Critical Business Skills (notes)

Lecture 1: strategy

Lecture 2: forces of competition

Porter suggests five forces of the market that can help explain why some industries (like
pharmaceuticals) are on average profitable, and why others (like computers and airlines)
generate little profit or even losses on average (despite high turnover or growth):
1. Barriers to entry. These protect incumbents from external competition. In the case
of airlines, jets can easily be leased, pilots trained by the military, local airports
subsidised to promote tourism. Apple, Dell and others started by building computers
in a dorm/garage.
2. Availability of substitutes. Instead of flying to Prague, you may take the car, the
train, and now business meetings can be held online. (Note: substituties is not the
same as rival products.)
3. Bargaining power of suppliers. In the case of airlines, OPEC is a cartel that sets oil
prices, labour has powerful unions.
4. Bargaining power of buyers. In airlines, buyers buy on price, there are sites that
allow direct comparison of prices (information available about what you buy for what
cost), a trip on one airline is the same as on another (product is homogenous, not
differentiated)
5. Competition on price. In the airline industry there is strong competition on price, but
in the pharmaceutical industry patents and regulation mitigate this, and the patient
has very few options and often does not even foot the bill directly (which is paid
through insurance or public finances). (Note that competition over price is harmful,
but not necessarily non-price competition. Pepsi and Coke avoided price-wars, but
through advertising & marketing created an over-all increase in the demand for soft-
drinks, benefiting both.)
A sixth force has been suggested, namely complements. E.g. intel sells chips, microsoft the
software; Gilette earns profit from blades, not razors. Initially we had cheap phones, but as
services like iTunes took off (selling music cheaply) the demand for powerful phones
increased. Now we need a smartphone for banking, transportation, even parking and public
lavatories.

In an idealized free market there are no entry/exit costs for the consumer, there is perfect
information about the products, and the products are homogenous. However, the economic
profit (which includes opportunity cost) is zero on average in such perfect markets. For the
company, it is desirable to create an imperfect market (given that it does not become subject
to anti-trust laws), e.g. by differentiating products and increasing cost of entry for competitors
and cost of exit for consumers, and obscuring information about the purchase (e.g. the
financial derivatives that nobody understood).

Note that growth and profit are not the same. In the 90-ies we saw a fast growth in the
computer-building industry, but the over-all industry did not generate profits. The industries
can look very different in different countries (e.g. wine production being an oligopoly in
Australia, but over 2000 smaller producers in France), and boundaries can be unclear (e.g.
Google and Amazon compete in many spaces in many ways; Google creates the software
for Samsung phones - a complement - but at the same time also produces a phone which
competes with samsung phones).

Lecture 3: The dangers of straddling

The difficult middle ground
Your position in a market can be rated along a dimension of low-cost -- differentiated (e.g.
Walmart always selling at the lowest cost vs. Mercedes differentiated on luxuary) and
broad/narrow targets (e.g. Walmart selling many products to all sorts of people everywhere
vs. an artisan selling his own pottery in one store to rich customers).

Broad
↑

Wal-mart

Low-cost ← JC Penny → Differentiated

Ryan Air Ducati

↓
Narrow/Niche

Competitive advantage is about maximizing economical value created (ve):

ve = vp - c
Where vp is the perceived value that customers are willing to pay, and c is the total cost of
producing and delivering the good/service. It follows you can choose three strategies:
● Low-cost: reduce c as much as possible (usually accepting some inevitable but
smaller decline in vp).
● Differentiated: increase vp as much as possible (usually accepting some inevitable
but smaller increase in c).
● Dual advantage: try to increase vp and decrease c.
The low-cost position is generally associated with lower gross margin (little profit per item
sold), but high asset turnover (selling many items), low overhead and high asset utilization
(e.g. items crammed into less space on cheaper shelves in dirtier environments).

Staying and keeping out of the middle

It is very difficult to keep a competitive advantage straddling the middle position (seeking
dual advantage, like JC Penny attempted), some say impossible. The ways companies end
up in this undesirable position can be: (1) failing to choose a strategy (e.g. because
desperate for growth); (2) trying to change strategy and failing; (3) emergence of new
competition or other external threats.
Starbucks found themselves in the difficult middle position after trying to widen the products
sold (move to a broader strategy), with the founder (then no longer CEO) eventually noting
that Starbucks was no longer about coffee, and that he could not even smell coffee going
into Starbucks. Starbucks had diluted the brand, and in fact improved performance after
refocusing on the coffee (i.e. differentiating) around 2008.

A company must be weary of emerging threats like (1) attempts to imitate, (2) substitutes,
and (3) hold-ups where buyers/suppliers get into position to extract more of your profit.
Unfortunately, as growth in a market slows, you often see strategies converging and herd
behaviour (driven by risk adversity and benchmarking) where the focus is on stealing
customers from each other instead of inventing. Old commitments can make a company’s
strategy rigid. Dell challenged IBM using Judo tactics. IBM had an efficient product line
producing standardized products with close contacts with resellers and suppliers. The
downside to this advantage was rigid commitments. IBM’s factories could not easily produce
customized computers, and selling online was delayed for fear of alienating resellers. In the
words of Keynes, “The difficulty is not the new idea, but escaping from the old ideas.”

Copying just one thing from another company and just dropping it in often does not work
very well. Like with IKEA it is not just assembling the furniture yourself, or just Scandinavian
design, but the totality of the experience that makes IKEA so successful. An example is
Casci vs Walmart, where Walmart failed to do well in the wholesale market. The customers
were simply different, having a higher income and different needs, and the whole Casco
experience was tailored to them, e.g. paying a fee, having to spend more (buying in bulk),
needing a way to transport the things you bought (large cars). It was not possible to just
copy the Walmart method.

Lecture 4: What Trader Joe does not do.

Trader Joe does not sell branded products (other than their own label), do not locate their
stores in expensive prestigious locations, do not offer spacious aisles or parking, there is no
self-checkout, no coupons, no TV-advertising, only a small selection (typically 10% of a
supermarket) and their products often change. Yet it has been very successful, targeting “the
intelligent customers” who could be “unemployed professors”. Trader Joe is an example of
not doing what the competition does, deciding on trade-offs (customers you do not want) and
instead carving out a completely new value proposition.

In Blue Ocean Strategy, the authors suggest that the disadvantageous middle position in
Porter’s generic strategic framework is both possible and prevalent. Possibly Trader Joe is
an example of successfully straddling the middle position, offering both low-ish cost and a
very unique (differentiated) experience that increases willingness to pay. However compared
to organic stores they offer a low-price strategy, and compared to most retail stores they
offer a differentiated experience, making characterization difficult.

Trader Joe actually does a number of things consistent with Porters generic strategies
model. They prevent price rivalry (products change), buyer power (they buyer does not know
who is making the product), supplier power (products change and suppliers are expendable
and not shown on label, do not depend on expensive locations), mitigate some substitutes
(creating a unique shopping experience that cannot be done online). Both frameworks in fact
point to the importance of creating a distinct position that is hard to imitate.

The authors of Blue Ocean Strategy mention CIrque du Soleil and Southwest Airlines as
examples of successfully straddling the middle position. The lecturer, however, expresses
doubts, since Cirque du Soleil actually charges a premium, and Southwest offers a low-cost
product that is distinct but not differentiated in the sense of increasing willingness to pay.
Note that, according to Porter’s generic strategies model, differentiation is not the same as
being different, but rather defined as optimising for perceived value (willingness to pay).

Very often CEOs want to grow (e.g. grow sales) and companies begin to violate deliberate
trade-offs to chase growth. This becomes particularly prominent in companies in saturated
markets. In Blue Ocean Strategy, the authors suggest four important questions in their four
actions framework:
● What can we deliberately not do that the competition does (eliminate or reduce)?
● What can we create that the competition does not do, or what can we enhance?
The combination of benchmarking (everybody trying to catch up with competitors), risk
aversion and focus on growth, create homogeny. One academic noted that she saw
heterogeneous homogeneity all around. On the shelves of a supermarket you can see all
sorts of bottles of water in different sizes and brands, but at the end of the day, it is just
water, and a very expensive route to it.

Lecture 5: First and second movers

Being the first to market can confer an advantage (e.g. GIlette in razors, Sony and the
walkman, Coca Cola and soft-drinks, Hoover and vacuum cleaners), but in many cases it
does not (e.g. Friendster predated but lost to Facebook, several search engines predated
but lost to Google, E-toys started selling toys online but disappeared). In fact, in one study
across 50 categories, only 15 of 50 categories had successful pioneers. Pioneers often lack
funding, and may find it difficult to be agile enough to adapt as original decisions need
revision, either because of complacency/ organizational inertia, the sunk cost trap (being
unable to cut losses, throwing good money after bad), and because of commitments.

There can be a first mover advantage conferred by:

1. Economies of scale, if the first mover can quickly grow big enough to take advantage
of falling cost per unit produced. Often pioneers are underfunded to take advantage
of the large investments usually required to benfrit from economies of scale. Often
the economies of scale are overestimated (declining or reversing as companies
become too big, too complex and too bureaucratic).
2. Network effects exist when the value (buyer’s willingness to pay) increases as more
people use the product. This is most evident in online games, social networks, and
online market places. Often there are also switching costs for the buyer, who is
locked-in to a product. Sometimes, however, users prefer less crowded or more
select members. (E.g. Friendster expanded into the asian market, but those users
were not interested in communicating with people in the US, whereas Facebook
initially targeted people with .edu emails, focusing on a select group that wanted to
interact.)
 3. A learning advantage can make the cost per unit produced fall because of the
experience gained, declining with the cumulative number of products sold (e.g. in
building a submarine). There may however be spillover effects, where
knowledge/experience is transferred to the competition. Intellectual property
regulations may mitigate against this, where applicable.

Other factors that may suggest a first mover advantage includes importance of subjective
value (e.g. brand), short expected life of market, high cost of imitation. The freemium
strategy is often used online, where there are low marginal costs for adding users, and
considerable network effects (increasing the value of each additional user).

Lecture 6: Netflix vs. Blockbusters

Innovation can be incremental or disruptive. Established businesses often fall back on
incremental innovation, making small improvements catering to their core customers. Large
established companies exercise rigorous financial control, but assessing investments in truly
innovative products is difficult or impossible. (Metrics like return on investment, or a
discounted cash flow analysis simply cannot be made reliably, since many parameters will
not be estimable in advance.) Investment in new, risky, poorly understood products also
have to compete with currently successful products and business models, shifting revenue
away from what works to what might work. Market researchers will tell you to be customer
centric, perhaps use focus groups to obtain suggestions from core customers. However, as
Steve Jobs noted, you “don’t invent the iPod with a focus group.” Disruptive innovation
involves creating fundamentally new products and business models. Established companies
often need to create subsidiaries, protected from the rest of the business, with the mandate
to go ahead and innovate.

Blockbuster’s core customer was the ‘soccer mom’, whose experience of crying children who
could not rent Finding Nemo because all copies had been rented out, yielded the hit-based
strategy, with entire walls filled with the number one hit, that later had to be sold at a
discount, and few available niche movies. Netflix did not want to be in the top hits business,
focusing on young males, who wanted to watch movies not on the top charts, did not want to
pay for late returns. The stake through Blockbusters heart, however, was when Red Box set
up vending machines, renting out only the top hits. Blockbuster ended up straddling the
market (neither offering top hits with high availability, or a broad selection of movies), as
customers turned to substitutes (internet rents, vending machines, streaming). [Note: is this
really a substitute?]

The lower cost per additional unit sold has led to less hit-based strategie. At one point, 21%
of revenue from Netflix movies came from movies not found in Blockbuster. Whereas
Walmart was the biggest music retailer, 90% of revenues typically came from the top 5% of
approximately 4500 albums. On Rhapsody, there were at one time 1.500.000 songs with
40% of revenue coming from streaming songs not available at Walmart, and even song
#900.000 being streamed once a year.

Polaroid is a company that actually had advanced research in digital photography since the
80-ies, but senior management resisted changes. Polaroid had made its money from the
razors-and-blades strategy, of selling cameras cheaply and special film at a high cost. In
digital cameras, a strong profit has to be made from the hardware, as no additional profit can
be extracted from supplies.

Even though the classical characterization of competition in the markets focuses on

incremental improvements, a bigger threat seems to come from disruptive innovations,
bringing entirely new products and new business models. Non-volatile computer storage has
undergone considerable advances, but through fundamentally different technologies (tapes,
disks, hard-disks, optical media, solid state storage), where incumbents are displaced by
newcomers as the key technology fundamentally changes.

In retrospect, the distinction between incremental and disruptive innovation seems

descriptive, but does it help us predict or prescribe advice? Christensen’s model of disruptive
innovation focuses on the error of established companies failing to seize the opportunities
presented by disruptive innovation. Conversely, companies may make huge misguided
investments, or develop into a disjointed firm without focus. It may also not be equally
applicable in all industries (see also Lepore J., 2014 in New Yorker).

Lecture 7: Anticipating your rival’s response

In entering a market or defending your market position, it is necessary to consider your
rival’s response. The incumbent may choose to defend their position aggressively, or to
accommodate (accepting perhaps a small loss of market share in order to preserve
profitability). You may need to consider:
1. The rival’s financial incentives. (Can they afford a short term hit to protect long term
interests? Are they under investor pressure to make profits now? Are they under
pressure - or committed - to expanding market share now? Can they put up a
targeted fight, which is less costly - e.g. offering products at a discount only to those
customers who are most price sensitive and likely to defect to the competition in a
price war?)
2. Are there important non-financial motives? (Are they over-committed to an idea, e.g.
sunk cost trap. Are the senior executives trying to reapply a formula that has worked
before.)
3. Are there political or contextual factors? (E.g. a French company cannot as easily
close a production facility or fire workers as an American company.)
Proctor and Gamble tried to enter the bleach market, dominated by Chlorox, and had a pilot
ready to test marketing in Portland. When Chlorox got wind of this, they dropped the
equivalent of a gallon of bleach per household on Portland, signalling that they were willing
to fight bitterly. For P & G, a big chemicals corporation, the additional investment needed to
fight the battle was not worth it, and they discontinued their attempts to enter the market.

Ryan Air entered the market, offering only 4 round trips a day on small planes between
Dublin and London, but at a price of E£ 98 (compared to E£ 166 on AIr Lingus and BA). For
Air Lingus or BA, reducing the price of tickets would lead to a considerable loss of profits.

Holland Sweeteners tried to enter the aspartame market when Nutrasweet’s patent expired.
Half of Nutrasweet’s sales were to Pepsi and Coke, and both companies would have liked to
reduce their dependence on Nutrasweet. However Nutrasweet had a considerable cost
advantage because of scale, and because of the learning curve. (In fact the price of
production had fallen continuously as the process had been gradually improved, and only a
few factories could supply the global demand.) Nutrasweet was therefore in a position to
dump the price of aspartame if need be. Also Holland Sweeteners was competing on price
alone, with no ability to differentiate its product. In fact, a major concern for Pepsi and Coke
was that (even though both would have liked to be less dependent on Nutrasweet) they were
caught in a prisoner’s dilemma; both were afraid to switch supplier first for fear that the other
would use a change of ingredient against them. (They were afraid the competitor would
suggest a change in ingredient caused a change in taste.)

Coke and Pepsi is an example of how cooperative behaviour between competitors may
appear, the two having advertised aggressively, jointly increasing the total market for soft
drinks, but never engaging in price wars. Typically this only happens when very few players
are on the market (with less risk of defection), who have known each other for a long time
(approximately 100 years for Pepsi and Coke), and a tacit agreement to play nice can
emerge.

Lecture 8: Why did Disney buy Pixar?

Sometimes firms compete in several businesses, often by forming conglomerates of
subsidiaries. Why do they choose to do this “under one roof”, rather than spontaneously
cooperating by the impetus of Adam Smith’s invisible hand of the market, or simply entering
into contracts or partnerships with other companies? The purpose is to leverage/achieve
scope economies, such that ultimately the units integrated into a conglomerate should be
better off than comparable rivals, and/or outperform comparable rivals. The conditions do not
always favour such integration, and there is a tendency to overvalue economies of scope,
unintentionally creating diseconomies of scope, destroying value rather than creating it.

In the case of Disney, the synergy comes from sharing characters across stores, theme
parks, films, and even hotels near the theme parks where you can have breakfast with
Mickey Mouse. This increases willingness to pay. (In other cases, the cause of synergy may
instead be due to a decrease in cost.) In the case of Disney, the characters are really
valuable, often appreciating in cost over time (as opposed to the value of machinery
depreciating). As Buffet commented, “The mouse has no agent” (unlike popular actors) and
can be used again and again, and in different ways. The characters are fairly specialized
entities, but that can be used in related products targeting children (e.g. films, toys, games,
theme-parks, themed hotels). Parts of the operation are kept in-house (e.g. hotels that need
to be themed need to be run as subsidiaries, design of toys), whereas others are out-
sourced (e.g. production of the toys).

The choice of how closely to cooperate is in part determined by the transaction cost. The
transaction cost helps explain why big firms exist (instead of smaller companies simply
cooperating as free-market agents or by contract). Entering into an agreement (e.g.
partnership or purchase agreement) has a cost in terms of time, risk, money and manpower
and can be cumbersome and inflexible. Doing something in-house also has a cost,
increasing the complexity of the organization and bureaucracy through the need of internal
coordination, and can require different locations. Three factors tend to increase the
transaction cost with external entities (hence favouring integration):
 1. Uncertainty. The agreement may need to be changed, or it may be difficult to
depend on the other party.
2. Frequency of interaction. Frequent interactions may be costly and difficult to
coordinate across organizational boundaries.
3. Asset specificity. If the asset subject to the transaction is very specific, opportunistic
behaviour may arise (since one party depends on the other very specific product).
[Also the value of acting on a free market may be reduced, because there are no
additional buyers?]

A resource/asset can be fungible (interchangeable) or generalized (allowing easy transfer

between units in general, such as brand management expertise or accounting) or
specialized (such as a patented production formula or specialized engineering skills,
important in one unit but with limited usefulness across different units). The most extreme
example is an oil refinery and an oil pipeline. The oil pipeline cannot be moved, and only
ships oil; the oil refinery can only function if it receives oil through that particular pipeline. If
these were separate companies operating independently, we might expect opportunistic
behaviour (e.g. raising the price of using the pipeline), with the pipeline having no other way
of raising revenue, and the refinery having no alternative supplier of the service.

Certain things are very difficult to agree by contract. For instance, in the case of Disney, how
do you contractually agree with a hotel how Mickey Mouse should behave around the
breakfast table and how to give the Disney experience? It is preferable to make that hotel
part of your business and monitor these things closely, and flexibly alter staff, decoration,
etc. A similar example is Starbucks which owns its locations (attempting to create a
Starbucks experience), rather than Dunkin Doughnuts which is a franchise (more of a quick
get your coffee and leave business).

In horizontal integration, the companies operate in different product markets. They may
diversify into different related product markets (related diversification), e.g. Disney (offering
movies, toys and theme-parks related to their characters) or Proctor and Gamble (offering a
wide range of chemical products). They may also seek to diversify into completely unrelated
markets - e.g. the Virgin group (selling records and an airline) or General Electric.

In vertical integration, the company operates in one market, but diversifies into different parts
of the supply chain. In backwards integration, they move closer to the raw product typically
by producing parts or extracting raw material (e.g. Apple producing ARM chips, or Amazon
beginning to publish books). In forward integration they move closer to the consumer (e.g.
Apple creating Apple stores).

Lecture 9: The diversification discount

In the past, we saw some successful conglomerates seeking unrelated diversification (e.g.
Sara Lee and Fortune Brands) but increasingly it seems the sum value after breaking up into
parts (the breakup value) is greater than the value of the whole. This lost value is referred to
as the diversification discount. (It can be measured quantitatively, e.g. by looking at ROI for
units vs. comparable competitors, or the estimated value of spinoffs compared to current
value of company.) In the US focused firms do well, stock prices often fall after
diversification, and both parents and spinoffs perform better after splitting. Since companies
may differentiate because they are not doing well, or choose to buy up companies that are
underperforming in the hope of fixing them, some of this needs to be interpreted cautiously.

Today there is considerable market skepticism to horizontal diversification, and event

companies pursuing related diversification find themselves under pressure to break up. (E.g.
HP split into two companies, Ebay split off PayPal, Ganette split up their
newspaper/publishing/broadcast operations.) It is however worth noting that one third of
firms actually traded higher than their breakup price, suggesting there was a benefit to
keeping the company together (although they were usually companies pursuing related
diversification).

In unrelated diversification, there is no synergy because of product relatedness (economy of

scope). Companies have instead argued there is a synergy because of common good
management (economy of governance). General Electric outperformed the market for a
hundred years, having widely diversified. GE was known for the “GE way” which included a
talent development process, six sigma, working out best practices, and other examples that
probably contributed to good governance in subsidiaries. However, subsidiaries were almost
all in manufacturing, competing on price, in mature sectors of the market and mature
technologies. It may not be that a clear dominant governance logic could be applied across
its units otherwise. Today, however, there seems to be no clear economy of governance in
GE. Presumably the competitors have learned about the GE way, so GE cannot offer its
subsidiaries any superior governance any more.

Classical reasons for unrelated diversification (but seemingly invalid in today’s US economy)
are:
1. Diversifying risk. Just like you want to diversify your portfolio, a company might want
to diversify risk (e.g. by having subsidiaries in cyclical and countercyclical phases).
2. Fuel startups with money from cash cows. The idea stems from the BCG matrix (see
below).
3. The company operates in a stable market, and wants to increase growth/profit.
4. Enhance value on the stock market by acquiring a performer.
The main problem is that the external market is more efficient than a CEO at determining
where to invest, so why not just return the money to the external market? (Note that even
traders do not beat the market long-term.) You can invest with very little overhead, but not
diversify. (E.g. the parallel to common sense diversification to manage risk breaks down
when you consider that as an individual you can diversify your stock portfolio easily/cheaply,
but a company will need a corporate office to diversify its operation!)

The diversification discount might not have existed in the USA in the 60-ies, and does not
seem to exist in India today. The capitalist market needs certain institutions to function well,
which may not exist in India today and may not have functioned as well in the USA in the 60-
ies, and the conglomerates may fill this institutional void. Today in the USA companies have
easy access to capital, consumer reports provide the purchaser with information about
products, market researchers about consumer tastes, government regulators certify quality,
etc. In a country like India, the brand House of Tata (?) may provide similar functions: (1) the
brand certifies the quality, (2) talent can be reallocated in the company, (3) cash can be
injected where capital may be hard to come by, (4) help with regulation, bureaucracy and
corruption by leveraging the contacts of the large firm.
Lecture 10: vertical integration.
A common (fallacious) argument is to vertically integrate to capture the margin with a
markup (i.e. capture the profit that otherwise would have gone to someone else). The
problem is: you will need to invest money in vertical integration, and is this money well
spent? Will you really sell your products more efficiently as an outside actor?

Disney had opened some successful stores, but customers started buying toys increasingly
from large stores (e.g. Walmart) rather than dedicated toy stores. Disney entered into an
agreement with Children’s Place, where they ran the stores under the Disney brand,
leveraging their expertise in retailing. The business declined further, and Children’s Place
exited the agreement. Steve Jobs was on Disney’s board, and made the following argument:
You should only forward integrate if you create an experience that increases willingness to
pay (like the Apple stores). Disney invested heavily in new stores, which were more
experiential.

Other companies have flagship stores that promote the brand, but the company does not
use the stores as the main mode of retail. (E.g. the M & M store in New York.)

It is possible to pursue a tapered/combined strategy. Zara has its own clothing factories in
Spain and North Africa. It allows them to pursue a fast follower strategy, rapidly creating new
clothes (with an eye on the major fashion houses), in small batches, producing them in their
factories, and selling them in their stores. At the same time, items like T-shirts and socks are
manufactured in cheap Asian factories by contract. The higher production costs in European
factories is offset by more flexibility, the stores being able to keep less inventory (and having
to mark down the cost of fewer items because of excess inventory).

Vertical integration can allow you to secure access to scarce supplies (or even prevent
competitors’ access to it), mitigate the power of suppliers/buyers who are in a position to
extract your profit (e.g. if Walmart is your major buyer and is known to be a tough negotiator,
or you rely on specialized components sold by only one company), elevate barriers to entry,
may allow you to differentiate your product and increase willingness to pay (e.g. Apple), and
help you acquire valuable information (e.g. perhaps you want to be talking to your customer,
instead of your retailer).

There are downsides to vertical integration. In your own factory, the incentives might be
lower if there is a guaranteed buyer. Apple finds itself competing with its customers. It is
difficult to switch to different technologies or processes. There are high fixed costs, which
might become problematic in a recession. Large investments are needed, and later the exit
barriers are high (and can be especially high in countries with more regulated labour
markets). There may be internal conflicts, and difficulties setting the transfer price (used as
an estimate of ‘cost’ of selling/buying internally). Different operations will require different
management practices, which may be a challenge for the executive team. You will
necessarily have a lower asset turnover, with less efficiency that has to be offset by a higher
profit margin in order to generate return for investors.
There has been a decline in vertical integration too, as the transaction cost has decreased
(allowing easier outsourcing as transportation, communication and IT has improved). In
Japan, close long-term partnerships has been an alternative to vertical integration.

Lecture 11: Mergers and acquisitions

Mergers and acquisitions can make sense, but very often fail to deliver on promises. More
specifically, the long running returns (that stockholders are interested in) are not realized.
Often the economies of scope or governance are overestimated, and integration after the
merger can be difficult.

Examples of failed mergers and acquisitions include Daimler buying Chrystler for $36bn,
only to sell it a few later for $7bn (actually less since, by the terms, some of that money was
ploughed back into Chrystler). Time and Warner merged at a cost of $182bn, only to split up
a few years later. There have been waves of mergers (e.g. in the alcoholic beverages
industry and the entertainment industry in the 90-ies) largely driven by herd behaviour.

A company usually pays an excess cost in acquiring another. Typically if a company trades
at $x, the buying company has to pay 120-140% of $x. They are willing to do this because
they believe the company is more valuable as a part of the purchasing company by
leveraging economies of scope or economies of governance. Often the value of the parent
company falls after an acquisition (because the market does not believe they will realize the
synergies), but the selling shareholders are of course happy. (This is akin to the winner’s
curse at auctions. Each buyer sets a price unaware of the other buyers’ price, where the
actual value is closer to the average, but the highest bidder wins.)

Acquisitions are often presented as mergers, but in actual fact, even in mergers, usually one
management team ends up taking over. Outright hostile takeovers may make sense if you
believe there are clear economies of governance that can be realized (i.e. if the buyer thinks
the bought company is poorly managed and can be worth more under new management).

If long-running returns (the basis of stock value, an estimate of earnings to come) so often
are not delivered, why do M&A occur? One possibility is the principal agent problem. In a
small company the principal (owner) and agent (who exercises daily control) are the same,
and interests are aligned. In a big company, the ownership is spread over many
shareholders with less insight into the company, and the CEO may be interested in empire
building, status of running a big company, power and publicity. Even if there is a board, the
CEO may have had a hand in selecting them or may even be the chairman, and the board
members lack insight into the daily activities of the company. There may be bonus plans and
payment in stocks, but even that is not perfect. The imperfections that remain after control
mechanisms are in place, is called the agency cost.

Additionally, if there are trends in the industry (such as in the entertainment industry in the
90-ies), risk averse CEOs look to copy competitors. With ever shorter tenures as CEO and
more commonplace firings, being able to say, “we are doing the same as everyone else,” is
safer when a strategy fails. Often CEOs argue that “we think there will be consolidation in
this industry, and only three companies will remain, and we should be one of them.” There
has been a tendency to believe globalization would lead to consolidation, where data
actually suggests the industries become more fragmented. CEOs also often find it easier to
talk about more predictable cost-cutting synergies of merger (rather than more speculative
revenue synergies from new products). Once committed to a merger, it can be very difficult
for an executive team to cut losses and abandon stated ideas. This can lead to bidding wars
simply “to win” where the cost exceeds the worth of the acquisition to the company. Often
divestment after unsuccessful mergers occur with the change of CEO, who is not beholden
to sunk costs.

Doing due diligence (studying firm and projecting what it is worth) is important, and how it is
done also affects success of later integration. There are quantitative models that can be
used (e.g. Discounted cash flows or price earning multiple methodologies) but ultimately the
models include a lot of assumptions and the results are often highly sensitive to those
assumptions. Therefore, often the analyses are shaped to give the desired results, so the
conclusion drives the analysis rather than the analysis driving the conclusion. Many
companies focus on the synergies, and overlook the investments needed to realize the
synergies, and the cost of anti-synergies.

Alternative to mergers and acquisitions include joint ventures. The advantages of joint
ventures (especially across geographical regions) include:
1. May be needed for government regulations
2. Cultural and language barriers
3. The local unit can operate independently
4. Opportunities to learn bilaterally
5. May be possible where the multinational company does not have the capital to
expand into a new market
Disadvantages include:
1. Multinational may lose control
2. May put their brand at risk
3. May lose intellectual property
4. And the local company may become too dependent on the multinational.

Lecture 12: The lean startup

(The marshmallow challenge, where kids do great, and business school graduates poorly.)

Many successful companies have pivoted product or strategy completely. Yelp started as an
automatic mailer to friends, but became a review system for restaurants. Twitter started as a
podcaster. Starbuck started by selling coff beans and machines.

The lean startup attempts to get the strategy right NOT from the beginning, but as soon as
possible. Get a minimally viable product off the ground quickly, and adapt from feedback.
Treat it as an experiment. Do not fall in love with your idea or product, but be ready to pivot.
Be ready to “fail often to succeed sooner”, small bets being better than the billion dollar bet.

A product does not a business make. You need a business model too. Startup investors do
not just look at the product and strategy (which they know will change), but also the team.
Are they able to learn, adapt, and pivot?
Ask yourself one simple question: What is the customer need or pain-point you are trying to
solve?

Lecture 13: the power of superior operations

Automation struggles with non-standard tasks or situations. Sometimes people prefer seeing
a friendly face. Production can be outsourced, or event moved off-shore. In some cases,
production has returned either as inflation in the low-cost country drove production prices up,
or as loss of control over operations caused problems. Toyota for a long time produced the
Lexus series only in Japan, but with improving capability in other countries and increasing
demand, operations strategy changed, with the car now also produced in the US and some
other countries.

Jeni’s ice ream originally sourced materials from nearby farms and mixed in small batches.
With increasing fame, new shops were opened and some grocery stores wanted to sell their
ice-cream. A new operations strategy was needed.

Operations strategy guides the processes, people and technology to deliver the product in
accordance with the vision. It needs ever ongoing revision. Some methodologies of
optimizing operations exist. Lean productions attempts to focus on processes adding value,
and six sigma attempts to reduce variability.

Lecture 14: Lean production

(This lecture was not really about lean production, in the broad sense, but more about
manufacturing strategy.)

As an entrepreneur, you may have developed a new product, but then face the difficulty of
becoming the provider of a new product. You will have to decide to “make or buy” (i.e. in-
source or out-source). You may decide to build a factory, but it requires substantial
investments and will incur running costs. You may estimate the cost and divide by projected
sales (for a price per unit estimate), but sales are very difficult top project, leading to either
disappointed customers or excess inventory sold at markdown. You may find it difficult to
scale or customise your product in your factories, something a dedicated manufacturer will
have specialized in (being their core business). However, if you out-source, the
manufacturer will not truly have your company’s best interest in mind, you may require
oversight that is taxing, and there may be a high transaction cost. Off-shoring creates
additional problems: there may be labour or environmental abuses that can damage your
brand, you will require experienced legal experts or consultants to help navigate the many
pitfalls, there may be theft of intellectual property, quality may suffer with expensive product
recalls as a result, and there may be unforeseen problems resulting from corruption, crime,
deficient infrastructure or unreliable transportation. For this reason, amongst others, near-
shoring or re-shoring has become a trend.

There are five manufacturing strategies:

 1. Ship to stock. Raw materials are ordered, goods produced, and delivered to
customers ahead of orders being placed. (E.g. fresh goods in a grocery store.) The
problem is that sales forecasts inevitably will be off, leading to excess inventory or
stock outages.
2. Make to stock. The goods are produced, but stored in a central stock. They can be
moved from the central store to the customer at short notice, incurring a small delay
in availability, but with considerably less inventory waste since the inventory is
pooled.
3. Assemble/configure to order (“mass customization”). The goods are produced to a
semi-finished state. Final customization and assembly takes place after order. This
was used by Toyota. SHipping a car to the US takes four weeks, but customized cars
are delivered in a few days to a couple of weeks, because the final assembly is done
in the US based on a stock of semi-finished parts made in Japan.
4. Make to order. The material is bought in advance, but no production takes place
before the order. (E.g. Chipotle Mexican grill or Nike’s customizable shoes.)
5. Buy to order. Nothing is done before the order comes in. (E.g. big industrial or
defense projects, infrastructure projects, buildings, art projects.)

Keeping inventory was used as a way to overcome other problems in the organization (e.g.
incorrect sales forecasts, quality problems, unreliable supplies). One aspect of lean
production is to reduce waste by not keeping excess inventory, and instead focus on the
problems, choosing or helping the suppliers to improve reliability, expecting perfection and
improving the processes.

Lesson 15: Service operations

Services are characterized by their intangibility as a delivery, where they provide an
experience or an outcome. Rather than marketing or producing good and earning money
from one-time sales, service deliverers co-create value with their customers and have an
ongoing relationship with their customer. Increasingly companies are turning to this, as a
way to keep the customer. (E.g. apple’s iTunes, Xerox no longer sells photocopy machines
but places a multifunction machine with the customer and charges by use.)

The service quality scale is often used to measure satisfaction, by comparing the gap
between expectation and perception after a service is delivered. (P>E is good.) The scale
measures five dimensions:
1. Responsiveness: how promptly does the provider respond to the customers needs?
2. Assurance: is the customer at ease that the service will be provided in accordance
with his wishes?
3. Tangibles: facility, equipment and personnel.
4. Empathy: caring and understanding in the contact.
5. Reliability: is the service delivered in a dependable and accurate manner?

Both expectations and perception of service are important, and always evolving. Sometimes,
paradoxically, providing that extra service in a “special situation” can raise expectations
unrealistically.
Lessons can be learned from the manufacturing sector. From the process improvement
branch of service ops management:
1. Standard work. Find the best way, document it, teach it to others.
2. Lean processes and process flow. E.g. Wendys drive-through improved lead time
(rather than opening up additional lanes), by looking at process time (time actually
taken) and takt time (time needed to keep up with demand). Changing
price/incentives to move business away from peaks (e.g. Toyota’s heujunka, Dell’s
dynamic computer pricing).

(E.g Zappo shoes. Encouraged to have open and honest dialogues, move away from
scripted conversations, no rules on call duration.)

Lecture 16: matching supply and demand

Undersupply hurts customer confidence, but over-supply leads to excess inventory and
costly markdowns. There is an inherent conflict between sales and operations. Sales are
pressed to make promises that are hard to keep, and operations are pressed to keep the
promises with marginal resources. S&OP-planning (sales & operations planning) is one way
to mitigate this.

There may be organizational incentives that lead to projections being skewed. For example,
if sales are rewarded for exceeding expectations, their sales projections are likely to be low.
If executives are rewarded for cost per unit, ops will pursue economies of scale and large
batches.

Sales forecasts
Sales forecasts can include:
1. Quantitative estimates of historical sales of similar (e.g. similar model printer) or
complementary items (e.g. printers and cartridges).
2. Qualitative information from market intelligence (sales of related products produced
by other companies, market inquiries, demographic changes), or expert opinion (e.g.
field sales representatives).
3. Combinations (e.g. a quantitative analysis, followed by consultation with expert
opinions about whether something unaccounted for lies ahead or has happened).

The capacity to deliver

The capacity to deliver is affected by your supplies, production and logistics/distribution.
Often the supply rests outside your control, but constraints may be absolute (simply not
available) or affect price (can be acquired at a higher cost or other tradeoff).

A material and resources plan (MRP) details the quantity and timing of all that is needed.
The master production schedule (MPS) details what the company is expected to produce
over time.
Logistics and distribution
How much can be stored and moved? Are there the trucks and the space?

Feedback
Everyone needs to communicate back when plans (inevitably) fall apart. This may mean
contacting buyers about adjusted delivery dates, or salers steering other customers away
from problematic products. Priorities need to be et about what is to give way when demands
are too high to meet.

Integrated S&OP
In 1958, Forester described demand amplification in a supply chain, where delays in reacting
to changes in demand would be amplified (the bullwhip effect). Each step in the supply chain
would see an increase in demand, and react to it by increasing their demand a little more.
Increasingly, companies are coordinating across company boundaries, replacing the need to
keep large inventories with the ready exchange of information.

Lecture 17: Right sizing inventory

The US inventory-to-sales ratio (IS-ratio) is around 1.30, meaning that companies keep a
stock worth 30% more than their sales. Inventory carrying/holding costs include: opportunity
cost of capital, insurance, tax, storage, risks (damages and theft) and products becoming
obsolete or out of date. Particularly small shops, who are vulnerable to reputation may feel
the need to keep inventory, but at the same time periods of poor cash flow is the leading
cause of small businesses failing. Some companies like Trader Joes and Aldi keep inventory
down by just stocking one of each type of product.

Two measures of efficiency of inventory handling include inventory turnover (or inventory
turns) and gross margin return on investment (GMROI).
cost (¿ your company )of goods sold
inventory turnover=
average inventory cost
gross margin( $)
GMROI=
average inventory cost
gross margin=gross profit=sales profit =net sales−cost of goods∨services sold
net sales−cost of goods
gross profit margin=
net sales

The cost of the goods sold is the price your company paid for them, plus discounts, minus
shipping. The average inventory cost is the value of the inventory averaged between the
beginning of the period and at the end. The gross margin is the net sale of goods minus the
cost of goods sold. This is the difference between what an item costs and what it sells for.
It's also known as the gross percentage of profit, or the margin.

Many consider that a product must have a GMROI of 3.2 to break even in the US. But other
things may matter too, such as customer relations with important customers that must not be
disappointed, or introduction of new items that drive sales requiring high initial inventories.
There is an order processing cost involved in processing each order of inventory, which may
lead to e.g. minimum order policies, volume discounts, etc.

Four strategies for buying inventory include:

1. Fixed quantity, fixed frequency. The same quantity is ordered at regular intervals
(e.g. newspaper subscription.)
2. Periodic review strategy (P-system). Inventories are checked at a regular interval,
with new orders being placed below a minimum inventory tolerated, bringing the
inventory up to the maximum inventory level tolerated.
3. Fixed quantities are ordered as inventories drop to zero, balancing annual cost of
holding vs annual administrative costs of ordering.
4. Just-in-time. Inventory is considered a liability, not an asset. Initially a kanban system
was used to signal need for replenishment. This is possible if supplier lead times are
short and reliable. Surges in demand or disruption of supplies present problems.

A prioritization (“ABC”) method can be used to balance the choice of erring on the side of
high or low inventory. Goods are prioritized, and inventory is prioritized such that:
A. Items where a stockout should be avoided. Goods old in high volumes, producing
high margins, or bought by best customer, or may be new items in a launch.
B. Items where a stockout would not be as bad. Goods fading in popularity, easily
substituted, and not bought by best customers.
C. Items that are on the way out. Goods falling in popularity, unprofitable, costly to keep,
or risk of becoming dead stock (i.e. losing resell value).

Lecture 18: Managing supply and suppliers

The supplies department can be responsible for half of a companies spending, and have a
huge impact on the quality and sustainability of your products (or defectiveness by choosing
shoddy supplies), and sets the tone for your suppliers’ eagerness to collaborate. Originally
these departments were simply purchasing departments. They later became procurement
departments, that also assessed the quality of suppliers and their qualifications, inspected
the suppliers’ processes. Increasingly strategic supply management is about value
engineering, figuring out how to reduce cost together, and event working with select
suppliers to generate ideas, co-branding and even joint ventures.

The lecturer recommends keeping open communications with the suppliers, giving them
opportunities to remedy problems (where often suppliers report being dropped without even
knowing there was a problem). Supplier score cards can be a starting point for feedback
conversations, typically with a few important metrics, often quality/cost/delivery, perhaps
responsiveness, invoice accuracy or ease of doing business. Independent actors can be
used to assess how suppliers like you as a customer (e.g. fairness, surprises, fair sharing of
benefits). Some companies use early supplier involvement in product development, to avoid
surprises lately, and even evoke suggestions and ideas from suppliers.

The supplier may also be motivated by non-financial rewards, such as access to markets,
intelligence, case-studies and introductions to other customers.
A RFI (request for information) is a way to gather general information about the a supplier. A
RFQ (... quote) spells out the needs and seeks the best price or service. A RFP (... proposal)
is an open-ended request for proposals to a described problem.

Instead of just considering purchasing costs, you often want to consider the total cost of
ownership (TCO), including purchasing price, cost of financing, cost of preparing for use,
cost of use (including inventory costs), post-use costs (e.g. loss of dissatisfied customers,
warranty costs from faulty products, liabilities if there are hazards).

Seasoned buyers will know who to approach and how. Mission critical supplies (either highly
visible to the customer, or that affect the quality of your product) should probably not be
sourced only with price in mind. When sourcing invisible commodity items, however, price is
more important. Companies may put on a reverse auction (where the sellers bid and lowest
price wins), but be careful if you only select a product on price. You never know what you will
get.

Sole sourcing (from one supplier) allows you to concentrate your spending, achieve volume
discounts, perhaps collaborate closely, but also creates exploitable dependency on one
supplier. Bargain shopping from many suppliers allows redundancy and forces suppliers to
compete on price, but often the strong suppliers avoid the “feeding frenzy”, leaving you with
the weaker suppliers. Many opt for dual or trisource sourcing.

Centralized control over purchases allows consolidation of spending and - since orders are
large - securing volume discounts and a high priority of service from the supplier. It can also
aid in standardization (such as in MacDonalds that tightly control the suppliers in order to
create a uniform experience). Decentralized solutions allows more flexibility to cater to local
needs and solutions.

Lecture 19: The long reach of logistics

In aq grocery store, up to 20% of items can be out of stock, with 4% loss of sales in the retail
industry due to stockouts (in a market living off 2-3% margins).

Distribution strategies include: Intensive (attempting to put the product in every household,
fighting competitors to blanket the market), selective, or exclusive (with limited number of
people buying but often with a customized buying experience, like luxury cars or jewelry, and
licenced distributors).

Proctor and Gamble coined the post Director of First Moment of Truth. The first moment of
truth is the product showing up at the store at the right time. The second moment of truth is
when the customer sees if it performs as expected. The point was that the second moment
of truth never happens unless the first has happened.

In order to place your products closer to the customer (to avoid stock-outs) you may have
warehouses or shops in more locations. However more location means more inventory -- in
particular more safety inventory. Whereas the cycle stock (for forecasted sales and normal
supply lead times) is not affected, the safety stock (for bursts of increased demands or
unexpected supply delays) increases proportional to the square root of the number of
locations.

As sales flatten and the market is saturated, additional sales locations may just lead to
cannibalization. Instead of a sale coming from a competitor (a good thing), sales come from
partner stores (a bad thing).

Companies may turn to third party logistics providers (3LP) instead. Other strategies include
VMI (vendor managed inventory) where the vendor places and manages inventory at a
buyer’s location, and takes responsibility for stock-outs. A step further is VOMI (vendor
owned and managed inventory) where the vendor also owns it (similar to consignment). This
can be advantageous for small stores/vendors, for whom it frees up cash.

Lecture 22 - an eye on the margin

Big customers are not always good customers, and certainly all business is not good
business. While financial accounting fulfills regulatory requirements for tracking and
reporting money in a company, managerial accounting exists for the in-house purpose of
making informed business decisions.

Margin analysis can be done by product, by product line, by service, by customer or by type
of customer (after segmenting the customer base). Especially in business-to-business sales,
there are typically a few big customers. It is then typical to isolate the biggest customers and
analyse them individually, and then segment the rest, reporting them by segment. Often an
80/20 pattern transpires, i.e. where something akin to 80% of profits come from 20% of
customers.

Focus on margins - not sales. Calculate a cost-to-serve per customer (or segment) in order
to arrive at a customer profit contribution. Start by looking at activities and processes, to
calculate a cost per activity. (ABC, activity based costing, Kaplan.) Usually there is a cost
driver (an important correlate of cost). For instance, for deliveries, this might be time or
distance travelled. Derive a way to estimate cost per activity (e.g. $2 per mile) which can
then be applies to estimate cost-to-serve (by looking at activity logs for each customer). Only
include costs that would go away if the cost-object (e.g. customer or segment) would go
away. Ignore splitting up fixed costs (e.g. warehousing) which would be there anyway, and
are hard to assign to a particular customer. Remember, an approximate solution to estimate
each customer’s contribution to profits is all we are after.

THe next step is to see if customers can be made more profitable, preferably by means not
visible to the customer (e.g. increasing cost-effectiveness of relevant business processes).
ALternatives include raising price or adjusting the service/product. Differentiated
services/products are becoming more common (e.g. who gets upgraded to first class). In the
worst case, customers can be fired, but overhead costs not included in the analysis still need
to be paid (perhaps needing more revenue at lower profitability at least temporarily), it may
be difficult to find new customers, and your reputation may be affected.
Lecture 23: supply chain management
The supply chain is a network of companies that work together to supply an end-use market
with a service or product.

Cooperation in the supply chain can realize benefits to all. Coca Cola enjoyed a two year
advantage on Pepsi because it cooperated with its supplier of corn syrup to develop a stevia
based sweetener alternative (which initially had the problem of a bitter after taste). Pepsi
also joined forces with another company, but that filed for re-organization, setting Pepsi
back.

Proctor and Gamble pioneered a connect and develop (C&D) strategy, to meet the goal of at
least 50% of innovation coming from ideas outside the company. They even set up an
innovation portal for “open source” ideas.

The lecturer recommends mapping relationships upstream and downstream to look if any
relationships to customers or suppliers need attention. Are there unexplored opportunities?
Are there over-dependencies? (Being dependent on an actor also means they wield power
over you.) Are there currently less important customers that can be anticipated to become
important?

Individuals or even teams might be dedicated as a part of investing in a limited number of

important relationship. You may wish to tailor your product or service to certain companies or
offer beneficial deals, but remember that there are other ways of making yourself valuable
that may not harm your bottom line. You can be easy to do business with, you can bring
ideas to the partner company, and you can recognize good partners.

Supply chain management requires the involvement of the whole company. Internal
integration refers to the internal processes needed for SCM, usually easier in smaller and
less bureaucratic companies. External integration refers to the external collaboration, usually
easier for big companies that are more powerful and command the attention of partners, can
designate teams to important partners, and that can invest in technology.

Lecture 24: reducing risk and building resilience.

In 2000 Nokia and Ericsson were dependent on the same chip from ROyal Phillips, but a
small fire caused a disruption in the supply lines. Nokia immediately enacted a crisis plan,
acquired capacity from other suppliers, event re-engineered design. Ericsson did nothing for
2 weeks, and then found that they could not secure supplies, because they had been
acquired by Nokia. Nokias share rose from 25% to 30% in a short time, and Ericsson made
significant losses, and was bought by Sony. In a study from 1989 to 2000 of large publicly
traded companies, there was a 10% stock price drop immediately after a supply chain
disruption.

Matel found themselves in trouble after a local supplier abroad used lead-based paint in
making the toys. A pet-food company found themselves in trouble after pets were poisoned
because a CHinese supplier had sold melamine contaminated vegetable protein products.
To understand risks:
● Make a 360 degree scan of the organization and the environment.
● Do a SWOT (strengths-weaknesses-opportunities-threats) analysis.
● Do a FMEA analysis (failure mode and effects analysis)
○ Brainstorm anything that can go wrong
○ Rate probability, severity and ability to detect occurrence.
○ Calculate a RPN (risk priority score) = p × s ×d to rank
● Map supply chain.
○ Start in the middle with one product or service
○ Map tier 1 supplies
○ Map tier 1 customers
○ Map tier 2 suppliers
○ Map tier 2 customers
○ Are you overly dependent on any one supplier or customer? (Note that your
tier 1 suppliers may both be dependent on the same tier 2 supplier!) Are you
overly dependent on ant select location (e.g. China’s dominance in the rare
earth metals market) or ingredient?
● There are
○ Known knowns - risks that are understood, perhaps event explainable or
predictable
○ Known unknowns - risks that are identified, but not understood
○ Unknown unknown - black swans, risks that can only be imagined, and are
not considered

To manage risks:
● Set up IT-systems to detect external and internal warning signals
● Encourage communication lines and information sharing
● Cross-train employees for different roles