Understanding Strategies

Management control systems are tools to implement strategies. Strategies differ between
organizations, and controls should be tailored to the requirements of specific strategies. Different
strategies require different task priorities; different key success factors; and different skills, perspectives,
and behaviors. Thus, a continuing concern in the design of control systems should be whether the
behavior induced by the system is the one called for by the strategy. Strategies are plans to achieve
organization goals. Therefore, in this chapter we first describe some typical goals in organizations. Then
we discuss strategies at two levels in an organization: the corporate level and the business unit level.
Strategies provide the broad context within which one can evaluate the optimality of the elements of
the management control systems discussed in Chapters 4 through 12. In Chapter 13 we discuss how to
vary the form and structure of control systems in accordance with variations in corporate and business
unit strategies.

Goals
Although we often refer to the goals of a corporation, a corporation does not have goals; it is an
artificial being with no mind or decision-making ability of its own. Corporate goals are determined by the
chief executive officer (CEO) of the corporation, with the advice of other members of senior
management, and they are usually ratified by the board of directors. In many corporations, the goals
originally set by the founder persist for generations. Examples are Henry Ford, Ford Motor Company;
Alfred P. Sloan, General Motors Corporation; Walt Disney, Walt Disney Company; George Eastman,
Eastman Kodak; and Sam Walton, Wal-Mart.

Profitability
In a business, profitability is usually the most important goal. Profitability is expressed, in the
broadest and most conceptually sound sense, by an equation that is the product of two ratios:

The product of these two ratios is the return on investment: 5% * 2.5 times ⫽ 12.5%. Return on
investment can be found by simply dividing profit (i.e., revenues minus expenses) by investment, but
this method does not draw attention to the two principal components: profit margin and investment
turnover.

In the basic form of this equation, “investment” refers to the shareholders’ investment, which
consists of proceeds from the issuance of stock, plus retained earnings. One of management’s
responsibilities is to arrive at the right balance between the two main sources of financing: debt and
equity. The shareholders’ investment (i.e., equity) is the amount of financing that was not obtained by
debt, that is, by borrowing. For many purposes, the source of financing is not relevant; “investment”
thus means the total of debt capital and equity capital.

“Profitability” refers to profits in the long run, rather than in the current quarter or year. Many
current expenditures (e.g., amounts spent on advertising or research and development) reduce current
profits but increase profits over time.

Some CEOs stress only part of the profitability equation. Jack Welch, former CEO of General
Electric Company, explicitly focused on revenue; he stated that General Electric should not be in any
business in which its sales revenues were not the largest or the second largest of any company in that
business. This does not imply that Welch neglected the other components of the equation; rather, it
suggests that in his mind there was a close correlation between market share and return on investment.

Other CEOs, however, emphasize revenues for a different reason: For them, company size is a
goal. Such a priority can lead to problems. If expenses are too high, the profit margin will not give
shareholders a good return on their investment. Even if the profit margin is satisfactory, the
organization may still not earn a good return if the investment is too large.

Some CEOs focus on profit either as a monetary amount or as a percentage of revenue. This
focus does not recognize the simple fact that if additional profits are obtained by a greaterthan-
proportional increase in investment, each dollar of investment has earned less.

Maximizing Shareholder Value

In the 1980s and 1990s the term shareholder value appeared frequently in the business
literature. This concept is that the appropriate goal of a for-profit corporation is to maximize
shareholder value. Although the meaning of this term was not always clear, it probably refers to the
market price of the corporation’s stock. We believe, however, that achieving satisfactory profit is a
better way of stating a corporation’s goal, for two reasons.1

First,“maximizing” implies that there is a way of finding the maximum amount that a company
can earn. This is not the case. In deciding between two courses of action, management usually selects
the one it believes will increase profitability the most. But management rarely, if ever, identifies all the
possible alternatives and their respective effects on profitability. Furthermore, profit maximization
requires that marginal costs and a demand curve be calculated, and managers usually do not know what
these are. If maximization were the goal, managers would spend every working hour (and many
sleepless nights) thinking about endless alternatives for increasing profitability; life is generally
considered to be too short to warrant such an effort.

Second, although optimizing shareholder value may be a major goal, it is by no means the only
goal for most organizations. Certainly a business that does not earn a profit at least equal to its cost of
capital is not doing its job; unless it does so, it cannot discharge any other responsibilities. But economic
performance is not the sole responsibility of a business, nor is shareholder value. Most managers want
to behave ethically, and most feel an obligation to other stakeholders in the organization in addition to
shareholders.
 Example. Henry Ford’s operating philosophy was satisfactory profit, not maximum profit. He
wrote, “And let me say right here that I do not believe that we should make such an awful profit on our
cars. A reasonable profit is right, but not too much. So it has been my policy to force the price of the car
down as fast as production would permit, and give the benefits to the users and laborers—with resulting
surprisingly enormous benefits to ourselves.”2

By rejecting the maximization concept, we do not mean to question the validity of certain
obvious principles. A course of action that decreases expenses without affecting another element, such
as market share, is sound. So is a course of action that increases expenses with a greaterthan-
proportional increase in revenues, such as expanding the advertising budget. So, too, are actions that
increase profit with a less than proportional increase in shareholder investment (or, of course, with no
such increase at all), such as purchasing a cost-saving machine. These principles assume, in all cases, that
the course of action is ethical and consistent with the corporation’s other goals.

Risk
An organization’s pursuit of profitability is affected by management’s willingness to take risks.
The degree of risk-taking varies with the personalities of individual managers. Never theless, there is
always an upper limit; some organizations explicitly state that management’s primary responsibility is to
preserve the company’s assets, with profitability considered a secondary goal. The Asian financial crisis
during 1996–1998 is traceable, in large part, to the fact that banks in Asia’s emerging markets made
what appeared to be highly profitable loans without paying adequate attention to the level of risk
involved.

Multiple Stakeholder Approach

Organizations participate in three markets: the capital market, the product market, and the
factor market. A firm raises funds in the capital market, and the public stockholders are therefore an
important constituency. The firm sells its goods and services in the product market, and customers form
a key constituency. It competes for resources such as human capital and raw materials in the factor
market, and the prime constituencies are the company’s employees and suppliers and the various
communities in which the resources and the company’s operations are located.

The firm has a responsibility to all these multiple stakeholders—shareholders, customers,

employees, suppliers, and communities. Ideally, its management control system should identify the
goals for each of these groups and develop scorecards to track performance.

Example. In 2005, the Acer Group, headquartered in Taiwan, was one of the largest computer
companies in the world, with annual sales of nearly $7 billion and 4 percent of the global PC market
share. The company subscribed to the multiple stakeholder approach and managed its internal
operations to satisfy the needs of several constituencies. To quote Stan Shih, the founder, “The
customer is number 1, the employee is number 2, the shareholder is number 3. I keep this message
consistent with all my colleagues. I even consider the company’s banks, suppliers, and others we do
business with are our stakeholders; even society is stakeholder. I do my best to run the company that
way.”3
 Lincoln Electric Company is well known for its philosophy that employee satisfaction was more
important than shareholder value. James Lincoln wrote:“The last group to be considered is the
stockholders who own stock because they think it will be more profitable than investing more in any
other way. The absentee stockholder is not of any value to the customer or to the worker, since he has
no knowledge of nor interest in the company other than greater dividends and an advance in the price
of his stock.”4 Donald F. Hastings, chairman and chief executive officer, emphasized that this was still
the company’s philosophy in 1996.5

The Concept of Strategy

Although definitions differ, there is general agreement that a strategy describes the general
direction in which an organization plans to move to attain its goals. Every well-managed organization has
one or more strategies, although they may not be stated explicitly. In the previous

section we described the typical goals of an organization. The rest of this chapter will deal with generic
types of strategies that can help an organization achieve its goals.

A firm develops its strategies by matching its core competencies with industry
opportunities. Exhibit 2.1 lays out schematically the development of a firm’s strategies. Kenneth R.
Andrews advanced this basic concept. According to Andrews, strategy formulation is a process that
senior executives use to evaluate a company’s strengths and weaknesses in light of the opportunities
and threats present in the environment and then to decide on strategies that fit the company’s core
competencies with environmental opportunities.6 Much attention during the past 30 years has focused
on developing more rigorous frameworks to conduct environmental analysis (to identify opportunities
and threats)7 and internal analysis (to identify core competencies).8

Strategies can be found at two levels: (1) strategies for a whole organization, and (2)
strategies for business units within the organization. About 85 percent of Fortune 500 industrial firms in
the United States have more than one business unit and consequently formulate strategies at both
levels.

Although strategic choices are different at different hierarchical levels, there is a clear need for
consistency in strategies across business unit and corporate levels. Exhibit 2.2 summarizes the strategy
concerns at the two organizational levels and the generic strategic options. The remainder of this
chapter will elaborate on the ideas summarized in Exhibit 2.2. Given the systems orientation of this
book,
we will not
attempt
an

exhaustive analysis of the appropriate content of strategies. We rather provide enough appreciation for
the strategy formulation process so the reader is able to identify the strategies at various organizational
levels as part of an evaluation of the firm’s management control system.

Corporate-Level Strategy
Corporate strategy is about being in the right mix of businesses. Thus, corporate strategy is concerned
more with the question of where to compete than with how to compete in a particular industry; the
latter is a business unit strategy. At the corporate level, the issues are (1) the definition of businesses in
which the firm will participate and (2) the deployment of resources among those businesses.
Corporatewide strategic analysis results in decisions involving businesses to add, businesses to retain,
businesses to emphasize, businesses to deemphasize, and businesses to divest.
In terms of their corporate-level strategy, companies can be classified into one of three categories. A
single industry firm operates in one line of business. ExxonMobil, which is in the petroleum industry, is
an example. A related diversified firm operates in several industries, and the business units benefit from
a common set of core competencies.Procter & Gamble (P&G) is an example of a related diversified firm;
it has business units in diapers (Pampers), detergent (Tide), soap (Ivory),toothpaste (Crest),shampoo
(Head & Shoulders),and other branded consumer products. P&G has two core competencies that
benefit all of its business units: (1) core skills in several chemical technologies and (2) marketing and
distribution expertise in low-ticket branded consumer products moving through supermarkets. An
unrelated business firm operates in businesses that are not related to one another; the connection
between business units is purely financial.Textron is an example.Textron operates in businesses as
diverse as writing instruments, helicopters, chain saws, aircraft engine components, forklifts, machine
tools, specialty fasteners, and gas turbine engines.

At the corporate level, one of the most significant dimensions along which strategic contexts differ is the
extent and type of diversification undertaken by different firms, as depicted in Exhibit 2.3.

Single Industry Firms

One axis in Exhibit 2.3—extent of diversification—relates to the number of industries in
which the company operates. At one extreme, the company may be totally committed to one industry.
Firms that pursue a single industry strategy include Maytag (major household appliances), Wrigley
(chewing gum), Perdue Farms (poultry), and NuCor (steel). A single industry firm uses its core
competencies to pursue growth within that industry.

Example. NuCor achieved growth of 20 percent annually over a 38-year period (1966–2004) by focusing
exclusively on the steel industry. The company used its three core competencies (manufacturing process
know-how, technology adoption and implementation know-how, and plant construction know-how) in
achieving these results.9

Unrelated Diversified Firms

At the other extreme, there are firms, such as Textron, that operate in a number of different industries.
The other axis in Exhibit 2.3—degree of relatedness—refers to the nature of linkages across the multiple
business units. Here we refer to operating synergies across businesses based on common core
competencies and on sharing of common resources. In the case of Textron, except for financial
transactions, its business units have little in common. There are few operating synergies across business
units within Textron. Textron headquarters functions like a holding company, lending money to business
units that are expected to generate high financial returns. We refer to such firms as unrelated diversified
firms or conglomerates. Conglomerates grow primarily through acquisition. Other examples of unrelated
diversified firms are Litton and LTV

Related Diversified Firms

Another group consists of firms that operate in a number of industries and their businesses
are connected to each other through operating synergies. We refer to these firms as related diversified
firms. Operating synergies consist of two types of linkages across business units: (1) ability to share
common resources, and (2) ability to share common core competencies. One way related diversified
firms create operating synergies is by having two or more business units share resources such as a
common sales force, common manufacturing facilities, and a common procurement function. Such
sharing of resources helps the firm reap benefits of economies of scale and economies of scope.

Example. Most of Procter & Gamble’s individual products share a common salesforce and a common
logistics; most of its products are distributed through supermarkets. Another key characteristic of
related diversified firms is that they possess core competencies that benefit many of their business
units. They grow by leveraging core competencies developed in one business when they diversify into
other businesses.

Example. Dow Corning diversified into several products and markets that use its core competencies in
silicon chemistry. Texas Instruments used its competence in electronic technology to diversify into
several industrial consumer products. In 2002, DaimlerChrysler AG diversified into used car trade
through a new unit called Motormeile. Motormeile sold all brands including those of its competitors.
Other examples of related diversified firms include Procter & Gamble, NEC, Canon, Philip Morris,
Emerson Electric, and DuPont.

Related diversified firms typically grow internally through research and development. The
role of the corporate office in a related diversified firm is twofold: (1) similar to a conglomerate, the
chief executive of a related diversified firm must make resource allocation decisions across business
units; (2) but, unlike a conglomerate, the chief executive of a related diversified firm must also identify,
nurture, deepen, and leverage corporatewide core competencies that benefit multiple business units.

Core Competence and Corporate Diversification Despite the dismal track record of
companies pursuing diversification, many have pursued this strategy since the 1960s. Porter writes:

I studied the diversification records of 33 large, prestigious U.S. companies over the 1950–1986 period
and found that most of them had divested many more acquisitions than they had kept. The corporate
strategies of most companies have dissipated, instead of creating shareholder value.10

Research has shown that, on average, related diversified firms perform the best, single
industry firms perform next best, and unrelated diversified firms do not perform well over the long
term.11 This is because corporate headquarters, in a related diversified firm, has the ability to transfer
core competencies from one business unit to another. A core competency is what a firm excels at and
what adds significant value for customers. Competency-based growth and diversification therefore have
significant potential for success.

Examples. Honda’s key core competency is its ability to design small engines. Honda used
this competency initially to enter the motorcycle business. Since then, Honda has leveraged its
competency in small engine technology in a variety of businesses such as automobiles, lawn mowers,
snow blowers, snowmobiles, and outdoor power tools. One of Federal Express’s core competencies is
logistics know-how. It used this competency to create the overnight mail business. Since then, the
company has used this competency to enter several new businesses. For instance, FedEx manages all
logistics (including internal inventory) for Laura Ashley, a leading cosmetics company.

The business units of a related diversified firm might be worse off if they were split up into
separate companies since a related diversified firm can exploit operating synergies across its business
units. For instance, if the business units of Honda (motorcycles, automobiles, lawn mowers, etc.) were
split up as separate companies, they would then lose the benefit of Honda’s expertise in small engine
technology.

Unrelated diversified firms, on the other hand, do not possess operating synergies. Most of
the failed corporate diversification attempts in the past were of this type. Nevertheless, some unrelated
diversified firms (e.g., General Electric) are highly profitable. Since we continue to see examples of
unrelated diversified firms, we discuss this type of corporate strategy.

Implications of Control System

Design Corporate strategy is a continuum with single industry strategy at one end of the
spectrum and unrelated diversification at the other end (related diversification is in the middle of the
spectrum). Many companies do not fit neatly into one of the three classes. However, most companies
can be classified along the continuum. A firm’s location on this continuum depends on the extent and
type of its diversification. Exhibit 2.4 summarizes the key characteristics of the generic corporate
strategies.

The planning and control requirements of companies pursuing different corporate level
diversification strategies (i.e., extent and type of diversification) are quite different. The key issue for
control systems designers, therefore, is: How should the structure and form of control differ across a
NuCor (a single industry firm), a Procter & Gamble (a related diversified firm), or a Textron (an unrelated
diversified firm)? In Chapters 4 through 12 we discuss the elements of the management control system.
In Chapter 13 we discuss how these control system elements should be designed so they implement a
given firm’s strategies.
Business Unit Strategies
Competition between diversified firms does not take place at the corporate level. Rather, a
business unit in one firm (Procter & Gamble’s Pampers unit) competes with a business unit in another
firm (Kimberly Clark’s Huggies unit). The corporate office of a diversified firm does not produce profit by
itself; revenues are generated and costs are incurred in the business units. Business unit strategies deal
with how to create and maintain competitive advantage in each of the industries in which a company
has chosen to participate. The strategy of a business unit depends on two interrelated aspects: (1) its
mission (“what are its overall objectives?”) and (2) its competitive advantage (“how should the business
unit compete in its industry to accomplish its mission?”).

Business Unit Mission

In a diversified firm one of the important tasks of senior management is resource deployment,
that is, make decisions regarding the use of the cash generated from some business units to finance
growth in other business units. Several planning models have been developed to help corporate level
managers of diversified firms to effectively allocate resources. These models suggest that a firm has
business units in several categories, identified by their mission; the appropriate strategies for each
category differ. Together, the several units make up a portfolio, the components of which differ as to
their risk/reward characteristics just as the components of an investment portfolio differ. Both the
corporate office and the business unit general manager are involved in identifying the missions of
individual business units.
 Of the many planning models, two of the most widely used are Boston Consulting Group’s two-
by-two growth–share matrix (Exhibit 2.5) and General Electric Company/McKinsey & Company’s three-
by-three industry attractiveness–business strength matrix (Exhibit 2.6). While these models differ in the
methodologies they use to develop the most appropriate missions for the various business units, they
have the same set of missions from which to choose: build, hold, harvest, and divest.

Build

This mission implies an objective of increased market share, even at the expense of short-term earnings
and cash flow (e.g., Merck’s bio-technology, Black and Decker’s handheld electric tools).

Hold

This strategic mission is geared to the protection of the business unit’s market share and competitive
position (e.g.: IBM’s mainframe computers).

Harvest

This mission has the objective of maximizing short-term earnings and cash flow, even at the expense of
market share (e.g., American Brands’ tobacco products, General Electric’s and Sylvania’s lightbulbs).

Divest

This mission indicates a decision to withdraw from the business either through a process of slow
liquidation or
outright sale.

While the
planning models can
aid in the formulation
of missions,
they are not
cookbooks. A business unit’s position on a planning grid should not be the sole basis for deciding its
mission.

In the Boston Consulting Group (BCG) model, every business unit is placed in one of four
categories—question mark, star, cash cow, and dog—that represent the four cells of a 2 ⫻ 2 matrix,
which measures industry growth rate on one axis and relative market share on the other (Exhibit 2.5).
BCG views industry growth rate as an indicator of relative industry attractiveness and relative market
share as an indicator of the relative competitive position of a business unit within a given industry.

BCG singles out market share as the primary strategy variable because of the importance it
places on the notion of experience curve. According to BCG, cost per unit decreases predictably with the
number of units produced over time (cumulative experience). Since the market share leader will have
the greatest accumulated production experience, such a firm should have the lowest costs and highest
profits in the industry. The association between market share and profitability has also been empirically
supported by the Profit Impact of Market Strategy (PIMS) database.12

Although the experience curve is a powerful analytical tool, it has limitations:

1. The concept applies to undifferentiated products where the primary basis of competition is on
price. For these products, becoming the low-cost player is critical. However, market share and
low cost are not the only ways to succeed. There are low market share firms (such as Porsche in
automobiles) that earn high profits by emphasizing product uniqueness rather than low cost.
2. In certain situations improvements in process technology may have a greater impact on the
reduction of per-unit cost than cumulative volume per se.
Example. Certain companies in the U.S. steel industry have greatly reduced their per-unit (ton)
cost of producing steel and recouped a large portion of worldwide market share by vast
investments in technological improvements, not by producing more tons of steel (on a
cumulative basis) than their competitors.
3. An aggressive pursuit of reducing cost via accumulated production of standardized items can
lead to loss of flexibility in the marketplace.
Example. The classic example of this problem is when, during the 1920s, Henry Ford
standardized the car (“I will give you any color provided it is black”) and aggressively reduced
costs. Ford lost its leadership in the auto industry when General Motors sold the consumers on
product variety (“A car for every purse and every purpose”), so much so that in 1927 Ford
discontinued the Model T and suffered a 12-month shutdown for retooling.13
4. Commitment to the experience curve concept can be a severe disadvantage if new technologies
emerge in the industry.
Example. Timex’s low-cost position in the watch industry, built over several years, was erased
overnight when Texas Instruments entered the market with digital watches.
5. Experience is not the only cost driver. Other drivers that affect cost behavior are: scale, scope,
technology, and complexity.14 A firm needs to consider carefully the relevant cost drivers at
work to achieve the low-cost position

BCG used the following logic to make strategic prescriptions for each of the four cells in Exhibit
2.5. Business units that fall in the question mark quadrant are typically assigned the mission:“build”
market share. The logic behind this recommendation is related to the beneficial effects of the
experience curve. BCG argued that, by building market share early in the growth phase of an
industry, the business unit will enjoy a low-cost position.These units are major users of cash, since
cash outlays are needed in the areas of product development, market development, and capacity
expansion.These expenditures are aimed at establishing market leadership in the short term, which
will depress short-term profits. However, the increased market share is intended to result in long-
term profitability. Some businesses in the question mark quadrant might also be divested if their
cash needs to build competitive position are extremely high.

Example. In the early 70s, RCA decided to divest its computer division because of the enormous
cash outflows that would have been required to build market share in such a capital-intensive and
highly competitive industry

Business units that fall in the star quadrant are typically assigned the mission:“hold” market
share. These units already have a high market share in their industry, and the objective is to invest
cash to maintain that position. These units generate significant amounts of cash (because of their
market leadership), but they also need significant cash outlays to maintain their competitive
strength in a growing market. On balance, therefore, these units are self-sufficient and do not
require cash from other parts of the organization.

Business units that fall in the cash cow quadrant are the primary sources of cash for the firm.
Because these units have high relative market share, they probably have the lowest unit costs and
consequently the highest profits. On the other hand, because these units operate in low-growth or
declining industries, they do not need to reinvest all the cash generated. Therefore, on a net basis,
these units generate significant amounts of positive cash flows. Such units are typically assigned the
mission: “harvest” for short-term profits and cash flows.

Businesses in the dog quadrant have a weak competitive position in unattractive industries.
They should be divested unless there is a good possibility of turning them around.
 The corporate office should identify cash cows with positive cash flows and redeploy these
resources to build market share in question marks.

The General Electric Company/McKinsey & Company grid (Exhibit 2.6) is similar to the BCG grid
in helping corporations assign missions across business units. However, its methodology differs from
the BCG approach in the following respects:

1. BCG uses industry growth rate as a proxy for industry attractiveness. In the General Electric
grid, industry attractiveness is based on weighted judgments about such factors as market
size, market growth, entry barriers, technological obsolescence, and the like.
2. BCG uses relative market share as a proxy for the business unit’s current competitive
position. The General Electric grid, on the other hand, uses multiple factors such as market
share, distribution strengths, and engineering strengths to assess the competitive position
of the business unit.

Control system designers need to know what the mission of a particular business unit is, but not
necessarily why the firm has chosen that particular mission. Since this book focuses on designing control
systems for ongoing businesses, it deals with the implementation of the build, hold, and harvest—but
not divest—missions. These missions constitute a continuum, with “pure build” at one end and “pure
harvest” at the other end. A business unit could be anywhere on this continuum, depending upon the
trade-off it is supposed to make between building market share and maximizing short-term profits.

Business Unit Competitive Advantage

Every business unit should develop a competitive advantage in order to accomplish its mission.
Three interrelated questions have to be considered in developing the business unit’s competitive
advantage. First, what is the structure of the industry in which the business unit operates? Second, how
should the business unit exploit the industry’s structure? Third, what will be the basis of the business
unit’s competitive advantage? Michael Porter has described two analytical approaches—industry
analysis and value chain analysis—as aids in developing a superior and sustainable competitive
advantage. Each is described below.

Industry Analysis
Research has highlighted the important role industry conditions play in the performance of
individual firms. Studies have shown that average industry profitability is, by far, the most significant
predictor of firm performance.15 According to Porter, the structure of an industry should be analyzed in
terms of the collective strength of five competitive forces (see Exhibit 2.7):16

1. The intensity of rivalry among existing competitors. Factors affecting direct rivalry are industry
growth, product differentiability, number and diversity of competitors, level of fixed costs,
intermittent overcapacity, and exit barriers
2. The bargaining power of customers. Factors affecting buyer power are number of buyers,
buyer’s switching costs, buyer’s ability to integrate backward, impact of the business unit’s
product on buyer’s total costs, impact of the business unit’s product on buyer’s product quality/
performance, and significance of the business unit’s volume to buyers.
3. The bargaining power of suppliers. Factors affecting supplier power are number of suppliers,
supplier’s ability to integrate forward, presence of substitute inputs, and importance of the
business unit’s volume to suppliers.
4. Threat from substitutes. Factors affecting substitute threat are relative price/performance of
substitutes, buyer’s switching costs, and buyer’s propensity to substitute
5. The threat of new entry. Factors affecting entry barriers are capital requirements, access to
distribution channels, economies of scale, product differentiation, technological complexity of
product or process, expected retaliation from existing firms, and government policy

We make three observations with regard to the industry analysis:

1. The more powerful the five forces are, the less profitable an industry is likely to be. In industries
where average profitability is high (such as soft drinks and pharmaceuticals), the five forces are
weak (e.g., in the soft drink industry, entry barriers are high). In industries where the average
profitability is low (such as steel and coal), the five forces are strong (e.g., in the steel industry,
threat from substitutes is high).
2. Depending on the relative strength of the five forces, the key strategic issues facing the business
unit will differ from one industry to another.
3. Understanding the nature of each force helps the firm to formulate effective strategies. Supplier
selection (a strategic issue) is aided by the analysis of the relative power of several supplier
groups; the business unit should link with the supplier group for which it has the best
competitive advantage. Similarly, analyzing the relative bargaining power of several buyer
groups will facilitate selection of target customer segments.

Generic Competitive Advantage

The five-force analysis is the starting point for developing a competitive advantage since it
helps to identify the opportunities and threats in the external environment. With this
understanding, Porter claims that the business unit has two generic ways of responding to the
opportunities in the external environment and developing a sustainable competitive advantage: low
cost and differentiation

Low Cost

Cost leadership can be achieved through such approaches as economies of scale in

production, experience curve effects, tight cost control, and cost minimization (in such areas as
 research and development, service, sales force, or advertising). Some firms following this strategy
include Charles Schwab in discount brokerage, Wal-Mart in discount retailing, Texas Instruments in
consumer electronics, Emerson Electric in electric motors, Hyundai in automobiles, Dell in
computers, Black and Decker in machine tools, NuCor in steel, Lincoln Electric in arc welding
equipment, and BIC in pens.

Differentiation

The primary focus of this strategy is to differentiate the product offering of the business unit,
creating something that is perceived by customers as being unique. Approaches to product
differentiation include brand loyalty (Coca-Cola and Pepsi Cola in soft drinks), superior customer
service (Nordstrom in retailing), dealer network (Caterpillar Tractors in construction equipment),
product design and product features (Hewlett-Packard in electronics), and technology (Cisco in
communications infrastructure). Other examples of firms following a differentiation strategy include
BMW in automobiles, Stouffer’s in frozen foods, Neiman-Marcus in retailing, Mont Blanc in pens,
and Rolex in wristwatches.

Value Chain Analysis

As noted in the previous section and as depicted in Exhibit 2.8, business units can develop
competitive advantage based on low cost, differentiation, or both. The most attractive competitive
position is to achieve cost-cum-differentiation. Both intuitively and theoretically, competitive advantage
in the market-place ultimately derives from providing better customer value for an equivalent cost or
equivalent customer value for a lower cost. Competitive advantage cannot be meaningfully examined at
the level of the business unit as a whole. The value chain disaggregates the firm into its distinct strategic
activities.
 The value chain is the complete set of activities involved in a product, beginning with extraction
of raw material and ending with postdelivery support to customers. Exhibit 2.9 depicts such a chain. A
company chooses those activities that it will carry out with its own resources and those that it will
obtain from outside parties. Value chain analysis seeks to determine where in the company’s operations
—from design to distribution—customer value can be enhanced or costs lowered:

For each value-added activity, the key questions are these:

1. Can we reduce costs in this activity, holding value (revenues) constant?

2. Can we increase value (revenue) in this activity, holding costs constant?
3. Can we reduce assets in this activity, holding costs and revenue constant?
4. Most importantly, can we do (1), (2), and (3) simultaneously?

By systematically analyzing costs, revenues, and assets in each activity, the business unit can achieve
cost-cum-differentiation advantage.

The value chain framework17 is a method for breaking down the chain—from basic raw
materials to end-use customers—into specific activities in order to understand the behavior of costs and
the sources of differentiation. Few if any firms carry out the entire value chain of a product with their
own resources. In fact, firms within the same industry vary in the proportion of activities that they carry
out with their own resources.

Examples. Chevron in the petroleum industry spans wide segments of the value chain in which it
operates, from oil exploration to service stations, but it does not span the entire chain. Fifty percent of
the crude oil it refines comes from other producers, and more than one-third of the oil it refines is sold
through other retail outlets. More narrowly, a firm such as Maxus Energy is only in the oil exploration
and production business. The Limited has “downstream” presence in retail outlets but owns no
manufacturing facilities. Reebok is a famous shoe brand, but the firm owns very few retail outlets.
Reebok does, however, own its factories. Nike, on the other hand, does only research, design, and
marketing; it outsources 100 percent of its athletic footwear manufacturing.

The value chain helps the firm to understand the entire value delivery system,notjust the
portion of the value chain in which it participates. Suppliers and customers, and suppliers’ suppliers, and
customers’ customers have profit margins that are important to identify in understanding a firm’s
cost/differentiation positioning, since the end-use customers ultimately pay for all the profit margins
along the entire value chain. Suppliers not only produce and deliver inputs used in a firm’s value
activities, but they significantly influence the firm’s cost/ differentiation position.

Example. Developments by steel “mini-mills” lowered the operating costs of wire products users who
are the customers of the customers of the mini-mill two stages down the value chain.
Similarly, customers’ actions can have a significant impact on the firm’s cost/differentiation advantage.

Example. When printing press manufacturers built a new press of “3 meters” width, the profitability of
paper mills was affected because paper machine widths must match some multiple of printing press
width. Mill profit is affected by customer actions even though the paper mill is two stages upstream
from the printer, who is a customer of the press manufacturer!

Summary
Every organization has one or more goals. Profitability is an important goal, but a firm should
also adopt goals vis-à-vis employees, suppliers, customers, and community.

Diversified firms undertake strategy formulation at two levels—corporate and business unit. At
the corporate level, the key strategic question is, What set of businesses should the firm be in? The
“generic” options for the corporate level strategic question are (1) a single industry firm, (2) a related
diversified firm, or (3) an unrelated diversified firm. A key concept in corporate level strategy is the
notion of core competence. A core competency is an intellectual asset in which a firm excels.

At the business unit level, there are two key strategic questions: (1) What should be the
business unit’s mission? (The “generic” business unit missions are build, hold, and harvest.) (2) How
should the business unit compete to accomplish its mission? (The “generic” competitive advantages are
low cost and differentiation.)

Three tools can help in developing business unit strategies: portfolio matrices, industry structure
analysis, and value chain analysis. Portfolio matrices typically position a business unit on a grid where
one axis is “market attractiveness” and the other axis is “market share.” Such matrices are useful in
deciding on the business unit mission.

Industry structure analysis is a tool to systematically assess the opportunities and threats in the
external marketplace. This is accomplished by analyzing the collective strength of five competitive forces
—existing competitors, buyers, suppliers, substitutes, and new entrants.

The value chain for a business is the linked set of value-creating activities to produce a product,
from basic raw material sources for component suppliers to the ultimate end-use product delivered into
the final consumers’ hands. Each business unit must be understood in the context of the overall chain of
value-creating activities of which it is only a part. Value chain analysis is a useful tool in developing
competitive advantage based on low cost, or differentiation, or, preferably, cost-cum-differentiation.

Control system designers need to be cognizant of the organization’s strategies since systems
have to support strategies.Chapters 4 through 12 describe the different elements of management
control. In Chapter 13 we discuss the planning and control requirements of different corporate and
business unit strategies.