2. Do you think there are any strategic groups in the U.S. airline industry? If so, what might they be? How might the nature of competition vary from group to group? Students answer will vary. While answering this question, they should keep in mind that within most industries, it is possible to observe groups of companies in which each company follows a strategy that is similar to that pursued by other companies in the group, but different from the strategy pursued by companies in other groups. These different groups of companies are known as strategic groups. 3. The economic performance of the airline industry seems to be very cyclical. Why do you think this is the case? Students’ answers may vary. Some of them may point out the fact that the 2000s have not been kinder to the industry. The airline industry lost $35 billion between 2001 and 2006. It managed to earn meager profits in 2006 and 2007, but lost $24 billion in 2008 as oil and jet fuel prices surged throughout the year. In 2009, the industry lost $4.7 billion as a sharp drop in business travelers—a consequence of the deep recession that followed the global financial crisis—more than offset the beneficial effects of falling oil prices. The industry returned to profitability in 2010–2012, and in 2012 it managed to make $13 billion in net profit on revenues of $140.5 billion. The reason behind this cyclical economic performance is associated with the deep recession in the late 2000s followed by the global financial crisis. 4. Given your analysis, what strategies do you think an airline should adopt in order to improve its chances of being persistently profitable? Students’ answer will vary. Some of them may say that an airline should try to keep its prices reasonable for all its customers. When the airline is anticipating a price hike, it should give at least 30 days prior notice to the customers. This way, the customers will be prepared for it. The airline could introduce programs, such as frequent flier miles, gift coupons, etc., that reward customer loyalty. Solution Manual for Strategic Management: Theory: An Integrated Approach Charles W. L. Hill, Gareth R. Jones, Melissa A. Schilling 9781285184494