In another article, I describe how to strategically analyze an existing company. In this article I describe the main strategic scenarios that a company can face:
- profitability issues
- decide what to do next
- mergers and acquisitions opportunity
- supply/demand issue
This framework is used when we have one of the following problems:
- Decline in price
- Decline in volume sold
- Increase in costs
Profit consists of revenues minus costs. The profit problem can thus be divided into two separate branches: cost and revenue. Revenues and costs can subsequently be segmented into revenues and costs per unit with the total volume of units sold. The branches of this segmentation are given in following image.
For each problem branch (e.g., revenue/unit or number of units sold) one should perform the following steps:
- SEGMENT the number, break it up into its component parts, and compare it to historical metrics to find where the issue is coming from.
- ISOLATE the key driver causing the problem.
- EXPLORE possible solutions.
Possible segments for the revenue to acquire data to explore are Product/Product Line; Distribution Channel; Region; Customer Type (new/old, big/small).
Possible segments for the costs to take into account are Fixed/Variable Costs; Raw Material Costs; Distribution Costs; Customer Costs.
Once the mathematical cause of the problem is understood, one has to understand why that number has declined/increased. This may lead to using the business situation framework described next.
Decide what to do next framework
The business situation framework is applied when facing one of the following questions:
- Should we enter a new market/start a new business?
- Should we introduce new products?
- How can we respond to competitor behavior?
- How can we respond to changes in demand?
- How can we ensure growth?
To address a business situation correctly, one has to take different perspectives into account. The four main perspectives are discussed below, namely, customer, product, company and competition.
Who is the customer?
- Identify segments (segment size, growth rate, % of total market).
- Compare current-year metrics to historical metrics (searching for trends).
What does each customer segment want?
- Identify key needs.
What price is each segment willing to pay?
- Determine price points and price elasticity/sensitivity.
Customer concentration and power
- Does one customer control all the demand, the "Walmart" effect.
The nature of the product
- Think about the product, its benefits, and why someone would buy it.
Commodity goods or easily differentiable goods?
- Could the company increase differentiation?
Identify complementary goods
- Can we piggyback off growth in complements or near complements?
- Are we vulnerable to indirect competitors, namely substitutes?
Determine product life cycle
- New vs. almost obsolete
Determine the packaging strategy
- Packaging can change, making a product more likely to meet the needs of specific customer segments, for example, razor with or without extra blades, with or without a service contract.
Capabilities and expertise
- Are we able to produce what clients want in the right quantity and of the right quality?
- Distribution channels should be adapted for each segment.
- Fixed and variable costs have to be studied and compared to industry norms.
- High fixed costs means a high barrier to entry through higher investment costs.
- The cost structure should be analyzed, especially when a decision involves high investment.
- Factors such as brand loyalty and brand awareness should be analyzed
- This could in some cases help understand poor or high results.
- Are we organized by product line? What is the point of contact for customers?
- Is the team organization in conflict with how customers want to do business?
Competitor concentration and structure
- Our strategy will be different depending on whether we are dealing with a monopoly, an oligopoly, or a competitive market share concentration.
- The segments, products, pricing strategies, distribution channels and brand loyalty of our competitors will influence our strategy.
- Are our competitors doing something that we are not?
Barriers to entry
- Do we need to worry about any new entrants to the market?
- Is the concentration of the market a problem?
- There is the example of Microsoft or Intel in the PC market industry regulatory environment.
- Is there any specific present or future regulation that can affect our market?
Life cycle of the industry
- In which part of the life cycle are we? If we are at the end of the product life cycle, it would be useless to invest in new infrastructure.
Mergers and acquisitions “fit” framework
The mergers and acquisitions framework has to be used when answering the following question:
- Is this merger a good idea?
This framework is particularly useful when, for example, company A is looking to acquire or merge with company B and the two companies are different. The various steps are about the identification of synergies and opportunities for one-way or mutual exploitation. A typical example is one of a company that has a minimal sales force but a high-quality product. This company could find synergies with a company that has an extended commercial network and poor products.
Typical sources of synergy are customers, products, distribution networks, resources, expertise, access to markets, physical assets, unique capabilities and overlapping cost structures.
A simple table like the one illustrated below can be used to depict all the synergies.
It should be noted that this framework does not answer the question of whether it is a good idea to merge/acquire. It assumes that one already knows that it is a good idea and whether this particular target company is a good fit.
To determine if merging/acquiring is a good idea, one can use the capacity expansion framework instead. In the case that company A and company B are identical, one can also use the capacity expansion framework.
The capacity framework is a good approach when facing the following issues:
- Capacity changes through acquisition or merger.
- Capacity is controlled by building/shutting down production lines.
- Capacity shift in response to change in demand.
This framework should only be used when industry capacity is the sole factor. In order to address the problem correctly, one should study the following three parameters: demand, supply and the cost of expansion.
The demand has to be studied with particular focus on the largest sources of demand and the largest growth rate. This should help understand where the majority of demand is coming from.
This can be done by using the following simple steps:
- The growth of the overall market should be detected.
- The growth in the firm’s market share should be studied. Then, for each segment of demand, one should determine:
- each segment’s share of the total demand;
- trends in demand by segment.
The supply potential of the industry has to be depicted and studied for each market segment. The effect of each increase in supply on the final price has to be studied. Factors such as the introduction of technology innovations during a capacity expansion or modernization can increase the productivity and lead to lower marginal costs.
Cost of expansion
The real cost of the investment has to be calculated in order to see if the firm can afford it. Secondly, one should analyze the opportunity cost. This is given by the payback period and by the break-even point.
The alternatives to expansion such as outsourcing, leasing and sub-contract strategies have to be investigated and compared to the cost/benefit of expansion.
Feedback from practice
One should always remember to compare current client year metrics (such as revenues, gross margins, unit sales, pricing, changes in segment mix and product mix) to competitors’ metrics. This will highlight whether an issue is a company-specific or industry-wide problem. Thus:
- Keep drilling down until you isolate the problem.
- If you realize a branch (or sub-branch) is not the problem, come up a level and work the remaining branches.
- When the units sold decline, it is useful to compare the company’s numbers to those of its competitors to determine if it’s an industry-wide or company-specific issue.
- Always compare current metrics to historical ones to identify the trend.
Totals and averages can be very misleading. If you take as an example total sales that are flat in the current year, segment A represents 20% of sales and segment B represents 80% of sales, and, in this case, segment A grew 100% this year and segment B declined by 25%. This shows the importance of segmenting in order to understand the whole picture.
Some possible points of segmentation are:
- Segmentation by revenues
(by product, channel, customer type, region, total revenues, revenue per unit, etc.);
- Segmentation by costs
(by fixed vs. variable, costs within each segment of a value chain, total costs, cost per unit, etc.)
- Segmentation by customers
(by demographics, needs, purchasing pattern, price point, etc.)
- Segmentation by competitors
(by channel, region, product, customer segment, etc.)