Business strategy part 1

BUSINESS
STRATEGY PART 1
Mcenroe ng

An Introduction to StrategicAnalysis
1. introduce the idea of the fundamental principle of business strategy.
2. two perspectives in strategy. On the source of economic grants.

■ definition from KennethAndrews a famous strategist who had a book in 1971, called
The Concept of Corporate Strategy
■ Strategy is the pattern of decisions in a company that determines and reveals its
objectives, purposes, or goals, produces the principal policies and plans for achieving
those goals, and defines the range of business the company is to pursue, the kind of
economic and human organization it intends to be, and the nature of the economic
and noneconomic contribution it intends to make to its shareholders, employees,
customers, and communities.

■ First, objectives, purposes, and goals. Defines the mission of the organization here. Part of
strategy is understanding what is the objective of the organization.
■ Polices and plans for achieving those goals.What is the way in which they're going to
deliver on this mission?
■ The range of business the company is to pursue, how do we define the scope of the
organization. What are the businesses and markets that it decides to plan? Is it a global
company or is it a more local company?
■ And then finally, what is the contribution it tends to make, both economic and non
economic? How does it create value and for whom does it create value for?
■ We start with this idea of the strategic mission.A firm's value, it's purpose, what's the scope
of its operations. How do we define the business?And how do we express its aspirations?

■ Strategic plan.
■ So the strategic plan is the way in which it achieves its strategic mission. How does the
firm position itself in its markets? How does it leverage its internal resources and
capabilities?To accomplish its strategic mission.
■ Last but not least, strategic action.This is where the rubber really hits the road.What
are the action a firm takes along with their plan to achieve their mission.This could
include things like a merger and acquisition, perhaps innovating a new product line, or
developing a robust supply chain. Once again, together these strategic actions help
define what the strategy of the organization is.

StrategicAnalysis
■ How does one assess a business strategy?
■ We define strategic analysis as the assessment of an organization's current
competitive position
■ and the identification of valuable competitive positions in the future and how to
achieve them.

StrategicAnalysis
■ First, strategic analysis is done from a generalist perspective.
■ We cross the functional boundaries of the business.
■ strategic analysis in my opinion is foundational.
■ we reference first principles primarily coming from economics, but from other
disciplines as well.
■ And that strategy ultimately serves as the base by which other activities of the
organization flow out of. So if you are coming up with a capital budgeting plan for the
organization or a marketing plan, those should be based on the overall strategic plan
you have for the organization.

StrategicAnalysis
■ Second, by emphasizing this idea of strategic reasoning.We need to think about
strategy in the context of the larger market and the larger competitive market that a
firm operates in.
■ to really understand strategy and when it's successful, we need to understand rivalry
and competitive dynamics over time and we need to do so in all of the complexity and
uncertainty of the real world that businesses and organizations deal with.

StrategicAnalysis
■ Third, our analysis needs to be grounded in analytics and data.
■ the strategist toolkit, a variety of different tools and frameworks one can use when
analyzing a business strategy.
■ And most importantly, ways we can integrate across these various frameworks and
tools, understanding when it's more appropriate to apply one tool or framework
versus another, and then ultimately how to bring them back together.

StrategicAnalysis
■ Now an obvious question is who does strategic analysis?
■ The first response of most people to this question would be well CEO or the President of a company or an
organization
■ But there's others as well. Entrepreneurs, small business owners, strategy is important to them as well.
■ And larger organizations, it's not uncommon to see aVP for strategic planning or even a Chief Strategy
Officer within those organizations.
■ People who are dedicated to analyzing the strategy for their organizations. For larger, multi business unit
companies, you might have general managers each within their own business units, who need to do
strategic analysis to advance their particular line of business.
■ But strategy is not limited to just those who're leading organizations. I would argue anyone who wishes to
evaluate a strategy needs to understand how to do strategic analysis. This might be investors or financial
analysts who are interested in what are the potential financial returns to a business. They would argue it is
impossible to do that if you don't have a fundamental understanding of what their strategy is moving
forward.

StrategicAnalysis
■ What about someone who wants to make recommendations for future strategic actions?
■ Things like management consultants and the like once again, it is fundamental to having
an understanding of their business strategy to be able to provide those recommendations.
■ Last but not least, we shouldn't lose sight of other, what we might call secondary
stakeholders.These are people who might be affected by an organization or have a stake in
an organization, but maybe aren't those direct constituencies you might think about, like
employees or customers.This could be anything from an activist group or to government
regulators.
■ For them, it is very often necessary and helpful to understand how businesses will react to
various stimuli and pressures put on them and to understand what is their strategic intent
and how they are thinking about strategy moving forward. So at the end of the day,
strategy and strategic analysis, in particular are really tools that are useful to a wide variety
of individuals and stakeholders, who are affected by organizations.

The Strategist's Challenge
■ When one is doing a strategic analysis one needs to ask three fundamental questions.
The first question is what are the values of the organization?And by this I mean the
values, the mission, the scope of the organization. How do they define themselves?

■ One way to analyze a firm's values or its missions is to look at its mission statements. Most
publicly traded companies have these displayed on their website or their corporate annual
report
■ TheWalt Disney Company, the mission of the Walt Disney Company is to be one of the
world's leading producers and providers of entertainment and information.
■ So first of all it defines the industry in which Disney operates, entertainment and
information, that's somewhat interesting.
■ Second, they define their aspirations.They want to be one of worlds leading producers. A
global company and one of the leaders producers within the entertainment and
information segment. Consider Google's mission statement.To organize the world's
information and make it universally accessible and useful.Very broad definition here. One
in which they express very high aspirations here in terms of what they're looking to
accomplish.

■ Contrast that with Dell. Dell's mission is to be the most successful computer company
in the world at delivering the best customer experience in markets we serve.They
define themselves as the computer company to find how they're going to deliver
better value. By delivering the best customer experience.
■ Citigroup is to be the most respected global financial services company. Like any other
public company, we're obligated to deliver profits and growth to our shareholders. Of
equal importance is to deliver these profits and generate growth responsibly.
■ Here is now we've incorporated values explicitly into the mission statement.Their
objective is beyond just delivering profits. But also to deliver profits and generate
growth in a responsible way. So you see these values starting to permeate their
statement.

■ The second thing you must ask yourself is about opportunities.
■ So opportunities are the external environment in which you operate in.What does the
market value?What does the market demand?
■ Kodak. For nearly 100 years, Kodak was one of the leading companies in the world.
Producers of film, pioneers in film, they had both capabilities and values and a mission
statement that allowed them to be highly successful. But the world changed and as you
might guess, with the advent of digital technology, Kodak declared bankruptcy a few years
back.What happened?
■ Well, the opportunity set changed for them ultimately. So while, wonderful organization,
great capabilities, wonderful mission and values, at the end of the day opportunities were
not available to them, at least in the way they had historically defined their business.

■ Last but not least, our capabilities and this is where we take a more internal focus.What
does the company do well?What are their capabilities?What are their assets that they
might have that they can leverage to meet market opportunities?
■ The idea of competitive advantage.
■ Competitive advantage is always relative to your competition. It's not sufficient to just be
good at something or even to be great at something. If everyone else is great as well. So if
you have a high quality product but everyone else in the market has a high quality product,
that's not a competitive advantage.
■ understanding those distinctive things that a firm does that differentiate it from it's peers.
Taking together values, opportunities, and capabilities define the Strategist's Challenge
and the three main questions we need to ask. It's at the intersection of those three
questions that reveals valuable competitive positions.Those positions within a market that
an organization can take that will allow them to survive and thrive and create the most
value for its stakeholders.

The Strategist's Challenge: value
competitive position
values
capabilitiesopportunities

Fundamental Principle of Business Strategy
■ In a perfectly competitive market, no firm realizes economic profits, or what are often
termed economic rents.
■ First off, this concept of economic profits or rents.
■ The definition is an economic profit or rent are returns in excess of what an investor
expects to earn from investments of similar risk.
■ In other words, in excess of the opportunity costs of capital.

Fundamental Principle of Business Strategy
■ This is the idea that the economic return you need from investment must exceed the
alternative uses you might have of that money.
■ Consider the following two examples. One company takes $100 million and turns that
into a $1 million profit.Another company takes $10 million and turns that into $1
million profit.
■ Clearly, the latter example is a more sound and attractive investment. Both generated
to be clear $1 million worth of profit, but the first one took more money to generate it.
■ This, in essence, gets to this idea of the opportunity cost of capital. How else could
they have invested that $100 million?Could they have invested it in another
investment that would have had a higher return than $1 million.

Fundamental Principle of Business
Strategy
■ Let me illustrate this with some data here. Here we have three companies, iconic companies.This is data from 1998. And it
expresses both, their accounting profits, what they report in the popular press and in their annual reports and their actual
economic profits, factoring in this opportunity cost of capital.
■ So first we have IBM. IBM north of $6 billion in accounting profit, yet when we calculate the opportunity cost of capital, mid-
$2 billion or so created there.
■ Compare that to Microsoft , four billion dollars in accounting profit reported. But nearly $4 billion in economic profit as well.
This is in part because of the nature of the software business.There's huge fix costs in developing an operating system
■ However, once you have the operating system built, the marginal cost is next to zero. And as a result, as BillGates once
famously said, it's like printing money once you have a dominant operating system. Compare that to General Motors.
■ General Motors in 1998 did produce a profit, accounting profit that is, nearly $3 billion. However, when we consider
economic profit, it was nearly a $5 billion loss. Why such a drastic difference there? Well, in part, it was because hundreds of
billions of dollars had been spent by General Motors to generate that $3 billion worth of profit. Again, the opportunity cost
of that capital could have been used in other ways that would have likely have been far more profitable than what General
Motors was doing with that money.

Strategy
■ So, one might ask, how do we measure economic profit?
■ A common way that strategy researchers use is what's calledTobin's Q.
■ In its simplest form,Tobin's Q is, in essence, the ratio of market value to book value.
■ Technically though, what we actually look at is the asset replacement value. So the firm's market
valuation.What the market thinks the company is worth versus the replacement value of the assets
on hand.
■ Facebook has a very high market valuation, so the market thinks it's very highly. But the replacement
value for its assets is probably fairly low when you think about the relatively small employment they
have and the number of assets they have on hand there.
■ That difference is what we're looking for here.WhatThis is does, in essence, is directly measure these
economic rents we're interested in, above the physical inputs that the company might possess.The
challenge withTobin's Q is it's often difficult to actually calculate this replacement value of assets
here, and requires a knowledge that you may not have at the organizational level. An alternative is
what's called discounted cash flow.

Strategy
■ Discounted cash flows are ways of measuring the value of the firm going forward.
■ It's a measure of the revenue minus the costs minus other investment the company
makes moving forward.We discount those cash flows because the value of money is
worth more today than in the future. And in essence this discount rate that we use
reflects the actual return on equity, in essence, this opportunity cost we're interested
in. So the discount rate would reflect both inflation.
■ But also the rate of return we expect to get above inflation for similar investments of
similar risk.And at the end of the day, we calculate what's called a net present value.
And a positive NPV, or net present value, indicates rents over and above the referent
returns to all other inputs. And this is somewhat the gold standard for measuring
economic profit.

Competitive Markets
■ fundamental principle. In a perfectly competitive market, no firm realizes economic
profits or rents.This suggests that the existence of economic profits suggests some
type of market inefficiency.
■ Your now talking about market inefficiency.The existence of these economic profits,
you must be exploiting some type of market inefficiency.

Competitive Markets
■ Here we have an industry, and we have a classic supply and demand curve. Our demand
curve is downward sloping, why is that?
■ Well on our x axis, or our horizontal axis, we have the quantity demanded.On the y axis, or
the vertical axis, we have price.
■ So the idea is as we lower prices more people will demand a gooder service, creating a
downward sloping demand curve. On the other hand we have supply coming from different
producers. And the assumption is as prices increase there is more supply that you're willing
to provide. So we have an upward sloping supply curve. Now the fundamental rule, if you
will, the fundamental law of competitive markets, is that prices tend to equilibriate where
supply equals demand. So we have P1 here at that intersection of supply and demand, and
that also implies a certain quantity demanded given by Q1. So this is great.This is what
happens at the market level. But now let's consider what this means at the firm level.

Competitive Markets
■ Consider a t-shirt vendor.
■ First question is what price do they charge, but we're going to argue that they are
what we call a price taker. Meaning, basically, that they charge whatever the market
prevailing price is in the market.

Competitive Markets
■ Now of course they could charge more than the market price. But if they do so,
arguably they would sell no, because people will go to a lower cost t-shirt vendor.
■ They could charge less price for their t-shirts, but in this case, we're trying to figure out
how they can maximize their profitability.And so you would argue they would charge
the maximum price they could with still being able to sell t-shirts. So in our graph, we
have two curves.

Competitive Markets
■ we have two curves. We have our average cost curve, and our marginal cost curve, AC
and MC.
■ The average cost has the shape that it does because it reflects the fact that there are
probably some fixed costs to producing, in our case here, our t-shirts. So to produce
just one t-shirt requires all the equipment. Perhaps the van has to bring the supply to
the venue. So it's quite expensive to sell that first t-shirt.
■ But as we sell more and more, we spread out those fixed costs across the t-shirts we
sold, lowering the average cost, the average cost per t-shirt sold. Eventually though,
maybe we'll run into a capacity constraint. Maybe we need to build another printing
press. Maybe we need to buy another van or hire another person, and as a result, our
average cost curve goes up.

Competitive Markets
■ The marginal cost curve, the MC, represents the marginal cost to sell one additional t-
shirt. How much more does it cost for me to sell that next t-shirt?
■ And technically, it is the derivative of the average cost curve. Now, our decision rule
here, if we did the math, is that the firm should set the quantity they sell to the place
where price equals marginal cost. And you can see this graphically by looking at the
spaces that it creates. P1 times Q1 gives you your revenue.

Competitive Markets
■ This tells you the amount of money that you
bring in from the sale of the t-shirts.
■ Q1 times AC gives you your cost.This is your
average cost times the quantity sold, gives
you your total costs.And that leaves then, a
profit left over at the end of the day.And
one can play around with different Q1
values, but you'll find that setting Q1 values,
such that price equals marginal costs,
maximizes the square of that green space
that's left over after subtracting costs.

Competitive Markets
■ Well, one could argue that others will observe the t-shirt vendor making money, and
decide, I'm gonna sell t-shirts as well. I'm going to enter into that market, and begin
selling t-shirts.What does that do to our industry?
■ Well, what it does is effectively shift out our supply curve. Now, for any given price,
there is more supply available on the market. But our laws of supply and demand don't
go away.What we find then, is that at the new supply curve and where it crosses our
demand curve, we have a lower price. So prices come down as a result of this
entry. And we now sell actually more t-shirts as an industry. Once again, supply must
equal demand, we get P2 and Q2. Prices come down, quantity sold as an industry,
goes up.

Competitive Markets
■ But our firm is still a price taker. So, their
new price is now P2, and our decision rule
still holds where we set the quantity sold
such that P price equals marginal costs,
giving us Q2. So what happens is while the
market is expanding, the amount we sell
goes down. In essence, the new entrance
steals market share from us by entering into
the industry.Well, what does this do to our
profitability? P2 times Q2, once again, gives
us our revenue. Q2 times our average cost
gives us our cost, and then the way I have it
drawn here, profits are competed away.

Competitive Markets
■ Now, technically, in a competitive market, economic profits are accounted away, but
actually, accounting profits can still exist. So while I've illustrated it here with all profits
going away, it is possible for there to be a little bit of green area there that might exist even
in a competitive market.
■ When a potential competitor might decide to enter the industry, they'll see what their
impact will be.And they might decide not to enter if they see the profitability gets so small
that they're better off investing their money in some other alternative.This gets at the
heart of this idea of the opportunity cost of capital. So it's not that the accounting profits
are competed away, but it's that these economic profits are competed away once we factor
in that cost to capital. So once again, the fundamental principle of business, in competitive
markets, economic profits are competed away. And then flipped around, for there to exist
economic profits, there must be some market inefficiency that prevents this race, if you
will, to the bottom of perfectly competitive markets.

A Little Calculus
■ We discussed the idea that in a competitive market a firm will set the quantity sold
such that price equals marginal cost.
■ where did we come up with that decision rule?
■ a little calculus here to understand why we have this decision rule that price should
equal marginal cost is where we should set our quantity.

A Little Calculus
■ Consider the following profit function. Profits equal simply revenues minus our
variable costs minus our fixed costs, variable cost being, again, the cost for producing
a certain number of goods, and the fixed cost being things we incur even before we
sell our first good.

A Little Calculus
■ Mathematically, we represent it using pi to represent profits.We have our revenues,
which is our price times the quantity sold.
■ We represent variable cost simply as a function of the quantity sold. So, C as a function
of q1. And then we have our fixed cost, represented by CF which is basically a fixed
parameter within the model.
■ remember to maximize an expression, an objective function.You take the derivative
with respect to the decision variable you have and you set it equal to zero.
■ here is the quantity sold. Once again, we are price takers.We are given the price by the
market. So we can just simply choose how many t-shirts, in our t-shirt example, we are
likely to sell.

A Little Calculus
■ we take the derivative, set it equal to zero and what we find is, the derivative for the
revenue of piece, ends up being the price.We represent the derivative or cost function
or variable cost function as simply as the derivative of the cost function with the c
prime q1.
■ The fixed costs fall out at this point, and once again we set it to zero. Moving things
around, we get P1 should equal the derivative of our cost function.The derivative of
our cost function, you might recall, is simply our marginal cost, hence giving us the
decision rule to set quantity such that price equals marginal cost. And then, once
again, it generates the following result that we see in our graph here. If you'd like to
play around with it, you can move q1 around. And you'll find that what maximizes the
size of the profits created in this case is placing q1 where we've placed it on the graph
here.

Two Perspectives on Economic Rents
■ the fundamental principle of business strategy is that in perfectly competitive
markets, no firm realized economic profits or rents.
■ This suggest that the existence of economic profits suggests some type of market
inefficiency and our task as strategists is to identify ways in which firms may capitalize
on these market imperfections. Now as obvious question is, are these markets actually
perfectly competitive?

Fact
■ Average industry returns vary even after controlling for risk. In other words when we
look across industries, even controlling for the different risk profiles we might see in
industries, we see that the returns vary across these industries.
■ Even more interestingly, we find that returns across companies within an industry vary
even more. So in other words, the variance of profitability within a given industry
tends to be very high.
■ And then third, the returns to individual companies and the structure of
these industries tends to vary over time so that the returns that a company might
get one day might be very different than what it gets 20 years from now.

■ Here we have three different sectors, computers, textiles, and pharmaceuticals.
■ The straight lines represent the central tendencies of those industries in terms of their
return to profitability.What you see is arguably pharmaceuticals are more profitable
than textiles, more profitable than computers. More importantly, we also see a
distribution of profitability within those segments.
■ So there'll be some firms that are doing very, very well and others who are doing
poorer, in fact, not even making positive returns. So we get variability both across
industries and then within industries. And then we have this dynamic perspective, that
say these curves are constantly shifting and moving over time as well.

Two
Perspectives on
Economic Rents
■ highlight here, the source
of economic rents.The
company has some special
advantage.
■ That is, in essence, what
we're trying to do as
strategists. Is identify those
underlying sources of
competitive advantage.

Two
Perspectives
on
Economic
Rents

■ There are two perspectives in the strategy literature on economic rents.
■ The idea of Monopoly Rents comes out of a branch of economics referred to as
industrial organizations economics or we'll call it the industrial organization view.
■ The idea of Monopoly Rents is that there's something that preventsThat shift in the
supply curve that we talked about previously, here. Some barrier to entry that
prohibits this competition to our perfectly competitive outcome.What could create
that?

■ Consider t-shirt vendor case.A barrier to entry there might be a license to operate.
Maybe the university gives a limited number of licenses to sell t-shirts outside the
stadium.
■ That would limit entry, prevent that supply curve from shifting out all the way, and
allow for the potential for profitability within the segment.
■ The key from the Monopoly Rents perspective here is that industry structure matters.
How do we think about and analyze the industry structure to understand when there
are these barriers to competition.

■ The second perspective is whats often referred to the Ricardian Rents perspective
named after David Ricardo, who is a famous 19th century economist.
■ Ricardo is probably most famous for his theory of comparative advantage.
■ This idea that there are certain nations that have things that they are better at doing
than others. In essence, this notion of competitive advantage.This is sometimes
referred to in the strategy literature as the Resource BasedView.

■ Unlike the Monopoly Rents perspective, there might actually be no barriers to entry.There
might be numerous firms entering into the segment but what's critical that there are
various barriers to imitation. So what you see in the graph here are two firms.
■ One and two, represented by the two sets of cost curves. AC1, MC1 versus AC2 and MC2.
What you see is that firm one has a lower cost structure than firm two.
■ At any given quantity or any given price, their costs are lower than their rivals'.As a result of
that both, as price takers, the second firm actually has a higher cost structure than the first.
And what's critical that as long as what's called the marginal producer in the market is able
to survive, in other words they cover their opportunity costs.
■ Anyone who has a lower cost structure than them could actually thrive and survive within
the industry and perhaps do quite well by themselves. Another way to think about
Ricardian Rents is in terms of differentiation.

■ So maybe, in our t-shirt vendor case, we have different designs. And my design is more valuable than
your design. It's more valued by customers than your design. As a result, I might have a higher what
we call willingness to pay for my product than you have for yours.
■ What's critical in both these examples, both the cost and differentiation example, is that there are
some barriers to imitation. By this we mean other competitors can't copy what you do. So in the cost
example, maybe it's a trade secret. Maybe you know better than your competitors how to produce
low cost t-shirts.
■ In the differentiation case, maybe there's some legal barrier to protection, like a copyright that you
have on your design.That prevent someone else from imitating your design.The key though once
again is there's some barrier to imitation so competitors can't copy what you do. And critical to this
Ricardian Rents perspective is that firm structure matters. It's not just the industry structure, but we
have to dive into the level of the firm as well. And understand firm structure. So together these two
perspectives on rents provide us a way of thinking about how firms achieve superior performance and
help us understand how to analyze their strategy.

Review
■ Here are some lessons from the module. First, we define business strategy by mission, plan, and actions.
These three elements help us understand what the strategy of an organization may be. We then use
strategic analysis as a way of assessing the viability of a business strategy.
■ We pointed out that strategic analysis is not just the purview of the CEO. In fact, strategic analysis is useful
for a wide variety of stakeholders who affect or are affected by an organization. Finally, we introduced the
idea of the strategist's challenge, and argued it is about balancing values, opportunities, and capabilities to
identify the desirable competitive positions that create and sustain value.
■ We went on to introduce the notion ofThe Fundamental Principle, that in perfectly competitive markets, no
firm realizes economic profits.We define economic profits as those returns in excess of the opportunity cost
of capital.
■ We observe that in the real world, product markets are rarely perfect and firms often have competitive
advantage. And we argued that the role of the strategist is then to identify these potential sources of
competitive advantage. And that broadly speaking, firms may capture these economic profits in one of two
ways, either through barriers to competition or through barriers to imitation.

Strategist'sToolkit: Competitor Analysis

Strategist's
Toolkit:
Environment
al Analysis
Environment
Demographic
trends
Socio-cultural
influences
Technological
developments
Macroeconomic
impacts
Political-legal
pressures
Global trade
issues

Reference
■ University ofVirginia

Business strategy part 1

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