MODULE 2

Analyze your firm’s external fit

Introduction to Strategy Audit and Evaluating
External Fit
Three types of fit to evaluate a strategy
Industry,
Competition,
Regulation …

External
Competitor reactions,
Technological change,
Demand changes …

Dynamic fit
Internal
Content: Positioning,
Activities, Capabilities …

Process: Incentives, Org

structure …
 The elements of a strategy
 Strategy = Distinctive array of interdependent choices that
address

• A desired outcome

• Where to compete (market positioning)

 Product
 Customers
 Geography

• Value proposition

• Source of CA (strategic positioning)

• High-level (cost vs. differentiation)
• Detailed level (activities, resources, capabilities)
Strategy Audit

Industry
Background

Firm
Positioning

Activities,
Resources,
Capabilities
 Drivers of profitability
 By how much is profitability of a firm driven by:
– Industry effects?
– Positioning effects?
– Corporate effects?
 Average Return on Invested Capital in U.S.
Industries, 1992–2006
45
10th percentile 25th percentile Median 75th percentile 90th percentile
7.0% 10.9% 14.3% 18.6% 25.3%
40

35

30 Source: Porter, 1996)

Number of Industries

25

20

15

10

0
0% 5% 10% 15% 20% 25% 30% 35% or higher 40%
or lower
ROIC

ROIC = EBIT/(Average invested capital – excess cash)

Source: “The Five Competitive Forces That Shape Strategy” Porter, Harvard Business Review, 2008
 Average ROIC, 1992–2006
Security Brokers and Dealers 40.9%
Prepackaged Software 37.6%
Soft Drinks 37.6%
Pharmaceuticals 31.7%
Perfums, Cosmetics, Toiletries 28.6%
Advertising Agencies 27.3%
Distilled Spirits 26.4%
Semiconductors 21.3%
Medical Instruments 21.0%
Tires 19.5%
Men's and Boys' Clothing 19.5%
Household Appliances 19.2%
Malt Beverages 19.0%
Child Day Care Services 17.6%
Household Furniture 17.0%
Drug Stores 16.5%
Grocery Stores 16.0%
Iron and Steel Foundaries 15.6%
Cookies and Crackers 15.4%
Mobile Homes 15.0%
Wine and Brandy 13.9%
Bakery Products 13.8%
Engines and Turbines 13.7%
Laboratory Equipment 13.4%
Book Publishing 13.4%
Oil and Gas Machinery 12.6%
Soft Drink Bottling 11.7%
Knitting Mills 10.5%
Hotels 10.4%
Airlines 5.9%
Catalog, Mail-Order Houses 5.9%

Source: “The Five Competitive Forces That Shape Strategy” Porter, Harvard Business Review, 2008
 Positioning
40%
Pharmaceuticals Trucking

35% 33.6%

30% 28.9%
Average Return on Equity, 1982–1993

25% 23.8% 23.6% Industry Average 24.2%

22.3%
22.2%
20.5%
20% 19.3%
18.3%

15% 14.0%
12.3%
Industry Average 10.4%
10% 8.7% 7.2%
7.0%

5% 3.0%

0%
-1.6%
-5% Roadway Carolina Consolidated
Merck Schering- Eli Lilly Pfizer Hunt Arkansas
Plough Freight Freightway Best
Marion Arnold Yellow Central Builders
Merrell Dow Bristol-Meyers Upjohn
Freight Transport
Note: Return on Equity = Net Income / Year End Shareholders’ Equity
Value creation
Strategy Audit

Industry
Background

Firm
Positioning

Activities,
Resources,
Capabilities
 Value creation and appropriation

Value appropriation
Utility (in money)
[Willingness to pay]
Buyer’s share

Price
Value
Firm’s share
created

Cost

Supplier’s share

Supplier’s cost
Industry analysis
 Value appropriation—Industry Analysis:
5 Forces

 Who wants to appropriate value?

– Buyers => lower price Supply

– Suppliers => increase cost
chain

 Who else limits the amount you can appropriate?

– Current competitors => lower price
– New competitors => lower price
– Substitution => lower price
– Complementors => lower WTP, or higher cost

 What other factors determine profitability in your industry?

– Regulation?
 Drivers of appropriation threats
 Customer Power
– Price sensitivity (volume; importance to their cost)
– Switching costs/customer lock-in (technical; brand)
– Ability to backward integrate

– For instance, shipping managers buying trucking services.

 Supplier Power
– How important are our sales to them?
– Switching costs for you
– Ability to forward integrate

For instance, Intel

 Drivers of appropriation threats (2)
 Barriers to Entry (new entry & substitutes)
– Scale-based benefits; Experience, learning effects
– Capital requirements
– Value of reputation, brand
– Access to distribution

– For instance, pharma detailing to doctors vs. TL trucking.

 Rivalry (existing competitors)

– Number of effective competitors
– Market growth
– Degree of differentiation
– Strategic stakes
– Patents

For instance, full-service US domestic airlines

Value proposition
Strategy Audit

Industry
Background

Firm
Positioning

Activities,
Resources,
Capabilities
 The elements of a strategy
 Strategy = distinctive array of choices that address
– A desired outcome
– Where to compete (market positioning)
• Product
• Customers
• Geography
– Value proposition
– Source of CA (strategic positioning)
 High-level (cost vs. differentiation)
 Detailed level (activities, resources, capabilities)
 Value Proposition
Willingness to pay
Value
appropriated by
customer
Value
Price
created

Cost
 Customers care about (WTP – Price), not just one or the other
 One can create value by increasing the customer’s willingness to pay or by
decreasing cost (iPod vs. Southwest)
 What factors drive willingness to pay?
 What factors drive cost?
 How to assess WTP
 Engineering estimate:
– WTP = Current price + (non-price) cost savings – switching costs

 Focus groups:
– Assess indifference point between $ and the product

 Quantitative analysis:
– Survey of potential customers: give various options of features and prices and customers
make (hypothetical) choices; from this one can estimate elasticities
– E.g., refrigerator: $1 annual savings from energy consumption = $2.45 higher WTP

 Auctions
Competitive advantage
 What is the size of your competitive
advantage?

CA = (WTP – Cost)you – (WTP – Cost)strongest competitor

Or

CA = (WTP – WTPcompetitor) + (Costcompetitor – Costyou)

 Why is Porsche still around?
 The role of nationality in buying cars
 Cup holders
 Implications
CA = (WTP – Cost)you – (WTP – Cost)strongest competitor

 To appropriate value, you need to create more value than your competitors
 You need to create some asymmetry in WTP and/or in Cost
 Being different, i.e., doing different things, is what is at the heart of strategy.
Positioning
 Strategic Positioning

High
Productivity Frontier
(State of Best Practice)

WTP

Low
High Low
Relative Cost Position

Source: “What Is Strategy?” Porter, Harvard Business Review, 1996

Strategic Positioning in the Airline Industry

HIGH SQ
BA

WTP

US SWA

LOW
HIGH LOW
Cost
 Differentiation and Cost Drivers
WTP drivers
Brand
Technological performance
After-sale services, etc.

WTP(a, b, c, ..)
WTP = “a*a + b*b + g*c + …“
Different segments differ in their weights

Cost drivers
Production costs
Logistical costs
Transportation costs
Service costs
 WTP drivers for airlines
Worst in Best in
Average
industry industry
1 2 3 4 5
Drivers of WTP:

Number of flights/Coverage

Point-to-point

On-time arrival/departure

Bags arrive

Meals

Lounges

Quality of frequent flier program

Friendly service; quality of seats

Market positioning
 The elements of a strategy
 Strategy = distinctive array of choices that address
– A desired outcome
– Where to compete (market positioning)
• Product
• Customers
• Geography
– Value proposition
– Source of CA (strategic positioning)
 High-level (cost vs. differentiation)
 Detailed level (activities, resources, capabilities)
 Market Positioning
 Identify the two, three dimensions on which firms differentiate themselves in
the market
 Plot your position vs. those of your competitors
 Provides an idea of where in the market space strategic convergence is likely
to happen and where there might be opportunities
Market Positioning in US Fast Food

High
Quality

Low High
Price Price

Low
Quality
Strategy Audit Summary
 Strategy Audit Summary
 What is the condition of the industry today?
 Where is the industry going?
 What are the WTP and cost drivers for different segments?
 Where are we positioned? Where are our competitors positioned?
 Where are our competitors moving?
 How strong are our capabilities vs. competitors vs. world-class?
 What are our key activities? Are they OE or SP?
 How are we using corporate? How are we leveraging other divisions?
 Strategy Audit
Tools

• Industry
Analysis Industry
• Scenarios Background

• Drivers of Cost Firm

and WTP Positioning
• Strategic
Positioning Activities,
Resources,
Capabilities
• Value Chain
• Activity System Strategic
Initiatives
Analyze the Structure of Your Industry
Assignment
 Industry Attractiveness

Highly Mildly Neutral Mildly Highly

Unattractive Unattractive Attractive Attractive

Threat of Value High Low

Appropriation Customer Customer
by Customers Power Power
Size of key customers: Large Small
Price sensitivity: High Low
Switching costs (technical): Low High
Switching costs (brand): Low High
Ability to backward integrate: Easy Difficult

Threat of Value High Low

Appropriation Supplier Supplier
by Suppliers Power Power
Size of key suppliers: Large Small
Price sensitivity: High Low
Your switching costs (technical): High Low
Your switching costs (brand): High Low
Ability to forward integrate: Easy Difficulty

Rivalry among High Rivalry Low Rivalry

competitors Number of effective competitors: Large Small
Market growth: Slow Fast
Degree of differentiation: Little High
Strategic stakes: High Low
Patents protect profits: No Yes
 Industry Attractiveness

Highly Mildly Neutral Mildly Highly

Unattractive Unattractive Attractive Attractive

Barriers to Low Entry High Entry

Entry Barriers Barriers
Scale-based benefits: Little Large
Experience, learning effects: Little Large
Capital requirements: Small Large
Value of reputation, brand: Unimportant Important
Access to distribution: Unimportant Important

Substitutes Many Few

Availability of close substitutes substitutes substitutes
for product or services:

Regulatory Impact of regulatory Negative Positive

Factors Changes:
 Industry Attractiveness

Highly Mildly Neutral Mildly Highly

Unattractive Unattractive Attractive Attractive

Complementors Other firms have exclusive Negative Positive

relationships with
complementors vs. we
have these relationships:

Other Factors Negative Positive

Other Factors Negative Positive

 Understanding the Industry
Make a mark in each row for “the average firm” and for “your firm.”

Industry Attractiveness
Current Future
Factors: Un- Neutral Attractive Un- Neutral Attractive
attractive attractive
Power of Customers
(make this industry…)
Power of Suppliers

Rivalry among
Competitors
Barriers to Entry

Availability of Substitutes

Regulatory Factors

Growth Rates
(make this industry…)
 Understanding the Industry

The two most significant factors affecting industry attractiveness are:

1.
2.

The two factors most likely to change significantly are:

1.
2.

The factors for which our firm is much better/much worse positioned (if any):
1.
2.
Evaluate the Positioning of your Organization
Assignment
 Differentiation
Make a mark in each row for “your firm” and 2–3 competitors.

Worst in Best in
Average
industry industry
1 2 3 4 5
Drivers of WTP:
(fill in relevant dimension)
 Cost
Make a mark in each row for “your firm” and 2–3 competitors.

Worst in Best in
Average
industry industry
1 2 3 4 5
Cost drivers:
 Strategic Positioning—
Now and Future

high

WTP

low

high low
relative cost position
1) Where are we located?
2) Where are our competitors currently located?
3) Where do we believe our competitors are moving toward?
4) Where do we see ourselves going?