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Strategic Management

2012-04-30T21:02:00.000+06:00

Strategic Management

Strategy

Strategy is a long-term plan formulated by the top-level management to match/fit the internal environment of an organization with external environment.

Alfred Chandler defined strategy as “the determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals.”

A Model of the Strategic Management Process

The strategic management process can be broken down into five different components. The five components are (1) selection of the corporate mission and major corporate goals; (2) analysis of the organization’s external competitive environment to identify opportunities and threats; (3) analysis of the organization’s internal operating environment to identify the organization’s strengths and weaknesses; (4) the selection of strategies that build on the organization’s strengths and correct its weaknesses in order to take advantage of external opportunities and counter external threats; and (5) strategy implementation.

Components of the Strategic Management Process:

Defining the Mission and Major Goals:

The first component of the strategic management process is defining the mission and major goals of the organization. The mission and major goals of an organization provide the context within which intended strategies are formulated and the criteria against which emergent strategies are evaluated.

External Analysis: The second component of the strategic management process is the analysis of the organization’s external operating environment. The objective of external analysis is to identify strategic opportunities and threats in the organization’s operating environment. Three interrelated environments should be examined at this stage: the immediate, or industry environment in which the organization operates, the national environment, and the wider macro environment.

Internal Analysis: Internal analysis, the third component of the strategic management process, serves to pinpoint the strengths and weaknesses of the organization. Such analysis involves identifying the quantity and quality of resources available to the organization. Building and maintaining a competitive advantage requires a company to achieve superior efficiency, quality, innovation, and customer responsiveness. Company strengths lead to superiority in these areas, whereas company weaknesses translate into inferior performance.

Strategic Choice: The next component involves generating a series of strategic alternatives, given the company’s internal strengths and weaknesses and its external opportunities and threats. The comparison of strengths, weaknesses, opportunities, and threats is normally referred to as a SWOT analysis. The purpose of the strategic alternatives generated by a SWOT analysis should be to build on company strengths in order to exploit opportunities and counter threats and to correct company weaknesses.

Strategy Implementation: Strategy implementation, the fifth component of the strategic management process, consists of four components: (1) designing appropriate organizational structures, (2) designing control systems, (3) marching strategy, structure, and controls, and (4) managing conflict, politics, and change.

Reasons for Fit Model’s Failure (Non-Psychological Factors)

Five explanations can be offered as to why formal strategic planning systems based on the fit model do not produce better results. We consider four of them as the non-psychological factors. The four explanations are as follows: (1) planning equilibrium, (2) planning under uncertainty, (3) ivory tower planning, and (4) strategic intent versus strategic fit.

Planning Equilibrium: For a valuable management technique such as formal planning to be a source of competitive advantage, some companies must have the technique while others do not. In such circumstances, we might expect those with the technique to outperform those lacking it. However, once everybody has the technique, it levels the playing field. A technique used by every company can no longer be a source of competitive advantage. In such a situation, we say that the technique is in equilibrium. Because almost all large companies currently have some kind of formal strategic planning process, a condition of planning equilibrium exists. Thus planning may be necessary to earn average profits, but it will not by itself allow a company to earn the above-average profits associated with competitive advantage.

Planning Under Uncertainty: Executives often assumed that it was possible to forecast the future accurately. But in the real world, the only constant is change. Even the best-laid plans can fall apart if unforeseen contingencies occur. The recognition that in an uncertain world the future cannot be forecast with sufficient accuracy led to the scenario approach to planning. Rather than try to forecast the future planners attempt to model the company’s environment and then use that model to predict a range of possible scenarios. Executives are then asked to devise strategies to cope with the different scenarios. The objective is to get managers to understand the dynamic and complex nature of their environment and to think through problems in a strategic fashion.

Ivory Tower Planning: A serious mistake made by many companies in their initial enthusiasm for planning has been to treat planning as an exclusively top management function. This ivory tower approach can result in strategic plans formulated in a vacuum by planning executives who have little understudying or appreciation of operating realities. As a consequence, they formulate strategies that do more harm than good. The ivory tower concept of planning can also lead to tensions between planners and operating personnel.

Correcting the ivory tower approach to planning involves recognition that, to succeed, strategic planning must comprise managers at all levels of the corporation. It is important to understand that much of the best planning can and should be done by operating managers. They are the ones closest to the facts. The role of corporate-level planners should be that of facilitators, who help operating managers do the planning.

Strategic Intent versus Strategic Fit: The strategic fit model of planning has been criticized by C. K. Prahalad of the University of Michigan and Gary Hamel of London Business School. They argue that the fit model is too static and limiting. They argue that adopting the fit model to strategy formulamon leads to a mindset in which management focuses too much on the degree of fit between the existing resources of a company and current environmental ooporturunes, and not enough upon building new resources and capabilities to create and exploit future opportunities. Strategies formulated via the fit model tend to be more concerned with today’s problems than tomorrow’s opporninities. As a result, companies that rely exclusive on the fit approach to strategy formulation are unlikely to be able to build and maintain a competitive advantage. This is particularly true in a dynamic competitive environment, where new competitors are continually arising and new ways of doing business are constantly being invented.

The secret of the success of companies like Toyota, Canon, and Komatsu is that they all had bold ambitions, which outstripped their existing resources and capabilities. All wanted to achieve global leadership, and they set out to build the resources and capabilities that would enable them to attain this goal. Consequently, the top management of these companies created an obsession with winning at all levels of the organization and then sustained that obsession over a ten- to twenty-year quest for global leadership. It is this obsession that Prahalad and Hamel refer to as strategic intent.

They argue that strategic intent also encompasses an active management process, which includes: “focusing the organization’s attention on the essence of winning; motivating people by communicating the value of the target; leaving room for individual and team contributions; sustaining enthusiasm by providing new operational definitions as circumstances change; and using intent consismndy to guide resource allocations.”

Thus underlying the concept of strategic intent is the notion that strategy formularion should involve setting ambitious goals, which stretch a company, and then finding ways to build the resources and capabilities necessary to attain those goals.

Reasons for Fit Model’s Failure (Psychological Factors)

Many managers are poor strategic decision makers. The reasons have to do with two related psychological phenomena: cognitive biases and groupthink.

Cognitive Biases: The rationality of human decision makers is bounded by our own cognitive capabilities. We are not supercomputers, and it is difficult for us to absorb and process large amounts of information effectively. As a result, we tend to fall back on certain rules of thumb, or heuristics, when making decisions. Many of these rules of thumb are actually quite useful, since they help us to make sense out of a complex and uncertain world. However, sometimes they also lead to severe and systematic errors in the decision making process. (Systematic errors are errors that appear time and time again). These systematic errors seem to arise from a series of cognitive biases in the way that human decision makers process information and reach decisions- Because of cognitive biases, many managers end up making poor strategic decisions.

The prior hypothesis bias refers to the fact that decision makers who have strong prior beliefs about the relationship between two variables and to make decisions on the basis of these beliefs, even when presented with evidence that their beliefs are wrong. Moreover, they tend to seek and use information that is consistent with their prior beliefs, while ignoring information that contradicts these beliefs. To put this bias in a strategic context, it suggests that a CEO who has a strong prior belief that a certain strategy makes sense might continue to pursue that strategy, despite evidence that it is inappropriate or failing.

Another well-known cognitive bias is referred to as escalating commitment. 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. This may be an irrational response; a more logical response would be to abandon the project and move on, (that is, to “cut your losses and run”), rather than escalate commitment. Feelings of personal responsibility for a project apparently induce decision makers to stick with a project, despite evidence that it is failing.

The bias of reasoning by analogy involves the use of simple analogies to make sense out of complex problems. For example, several companies have relied on the analogy of a three-legged stool to justify diversifying into business areas of which they had little prior knowledge. The analogy suggests that a stool with fewer than three legs— and by extension, a company that is active in fewer than three different businesses— is unbalanced.

Representativeness is a bias rooted in the tendency to generalize from a small sample, or even a single vivid anecdote. Generalizing from small samples, however, 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.

The final cognitive bias is referred to as the illusion of control. Illusion of control is the tendency to overestimate one’s ability to control events. 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. Senior managers are typically overconfident about their abilities to create value by acquiring another company. Hence, they 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.

Groupthink: The biases just discussed are individual biases. However, most strategic decisions are made by groups, not individuals. Thus the group context within which decisions are made is clearly an important variable in determining whether cognitive biases will operate to adversely affect the strategic decision-making processes. The psychologist Irvin Janis has argued that many groups are characterized by a process known as groupthink and that as a result many groups do make poor strategic decisions. Groupthink occurs when a group of decision makers embarks on a course of action without questioning underlying assumptions. Typically, a group coalesces around a person or policy. It ignores or filters out information that can be used to question the policy, and develops after-the-fact rationalizations for its decision. Thus commitment is based on an emotional rather than an objective, assessment of the correct course of action. The consequences can be poor decisions. Groupthink-dominated groups are characterized by strong pressures toward uniformity, which make their members avoid raising controversial issues questioning weak arguments, or calling a halt to softheaded thinking.

Techniques for Improving Decision Making

The existence of cognitive biases and groupthink raises the issue of how to bring critical information to bear on the decision mechanism so that strategic decisions made by the company are realistic and based on thorough evaluation. Two techniques known to counteract groupthink and cognitive biases are devil’s advocacy and dialectic inquiry. Devil’s advocacy and dialectic inquiry, have been proposed as two means of guarding against the weaknesses of the expert approach.

Devil’s advocacy involves the generation of both a plan and a critical analysis of the plan. One member of the decision-making group acts as the devil’s advocate, bringing out all the reasons that might make the proposal unacceptable. In this way, decision makers can become aware of the possible perils of recommended courses of action.

Dialectic inquiry is more complex, for it involves the generation of a plan (a thesis) and a counterplan (antithesis). The plan and the counterplan should reflect reasonable but conflicting courses of action. Corporate decision makers consider a debate between advocates of the plan and counterplan. The purpose of the debate is to reveal problems with definitions, recommended courses of action, and assumptions. As a result, corporate decision makers and planners are able to form a new and more encompassing conceptua1ization of the problem, which becomes the final plan (a synthesis).

Mission and Goals Mission Statement

The corporate mission statement is the first key indicator of how an organization views the claims of its stakeholders. Its purpose is to set the organizational context within which strategic decisions will be made— in other words, to give an organization strategic focus and direction. All strategic decisions flow from the mission statement. Typically, the mission statement defines the organization’s business, stares its vision and goals, and articulates its main philosophical values. In examining how organizations formulate such statements, we concentrate on these three main components. Vision and Major Goals

The second component of a company’s mission statement, the detailing of its vision and major corporate goals, is a formal declaration of what the company is trying to achieve. The spelling out of the vision and major goals gives direction to the corporate mission statement and helps guide the formulation of strategy.

Strategic Intent, Vision, and Goals

“Strategic intent” refers to the intention of a business to coordinate and drive the whole of the organization towards predetermined sets of goals or objectives. Strategic intent gives a notion that managers should set ambitious goals that stretch a company. Often, the vision presented in a company’s mission statement articulates the company’s strategic intent. Thus, Weyerhaeuser’s vision, proclaimed in its mission statement, is to be “the best forest products company in thee world”. This is Weyerhaeuser's strategic intent. - Another example, the mission statement of Philip Morris Companies, Inc. This company’s vision, or its strategic intent, is to be “the most successful consumer packaged goods company in the world”. Both Philip Morris and Weyerhaeuser have adopted ambitious visions, which are likely to stretch their respective organizations.

Beyond articulating their vision, many companies also stare other major goals in their mission statement. These goals specify how a company intends to go about attaining its strategic intent. So, for example, Weyerhaeuser mission statement tells the company that it intends to attain its vision by focusing on total quality, empowering its employees, and striving to satisfy customers. The Philip Morris statement makes plain the company’s intent to achieve its vision by maximizing productivity and synergy and stressing total quality management. Both companies list other specific goals. All these goals shape the choice of strategies. The goal of maximizing productivity, for instance, indicates that when Philip Morris reviews its strategic options, it will favor strategies that increase its productivity.

Maximizing Stockholder Wealth

Although most profit-seeking organizations operate with a variety of major corporate goals, within a public corporation all these goals should be directed toward one end: maximizing stockholder wealth. Stockholders provide a company with capital and in exchange expect an appropriate return on their investment. A company’s stockholders are its legal owners. Consequently, the overriding goal of most corporations is to maximize stockholder wealth, which involves increasing the long-run return earned by stockholders from owning shares in the corporation.

Stockholders receive returns in two ways: from dividend payments and from capital appreciation in the market value of a share (that is, by increases in stock market prices). A company can best maximize stockholder returns by pursuing strategies that maximize its own return on investment (ROI), which is a good general indicator of a company’s efficiency. The more efficient a company is, the better its future prospects look to stockholders and the greater is its ability to pay dividends. Furthermore, higher ROI leads to greater demand for a company’s shares. Demand bids up the share price and leads to capital appreciation.

The Short-Term Problem

As management theorist Peter F. Drucker and many others have pointed out, there is danger in emphasizing only ROI. An overzealous pursuit of ROI can misdirect managerial attention and encourage some of the worst management practices, such as maximizing short-run rather than long-run ROI. A short-run orientation favors such action as cutting expenditures judged to be nonessential in that span of time— for instance, expenditures for research and development, marketing, and new capital investments. Although decreasing current expenditure increases current ROI the resulting underinvestment, lack of innovation, and poor market awareness jeopardize long-run ROI. Yet despite these negative consequences, managers do make such decisions because the adverse effects of a short-run orientation may not materialize and become apparent to stockholders for several years. By that time the management team responsible may have moved on, leaving others to pick up the pieces.

In a now famous Harvard Business Review article, Robert H. Hayes and William J. Abernathy argue that the widespread focus on short-runt ROI has been a major factor for the long-run loss of international competitiveness by U.S. companies.

Secondary Goals

To guard against short-run behavior, Drucker suggests that companies adopt a number of secondary goals in addition to ROI. These goals should be designed to balance short-run and long-run considerations. Drucker's list includes secondary goals relating to these areas: (1) market share, (2) innovation, (3) productivity, (4) physical and financial resources, (5) manager performance and development. (6) worker performance and attitude, and (7) social responsibly. Although such secondary goals need not be part of a mission statement, many of the most important ones are. Even if a company does not recognize secondary goals explicitly, it must recognize them implicitly through a commitment to long-run profitability.

Corporate Philosophy

The third component of a mission statement is a summing up of the corporate philosophy: the basic beliefs, values, aspirations, and philosophical priorities that the strategic decision makers are committed to and that guide their management of the company. It tells how the company intends to do business and often reflects the company’s recognition of its social and ethical responsibility. Thus a statement of cooperate philosophy can have an important impact on the way a company conducts itself.

Many companies establish a philosophical creed to emphasize their own distinctive outlook on business. A company’s creed forms the basis for establishing its corporate culture. The credo Johnson & Johnson expresses Johnson & Johnson’s belief that the company’s first responsibility is to the doctors, nurses, and patients who use J&J products. Next come its employees, the communities in which these employees live and work, and finally the stockholders. The credo is prominently displayed in every manager’s office; and according to the Johnson & Johnson managers, the credo guides all important decisions.

Corporate Stakeholders Stakeholders and The Mission Statement

Stakeholders are individuals or groups that have some claim on the company. They can be divided into internal claimants and external claimants. Internal claimants are stockholders and employees, including executive officers and board members. External claimants are all other individuals and groups affected by the company’s actions. Typically, they comprise customers, suppliers, governments, unions, competitors, local communities and the general pubic.

All stakeholders can justifiably expect that the company will attempt to satisfy their particular demands. Stockholders provide the enterprise with capital and in exchange expect an appropriate return on their investment. Employees provide labor and skills and in exchange expect commensurate income and job satisfaction. Customers want value for money. Suppliers seek dependable buyers. Governments insist on adherence to legislative regulations. Unions demand benefits for their members in proportion to their contributions to the company. Rivals seek fair competition. Local communities want companies that are responsible citizens. The general public seeks some assurance that the quality of life will be improved as a result of the company’s existence.

A company has to take these claims into account when formulating its strategies, or else stakeholders may withdraw their support. Stockholders may sell their shares, employees leave their jobs, and customers buy elsewhere. Suppliers are likely to seek more dependable buyers, whereas governments can prosecute the company. Unions may engage in disruptive labor disputes, and rivals may respond to unfair competition. Communities may oppose the company’s attempts to locate its facilities in their area, and the general public may form pressure groups, demanding action against companies that impair the quality of life. Any of these reactions can have a disastrous impact on an enterprise.

A mission statement enables a company to incorporate stakeholder claims into its strategic decision making and thereby reduce the risk of losing stakeholder support. The mission statement thus becomes the company’s formal commitment to a stakeholder group; it carries the message that strategies will be formulated with the claims of those stakeholders in mind. Any strategies that the company generates should reflect its major corporate goal, i.e., shareholder wealth maximization. Similarly, the mission statement should recognize additional stakeholders claims in its secondary goals and philosophy.

Stakeholder Impact Analysis

A company cannot always satisfy the claims of all stakeholders. The claims of different groups may conflict, and in practice few organizations have the resources to manage all stakeholders. For example, union claims for higher wages can conflict with consumer demands for reasonable price and stockholder demands for acceptable returns. Often the company must make choices. To do so, it must identify the most important stakeholders and give highest priority to pursuing strategies that satisfy their needs. Stakeholder impact analysis can provide such identification. Typically, stakeholder impact analysis involves the following steps:

1. Identifying stakeholders

2. Identifying stakeholders’ interests and concerns

3. As a result, identifying what claims stakeholders are likely to make on the organization

4. Identifying the stakeholders that are most important from the organization’s perspective

5. Identifying the resulting strategic challenges.

Such an analysis enables the company to identify the stakeholders most critical to its survival and allows it to incorporate their claim into the mission statement explicitly. From the mission statement, stakeholder claims then feed down into the rest of the strategy formulation process. For example, if community involvement is identified as a critical stakeholder claim, it must be incorporated in the mission statement, and any strategies that conflict with it must be rejected.

Mechanisms to Hold in Check the Empire Building attitudes of CEOs.

There is a need for mechanisms that allow stockholders to remove incompetent or ineffective managers. A number of governance mechanisms perform this function, including stockholder meetings, the board of directors, stock-based compensation schemes, the takeover market, and leveraged buyouts.

Stockholders Meeting

The constitution of most publicly held corporations specifies that companies should hold stockholder meetings at least once a year. These meetings provide a forum in which stockholders can voice their approval or discontent with management. In theory, at such meetings stockholders can propose resolutions that, if they receive a majority of stockholder votes, can shape management policy, limit the strategies management can pursue, and remove and appoint key personnel. In practice, though, until quite recently stockholder meetings functioned as little more than rubber stamps for management resolutions. Stockholders must finance their own challenges and, in many cases, meet stiff regulations limiting the number of proxy votes they can solicit. Thus proposing resolutions critical of management was normally deemed too expensive and difficult to be worthwhile. Rather; it was understood that stockholders could best show dissatisfaction with a company by selling their shares.

The Role of Board

Stockholder interests are looked after within the company by the board of directors. Board members are directly elected by stockholders, and under corporate law the board represents the stockholders’ interests in the company. Thus the board can be held legally accountable for the company’s actions. Its position at the apex of decision making within the company allows the board to monitor corporate strategy decisions and ensure that they are consistent with stockholder interests. If the board’s sense is that corporate strategies are not in best interest of stockholders, it can apply sanctions such as voting against management nominations to the board of directors or submitting their own nominees. In addition, the board has the legal authority to hire, fire, and compensate corporate employees, including, most importantly, the CEO.

The typical board comprises a mix of insiders and outsiders. Inside directors are required because they have valuable information about the company’s activities. Without such information the board cannot adequately perform its monitoring function. But since insiders are full-time employees of the company, their interests tend to be aligned with those of management. Hence, outside directors are needed to bring objectivity to the monitoring and evaluation processes. Outside directors are not full-time employees of the company. Many of then are full-time professional directors who hold positions on the boards of several companies. The need to maintain a reputation as competent out-side directors gives them an incentive to perform their tasks as objectively and effectively as possible.

Stock-Based Compensation Schemes

To get around the problem of captive boards, stockholders have urged many companies to introduce stock-based compensation schemes for their senior executives. These schemes are designed to align the interests of mangers with those of stockholders. In addition to their regular salary, senior executives are given stock options in the firm. Stock options give managers the right to buy the company’s shares at a predetermined price, which may often turn out to be less than the market price of the stock. The idea behind stock options is to motivate managers to adopt strategies that increase the share price of the company, for in doing so they will also increase the value of their stock.

The Takeover Constraint and Corporate Raiders

If the board is loyal to management rather than to stockholders or if the company has not adopted stock-based compensation schemes, then, as suggested earlier, management may pursue strategies and take actions inconsistent with maximizing stockholder wealth. Stockholders, however, still have some residual power, for they can always sell their shares. If they start doing so in large numbers, the price of the company’s share will decline. If the share price falls far enough, the company might be worth less on the stock market than the book value of its assets, at which point it may become a takeover target.

The risk of being bought out is known as the takeover constraint. The takeover constraint effectively limits the extent to which managers can pursue strategies and take actions that put their own interests above those of stockholders. If they ignore stockholder interests and the company is bought out, senior managers typically lose their independence and probably their jobs as well. So the threat of takeover can constraint management action.

Corporate raiders are individuals or institutions that buy up large blocks of shares in companies that they think are pursuing strategies inconsistent with maximizing stockholder wealth. They argue that if these companies pursued different strategies, they could create more wealth for stockholders. Raiders buy stock in a company either to take over the business and run it more efficiently or to bring on a change in the top management, replacing the existing team with one more likely to maximize stockholder welfare.

Poison Pills and Golden Parachute

One response by management to the threat posed by takeovers has been to create so-called poison pills. The purpose of a poison pill is to make it difficult for a raider to acquire a company. Another response to the threat posed by takeovers has been the increasing use of golden parachute contracts. Golden parachutes are severance contracts that handsomely compensate top-level managers for the loss of their jobs, in the event of a takeover. These contracts came into being because of fears that takeover threats were forcing managers to focus on maximizing short-term earnings in an attempt to boost the company’s current stock price, thereby reducing the risk of takeover at the expense of long-run investments in R&D and new capital equipment. Managers also complained that the threat of takeover diminished their willingness to fund risky but potentially profitable investments. Advocates of golden parachute contracts argue that by reducing managers’ concerns about losing their jobs, the contracts encourage managers to focus on long-run investment and take necessary risks. In addition, because they lessen worry about job loss, golden parachute contracts make it more likely that top management will review takeover proposals objectively, taking stockholder interests into account when deciding how to respond.

Leveraged Buyouts

The leveraged buyout (LBO) is a special kind of takeover. Whereas in a typical takeover a raider buys enough stock to gain control of a company, in an LBO a company’s own executives are often (but not always) among the buyers. The management group undertaking an LBO typically raises cash by issuing bonds and then uses that cash to buy the company’s stock. Thus LBOs involve a swap of equity for debt. In effect the company replaces its stockholders with creditors (bondholders), transforming the corporation from a public into a private entity. However, often the same institutions that were major stockholders before an LBO are major bondholders afterward. The difference is that as stockholders they were not guaranteed a regular dividend payment from the company; as bondholders they do have such a guarantee.

Shaping the Ethical Climate of an Organization

To foster awareness that strategic decisions have an ethical dimension, a company must establish a climate that emphasizes the importance of ethics. This requires at least three steps. First, top managers have to use their leadership position to incorporate an ethical dimension into the values that they stress. These values, which shape the way business is conducted both within and by the corporation, have an important ethical component. Among other things, they stress the need for confidence in and respect for people, open communication, and concern for the individual employee.

Second, ethical values must be incorporated into the company’s mission statement. Third, ethical values must be acted on. Top managers have to implement hiring, firing and incentive systems that explicitly recognize the importance of adhering to ethical values in strategic decision making.

Thinking Through Ethical Problems

Besides establishing the right kind of ethical climate in an organization, managers must be able to think through the ethical implications of strategic decisions in a systematic way. A number of different frameworks have been suggested as aids to the decision-making process.

In step 1— evaluating a proposed strategic decision from an ethical standpoint— managers must identify which stakeholders the decision would affect and in what ways. Most importantly, they need to determine if the proposed decision would violate the rights of any stakeholders. The term rights refers to the fundamental entitlements of a stakeholder. For example, one might argue that the right to information about health risks in the workplace is a fundamental entitlement of employees.

Step 2 involves judging the ethics of the proposed strategic decision, given the information gained in step 1. This judgment should be guided by various moral principles that should not be violated. The principles might be those articulated in a corporate mission statement or other company documents. In addition, there are certain moral principles that we have adopted as members of society— for instance, the prohibition on stealing— and these should not be violated. The judgment at this stage will also be guided by the decision rule that is chosen to assess the proposed strategic decision. Although long-run profit maximization is rightly the decision rule that most companies stress, this decision rule should be applied subject to the constraint that no moral principles are violated.

Step 3, establishing moral intent, means that the company must resolve to place moral concerns ahead of other concerns in cases where either the rights of stakeholders or key moral principles have been violated. At this stage input from top management might be particularly valuable. Without the proactive encouragement of top managers, middle-level managers might tend to place the narrow economic interests of the company before the interests of stakeholders. They might do so in the often erroneous belief that top managers favor such an approach.

Step 4 requires the company to engage in ethical behavior. Clearly, Johnson & Johnson fulfilled this requirement during the Tylenol poisoning scare by pulling all of its product off retail stores shelves at great cost to the company.

Corporate Social Responsibility

Corporate social responsibility is a set of obligations an organization has to enhance the society in which the business organization operates. Corporate social responsibility is the series of obligation on the part of companies to build certain social criteria into their strategic decision making. The concept implies that when companies evaluate decisions from an ethical prospective, there should be a presumption in favor of adopting courses of action that enhance the welfare of society at large. The goals selected might be quite specific: to enhance the welfare of communities in which a company is based, improve the environment, or empower employees to give them a sense of self worth.

Social Responsibility Approaches

There are four approaches that an organization can take enhancing its obligations to the society that along a continuum ranging from lowest to highest socially responsible practices.

Social obstruction is a social responsibility approach in which an organization does as little as possible to enhance the society and solve the societal problems.

Social obligation is a social responsibility approach in which organizations do as required of it legally but nothing more to enhance the society.

Social response is a sort social responsibility in which organizations meet the basic ethical and social obligations and sometimes go beyond these in some selected cases.

Social contribution is a social responsibility approach in which organizations view them as the citizens and proactively come forward to address the social problems.

The External Environment The Five Forces Model

An industry can be defined as a group or companies offering products or services that are close substitutes for each other. Close substitutes are products or services that satisfy the same basic consumer needs. For example, tea and coffee are close substitutes.

Managers have to analyze competitive forces in an industry environment in order to identify opportunities and threats confronting to a company. Michael E. Porter of the Harvard School of Business Administration has developed a framework that helps managers in this analysis. Porter’s framework, known as the five forces model focuses on five forces that shape competition within an industry: (1) the risk of new entry by potential competitors, (2) the degree of rivalry among established companies within an industry, (3) the bargaining power of buyers, (4) the bargaining power of suppliers, and (5) the closeness of substitutes to an industry’s products.

Potential Competitors

Established companies try to discourage potential competitors from entering, since the more companies enter an industry, the more difficult it becomes for established companies to hold their share of the marker and to generate profits. Thus a high risk of entry by potential competitors represents a threat to the profitability of established companies. On the other hand, if the risk of new entry is low, established companies can take advantage of this opportunity to rise prices and earn greater returns.

The strength of the competitive force of potential rivals is largely a function of the height of barriers to entry. The concept of barriers to entry implies that there are significant costs to joining an industry. The greater the costs that potential competitors must bear, the greater are the barriers to entry. High entry barriers keep potential competitors out of an industry, even when industry returns are high. The classic work on barriers to entry was done by economist Joe Bain, who identified three main sources of barriers to new entry: brand loyalty, absolute cost advantages, and economies of scale.

Brand Loyalty: Brand loyalty is buyers’ preference for the products of established companies. A company can create brand loyalty through continuous advertising of brand and company names, parent protection of products, product innovation through company research and development programs, an emphasis on high product quality, and good after-sales service. Significant: brand loyalty makes it difficult for new entrants to take marker share away from established companies. Thus it reduces the threat of entry by potential competitors since they may see the task of breaking down well-established consumer preferences as too costly.

Absolute Cost Advantages: Lower absolute costs give established companies an advantage that is difficult for potential competitors to match. Absolute cost advantages can arise from superior production techniques. These techniques can be due to past experience, patents, or secret processes, control of particular inputs required for production, such as labor, materials, equipment, or management skills, or access to cheaper funds because existing companies represent lower risks than established companies. If established companies have an absolute cost advantage, then again the threat of entry decreases.

Economies of Scale: Economics of scale are the cost advantages associated with large company size. Sources of scale economies include cost reductions gained through mass-producing a standardized output, discounts on bulk purchases of raw-material inputs and component parts, the spreading of fixed costs over a large volume, and scale economics in advertising. If these cost advantages are significant, then a new entrant faces the dilemma of either entering on a small scale and suffering a significant cost disadvantage or taking a very large risk by entering on a large scale and bearing significant capital costs. A further risk of large-scale entry is that the increased supply of products w1il depress prices and result in vigorous retaliation by established companies. Thus, when established companies have economies of scale, the threat of entry is reduced.

Rivalry Among Established Companies The second of Porters five competitive forces is the extent of rivalry among established companies within an industry. If this competitive force is weak, companies have an opportunity to raise prices and earn greater profits. But if it is strong, significant price competition, including price wars, may result from the intense rivalry. Price competition limits profitability by reducing the margins. The extent of rivalry among established companies within an industry is largely a function of three factors: (1) Industry competitive structure, (2) demand conditions, and (3) the height of exit barriers in the industry.

Competitive Structure: Competitive structure refers to the number and size distribution of companies in an industry. Different competitive structures have different implications for rivalry. Structures vary from fragmented to conso1idated. A fragmented industry contains a large number of small or medium-sized companies, none of which is in a position to dominate the industry. A consolidated industry is dominated by a small number of large companies or, in extreme cases, by just one company (a monopoly). Fragmented industries range from agriculture, video rental, and health clubs, to real estate brokerage and suntanning parlors. Consolidated industries include aerospace, automobiles, and pharmaceuticals. The range of structures and their different characteristics are illustrated in the following Figure:

Figure: The Continuum of Industry Structures

Many fragmented industries are characterized by low entry barriers and commodity type products that are hard to differentiate. The combination of these traits tends to result in boom-and-bust cycles. Low entry barriers imply that whenever demand is strong and profits are high there will be a flood of new entrants hoping to cash in on the boom. Often the flood of new entrants into a booming fragmented industry creates excess capacity. Once excess capacity develops, companies start to cut prices in order to utilize their spare capacity. The difficulty companies face when trying to differentiate their products from those of competitors can worsen this tendency. The result is a price war, which depresses industry profits, forces some companies out of business and deters potential new entrants.

In general, the more commodity-like an industry’s product, the more vicious will be the price war. This bust part of the cycle continues until overall industry capacity is brought into line with demand (through bankruptcies), at which point prices may stabilize again.

A fragmented industry structure, then, constitutes a threat rather than an opportunity. Most booms will be relatively short-lived because of the case of new entry and will be followed by price war and bankruptcies. Since differentiation is often difficult in these industries, the best strategy for a company to pursue in such circumstances may be one of cost minimization. This strategy allows a company to rack up high returns in a boom and survive any subsequent bust.

The nature and intensity of competition for consolidated industries are much more difficult to predict. The one certainty about consolidated industries is that companies are interdependent—that is the competitive actions of one company directly affect the profitability of others in the industry.

Thus, in a consolidated industry, the competitive action of one company directly affects the market share of its rivals, forcing a response from them. The consequence of such competitive interdependence can be a dangerous competitive spiral, with rival companies trying to undercut each other’s prices, pushing industry profits down in the process.

Clearly, the interdependence of companies in consolidated industries and the possibility of a price war constitute a major threat. Companies often seek to reduce this threat by following the price lead set by a dominant company in the industry. However, companies must be careful, for explicit price-fixing agreements are illegal, although tacit agreements are not. A tacit agreement is one arrived at without direct communication. Instead, companies watch and interpret each other’s behavior. Normally, tacit agreements involve following the price lead set by a dominant company.

Demand Conditions: Industry demand conditions are another determinant of the intensity of rivalry among established companies. Growing demand tends to moderate competition by providing greater room for expansion. Demand grows when the market as a whole is growing through the addition of new consumers or when existing consumers are purchasing more of an industry’s product. When demand is growing, companies can increase revenues without taking market share away from other companies. Thus growing demand gives a company a major opportunity to expand operations.

Conversely, declining demand results in more competition as companies fight to maintain revenues and market share. Demand declines when consumers are leaving the marketplace or when each consumer is buying less. When demand is declining, a company can attain growth only by taking market share away from other companies. Thus declining demand constitutes a major threat, for it increases the extent of rivalry between established companies.

Exit Barriers: Exit barriers are a serious competitive threat when industry demand is declining. Exit barriers are economic, strategic, and emotional factors that keep companies competing in an industry even when returns are low. If Exit barriers are high, companies can become locked into an unfavorable industry. Excess productive capacity can result. In turn, excess capacity rends to lead to intensified price competition, with companies cutting prices in an attempt to obtain the orders needed to utilize their idle capacity. Common exit barriers include the following:

1. Investments in plant and equipment that have no alternative uses and cannot be sold off. If a company wishes to leave the industry, it has to write off the book value of these assets.

2. High fixed costs of exit, such as severance pay to workers who are being made redundant

3. Emotional attachments to an industry, as when a company is unwilling to exit from its original industry for sentimental reasons.

4. Strategic relationships between business units. For example, within a multi industry company, a low-return business unit may provide vital inputs for a high-return business unit based in another industry. Thus the company may be unwilling to exit from the low-return business.

5. Economic dependence on the industry, as when a company is not diversified and so relies on the industry for its income.

The Bargaining Power of Buyers The third of Porter’s five competitive forces is the bargaining power of buyers. Buyers can be viewed as a competitive threat when they force down prices or when they demand higher quality and better service (which increase operating costs). Alternatively, weak buyers give a company the opportunity to raise prices and earn greater returns. Whether buyers are able to make demand on a company depends on their power relative to that of the company. According to Porter, buyers are most powerful in the following circumstances:

When the supply industry is composed of many small companies and the buyers are few in number and large. These circumstances allow the buyers to dominate supply companies.

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 on the buyers for a large percentage of its total orders.

When the buyers can switch orders between supply companies at a low cost, thereby playing off companies against each other to force down prices.

When it is economically feasible for the buyers to purchase the input from several companies at once.

When the buyers can use the threat to supply their own needs through vertical integration as a device for forcing down prices.

The Bargaining Power of Suppliers

The fourth of Porter’s competitive forces is the bargaining power of suppliers. Suppliers can be viewed as a threat when they are able to force up the price that a company must pay for input or reduce the quality of goods supplied, thereby depressing the company’s profitability. Alternatively, weak suppliers give a company the opportunity to force down prices and demand higher quality. As with buyers, the ability of suppliers to make demands on a company depends on their power relative to that of the company. According to Porter suppliers are most powerful in the following circumstances:

1. When the product that suppliers sell has few substitutes and is important to the company.

2. When the company’s industry is not an important customer to the suppliers. In such instances, the suppliers’ health does not depend on the company’s industry, and suppliers have little incentive to reduce prices or improve quality.

3. When supplier’s respective products are differentiated to such an extent that it is costly for a company to switch from one supplier to another. In such cases, the company depends on its suppliers and cannot play them off against each other.

4. When, to raise prices, suppliers can use the threat of vertically integrating forward into the industry and competing directly with the company.

5. When buying companies cannot use the threat of vertically integrating backward and supplying their own needs as a means to reduce input prices.

The Threats of Substitute Products

The final force in Porter’s model is the threat of substitute products— the products of industries that serve similar consumer needs as those of the industry being analyzed. For example, companies in the coffee industry compete indirectly with those in the tea and soft-drink industries. (All three industries serve consumer needs for drinks.) The prices that companies in the coffee industry can charge are limited by the existence of substitutes such as tea and soft drinks. If the price of coffee rises too much relative to that of tea or soft drinks, then coffee drinkers will switch from coffee to those substitutes.

The existence of close substitutes presents a strong competitive threat, limiting the price a company can charge and thus its profitability. However, if a company’s products have few close substitutes (that is, if substitutes are a weak competitive force), then, other things being equal, the company has the opportunity to raise prices and earn additional profits. Consequently, its strategies should be designed to take advantage of this fact.

The Role of the Macroenvironment

So far we have treated industries as self-contained entities, yet in practice they are embedded in a wider Macro environment. That is, the broader economic, technological, demographic, social, and political environment (Shown in the following Figure). Changes in the macroenvironment can have a direct impact on any one of the five forces in Porter's model, thereby altering the relative strength of these forces and with it, the attractiveness of an industry.

Figure: The Role of Macro environment

The Macroeconomic Environment: The state of the macroeconomic environment determines the general health and well-being of the economy. This in turn affects a company’s ability to earn an adequate rate of return. The four most important macroeconomic indicators in this context are the growth rate of the economy, the interest rates, currency exchange rates, and inflation rates.

Because it leads to an expansion in consumer expenditure, economic growth tends to produce a general easing of competitive pressures within an industry. This gives companies the opportunity to expand their operations. Because economic decline leads to a reduction in consumer expenditure, it increases competitive pressures. Economic decline frequently causes price wars in mature industries.

The level of interest rates can determine the level of demand for a company’s products. Interest rates are important whenever consumers routinely borrow money to finance their purchase of these products. Rising interest rates are a threat and falling rates an opportunity.

Currency exchange rates define the value of different national currencies against each other. Movement in currency exchange rates has a direct impact on the competitiveness of a company’s products in the global marketplace. For example, when the value of the dollar is low compared with the value of other currencies, products made in the United States are relatively inexpensive and products made overseas are relatively expensive. A low or declining dollar reduces the threat from foreign competitors while creating opportunities for increased sales overseas.

Inflation can destabilize the economy, producing slower economic growth, higher interest rates, and volatile currency movements. If inflation keeps increasing, investment planning becomes hazardous. The key characteristic of inflation is that it makes the future less predictable. In an inflationary environment, it may be impossible to predict with any accuracy the real value of returns that can be earned from a project five years hence. Such uncertainty makes companies less willing to invest. Their holding back in turn depresses economic activity and ultimately pushes the economy into a slump. Thus high inflation is a threat to companies.

The Technological Environment: Technological change can make established products obsolete overnight. At the same time it can create a host of new product possibilities. Thus it is both creative and destructive— both an opportunity and a threat. One of the most important impacts of technological change is that can affect barriers to entry and as a result, radically reshape industry structure.

The Social Environment: Like technological change, social change creates opportunities and threats. One of the major social movements of the 1970s and 1980s was the trend toward greater health consciousness. Its impact has been immense, and companies that recognized the opportunities early have often reaped significant gains. For example, the Coca-Cola Company, by introducing diet colas and fruit-based soft drinks first, capitalized on the growing health trend and was able to gain market share. At the same time the health trend has created a threat for many industries. The tobacco industry, for example is now in decline as a direct result of greater consumer awareness of the health implications of smoking. Similarly, the sugar industry has seen sales decrease as consumers have decided to switch to artificial sweeteners.

The Demographic Environment: The changing composition of the population is another factor that can create both opportunities and threats. For example, as the baby-boom generation of the 1960s has moved through the population, it has created a host of opportunities and threats. Currently, baby boomers are getting married and creating an upsurge in demand for the consumer appliances normally bought by couples marrying for the first time. Thus companies such as Whirlpool Corporation and General Electric Co. are looking to capitalize on the predicted upsurge in demand for washing machines, dishwashers, spin dryers, and the like. The other side of the coin is that industries oriented toward the young, such as the toy industry, have seen their consumer base decline in recent years.

The Political and Legal Environment: Political and legal factors also have a major effect on the level of opportunities and threats in the environment. One of the most significant trends in recent years has been the move toward deregulation. By eliminating many legal restrictions, deregulation has lowered barriers to entry and opened a number of industries to intense competition. The deregulation of the airline industry, for example, created the opportunity to establish low-fare carriers— an opportunity that Texas Air, and others tried to capitalize on. At the same time the increased intensity of completion created many threats, including, most notably, the threat of prolonged fare wars, which have repeatedly thrown the airline industry into turmoil during the last decade.

For the future, fears about the destruction of the ozone layer, acid rain and global warming may be near the top of the political agenda. Given these concerns, governments seem increasingly likely to enact tough environmental regulations to limit air pollution.

Strategic Groups within Industries

The Concept of Strategic Groups: In practice, companies in an industry often differ from each other with respect to factors such as distribution channels used, market segments served, product quality, technological leadership, customer service, pricing policy, advertising policy, and promotions. Within most industries, it is possible to observe groups of companies in which each member follows the same basic strategy as other companies in the group but a strategy different from the one followed by companies in other groups. These groups of companies are known as strategic groups.

Normally, a limited number of groups capture the essence of strategic differences between companies within an industry. For example, in the pharmaceutical industry two main strategic groups stand out (see the following Figure). One group, which includes such companies as Merck, Eli Lilly and Pfizer, is characterized by heavy R&D spending and a focus on developing new proprietary blockbuster drugs. The companies in this proprietary group are pursuing a high-risk/high-return strategy. It is a high-risk strategy because basic drug research is difficult and expensive. It is also a high-return because they can charge high prices as the innovator has monopoly on its production and sale.

Figure: Strategic Groups in the Pharmaceutical Industry

The second strategic group might be characterized as the generic drug group. This group of companies, which includes Marion Labs, ICN Pharmaceuticals, and Carter Wallace, focuses on the manufacture of generic drugs— low-cost copies of drugs pioneered by companies in the proprietary group whose patents have now expired. The companies in this group are characterized by low R&D spending and an emphasis on price competition. They are pursuing a low-risk, low-return strategy. It is low risk because they are not investing millions of dollars in R&D. It is low-return because they cannot charge high prices.

Implications of Strategic Groups: The concept of strategic groups has a number of implications for industry analysis and the identification of opportunities and threats. First, a company’s immediate competitors are those in its strategic group. Since all the companies in a strategic group are pursuing similar strategies, consumers tend to view the products of such enterprises as being direct substitutes for each other. Thus a major threat to a company’s profitability can come from within its own strategic group.

Second, different strategic groups can have a different standing with respect to each of Porter’s five competitive forces. In other words, the risk of new entry by potential competitors, the degree of rivalry among companies within a group, the bargaining power or buyers, the bargaining power of suppliers, and the competitive force of substitute products can all vary in intensity among different strategic groups within the same industry.

Third, some strategic groups are more desirable than others, for they have lower level of threats and greater opportunities. If the environment of one strategic group is more favorable, then moving into that group can be regarded as an opportunity. But moving to another strategic groups involve costs due to mobility barriers. Mobility barriers are factors that inhibit the movement of companies between groups in an industry. They include broth the barriers to entry into a group and the barriers to exit from a company’s existing group. A company planning entry into another strategic group must evaluate the height of mobility barriers before deciding whether the move is worthwhile.

Mobility barriers also imply that companies within a given group may be protected to a greater or lesser extent from the threat of entry by companies based in other strategic groups. If mobility barriers are low, then the threat of entry from companies in other groups may be high, effectively limiting the prices companies can charge and the profits they can earn without attracting new competition. If mobility barriers are high, then the threat of entry is low, and companies within the protected group have an opportunity to raise prices and earn higher returns without attracting entry.

Limitations of the Five Forces and Strategic Group Models

The five forces and strategic group models constitute very useful ways of thinking about and analyzing the nature of competition within an industry. However, managers need to be aware of their shortcomings. Both models (1) present a static picture of competition which slights the role of innovation and (2) de-emphasize the significance of individual company differences while overemphasizing the importance of industry and strategic group structure as determinants of company profit rates.

Static Model in a Dynamic World: Over any reasonable length of time, in many industries competition can be viewed as a process driven by innovation. Companies that pioneer new products processes or strategies can often earn enormous profits. This prospect gives companies a strong incentive to seek innovative products, processes, and strategies. Successful innovation can revolutionize industry structure. In recent decades one or the most common consequences of innovation has been to lower the fixed costs or production, thereby reducing barriers to entry and allowing new, and smaller, enterprises to compete with large established organizations.

But both the five forces and strategic group models present a static picture of competition which ignores the role of innovation. The five forces and strategic group models are applicable while the industry is in a steady state bur not while it is undergoing radical restructuring due to innovation or some other discontinuity. (Deregulation of an industry is another example of a discontinuity.) Because the five forces and strategic group models are static they cannot adequately capture what occurs during such periods of rapid change, but they are certainly useful tools for analyzing industry structure during periods of stability.

Industry Structure and Company Difference: The second criticism of the five forces and strategic group models is that they overemphasize the importance of industry structure as a determinant of company performance and underemphasize the importance of differences between companies within an industry or strategic group. But studies suggest that the individual resources and capabilities of a company are far more important determinants of its profitability than is the industry or strategic group of which the company is a member. Although these findings do not make the five forces and strategic group models irrelevant, they do mean that the models have limited usefulness. A company will not be profitable just because it is based in an attractive industry or strategic group; much more is required.

Competitive Changes During Industry Evolution

Over time most industries pass through a series of well-defined stages, from growth through maturity and eventually into decline. These stages have different implications for the form of competition. The strength and nature of each of Porter’s five competitive forces typically changes as an industry evolves. This is particularly true regarding potential competitors and rivalry, and we focus on these two forces in our discussion. The changes in the strength and nature of these forces give rise to different opportunities and threats at each stage of an industry’s evolution.

The industry life cycle model is a useful tool for analyzing the effect of industry evolution on competitive forces. The model is similar to the product life cycle model discussed in the marketing literature. Using the industry life cycle model we can identify five industry environments, each linked to a distinct stage of an industry evolution: (1) an embryonic industry environment, (2) a growth industry environment, (3) a shakeout environment, (4) a mature industry environment, and (5) a declining industry environment (see the following Figure).

Figure: Stages of Industry Life Cycle

Embryonic Industry: An embryonic industry is one that is just beginning to develop. Growth at this stage is slow because of such factors 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 at this stage in an industry’s evolution tend to be based on access to key technological know-how rather than cost economies or brand loyalty. If the core know-how required to compete in the industry is complex and difficult to grasp, barriers to entry can be quite high and incumbent companies will be protected from potential competitors. Rivalry in embryonic industries is based not so much on price as upon educating customers, opening up distribution channels, and perfecting the design of the product. Such rivalry can be intense, and the company that is first to solve design problems often has the opportunity to develop a significant market position. An embryonic industry may also be the creation of one company’s innovative efforts, as happened with personal computers (Apple), and photocopiers (Xerox). In such circumstances, the company has a major opportunity to capitalize on the lack of rivalry and build up a strong hold on the market.

Growth Industries: Once demand for the industry’s product begins to take off, the industry develops the characteristics of a growth industry. In a growth industry, first-time demand is expanding rapidly as many new consumers enter the market. Typically, an industry grows when consumers become familiar with the product, when prices fall because experience and scale economies have been attained, and when distribution channels develop.

Normally, the importance of control over technological knowledge as a barrier to entry diminishes by the time an industry enters its growth stage. Because few companies have yet achieved significant scale economies or differentiated their product sufficiently to guarantee brand loyalty, other barriers to entry tend to be low as well. Consequently, the threat from potential competitors generally is highest at this point. Paradoxically, though, high growth usually means that new entrants can be absorbed into an industry without a marked increase in competitive pressure.

During an industry’s growth stage, rivalry tends to be low. Rapid growth in demand enables companies to expand their revenues and profits without taking market share away from compactors. A company has the opportunity to expand its operations. In addition, a strategically aware company takes advantage of the relatively favorable environment of the growth stage to prepare itself for the intense completion of the coming industry shakeout.

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. In a saturated market, there are few potential first-time buyers left. Most of the demand is limited to replacement demand.

As an industry enters the shakeout stage, rivalry between companies becomes intense. What typically happens is that companies that have become accustomed to rapid growth during an industry’s growth phase continue to add capacity at rates consistent with past growth. Managers use historic growth rates to forecast future growth rates, and they plan expansions in productive capacity accordingly. As an industry approaches maturity, however, demand no longer grows at historic rates. The consequence is the emergence of excess productive capacity. This condition is illustrated in the following Figure, where the solid curve indicates the growth in demand over time and the broken curve indicates the growth in productive capacity over time. As we can see, past point t₁, the growth in demand slows as the industry becomes mature. However, capacity continues to grow until time t₂. The gap between the solid and the broken lines signifies excess capacity. In an attempt to utilize this capacity, companies often cut prices. The result can be an intense price war, which drives many of the most inefficient companies into bankruptcy. This is itself enough to deter new entry.

Figure: Growth in Demand and Capacity

Mature Industries: The shakeout stage ends when the industry enters its mature stage. In a mature industry, the market is totally saturated and demand is limited to replacement demand. During this stage, growth is low or zero. What little growth there is comes from population expansion bringing new consumers into the market.

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. Competition for market share develops, driving down prices. Often the result is a price war. To survive the shakeout, companies begin to focus both on costs minimization and on building brand loyalty. By the time an industry matures, the surviving companies are those that have brand 1oyalty and low-cost operations. Because both of these factors constitute a significant barrier to entry, the threat of entry by potential competitors the greatly diminished. High entry barriers in maturity industries give companies the opportunity to increase prices profits. As a result of the shakeout, most industries in the maturity stage have consolidated and become oligopolies.

Declining Industries: Eventually, most industries enter a decline stage. In the decline stage, growth becomes negative for a variety of reasons, including technological substitution (for example, air travel for rail travel), social changes (greater health consciousness hitting tobacco sales), demographics (the declining birthrate hurting the market for baby and child products), 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 vicious as in the shake out stage. The main problem in a decline industry is that falling demand leads to the emergence of excess capacity. In trying to utilize this capacity, companies begin to cut prices, thus sparking a price war. Exit barriers play a part in adjusting excess capacity. The greater the exit barriers, the harder it is for companies to reduce capacity and the greater is the threat of severe price competition.

Variations on the Theme: It is important to remember that the industry life cycle model is a generalization. In practice, industry life cycles do not always follow all the stages. In some cases, growth is so rapid that the embryonic stage is skipped altogether, as happened in the personal computer industry. In other instances, industries fail to get past the embryonic stage. Industry growth can be revitalized after long periods of decline, either through innovations or through social changes. The time span of the different stages can also vary, significantly from industry to industry. Some industries can stay in maturity almost indefinitely if their products become basic necessities of life, as is the case for the automobile industry. Others skip the mature stage and go straight into decline. Still other industries may go through not one but several shakeouts before they enter full maturity.

Globalization and Industry Structure

Globalization involves both the globalization of production and of markets. The globalization of production refers to the dispersion of parts of production process to different locations around the globe to take advantage of national differences in the cost and quality of factors to production (that is, labor, energy, land, and capital). The objective is to lower costs and boost profits.

The globalization of markets refers to away from an economic system in which national markets are distinct entities, isolated from each other by trade barriers and barriers of distance, time, and culture, and toward a system in which national markets are merging into one huge global marketplace. According to this view, the tastes and preferences of consumers in different nations are beginning to come together on some global norm.

The Causes of Global Shift:

Two factors underlie the trend toward the increasing globalization of markets and production. Since the end of World War II, barriers to the free flow of goods, services, and capital between countries have decreased, and dramatic changes have occurred in communication, information, and transportation technologies.

In the aftermath of World War II, the advanced industrial nations of the West committed themselves to the goal of removing barriers to the free flow of goods, services, and capital between nations. The goal of removing barriers to the free flow of goods was enshrined in an international treaty known as the General Agreement on Tariffs and Trade (GATT). Under the umbrella of the GATT, in the half century since World War II there has been a significant lowering of barriers to the free flow of goods.

The result of the GATT has, been to facilitate the globalization of markets and production. The lowering of trade barriers has allowed companies to view the world, rather than a single country, as their market. It has also made it increasingly possible to base individual production activities at the optimal locations for them, serving the world market from those locations. Thus a company might design a product in one country, produce component parts in two other counters, assemble the product in yet another country, and then export the finished product around the world.

If the lowering of trade barriers made the globalization of markets and production a theoretical possibility, technological change has transformed this into a tangible reality. Perhaps the single most important innovation has been the development of the microprocessor, which underlies many of the recent advances in communications technology, information processing and transportation technology. These technological innovations have dramatically lowered the real costs of information processing and communications over the last two decades. Lower costs in turn have made it possible for companies to manage globally dispersed production systems. Indeed, a worldwide communications network has become essential to the functioning of many companies.

Besides communications and information-processing technology the development commercial jet aircraft has helped knit together the worldwide operations of many international businesses. By jetliner, it takes a day at most for an American manager to travel to her company’s European or Asian operations, greatly increasing her ability to oversee a globally dispersed production system.

Technological innovation has also facilitated the globalization of markets. Low-cost jet travel has resulted in the mass movement of people between countries. This has helped reduce the cultural distance between countries and has laid the ground for some convergence of consumer tastes and preferences. At the same time global communications networks and global media are helping to create a worldwide culture.

The Consequences of Global Shift:

The trend toward the globalization of production and the globalization of markets has several important implications for competition within an industry. First, it is crucial for companies to recognize that industry boundaries do not stop at national borders. Because many industries are becoming global in scope, actual and potential competitors exist not only in a company’s home market bur also in other national markets. Companies that scan just their home market can be caught unprepared by the entry of efficient foreign competitors.

Second, the shift from national to global markets during the last twenty years has intensified competitive rivalry in industry after industry. National markets that were once consolidated oligopolies, dominated by three or four companies and subjected to relatively little foreign competition, have been transform into segments of fragmented global industries, where a large number of companies battle each other for market share in country after country. This rivalry has driven down profit rates and made it all the more critical for companies to maximize their efficiency, quality, customer responsiveness, and innovative ability.

Third, as competitive intensity has increased, so has the rate of innovation. Companies strive to gain an advantage over their competitors by pioneering new products, processes, and ways of doing business. The result has been to compress product life cycles and make it viral for companies to stay on the leading edge of technology.

Finally, it should be noted that even though globalization has increased both the threat of entry and the intensity of rivalry within many formerly protected national markets, it has also created enormous opportunities for companies based in those markets. The steady decline in trade barriers has opened up many once protected markets to companies based outside them.

National Context and Competitive Advantage

The national context of a country influences the competitiveness of companies based within it. Despite the globalization of production and markets, many of the most successful companies in certain industries are still clustered in a small number of countries. The national context within which a company is based may have an important bearing on the competitive position of that company in the global market place.

Companies need to understand how national context can affect competitive advantage, for then they will be able to identify (1) where their most significant competitors are likely to come from and (2) where they might want to locate certain productive activities.

Economic theory stresses that factor conditions— the cost and quality of factors of production— are a prime determinant of the competitive advantage that certain countries might have in certain industries. Factors of production include basic factors, such as land, labor, capital, and raw materials, and advanced factors such as technological know-how-managerial sophistication, and physical infrastructure (that is, roads, railways, and ports).

According to Porter there are four basic determinants of a nation’s competitive position in certain industries: factor conditions, industry rivalry, demand conditions, and related and supporting industries (see the following Figure).

Figure: The Determinants of National Competitive Advantage

He argues that a country will have a competitive advantage in a particular industry under the following conditions:

1. The country has the right mix of basic and advanced factors of production to support that industry.

2. Intense rivalry between local companies in that industry has forced them to be efficient.

3. Strong local demand conditions have helped foster a strong local industry, while demanding consumers have forced companies to become more efficient.

4. Related and supporting industries are also internationally competitive, thus providing companies in the focal industry with low-cost and high-quality inputs and complementary products.

Competitive Advantage: Resources, Capabilities, and Competencies Overview

Competitive advantage comes from an ability to lower costs through high efficiency, provide consistently high quality products, and be responsive to customer needs. Efficiency, quality, innovation, and customer responsiveness can be regarded as the four main building blocks, or dimensions, of competitive advantage. Companies that have achieved a competitive advantage typically excel on at least one of these four main dimensions. In turn, these dimensions are the product of an organization’s competencies, resources, and capabilities.

Competitive Advantage: Low Cost and Differentiation

We say that a company has a competitive advantage when its profit rate is higher than the average for its industry. Profit rare is normally defined as some ratio, such as return on sales (ROS) or return of assets (ROA).

The most basic determinant of a company’s profit rare is its gross profit margin (Π), which is simply the difference between total revenues (TR) and total costs (TC), divided by total costs:

Π = (TR – TC)/TC

To put it another way,

Π = {(Unit Price x Unit Sales) – (Unit Cost x Unit Sales)}/(Unit Cost x Unit Sales).

It allows that for a gross profit margin to be higher than the average for the industry one of the following must be occurring:

The company’s unit price must be higher than that of the average company and its unit cost must be equivalent to that of the average company.

The company’s unit cost must be lower than that of the average company and its unit price must be equivalent to that of the average company.

The company must have both a lower unit cost and a higher unit price than the average company.

Thus, to achieve a competitive advantage, a company must either have lower costs than its competitors, or it must differentiate its products in some way so that it can charge a higher price than its competitors, or it must do both simultaneously.

When a company charges a higher unit price than the industry average, it is engaging in premium pricing. For a consumer to be prepared to pay a premium price, the company must be adding value to the product, from the consumer’s perspective, in a way that competitors are not. Adding value requires differentiating the product from those offered by competitors along one or more dimensions, such as quality, design, delivery time and after-sales services and support.

Building on these basic ideas, Michael Porter has referred to low cost and differentiation as generic business-level strategies. That is, the strategies represent the two fundamental ways of trying to obtain a competitive advantage in an industry. A low-cost strategy is based on doing everything possible to lower unit costs. A differentiation strategy is based on doing everything possible to differentiate products from those offered by competitors in order to be able to charge a premium price.

The Generic Building Blocks of Competitive Advantage Four factors build competitive advantage: efficiency, quality, innovation, and customer responsiveness. They are the generic building blocks of competitive advantage (Shown in the following Figure). These factors are generic in the sense that they represent four basic ways of lowering costs and achieving differentiation that any company can adopt, regardless of its industry or the products or services it produces. It should be noted that these factors highly interrelated. Thus, superior quality can lead to superior efficiency, while innovation can enhance efficiency, quality and customer responsiveness.

Figure: Generic Building Blocks of Competitive Advantage

Efficiency: A company is a device for transforming inputs into outputs. Inputs are basic factors of production such as labor, land, capital, management, technological know-how, and so on. Outputs are the goods and services that a company produces. Efficiency is measured by the cost of inputs required to produce a given output. The more efficient a company, the lower is the cost of inputs required to produce a given output. Thus efficiency helps a company attain a low-cost competitive advantage.

One of the keys to achieving high efficiency is to utilize inputs in the most productive way possible. The most important component of efficiency for most companies is employee productivity, which is usually measured by output per employee. Holding all else constant, the company with the highest employee productivity in an industry will typically have the lowest costs of production.

Quality: Quality products are goods and services that are reliable in the sense that they do the job they were designed for and do it well. The impact of high product quality on competitive advantage is twofold. First, providing high-quality products creates a brand name reputation for a company’s products. In turn, this enhanced reputation allows the company to charge a higher price for its products.

The second impact of quality on competitive advantage comes from the greater efficiency, and hence lower unit costs brought about by higher product quality. The major effect here is through the impact of quality on productivity. Higher product quality means that less employee time is wasted making defective products or providing substandard services and less time has to be spent fixing mistakes. This translates into higher employee productivity and lower unit costs. Thus high product quality not only lets a company charge higher prices for its product; it also lowers costs (Shown in the following Figure).

Figure: Impact of Quality on Profits

Innovation: Innovation can be defined as anything new or novel about the way a company operates or the products it produces. Thus innovation includes advances in the kinds of products, production processes, management systems, organizational structures, and strategies developed by a company.

Innovation is perhaps the single most important building block of competitive advantage. In the long run, competition can be viewed as a process driven by innovation. Although not all innovations succeed, those that do can be a major source of competitive advantage. The reason is that, by definition, successful innovation gives a company something unique— something that its competitors lack (until they imitate the innovation). Thus, uniqueness may allow a company to differentiate itself from its rivals and charge a premium price for its product. Alternatively, it may allow a company to reduce its unit costs far below those of competitors.

Customer Responsiveness: To achieve customer responsiveness, a company must give its customers exactly what they want when they want it. Consequently, a firm must do everything possible to identify customer needs and to satisfy them. Among other things, achieving superior customer responsiveness involves giving customers value for money. Steps taken to improve the efficiency of a company’s production process and the quality of its output are consistent with this goal. In addition, satisfying customer needs may require the development of new products with features that existing products lack. In other words, achieving superior efficiency, quality, and innovation are all part of achieving superior customer responsiveness.

Another factor that stands out in any discussion of customer responsiveness is the need to customize goods and services to the unique demands of individual customers. For example, the production of different types of soft drinks and beers in recent years can be viewed partly as a response to this trend.

An aspect of customer responsiveness that has drawn increasing attention is customer response time—the time that it takes for a good to be delivered or a service to be performed.

Besides quality, customization, and response time, other sources of enhanced customer responsiveness are superior design, superior service, and superior after sales service and support. All these factors enhance customer responsiveness and allow a company to differentiate itself from its less responsive competitors. In turn, differentiation enables a company to build brand loyalty and to charge premium price for its products.

Summary: Efficiency, quality, customer responsiveness, and innovation are all important elements in obtaining a competitive advantage. Superior efficiency enables a company to lower its costs; superior quality lets both charge a higher price and lower its costs; superior customer responsiveness allows it to charge a higher price; and superior innovation can lead to higher prices or lower unit costs (Shown in the following Figure). Together, these four factors create a low-cost or differentiation advantage for a company, which brings above average profits and enables it to outperform its competitors.

Figure: Impact of Efficiency, Quality, Customer Responsiveness, and Innovation on Unit Costs and Prices

Distinctive Competencies, Resources, and Capabilities

A distinctive competency refers to a unique strength that allows a company to achieve superior efficiency, quality, innovation, or customer responsiveness (Shown in the following Figure). A firm with a distinctive competency can charge a premium price for its products or achieve substantially lower costs than its rivals. Consequently, it can earn a profit rate substantially above the industry average.

Resources and Capabilities: The distinctive competencies of an organization arise from two complementary sources: its resources and capabilities. Resources refer to the financial, physical, human, technological, and organizational resources of the company. These can be divided into tangible resources (land- buildings, plant, and equipment) and intangible resources (brand names, reputation, patents, and technological or marketing know-how). To give rise to a distinctive competency a company’s resources must be both unique and valuable. A unique resource is one that no other company has. For example, Polaroid’s distinctive competency in instant photography was based on a unique intangible resource: the technological know-how involved in instant film processing. This know-how was protected from imitation by a thicker of patents. A resource is valuable if it in some way helps create strong demand for the company’s products. Thus Polaroid’s technological know-how was valuable because it created strong demand for its photographic products.

Capabilities refer to a company’s skills at coordinating its resources and putting them to productive use. These skills reside in an organization’s routines, that is, in the way a company makes decisions and manages its internal processes in order to achieve organizational objectives. More generally, a company’s capabilities are the product of its organizational structure and control systems. These specify how and where decisions are made within a company, the kind of behaviors the company rewards, and the company’s cultural norms and values.

The Durability of Competitive Advantage

We need to address that how long will a competitive advantage last once it has been created. The durability of a company’s competitive advantage depends on three factors: the height of barriers to imitation, the capability of competitors to imitate its innovation, and the general level of dynamism in the industry environment.

Figure: Factors Influencing the Durability of Competitive Advantage

Barriers to Imitation: Barriers to imitation are factors that make it difficult for a competitor to copy a company’s distinctive competencies. Since distinctive competencies allow companies to earn superior profits, competitors want to imitate them. However, the greater the barrier to such imitation, the more sustainable is a company’s competitive advantage. It is important to note at the outset that ultimately almost any distinctive competency can be imitated by a competitor. The critical issue is time. The longer it takes competitors to imitate a distinctive competency, the greater the opportunity that the company has to build a strong market position and reputation with consumers, which is then difficult for competitors to attack. Moreover, the longer it takes to achieve an imitation, the greater is the opportunity for the imitated company to improve on its competency, or build other competencies, thereby staying one step ahead of the competition.

Imitating Resources: The easiest distinctive competencies for prospective rivals to imitate tend to be those based on possession of unique and valuable tangible resources, such as buildings, plant, and equipment. Such resources are visible to competitors and can often be purchased on the open market.

Intangible resources can be more difficult to imitate. This is particularly true of brand names. Brand names are important because they symbolize a company’s reputation. Customers will often display a preference for the products of such companies because the brand name is an important guarantee of high quality. Although competitors might like to imitate well -established brand names, the law prohibits them from doing so.

Marketing and technological know-how are also important intangible resources. Unlike brand names, however, company-specific marketing and technological know-how can be relatively easy to imitate. In the case of marketing know-how, the movement of skilled marketing personnel between companies may facilitate the general dissemination of know-how. With regard to technological know-how, in theory, the patent system should make technological know-how relatively immune to imitation. Patents give the inventor of a new product a seventeen-year exclusive production agreement.

Imitating Capabilities: Imitating a company’s capabilities tends to be more difficult than imitating its tangible and intangible resources, chiefly because a company’s capabilities are often invisible to outsiders. Since capabilities are based on the way in which decisions are made and processes are managed deep within a company, by definition, it is hard for outsiders to discern the nature of a company’s internal operations.

On its own, however, the invisible nature of capabilities would not be enough to halt imitation. In theory, competitors could still gain insights into how a company operates by hiring people away from that company. However, a company’s capabilities rarely reside in a single individual. Rather, they are the product of how numerous individuals interact within a unique organizational setting. It is possible that no one individual within a company may be familiar with the totality of a company’s internal operating routines and procedures. In such cases, hiring people away from a successful company in order to imitate its key capabilities may not be helpful.

To sum up, since resources are easier to imitate than capabilities, a distinctive competency based on a company’s unique capabilities is probably more durable (less imitable) than one based on its resources. It is more likely to form the foundation for a long-run competitive advantage.

Capability of Competitors: According to work by Pankaj Ghemawat, a major determinant of the capability of competitors to rapidly imitate a company’s competitive advantage is the nature of the competitors’ prior strategic commitments. By strategic commitment, Ghemawat means a company’s commitment to a particular way of doing business— that is, to developing a particular set of resources and capabilities. Ghemawat’s point is that once a company has made a strategic commitment it will find it difficult to respond to new competition if doing so requires a break with this commitment. Therefore, when competitors already have long-established commitments to a particular way of doing business, they may be slow to imitate an innovating company’s competitive advantage. Its competitive advantage will thus be relatively durable.

Industry Dynamism: A dynamic industry environment is one that is changing rapidly. We examined the factors that determine the dynamism and intensity of competition in an industry. The most dynamic industries tend to be those with a very high rate of product innovation— for instance, the consumer electronics industry and the personal computer industry. In dynamic industries, the rapid rate of innovation means that product life cycles are shortening and that competitive advantage can be transitory (temporary). A company that has a competitive advantage today may find its market position outflanked tomorrow by a rival’s innovation.

Why Do Companies Fail? We define a failing company as one whose profit rare is substantially lower than the average profit rate of its competitors. A company can lose its competitive advantage bur still nor fail. It may just earn average profits. Failure implies something more drastic. Failing companies typically earn low or negative profits; in other words, they are at a competitive disadvantage. We explore three related reasons for failure: inertia, prior strategic commitments, and the Icarus paradox.

Inertia: The inertia argument is that companies find it difficult to change their strategies and structures in order to adapt to changing competitive conditions.

The role of an organization’s capabilities can cause inertia. Earlier we argue that organizational capabilities can be a source of competitive advantage; their downside, however, is that they are difficult to change. Recall that capabilities are the way a company makes decisions and manages its processes. Capabilities are difficult to change because a certain distribution of power and influence is embedded within the established decision-making and management processes of an organization. Those who play key roles in a decision-making process clearly have more power. It follows that changing the established capabilities of an organization means changing its existing distribution of power and influence, and those whose power and influence would diminish resist such change. Proposals for change trigger turf battles. This power struggle and the political resistance associated with trying to alter the way in which an organization makes decisions and manages its process— that is, trying to change its capabilities— bring on inertia. This is not to say that companies cannot change. However, because change is so often resisted by those who feel threatened by it, in most cases, change has to be crisis induced.

Prior Strategic Commitments: Ghemawat has argued that a company’s prior strategic commitments not only limit its ability to imitate rivals, but may also cause competitive disadvantage. IBM, for instance, had made major investments in the mainframe computer business. As a result, when the market shifted, it was struck with significant resources that were specialized to that particular business. The company had manufacturing facilities geared to the production of mainframes, research organizations that were similarly specialized, and a mainframe sales force. Since these resources were not well suited to the newly emerging personal computer business, IBM’s current difficulties were in a sense inevitable. Its prior strategic commitments locked IBM into a business that was shrinking. Shedding these resources was bound to cause hardship for all organization stakeholders.

The Icarus Paradox: In a recent book, Danny Miller proposed that the roots of competitive failure can be found in what he termed the Icarus paradox. Icarus is a figure in Greek mythology who made himself a pair of wings to escape from an island where he was being held prisoner. He flew so well that he went higher and higher, ever closer to the sun, until the hear of the sun melted the wax that held his wings together and he plunged to his death in the Aegean Sea. The paradox is that his greatest asset, his ability to fly, caused his demise. Miller argues that the same paradox applies to many once successful companies. According to Miller, many companies become so dazzled by their early success that they believe more of the same types of effort is the way to future success. As a result, however, a company can become so specialized and inner-directed that it loses sight of market realities and the fundamental requirements for achieving a competitive advantage. Sooner or later this leads to failure.

Miller identifies four major categories among the rising and failing companies. The “craftsmen”, such as Texas Instruments and Digital Equipment Corp. achieved early success through engineering excellence. But then the companies became so obsessed with engineering details that they lost sight of market realities. Then there are the “builders”, for instance, Gulf & Western and ITT. Having built successful, moderately diversified companies, they then became so enchanted with diversification for its own sake that they continued to diversify far beyond the point at which it was profitable to do so. Miller’s third group is the “ pioneers” like Wang Labs. Enamored of their own originally brilliant innovations, they continued to search for additional brilliant innovations, but ended up producing novel but completely useless products. The final category comprises the “salesman”, exemplified by Procter & Gamble. They became so convinced of their ability to sell anything that they paid scant attention to product development and manufacturing excellence and as a result spawned a production of bland, inferior products.

Building Competitive Advantage Through Functional Level Strategies The Value Chain The value a company creates is measured by the amount that buyers are willing to pay for a product or service. A company is profitable if the value it creates exceeds the cost of performing value-creation functions such as manufacturing, and marketing. To gain a competitive advantage, a company must either perform value-creation functions at a lower cost than its rivals or perform them in a way that leads to differentiation and a premium price. That is, it must pursue the strategies of low cost or differentiation.

Value chain consists of those steps/functions that add value to the products without (sometimes) distinguishing where they are being added. The value chain is divided between primary activities and support activities (shown in the following Figure). Each activity adds value to the product.

Figure: The Value Chain

Primary activities have to go with the physical creation of the product, its marketing and delivery to buyers, and its support and after-sales service.

Support activities are the functional activities that allow the primary activities of manufacturing and marketing to take place. The materials management function controls the transmission of physical materials through the value chain, from procurement through operations and into distribution. The efficiency with which this is carried out can lower the cost of value creation. In additions, an effective materials management function can monitor the quality of inputs into the manufacturing process. This results in an increase in the quality of a company’s outputs, thereby facilitating premium pricing. The R&D function develops new product and process technologies. Technological developments can lower manufacturing costs and result in the creation of more attractive products that demand a premium price. Thus R&D can affect primary manufacturing and marketing activities, and through them value creation. The human resource function ensures that the company has the right mix of skilled people to perform its value-creation activities effectively.

The final support activity is the company infrastructure, which has a somewhat different character from the other support activities. Infrastructure is the company-wide context within which all the other value-creation activities take place; it includes the company’s organizational structure, control systems, and culture. Since top management can exert considerable influence in shaping these aspects of a company, top management should also be viewed as part of the infrastructure. Top management, through strong leadership, can consciously shape the infrastructure of a company, and through that the performance of all other value-creation activities that take place within it.

An important point to note is that achieving the goals of superior efficiency, quality, innovation, and customer responsiveness requires strategies that embrace several distinct value-creation activities. Indeed, these goals can be regarded as goals that cut across the different value-creation functions of a company. Attaining these goals demands substantial cross-functional integration (Shown in the following Figure).

Figure: Cross-Functional Goals and the Value Chain Achieving Superior Efficiency

A company can be viewed as a device for transforming inputs into outputs. Inputs are basic factors of production such as labor, land, capital, management, technological know-how, machinery, and so on. Outputs are the goods and services that a company produces. Efficiency is measured by the cost of inputs required to produce a given output. The more efficient a company, the lower is the cost of inputs required to produce a given output. Put another way, an efficient company has higher productivity than its rivals, and therefore, lower costs. Here we review the various steps that companies can take to boost their efficiency and, accordingly, lower their unit costs. Before moving on, however, we must stress one key point: achieving superior quality plays a major role in achieving superior efficiency.

Economies of Scale, Learning Effects, and the Experience Curve: One way of achieving superior efficiency is by gaining economies of scale and learning effects. Both of these concepts underlie a phenomenon referred to as the experience curve. Before discussing the experience curve, we must consider economies of scale and learning effects.

Economies of Scale: Economies of scale are unit-cost reductions associated with a large scale of output. One source of economies of scale is the ability to spread fixed costs over a large production volume. Fixed costs are costs that must be incurred to produce a product whatever the level of output; they include the costs of purchasing machinery, the costs of setting up machinery for individual production runs, and the costs of advertising and R&D. Spreading fixed costs over a large volume of output lets a company reduce unit costs. Another source of scale economies is the ability of companies producing in large volumes to achieve a greater division of labor and specialization. Specialization, in turn, is said to have a favorable impact on employee productivity, mainly because it enables individuals to become very skilled at performing a particular task.

But these economies do not continue indefinitely. Indeed, most experts agree that after a certain minimum efficient scale (MES) of output is reached there are few, if any, additional scale economies to be had from expanding volume. (Minimum efficient scale refers to the minimum plant size necessary to gain significant economies of scale.) In other words, as shown in the following Figure, the long-run unit cost curve of a company is L-shaped. At outputs beyond MES in this Figure, additional cost reductions are hard to come by.

Figure: A

Figure: A Typical Long-Run Unit-Cost Curve

Learning Effects: Learning effects are cost savings that come from learning by doing. Labor, for example, learns by repetition how best to carry out a task. In other words, labor productivity increases over time, and unit costs fall as individuals learn the most efficient way to perform a particular task. Equally important, in new manufacturing facilities management typically learns how best to run the new operation. Hence, production costs decline because of' increasing labor productivity and management efficiency.

Learning effects tend to be more significant in situations where a technologically complex task is repeated, since there is more to learn. Thus learning effects will be more significant in an assembly process involving 1,000 complex steps than in an assembly process involving 100 simple steps. No matter how complex the task, however, learning effects typically die out after a limited period of time. Indeed, it has been suggested that they are really important only during the start-up period of a new process and cease after two or three years.

The Experience Curve: The experience curve refers to systematic unit-cost reductions that have been observed to occur over the life of a product. According to the experience curve concept, unit manufacturing costs for a product typically decline by some characteristic amount each time accumulated output of the product is doubled (accumulated output is the total output of a product since its introduction). There is a relationship between unit manufacturing costs and accumulated output (Shown in the following Figure).

Figure: A Typical Experience Curve

Economies of scale and learning effects underlie the experience curve phenomenon. Put simple, as a company increases the accumulated volume of its output over time, it is able to realize both economies of scale (as volume increases) and learning effects. Consequently, unit costs fall with increases in accumulated output.

The strategic significance of the experience curve is clear. It suggests that increasing a company’s product volume and market share will also bring cost advantages over the competition. Thus company A in the above Figure, because it is further down the experience curve, has a clear cost advantage, over company B.

The concept is perhaps most important in those industries where the production process involves the mass production of a standardized output (for example, the manufacture of semiconductor chips). If a company wishes to become more efficient, and thereby attain a low-cost position, it must try to ride down the experience curve as quickly as possible. This involves constructing efficient scale manufacturing facilities even before the company has the demand, and the aggressive pursuit of cost reductions from learning effects. The company might also need to pursue an aggressive marketing strategy, cutting prices to the bone and stressing heavy sales promotions in order to build up demand, and hence accumulated volume, as quickly as possible. Once down the experience curve, because of its superior efficiency, the company is likely to have a significant cost advantage over its competitors.

However, the company furthest down the experience curve must not become complacent about its cost advantage. More generally, there are three reasons why companies should not become complacent about their efficiency-based cost advantages derived from experience effects. First, since neither learning effects nor economies of scale go on forever, the experience curve is likely to bottom out at some point; indeed, it must do so by definition. When this occurs, further unit-cost reductions from learning effects and economies of scale will be hard to come by. Thus, in time, other companies can catch up with the cost leader. Once this happens, a number of low-cost companies can have cost parity with each other. In such circumstances, establishing a sustainable competitive advantage must involve other strategic factors besides the minimization of production costs by utilizing existing technologies— factors such as better customer responsiveness, product quality, or innovation.

Second, cost advantages gained from experience curve effects can be made obsolete by the development of new technologies. Technological change can alter the rules of the game, requiring that former low-cost companies take steps to reestablish their competitive edge.

A further reason for avoiding complacency is that high volume does not necessarily give a company a cost advantage. Some technologies have different cost functions. For example, the steel industry has two alternative manufacturing technologies: an integrated technology, which relies on the basic oxygen furnace, and a minimill technology, which depends on electric arc furnace. As illustrated in the following Figure, the minimum efficient scale (MES) of the electric arc furnace is located at relatively low volumes, whereas the MES of the basic oxygen furnace is located at relatively high volumes. Even when both operations are producing at their most efficient output levels, steel companies with basic oxygen furnaces do not have a cost advantage over minimills.

Figure: Unit Production Costs in an Integrated Steel Mill and a Minimill

Consequently, the pursuit of experience economies by an integrated company using basic oxygen technology may not bring the kind of cost advantages that a naive reading of the experience curve phenomenon would lead the company to expect. Indeed, in recent years integrated companies have not been able to get enough orders to run at optimum capacity. Hence their production costs have been considerably higher than those of minimills. More generally, in many industries new flexible manufacturing technologies hold out the promise of allowing small manufacturers to produce at unit costs comparable to those of large assembly-line operations.

Flexible Manufacturing (Lean Production) and Efficiency: Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass production of a standardized output. The tradeoff implicit in this idea is one between costs and product variety. Producing greater product variety form a factory implies shorter production runs, which in turn implies an inability to realize economies of scale. That is, increasing product variety makes it difficult for a company to increase its manufacturing efficiency and thus reduce its unit costs. According to this logic, the way to increase efficiency and drive down unit costs is to limit product variety and produce a standardized product in large volumes (see the following Figure-a).

Figure: The Tradeoff Between Costs and Product Variety

This view of manufacturing efficiency has been challenged by the rise of flexible manufacturing technologies. The term flexible manufacturing technology— or lean production, as this technology is often called— covers a range of manufacturing technologies designed to (1) reduce setup times for complex equipment, (2) increase the utilization of individual machines through better scheduling, and (3) improve quality control at all stages of the manufacturing process. Flexible manufacturing technologies allow the company to produce a wider variety of end products at a unit cost that at one time could only be achieved through the mass production of a standardized output (see the above Figure-b). Indeed, recent research suggests that the adoption of flexible manufacturing technologies may actually increase efficiency and lower unit costs relative to what can be achieved by the mass production of a standardized output. Flexible manufacturing technologies vary in their sophistication and complexity.

Flexible machine cells are one common flexible manufacturing technology. A flexible machine cell is a grouping of various types of machinery, a common materials handler, and a centralized cell controller (computer). Each cell normally contains four to six machines capable of performing a variety of operations. The typical cell is dedicated to the production of a family of parts or products. The settings on machines are computer controlled. This allows each cell to switch quickly between the production of different parts or products. Improved capacity utilization and reductions in work-in-progress (that is, stockpiles of partly finished products) and waste are major efficiency benefits of flexible machine cells.

Besides, improving efficiency and lowering costs, flexible manufacturing technologies let companies customize products to the unique demands of small consumer groups—at a cost that at one time could only be achieved by mass producing a standardized output. Thus they help a company increase its customer responsiveness.

Marketing Strategy and Efficiency: Marketing strategy— the position that a company takes with regard to pricing, promotion, advertising, product design, and distribution— can play a major role in boosting a company’s efficiency. Some of the steps leading to greater efficiency are fairly obvious. For example, we have already discussed how riding down the experience curve to gain a low-cost position can be facilitated by aggressive pricing, promotions, and advertising— all of which are the task of the marketing function. However, there are other aspects of marketing strategy that have a less obvious but no less important impact on efficiency. Perhaps the most important is the relationship between customer defection rates and unit costs.

Customer defection rates are the percentage of a company’s customers that defect every year to competitors. Defection rates are determined by customer loyalty, which in turn is a function of the ability of a company to satisfy its customers. Because acquiring a new customer entails certain one-time fixed costs for advertising, promotions, and the like, there is a direct relationship between defection rates and costs. The longer a company holds on to a customer, the greater is the volume of customer-generated unit sales that can be set against these fixed costs, and the lower the average unit cost of each sale. Thus lowering customer defection rates allows a company to achieve substantial cost economies. This is illustrated in the following Figure, which shows that high defection rates imply high average unit costs (and vice-versa).

Figure: The Relationship Between Average Unit Costs and Customer Defection Rates

One consequence of the relationship summarized in the above Figure is a relationship, illustrated in the following Figure, between the length of time that a customer stays with the company and profit per customer. Because of the fixed costs of acquiring new customers, serving customers that stay with the company only for a short time before switching to competitors can often yield a negative profit. However, the longer a customer stays with the company, the more the fixed costs of acquiring that customer can be spread out over repeat purchases, which boosts the profit per customer. Thus, as shown in the following Figure, there is a positive relationship between the length of time that a customer stays with a company and profit per customer

Figure: The Relationship Between Customer Loyalty and Profit Per Customer

The key message is that reducing customer defection rates and building customer loyalty can be a major source of cost saving. Because it leads to lower unit costs, reducing customer defection rates by just 5 percent can increase profits per customer anywhere from 25 percent to 85 percent depending on the industry. A company reduces customer defection rates by building brand loyalty, which in turn requires that the company be responsive to the needs of its customers.

Materials Management Strategy, JIT and Efficiency: The contribution of materials management to boosting the efficiency of a company can be just as dramatic as the contribution of manufacturing and marketing. Materials management encompasses the activities necessary to get materials to a production facility, through the production process, and out through a distribution system to the end user. The potential for reducing costs through more efficient materials management is enormous. Even a small reduction in material management costs can have substantial impact on profitability. In a saturated market, it would be much easier to reduce materials costs.

Improving the efficiency of the materials management function typically requires the adoption of just-in-time (JIT) inventory systems. The basic philosophy behind JIT is to economize on inventory holding costs by having materials arrive at a manufacturing plant just in time to enter the production process and not before. The major cost saving comes from increasing inventory turnover, which reduces inventory holding costs, such as warehousing and storage costs.

The drawback of JIT systems is that they leave a firm without a buffer stock of inventory. Although buffer stocks of inventory are expensive to store, they can help tide a firm over shortages on inputs brought about by disruption among suppliers (for instance. a labor dispute at a key supplier). Buffer stocks can also help a firm respond quickly to increases in demand.

R&D Strategy and Efficiency: The role of superior research and development in helping a company achieve greater efficiency is twofold. First, the R&D function can boost efficiency by designing products that are easy to manufacture. By cutting down on the number of parts that make up a product, R&D can dramatically decrease the required assembly time, which translates into higher employee productivity and lower unit costs.

The second way in which the R&D function can help a company to achieve greater efficiency is by pioneering process innovations. A process innovation is an innovation in the way production processes operate that improves the efficiency of those processes. Process innovations have often been a major source of competitive advantage.

Human Resources Strategy and Efficiency: Employee productivity is one of the key determinants of an enterprise’s efficiency and cost structure. The more productive the employees, the lower will be the unit costs. The challenge for a company’s human resource function is to devise ways to increase employee productivity. It has three main choices: training employees; organizing the work force into self-managing teams; and linking pay to performance.

Employee Training: Individuals are a major input into the production process. A company that employs individuals with higher skills is likely to be more efficient than one employing less skilled personnel. Individuals who are more skilled can perform tasks faster and more accurately and are more likely to learn the complex tasks associated with many modem production methods than individuals with lesser skills. Training can upgrade employee skill levels, bringing the firm productivity-related efficiency gains.

Training programs have four main components. First, rotating employees through various departments lets them acquire general skills. Second, companies may use extensive off-the-job training. Third, many companies encourage their employees to develop skills through correspondence courses, whose costs the employers often reimburse on completion of the program. Finally, participation in team activities focused on improving company performance results in a general upgrading of employee skill levels.

Self-Managing Teams: Self-managing teams are a relatively recent phenomenon. The growth of flexible manufacturing cells, which group workers into teams, has undoubtedly facilitated the spread of self-managing teams. The typical team comprises five to fifteen employees who produce an entire product or subassembly. Team members learn all team tasks and rotate from job to job. A more flexible work force is one result. Team members can fill in for absent coworkers. Teams also take over managerial duties such as work and vacation scheduling, ordering materials, and hiring new members. The greater responsibility thrust on team members and the empowerment it implies are seen as motivators. (Empowerment is the process of giving lower-level employees decision-making power.) People often respond well to being given greater autonomy and responsibility. Performance bonuses linked to team production and quality targets work as an additional motivator.

Pay for Performance: People work for money, so it is hardly surprising that linking pay to performance can help increase employee productivity. However, the issue is not quite as simple as just introducing incentive pay systems; it is also important to define what kind of performance is to be rewarded and how. Some of the most efficient companies in the world, mindful that cooperation among employees is necessary to realize productivity gains, do not link pay to individual performance. Instead they link pay to group or team performance. Bonus pay is linked to the ability of the team to meet productivity and quality goals. This creates a strong incentive for individuals to cooperate with each other in pursuit of team goals; that is, it facilitates teamwork.

Infrastructure and Efficiency: The infrastructure sets the context within which all other value-creation activities take place. It follows that the infrastructure can help in achieving efficiency goals. Above all, the infrastructure can foster a company-wide commitment to efficiency and promote cooperation among different functions in pursuit of efficiency goals.

A company-wide commitment to efficiency can be built through top management leadership. The leadership task is to articulate a vision that recognizes the need for all functions of the company to focus on improving their efficiency. It is not enough just to improve the efficiency of manufacturing, or marketing, or R&D. Achieving superior efficiency requires a company-wide commitment to this goal, and this can be articulated only by top management. A further leadership task is to facilitate cross-functional cooperation needed to achieve superior efficiency. Achieving Superior Quality

Achieving superior quality gives a company two advantages. The enhanced reputation for quality lets the company charge a premium price for its product, and the elimination of defects from the manufacturing process increases efficiency and hence lowers costs.

The main concept utilized to enhance quality is total quality management (TQM). TQM is a management philosophy that focuses on improving the quality of a company’s products and services and stresses that all company operations should be oriented toward this goal. A company-wide philosophy, it requires the cooperation of all the different functions if it is to be successfully implemented.

The TQM Concept: The total quality management (TQM) concept was first developed by a number of American consultants, including W. Edwards Deming, Joseph Juran, and A. V. Feigenbaum. The philosophy underlying TQM, as articulated by Deming, is based on the following five-step “chain reaction”:

1. Improved quality means that costs decrease because of less rework, fewer mistakes, fewer delays, and better use of rime and materials.

2. As a result, productivity improves.

3. Better quality leads to higher market share and allows the company to rise prices.

4. This increases the company’s profitability and allows it to stay in business.

5. Thus the company creates more jobs.

Achieving Superior Innovation

In many ways innovation is the single most important building block of competitive advantage. Successful innovation of products or processes gives a company something unique that its competitors lack. This uniqueness may allow a company to charge a premium price or lower its costs structure below that of its rivals. Competitors, however, will try to imitate successful innovations. Often they will ultimately succeed, although high barriers to imitation can slow it down. Therefore, maintaining a competitive advantage requires a continuing commitment to innovation. Achieving Superior Customer Responsiveness

Achieving superior customer responsiveness involves giving customers value for money, and steps taken to improve the efficiency of a company’s production process and the quality of its output should be consistent with this aim. In addition, giving customers what they want may require the development of new products that have features not incorporated in existing ones. In other words, achieving superior efficiency, quality, and innovation are all part of achieving superior customer responsiveness. There are two other prerequisites for attaining this goal. The first is to focus on the company’s customers and their needs, and the second, to find ways to better satisfy those needs.

Business Level Strategy

Foundations of Business-Level Strategy We discuss Derek F. Abell’s view of the process of business definition as involving decisions about (1) customer needs, or what is to be satisfied, (2) customer groups, or who is to be satisfied, and (3) distinctive competencies, or how customer needs are to be satisfied. These three decisions are at the heart of business-level strategy choice because they provide the source of a company’s competitive advantage over its rivals and determine how the company will compete in a business or industry. Consequently, we need to look at the ways in which companies can gain a competitive advantage at the business level.

Customer Needs and Product Differentiation: Customer needs are anything that can be satisfied by means of the characteristics of a product or service. Product differentiation is the process of creating a competitive advantage by designing products— goods and services— to satisfy customer needs. All companies must differentiate their products to a certain degree in order to attract customers and satisfy some minimal level of customer needs.

Some companies offer the customer a low-priced product without engaging in much product differentiation. Others seek to create something unique about their products so that they satisfy customer needs in ways that other products cannot. The uniqueness may relate to the physical characteristics of the product, such as quality or reliability, or it may lie in the product's appeal to customers’ psychological need, such as the need for prestige or status.

Customer Groups and Market Segmentation: Market segmentation may be defined as the way a company decides to group customers, based on important differences in their needs or preferences, in order to gain a competitive advantage. In general, a company can adopt three alternative strategies toward market segmentation. First, it may choose not to recognize that different groups of customers have different needs and may adopt the approach of serving the average customer. Second, a company may choose to segment its market into different constituencies and develop a product to suit the needs of each group. Third, a company can choose to recognize that the market is segmented but concentrate on servicing only one market segment, or niche.

A company wants to make complex product/market choices and creates a different product tailored to each market segment rather than create a single product for the whole market. Because the decision to provide many products for many market niches allows a company to satisfy customer needs better. As a result, customer demand for the company’s products rises and generates more revenue than would be the case if the company offered just one product for the whole market. Instead, price is the main criterion used by customers to evaluate the product, and the competitive advantage lies with the company that has superior efficiency and can provide the lowest-priced product.

Deciding on Distinctive Competencies: The third issue in business-level strategy is to decide what distinctive competencies to pursue to satisfy customer needs and groups. In this context, distinctive competencies are the means by which a company attempts to satisfy customer needs and groups in order to obtain a competitive advantage. There are four ways in which companies can obtain a competitive advantage: through achieving superior efficiency, quality, innovation, and customer responsiveness. In making business strategy choices, a company must decide how to organize and combine its distinctive competencies to gain a competitive advantage.

Choosing a Generic Competitive Strategy at the Business Level Companies pursue a business-level strategy to gain a competitive advantage that allows them to outperform rivals and achieve above-average returns. They can choose from three generic competitive approaches: cost leadership, differentiation, and focus. These strategies are called generic because all business or industries can pursue them regardless of whether they are manufacturing, service, or not-for-profit enterprises. Each of the generic strategies results from a company making consistent choices on product, market, and distinctive competencies-choices that reinforce each other. The following Table summarizes the choices appropriate for each generic strategy. Product/Market/Distinctive-Competency Choices and Generic Competitive Strategies
Cost Leadership		Differentiation		Focus
Product differentiation	Low (principally by price)		High (principally by uniqueness)		Low to high (price or uniqueness)
Market segmentation	Low (mass market)		High (many market segments)		Low (one or a few segments)
Distinctive competency	Manufacturing and materials management		Research and development, sales and marketing		Any kind of distinctive competency

Advantages and Disadvantages: The cost leader is protected from industry competitors by its cost advantage. Its lower costs also mean that it will be less affected than its competitors by increases in the price of inputs if there are powerful suppliers and less affected by a fall in the price it can charge for its products if there are powerful buyers. Moreover, since cost leadership usually requires a big market share, the cost leader purchases in relatively large quantities, increasing bargaining power vis-a-vis suppliers. If substitute products start to come into the market, the cost leader can reduce its price to compete with them and retain its market share. Finally, the leader's cost advantage constitutes a barrier to entry, since other companies are unable to enter the industry and match the leader's costs or prices. The cost leader is therefore relatively safe as long as it can maintain its cost advantage-and price is the key for a significant number of buyers.

The principal dangers of the cost-leadership approach lurk in competitors ability to find ways of producing at lower cost and beat the cost leader at its own game. Finally, the cost-leadership strategy carries a risk that the cost leader, in the single minded desire to reduce costs, may lose sight of changes in customer tastes. Thus a company might make decisions that decrease costs but drastically affect demand for the product.

Differentiation Strategy: The objective of the generic strategy of differentiation is to achieve a competitive advantage by creating a product—good or service—that is perceived by customers to be unique in some important way. The differentiated company’s ability to satisfy a customer need in a way that its competitors cannot means that it can charge a premium price—a price considerably above the industry average. The ability to increase revenues by charging premium prices (rather than by reducing costs like the cost leader) allows the differentiator to outperform its competitors and gain above-average profits. The premium price is usually substantially above the price charged by the cost leader, and customers pay it because they believe the product's differentiated qualities to be worth the difference. Consequently, the product is priced on the basis of what the market will bear.

Strategic Choices: A differentiator chooses a high level of product differentiation to gain a competitive advantage. Product differentiation can be achieved in three principal ways; qualities, innovation, and customer responsiveness. Innovation is very important for technologically complex products, where new features are the source of differentiation, and many people pay a premium price for new and innovative products, such as a state-of-the-art computer, stereo, or car. When differentiation is based on customer responsiveness, a company offers comprehensive after-sales service and product repair. This is an especially important consideration for complex products such as cars and domestic appliances, which are likely to break down periodically.

Finally a product's appeal to customers’ psychological desires can become a source of differentiation. The appeal can be to prestige or status, as it is with BMWs and Rolex watches; to patriotism, as with buying a Chevrolet to safety of home and family, as with Prudential Insurance; or to value for money, as with Sears and JC Penny. Differentiation can also be tailored to age groups and socioeconomic groups. Indeed, the bases of differentiation are endless. A company that pursues a differentiation strategy strives differentiate itself along as many dimensions as possible. The less it resembles its rivals, the more it is protected from competition and the wider is its market appeal.

Generally, a differentiator chooses to segment its market into many niches. Now and then a company offers a product designed for each market niche and decides to be a broad differentiator, but a company might choose to serve just those niches where it has a specific differentiation advantage. For example, Sony produces twenty four models of television, filling all the niches from midpriced to high-priced sets.

Finally, in choosing which distinctive competency to pursue, a differentiated company concentrates on the organizational function that provides the sources of its differentiation advantage. Differentiation on the basis of innovation and technological competency depends on the R&D function. Efforts to improve customer service depend on the quality of the sales function. A focus on a specific function does not mean, however, that the control of costs is not important for a differentiator. A differentiator does not want to increase costs unnecessarily and tries to keep them somewhere near those of the cost leader. But, since developing the distinctive competency needed to provide a differentiation advantage is often expensive, a differentiator usually has higher costs than the cost leader. Still, it must control all costs that do not contribute to its differentiation advantage so that the price of the product does not exceed what customers are willing to pay. Since bigger profits are earned by controlling costs, as well as by maximizing revenues, it pays to control costs, though not to minimize them to the point of losing the source of differentiation.

Both Cost Leadership and Differentiation: Recently, changes in production techniques— in particular, the development of flexible manufacturing technologies— have made the choice between cost-leadership and differentiation strategies less clear-cut. Because of technological developments, companies have found it easier to obtain the benefits of both strategies. The reason is that the new flexible technologies allow firms to pursue a differentiation strategy at a low cost.

Traditionally, differentiation was obtainable only at high cost because the necessity of producing different models for different market segments meant that firms had to have short production runs, which raised manufacturing costs. In addition, the differentiated firm had to bear higher marketing costs than the cost leader because it was servicing many market segments. As a result, differentiators had higher costs than cost leaders that produced large batches of standardized products. However, flexible manufacturing may enable a firm pursuing differentiation to manufacture a range of products at a cost comparable to that of the cost leader. The use of robots and flexible manufacturing cells reduces the costs of retooling the production line and the costs associated with small production runs.

A firm can also reduce both production and marketing costs if it limits the number of models in the product line by offering packages of options rather than letting consumers decide exactly what options they require.

Just-in-time inventory systems can also help reduce costs and improve the quality and reliability of a company's products. This is important to differentiated firms, where quality and reliability are essential ingredients of the product's appeal.

Focus Strategy: The third pure generic competitive strategy, the focus strategy, differs from the other two chiefly because it is directed towards serving the needs of a limited customer group or segment. A focused company concentrates on serving a particular market niche, which may be defined geographically, by type of customer, or by segment of the product line. For example, a geographical niche may be defined by region or even by locality. Selecting a niche by type of customer might mean serving only the very rich or the very young or the very adventurous. Concentrating only on a segment of the product line means focusing only on vegetarian foods or on very fast motor cars or on designer clothes. In following a focus strategy, a company is specializing in some way.

Once it has chosen its market segment, a company may pursue a focus strategy through either a differentiation or a low-cost approach. In essence, a focused company is a specialized differentiator or cost leader. Because of their small size few focus firms are able to pursue cost leadership and differentiation simultaneously. If a focus firm uses a low-cost approach, it competes against the cost leader in the market segments where it has no cost disadvantage. For example, in local lumber or cement markets, the focuser has lower transportation costs than the low-cost national company. The focuser may also have a cost advantage because it is producing complex or custom-built products that do, not lend themselves easily to economies of scale in production and therefore offer few experience-curve advantages. With a focus strategy, a company concentrates on small-volume custom products, where it has a cost advantage, and leaves the large-volume standardized market to the cost leader.

If a focuser pursues a differentiation approach, then all the means of differentiation that are open to the differentiator are available to the focused company. The point is that the focused company competes with the differentiator in only one or in just a few segments. For example, Porsche, a focused company, competes against General Motors in the sports car segment of the car market but not in the other segments. Focused companies are likely to develop differentiated product qualities successfully because of their knowledge of a small customer set (such as sports car buyer) or knowledge of a region. Furthermore, concentration on a small range of products sometimes allows a focuser to develop innovations faster than a large differentiator can. However, the focuser does not attempt to serve all market segments because doing so would bring it into direct competition with the differentiator. Instead, a focused company concentrates on building market share in one market segment and, if successful, may begin to serve more and more market segments and chip away at the differentiator's competitive advantage.

Being Stuck in the Middle: Each generic strategy requires a company to make consistent product/market/distinctive-competency choices to establish a competitive advantage. In other words, a company must achieve a fit among the three components of business level strategy. Thus, for example, a low-cost company cannot go for a high level of market segmentation, like a differentiator, and provide a wide range of products because doing so would raise production costs too much and the company would lose its low-cost advantage. Similarly, a differentiator with a competency in innovation that tries to reduce in expenditures on research and development or one with a competency in customer responsiveness through after-sales service that seeks to economize on its sales force to decrease costs is asking for trouble because it will lose its competitive advantage as its distinctive competency disappears.

Some stuck-in-the-middle companies started out pursuing one of the three generic strategies but made wrong decisions or were subject to environmental changes. Losing control of a generic strategy is very easy unless management keeps close track of the business and its environment, constantly adjusting product/market choices to suit changing industry conditions. A focuser can get stuck in the middle when it becomes overconfident and starts to acts like a broad differentiator.

To sum up, successful management of a generic competitive strategy requires strategic managers to attend to two main matters. First, they need to ensure that the product/market/distinctive-competency decisions they make are oriented toward one specific competitive strategy. Second, they need to monitor the environment so that they can keep the firm's sources of competitive advantage in tune with changing opportunities and threats.

Choosing an Investment Strategy at the Business Level

An investment strategy refers to the amount and type of resources—both human and financial—that must be invested to gain a competitive advantage. Generic competitive strategies provide competitive advantages, but they are expensive to develop and maintain. Differentiation is the most expensive of three because it requires that a company invest resources in many functions, such as research and development and sales and marketing, to develop &distinctive competencies. Cost leadership is less expensive to maintain once the trial investment in a manufacturing plant and equipment has been made. It does not require such sophisticated research and development or marketing efforts. The focus strategy is cheapest because fewer resources are needed to serve one market segment than to serve the whole market

In deciding on an investment strategy, a company must evaluate the potential returns from investing in a generic competitive strategy against the cost of developing the strategy. In this way, it can determine whether a strategy is likely to be profitable to pursue and how profitability will change as industry competition changes. Two factors are crucial in choosing an investment strategy: the strength of a company's position in an industry relative to its competitors and the stage of the industry life cycle in which the company is competing.

Competitive Position: Two attributes can be used to determine the strength of a company's relative competitive position. First, the larger a company's market share, the stronger is its competitive position and the greater are the potential returns from future investment. This is because a large market share provides experience-curve economies and suggests that the company has developed brand loyalty. The strength and uniqueness of a company's distinctive competencies are the second measure of competitive position. If it is difficult to imitate a company's research and development expertise, its manufacturing or marketing skills, its knowledge of particular customer segments, or its unique reputation or brand name, the company's relative competitive position is strong and its returns from the generic strategy increase. In general, the companies with the largest market share and strongest distinctive competencies are in the best position.

These two attributes obvious reinforce one another and explain why some companies get stronger and stronger over time. A unique competency leads to increased demand f or the company's products, and then, as a result of larger market share, the company has more resources to investing developing its distinctive competency. Companies with a smaller market share and little potential for developing a distinctive competency are in a weaker competitive position. Thus they are less attractive sources for investment.

Life Cycle Effect: The second main factor influencing the investment attractiveness of a generic strategy is the stage of the industry life cycle. Each life cycle stage is accompanied by a particular industry environment, presenting different opportunities and threats. Each stage, therefore, has different implications for the investment of resources needed to obtain a competitive advantage. For example, competition is strongest in the shakeout stage of the life cycle and least important in the embryonic stage, so the risks of pursuing a strategy change over time. The difference in risk explains why the potential returns from investing in a competitive strategy depend on the life cycle stage.

Choosing and Investment Strategy: The following Table summarizes the relationship among the stage of the life cycle, competitive position, and investment strategy at the business level. Choosing An Investment Strategy at the Business Level
Strong competitive position		Weak competitive position
Stage of industry life cycle
Embryonic	Share building		Share building
Growth	Growth		Market concentration
Shakeout	Share increasing		Market concentration or harvest/liquidation
Maturity	Hold -and-maintain or profit		Harvest or liquidation/divesture
Decline	Market concentration, harvest, or asset reduction		Turnaround, liquidation, or divesture

Embryonic Strategy: In the embryonic stage, all companies, weak and strong, emphasize the development of a distinctive competency and a product/market policy. During this stage, investment needs are great because a company has to establish a competitive advantage. Many fledgling companies in the industry are seeking resources to develop a distinctive competency. Thus the appropriate business-level investment strategy is a share-building strategy. The aim is to build market share by developing a stable and unique competitive advantage to attract customers who have no knowledge of the company's products.

Companies require large amounts of capital to build research and &development competencies or sales and service competencies. They cannot generate much of this capital internally. Thus a company's success depends on its ability to demonstrate a unique competency to attract outside investors, or venture capitalists. If a company gains the resources to develop a distinctive competency, it will be in a relatively stronger competitive position. If it falls, its only option may be to exit the industry. In fact, companies in weak competitive positions at all stages in the life cycle may choose to exit the industry to cut their losses.

Growth Strategies: At the growth stage, the task facing a company is to consolidate its position and provide the base it needs to survive the coming shakeout. Thus the appropriate investment strategy is the growth strategy. The goal is to maintain a company's relative competitive position in a rapidly expanding market and, if possible, to increase it-in other words, to grow with the expanding market. However, other companies are entering the market and catching up with the industry innovators. As a result, companies require successive waves of capital infusion to maintain the momentum generated by their success in the embryonic stage. For example, differentiators are engaging in massive research and development, and cost leaders are investing in plant to obtain experience-curve economies. All this investment is very expensive.

Companies in a weak competitive position at this stage engage in a market concentration strategy to consolidate their position. They seek to specialize in some way and adopt a focus strategy to reduce their investment needs. If very weak, they may also choose to exit the industry.

Shakeout Strategies: By the shakeout stage, demand is increasing slowly and competition by price or product characteristics has become intense. Thus companies in strong competitive positions need resources to invest in a share increasing strategy to attract customers from weak companies that are exiting the market. In other words, companies attempt to maintain and increase market share despite fierce competition. The way companies invest their resources depends on their generic strategy. Weak companies exiting the industry engage in a harvest or liquidation strategy.

Maturity Strategies: By the maturity stage, a strategic group structure has emerged in the industry, and companies have learned how their competitors will react to their competitive moves. At this point companies want to reap the rewards of their previous investments in developing a generic strategy. As market growth slows in the maturity stage, a company’s investment strategy depends on the level of competition in the industry and the source of the company’s competitive advantage.

In environments where competition is high because technological changes is occurring or where barriers to entry are low, companies need to defend their competitive position. Strategic managers need to continue to invest heavily in maintaining the company’s competitive advantage. Both low-cost companies and differentiators adopt a hold-and-maintain strategy to support their generic strategies. They expend resources to develop their distinctive competency so as to remain the market leaders.

Decline Strategies: The initial strategies that companies can adopt in decline stage are market concentration and asset reduction. With a market concentration strategy, a company attempts to consolidate its product and market choices. It narrows its product range and exits marginal niches in an attempt to redeploy its investments more efficiently and improve its competitive position. Reducing customer needs and the customer groups served may allow the company to pursue a focus strategy in order to survive the decline stage.

An asset reduction strategy requires a company to limit or decrease its investment in a business and to extract, or milk, the investment as much as it can. This approach is sometimes called a harvest strategy because the company reduces to a minimum the assets it employs in the business and forgoes investment for the sake of immediate profits. A market concentration strategy generally indicates that a company is trying to turn around its business so that it can survive in the long run. A harvest strategy implies that a company will exit the industry once it has harvested all the returns it can. At any stage of the life cycle, companies that are in weak competitive positions may apply turnaround strategies.

If a company decides that turnaround is not possible, either for competitive or for life cycle reasons, then the two remaining investment alternatives are liquidation and divestiture. As the terms imply, the company moves to exit the industry either by liquidating its assets or by selling the whole business. Both can be regarded as radical forms of harvesting strategy because the company is seeking to get back as much as it can from its investment in the business.

Business Level Strategy and the Industry Environment Strategy in Fragmented Industries A fragmented industry is one composed of a large number of small and medium sized companies. There are several reasons why an industry may consist of many small companies rather than a few large ones. In some industries there are few scale economies, and so large companies do not have an advantage over smaller enterprises. Indeed, in some industries there are diseconomies of scale. Many home-buyers, for example, have a preference for dealing with local real estate agents, whom they perceive as having better local knowledge than national chains. Similarly, in the restaurant business, many individuals have an aversion to national chains and prefer the unique style-of a local restaurant. In addition, because of the lack of scale economies, many fragmented industries are characterized by low barriers to entry and new entry keeps the industry fragmented. The video rental industry exemplifies this situation: the costs of opening up a video rental store are very moderate and can be borne by a single entrepreneur. High transportation costs, too, can keep an industry fragmented, for regional production may be the only efficient way to satisfy customer needs, as in the cement business. Finally, an industry may be fragmented because customer needs are so specialized that only small job lots of products are required, and thus there is no room for a large mass production operation to satisfy the market.

To grow, consolidate their industries, and become the industry leaders, they are utilizing three main strategies: (1) chaining, (2) franchising, and (3) horizontal merger.

Chaining: Companies like Wal-Mart Stores and Midas International Corporation are pursuing a chaining strategy in order to obtain the advantages of a cost-leadership strategy. They establish networks of linked merchandising outlets that are so interconnected that they function as one large business entity. The amazing buying power that these companies possess through their nationwide store chains allows them to negotiate large price reductions with their suppliers and promotes their competitive advantage. They overcome the barrier of high transportation costs by establishing sophisticated regional distribution centers, which can economize on inventory costs and maximize responsiveness to the needs of stores and customers (this is Wal-Mart’s specialty). Last but not least, they realize economies of scale from sharing managerial skills across the chain and from nationwide, rather than local, advertising.

Franchising: For differential companies in fragmented industries, such as McDonald’s or Century 21 Real Estate Corporation, the competitive advantage comes from the business strategy of franchising. With franchising, a local store operation is both owned and managed by the same person. When the owner is also the manager, he or she is strongly motivated to control the business closely and make sure the quality and standards are consistently high so that customer needs are always satisfied. Such motivation is particularly critical in a strategy of differentiation, where it is important for a company to maintain its uniqueness. One reason that industries fragment is the difficulty of maintaining control over, and the uniqueness of, the many small outlets that must be operated. Franchising avoids this problem. In addition, franchising lessens the financial burden of swift expansion, and so permits rapid growth of the company. Finally, a differentiator can reap the advantages of large-scale advertising, as well as the purchasing, managerial, and distribution economies of a large company, as McDonald's does very efficiently. Indeed, McDonald's is able to pursue cost leadership and differentiation simultaneously only because franchising allows costs to be controlled locally and differentiation can be achieved by marketing on a national level.

Horizontal Merger: Companies like Dillard's and Blockbuster Entertainment have been choosing a business-level strategy of horizontal merger to consolidate their respective industries. Such companies have arranged mergers of small companies in an industry in order to create a few large companies. For example, Dillard's arranged the merger of regional store chains in order to form a national company. By pursuing horizontal merger, companies are able to obtain economies of scale or secure a national market for their product. As a result, they are able to pursue a cost-leadership or a differentiation strategy.

The challenge in a fragmented industry is to choose the most appropriate means-franchising, chaining, or horizontal merger-of overcoming a fragmented market so that the advantages of the generic strategy can be realized. It is difficult to think of any major service activities from consulting and accounting firms to businesses satisfying the smallest consumer need, such as beauty parlors and car repair shops-that have not been merged and consolidated by chaining or franchising.

Strategy in Embryonic and Growth Industries Embryonic industries are typically created by the innovations of pioneering companies. But high profits that innovating companies often reap in an embryonic industry also attract potential imitators, spurring them to enter the market. Typically, such entry is most rapid in the growth stage of an industry and may cause the innovator to lose its commanding competitive position. The following Figure shows how the profit rate enjoyed by the innovator in an embryonic industry can decline as imitators crowd into the market during its growth stage. Thus Apple's onetime monopoly position was competed away as hordes of other personal computer makers entered into the market in the early and mid 1980s, trying to share in Apple's success. Once its patents expired, Xerox, too, faced many imitators, and some of them, such as Canon and Ricoh were ultimately very successful in the photocopier market. In the fast-food market, the early success of McDonald's drew imitators including Burger King, Wendy's, and Foodmaker, with its Jack-in-the-Box restaurants.

Figure:

Figure: How an Innovator’s Profits Can Be Competed Away

Given the inevitability of imitation, the key issue for an innovating company in an embryonic industry is how to exploit innovation and build an enduring long-run competitive advantage based on low cost or differentiation. Three strategies are available to the company: (1) to develop and market the innovation itself; (2) to develop and market the innovation jointly with other companies through a strategic alliance or joint venture; and (3) to license the innovation to others and let them develop the market.

The optimal choice of strategy depends on three factors. First, does the innovating company have the complementary assets to exploit its innovation and obtain a competitive advantage? Second, how difficult is it for imitators to copy the company's innovation—in other words, what is the height of barriers to imitation? And third, are there capable competitors that could rapidly imitate the innovation? Before we discuss the optimal choice of innovation strategy, we need to examine these factors.

Complementary Assets: Complementary assets are the assets required to successfully exploit a new innovation and gain a competitive advantage. Among the most important complementary assets are competitive manufacturing facilities capable of handling rapid growth while maintaining high product quality. Such facilities enable the innovator to move quickly down the experience curve without encountering production bottlenecks and/or product quality problems. An inability to satisfy demand because of these problems can create an opportunity for imitators to enter the marketplace.

Complementary assets also include marketing know-how, an adequate sales force, access to distribution systems, and an after-sales service and support network. All of these assets can help an innovator build brand loyalty. They also help the innovator achieve market penetration more rapidly.

Barriers to Imitation: We first consider barriers to imitation in Chapter 4, in discussing the durability, of competitive advantage. As you may recall, barriers to imitation are factors that prevent rivals from imitating a company's distinctive competencies. They can also be viewed as factors that prevent rivals, particularly late movers, from imitating a company's innovation. Although ultimately any innovation can be copied, the higher the barriers to imitation, the longer it takes for rival, to imitate the innovation. Barriers to imitation give an innovator time to establish a competitive advantage and build more enduring entry barriers in the newly created market.

Capable Competitors: Competitors’ capability to imitate a pioneer’s innovation depends primarily on two factors: (1) R&D skills and (2) access to complementary assets. Other things being equal, the greater the number of capable competitors with to the R&D skills and, complementary assets needed to imitate an innovation, the more rapid is imitation likely to be. R&D skills are the ability of rivals to reverse-engineer an innovation in order to find out how it works and quickly develop a comparable product.

Three Innovation Strategies: The way in which these three factors— complementary assets, barriers to imitation, and the capacity of competitors— influence the choice of innovation strategy is summarized in the following Table. The strategy of developing and marketing the innovation alone makes most sense when the barriers to imitating a new innovation are high, when the innovator has the complementary assets necessary to develop the innovation, and when the number of capable competitors is limited. High barriers to imitation buy the innovator time to establish a competitive advantage and build enduring barriers to entry through brand loyalty and/or experience- based cost advantages. Complementary assets allow rapid development and promotion of the innovation. The fewer the number of capable competitors, the less likely it is that any one of them will succeed in circumventing barriers to imitation and quickly imitating the innovation. Strategies for Profiting from Innovation
Strategy	Does Innovator Have All Required Complementary Assets?	Likely Height of Barriers to Imitation	Number of Capable Competitors
Go It Alone	Yes	High	Few
Enter into Alliance	No	High	Limited
License Innovation	No	Low	Many

The strategy of developing and marketing the innovation jointly with other companies through a strategic alliance or joint venture makes most sense when barriers to imitation are high, there are several capable competitors, and the innovator lacks complementary assets. In such circumstances, it makes sense to enter into an alliance with a company that already has the complementary assets, in other words, with a capable competitor. Theoretically, such an alliance should prove to be mutually beneficial, and each partner can share in high profits that neither could earn on its own.

The third strategy, licensing, makes most sense when barriers to imitation are low, the innovating company lacks the complementary assets, and there are many capable competitors. The combination of low barriers to imitation and many capable competitors makes rapid imitation almost certain. The innovator's lack of complementary assets further suggests that an imitator will soon capture the innovator's competitive advantage. Given these factors, since rapid diffusion of the innovator's technology through imitation is inevitable, by licensing out its technology the innovator can at least share in some of the benefits of this diffusion. Strategy in Mature Industries

As a result of fierce competition in the shakeout stage, an industry becomes consolidated, and so a mature industry is often dominated by a small number of large companies. Although it may also contain medium-sized companies and a host of small specialized ones, the large companies determine the nature of industry competition because they can influence the five competitive forces. Indeed, these are the companies that developed the most successful generic competitive strategies to manage the industry environment.

By the end of the shakeout stage, strategic groups of companies pursuing similar generic competitive strategies have emerged in the industry. For example, all the companies pursuing a low-cost strategy can be viewed as composing one strategic group. All those pursuing differentiation constitute another, and the focusers form a third. Companies have learned to analyze each other's strategies, and they know that their competitive actions will stimulate a competitive response from rivals in their strategic group and from companies in other groups that may be threatened by these actions.

In mature industries, companies choose competitive moves to maximize their competitive advantage within the structure of industry competition. Indeed, to understand business-level strategy in mature industries, one must understand how large companies try to collectively stabilize industry competition to prevent entry, industry overcapacity, or cutthroat price competition, which would hurt all companies.

The generic strategy pursued by one company directly affects other companies because companies are competing against one another in the same industry. How, then, can companies manage industry competition so as to simultaneously protect their individual competitive advantage and maintain industry rules that preserve industry profitability. Strategies to Deter Entry in Mature Industries

Industry companies can utilize three main methods to deter entry by potential rivals and hence maintain and increase industry profitability. These methods are product proliferation, price cutting, and maintaining excess capacity.

Product Proliferation: Companies seldom produce just one product. Most commonly, they produce a range of products aimed at different market segments so that they have broad product lines. Sometimes, to reduce the threat of entry, companies tailor their range of products to fill a wide range of niches, thus creating a barrier to entry by potential competitors. This strategy of pursuing a broad product line to deter entry is known as product proliferation.

Price Cutting: In some situations, pricing strategies involving price cutting can be used to deter entry by other companies, thus protecting the profit margins of companies already in an industry. For example, one price-cutting strategy is to initially charge a high price for a product and seize short-term profits, but then to aggressively cut prices in order to simultaneously build market share and deter potential entrants. The incumbent companies signal to potential entrants that if they do enter the industry, the incumbents will use their competitive advantage to drive down prices to a level where new companies will be unable to cover their costs. This pricing strategy also allows a company to ride down the experience curve and obtain economies of scale. Since costs would be falling along with prices, profit margins could still be maintained.

Maintaining Excess Capacity: A further competitive technique that allows companies to deter entry is to maintain a certain amount of excess productive capacity. As you will see in the next section, excess capacity is a major factor affecting the level of competition in an industry because it may lead to price cutting and reduced industry profitability. However, existing companies may prefer to possess some limited amount of excess capacity because it serves to warn potential entrants that if they enter the industry, existing firms can retaliate by increasing output and forcing down prices until entry would become unprofitable. But the threat to increase output has to be credible; collectively, industry incumbents must be able to quickly raise the level of production if entry appears likely. Strategies to Manage Rivalry in Mature Industries

Beyond seeking to deter entry, companies also wish to utilize strategies to manage their competitive interdependence and decrease rivalry because unrestricted competition over prices or output will reduce the level of company and industry profitability. Several strategies are available to companies to manage industry relations. The most important are price signaling, price leadership, nonprice competition, and capacity control.

Price Signaling: Price signaling is the first means by which companies attempt to structure industry competition in order to control rivalry among competitors. Price signaling is the process by which companies convey their intentions to other companies about pricing strategy and how they will compete in the future or how they will react to the competitive moves of their rivals. There are several ways in which price signaling can help companies defend their generic competitive strategies.

First, companies may use price signaling to announce that they will respond vigorously to hostile competitive moves that threaten them. For example, companies may signal that if one company starts to cut prices aggressively they will respond in kind to maintain the status quo and prevent any company from gaining a competitive advantage.

A second, and very important, purpose of price signaling is to indirectly allow companies to coordinate their actions and avoid costly competitive moves that lead to a breakdown in industry pricing policy. One company may signal that it intends to lower prices because it wishes to attract customers who are switching to the products of another industry, not because it wishes to stimulate a price war. On the other hand, signaling can be used to improve industry profitability.

Price Leadership: Price leadership—the taking on by one company of the responsibility for setting industry prices-is another way of using price signaling to enhance the profitability of product/market policy among companies in a mature industry. By setting prices, the industry leader implicitly creates the price standards that other companies will follow. The price leader is generally the strongest company in the industry, the one with the best ability to threaten other companies that might cut prices or increase their output to seize more market share.

Nonprice Competition: A third very important aspect of product/market strategy in mature industries is the use of nonprice competition to manage industry rivalry. Applying various techniques to try to prevent costly price cutting and price wars does not preclude competition by product differentiation. In many industries, product differentiation is used as the principal competitive weapon to prevent competitors from obtaining access to a company's customers and attacking its market share. In other words, companies rely, on product differentiation to deter potential entrants and manage industry rivalry. It allows them to compete for market share by offering products with different or superior features or by applying, different marketing techniques.

Figure: Four Non-Price Competitive Strategies

Market Penetration: When a company concentrates on expanding market share in its existing product markets, it is engaging in a strategy of market penetration. Market penetration involves advertising to promote and build market for product differentiation. In a mature Industry, the thrust of advertising is to influence consumer brand choice and create a brand name reputation for the company and its products. In this way, a company can increase its market share by attracting the customers of its rivals. Because brand name products often command premium prices, building market share in this situation is very profitable.

Product Development: Product development is the creation of new or improved products to replace existing ones. The wet shaving industry exemplifies an industry that depends on product replacement to create successive waves of consumer demand, which then create new sources of revenue for industry companies. In 1989, for instance, Gillette came out with its new Sensor shaving system, giving a massive boost to its market share. In turn, Wilkinson Sword responded with its version of the product.

Product development is important for maintaining product differentiation and building market share. For instance, the laundry detergent Tide has gone through more than fifty different changes in formulation during the past forty years to improve its performance.

Market Development: Market development involves finding new market segments for a company's products. A company pursuing this strategy wants to capitalize on the brand name it has developed in one market segment by locating new market segments in which to compete. In this way, it can exploit the product differentiation advantages of its brand name.

Product Proliferation: Product proliferation can be used to manage industry rivalry, as well as to deter entry. The strategy of product proliferation generally means the large companies in an industry all have a product in each market segment or niche and compete head-to-head for customers. If a new niche develops, like convertibles or oat bran cereals, then the leader gets a first-mover advantage, but soon all the other companies catch up, and once again competition is stabilized and industry rivalry is reduced. Product proliferation thus allows the development of stable industry competition based on product differentiation, not price-that is, nonprice competition based on the development of new products. The battle is over a product's perceived quality and uniqueness, not over its price.

Capacity Control: Although nonprice competition helps mature industries avoid the cutthroat competing that reduces both company and industry levels of profitability, in some industries price competition does periodically break out. This occurs most commonly when there is industry overcapacity, that is, when companies collectively produce too much output so that reducing price is the only way to dispose of it. If one company starts to cut prices, then the others quickly follow because they fear that the price cutter will be able to sell all its inventory and they will be left holding unwanted goods. Capacity control strategies can influence the level of industry output.

Excess capacity may be caused by a shortfall in demand, as when a recession lowers the demand for automobiles and causes companies to give customers price incentives. In that situation, companies can do nothing except wait for better times. However, by and large excess capacity results from industry companies’ simultaneous response to favorable conditions: they all invest in new plants to be able to take advantage of the predicted upsurge in demand. Paradoxically, each individual company's effort to outperform the others means that collectively the companies create industry overcapacity, which hurts them all. The following Figure illustrates this situation.

Figure: Changes in Industry Capacity and Demand

Choosing a Capacity Control Strategy: In general, companies have two strategic choices: (1) each company individually must try to preempt its rivals and seize the initiative, or (2) the companies collectively must find indirect means of coordinating with each other so that they are all aware of the mutual effects of their actions.

To preempt rivals, a company must forecast a large increase in demand in the product market and then move rapidly to establish large-scale operations that will be able to satisfy the predicted demand. By achieving a first-mover advantage, the company may deter other firms from entering the market since the preemptor will usually be able to move down the experience curve, reduces its costs and therefore its prices as well, and threaten a price war if necessary.

As for coordination as a capacity control strategy, collusion on the timing of new investments is illegal under antitrust law, but tacit coordination is practiced in many industries as companies attempt to understand and forecast the competitive moves of their rivals. Generally, companies use market signaling to secure coordination. They make announcements about their future investment decisions in trade journals and newspapers. In addition, they share information about their production levels and their forecasts of industry demand so as to bring industry supply and demand into equilibrium. Thus a coordination strategy reduces the risks associated with investment in the industry.

Strategy in the Global Environment Profiting From Global Expansion

Expanding globally allows companies, large or small, to increase their profitability in ways not available to purely domestic enterprises. Companies that operate internationally can (1) earn a greater return from their distinctive competencies; (2) realize what we refer to as location economies by dispersing individual value creation activities to those location where they can be performed most efficiently; and (3) ride down the experience curve ahead of competitors, thereby lowering the costs of value creation.

Transferring Distinctive Competencies: Distinctive competencies are defined there as unique strengths that allow a company to achieve superior efficiency, quality, innovation, or customer responsiveness. Such strengths typically find their expression in product offerings that other companies find difficult to match or imitate. Thus distinctive competencies form the bedrock of a company’s competitive advantage. They enable a company to lower costs or value creation and/or to perform value-creation activities in ways that lead to differentiation and premium pricing.

Companies with valuable distinctive competencies can often realize enormous returns by applying those competencies, and the products they produce to foreign market where indigenous competitors lack similar competencies and products.

Realizing Location Economies: Location economies are the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value-creation activity in the optimal location for that activity can have one of two effects: lower the costs of value creation, helping the company achieve a low-cost position, or enable a company to differentiate its product offering and charge a premium price. Thus efforts to realize location economies are consistent with the generic business-level strategies of low cost and differentiation.

Moving Down the Experience Curve: The experience curve refers to the systematic decrease in production costs that have been observed to occur over the life of a product. It follows that the key to riding down the experience curve as rapidly as possible is to increase the accumulated volume produced by a plant as quickly as possible. Since global markets are larger than domestic markets, companies that serve a global market from a single location are likely to build accumulated volume faster than companies that focus primarily in serving their home market or on serving multiple markets from multiple production locations. Thus serving a global market from a single location is consistent with moving down the experience curve and establishing a low-cost position. In addition, to get down the experience curve quickly, companies need to price and market very aggressively so that demand expands rapidly. They also need to build production capacity capable of serving a global market. Another point to bear in mind is that the cost advantages of serving the world market from a single location will be the more significant if that location is also the optimal one for performing that value-creation activity; that is, if the company is simultaneously realizing cost economies from experience -curve effects and from location economies.

Pressures for Cost Reductions and Local Responsiveness

Companies that compete in the global market place typically face two types of competitive pressures: pressures for cost reductions and pressures to be locally responsive. These competitive pressures place conflicting demands on a company. Responding to pressures for cost reductions requires that a company try to minimize its unit costs. To attain this goal a company may have to base its productive activities at the most favorable low-cost location, wherever in the world that might be. It may also have to offer a standardized product to the global marketplace in order to ride down the experience curve as quickly as possible. On the other hand, responding to pressures to be locally responsive requires that a company differentiate its product offering and marketing strategy from country to country in an effort to accommodate the diverse demands arising from national differences in consumer tastes and preferences, business practices, distribution channels, competitive conditions, and government policies. Because differentiation across countries can involve significant duplication and a lack of product standardization, it may raise costs.

Pressures for Cost Reductions: Increasingly, international companies must cope with pressures for cost reductions. To respond to these pressures, a company needs to lower the costs of value creation by mass-producing a standardized product at the optimal location in the world, in order to realize location and experience curve-economies. Pressures for cost reductions can be particularly intense in industries producing commodity-type products, where meaningful differentiation on nonprice factors is difficult and price is the main competitive weapon. Products that serve universal needs tend to fall into this category. Universal needs exist when the tastes and preferences of consumers in different nations are similar, if not identical. This obviously, applies to conventional commodity products such as bulk chemicals. petroleum, steel, sugar, and the like. It also tends to be true for many industrial and consumer products-for instance, hand-held calculators, semiconductor chips, and personal computers. Pressures for cost reductions are also intense in industries where major competitors are based in low-cost locations, where there is persistent excess capacity, and where consumers are powerful and face low switching costs. Many commentators have also argued that the liberalization of the world trade and investment environment in recent decades has generally increased cost pressures by facilitating greater international competition.

Pressures for Local Responsiveness: Pressures for local responsiveness arise from differences in consumer tastes and preferences; differences in infrastructure and traditional practices; differences in distribution channels; and host government demands.

Differences in Consumer Tastes and Preferences: Strong pressures for local responsiveness emerge, when consumer tastes and preferences differ significantly between countries, as they may for historic or cultural reasons. In such cases, product and/or marketing messages have to be, customized to appeal to the tastes and preferences of local consumers. This typically creates pressures for the delegation of production and marketing functions to national subsidiaries.

Differences in infrastructure and Traditional Practices: Pressures for local responsiveness arise from differences in infrastructure and/or traditional practices among countries, creating a need to customize products accordingly. Fulfilling this need may require the delegation of manufacturing and production functions to foreign subsidiaries.

Differences in Distribution Channels: A company's marketing strategies may have to be responsive to differences in distribution channels among countries. This may necessitate the delegation of marketing functions to national subsidiaries.

Host Government Demands: Economic and political demands imposed by host country governments may necessitate a degree of local responsiveness. For example the politics of health care around the world requires that pharmaceutical companies manufacture in multiple locations. Pharmaceutical companies are subject to local clinical testing, registration procedures, and pricing restrictions, all of which make it necessary that the manufacturing and marketing of a drug should meet local requirements. Moreover, since governments and government agencies control a significant proportion of the health care budget in most countries, they are in a powerful position to demand a high level of local responsiveness. More generally, threats of protectionism, economic nationalism, and local content rules which dictate that a certain percentage of a product should be manufactured locally all dictate that international businesses manufactured locally. Part of the motivation for Japanese auto companies setting up U.S. production, for example, is to counter the threat of protectionism increasingly voiced by the U.S Congress.

Implications: Pressures for local responsiveness imply that it may not be possible for a company to realize the full benefits from experience-curve and location economies. For example, it may not be possible to serve the global marketplace from a single low-cost location, producing a globally standardized product and marketing it worldwide to achieve experience-curve cost economies. In practice, the need to customize the product offering to local conditions may work against the implementation of such a strategy. Automobile companies, for instance, have found that Japanese, American, and European consumers demand different kinds of cars, which means customizing products for local markets. In response, companies like Honda, Ford, and Toyota are pursuing a strategy of establishing top-to-bottom design and production facilities in each of these regions so that they can better serve local demands. Although such customization brings benefits, it also limits the ability of a company to realize significant experience-curve cost economies and location economies.

Strategic Choice There are four basic strategies that companies use to enter and compete in the international environment: an international strategy, a multi domestic strategy, a global strategy, and a transnational strategy. Each of these strategies has its advantages and disadvantages. The appropriateness of each strategy varies with the extent of pressures for cost reductions and local responsiveness. The following Figure illustrates when each of these strategies is most appropriate. In this section we describe each strategy, identify when it is appropriate, and discuss its pros and cons.

Figure: Four Basic Strategies

International Strategy: Companies that pursue an international strategy try to create value by transferring valuable skills and products to foreign markets where indigenous competitor lack those skills and products. Most international companies have created value by transferring differentiated product offerings developed at home to new markets overseas. Accordingly, they tend to centralize product development functions (for instance, R&D) at home. However, they also tend to establish manufacturing and marketing functions in each major country in which they do business. But although they may undertake some local customization of product offering and marketing strategy, this tends to be rather limited in scope. Ultimately, in most international companies the head office retains tight control over marketing and product strategy.

An international strategy makes sense if a company has a valuable distinctive competency that indigenous competitors in foreign markets lack and if the company faces relatively weak pressures for local responsiveness and cost reductions. In such circumstances, an international strategy can be very profitable. However, when pressures for local responsiveness are high, companies pursuing this strategy lose our to companies that place a greater emphasis on customizing, the product offering and market strategy to local conditions. Moreover, because of the duplication of manufacturing facilities, companies that pursue an international strategy tend to inappropriate in industries where cost pressures are high

Multi domestic Strategy: Companies pursuing a multi domestic strategy orient themselves toward achieving maximum local responsiveness. Like companies pursuing an international strategy, they tend to transfer skills and products developed at home to foreign markets. However, unlike international companies, multi domestic ones extensively customize both their product offering and their marketing strategy to different national conditions. Consistent with this approach, they also tend to establish a complete set of value-creation activities— including production, marketing, and R&D— in each major national market in which they do business. As a result, they generally cannot realize value from experience-curve effects and location economics and therefore often have a high-cost structure.

A multi domestic strategy makes most sense when there are high pressures for local responsiveness and low pressures for cost reductions. The high-cost structure associated with the duplication of production facilities makes this strategy inappropriate in industries where cost pressures are intense. Another weakness of this strategy is due to the fact that many multi domestic companies have developed into decentralized federations in which each national subsidiary functions in a largely autonomous manner. Consequently, after a time they begin to lose the ability to transfer the skills and products derived from distinctive competencies to their various national subsidiaries around the world.

Global Strategy: Companies that pursue a global strategy focus on increasing profitability by reaping the cost reductions that come from experience-curve effects and location economies. That is, they are pursuing a low-cost strategy. The production, marketing, and R&D activities of companies pursuing a global strategy are concentrated in a few favorable locations. Global companies tend not to customize their product offering and marketing strategy to local conditions. This is because customization raises costs since it involves shorter production runs and the duplication of functions. Instead, global companies prefer to market a standardized product worldwide so that they can reap the maximum benefits from the economies of scale that underlie the experience curve. They also tend to use their cost advantage to support aggressive pricing in world markets.

This strategy makes most sense in those cases where there are strong pressures for cost reductions and where demands for local responsiveness are minimal. Increasingly, these conditions prevail in many industrial goods industries. In the semiconductor industry, for example, global standards have emerged, creating enormous demands for standardized global products. Accordingly, companies such as Intel, Texas Instruments, and Motorola all pursue a global strategy. However, these conditions are not found in many consumer goods markets, where demands for local responsiveness remain high (as in the markets for audio players, automobiles, and processed food products). The strategy is inappropriate when demands for local responsiveness are high.

Transnational Strategy: In today’s environment, competitive conditions are so intense that in order to survive in the global marketplace companies must exploit experience- based cost economies and location economies, transfer distinctive competencies within the company, and at the same time pay attention to pressures for local responsiveness. Moreover, in the modern multinational enterprise, distinctive competencies do not reside just in the home country but they can develop in any of the company’s worldwide operations. The flow of skills and product offerings should not be all one way, from home company to foreign subsidiary, as in the case of companies pursuing an international strategy. Rather, the flow should also be from foreign subsidiary to home country, and from foreign subsidiary to foreign subsidiary— a process referred to as global learning. The strategy pursued by companies that are trying to achieve all of these objectives simultaneously is called a transnational strategy.

A transnational strategy makes sense when a company faces high pressures for cost reductions and high pressures for local responsiveness. In essence, companies that pursue a transnational strategy are trying to simultaneous1y achieve low-cost and differentiation advantages. In practice the strategy is not an easy one to pursue. As mentioned earlier, pressures for local responsiveness and cost reductions place conflicting demands on a company. Being locally responsive raises costs, which obviously makes cost reductions difficult to achieve. To pursue a transnational strategy effectively, a company can do the followings.

To deal with cost pressures, a company can redesign its products to use many identical components and invested in a few large-scale component manufacturing facilities, sited at favorable locations, to fill global demand and realize scale economies. At the same time the company augments the centralized manufacturing of components with assembly plants in each of its major global markets. At these plans it can add local product features, tailoring the finished product to local needs. Thus the company would be able to realize many of the benefits of global manufacturing while reacting to pressures for local responsiveness by differentiating its product among national markets.

Summary: The advantages and disadvantages of each of the four strategies discussed above are summarized in the following Table. Although a transnational strategy appears to offer the most advantages, it should not be forgotten that implementing it raises difficult organizational issues. More generally, the appropriateness of each strategy depends on the relative strength of pressures for cost reductions and for local responsiveness. The Advantages and Disadvantages of the Four Traditional Strategies
Strategy	Advantages	Disadvantages
Global	Ability to exploit experience-curve effect Ability to exploit location economies	Lack of local responsiveness
International	Transfer of distinctive competencies to foreign markets	Lack of local responsiveness Inability to realize location economies Failure to exploit experience-curve effect
Multi domestic	Ability to customize product offerings and marketing in accordance with local responsiveness	Inability to realize location economics Failure to exploit experience-curve effect Failure to transfer distinctive competencies to foreign markets
Transnational		Ability to exploit experience-curve effects Ability to exploit location economics Ability to customize product offerings and marketing in accordance with local responsiveness Reaping benefits of global learning

Mathematical problem 02 (Budget)

2012-03-06T07:36:00.001+06:00

Problem:

A company has four sales regions- 1, 2, 3, and 4.

Its salesmen are expected to sale the following g number of units, during the first quarter of 2012 assuming the average selling to be Tk. 30 per unit.

Priority/ Month	1	2	3	4
January	1000	1500	2500	3500
February	2000	1800	2800	4000
March	2500	2000	3000	4500

Prepare the sale budget.

Solution:

Sales Budget

(For the 1^st quarter of - 2012)

Division	January			February			March			Total (TK.)
Division	Units	Price	value	Unit	Price	Value	Units	Price	Value	Total (TK.)
1	1000	30	30000	2000	30	60000	2500	30	75000	165000
2	1500	30	45000	1800	30	54000	2000	30	60000	159000
3	2500	30	75000	2800	30	84000	3000	30	90000	249000
4	3500	30	105000	4000	30	120000	4500	30	135000	360000
Total			255000			318000			360000	933000

Mathematical problem 01 (Budget)

2012-03-06T07:34:00.000+06:00

Problem:

A company manufactures 2 products – A and B. Its sales department has 3 divisions-

i. North;

ii. south ; and

iii. East.

Preliminary sales budget for the year ending 31^st December, 2011 based on the assessment of the divisional management were:

Product A: North: 200000 units,

South: 500000 units,

East: 100000 units.

Product B: North: 300000 units,

South: 400000 units,

East: (nil)

Sales price: A – Tk 4 per unit;

B- Tk 3 per unit.

Arrangements are made for the extensive advertisement of product A and B. And it is estimated that north division sales will increase by 100000 units.

Arrangements are also made to advertise and distribute product B in the Eastern area in the 2^nd half of 2011. Funds raised are expected to be 500000 units.

Since the estimated sales of the south division represented on unsatisfactory target, it is agreed to increase both the estimates by 10%.

Prepare sales budget for the year to 31^st December, 2011.

Solution:

Sales Budget

(For the Year- 2011)

Division	A			B			Total (Tk)
Division	Units	Price	Value	Units	Price	Value	Total (Tk)
North	300000	4	1200000	400000	3	1200000	2400000
South	550000	4	2200000	440000	3	1320000	3520000
East	100000	4	400000	50000	3	1500000	1908000
Total			3800000			4020000	7820000

Different types of Budget

2012-03-06T07:31:00.001+06:00

Different types of budgets have been developed keeping in view their necessity. Budget can be classified on the basis of coverage, capacity, condition and period.

Types of Budget

Functional Budget

Functional budget is a budget which relates to any of the functions of any under takings, e.g., sales, production, research and development, etc. commonly used functional budgets are-

i. Sales budget,

ii. Production budget,

a. Raw material budget,

b. Labor budget,

c. Plan utilization budget,

d. Overhead budget.

iii. Purchase budget,

iv. Capital expenditure budget,

v. Administration budget,

vi. Cost budget,

vii. Research and development budget.

Sales budget

The sales budget is the foundation upon which the other functional budgets are prepared. So, sales budget being the principal factor and is the most important budget and forms the basis on which all other budgets are prepared. I brief, sales budget is the statement of planned sales in terms of quantity and value and analyzed byproducts.

For forecasting sales, it is necessary to consider the following factors:

a. Historical analysis of sales,

b. Market analysis,

c. Salesman’s estimates,

d. General trade and business conditions,

e. Report of salesman,

f. Special conditions,

g. Seasonal fluctuations,

h. Financial aspects,

i. Adequate return on capital employed,

j. Competition,

k. Planned capacity,

l. Sales promotions,

m. Customers’ tastes,

n. Policy of the concern,

o. Government intervention,

p. Government policy regarding export and import,

q. Product profitability,

r. Tax policy.

Criticism of Budgets of Bangladesh

2012-03-06T07:27:00.000+06:00

After the immediate declaration of budget of Bangladesh Government, it is usually noticed that the economists of Bangladesh come forward with their comments on published budget.

The followings are the usual points which are commented by the economists:

i. Measures have been taken to maintain the rate of taxes at reasonable and flexible.

ii. Tax collection procedure has been easier.

iii. Attention has been given to protect the interest of the local industries in the case of indirect taxes.

iv. Protection in the small industries has been given in such a way that will have survived our local industries. As a result, this will help to increase the establishment of backward linkage industries.

v. Everyone appreciates the policy which gives the financial allowances for the old aged people, destitute, widows and divorced women.

vi. VAT policy, which is followed by the budget, is another new dimension to collect government revenue.

vii. Increased allocation for the education sector and agriculture sectors is considered as a positive step for the developing country like Bangladesh.

viii. National budget addresses the stipend for female education, female illiteracy rate and results.

ix. Tax exemption from the new materials of the industrial goods will be helpful for boosting exports.

x. General consumers will be benefitted as a result of the exemption from all kinds of food grains and fertilizers for the boost up of agriculture sectors.

xi. National budget also address the capital market and try to apply necessary steps to make it strengthen and as a result investment is encouraged for the potential investors.

xii. The agriculture productivity will increase for providing subsidiary to the tune one TK 100 -300 crore in this sector.

xiii. The growth rate of the budget is seemed to be ambitious, and set at 7%. But it will be challenging to attain.

xiv. The previous budget were very big and we think that were not realistic.

Difficulties in preparation of a Budget

2012-03-06T07:25:00.002+06:00

It is really difficult to prepare appropriate and accurate budget for the 3^rd world country. And Bangladesh is not exception at all. The difficulties of preparation of a budget are as follows:

i. Data/ information which are collected from different offices, departments, organizations etc. are not similar in nature; rather contradictory.

ii. There is wide difference between exits of expenditure and income of country.

iii. Revenue collection measures of the government are not effective.

iv. It is difficult to determine the priority of the development programs of the country.

v. Excessive expenditure of the country.

vi. Difficult of industrial failure, faulty and irregular supply of electricity which disrupts the production and services, damages or any destruction makes a serious problem to prepare an effective budget.

vii. It is absolutely difficult to minimize the target fixed and progress achieved.

viii. Uncertainty of foreign aid, grants, and loan are the crucial problem in preparing budget.

ix. High rate of inflation, manipulates the training and development activities.

Types of Budget

2012-03-06T07:23:00.001+06:00

On the basis of income and expenditure budget is two, these are:

1. Development budget

2. Revenue budget

Development budget

Development budget is the annual development budget (ADP) of the government. It is taken up for current and future capital formation. Broadly speaking- development budget launched for mobilizing country’s resources, credits, sources of direct income, developing service sector for aiding the sources of indirect income, developing energy and agriculture sectors. Necessary funds for preparing development budget comes from revenue surplus, revenue, internal resources, loan, external debts and grants, remittances and foreign trade.

Revenue Budget

Revenue budget includes the financing of administrative machinery of the government, defense service, law and orders, Public health, education and other services, it is also called operation and maintenance budget of the government. To maintain the aforesaid recurring expenses, the government imposes different types of taxes for meeting expenses of this budget, some of which are direct expenses including excise duties

Why we need budget? / Significance/ importance of budget.

2012-03-06T07:21:00.001+06:00

The necessity of preparation of budget by the government of Bangladesh is explained below:

i. Budget is the statement of annual income and expenditure of the government.

ii. Budget is a document of guideline of economic activities of the country.

iii. Budget determines the area of all activities of the government.

iv. It helps to adopt the financial planning for a particular period.

v. Budget is also the reflection of the government development programs.

vi.Buddget also determines the priority of development programs.it is the prediction of development of a country.

vii. Budget helps to determine costs estimation for unseen items.

viii. Budget indicates the statement of accounts of service sectors.

ix. It is the prediction of the development of the country.

x. Budget indicates the sources of revenue collection of the government.

xi. Budget is the controller of public income and expenditure.

National Budget

2012-03-06T01:54:00.000+06:00

Budget is the idea or design for future prospects. A national budget is the process which helps in preparing accurate statement of income and expenditure of a country. Therefore budget of any country is the statement of total income and expenditure of the subsequent year calculated on the basis of economic activities of the total population. That is why budget of any country is not only the statement of domestic income and expenditure but also the lists of income received through domestic resources, external remittances as well as foreign trade. And at the same time expenditure incur4ed for subsequent year in the various sectors of economy.

What is budget and Budgeting/ Define: Budget & Budgeting

2012-03-06T01:48:00.000+06:00

Budget is a matter of future action. It must be quantitative but not qualitative. So, it is a numerical blueprint of future action which is related with economical activities.

On the other hand, budget is a law relating to one country’s economic activity. It is an important part of a country’s constitution.

On the other hand, the act of preparing budget is called budgeting.

Mathematical Problem (Simplex Model)

2012-02-29T00:44:00.001+06:00

Problem 3: Dell Inc. manufactures two sizes of baseball- little league and major league. The company earns a profit of $2 of little league baseball and $3 per of major league baseball. Each product is assembled and packaged. There is a maximum of 1,800 hours available between the assembling and packaging department during a given time period. It takes 9 minutes to assemble a box of little league baseball and 15 minutes to assemble a box of major league baseball. A box of little league requires eleven minutes packaging whereas 5 minutes to major league. Dell Inc. seeks 2 combination of little league baseball and major league baseball that will maximize total profit within the available assembling and packaging time.

Requirement: Formulate this problem with simplex model and solve it.

Key column / Key Row / Key number

2012-02-29T00:42:00.000+06:00

Key column: In a simplex table the column which contains the most positive number in the objective row is called Key column or pivot column.

Key Row: In a simplex table the raw which contains the lowest displacement ratio is called key row or pivot row.

Key number: In a simplex table the number which lies at the intersection of the key row and key column is called key number.

Surplus variables

2012-02-29T00:39:00.000+06:00

Surplus variables

In a linear programming model when a structural constraint is in the “Greater than or equal to” form a non-negative variable is deducted to the left hand side to convert inequality into equation, then these variables are called as slack variables.

For example: 3X + 5Y ≤ 100

Or, 3X - S₁ + 5Y - S₂ = 100.

Here S₁and S₂ are Surplus variables.

Slack Variables

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Slack Variables

In a linear programming model when a structural constraint is in the “less than or equal to” form a non-negative variable is added to the left hand side to convert inequality into equation, then these variables are called as slack variables.

For example: 3X + 5Y ≤ 100

Or, 3X + S₁ + 5Y + S₂ = 100.

Here S₁and S₂ are slack variables.

Simplex Method

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Simplex Method

A methodology designed to systematically solve large scale linear programming problems. This method is an algebraic approach based equality relationship. Yet linear programs typically involve inequality. To use the simplex method, the decision makers first must convert each inequalities restriction into equality through adding slack variables of deducting surplus variables. Simplex method was first introduced by G.B Dantzig and his associates in 1947 in USA among the department of airforce.

Problems on Linear Programming

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Problem 1: Rahim Factory manufactures two articles- share and towel. To manufacture share a certain machine has to be worked for 1.5 hours and in addition a craftsman has to work for two hours. To manufacture the towel the machine has to work for 2.5 hours, in addition the craftsman has to work for 1.5 hours. In a week, the factory can avail 80 hours of machine and 70 hours of craftsman. The profit on each share is Tk 50 that on each towel is TK 40.

If all the articles produced can be sold away, find how many of each kind i.e., share and towel should be produced to earn maximum profit per week. Formulate the model using linear programming model and solve it.

Problem 2: Mrs Saleha has learnt from a nutrition book that her family needs at least 330 gm of protein and 45 mg of iron per day. These nutrients can be obtained from meat and vegetables. Each pound of meat costs on an average of $1.6 and contains average of 150 gm. and 15 mg of iron, while each pound of vegetable costs 50 cents ($1/2) and has 10 gm. of protein and 5 mg of iron. Mrs. Saleha wants to determine the quantities of food that meet the nutritional requirements at least costs.

Mathematical Problem (Linear Programming)

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Problem:

Zenith Inc. manufactures two types of kitchen utensils:

1. Knives.

2. Forks.

Both must be pressed and polished. The shop manager estimates that there will be a maximum 70 hours available next week in pressing machine center and 100 hours in polishing machine center. However each case of knives requires an estimated 12 minutes (.20 hour) of pressing and 30 minutes (.50 hour) of polishing while in case of forks requires 24 minutes (.40hour) of pressing and 15 minutes (.25 hour) of polishing. The company can sell as many knives as it produces at the prevailing market price of Tk 12 per case. Forks can be sold for Tk 9 per case. Cost of production per case knives is Tk 4 and forks Tk 3.

Zenith wants to determine how many cases of knives and forks the company should produce to maximize profit.

Solution (Equation type expression):

Zenith’s problem is to determine the quantity of knives and forks that will maximize profit and selected quantities cannot be used more than available pressing and polishing time.

Objective: To maximize profit.

Zenith’s total profit = The contribution from knives + the contribution from forks.

Since,

Each case of knives can be sold @ Tk 12

Each case of knives’ production cost@ Tk 4

So, contribution from each case of knives = Tk (12-4) = Tk 8

Since,

Each case of forks can be sold @ Tk 9

Each case of fork’s production cost@ Tk 3

So, contribution from each case of forks = Tk (9-3) = Tk 6

This Tk 8 and Tk 6 per case knives and per case forks contribution multiplied by number of cases gives total profit from knives and forks respectively.

By letting,

X= Number of knives zenith will produce in next week.

Y= Number of forks zenith will produce in next week.

Z= Zenith’s want of total profit.

Now we can represent Zenith’s total profit,
Z= 8X + 6Y ------------- (I)

The company wants to choose the level of decision variables (X and Y) that maximizes total profit (Z). The objective can be expressed as,
Maximize Z = 8X + 6Y ---------(II)

Restrictions:

Available pressing and polishing capacity will limit knives and forks Zenith can produce. Since each case of knives uses .20 hour of pressing time i.e., .20X is the total time required to press X cases knives, similarly .40Y is the total time required to press Y cases of forks.

Consequently, .20X + .40Y gives the total time required to press X cases of knives and Y cases of forks.

Zenith can select any product combination doesn’t require more than 70 hours available pressing time. The mathematical representation of this condition will be-
.20X + .40Y ≤ 70 (hour) ----------- (III)

Another system constraint deals with polishing operation management of the business/ company knows that each case of knives uses .50 hour and each case of forks uses .25 hour polishing hour.

Since, there are only 100 hours of polishing time. So we can represent the above description as following:
.50X + .20Y ≤ 100 (hour) ------------ (IV)

It is physically impossible for zenith to produce negative number of knives and forks. Therefore, management must ensure that decision variables X and Y have values greater than or equal to 0 (zero).

Symbolically, X ≥ 0 and Y ≥ 0
In abbreviated form X, Y ≥ 0 ------------ (V)

Complete Formulation:

By collecting objective function (II), system constraints (III) and (IV) and non-negativity condition (V), zenith’s management can be represented the machine shop problem with the following mathematical equation/ function:

Maximize, Z = 8X + 6Y
Subject to,
.20X + .40Y ≤ 70 (System Constraints)
.50X + .25Y ≤ 100 (System Constraints)
X, Y ≥ 0 (Non-negative function)

Solution (Numerical Expression):

Let us, first consider the inequality into equation we have,
.20X + .40Y = 70 --------- (I)

And .50X + .25Y = 100 -------- (II)

For the equation number (I), when X=0 then

.20 x 0 + .40Y = 70

Or, Y = 175 [X, Y= 0, 175]

When Y=0 then

.20X + .40 x 0 = 70

Or, X = 350 [X, Y= 350, 0]

For the equation number (II), when X=0 then

.50 x 0 + .25Y = 100

Or, Y = 400 [X, Y= 0, 400]

When Y=0 then

.50X + .25 x 0 = 70

Or, X = 200 [X, Y= 200, 0]

Now equation number (I) multiplied by 5 and equation number (II) multiplied by 2. Then deduct (II) from (I), we get-

X + 2Y = 350

X + .50Y = 200

-------------------

1.50Y = 150

So, Y = 100

Putting the value of Y, in equation (I) we get,

.20X + .40 x 100= 70

Or, X = 150

So, X, Y = 150, 100

Now all the values of X and y are ---

For equation Number (I)

When X = 0, then X, Y = 0, 175

When Y = 0 then X, Y = 350, 0

For equation Number (II)

When X = 0, then X, Y = 0, 400

When Y = 0 then X, Y = 200, 0

And X, Y = 150, 100

Putting the above values on graph, we get---

Click on the picture to see the original size.

By putting values of variables on X and Y axis and using shadow, we get the crossing point of two lines at (150, 100). So it would be the target point where zenith may get highest profit or lowest profit.

Now, Z = 8X + 6Y

= 8 x 1500 + 6x 100

= 1800

Competitive analysis:

Corner point	Total profit
0, 175	Z = (8 x 0) + (6 x 175)= 1050
0, 0	Z = (8 x 0) + (6 x 0)= 0
200, 0	Z = (8 x 200) + (6 x 0)= 1600
150, 100	Z = (8 x 150) + (6 x 100)= 1800

Comment:

Under the above solution, we suggest the production manager to produce 150 cases of knives and 100 cases of forks to maximize profit or minimize costs.

Mathematical Problem

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Problem:

Nabila is a university student. She produces playing tools for children with clay. She would like to earn as much as possible. She uses her spare time to produce these tools. She has a specified amount of time for this work. Nabila earns a given amount of profit per product. There is practically an unlimited demand of her work. Show the above description with mathematical expression.

Solution:

Since Nabila wants to earn as much as possible, her objective is to maximize profit. Total earnings are determined multiplying the profit per playing tool and number of playing tools produced.

By Letting,

P= total profit,

R= Profit per playing tool.

Q= Number of playing tools produced.

Nabil’s objective is to maximize profit can be stated as follows:

P=QR---------------------- (i)

This type of mathematical expression is called objective function or goal of the problem.

Here, Total profit is restricted by Nabila’s available time. The demand for her work will equal to the time utilized per playing tool multiplied by quantity of playing tools. This demand must not exceed her available time.

By Letting,

t= Time utilized per playing tool,

T= Nabila’s available time.

The relationship can be described with the following mathematical expression:

tQ, ≤ T ------------------ (ii)

The symbol less than equal to (≤) indicates that the total time required must be less than or equal to the available time period. This type of expression is known as constraints.

Another restriction is that Nabila cannot produce a negative number playing tool, i.e.,

Q ≥ 0 ---------------- (iii)

The above mathematical expression states that the quantity of pages must be greater than or equal to zero (0). This type of expression is known as non-negative function.

Nabila’s problem is to determine the quantity of pages (Q) that will maximize her profit (P) per period from the production service. This problem also recommended quantity must not require more than his available time.

By accumulating, the equation number (i), (ii), (iii), Jackson’s problem can be represented with the following mathematical model:

Maximize P= QR----------- (i)

Subject to, tq ≤T--------------- (ii)

Q ≥ O ------------------- (iii)

Role of Quantitative Techniques (QT) in Industry and Business.

Quantitative technique especially operation research technique has gained increasing importance since World War II in the technology of business administration. This technique greatly helps in tackling the integrated and complex problems of the modern business and industry. Quantitative techniques for decision making are infecting examples of the use of scientific management. However the roles of quantitative techniques are explained below.

1. They provide a tool for scientific analysis:

These techniques provide the executives with a more precise description of a cause. They replace the intuitive and subjective approach. The use of these techniques has transformed the conventional techniques of operational and investment problems in business and industry. Quantitative techniques thus encourage and enforce disciplined thinking about organization’s problems.

2. They provide solutions for various business problems:

The quantitative techniques are being used in the field of production, procurement, marketing, and such other fields. Problems like- how best can the manager and executives allotted the available resources to various departments. So that in a given time the profit are maximized or costs are minimized planning decision business and industry largely governed by the picture of anticipated demands and quantitative techniques help to forecast about demand. So, quantitative techniques are very important.

3. They enable proper deployment of resources:

Quantitative techniques render valuable help in proper deployment of resources. For example- Programming- Evaluation- Review- Technique (PERT) requires various related data to identify critical path. In the same way when it require supply data and determine the probability of completing an event or project itself by specified data.

4. They help in minimizing waiting and servicing costs:

The waiting line and/ or queuing theory help the management in minimizing the total waiting and servicing costs. This technique also analyses the feasibility of adding facilities and thereby helps the business people to take the correct and profitable decision.

5. They assist in choosing an optimum strategy:

Game theory is specially used to determine the optimum strategy in a competitive situation and enable the businessman to maximize profits or minimize losses by adopting optimum strategy.

6. They help in resources allocation:

They render great help in optimum resource allocation by the help of linear programming. Linear programming techniques are popularly used by modern management in resource allocation and selecting production mix.

7. They facilitates the process of decision making:

The decision theory enables the businessman to select the best courses of action when information is given in probabilistic form.

8. Inventory problem:

These techniques enable the management to decide when to buy and how much to buy.

9. Statistical techniques:

Statistical techniques are also of great help to business man in more than one way. Some of the statistical techniques are considerable importance in sales forecasting whereas other facilitates from comparison between the various phenomena. In statistics there are various techniques such as quality control technique, sampling theory to decision making, various significant tests to judge the reliability etc. Similarly regression analysis, variance analysis, time series analysis, index number etc are useful tools of statistical analysis from where business get a great help and right decision is being taken.

Limitation of Quantitative Techniques (QT)

Management Science Process

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Quantitative decision making is not a substitute for competent management. Rather it is methodology that can significantly improve the executive decision making. So, every business students should learn about it. Followings are the graphical representation and description of management science process:

Management Science Process

Define the problem:

The First step of the management science process is to define the problem. Quantitative decision making approach is problem oriented. So we should define the managerial problem clearly and concisely. The problem must be stated precisely and that should be suitable for analysis. Many operation research studies were failed simply because the problem was poorly defined. So at first we should emphasize more on it.

Formulate a quantitative model:

In the second step, we need to formulate a model. In formulating model, we should consider controllable and uncontrollable inputs. A model is a simplified representation of real objects or situations. The representation inputs only essential, relevant and important features.

Gather relevant quantitative data:

Organization would gather data from past accounting records, sales, financial, inventory, production and engineering records and reports. Published documents such as government statistical summaries may be important sources of data. Managers and operating personnel can provide information about markets, financial conditions, productivity and other factors that are unavailable elsewhere.

Analyze and solve the quantitative model:

In this step we have to analyze collected data and solve the quantitative model. In most cases, there is tremendous volume of available data and a considerable amount of time is required to collect and organize the information. Furthermore, data are usually not in form of suitable form for decision making purposes. More effort then, is necessary for processing and analyzing the data. As a result many organizations have designed and implemented formal system for collecting, analyzing and reporting relevant and timely information. Such a structure id referred to MIS (management Information System).

Implement the solution:

It is the last phase of decision making. The quantitative technique analysis process is not complete, until the model’s solution information is reported to the decision maker and results are implemented. Such data constitute only one of the inputs considered by the manager when a final decision is being made. So it shows the success or failure of the process. For this reason it is called vital step among all.

Battle’s Circus

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Blackett’s Circus was one of the most publicized operation research groups on Great Britain. During Second World War Professor P. M. S Blackett of the University of Mancherter was the director of this group. The group was formed by eleven members. They were-

3 Physiologists.
2 Mathematical physicists.
1 Astro physiologist.
1 Army officer.
1 Surveyor.
1 General physicist.
2 Mathematicians.

The group was formed for the following reasons:

For increasing the early coming radar systems;
In empty aircraft gunnery;
In empty submarine war-fare;
In civilian defense;
For determining convoy size; and
For conducting bombing raids upon Germany.

Historical background of Operation Research

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No science has been even been born on a single day. Operation research is not exception of it. Its root is as old as science and society. Those are roots of operation research extend to early 1800’s. But completely disclosed in 1885 When F. W. Taylor emphasized the application of scientific analysis to the method of production.

After then, in 1914, F. W. lanchester used mathematical equation in the field of forecasting outcomes of military battles. In 1917, A. K. Erlong used queuing theory in the field of production of waiting time for callers using an automatic telephone exchange. In 1924, W. Shewhard used the theory of probability and statistical inference in case of production quality control charge and in 1930 H. C. Levinson used mathematical expression in the field of marketing relationship.

The name operation research was evolved in the year 1940. During Second World War, a team of scientist (Blackett’s Circus) in UK applied scientist method to study military operations to win the world and the techniques thus developed was named as operation research.

Later on, the economic crisis of UK required radical improvement. This resulted in an industrial revolution and the operation research techniques so far developed in defense problems to provide a more vigorous and scientific approach to the problems. After a decade of second world war, operation research techniques was rapidly developed in the field of industrial, academic and government organizations.

After the Second World War, due to high development technology, people used machinery instead of manpower as controller. The new revolution began around 1970’s when electric computers were available in market.

In business sector, from 1950, the operation research techniques were used highly. Not only these, even in America it was introduced as an academic subject. Since then, this subject has been gaining ever increasing importance to the students of mathematics, statistics, commerce, economics etc.

Nowadays, we cannot think any business without operation research techniques.

How a mathematical model is formulated?

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We can visualize the formulation of mathematical problem by solving the following problem.

Problem: Jackson is a college student, who earns money by typing letter and menu scripts in his spare times. He has a given amount of spare time available in a given period and each page of a project utilizes a specified amount of that time. Jackson earns a given profit per page. There is practically an unlimited demand for his work. Jackson wants to earn as much money as possible.

Solution: since Jackson wants to earn as much as possible, his objective is to maximize profit. Total earnings are determined multiplying the profit per page and typing number of pages.

By Letting,

P= total profit,

R= Profit per page,

Q= number of Pages

Jackson’s objective is to maximize profit can be stated as follows:

P=QR---------------------- (i)

This type of mathematical expression is called objective function or goal of the problem.

Here, Total profit is restricted by Jackson’s available time. The demand for his work will equal to the time utilized per page multiplied by quantity of pages. This demand must not exceed his available time.

By Letting,

t= Time utilized per page,

T= Jackson’s available time.

The relationship can be described with the following mathematical expression:

tQ, ≤ T ------------------ (ii)

The symbol less than equal to (≤) indicates that the total time required must be less than or equal to the available time period. This type of expression is known as constraints.

Another restriction is that Jackson cannot type a negative number of pages, i.e.,

Q ≥ 0 ---------------- (iii)

The above mathematical expression states that the quantity of pages must be greater than or equal to zero (0). This type of expression is known as non-negative function.

Jackson’s problem is to determine the quantity of pages (Q) that will maximize his profit (P) per period from the typing service. This problem also recommended quantity must not require more than his available time.

By accumulating, the equation number (i), (ii), (iii), Jackson’s problem can be represented with the following mathematical model:

Maximize P= QR----------- (i)

Subject to, tq ≤T--------------- (ii)

Q ≥ O ------------------- (iii)

What is Model?

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A model is a simplest representation of real objects or situations.

Here, the representation includes only essential and relevant features. For example: A scale model rail road is a physical replica of general appearance and the operating characteristics of the real of the real things. There are 3 types of model. These are-

1. Iconic Model;

2. Analog model; and

3. Mathematical model.

1. Iconic Model: A physical replica of the real situation or object is called iconic model. For example, Toys, Photograph of rail road etc.

2. Analog model: A physical form that doesn’t look like the real object or situation is called analog model. For example, An organization’s chart, Graphical representation etc.

3. Mathematical Model: A system of symbols and mathematical expression that represents the real situation is called mathematical model. For example,

P=QR, Where,

P= Total Profit,

Q= Quantity Produced

R= Profit per Unit.

What are Budget and Budgeting? Or, Define: Budget & Budgeting.

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Budget is a matter of future action. It must be quantitative but not qualitative. So, it is a numerical blueprint of future action which is related with economical activities.

On the other hand, budget is a law relating to one country’s economic activity. It is an important part of a country’s constitution.

On the other hand, the act of preparing budget is called budgeting.

Operation Research

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Operation Research

Operation Research is also known as-

i. Quantitative techniques for decision making.

ii. Management Science.

iii. Quantitative techniques.

iv. Operation management.

Meaning of Operation Research:

Before coming to the answer, we should know – what is Operation? And what is Research?

Operation:An operation is a set of acts required for the accomplishment of some desired outcomes or objectives.

Research: Research is a systematic quest to discover the hidden truth.

Operation Research is a systematic and scientific method of providing executive departments with a quantitative basis for decision regarding the operation under their control.

--Morse and Kimball.

Operation research is a scientific approach to problem solving for executive management.

--H. M. Wagner

On the other hand, Operation research is the application of scientific method by interdisciplinary teams to problem involving the control of organized systems so as to provide solutions which best to serve the purpose of the organization as a whole.

So we can say that operation research or quantitative technique may be defined as those techniques which provide the decision makers with a systematic and powerful means of analysis and help based on quantitative data in exploring policies for achieving predetermined goals.

Important Operation Research Techniques

(Tools of Operation Research)

1. Linear Programming:

These techniques are used in finding a solution for optimizing a given objective, such as profit maximization or cost minimization under certain constraints. Linear Programming techniques solve product mix and distribution problems of business and industry. It is a technique used to allocate scare resources in an optimum manner in problems of scheduling product mix and so on.

2. Queuing Theory:

Waiting line or queuing line deals with mathematical study of queues. The queues are formed whenever the current demand for service exceeds the current capacity to provide that service. Waiting line technique concerned itself with the random arrival of customers at a service station where the facility is limited. Mainly with the help of it we can find the optimum capacity to be installed which will lead to a short of economic balance between cost of service and cost of waiting.

3. Game Theory:

Game theory is used to determine the optimum strategy in competitive situation. Simply as possible competitive situation is that of two persons are involved, one person wins exactly and other person losses.

4. Inventory Control Planning:

Inventory control planning aims at optimizing inventory levels. Inventory may be defined as the useful idle resource which has economic value, such as- raw material, spare parts, finished products etc. Mainly it helps to get answer of two questions- How much to buy? And when to buy?

5. Decision Theory:

Decision theory concerned with making sound decision under conditions of certainty, risk and uncertainty. From the various alternatives decision theory helps to select the best one.

6. Network Analysis:

Network analysis involves the determination of an optimum sequence of performing certain operations concerning some jobs. In order to minimize the overall time and/ or cost, it uses various models-

Programming evaluation and review techniques (PERT);
Critical path method (CPM);
Gantt Chart etc.