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( 4 ) PART 2 CONCEPTS AND TOOLS FOR STRATEGIC PLANNING
CHAPTER 5 COMPETITIVE COST DYNAMICS: THE EXPERIENCE CURVE
PRESENTATION OF THE EXPERIENCE CURVE
The effective management of the total cost of manufactured products is a fundamental concern for the long-term profitability of a firm operating in competitive markets. To a great extent, the internal strength of a business rests on the firm's ability to deliver products at costs which are lower than those of the competitors. From this perspective the cost of a product should not be viewed as the simple accumulation of direct and allocated expenses required for its manufacturing and sale, but as a central indicator of the firm's capability for managing its internal resources to attain a productivity advantage over its competitors. The experience curve provides an empirical relationship between changes in direct manufacturing cost and the accumulated volume of production. Although its origins go back to the beginning of this century, it was only in the late 1960s that the Boston Consulting Group began to emphasize its role for strategic decision making. In Figure 6.1 we present an 85% experience curve. In the horizontal axis we have the accumulated volume of production [in units], and in the vertical axis the deflated direct cost per unit, which is the actual cost corrected by the inflation rate. The experience curve shows that the cost of doing a repetitive task decreases by a fixed percentage each time the total accumulated volume of production [in units] doubles. In the example given in the figure, the total cost drops from 100 when the total production was 10 units, to 85 [=100 x 0.85] when it increased to 20 units, and to 72.25 [=85 x 0.85] when it reached 40 units. This relationship between accumulated volume of production and deflated direct cost is expressed in a log-log graph as a straight line, which is easier to work with. In figure 6.2 We display the 85% experience curve shown above in this kind of graph. The cost predicted by the experience curve effect can be obtained from a simple negative exponential relationship of the following type: Ct= Co(Pt/Po ) - a Co ,Ct = Cost per unit [corrected by inflation] at times 0 and t, respectively; Po ,Pt = Accumulated production at times 0 and t, respectively; a = Constant, industry dependent.
MANAGING THE EXPERIENCE CURVE: REASONS FOR THE REDUCTION OF COST
Although the impact of experience on lowering costs has been measured empirically in a wide spectrum of industries - ranging from broiler chickens to integrated circuits - its benefits can only be realized by careful management. The effects of the experience curve can be observed in every stage of the value added chain. Its impact affects in a distinctive way each one of the value added steps covering research and development, procurement of raw materials, fabrication, assembly, marketing, sales, and distribution. In this section we discuss the most important factors that contribute to the systematic decrease in cost with accumulated volume. 1] Learning. The repetitive performance of a task allows a person to develop a specialized set of skills which permits the completion of the assignment in a more efficient way. 2] Specialization and Redesign of Labor Tasks. The increased volume of production lends itself to a divisionalization of labor that allows for specialization and standardization to take place, thus contributing greatly to productivity improvements. 3] Product and Process Improvements. As volume increases, many opportunities become available for product and process improvements leading toward higher productivity and cost reductions. An important factor for the realization of these opportunities is the implementation of a broad standardization policy affecting all significant steps in the value added chain. Changes in the product characteristics that generate significant increases in productivity are design modifications, better utilization and substitution of materials, and rationalization of the product-mix; all of them dictated by the increased experience resulting from larger volumes of production. Added opportunities for cost reduction arise from changes in the manufacturing process. Improved technologies, layout changes, better ways for handling and storing materials, parts , and products; adoption of more efficient maintenance schema, and better distribution of final products are just some of the broad alternatives open to drive costs down through the accumulation of experience. In general, the idea is to look for all those improvements of the industrial process that can profitability reduce the cost schedule. 4] Methods and Systems Rationalization. There is an increasing number of opportunities to improve the performance of a firm by introducing more up-to-date technology in the handling of operational activities. By introducing rationalization of procedures and extensive use of computers and automation, all hierarchical layers of firms become confronted with substantial changes in their normal administrative and managerial duties. 5] Economies of Scale. The substantial cost reduction observed in an historical series of real costs can be partly explained by the impact of accumulated volume of production and partly by the changes of scale induced by the increased throughput required from a firm as time passes. The economies of scale correspond to the decline in unit costs as throughput increases. Scale economies can be present in nearly every function and many technological factors concur to explain the downward trend of the cost-curve as a result of increased volume per period. The most dominant among them are: - The availability of improved technological processes for high-volume production; - The indivisibility of many resources that can only be profitably used when adopted in fairly large operations. - The backward and forward integration of manufacturing processes and business activities, which can be justified only for very large firms operating in stable environments; - The sharing of resources, mainly the ones managed at the corporate level, which is an alternative open mainly to diversified firms with businesses in related product markets. Similarly, scale effects can be observed in distribution, sales, R & D, general administrative activities, and in all stages of a productive operation. It is apparent from these comments that cost reductions with scale are another clue for dedicated managers to improve their competitive cost position in the marketplace, because it signals factors that, when properly managed, can reduce the total cost of a product. 6] Know-How. This represents an enriched understanding of the managerial, technological, and operational factors that contribute to the efficiency of the firm. Knowledge is hard to transfer because it represents the accumulated experience that has been gained through the passage of time. If know-how is properly consolidated and protected, it can give a significant competitive edge to that firm which is the leader in its industry.
CONVENTIONAL STRATEGIC IMPLICATIONS OF THE EXPERIENCE CURVE
The decline in unit costs produced by an increase of accumulated production has led to the isolation of market share as a primary variable to identify the strength of the strategic position of a business within a given industry. Those who advocate this view, primarily among them the Boston Consulting Group, state following chain of causal relationships: High Market Share___ High Accumulated Volume ___ Low Unit Cost ___ High Profitability The association between market share and profitability has received some empirical support in the work of project PIMS[Profitability Impact on Marketing Strategies]. The implications of these relationships are clearly depicted in Figure 6.6, which shows the positioning within a common experience curve of four competing firms. It can be observed that firm A, the leader of the group, has a commanding advantage over its competitors, while firm D is struggling for its survival that is determined by the strategic moves of firm A, and by its ability to sustain long-term losses. Under this approach, the only alternative for firm D to improve its situation is to move aggressively in its search for an increase in market share. Bruce Henderson, proposes the "rule of three and Four', which indicates that a stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest. There are two primary reasons argued by Henderson to sustain this hypothesis. A ratio of 2 to 1 in market share between any two competitors seems to be the equilibrium point in which it is neither practical nor advantageous for either competitor to increase or decrease share. Any competitor with less than one quarter the share of the largest competitor cannot be an effective competitor. The most important strategic implications suggested by Henderson are: If there is a large number of competitors, a shakeout is nearly inevitable in the absence of some external constraint or control on competition. All competitors wishing to survive will have to grow faster than the market in order even to maintain their relative market shares with fewer competitors. The eventual losers will have increasingly large negative cash flows if they try to grow at all. All except the two largest share competitors either will be losers, and eventually be eliminated, or will be marginal cash traps reporting profits periodically and reinvesting forever The quicker an investment is cashed out or a market position, second only to the leader is gained, then the lower the risk and the higher the probable return on investment. Definition of the relevant market and its boundaries becomes a major strategy evaluation. The validity of this rule is arguable. The main reason for presenting it is to illustrate the way in which a complete set of normative implications have been derived by making a particular interpretation of the experience curve effects. What is interesting from this posture is that industry concentration should tend to be very high under stable conditions, and that failing to observe this fact may be due to a faulty definition of an appropriate market, which has very negative strategic implications for the firm, or to the presence of government regulations which prevent the natural course of strategic adjustment to take place.
Although cost has a fairly predictable trend along the experience curve, prices do not behave that way. At the early stages of a product introduction, price becomes a strategic decision variable for the innovating firm. The major question to be resolved is whether to keep a fairly high price in the initial phases, at a time which is possible for the innovator to impose a monopolistic rent and enjoy an extraordinarily high profitability level, or to lower the prices at the same rate at which costs decline to discourage the entry of competing firms into this business.The more frequent relationship observed is the one depicted in figure 6.7.In the introduction and embryonic stages prices tend to be fairly stable, providing a real bonanza for the innovative firm. It is only at the final stages of the embryonic phase where the entry of new competitors generate a turbulent shakeout in the industry with a rate of price reductions much faster than the cost decline. Quite often, a complete restructuring of the industry takes place at this stage and even the innovator might be forced out of business. Such was the case with Bowmar in electronic hand calculators. At the end of the shakeout phase, only a few of the most efficient producers can survive, and despite their small number, the expectation is that the profit margin is consistent with a perfect market situation throughout the maturity stage of the product.
ADDITIONAL CONSIDERATIONS FOR THE USE OF THE EXPERIENCE CURVE IN STRATEGIC PLANNING
Determining the Appropriate Chronology of the Accumulated Experience
There are two basic issues regarding the chronology of the experience curve: One is the detection of the starting point for the accumulation of experience, and the other is the need to recognize that, occasionally, shifts in the experience curve tend to take place during a significantly long time span. Figure 6.8 illustrates this last point. The use of an average slope will grossly underestimate the existing experience effects due to recent technological advances, or significant capacity expansions resulting from major capital investment commitments.
Assessing the Proper Starting Position of a New Entrant
First, when a new entrant is supporting its business on a technology that has a completely different experience curve behavior, as shown in the situation represented in Figure 6.9. In spite of the larger accumulated volume of firm A as compared with the new entrant, this fact is not translated into a cost advantage due to the different pattern of the respective experience curves. The dominance of the Japanese in the U.S. steel industry might be explained by the distinct technological base that supports the Japanese industry. A second reason to explain an improved position of a new entrant, other than technological differences, is originated in quick transfer of technology, know-how, and smart followership. In today's industrial world, characterized by increasingly fast communications, it is often impossible to retain absolute proprietorship in process and product technology. Figure 6.10 exhibits a new entrant B with an experience curve of identical slope with leader A, but its initial position is significantly better than would have been predicted if no technological transfer had taken place.
Market Share Is Not the Only Game
There are certain industries in which experience does not seem to play a fundamental role in cost reduction. In those industries, the strategic positioning of a business does not rely exclusively in cost advantages. In this setting, it is useful to distinguish between specialty and commodity products. Commodity products are characterized by having very few, if any, opportunities for differentiation that can induce the consumer to pay a price premium. Specialty products, on the contrary, are sustained by the capability of a firm to offer very distinctive features which are highly valued by the consumer. The closer a business is to a commodity, the more significant its cost becomes as a crucial strategic decision variable.
Market Share Should Not be Measured Just at the End of the Value-Added Chain
A productive activity is not a monolithic process, but is composed of many different steps and functions, that can be ordered in terms of stages of value-added. Among these stages, one could recognize research and development, manufacturing of parts and components, subassembly, marketing, distribution, and retailing. Although experience will affect all these stages, seldom will its impact be felt homogeneously across them. Figure 6.11 illustrates this point. It shows, for example, that experience in retailing is not as important as in the subassembly process. Besides the different experience effect on each of the stages due to the nature of the work, it is quite common that impact of product mixes contributes to the accumulation of different volumes at each stage. Therefore, experience will accrue more rapidly to those stages which are more heavily loaded by the entire set of items produced. Both of these two effects, the different impact of experience in cost and the different rate of accumulation of experience in the various stages of value added, is a message that consulting firms like strategic planning associates and Braxton are advocating quite forcefully in recent years. They argue that a trap one could fall into is to measure market share just at the end of the productive chain, without recognizing the two indicated effects. One example will be used to illustrate this argument.In a business, the leader of the market is firm A with a relative market share of four times the one held by its competition, firm B. At first sign, it looks as if firm A has an insurmountable advantage, but this primary impression is very much tempered when considering that the business may be conceptualized in terms of two stages of value added: manufacturing and distribution. In the manufacturing stage, firm A has the 4 to 1 advantage over firm B, but in the distribution stage, it is firm B which has an advantage of 3 to 1 in terms of market share, because this business is just one of many others that share the same system of distribution. Assuming that experience in both stages has the same impact over cost, and that each stage contributes with half the final value of the product, we could use a normalized market share to determine the relative standing of the two firms in the business. The market share thus obtained for firm A is Market Manufac- Manufacturing Distribution Distribution share = turing x Value + market x value Share Added Share Added 4 to 1 1 to 3 = or x 0.5 + or x 0.5 4/5 1/4 =0.525 Similarly, for firm B we obtain [Market Share] = 0.475. The relative market share of firm A over firm B in terms of this weighted measure of experience is only 0.525/0.475 - 1.10 times, which is far smaller than the 4 to 1 observed in the market for the final product. Figure 6.12 illustrates this point.
Rigidities Introduced by Overemphasizing Experience
Too much emphasis on economies of scale might impair the ability of the firm to respond in a flexible way to the technological advances, environmental changes, and innovations taking place outside the firm. Likewise, it might prevent the realization of product differentiation to capture a wider range of customers. In other words, a successful firm might find itself trapped to its existing business base preventing the needed adaptation for a long term and sustained profitability.Success could be your worst enemy.
MANAGERIAL USES OF THE EXPERIENCE CURVE
Diagnosis of the Industry Cost Structure
A critical assessment pertaining to the industry cost structure is the determination of the experience curve relevant to each one of the competitors in the industry. In the case where a single experience curve is common to everybody, the market share position of each competitor is crucial in assessing their corresponding strength. When this is not the case, the proper identification of the stages of value added and the different technologies in use could provide invaluable insights for the strategic positioning of an existing business in that industry, or for a new entrant in an established but stagnant industry. This might explain highly successful strategies such as the entry of Phillip Morris with Miller Light into the beer industry. Normally, entry into an aging industry is regarded as a highly unnatural and unproductive strategy. The success of Phillip Morris, however, was due to a coherent integrated set of strategies which included: heavy investment in new, modern, and efficient production facilities;introduction of an innovative product with high potential market; and impressive marketing and distribution support. The final effect of this approach was to position Phillip Morris in a completely different experience curve than each one of its competitors. The entry of Procter and Gamble into the paper towel business against Scott Paper illustrates the need to identify market share by stages of value added. If market share, and therefore accumulated experience, would only be measured by the products sold to the final consumer, one would have concluded that Procter and Gamble had nothing to do in that business. The strong dominance of Procter and Gamble at the marketing and distribution stage of value added, however, allowed them to start with a position much stronger than otherwise anticipated. It is this kind of strategic positioning that has permitted Procter and Gamble to enter late in many other consumer-product markets, without apparently having much of a disadvantage in its cost structure.
Very often high technology firms, where experience plays a fundamental role, have to bid for contracts which, if accepted, would displace them significantly to the right of the experience curve, thus affecting the cost of the units produced. In those cases, it is essential to forecast these cost projections so that the bids will incorporate the cost reduction effects. If the bid were to be accepted, the firm would now face the imperious need to use those projections, which constituted the base for cost estimates, as a control mechanism. The actual cost being realized would then be plotted in the experience curve charts against the original estimates to detect whatever deviation might be taking place. They would call for immediate managerial attention to correct potential lack of productivity in critical areas.
The Selection of a Generic Strategy
Michael Porter [1980] has advocated three major generic strategies to be considered by a firm to identify the position of a given business. The first strategy aims at cost leadership, which can only be sustained if the firm is able to achieve lower costs than any of its competitors. The strategy represents the essence of exploiting the experience curve effects. The second generic strategy seeks for differentiation and the basic goal is to attempt to position, in a given business, in a particular way that provides a distinctive thrust over the firm's competitors, aimed at achieving a prominence in the overall industry where the business is placed. The third basic generic strategy consists of targeting a particular market segment where the firm can develop a distinctive strength. Strategy is basically aimed at securing a long-term sustainable advantage in a competitive market. The three generic strategies discussed above attempt to pursue that goal in quite distinct ways. The justification for this positioning can be understood after recognizing the U-Shape effect that is observed in the behavior of profitability of firms competing in some industrial sectors [See Figure 6.13]. The message that emerges from the observation of this curve indicates that if a firm can achieve a certain level of sales that allows the exploitation of the full benefits of the experience curve, strategies leading toward cost leadership could truly pay off. If this is not the case, two basic alternatives are still open, one leading toward unique differentiation, where the firm can enjoy a price-premium based on the special character of products offered, and the other is to resign to compete in the overall industry and find a niche by targeting the output of the firm to a particular market. The worst alternative is to find oneself in the lower end of the U-curve with no cost advantage and no distinctive value to offer.
The experience curve with its implicit message for the benefits to be attained by increased volume of production is still valid and relevant. A blind and narrow pursuit of seeking cost reductions by simply accumulating experience, however, could lead to an unexpectedly adverse position in the market place.
CHAPTER 7 : THE USE OF THE GROWTH-SHARE MATRIX IN STRATEGIC PLANNING
A decisive impulse for strategic planning activities came from the ideas promoted by the Boston consulting Group [BCG] in the late 1960s [Henderson 1973, 1979]. The essence of the BCG approach is to present the firm in terms of a portfolio of business, each one offering a unique contribution with regard to growth and profitability. The firm is then viewed not just as a single monolithic entity, but as composed by many largely independent units whose strategic directions are to be distinctively addressed. Our presentation follows closely Hax and Majluf [1983]. In order to visualize the particular role to be played by each business unit, BCG developed the growth-share matrix, in which each business is plotted on a four-quadrant grid, like the one shown in Figure 7.1. The horizontal axis corresponds to the relative market share enjoyed by a business, as a way of characterizing the strength of the firm in that business. The vertical axis indicates market growth, representing the attractiveness of the market in which the business is positioned. The area within each circle is proportional to the total sales generated by that particular business. There are three basic insights a manager can gain from the growth-share matrix. First, the graphical display provides a powerful and compact visualization of the strengths of the portfolio of businesses of the firm. Second, it is a mechanism to identify the capability for cash generation as well as the requirements of cash for each business unit, and thus it contributes to assist in balancing the firm cash-flow. And third, because of the distinct characteristics of each business unit, it can suggest unique strategic directions for each business.
MEASURING THE EXTERNAL ATTRACTIVENESS OF THE MARKET
The market-growth rate, which is plotted in the vertical axis of the matrix, is used as a proxy to identify the external attractiveness of the market for each one of the firm's businesses. This measure is based on historical data providing a static picture of the corporation in the last year. For example, at the end of 1982 the market growth rate is measured as follows: Market growth rate 1982 = {[total market 1982 - total market 1981]/Total market 1981} x 100 This indicator provides a measure of attractiveness for the total industry irrespective of the position a given firm might have in it. The rationale for its selection stems from the business life-cycle concept, which postulates that a business follows, throughout its entire life, a process of evolution characterized by four stages identified as embryonic, growth, maturity, and aging, as shown in Figure 7.2. There are other factors besides market growth that can assist in positioning a given business in its life cycle. Nonetheless, the growth rate is a key indicator to describe the external attractiveness of that business. This concept has enormous implications for strategic planning. When the whole industry is growing at a very high rate, it is possible for a firm to penetrate aggressively in that industry and significantly increase its market share, without necessarily eroding the total sales of its competitors. Actual sales will continue to grow for the majority of the key competitors in that industry, thus providing a comfortable feeling to them, without realizing that they may be losing participation in those markets. For a mature or aging business, however, it is no longer possible to gain market share without decreasing the dollar sales of a competitor. Managing a firm in a slow-growth economy is a difficult task. Further implications of the life-cycle curve for strategic planning have been extensively developed by Arthur D. Little, Inc., which has proposed its own portfolio matrix based on the stages of the business life-cycle [Osell and Wright 1980]. This methodology is presented in Chapter. 9 The next step required to position a business in the growth-share portfolio matrix is the selection of a cut off point to separate high growth from low growth businesses. In figure 7.1, that cut off point is arbitrarily set up at 10%. How is cut off point selected in practice ? Whenever all the businesses of the firm belong to the same industry, the decision is straightforward. The cut off point is selected as the average growth for that industry. When businesses are above the cut off point, they are in the embryonic or growth stage, while if they are below it, they are in the maturity or aging stage. In highly diversified firms, where there is no industry commonality, one might select a measurement of the overall economy growth, such as GNP growth, if the business are all conducted within a given country. Otherwise, a weighted average of the growth rate of each individual business seems to be a logical selection. Occasionally, it is legitimate and convenient to set up as a cut off point a corporate growth target, which will separate those businesses which are positively contributing to the realization of the target from those which are detracting from it. Notice that if market-growth is expressed in deflated dollars, the cut off point should measure the real growth of either the industry, economy, or corporate target. If nominal market-growth rates are used, the definition of the cut off point should also involve nominal values.
MEASURING THE INTERNAL STRENGTH OF THE BUSINESS
At first sight, market share seems to be logical selection to identify the business strength in a competitive environment. What would you say, however, about a firm that in given business conducts a 10% market share? Is the firm strong or weak ? The answer to that question depends on the nature of the fragmentation of the industry in which that business is placed. If the industry were pharmaceutical, most likely the firm would have an extraordinarily strong competitive position; however, if it were the the U.S automobile industry, that firm would be about to collapse. This type of reasoning led to the adoption of relative market share as a measure for the internal strength of a given business. Going back to our 1982 example, relative market share is defined as follows: Relative Market Share 1982 = [Business Sales 1982]/[Leading Competitor's sales 1982.] Notice that this quantity is not expressed as a percentage. It indicates the number of times the sales of a business exceed that of the most important competitor; for example, a relative market share of 2 means that business sales are two times larger than sales of the most important competitor , while a relative market share of 0.5 means that the business sales are only half as much as those of the leading competitor. Moreover, as it can be depicted from Figure 7.1., the relative market share positioning of each business is plotted in the growth-share matrix in a semi-log scale. The reason for this selection is that market share is linked to accumulated volume, and this in turn is related to the experience curve. The decline of costs resulting from the experience curve effect follows a linear relationship when plotted in a semi-log scale. The strategic implications of the experience curve were analyzed in Chapter 6. Briefly stated: Higher Higher Lower Higher Market Share Accumulated Unit Costs Profitability Volume The growth-share matrix requires the identification of a cut off point to separate between businesses of high and low internal strength. It should come as no surprise, after recalling Henderson's rule of three and four discussed in Chapter 6 and presented in Henderson [1979], that in its initial proposition BCG selected a relative market share of 1.0 to perform this distinction. This implies that only being the market leader [that is, having a relative market share greater than one], can carry significant strength. Moreover, as is apparent from Figure 7.1, the basic cut off line has been drawn at a relative market share of 1.5, because only by enjoying that kind of competitive advantage, a firm can truly exercise a significant dominance in a business.
MEASURING THE CONTRIBUTION OF EACH BUSINESS UNIT TO THE FIRM
Besides positioning a business in terms of its industry attractiveness and competitive strength, there is a third parameter that is used in the growth-share matrix to characterize the portfolio of the firm. This parameter is the contribution of the business to the firm, which is measured in terms of sales, and is represented by the area within the circles in the matrix in Figure 7.1 Sales is preferred as a measure of contribution, because it provides an easier comparison standard against the portfolio of the firm's competitors.
CASH-FLOW IMPLICATIONS OF THE GROWTH-SHARE MATRIX
The businesses in each quadrant have distinctive characteristics with regard to cash flow:
1] THE STARS: They generate large amounts of cash, because of their successful status, but at the same time, require a significant inflow of cash resources if the firm wants to sustain its competitive strength in that rapidly growing market. As a result, the final excess of cash contributed to or the deficit required from the overall organization is relatively modest.
2] THE CASH COWS: These businesses are the central sources of cash for the organization. Because of their extremely high competitive strength in a declining market, they generate more cash than they can wisely reinvest into themselves. Therefore, they represent a source of large positive cash that could be available to support the development of other businesses within the firm. Incidentally, this fact clearly corroborates that, ultimately, the resource allocation process has to be centralized at a higher managerial level in the organization. Otherwise, the manager of a cash cow will tend to reinvest the proceeds of its business in its own domain,suboptimizing the uses of its resources.
3] THE QUESTION MARKS: These businesses correspond to major untapped opportunities, which appear as very attractive because of the high market-growth rate they enjoy. The firm, however, has not achieved a significant presence in the corresponding market. A decision is called for selectively identifying among them those businesses that can be successfully promoted to a leading position. This is a key strategic decision in this planning approach that carries with it the assignment of large amounts of cash to a business, because reaching a leading position in a rapidly growing market requires committing important cash resources. At the same time, the firm might be ready to admit that its internal strengths are not appropriate for advancing a business, in spite of its high degree of attractiveness, because of the characteristics of the competitors the firm faces. This would call for the toughest of decisions: An admission that the best course of action to follow is to withdraw or liquidate.
4] THE DOGS: These businesses are clearly the great losers: unattractive and weak. They are normally regarded as "cash Traps", because whatever little cash they generate is needed for maintaining their operations. If these is no legitimate reason to suspect a turnaround in the near future, the logical strategy to follow would be harvesting or divesting.
SUGGESTIONS FOR STRATEGIC POSITIONING
The primary objectives of the corporation, which are implicit in the conceptualization initially done by BCG, are growth and profitability [Henderson and Zakon 1980]. The argument is that the fundamental advantage that a multibusiness organization possesses is the ability to transfer cash from those businesses which are highly profitable, but have a limited potential for growth, to those which offer attractive expectations for a sustained future growth and profitability. This philosophy leads to an integrative management of the portfolio that will make the whole larger than the sum of the parts. For this synergistic result to be obtained, a fairly centralized resource allocation process would be required which would produce a balanced portfolio in terms of the generation and uses of cash. Another contribution of BCG, besides the balanced portfolio idea, resides in their selection of market share to express the basic strategic positioning desired for each business. They chose to identify four major strategic thrusts in terms of market share: - Increase market share - Hold market share. Harvest. - Withdraw or divest. Although the realization of these strategic thrusts would demand spelling out the content of multifunctional programs for each business, it is unarguable that the thrusts expressed in terms of market share reveal the basic message for the desired positioning of a business in a competitive environment. This way of articulating the strategic thrust in terms of market share has been adapted by most of the alternative methodologies for portfolio analysis.
FURTHER REFINEMENTS FOR THE ANALYSIS OF A PORTFOLIO OF BUSINESSES USING THE GROWTH-SHARE MATRIX
Measuring the Historical Evolution of the Growth-Share Positioning
One could argue that the graphical representation of the growth-share matrix described so far provides just a static snapshot of the business portfolio of a firm ignoring the historical trends of those businesses. We will now address this concern. A very powerful tool that has been used to understand the implicit or explicit strategies of a firm is depicted in Figure 7.6 in the so-called "Share-Momentum Graph" [Lewis 1977]. The graph is constructed by picking a relevant time-frame, say five years, and by plotting the position of each business unit in terms of two dimensions: the total market growth for that period and the growth rate of sales for that business unit for the same period. These values should be defined consistently either in nominal or real terms. As before, the area within each circle is proportional to the total sales of each business for the lasts year of the chosen period. Those businesses falling in the diagonal have growth at exactly the same rate as the industry, and therefore, the firm has been able to hold market share during the period of analysis. Businesses falling below the diagonal have increased their sale at a rate higher than their respective markets. Such is the case of businesses A,B and C in Figure 7.6. Obviously, this can only happen if those businesses have increased market share over the last five years. The opposite is true for businesses falling above the diagonal, such as businesses D and E in the same figure. The implications of this chart are straightforward but yet quite revealing. It is entirely possible that a business in a high growth industry experiences a gain in net sales during the year while losing market share. If managers are not cognizant of this fact, they might feel quite proud of their historical performance, ignoring the grave consequences of their decline in competitive strength. Thus the chart provides a meaningful diagnostic tool to detect the observable trends in the growth-share positioning of their businesses, and in verifying the degree of consistency that might exist between the historical trend and the intended strategic positioning of the business. Another use of the share-momentum chart is to apply it not only to our own firm but also to all our key competitors. The information required to develop this chart for all key competitors is basically the same information used to put together the original growth-share matrix; that is, total market figures and competitors' sales information. By properly analyzing the share-momentum chart for each competitor, we end up with a valuable intelligence with regard to their strategies. This information could reveal areas of vulnerability of key competitors that can be advantageously exploited, or areas with unsurmountable barriers for a firm to penetrate them. A different approach to capture the dynamic nature of a portfolio is to use the original gorwth-share matrix to portray the historical movements of each business unit through a sequence of time periods [see Figure 7.9]. We have found this tool not to be as effective as a share-momentum chart, because of the erratic variations that often are observed in a yearly analysis, and the clumsiness of the resulting chart when a five year time frame is represented in it. Also the cut-off point to separate high from a low market growth tends to change-each year. This could be remedied by simply using an average growth rate for the five year period; however, such an average might distort the final representation of the portfolio by hiding important clues for strategic analysis which are only revealed by the yearly representative of data. An illustration of this approach is described in Hax and Majluf [1978].
A concept developed by Zakon [1976], the maximum-sustainable growth, pointed to a critical dimension of the growth objective of the firm. It represents the maximum growth that the firm can support by using its internal resources as well as its debt capabilities. Expressed in very simple terms, Zakon derived the following formula for the maximum-sustainable growth: g = p.[ROA + D/E (ROA -i)] Where: G= maximum-sustainable growth, expressed as a yearly rate of increase of the equity base. p = percentage of retained earnings. ROA = after-tax return on assets. D = Total debt outstanding E = Total equity. i = After-tax interest on debt. This formula is derived through the following steps. Total assets are computed as total debt plus total equity as indicated below: A = D +E. Therefore, after-tax profits may be computed as: II = (D + E). ROA - D.i. An equivalent expression for it is. II = E.ROA + D (ROA - i). The maximum growth of equity depends on the amount of retained earnings.Assuming that p is the retention ratio [equal to retained earnings over total earnings] and that g is the growth of equity, we can establish the following: g = p.II/E = p.[ROA + D/E.(ROA -i)]. If we assume that the debt-equity ratio remains constant, and that the increment of equity will be followed by a similar increment of debt, we can conclude that the expression above corresponds to the actual growth of total assets under the stated conditions. The expression just derived represents a first cut and gross approximation of the maximum-sustainable growth that assumes a stable debt-equity ratio and dividend-payout policy, as well as a fixed overall rate of return on assets and cost of debt. Although a coarse approximation, this number might represent a guidance for corporate growth that should be taken into consideration at a corporate level. There are many variations of alternative expressions for the maximum-sustainable growth. Our aim has been to present the simplest of those expressions, so as to stress the underlying concept which is that a firm faces an upper bound in its objectives for future growth when the financing policy does not consider the issuing of new shares.
THE HIERARCHICAL NATURE OF THE APPLICATION OF THE GROWTH-SHARE MATRIX
The growth-share matrix is primarily intended to analyze a portfolio from a corporate perspective. It is only at that level where the fundamental message of cash balance is meaningful. However, it is perfectly legitimate to continue the segmentation of a business further in the organizational hierarchy as a diagnostic tool to understand the different positioning of individual product lines or market segments belonging to a given business see figures 7.10 ,7.11. Another important segmentation which is crucial to multinational firms is to position a business unit across the various countries it serves. Normally, the most puzzling and difficult issue to be resolved by a business manager in a multinational setting is to deal with the complexities posed by contradictory positions of a given business in various countries. Using the BCG terminology, what could be a Star in the U.S. might be a Cash Cow in Colombia, A Dog in Germany, and a Question Mark in Saudi Arabia. It is a nontrivial matter to come out with coherent international strategy under that situation see figure 7.12.
A CRITIQUE OF THE BCG APPROACH
An Issue of Nomenclature
A common complaint about the approach popularized by BCG is the selection of labels that were used to classify the positioning of the various businesses of the firm.
The Reliance on Market Definition
We indicated in Chapter 6 that it could be a severe pitfall to measure the performance and, therefore, the competitive strength of the firm, on the achieved market-share at the end of the value added chain. The question of shared resources among various businesses at each functional level cannot be ignored. This issue is not addressed by measuring market share at the consumer end. For the growth-share matrix to provide a clear representation of the profitability and competitive strength of each business, it is mandatory that each of the business units portrayed in the matrix are totally independent and autonomous. If this is not the case, we might face misleading representations; that is, Dogs, which are very healthy, Cash Cows which have no milk, Question Marks which are not questionable, and Stars which are not shining. Obviously, managing a business portfolio cannot be reduced to such a simplistic formula. BCG never intended its tool to be applied so naively. Another important issue has to do with the definition of the proper market in which a business competes. Relative market share is an index that compares a business's strength in relation to a competitor's. This introduces subtle issue concerning the definition of the market we use as a yardstick to measure the business position. There are two traps that one could fall into: one is to define the market so narrowly that we will end up invariably as the leader of the segment; the opposite is to define it so broadly that the business is unrealistically represented as weak. A proper market definition is, as we said before, a very subtle issue. It is unfortunate that this approach to business analysis rests so heavily on such an imponderable matter.
Validity of the Indicators Needed to Measure Internal Strength and Market Opportunities
There are two separate issues that one could raise in terms of the indicators used in the growth-share matrix for positioning the different business units. The first one relates to the causality of the measurements selected to identify profitability and growth. Is market share really a major underlying factor determining profitability? Is industry growth really the only variable that can fully explain growth opportunities? Certainly, these are questions subject to a great deal of debate. The second but related objection to the indicators selected in this approach is that a true portfolio positioning should attempt to identify the competitive strengths and the industry attractiveness of each business unit. All portfolio representations offered as alternatives to the growth-share matrix depart from this approach by establishing that these two dimensions cannot be grasped by a single measurement, but are the composite result of a wider set of critical factors which need to be identified and assessed prior to producing a final positioning of the business units.
A Challenge to the Basic Premises of the BCG Approach
Marakon, a management consulting company, has presented a theoretically better grounded approach for strategic investment planning, which represents a significant challenge to the conclusions derived from the growth-share approach. Marakon's views can be summarized in the following three statements [Marakon 1980]: - Growth and profitability are not generally tightly linked. In fact they tend to compete or tradeoff. - Good planning should not call for passing up profitable investment opportunities. - Ideal business portfolios are not necessarily balanced in terms of internal cash flows] Please see figure 7.14. 7.15 and 7.16. We will now briefly analyze these three statements: The fact that growth and profitability tend to compete can be easily seen from the implications in Figure 7.14, where return on investment [ROI], a well-accepted measurement of profitability, is plotted against business growth to describe the investment options available to a given business unit. The horizontal cut-off line represents the business-unit cost of capital. Any investment option that falls above the line implies an attractive investment opportunity. The vertical cut-off line identifies the market growth rate for that business unit. A strategy that falls on that line corresponds to a holding market-share strategy; one to the left of the line implies a decreasing market-share strategy; one to the right of the line implies an increasing market-share strategy. As can be seen from the figure, a decreasing share strategy should be much more selective in the acceptance of its investment projects, thus leading to a higher ROI. Contrarywise, an increasing share strategy would have to accept more marginal projects, thus reducing the resulting ROI. This represents the profitability-growth tradeoff alluded to by Marakon. Sound financial principles would suggest that a firm should accept all projects above its cost of capital. This will favor the increasing share strategy depicted in Figure 7.14, regardless of the position of the business in the growth-share matrix. The second statement of Marakon - that a firm should not pass up profitable investment opportunities - is directly linked to the previous argument. More formally, it is supported by the so-called additivity principle which states that every investment opportunity should be judged on its own merits and should be accepted or rejected depending on whether its projected return on investment falls above or below the cost of capital associated with that investment opportunity. In other words, there are not magic financial synergisms. The value of the firm is simply equal to the sum of the values of its components. To explain the third statement of Marakon - that ideal portfolios are not necessarily balanced - it is useful to understand first the implications of cash generation and cash use in terms of the profitability and growth dimensions. Figure 7.15 provides a valuable insight into this question. The vertical axis corresponds to the ROE earned by a given business and the horizontal axis represents the corresponding business equity growth. A business placed in the diagonal is growing at the same rate of its ROE, and neither generates cash to or requires cash from the firm: it is a cash-neutral business. Similarly, businesses above the diagonal are cash generators and those below the diagonal are cash users. The understand this line of reasoning, consider that the total equity investment in the business is E and the earnings generated are II. By the definition of return on equity [ROE], we can state that: II = E. ROE. If we apply all earnings to the same business in order to tap new investment opportunities, the business growth as measured by the growth of the total investment is: g = II/E. This ratio is precisely the ROE of the business. Therefore, we can assert that a business growing at the same rate of its ROE is cash neutral from the corporate perspective. We can see that there can be good businesses [that is, businesses that earn more than the cost of capital] that generate cash [for example, business A], while others require cash [for example, business D]. Similarly, cases depicted as B and E are examples of poor businesses that generate and require cash, respectively. The final message become clear in Figure 7.16. We can observe that a highly profitable portfolio may well be out of cash balance, while a rather poor portfolio may be perfectly balanced. The profitability matrix and its implications for strategic planning are comprehensively discussed in Chap;ter 10.
THE NEW BCG APPROACH: A STRATEGY FOR THE EIGHTIES
We would like to conclude this chapter by describing briefly the new matrix advocated by BCG in response to the misleading use of the growth-share matrix, as well as to the changing nature of the competitive environment faced by business firms. Commenting on the 1981 BCG Annual Perspective, Lockridge expresses: In the 1970's, high inflation coupled with low growth, increased competition in the traditional fields, added regulation, and dramatic growth in international trade, again changed the rules of the game. Strategies in pursuit of market share and low-cost position alone met unexpected difficulties as segments specialists arose and multiple competitors reached economies of scale. The most successful companies achieved their success by anticipating market evolution and creating unique and defensible advantages over their competitors in the new environment. To characterize this new environment, BCG proposes a new matrix following two different dimensions: The size of the competitive advantage, and the number of unique ways in which that advantage can be achieved. The resulting matrix and the new four-quadrant grid is shown in 7.17, where four categories of businesses are recognized: Volume, Stalemate, Fragmented, and Specialization. It is only in the volume business where the previous strategies of market-share leadership and cost reduction are still meaningful. In this category, one would continue to observe a close association between market-share and profitability, as shown in Figure 7.18. A typical example of this industry would be the American automobile prior to the emergence of foreign competitors. The Stalemate businesses are in industries where profitability is low for all competitors and it is not related to the size of the firm. The difference between the most profitable and the least profitable firm is relatively small [see Figure 7.18]. The American steel industry provides an illustration of this category. The profitability of business in the Fragmented category is uncorrelated with market share [see Figure 7.18]. There are poor performers which are both large and small firms, and there are good performers also independent of size. Their performance depends on how the firm exploits the very many ways to achieve a competitive advantage. A typical example in this category would be restaurants. Finally, the specialization category shows that the most attractive profitability is enjoyed by the smallest businesses which are able to distinguish themselves among their competitors by pursuing a focused strategy [see Figure 7.18]. The Japanese automobile manufacturers pursue that strategy for entering the American automobile industry. It is our interpretation of this matrix that the horizontal axis, pertaining to the size of the advantage, is definitely linked to the barriers of entry, because it is only with high barriers that a firm could sustain a long term defensible advantage over its competitors. Likewise, the number of approaches to achieve advantages seems to be strongly linked to the issue of differentiation. At the extremes of the differentiation range we encounter the commodity and specialty products.
The growth-share matrix made a major contribution to strategic thinking. It was particularly useful to support managerial decisions during the sixties and early seventies, when the U.S economy was still exhibiting a reasonably healthy growth. These days, a naive use of the matrix could lead to inappropriate and misleading strategic recommendations.
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