The use of decision-making techniques to enhance performance is a core area of the syllabus.
This chapter explains three models that could well be tested as a part of a longer question. You could also be asked to discuss problems in performance measurement, as part of a question. This is likely to be in response to a scenario given in a question.
Exam Focus Point
In the past, examiners have commented on how students do not answer the question set. A common fault is candidates writing all they know on a particular topic without applying that knowledge to the question set. You must make sure that you know the material in this chapter well so that you can select which models to evaluate when answering a question. This advice also applies in deciding what problems to discuss when considering a scenario that you are given to analyse
STRATEGIC MODELS USED IN PLANNING AND ASSESSING BUSINESS PERFORMANCE
In this section, we review three strategic models that aid the formulation of strategy and the appraisal of business performance. Each model looks at a different aspect of the business environment in which a business operates.
- Porter’s Five forces considers the sources of competition in an industry or sector.
- The Boston Consulting Group matrix helps management assess products, services and strategic business units in terms of their market potential. This is measured in terms of market share and market growth and can therefore suggest the attractiveness of entering or remaining in an industry or sector.
- The Ansoff growth vector matrix uses a matrix consisting of new or existing products and/or markets to generate possible strategies to use to achieve growth.
Remember that the models are useful but they have limitations. Some of these are mentioned below so bear these in mind when you evaluate their usefulness in performance management and apply them to particular scenarios.
Porter’s Five Forces Model
Porter’s Five Forces Model suggests the importance of pressure from five competitive forces on profit.
- Threat of new entrants (which will be affected by barriers to entry and expected reaction from existing firms).
- Threat of substitutes (which will be determined by the level of innovation of existing producers, the ability of existing competitors to finance responses to the threat and the propensity of buyers to substitute).
- Bargaining power of buyers (which will be linked to the number of buyers).
- Bargaining power of suppliers (supplier power and the impact on costs being greater when there are fewer of them).
- Rivalry between existing competitors (the strength of rivalry being determined by number of competitors, market power, brand identity, producer differences cost structure and so on).
The threat of new entrants (and barriers to entry to keep them out)
A new entrant into an industry will bring extra capacity and more competition. The strength of this threat is likely to vary from industry to industry and depends on two things.
- The strength of the barriers to entry. Barriers to entry discourage new entrants.
- The likely response of existing competitors to the new entrant.
Barriers to entry
- Scale economies. High fixed costs often imply a high breakeven point, and a high breakeven point depends on a large volume of sales. If the market as a whole is not growing, the new entrant has to capture a large slice of the market from existing competitors. This is expensive (although Japanese companies have done this in some cases).
- Product differentiation. Existing firms in an industry may have built up a good brand image and strong customer loyalty over a long period of time. A few firms may promote a large number of brands to crowd out the competition.
- Capital requirements. When capital investment requirements are high, the barrier against new entrants will be strong, particularly when the investment would possibly be high-risk.
- Switching costs. Switching costs refer to the costs (time, money, convenience) that a customer would have to incur by switching from one supplier’s products to another’s. Although it might cost a consumer nothing to switch from one brand of frozen peas to another, the potential costs for the retailer or distributor might be high.
- Access to distribution channels. Distribution channels carry a manufacturer’s products to the end-buyer. New distribution channels are difficult to establish, and existing distribution channels hard to gain access to.
- Cost advantages of existing producers, independent of economies of scale include:
- Patent rights
- Experience and know-how (the learning curve) (iii) Government subsidies and regulations
Favoured access to raw materials
A little while ago, it was assumed that, following the success of Japanese firms worldwide in motor vehicles (Nissan, Honda, Toyota) and consumer electronics (e.g. Sony, JVC, Matsushita), no Western companies were safe from Japanese competition. Kao (household goods), Suntory (drinks), Nomura (banking and securities) were seen as successors to firms such as Procter and Gamble and Heineken.
This has not happened: for example, Japanese pharmaceutical firms, such as Green Cross, have not achieved the world domination (anticipated in 1982). US and European firms are still dominant in this industry.
Perhaps cars and consumer electronics are the exception rather than the rule. The reason for this might be distribution. Normally, outsiders do not find it easy to break into established distribution patterns. However, distribution channels in cars and consumer electronics offered outsiders an easy way in.
- The car industry is vertically integrated, with a network of exclusive dealerships. Given time and money, the Japanese firms could simply build their own dealerships and run them as they liked, with the help of local partners. This barrier to entry was not inherently complex.
- Consumer electronics
- In the early years, the consumer electronics market was driven by technology, so innovative firms such as Sony and Matsushita could overcome distribution weaknesses with innovative products, as they had plenty to invest. This lowered entry barriers.
- Falling prices changed the distribution of hifi goods from small specialist shops to large cut-price outlets. Newcomers to a market are the natural allies of such new outlets: existing suppliers prefer to shun ‘discount’ retailers to protect margins in their current distribution networks.
Japanese firms have not established dominant positions in:
- Healthcare, where national pharmaceuticals wholesalers are active as ‘gatekeepers’
- Household products, where there are strong supermarket chains
- Cosmetics, where department stores and specialist shops offer a wide choice.
Entry barriers might be lowered by the impact of change:
- Changes in the environment
- Technological changes
- Novel distribution channels for products or services
The threat from substitute products
A substitute product is a good or service produced by another industry which satisfies the same customer needs.
The major supermarket chains in the UK are all able to provide substitutes for most of the products stocked by the other chains. This means that they must keep prices competitive with each other.
Supermarkets have also expanded into products offered by specialist retailers such as electrical goods and books. This means these retailers also have substitutes for their products and must keep their prices linked to those of the supermarkets for equivalent products.
The bargaining power of buyers
Customers want better quality products and services at a lower price. Satisfying this want might force down the profitability of suppliers in the industry. Just how strong the position of customers will be depends on a number of factors.
- How much the customer buys
- How critical the product is to the customer’s own business
- Switching costs (i.e. the cost of switching supplier)
- Whether the products are standard items (hence easily copied) or specialised
- The customer’s own profitability: a customer who makes low profits will be forced to insist on low prices from suppliers
- Customer’s ability to bypass the supplier (or take over the supplier)
- The skills of the customer purchasing staff, or the price-awareness of consumers
- When product quality is important to the customer, the customer is less likely to be price-sensitive, and so the industry might be more profitable as a consequence
The market for high end jewellery is one where the customer is concerned with quality ahead of price. Customers do set themselves price limits but they are more concerned with reputation and the implied worth to the recipient of the jewellery.
The bargaining power of suppliers
Suppliers can exert pressure for higher prices. The ability of suppliers to get higher prices depends on several factors.
- Whether there are just one or two dominant suppliers to the industry, able to charge monopoly or oligopoly prices
- The threat of new entrants or substitute products to the supplier’s industry
- Whether the suppliers have other customers outside the industry, and do not rely on the industry for the majority of their sales
- The importance of the supplier’s product to the customer’s business
- Whether the supplier has a differentiated product which buyers need to obtain
- Whether switching costs for customers would be high
De Beers and the diamond trade
De Beers established a near monopoly over the supply of diamonds to the diamond trade from the 1930’s the beginning of the 21st century. During the twentieth century, De Beers sold between 85% and 90% of the diamonds mined worldwide. Diamond dealers traditionally had to source their rough diamonds from De Beers. Prices were kept high and supply was rationed. In fact, diamonds are not rare as there are diamond mines in many countries including Canada and Australia.
In July 2004 De Beers pleaded guilty in a US court to price fixing and had to pay a $10m fine. One rival, the Lev Leviev Group, decided to invest in its own diamond mining operations, thereby bypassing De Beers entirely.
Source: various including BBC website
The rivalry amongst current competitors in the industry
The intensity of competitive rivalry within an industry will affect the profitability of the industry as a whole. Competitive actions might take the form of price competition, advertising battles, sales promotion campaigns, introducing new products for the market, improving after sales service or providing guarantees or warranties. Competition can stimulate demand, expanding the market, or it can leave demand unchanged, in which case individual competitors will make less money, unless they are able to cut costs.
Factors determining the intensity of competition
- Market growth. Rivalry is intensified when firms are competing for a greater market share in a total market where growth is slow or stagnant.
- Cost structure. High fixed costs are a temptation to compete on price, as in the short run any contribution from sales is better than none at all. A perishable product produces the same effect.
- Switching. Suppliers will compete if buyers can switch easily (e.g. Coke vs. Pepsi).
- Capacity. A supplier might need to achieve a substantial increase in output capacity, in order to obtain reductions in unit costs.
- Uncertainty. When one firm is not sure what another is up to, there is a tendency to respond to the uncertainty by formulating a more competitive strategy.
- Strategic importance. If success is a prime strategic objective, firms will be likely to act very competitively to meet their targets.
- Exit barriers make it difficult for an existing supplier to leave the industry. These can take many forms.
- Non-current assets with a low break-up value (e.g. there may be no other use for them, or they may be old)
- The cost of redundancy payments to employees
- If the firm is a division or subsidiary of a larger enterprise, consider the effect of withdrawal on the other operations within the group
- The reluctance of managers to admit defeat, their loyalty to employees and their fear for their own jobs
- Government pressures on major employers not to shut down operations, especially when competition comes from foreign producers rather than other domestic producers
Using the five forces model: a caution
The five forces model provides a comprehensive framework for analysing the competitive environment. However, it must be used with caution. It’s very comprehensiveness can encourage a feeling of omniscience in those who use it: a sense that all factors have been duly considered and dealt with. Unfortunately, no one is actually omniscient. Any analysis must pursue as high a degree of objectivity as possible. If there is too much subjectivity, unfounded complacence will result.
The creation in the UK of direct motor insurance selling by Direct Line Insurance is a case in point. Existing motor insurers’ view of the threat from new entrants was that the need to create a distribution network of local agents and brokers was an effective barrier to entry. Direct Line’s centralised call-centre approach simply bypassed the barrier.
The effect of subjectivity appears at an early stage in any analysis using the five forces approach. It is necessary to define with great care just what market or market segment one is dealing with. For a large organisation, or one operating in a complex environment, this may be extremely difficult. BPP’s provision of classroom training in accountancy is a good example. The market for training for potential chartered accountants is subject to considerable customer bargaining power, since there are a few large firms that predominate. ACCA and CIMA courses, on the other hand, are more subject to the rivalry of existing competitors, since, as well as other commercial training providers, universities and local technical colleges are also sources of competition.
The need for careful analysis is, perhaps, most demanding in the area of substitute products or services. It takes a particular alertness to discern potential substitutes in the early stages of their development.
Boston Consulting Group (BCG) Portfolio matrix
The BCG portfolio matrix provides a method of positioning products through their life cycles in terms of market growth and market share.
- Stars are products with a high share of a high growth market. In the short term, items require investment in excess of the cash they generate in order to maintain their market position, but promise high returns in the future.
- In due course, however, stars will become cash cows, with a high share of a low growth (mature) They require very little investment and generate high levels of cash income. The important strategic feature of cash cows is that they are already generating high cash returns, which can support the stars.
- Question marks are competitive products with a low share of a high growth market. They have the potential to become stars but a question mark hangs over their ability to achieve sufficient market retention to justify further investment.
- Dogs are products with a low share of a low growth market. They should be allowed to die, or be killed off.
The matrix must be managed so that an organisation’s product range is balanced. Four basic strategies can be adopted.
- This involves increasing the market share, even at the expense of short-term profits. A ‘build’ strategy might be to turn a question mark into a star. A penetration pricing policy (covered in the syllabus for Paper F5 Performance Management) and investment in stabilising quality and brand loyalty may be required.
- This involves preserving market share and ensuring that cash cows remain cash cows. Additional investment in customer retention through competitive pricing and marketing may be required.
- This involves using funds to promote products which have the potential to become future stars or to support existing stars.
- This involves eliminating dogs and question marks which are under performing.
Using the BCG matrix: cautions
- The model is probably too simplistic in the four classifications used. Some divisions or products could fall into more than one category.
- The market is not always easy to define especially if a company operates in a specialist market.
- The model requires the collection of a large amount of data and this can be costly and time consuming.
- The model fails to consider the relationship between divisions or any links between products.
Product-market mix: Ansoff’’s growth vector matrix
The Ansoff matrix identifies various options.
- Market penetration: current products, current markets
- Market development: current products, new markets
- Product development: new products, current markets
- Diversification: new products, new markets
All of these can secure growth.
We mentioned Ansoff’s matrix briefly in Study Unit 20. There we looked at its role in closing the gap found by gap analysis.
Present products and present markets: market penetration Market penetration. The firm seeks to:
Maintain or to increase its share of current markets with current products, e.g.
through competitive pricing, advertising, sales promotion
- Secure dominance of growth markets
- Restructure a mature market by driving out competitors
- Increase usage by existing customers (e.g. ‘airmiles’, loyalty cards)
Present products and new markets: development
- New geographical areas and export markets
- Different package sizes for food and other domestic items
- New distribution channels to attract new customers
- Differential pricing policies to attract different types of customer and create new market segments.
New products and present markets: product development
Product development is the launch of new products to existing markets.
- Product development forces competitors to innovate
- Newcomers to the market might be discouraged
- The drawbacks include the expense and the risk.
New products and new markets: diversification
Diversification occurs when a company decides to make new products for new markets. It should have a clear idea about what it expects to gain from diversification.
- New products and new markets should be selected which offer prospects for growth which the existing product-market mix does not.
- Investing surplus funds not required for other expansion needs. (The funds could be returned to shareholders.)
Closing the profit gap and product-market strategy
The aim of product-market strategies is to close the profit gap that is found by gap analysis. A mixture of strategies may be needed to do this.
It is worth remembering that divestment is a product-market option to close the profit gap, if the business is creating losses.
A related question is what do you do with spare capacity – go for market penetration, or go into new markets. Many companies begin exporting into new overseas markets to use surplus capacity.
The strategies in the Ansoff matrix are not mutually exclusive. A firm can quite legitimately pursue a penetration strategy in some of its markets, while aiming to enter new markets.
CRITICISMS OF PERFORMANCE INDICATORS
Performance measures are open to misinterpretation and manipulation. You need to be aware of this when you apply these measures.
Non-financial indicators versus financial measures
If performance measurement systems focus entirely on those items that can be expressed in monetary terms, managers will concentrate on only those variables and ignore other important variables that cannot be expressed in monetary terms.
For example, pressure from senior management to cut costs and raise productivity will produce short-term benefits in cost control but, in the long term, managerial performance and motivation are likely to be affected. Labour turnover will increase and product quality will fall.
Reductions in cost can easily be measured and recorded in performance reports. Employee morale cannot. Performance reports should therefore include not only financial measures but other important variables too, to give an indication of expected future results from current activity. The wider implications for the organisation of achieving a particular indicator should always be considered.
Pursuit of detailed operational goals
A danger of indicators measuring operational performance, especially non-financial indicators, is that managers might be led into pursuing detailed operational goals, becoming blind to the overall objectives that these goals were meant to attain.
Not measuring what is supposed to be measured
Sometimes performance indicators do not actually measure what they are supposed to be measuring.
For example, suppose that an organisation wished to measure the efficiency of its production workforce and used profit margin to do so.
Although profit margin is a key measure of efficiency (the efficiency with which sales have been used to generate profit), the production workforce cannot directly affect the revenue earned. Use of the indicator should therefore be questioned. Or maybe the organisation should instead be measuring the workforce’s productivity.
Manipulating the way in which performance is measured
Suppose a poster in a doctor’s surgery states that the doctor sees 98% of patients punctually. This sounds impressive. But you need to ask how ‘punctually’ has been defined. It could be that punctual means the patient was seen within ten minutes of the appointment time. You should also consider whether such a statement was based on the experience of all patients, or whether a sample was used. And if a sample was used, could it be biased? What if the doctor cut short the appointments of those patients he knew not to be in the sample in order to ensure those patients in the sample were seen on time.
- Porter’s Five Forces Model suggests the importance of pressure from five competitive forces on profit.
- The BCG portfolio matrix provides a method of positioning products through their life cycles in terms of market growth and market share.
- The Ansoff matrix identifies various options.
- Market penetration: current products, current markets
- Market development: current products, new markets
- Product development: new products, current markets
- Diversification: new products, new markets All of these can secure growth.
- Performance measures are open to misinterpretation and manipulation. You need to be aware of this when you apply these measures.