1 Chapter 1 - Basics of Business Strategy
1.1 Introduction to Strategy
We all have an idea about what a strategy is. However, few of us can clearly explain it. We can say that a strategy is a “smart” or effective way of doing something, usually something not easy to do. We also have an idea about what a business strategy is. We can transfer what we know about strategy to the business or organizational context. Then, we can imagine that business strategy is a set of methods or actions usually designed to improve the bottom line of the organization: sales and profits.The process of developing and implementing a successful business strategy is one of the most complex task (if not the most complex task) of a manager/executive. A successful business strategy can make the difference between live or die in this global competitive business environment. Unfortunately, learning to be a good manager or executive that successfully elaborates and deploys a business strategy takes a long time. Then, only experience in the real world will make you a good business strategist. This experience includes making mistakes and learning from them. However, if you learn the basic distinctions about elaborating and implementing a business strategy you will be in a much better position when making real strategic decisions for a company or for your own company.
In this note we will explore in more detail about this “intuitive” concept of business strategy that seems to be easy to grasp, but very difficult to apply in the real world. Difficult concepts are better explained with examples. The note first present a simple example to understand why managers cannot apply a comprehensive rational way of thinking when elaborating a business strategy. Then the concept of business strategy is defined along with business objectives, strategic management process and the process of formulating/elaborating a business strategy.
1.2 Can we think rationally when elaborating a strategy?
When we have to make an important decision, we usually try to think rationally. Thinking rationally implies to consider all possible alternatives, evaluate each alternative objectively, and then make a decision. Imagine you are a soccer coach. Do you know how many different soccer teams could you send to the field if you have to pick from 15 players? I mean by different teams if at least one player is replaced. If you do the math (this is a simple formula for combinations), the response is 1,365 different teams - without considering the positions of each player. 1
Besides making a decision about the first 11 players to start the game, you as a coach have to make the decision about the exact configuration of the positions – who will play which position. Do you know how many different team configurations can be defined from these 15 players? (To do the math, you have to use the formula for permutations). 2
Doing the math you can come up with 54,486,432,000 different team configurations – more than 54 thousand million team configurations. This number is almost equal to the number of seconds in 2,000 years! Now imagine this number if you have to select from 25 players instead of 15 players? The number is bigger than 1.7*10^{14}, which is more than 170 million of millions! Now, you have to make many decisions during the game according to a “strategy” –for example, being more defensive than offensive, specific tactics by player, the number of replacements, the time of each replacement, etc. If we consider all these decisions, the total number of possible outcomes for all possible team configurations becomes a ridiculous huge number.
In this context, a coach has to a) have a clear vision of the game, b) know his or her team’s weaknesses and strengths, c) know about the opposite team, then d) set objective(s) -in this simple context would be to win the game- e) formulate or craft a strategy according to the objective(s), and f) finally implement and execute the strategy. During the strategy implementation, the coach has to make many decisions. For example, select the players that better match the strategy, define the different “tactics” to follow during the game –maybe by player, be alert for possible contingencies or unexpected outcomes to make rapid and effective decisions, etc.
What might be the best way to decide each of these lines of action? Many people would respond that before making a decision, it is needed to think in a pure rational way. In order to be pure rational, it is needed to consider all possible outcomes before making a decision. Do you think that this will be effective or feasible for a coach? What is the real process of decision-making a coach follows? How he or she would define the general strategy? We can think in several justified responses for these questions. However, it is true that the coach will not follow a perfect, pure “rational” decision-making process. Besides rational thinking, personal experience and intuition also become very important factors.
1.3 Defining Business Strategy
Now, moving to the context of the organization –the business world, do you think that executives have the same level of complexity than sport coaches when making decisions to formulate and implement a strategy? The number of different possibilities that can happen in an organization is much bigger than in the case of a soccer game. In a soccer game, the time frame is just 90 minutes; in the organization the time frame might or might not have a deadline. In a soccer game, the main objective is to score more valid goals than the other team; in the business world, more than one objective can be defined.
However, the decision making process is similar for both cases. The decision maker has to have a clear vision, know his or her company’s weaknesses and strengths, know about the competition, then set objectives accordingly, craft a strategy to achieve these objectives, and finally, implement/execute the strategy.
An organization’s strategy is a combination of a general line of actions and business approaches that executives and/or managers define in order to achieve business objectives, be competitive in the market, and constantly attract customers. The execution of the strategy in an organization usually involves many operational daily decisions made by different executives, middle managers, and employees.
A business strategy has to be aligned to the business model of the company. A business model specifies what the business sells and how it makes profits. The process that managers and executives follow to create a business strategy is called strategic management process. Before examining in detail the strategic management process, we need to define what a business objective is.
1.4 Business Objectives
A business objective is a statement that clearly specifies a future business achievement. A well-written business objective must have the following characteristics: a) be specific (S) and clear, b) be measurable (M), c) be attainable (A), d) be relevant (R), and e) be timely (T). These characteristics are usually labeled as “SMART”. What do these characteristics mean?
A business objective is specific if the objective clearly mentions which results or outcomes will be obtained- the achievement- and if necessary, to whom this achievement will be directed. A measurable objective explicitly mentions numeric indicators, usually performance indicators. In other words, it must be related to a number or simple fact that can be easily quantified in the future. When the objective is feasible in a specified time frame with the company’s resources, then the objective would be attainable. A relevant objective must be aligned to company’s vision and mission. A timely objective must clearly specify the time frame of the objective -when the company will achieve the objective.
1.5 Strategic Management Process
When elaborating a business strategy, it is easy to get confused between business objectives and business strategies. Business objectives basically specify which will be the future achievements of the company and must be “SMART”. A business strategy is a general line of actions and approaches designed to achieve the business objectives. To elaborate a well designed business strategy it is recommended to follow a strategic management process:
The business mission states “what” the company is about and what type of products and/or services the company offers. The business vision states to “where” the company is headed in the near future. The objectives should lead are performance indicators the set of results and outcomes that push the company where its vision states. A strategy is a general line of action along with business approaches tailored to achieve the objectives.
The implementation of the strategy usually is a complex process in which all employees are involved and is reflected in business operations, which in turn impact business performance –the bottom line of the company. During and after a business strategy is implemented, specific key performance indicators should be used to monitor how the strategy is contributing to accomplish business objectives. Several methodologies can be used in this monitoring process such as Balance Score Card, surveys to measure customer or employee satisfaction, financial ratio analysis, etc. These methodologies are vast and well documented, but for now keep in mind that it is a good habit to measure and interpret financial performance during and after a strategy implementation.
A business strategy is usually formulated at different levels, depending on the size of the company. For example, for big corporations usually there are a) corporate-level strategy, b) business-level strategy, c) functional-level strategies, and d) operating-level strategies. In the US, public companies (those firms that issue stocks in a financial market) must release their business strategy along with many financial and operational reports each quarter. Since this information is available in the SEC EDGAR online database (http://www.sec.gov/edgar.shtml), these firms might not release their detailed version of their strategy. However, it is illustrative how these companies describe their business strategies. I provide an example of a business strategy: the Apple, Inc’s business strategy stated in its 2018 annual report (2014 Apple 10K report):
The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software and services to provide its customers products and solutions with innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of digital content and applications through its Digital Content and Services, which allows customers to discover and download or stream digital content, iOS, Mac, Apple Watch and Apple TV applications, and books through either a Mac or Windows personal computer or through iPhone, iPad and iPod touch® devices (“iOS devices”), Apple TV, Apple Watch and HomePod. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. Therefore, the Company’s strategy also includes building and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The Company believes ongoing investment in research and development (“R&D”), marketing and advertising is critical to the development and sale of innovative products, services and technologies. 3
This is an example of a corporate business strategy. However, we have to consider that this information is publicly available. Then, it is likely that Apple only discloses very general lines of actions and does not release important details or strategic plans on these type of public disclosures.
In the case of Mexican public firms, it is possible to download annual reports in the Mexican Exchange, Bolsa Mexicana de Valores (www.bmv.com.mx). For example, the 2016 annual report of Grupo Alfa, S.A.B. de C. V states the following business strategy:
ALFA ha venido desarrollando una estrategia que busca capturar las oportunidades de crecimiento que le brindan sus negocios actuales y aquéllos relacionados, ya sea de manera orgánica o por adquisiciones. Al efecto, las empresas de ALFA elaboran planes de inversión que permitan alcanzar los objetivos señalados, aprovechando las habilidades que ellas han desarrollado con el tiempo. ALFA estudia los supuestos macroeconómicos y de negocio en que se basan los planes de inversión de sus empresas, asegurándose de Reporte Anual 2016 12 alcanzar las metas financieras establecidas. También, vigila que dichos planes individuales armonicen con sus propios objetivos estratégicos de largo plazo. Para la autorización de los proyectos de inversión de sus empresas, ALFA sigue una estricta disciplina. Al efecto, ALFA ha establecido parámetros de rentabilidad mínima de proyectos, así como de niveles de apalancamiento máximo, buscando el uso eficiente del capital dentro de un marco de riesgo financiero adecuado. Además de los proyectos de inversión de sus empresas principales, y dada su naturaleza de empresa controladora, ALFA analiza constantemente oportunidades para maximizar el valor del capital de sus accionistas, a través de manejar en forma dinámica su portafolio de negocios. Así, frecuentemente se analizan potenciales adquisiciones en los negocios relacionados, o en otros donde pueda aprovechar sus fortalezas. 4
1.6 Formulating a business strategy
Formulating a business strategy is one of the most complex and important task of a manager. The more important issue to address when formulating a business strategy is competitive advantage. A business strategy has to clearly state how the company creates and sustains competitive advantage. A business strategy has to specifies how the company develops organizational capabilities, and how these capabilities contribute to the company’s competitive advantage.
Once we know what the process of strategic management is, the big question is how to formulate the right strategies. Before formulating a business strategy, executives need to know the external environment – who are the company’s stakeholders, what is the value chain of the industry including customers, suppliers, competitors – and also internal factors –organizational capabilities, and detailed current situation of the company in terms of financial facts and human capital–. External stakeholders, market and industry tendencies, and regulations have to be constantly monitored. Specific environmental scanning techniques are used for this monitoring. With the external environment, threats and opportunities have to be identified. Looking at internal factors, the main strengths and weaknesses of the organization have to be identified. This process is known as the SWOT analysis (Strenghts-Weaknesses-Opportunities-Threaths).
SWOT analysis helps a company to identify internal strengths in order to a) capitalize external opportunities, and b) cope with external threats. The identification of weeknesses helps the company identify potential improvements in human capital or simply adjust business objectives accordingly. Internal strengths and weaknesses are attributes or characteristics related with the internal capabilities of employees, teams, executives, or business units. It is common to talk about weeknesses when indeed, we are talking about threats. For example, when a competitor come up with a innovative product that is cheaper and better than the main product of your company, some people can say that one weakness is that the company is “not innovative enough” or the company is not offering a competitive product. This is more an external threat instead of an internal weakness. Remember that an internal weakness is related to the capability of the company’s employees, not an attribute related to current products or services.
In the Appendix A, I suggest a practical guide to perform analysis when formulating a business strategy.
It is important to define what competitive advantage is. A competitive advantage is an attribute of a company and/or its services and products that is a) valuable for a customer, b) it is perceived as unique , and c) it is difficult to imitate. Due to the tough competitive environment and the diffusion of communication technologies, it is difficult for a company to maintain a competitive advantage over time. Then, a company needs to come up with strategies to make its products or services difficult to imitate. This sounds easy, but it is very complicated in the real world.
1.7 Stating the competitive adavantage - The Porter’s theory of competition
In order to know whether a specific mix of products and/or services can offer competitive advantage to the company, it is needed to know the industry and the main external forces that significantly impact the competitive advantage of the company’s products or services. Intuitively, you can think that you need to know your competition before you can identify your competitive advantage. Then, when we think about competitors, we usually come up with one or two main current rivals of a company. However, before understanding competition, as suggested by Michael Porter, we need to study the whole industry structure: not only competitors, but also suppliers, customers, new entrants and substitute products. In his seminal work of 1985, Michael Porter defined the more important external competitive forces of a company as Porter (2008):
Threat of new entrants – how easy will be for a direct competitor to get in the market? this is mainly given by the entry barriers. For example, in the aerospace industry, the barrier to entry is high since a new competitor needs to have substantial access to capital, specialized human capital and technology, etc.
Bargaining power of suppliers – if a supplier has many options to whom to sell its products, then the incumbent company (the customer of the supplier) will have very few arguments to negotiate conditions and prices.
Bargaining power of customers – the more options a customer has to obtain the same or similar product, the less power the incumbent company will have to establish prices and conditions with the customer.
Threat of substitute products – How easy will be for a customer to satisfy his/her needs with alternative products or services with attractive prices?
Rivalry among existing competition in the industry – how fierce is the competition among direct and indirect competitors?
As stated by Porter (2008), “Industry structure drives competition and profitability”. Industry structure is given by how these 5 forces interact with each other, and the level of strength of each force.
If a company identifies and understands these competitive forces, the company will be in a better shape to improve its competitive position in the market, which might lead to better financial performance.
1.8 Generic types of competitive strategies
Michael Porter defines five generic types of competitive strategy Porter (2008) according to the market target –market niche vs broad market– and the type of competitive advantage –low cost vs differentiation–. The following figure illustrates these five strategies:
The differenciation stratey aims to offer unique features in products and/or services. For example, superior service, innovative technology, high quality, engineering design, etc. These unique features allow the company to establish premium prices, increase sales and gain customer loyalty. The low-cost strategy focuses on efficiency that leads to low prices to customers, but mantainging a minimum level of quality. The low-cost strategy allows a company generates wealth with low margins, but selling high volumes to a broad market, while differentiation strategy aims to generate wealth with high margins -justified with unique product features - targeting a specific market niche.
Return on Assets (ROA) is a simple but important financial ratio that provides insight information about business strategy. ROA is equal to the ratio of Net Income (at the end of a period) to Total Assets (at the beginning of the period).
ROA_{t} = \frac{NI_{t}}{TA_{t-1}}
Net income is equal to total sales minus fixed and variable costs, and also taxes and financial expenses. Usually Net Income (NI) does not clearly reflect the capability of the firm to generate profits from operations since financial expenses and taxes can be manipulated following accounting rules. Compared with NI, Earnings before interest and taxes (EBIT) better reflects firm productivity. I will call ROABIT when ROA is calculated using EBIT instead of NI as numerator. We can separate ROA in two ratios if we multiply ROA times \frac{Sales}{Sales}, which is one. Let’s do some simple math to decompose ROA:
Multiplying ROA by Sales divided by Sales we do not change its value, but we can express ROA in terms of profit margin and asset turn over:
ROA_t = \frac{NI_{t}}{TA_{t-1}}*\frac{Sales_{t}}{Sales_{t}}
ROA_t=\frac{NI_{t}}{Sales_{t}}*\frac{Sales_{t}}{TA_{t-1}}=ProfitMargin*AssetTurnOver
In case of ROABIT:
ROABIT_t=\frac{EBIT_{t}}{Sales_{t}}*\frac{Sales_{t}}{TA_{t-1}}=OperatingProfitMargin*AssetTurnOver
Then we can say that ROA = (Profit Margin) * (Asset Turn Over). This is the main derivation of the “Du Pont” analysis. Du Pont corporation developed this simple but very useful method in the 1970’s to decompose financial ratios. A company that follows a low-cost strategy usually focuses on maximizing Asset Turn Over (ATO). A company can maximize ATO with high sales volume targeting a broad market and offering low prices. A company that follows a differentiation strategy usually focuses on maximizing Profit Margin by offering high prices justified by unique features of services/products. It is important to note that companies that follow a low-cost strategy will also minimize costs so profit margin can increase, but the main reason of high ROA will be due to high levels of ATO.
We can now redefine competitive advantage as superior performance due to either differentiation, cost efficiency or both. However, to better understand competitive advantage for a company, we have to analyze the internal key activities of a company in order to identify the sources of this competitive advantage. This is why we need to study value chain analysis.
1.9 Value chain analysis
Value chain analysis is a method to study how each business activity of an organization contributes to generate or add business value. This framework classifies business activities as follows:
• Primary activities – those business activities that directly add value to the core products and/or services
• Support activities – those business activities that indirectly add value to the products and/or services, but directly support the primary activities.
From this business perspective, now it is easy to visualize how a business strategy can enhance both business efficiency and effectiveness.
The following figure illustrates an organizational value chain with examples of information technology innovations that can support each activity.
We can define the value chain as the sequence of all activities that an organization performs in order to design, produce, sell, distribute, deliver and support its products and services. In the figure we can see an example of strategies mainly focused on information technology implementations to improve efficiency or effectiveness of each activity of a business. Information technology can significantly improve business performance, so it is always important to consider IT when developing a business strategy. From this analysis it is possible to visualize the current status of IT in an organization and what should be the more important IT initiatives to enhance business effectiveness.
To differentiate between business efficiency from business effectiveness, I like the following definitions by Peter Drucker: a) efficiency is “doing things right”, while b) effectiveness is “doing the right things.” Interestingly, he also defines Management as “doing things right”, while Leadership as “doing the right things”.
We can use value chain analysis to better understand internal operations of a company, and how the company can innovate or change in any of the primary of support activities in order to be more efficient and/or effective.
1.10 Blue ocean: a different approach to business strategy
Besides the well-known and diffused strategy school of thought proposed by Michael Porter, a more recent perspective of strategy proposed by INSEAD professors Chan Kim and Renée Mauborgne Kim and Mauborgne (2005) is emerging.
They propose a simple way to formulate strategies focused on value innovation. The existing marketplace and possible new marketplace together is considered to be the whole ocean. The key to formulate effective strategies is to find those new market spaces –called Blue Oceans- that no other competitors have explored. They argue that innovations not only in products but in services and business processes are the way to create these new market spaces.
Although we can say that this strategy is similar to that of Porter’s when we look at the differentiation strategy, they differ in the way they perceive the relationship between strategy and structure. The main difference is that Porter’s perspective puts more importance on the outside of the company, while Blue Ocean perspective emphasizes more on the inside of the company – on the capability to create innovations– . Then, Porter proposes that business strategy has to be defined in terms of external forces, which are out of control of the company. However, the Blue Ocean perspective assumes that a very powerful and innovative business strategy coming from the inside can even shape the environment in the near future. I think that both perspectives are good for companies. Depending on the situation of a company and specific external industry environment, we can use any of these two perspectives, or even combine both to come up with an integrated strategic view.
1.11 Managers’ decision-making process
It would be great to know a good recipe to formulate and implement effective business strategies. However, this cannot be explicitly described or taught. The only way a manager learns to formulate effective business strategies is by acting and learning from results.
There is a very interesting psychological perspective of human behavior called the observer model proposed by Fernando Flores and refined by Rafael Echeverria (Echeverria2005?). The following figure illustrate this model:
According to this model, our human actions are determined by the way we see and perceive the world, and results will depend directly on the way we perform our actions. From this model, a learning theory is proposed. When we perform certain actions and get some results, we can learn by changing our actions to see if the results improve. This is called the first-level of learning. However, there is a much more effective way of learning: changing our observer. In other words, changing the way we perceive the world. This is the second-level of learning, and the most powerful way to learn and change. We can change the way we observe or perceive the world when we have a shift in our paradigms. A paradigm is a strong belief that is shared by many people with whom we usually have contact with.
Our “observer” is formed over time and shapes our believes, while our “Action” habits are constructed by trial and error. Managers or executives who become experts in formulating and implementing business strategies usually have a great ability to change their “observers” according to the environment and internal organizational capabilities.
1.12 Appendix A. Practical guide for case analysis to write a strategic plan
As I mentioned before, formulating and coming up with a business strategy is the most complex task of a business professional. Unfortunately, the best way to learn to be a good “strategist” is by practicing with real cases. However, it is very effective to first learn about the concepts of business strategy explained in this note, and also practicing with fake or your own business cases. In this guide, I suggest a simple but effective way of doing a simple case analysis and writing a clear and coherent strategic plan for any organization. It is important to note that this is not the best guide, and it is expected that the best guide will be the one you construct yourself with your own knowledge and experience.
| Section | Brief description | What you have to WRITE |
|---|---|---|
| 1. Business and Industry FACTS. | For the internal information, you have to analyze current and recent financial situations, current organizational structure. Look for the important PROBLEMS or CHALLENGES the company is facing. For the external information, you have to do your own research to identify the most important facts of the market, the industry and government regulations. | 1. Firm Highlights — write relevant financial and non-financial highlights. You can consider financial highlights related to: a) Growth b) Profitability 2. Industry overview — relevant statistics about the industry (e.g. market shares, main players, etc). According to the case, you can apply any of the tools described in the note such as the “5 forces”, value chain analysis, etc. (If you do not have any information about the industry, consider assumptions) |
| 2. ASSUMPTIONS | You have to explicitly state your assumptions for the information you could not obtained, and also your own perceptions about the current situations. Only state the assumptions you consider important for your strategy formulation you are about the develop. | 1. Assumptions related to the Firm. For example, here you describe the internal strength and weaknesses you think the company have. Remember that strength and weaknesses are related to the people capabilities, not to the current situation of the products or external threats. Also, you can state important problems you perceive the company has to face. 2. Assumptions related to the industry. Here you can make assumptions about competitors, government regulations, etc. 3. Assumptions related to the target market. Here you can describe the target market in terms of demography, customer profile, regions, etc. |
| 3. BUSINESS OBJECTIVES – Short and Long-term objectives | According to your facts and assumptions where you clearly identify the main problems and challenges, state a few “SMART” business objectives. State between 1 to 4 short-term and other 1 to 4 long-term objectives. You can classify the objectives into two types: a) business growth b) business profitability. |
You have to write a list of short-term and long-term SMART objectives. You can list them in a table with a classification of: a) Growth b) Profitability objectives. |
| 4. Short-term and long-term STRATEGIES | According to the objectives, you have to explain the short-term and long-term strategies you propose to reach these objectives. | You can write first a list of the short-term and long-term strategies indicating to which business objective each strategy is tailored. You can do this in a table. Then, you have to MAKE THE CASE (be convincing in explaining your strategy) for each strategy you propose. Make sure you propose clear and logical LINES OF ACTIONS for each strategy. You have to be coherent with the development of your lines of action in relation with the objectives, facts and assumptions. DO NOT state vague and very general strategies such as: “Make a marketing campaign to increase our sales”. When you write a very general strategy that can be applied to ANY company ANY time, you are not being specific enough. DO NOT state strategies like “Do a marketing research to decide which new products we can offer”. Do not say that you will do a study to then decide what your strategic plan!! you are proposing a strategic plan! |
The total number of combinations of 15 subjects into 11 places when order does not matter is: C\left( \begin{array}{c} 15\\ 11 \end{array} \right)=\frac{15!}{11!\left(15-11!\right)}=1,365.↩︎
The number of permutations of 15 subjects into 11 places is: P\left( \begin{array}{c} 15\\ 11 \end{array} \right)=\frac{15!}{\left(15-11\right)!}=54,486.43 million.↩︎
The complete report can be accessed directly from the EDGAR database at https://www.sec.gov/Archives/edgar/data/320193/000032019318000145/a10-k20189292018.htm.↩︎
The complete annual report can be accessed directly from the BMV at: https://www.bmv.com.mx/docs-pub/infoanua/infoanua_746640_2016_1.pdf.↩︎