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Strategic Management for the Capstone Business Simulation ® and Comp -XM ® : Analysis and Assessment Michael L. Pettus, Ph.D. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced or used in any form or by any means - graphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution, or information storage and retrieval systems without the writt en permission of the author, Michael L. Pettus. [email protected] Copyright 2012 ® is a registered trademark of Management Simulations, Inc. 6th Edition 2 “I like this new 6th edition” Professor Renee English Webster University “This text is excellent as a strategic management text which uses the Capstone simulation and cases to explain the linkages of strategic management concepts to real world business problems.” Joseph Mahoney, Ph.D. Caterpillar Chair in Strategic Management University of Illinoi s Associate Editor, Strategic Management Journal “If you use the Capstone simulation this strategic management text must be used. No other strategic management text can drive the concepts of strategic management into a real world based simulation.” Peter Wright, Ph.D. Free Enterprise Chair in Strategic Management University of Memphis 3 Acknowledgments I would like to thank many people for their hard work and dedication to the construction of this book. First, I would like to thank Dan Smith, founder of the Capstone Business Simulation, for giving me the opportunity to prepare the book. Second, I woul d like to thank all the students who spent hundreds of hours word processing this book: Karen Knight and Tim Wiggenbach deserve special recognition. Amanda Walker was especially helpful in the construction of this second edition. Denisa Smaldone was very helpful in the development of the third edition. Victoria Dudleston was instrumental in the constructing of the fourth edition. Kelsey Lee was very important, and made significant contributions, in the construction of the 5 th edition. Audra Davis was cru cial in terms of assistance of the updated 5 th edition. Maddison Harner was outstanding in terms of assistance in creating the 6th edition. Someday all of you will walk with industry giants. Third, there are two people who were vital to the construction of this book: May Zelner of Capstone Business Simulation and Hans Royal -Hedinger of Millikin University. Without the hard work of these individuals, this book would never have been accomplished. If I were to pick a number of individuals to start a busine ss, May and Hans would be among my ten top picks in the world! Someday both of you will walk with captains of industry. Fourth, I would like to thank Eddie Schwertz of Webster University for his review of the 6th edition 4 Michael L. Pettus earned a PhD in strategic management from the University of Illinois in 1997 and has more than 30 years of global experience in airline, airfreight and trucking industries. He is published in the Academy of Management Journal , the Strate gic Management Journal , and many leading practitioner journals. He is the author of Growth from Chaos (2003: Praeger) which explores corporate growth in deregulated transportation industries. This book, Strategic Management for the Capstone Business Simu lation and Comp - XM, which is now in its 6th edition, explains how the content of strategic management is integrated into business simulations. 5 This book is dedicated to CAT. 6 Summary Table of Contents Chapter 1 ................................ ................................ ................................ ..... 15 Managing Environmental Turbulence ................................ ..................... 15 Chapter 2 ................................ ................................ ................................ ..... 37 Industry Analysis and Industry Evolution for the 21 st Century ............ 37 Chapter 3 ................................ ................................ ................................ ..... 59 Utilizing Internal Analysis to Build Competitive Advantage Over Rivals ................................ ................................ ................................ ............ 59 Chapter 4 ................................ ................................ ................................ ..... 79 Business Level Strategy ................................ ................................ .............. 79 Chapter 5 ................................ ................................ ................................ ..... 97 Analysis of Markets and Positioning ................................ ......................... 97 Chapter 6 ................................ ................................ ................................ ... 121 Growth by Internal Development ................................ ........................... 121 Chapter 7 ................................ ................................ ................................ ... 141 Corporate Level Strategies and Restructuring ................................ ...... 141 Chapter 8 ................................ ................................ ................................ ... 167 Growth Via Strategic Alliances ................................ ............................... 167 Chapter 9 ................................ ................................ ................................ ... 191 Acquisition Strategies ................................ ................................ ............... 191 Chapter 10 ................................ ................................ ................................ . 215 International Strategies ................................ ................................ ............ 215 Chapter 11 ................................ ................................ ................................ . 245 Strategic Leadership Decision Making ................................ ................... 245 Chapter 12 ................................ ................................ ................................ . 267 Wealth Creation ................................ ................................ ........................ 267 Chapter 13 ................................ ................................ ................................ . 283 Conducting Case Analysis: An Exercise in Wealth Creation ............... 283 Chapter 14 ................................ ................................ ................................ . 295 Comp -XM® ................................ ................................ ............................... 295 Appendix ................................ ................................ ................................ .... 313 Glossary ................................ ................................ ................................ ..... 315 Index ................................ ................................ ................................ ........... 321 7 Detailed Table of Contents Chapter 1 ................................ ................................ ................................ ..... 15 Managing Environmental Turbulence ................................ ...................... 15 Learning and Assessment Goals ................................ ................................ ..................... 16 U.S. Economic Collapse ................................ ................................ ................................ ...18 U.S. Government Stimulus Plan ................................ ................................ ..................... 20 U.S. Auto Industry ................................ ................................ ................................ ........... 20 International Recession ................................ ................................ ................................ ...21 The "Secret" Global Bailout ................................ ................................ ........................... 23 Economic Status as of 3 rd Quarter 2011 ................................ ................................ ........ 25 Economic Conditions During 1 st Quarter 2012 ................................ ............................. 26 Discussion Questions ................................ ................................ ................................ ....... 31 References ................................ ................................ ................................ ......................... 32 Harvard Business Cases for Chapter 1 ................................ ................................ .......... 36 Professor Case for Chapter 1 ................................ ................................ .......................... 36 Chapter 2 ................................ ................................ ................................ ..... 37 Industry Analysis and Industry Evolution for the 21 st Century ............ 37 Learning and Assessment Goals ................................ ................................ ..................... 38 The Competitive Environment in the 21 st Century ................................ ...................... 39 Industry Structure ................................ ................................ ................................ ........... 40 Industry Classification ................................ ................................ ................................ .... 40 Porter’s Five Forces ................................ ................................ ................................ ......... 42 Potential Entrants (Threat of New Entrants) ................................ ............................. 42 Bargaining Power of Suppliers ................................ ................................ ................. 43 Bargaining Power of Buyers ................................ ................................ ..................... 43 Threat of Substitutes ................................ ................................ ................................ . 43 Degree of Rivalry ................................ ................................ ................................ ...... 44 Industry Analysis Using Porter’s Five Forces Model ................................ ................... 45 Industry Evolution ................................ ................................ ................................ ........... 46 Introduction Stage ................................ ................................ ................................ ..... 47 Growth Stage ................................ ................................ ................................ ............ 47 Maturity Stage ................................ ................................ ................................ ........... 47 Decline Stage ................................ ................................ ................................ ............ 48 Industry Forces During Introduction Stage ................................ ............................... 50 Industry Forces During Growth Stage ................................ ................................ ...... 50 Industry Forces During Maturity Stage ................................ ................................ .... 51 Industry Forces During Decline Stage ................................ ................................ ...... 51 The Upside of Declining Industries ................................ ................................ .......... 52 Discussion Questions ................................ ................................ ................................ ....... 53 References ................................ ................................ ................................ ......................... 54 Intel Mini Case ................................ ................................ ................................ ................. 55 Harvard Business Cases for Chapter 2 ................................ ................................ .......... 57 8 Professor Case for Chapter 2 ................................ ................................ .......................... 57 Chapter 3 ................................ ................................ ................................ ..... 59 Utilizing Internal Analysis to Build Competitive Advantage Over Rivals ................................ ................................ ............... 59 Learning and Assessment Goals ................................ ................................ ..................... 60 The Resource -Based View ................................ ................................ ............................... 61 Criteria for Competitive Advantage ................................ ................................ .......... 61 Value Chain Analysis and Capstone Simulation ................................ .......................... 68 Technology Development ................................ ................................ ......................... 68 Human Resource Management ................................ ................................ ................. 69 Firm Infrastructure ................................ ................................ ................................ .... 69 Procurement ................................ ................................ ................................ .............. 69 Inbo und and Outbound Logistics ................................ ................................ .............. 70 Operations ................................ ................................ ................................ ................. 70 Marketing and Sales ................................ ................................ ................................ .. 70 Service ................................ ................................ ................................ ....................... 71 Global Outsourcing ................................ ................................ ................................ ......... 71 Discussion Questions ................................ ................................ ................................ ....... 74 References ................................ ................................ ................................ ......................... 75 Ryder Mini Case ................................ ................................ ................................ .............. 77 Harvard Business Cases for Chapter 3 ................................ ................................ .......... 78 Professor Case for Chapter 3 ................................ ................................ .......................... 78 Chapter 4 ................................ ................................ ................................ ..... 79 Business Level Strategy ................................ ................................ .............. 79 Learning and Assessment Goals ................................ ................................ ..................... 80 Key Success Factors ................................ ................................ ................................ ......... 81 Determining Key Success Factors ................................ ................................ ............ 81 Utilizing Key Success Factors over Time ................................ ................................ . 82 Generic Business Level Strategies ................................ ................................ .................. 82 Cost leadership ................................ ................................ ................................ .......... 83 Focused low cost ................................ ................................ ................................ ....... 83 Differentiation ................................ ................................ ................................ ........... 83 Focused differentiation ................................ ................................ ............................. 84 Walmart Expansion ................................ ................................ ................................ ... 85 Competitive Dynamics ................................ ................................ ................................ ..... 87 SWOT Analysis ................................ ................................ ................................ ........ 87 Strengths ................................ ................................ ................................ ................... 87 Weaknesses ................................ ................................ ................................ ............... 88 Opportunities ................................ ................................ ................................ ............. 88 Threats ................................ ................................ ................................ ....................... 88 SWOT Analysis of American and Southwest Airline s ................................ ............. 89 Competitive dynamics over time ................................ ................................ .............. 90 Discussion Questions ................................ ................................ ................................ ....... 93 References ................................ ................................ ................................ ......................... 94 Dell Mini Case ................................ ................................ ................................ .................. 95 Harvard Business Cases for Chapter 4 ................................ ................................ .......... 96 9 Professor Case for Chapter 4 ................................ ................................ .......................... 96 Chapter 5 ................................ ................................ ................................ ..... 97 Analysis of Markets and Positioning ................................ ......................... 97 Learning and Assessment Goals ................................ ................................ ..................... 98 Market Segmentation ................................ ................................ ................................ ...... 99 Market Segmentation of the Airline Industry …………………….………………99 Product Positioning…………………………………………………………………101 Sales Forecasting ................................ ................................ ................................ ............ 103 Sales Forecasting Methods ................................ ................................ ..................... 103 Sales Forecasting and Capstone Simulation ................................ ................................ 104 Marketing Mix Variables ................................ ................................ .............................. 110 Product Variable ................................ ................................ ................................ ..... 110 Price Variable ................................ ................................ ................................ .......... 111 Promotion Variable ................................ ................................ ................................ . 111 Distribution Variable ................................ ................................ .............................. 113 Discussion Questions ................................ ................................ ................................ ..... 115 References ................................ ................................ ................................ ....................... 116 Proctor and Gamble (P&G) Mini Case ................................ ................................ ....... 117 Harvard Business Cases for Chapter 5 ................................ ................................ ........ 119 Professor Case for Chapter 5 ................................ ................................ ........................ 119 Chapter 6 ................................ ................................ ................................ ... 121 Growth by Internal Development ................................ ........................... 121 Learning and Assessment Goals ................................ ................................ ................... 122 Internal Development Strategies ................................ ................................ .................. 123 Market Penetration ................................ ................................ ................................ .. 123 Market Development ................................ ................................ .............................. 125 Product Development ................................ ................................ .............................. 127 Diversification ................................ ................................ ................................ ......... 129 Competition ................................ ................................ ................................ .................... 129 Internal Development and Capstone Simulation ................................ ........................ 130 Growth by Market Penetration ................................ ................................ ................ 130 Growth by Market Development ................................ ................................ ............ 131 Growth by Product Development ................................ ................................ ........... 133 Growth by Diversifi cation ................................ ................................ ...................... 135 Discussion Questions ................................ ................................ ................................ ..... 136 References ................................ ................................ ................................ ....................... 137 Starbucks Mini Case ................................ ................................ ................................ ...... 139 Harvard Business Cases for Chapter 6 ................................ ................................ ........ 140 Professor Case for Chapter 6 ................................ ................................ ........................ 140 10 Chapter 7 ................................ ................................ ................................ ... 141 Corporate Level Strategies and Restructuring ................................ ...... 141 Learning and Assessment Goals ................................ ................................ ................... 142 Diversification ................................ ................................ ................................ ................ 143 Diversification and Performance ................................ ................................ ............ 143 Diversification and Value Chain Analysis ................................ .............................. 145 Same Industry Diversification ................................ ................................ ...................... 146 Related Industry Diversification ................................ ................................ .................. 14 7 Unrelated Industry Diversi fication ................................ ................................ .............. 148 Diversification and Risk ................................ ................................ ......................... 148 Business Strengths and Indu stry Attractiveness ................................ ........................ 149 Industry Attractiveness ................................ ................................ ........................... 150 Business Strength ................................ ................................ ................................ .... 151 Restructuring ................................ ................................ ................................ ................. 152 Downsizing ................................ ................................ ................................ ............. 152 Downscoping ................................ ................................ ................................ .......... 153 Realignment ................................ ................................ ................................ ............ 154 Restructuring and the Capstone Simulation ................................ ............................... 154 Discussion Questions ................................ ................................ ................................ ..... 160 References ................................ ................................ ................................ ....................... 161 General Electric (G.E.) Mini Case ................................ ................................ ............... 165 Harvard Busines s Cases for Chapter 7 ................................ ................................ ........ 166 Professor Case for Chapter 7 ................................ ................................ ........................ 166 Chapter 8 ................................ ................................ ................................ ... 167 Growth Via Strategic Alliances ................................ ............................... 167 Learning and Assessment Goals ................................ ................................ ................... 16 8 Trust ................................ ................................ ................................ ................................ 170 Scale of Coverage ................................ ................................ ................................ ........... 171 Relationship -Specific Assets ................................ ................................ ......................... 171 Complementary Capabilities ................................ ................................ ........................ 171 Interfirm Knowledge Sharing ................................ ................................ ...................... 171 Scale Alliances ................................ ................................ ................................ ................ 172 Link Alliances ................................ ................................ ................................ ................. 174 Joint Ventures ................................ ................................ ................................ ................ 176 The Downside of Strategic Alliances and Joint Ventures ................................ .......... 177 Strategic Alliance s and the Recession ................................ ................................ .......... 177 The Future of Strategic Allia nces ................................ ................................ ................. 17 8 Strategic Alliances and Capstone Simulation ................................ ............................. 17 9 Discussion Questions ................................ ................................ ................................ ..... 183 References ................................ ................................ ................................ ....................... 184 Oneworld Airline Strategic Alliance Mini Case ................................ ......................... 188 Harvard Business Cases for Chapter 8 ................................ ................................ ........ 189 11 Professor Case for Chapter 8 ................................ ................................ ........................ 189 Chapter 9 ................................ ................................ ................................ ... 191 Acquisition Strategies ................................ ................................ ............... 191 Learning and Assessment Goals ................................ ................................ ................... 192 Impact of the Global Recession on Mergers and Acquisitions ................................ .193 Attributes of Successful Acquisitions ................................ ................................ ........... 197 Access to International Markets ................................ ................................ .............. 197 Synergies Resulting from Economies of Scale ................................ ....................... 198 Synergies Resulting from Economies of Scope ................................ ...................... 198 Reduce Costs of N ew Product Development ................................ .......................... 198 Entry into More Attractive Industries ................................ ................................ ..... 199 Problems with Acquisitions ................................ ................................ .......................... 199 Paying Too Much ................................ ................................ ................................ .... 199 Inability to Achieve Synergies ................................ ................................ ................ 199 Failure to Retain Key Personnel ................................ ................................ ............. 200 Too Much Debt ................................ ................................ ................................ ....... 200 Invest in Mature Industries ................................ ................................ ..................... 201 Process for Achieving Successful Acquisitions ................................ ............................ 202 Due Diligence ................................ ................................ ................................ ......... 202 Engage in Friendly Acquisitions ................................ ................................ ............. 202 Maximize Resource Utilization ................................ ................................ .............. 202 Diversify Into Firms That Have Strong Brand Names ................................ ........... 203 Acquire High Growth Firms ................................ ................................ ................... 204 Hostile Acquisitions ................................ ................................ ................................ ....... 204 Are Acquisitions Beneficial? ................................ ................................ ......................... 205 Acquisitions as a Source of Innovation ................................ ................................ ........ 206 Discussion Questions ................................ ................................ ................................ ..... 208 References ................................ ................................ ................................ ....................... 209 Pfizer Mini Case ................................ ................................ ................................ ............. 212 Harvard Business Cases for Chapter 9 ................................ ................................ ........ 213 Professor Case for Chapter 9 ................................ ................................ ........................ 213 Chapter 10 ................................ ................................ ................................ . 215 International Strategies ................................ ................................ ............ 215 Learning and Assessment Goals ................................ ................................ ................... 216 Factors Encouraging International Expansion ................................ ........................... 217 Innovation in Domestic Market ................................ ................................ .................... 220 Determining International Country Attractiveness ................................ ................... 220 Role of Government ................................ ................................ ................................ ....... 221 Determination of International Industry Attractiveness ................................ ........... 223 Determination of Firms’ Business Strengths ................................ .............................. 226 Adaptation Versus Standardization ................................ ................................ ............. 228 Determination of International Modes of Entry ................................ ......................... 228 12 Exporting ................................ ................................ ................................ ................. 228 Licensing/Franchising ................................ ................................ ............................. 230 Strategic Alliances ................................ ................................ ................................ .. 231 Acquisitions ................................ ................................ ................................ ............ 231 Foreign Direct Investment ................................ ................................ ...................... 232 Competition within International Markets Intensifies ................................ .............. 233 Relocate to Low Cost Markets ................................ ................................ ...................... 233 New Innovation in Home Markets ................................ ................................ ............... 233 Discussion Questions ................................ ................................ ................................ ..... 235 References ................................ ................................ ................................ ....................... 236 IKEA Mini Case ................................ ................................ ................................ ............. 239 L’Oreal Mini Case ................................ ................................ ................................ ......... 241 Harvard Business Cases for Chapter 10 ................................ ................................ ...... 243 Professor Case for Chapter 10 ................................ ................................ ...................... 243 Chapter 11 ................................ ................................ ................................ . 245 Strategic Leadership Decision Making ................................ ................... 245 Learning and Assessment Goals ................................ ................................ ................... 246 Strategic Leadership ................................ ................................ ................................ ...... 247 Customers ................................ ................................ ................................ ....................... 249 Employees ................................ ................................ ................................ ....................... 250 Collective Bargaining Organizations ................................ ................................ ........... 251 Shareholders ................................ ................................ ................................ ................... 252 Board of Directors ................................ ................................ ................................ ......... 252 Investment Community ................................ ................................ ................................ .253 Senior Managers and Ethical Decision Making ................................ .......................... 253 Strategic Leadership and Growth ……………………………………………….. ....255 Scandals and Strategic Leadership ................................ ................................ .............. 257 Industry Evolution and Strategic Leadership ................................ ............................. 258 Introduction ................................ ................................ ................................ ............. 258 Growth ................................ ................................ ................................ .................... 259 Maturity ................................ ................................ ................................ ................... 259 Decline ................................ ................................ ................................ .................... 260 Discussion Questions ................................ ................................ ................................ ..... 261 References ................................ ................................ ................................ ....................... 262 Hershey Mini Case ................................ ................................ ................................ ......... 264 Harvard Business Cases for Chapter 11 ................................ ................................ ...... 265 Professor Case for Chapter 11 ................................ ................................ ...................... 265 13 Chapter 12 ................................ ................................ ................................ . 267 Wealth Creation ................................ ................................ ........................ 267 Learning and Assessment Goals ................................ ................................ ................... 268 Balanced Scorecard and Wealth Creation ................................ ................................ ..269 Customer Wealth ................................ ................................ ................................ ........... 271 Consumer Costs ................................ ................................ ................................ ...... 272 Firm Costs ................................ ................................ ................................ ............... 272 Shareholder Wealth ................................ ................................ ................................ ....... 273 Liquidity Ratios ................................ ................................ ................................ ...... 274 Asset Management Ratios ................................ ................................ ....................... 274 Debt Management Ratios ................................ ................................ ........................ 275 Profitability Ratios ................................ ................................ ................................ .. 275 Economic Value Added (EVA) and Market Value Added (MVA) ........................ 275 Employee Wealth ................................ ................................ ................................ ........... 276 Positioning for Future Wealth ................................ ................................ ...................... 277 Capstone Simulation Measures of Wealth Creation ................................ .................. 280 Discussion Questions ................................ ................................ ................................ ..... 281 References …………………………………………………………………………..282 Chapter 1 3 ................................ ................................ ................................ . 283 Conducting Case Analysis: An Exercise in Wealth Creation ............... 283 Industry Structure ................................ ................................ ................................ ......... 286 Competitive Dynamics for the Capstone Simulation ................................ ................. 289 Wealth Creation Measures ................................ ................................ ........................... 290 Conclusion ................................ ................................ ................................ ...................... 291 Recommendations ................................ ................................ ................................ .......... 293 Chapter 14 ................................ ................................ ................................ . 295 Comp -XM® ................................ ................................ ............................... 29 6 Balanced Scorecard ................................ ................................ ................................ ....... 301 Board Query Questions ................................ ................................ ................................ .308 Appendix ................................ ................................ ................................ .... 313 U.S. Domestic Data Sources ................................ ................................ .......................... 313 International Data Sources ................................ ................................ ........................... 314 Glossary ................................ ................................ ................................ ..... 315 Index ................................ ................................ ................................ ........... 321 14 15 Chapter 1 Managing Environmental Turbulence 16 Learning and Assessment Goals 1. Understand why we are in a recession within the U.S. 2. Understand why a global recession has occurred. 3. Understand the role the U.S. Government is playing to improve economic conditions with its economic stimulus plan. 4. Understand the economic state of affairs as of 2011. 5. Understand, at the firm level, what has to happen to be able to grow in turbulent economic environments. 6. Understand how firms can maintain competitive posit ions in times of economic turbulence. 17 We live in a chaotic, changing world. The economic ramifications of 2007 -2010 have had a negative economic impact on most emerging and fully developed countries throughout the world. The United States has been very significantly impacted by this economic downturn. Some economists believe that the 2007 -2010 time period represented a depression rather than a recession. Are the 1930’s depression conditions upon us during 2007 -2010? The Great Depression of the 1930’s m ay have a more modern version. However, the solutions to this current economic crisis need 2011 solutions. This chapter will address ways of dealing with current economic conditions. If firms are to be successful in current economic times, a number of d ecisions will need to be made which address conditions specific to modern times. The first question that needs to be raised is, “Are we in a depression or a recession?” In the United States, the Business Cycle Dating Committee of the National Bureau of E conomic Research (NBER) is generally seen as the authority for dating U.S. recessions. The NBER defines an economic recession as: “a significant decline in [the] economic activity spread across the country, lasting more than a few months, normally visible in a reduction in real GDP growth, real personal income, employment (non -farm payrolls), industrial production, and wholesale -retail sales 1.” Academics, economists, policy makers, and businesses defer to the determination measurement by the NBER for the precise dating of a recession’s onset and end 2. A depression is a severe economic downturn that results in a decline in real GDP exceeding 10% and is a recession lasting three or more years 3. Table 1.1 identifies the conditions in the Great Depression of the 1930’s and current (2007 -2010) economic condition. Table 1.1 Comparison of the Great Depression (1930s) to the Current (2007 -2010) Economic Conditions Factor 2007 -2010 1930’s GDm Less than 5% Down 30% Unemployment RJ10B 25 J30B Consumer prices Fairly stable Down 2M J30B During the 1930’s depression gross domestic product fell by over 30 % 4. Since 2007 gross domestic product has fallen by less than 5 %. While in 2007 -2010 unemployment hovered about 5 -10 %, unemployment during the 1930’s depression was approximately 25 -30 %. In the 2007 -2010 time period, consumer prices have held fairly stable; however, during the Great Depression there was between a 20 -30 % reduction in consumer prices. Fortunately, this economic downturn doe s indeed appear to be a recession as opposed to a depression. However, the U.S. economy is currently experiencing its worst crisis since the Great Depression 5. The U.S. Government has played a very significant role (e.g. Chrysler and G.M.) throughout thi s period of recession. In essence, the government has been regulating economic conditions (e.g. economic stimulus package). As the government reduces its regulatory role, firms will 18 need to learn how to adjust to the new economic environment. These new e conomic conditions (2007 -2010) have had a significant impact upon industries and firms. Let us begin with what caused the current (2007 -2009) economic crisis. U.S. Economic Collapse What happened was caused by a combination of two factors. The first fac tor was people losing their jobs causing them not to be able to pay their mortgages. In the U.S., significant job losses have been going on since December 2007 and have accelerated in September 2008. In 2008, 2.6 million jobs were lost. From January thr ough April of 2009, 2.6 million jobs were also lost. The rise of advanced economies in Russia, Brazil, India, and China increased the total global labor pool dramatically. Recent improvements in communication and education in these countries has allowed workers to compete more effectively with workers in traditionally strong economies, such as the United States. This surge in labor supply has provided downward pressure on wages and contributed to unemployment. The second factor that has contributed to t he challenging economic conditions is falling housing prices in the U.S. Historically, the U.S. housing market has been very strong. From the mid -1990 to 2005, housing prices grew. During the same period of time, the U.S. gross domestic product (GDP) per capita was rising. Housing prices stopped increasing in 2006, started to decrease in 2007, decreased in 2008 and have fallen about 25% from the peak in 2005 6. During 2007 -2010, the decline in prices meant that homeowners had more difficulty refinancing t heir mortgage rates. This action caused delinquencies and defaults of mortgages to increase sharply, especially among subprime borrowers. Sub -prime loans were made to customers who had spotty credit histories. In 2006, it was estimated that over half of the loans were sub - prime. Banks who had financed these mortgages tried to sell the loans to other banking institutions. In order to sell the loans, these institutions had to lower the price. These actions made the initial bank and the bank who acquired the loans worse off. In general, this is what led to the demise of Bear Stearns and Lehman Brothers. Many other firms were also dramatically affected. From Table 1.2, the top U.S. bankruptcy filings of all times included six firms in 2008 and 2009. 19 Table 1.2 Top 10 U.S. Bankruptcy Filings of all Time Company Bankruptcy Date Assets ($ billions) 1. Lehman Brothers 6/15/2009 691 2. Washington Mutual 9/26/2008 328 3. Worldcom Inc. 7/21/2002 104 4. General Motors 6/1/2009 91 5. Enron 12/2/2001 66 6. Conseco Inc. 12/17/2002 61 7. Chrysler 4/30/2009 39 8. Thornburg Mortgage 5/1/2009 36 9. Pacific Gas and Electric 4/6/2009 35 10. Texaco Inc. 4/12/1987 34 Although the economic crisis started in the home mortgage market, it spread to commercial real estate, corporate junk bonds, and other forms of debt. Total losses to U.S. banks reached as high as one -third of the total bank capital. The crisis has led to a sharp reduction in bank lending, which in turn caused a severe recession in the U.S. economy 7. How mortgages were affected needs to be discussed. Borrowers were given low mortgage rates from banks for the first two to three years (these initial low rates were called “teaser rates”) 8. The strategy was that by the time the tease r rates expired and the rates were to be adjusted upward, the value of their homes would have increased enough so that a new mortgage could be taken out and the old mortgage paid off. However, this strategy worked only as long as housing prices were incre asing. When housing prices stopped increasing in 2006, this strategy no longer worked 9. Old mortgages could no longer be refinanced, so the borrowers were stuck with higher mortgage rates that they could not afford, and the default rates started to increase. From the first quarter of 2006 to the third quarter of 2008, the percentage of mortgages in foreclosure more than doubled from 4.5 % to 10 % 10. This foreclosure rate was the highest since the Great Depression. 11 According to data from Bankrupt cy Data.com, a division of New Generation Research, Inc., bankruptcy filings among publicly traded companies surged 74 % in 2008 12. There were 136 bank bankruptcy filings in 2008, compared with 78 in 2007. While the year -over -year growth in bankruptcies rose quickly, the value of the firms seeking protection grew much faster. The 136 banks seeking bankruptcy protection in 2008 had about $1.16 trillion in assets, compared with just $70.5 billion in assets for banks filing for bankruptcy protection in 2007 13. 20 U.S. Government Stimulus Plan The U. S. government has tried to stabilize this economic crisis. President Obama’s economic stimulus package, $787 billion, has been an attempt to get the economy back on track. On February 10, 2009, the Senate vote d 61 -37 to approve President Obama’s economic stimulus bill. The first piece of the plan would create one or more banks that would rely on taxpayer and private money to purchase and hold the banks’ bad assets 14. In the credit markets, the administration and the Fed are proposing to expand a lending program that would spend as much as $1 trillion to make up for the $1.2 trillion decline created between 2006 and 2009 by issuing securities backed primarily by consumer loans 15. The second major component of the plan would give banks capital with which to lend. Banks that receive new government assistance will have to cut the salaries and perks of their executives and sharply limit dividends and some corporate acquisitions 16. The third piece of the plan would use the last $350 billion that the Treasury has allocated for the bailout to rely on the Federal Reserve’s ability to create money. The Fed’s money will enable the government to become involved in the management of markets and banks 17. By comparing the f irst six months of 2006 with the first six months of 2009, results have not been promising. Retail sales have decreased from $360 billion in 2006 to $340 billion in 2009 18. Construction of new homes has declined from approximately 2 million in 2006 to le ss than 500,000 in 2009 19. The purchasing managers’ index shows the manufacturing sector activity has declined significantly since 2006 20. Orders for nondefense capital goods have decreased from over $60 billion in 2006 to less than $50 billion in 2009 21. Jobless claims have increased from 300,000 to over 600,000 22. In 2009, the number of people who are receiving jobless benefits rose to 670,000 million individuals. This is the highest total since 1967 23. The impact of the recession upon the U.S. auto industry has been especially severe. U.S. Auto Industry G.M. and Chrysler have received billions of dollars in government funds to try to return to profitability. As of mid 2009, nothing positive has happened. Chrysler has emerged from Chapter 11 bankruptcy (7 th largest filing of all time: Table 1) and G.M. has had to receive several billion dollars in additional government aid. G.M. is in a particularly difficult position. On March 30, 2009, Rick Wagoner, the CEO of G.M. was forced to resign. T his was one of the first times that a U.S. government has forced out a CEO of a publically held company 24. This would appear to have been a necessary move. G.M. has not turned a profit since 2004. Between 2004 -2008, G.M. has lost 82 billion dollars 25. G.M.’s stock was trading at $70/share in June 2000. On March 30, 2009 the stock was trading at $3.62. In May 2009, the stock was trading at $0.75 26. Because of these conditions, G.M. has had to borrow money from the government. As part of President Oba ma’s bailout plan, G.M. borrowed $15.4 billion 27. In addition, G.M. was forced to borrow an additional $4 billion during the first quarter of 2009 to stay in business 28. In addition, G.M. eliminated its Pontiac division and cut 21,000 employees 29. On Ma y 16, 2009, G.M. began to close 1100 of its dealerships 30. On June 1, 2009, GM went into Chapter 11 bankruptcy protection (4 th largest filing of all time: Table 1 .2). Several other businesses of G.M. were affected. The Saturn brand was discontinued in 2 009. In 2010, th e Hummer brand was discontinued. G.M. has exited 21 Chapter 11 Bankruptcy Protection a nd has been increasing revenue s, earnings and earnings per share in 2010 and 2011 . Chrysler has taken a somewhat different approach. Chrysler has obtai ned $9 billion in bailout funds and exited Chapter 11 bankruptcy protection after 45 days on June 12, 2009. Chrysler has looked to Fiat for assistance. The U.S. Government has put in place goals for Fiat if it desires to increase its ownership of Chrysle r. Fiat will be allowed to expand its ownership of Chrysler up to a majority stake if the Italian auto maker meets certain goals 31. Fiat will get an initial 20% stake in Chrysler and can increase its holdings in increments of five percentage points, up t o 35%, if it achieves three milestones by January 1, 2013. Fiat will get the first increase once it starts producing Fiat engines in the U.S. To receive the second increase, Fiat must develop a vehicle in the U.S. that can go 40 miles on a gallon of gaso line. 32 Fiat can get a third increase if Chrysler is able to generate more than $1.5 billion in sales outside of North America, according to a “Master Transaction Agreement” that was filed on May 9, 2009 in the U.S. Bankruptcy Court in Manhattan. 33 The agreement also gives Fiat the option to purchase an additional 16% of Chrysler. If Fiat meets all three goals and exercises its options, it could eventually end up with a 51% stake in Chrysler. 34 Fiat won’t be able to take full control of Chrysler until it pays off the loans Chrysler has received from the U.S. government. Prior to that point, Fiat’s ownership will be capped at 49.9%. Until the loans are repaid, any Fiat stake above 35% will be held in a trust controlled by the U.S. treasury. 35 As of May 2011, Chrysler has some success with repayment of its loans. Chrysler used a $1.3 billion investment from Fiat to repay its loans. Fiat, which has had management control over Chrysler since it emerged from bankruptcy protection in 2009, paid that amount to increase its stake in Chrysler to 46 percent. The refinancing will allow it to retire a $5.9 billion balance on the U.S. loans and $1.6 billion to the governments of Canada and Ontario 36. As of 2011, Fiat has an agreement to buy the U.S. Treas ury’s remaining 6% stake in Chrysler Group LLC, a move that would bring an end to the U.S. government’s involvement in Chrysler 37. The Canadian and U.S. governments had taken stakes in Chrysler after providing the automaker $7.6 billion in bankruptcy loan s. Chrysler formally repaid those loans in 2011 38. This agreement could allow Fiat to skip a Chrysler IPO and move forward with its ambitions to combine Chrysler and Fiat into a single automaker with global footprints. In 2011, the combination sold 1.4 million vehicles, a 26% increase from the prior year. For 2011, Fiat/Chrysler generated sales of 59.55 billion Euros and profit of 1.07 billion Euros. Chrysler is optimistic about its future. Sergio Marchionne, who is CEO of Fiat and Chrysler, said profit for 2012 should increase to $1.5 billion and revenue rise 18% over 2011 to $65 billion. As of 2012, the two largest stake holders are Fiat and UAW. As of 2012, Chrysler is owned by Fiat and the UAW. Fiat has a 53.5 percent share and the UAW has a 14.5 p ercent share. International Recession This recession (2007 -2010) has not been experienced solely in the U.S.; it is having negative impacts in several international markets. During 2006 and 2007 global investors with significant amounts of cash were lo oking for ways to invest their funds. As discussed earlier, Wall Street investment firms began to consolidate investments with 22 both prime and sub -prime loans. As housing prices declined many large and well established investment and commercial banks in E urope suffered huge losses. This was the beginning of the global recession. This recession has resulted in a sharp drop in international trade, rising unemployment and a reduction in commodity prices. This impacted not only the U.S. investors but intern ational investors as well. Wall Street hedge funds held by large institutional investors and foreign banks who had bought some of the consolidated loans had difficulty selling the loans 39. Banks stopped lending in an effort to conserve cash. The worldwid e recession became worse because investors who had funds were not investing. This action caused stock markets worldwide to plummet. As stock prices fell, firms cut expenses to try to keep up with the declining stock prices. This caused a significant inc rease in unemployment and individuals stopped making purchases except for necessities. The collapse of the housing market in the U.S. had a direct impact not only on the nation’s mortgage banks but also upon U.S. and international home builders, real esta te, and home supply retail outlets. The continuing development of this crisis led to a global economic collapse 40. Beginning with failures caused by misapplication of risk controls for bad debts, collateralization of debt insurance and fraud, large finan cial institutions in the United States and Europe faced a credit crisis and a slowdown in economic activity. The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock i ndexes, and large reductions in the market value of equities and commodities. Other impacts were felt in international markets. In 2009, currency values, oil prices and other commodity prices increased significantly while housing prices in the European U nion continued to decline. Steep declines in the economies of three of the U.S.’s biggest trading partners – Mexico, Japan and Germany – underscored the severity of the global recession and put pressure on major industrialized nations to revive global tra de talks 41. Mexico has been affected significantly. Mexico’s gross domestic product fell at an annualized rate of 21.5% in the first quarter of 2009. This was the worst performance since the 1995 peso crisis which led to an International Monetary Fund a nd U.S. Treasury financial rescue. Mexico, during the past 15 years, has depended on demand for goods from the U.S. to stabilize its economy. About a fifth of Mexico’s economy depends on manufacturing exports to the U.S., and this dramatic drop in demand has hit Mexico hard 42. During the first quarter of 2009, Mexican auto production slid 41% compared to the same period the year before. Mexico’s decline was followed by Japan’s as its economy contracted in the first quarter of 2009 by 15.2%, its worst pe rformance since 1955 43. Germany’s first quarter of 2009 showed a decline in GDP by 14.5%, which was the worst since 1970. All of these countries depend heavily on exports to the U.S. This is no longer happening because U.S. consumers have cut back purch ases from these countries. Many industrialized countries went into recession in 2008. The following countries went into recession in the third quarter of 2008: Japan, Sweden, Hong Kong, Singapore, Italy, Turkey and Germany 44. In addition, the fifteen nations in the European Union that use the euro went into recession in the third quarter of 2008. The following countries went into recession in the fourth quarter of 2008: United Kingdom, Spain, Taiwan, Estonia, Latvia, Ireland, New Zealand, Russia, Net herlands, and Iceland 45. It is possible that some of these countries may have obtained funds from the U.S. Federal Reserve. 23 I would like to thank one of our professors, David Baker, for bringing the following recent events to my attention. THE “SECR ET” GLO BAL BAILOUT In October of 2011, the government accountability office (GAO) conducted an audit of the Federal Reserve. Ben Bernanke, chairman of the Federal Reserve vigorously objected to this audit. He had good reason for his objection. The results of the audit were shocking. During the period of the recession (2007 -2010), the Federal Reserve “loaned” $16 trillion (000,000,000,000) in funds to U.S. banks, international banks, and international firms. 46 These funds were loaned at zero per cent interest. The Federal Reserve had not informed the U.S. Congress about this “global bailout.” 47 It does not seem reasonable that the U.S. Federal Reserve should be loaning this level of funds to international banks and international firms during a rec ession within the U.S. The list of institutions that received the most money from the Federal Reserve can be found on page 131 of the GAO Audit and are as follows: Economic Status as of Mid -2011 Many economists believe that the global recession ended in 2010. Paul Dales, senior U.S. economist believes that “the economy is unlikely to grow at a decent rate anytime in the next year or two.” High oil prices are one reason that consumers are spending less than they might have on other things, like clothing and household goods. Consumer spending drives about 70 percent of the economy. A political impasse over general budget cuts, combined with Europe’s debt crisis, is also creating uncertainty. Higher gas and food prices have erased any pay raises workers are getting. Americans have responded by spending less. High energy prices are putting pressure on businesses to raise their prices. Workers are seeing limited, if any, pay increases because they lack leverage in a market where jobs are still hard to find. This limits businesses ability to raise prices, even though many companies are facing higher costs. Citigroup: $2.5 trillion Morgan Stanley: $2.04 trillion Merrill Lynch: $1.949 trillion Bank of America: $1.344 trillion Barclays PLC (United Kingdom): $868 billion Bear Sterns: $853 billion Goldman Sachs: $814 billion Royal Bank of Scotland (UK): $541 billion JP Morgan Chas e: $391 billion Deutsche Bank (Germany): $354 billion UBS (Switzerland): $287 billion Credit Suisse (Switzerland): $262 billion Lehman Brothers: $183 billion Bank of Scotland (United Kingdom): $181 billion BNP Paribas (France): $175 billion And many more including banks in Belgium of all places http://www.scribd.com/doc/60553686/GAO -Fed -Investigation TABLE 1.3 Institutions Bailed Out by the Federal Reserve 24 U.S. increases in hiring have not manifested themselves in the first half of 2011. Disappointing U.S. econ omic data followed poor manufacturing reports around the globe. The numbers, together with evidence of a continuing downdraft in housing and signs that companies and consumers remain apprehensive about spending, suggest the economy recovery will be slow. With unemployment high, the housing market not expanding and ongoing financial turmoil in Europe, the slowdown could turn into something more ominous. Despite cautious outlook for 2011, 36 of the 38 economists surveyed oppose any further efforts by the F ed to invigorate growth. The Fed has already cut short -term interest rates to near zero. And it’s ending a program to buy $600 billion in Treasury bonds to keep longer -term rates low to help increase spending and hiring. Economists say another round of bond -buying wouldn’t provide much benefit, if any. Some fear it could make things worse by unleashing high inflation and disrupting financial markets. When it buys bonds, the Fed, in effect, prints massive amounts of money. All that extra money in the s ystem raises the nominal value of the things we buy, weakening the dollar, and it can create bubbles in the prices of stocks and commodities. Some economists believe that the second half of 2011 will show improvement in economic conditions. The reason is that the main causes of the slowdown – high oil prices and manufacturing delays because of the disaster in Japan – have started to fade. Oil prices have been falling since Memorial Day (2011). Economists surveyed by the Association Press (AP) predicted unemployment would fall to 8.7 percent at year’s end. However, the economy is still carrying too much baggage from the financial crisis – damaged banks, depressed home prices, and debt -burdened consumers – to achieve much liftoff. The global economy is expected to grow as reported by the Organization for Economic Co -operation and Development (OECD). This organization’s mission is to improve the economic and social wellbeing of people around the world. The member nations of OECD ar e Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republi c, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom, and the U.S. OECD economists expect that economic recovery will take place at different speeds for different counties. OECD’s projections are identified in Table 1.3. Table 1.3 Gross Domestic Product (GDP) for 2010 and 2011 Increase (in percent) Location 2011 2012 United States 2.6 3.1 European Union 2.0 2.0 Japan 0.9 2.2 Rest of the World 4.2 4.6 While the table shows modest growth rates for all nations, the statistics show that the fully developed nations are expected to grow at lower rates than the remainder of the 25 world. However, there are significant events which could significantly lower all of these projections. Risks include possibility of further increases in oil and commodity prices, which could feed into cause inflation; a stronger -than -projected slowdown in China; the unsettled fiscal situation in the United States and Japan; and renewe d weakness in housing markets in many OECD countries. The top challenge facing countries is widespread unemployment, which affects more than 50 million people of OECD nations. Governments must ensure that employment services match the unemployed to jobs. They should also rebalance employment protection towards temporary workers; consider reducing taxes on labor via targeted subsidies for low paid jobs; and promote work -sharing arrangements that can minimize employment losses during downturns. Economic S tatus as of 3 rd Quarter 2011 In the third quarter of 2011, many analysts took the position that the U.S. may be entering another recession: this assumes that we came out of the 2007 -2010 recession in 2011. In October 2011, Ben Bernanke warned that the “U. S. economic recovery was close to faltering.” Bernanke noted that job growth had slowed from earlier in the year.

Further, Bernanke state that “a 9 percent unemployment and very slow growth is not a good situation.” An article in the October 2011 Wall Str eet Journal stated that “Stocks Log Worst Quarter Since 2009.” The Dow Jones industrial average for the third quarter of 2011 was down by 12 percent. This was the worst percentage decline since the first quarter of 2009.

Many Wall Street analysts are reduc ing their forecasts for growth and company earnings. Household income has declined in the third quarter of 2011 to income levels in 1996. Household income has dropped for the third year in a row. The American dream of homeownership has felt its biggest d rop since the Great Depressions, according to new 2010 census figures. The analysis by the Census Bureau found the homeownership rate fell to 65.1 percent last year. Analysts say the U.S. may never return to its housing boom peak in which nearly 70 percent of occupied households were owned by their residents. The reason: a longer -term economic reality of tighter credit, prolonged job losses and reduced government involvement. Given depressed housing values that could continue for at least another four to fi ve years, it now makes more sense in most cases to rent than own. The depressed situation in the U.S. is also being felt in international markets. Europe’s financial crisis has intensified as banks moved to obtain more dollars for loans to their U.S. cust omers, and some multinational firms began looking to banks outside the European Union for loans. In early October, Bernanke stated that “Europe has a debt crisis and world markets are in turmoil.” The European debt crisis has continued for than a year. Thi s crisis has made markets worldwide more volatile. Investors globally have grown alarmed about the risk of financial chaos spreading from Europe where banks are exposed to the shaky finances of Greece and other governments. Stock markets in the U.S., Europ e, and Japan all posted declines from the second quarter of 2011. The state of affairs in emerging markets is also unstable. Historically, China has been a growth market. This market is slowing down. Greece continues to be in a debt crisis. Indian stocks lost more than four percent in the third quarter of 2011. Indonesian stocks fell by nine percent and Mexican stocks also dropped by five percent in 2010. However the 1 st quarter of 2012 showed very positive results within the United States. 26 U.S. Economic Conditions During First Quarter of 2012 As of the first quarter of 2012, the U.S. economy was moving from a period of recession to a period of growth. During these first few months of 2012, financial conditions in the United States have improved. As of M arch 1, 2012, the Dow Jones Industrials closed above the 13,000 points for the first time since April 25, 2007. The other industrial averages have also fared well as of this point in time. The Standard & Poor’s 500 is up 9 percent, the Russell 2000 index of smaller stocks is up 11 percent , and the Nasdaq composite index, dominated by technology stocks, is up 14%. 48 The Nasdaq has not traded so high since December 2000, during the bursting of the bubble in technology stocks. 49 Likewise, the Nasdaq composite index briefly broke through 3, 000 on Wednesday, Feb. 29, 2012. This was the first time since the collapse in dot -com stocks more than a decade ago. February 2012 , was the best month on Wall Street in 14 years. 50 Apple, Nas daq’s biggest component, topped $500 billion in market value, the only company above the half -trillion mark and only the sixth in U.S. corporate history to grow so big. There is good news from an unemployment perspective also. The economy has been creati ng more jobs since last fall, producing an average of 223,000 new jobs in the months of December and January. 51 U.S. companies have emerged from the recession more productive, more profitable, flush with cash and less burdened by debt. 52 An analysis by the Wall Street Journal of corporate financial reports finds that cumulative sales, profits and employment last year among members of the Standard & Poor’s 500 -stock index , exceeded the totals of 2007. This was before the recession and financial crisis. 53 27 Table 1.4 U.S. Recover y 2011 Measure Increase from 2007 to 2011 Revenues 17.1 Net Income 22.7 Employees 5.1 Cash 49.9 Capital Spending 16.3 Source: Standard &Poors 2012 Many measures from firms in the Standard & Poors index have increased significantly since 2007 (Table 1.4). Increasing cash revenues (49.9%) have led to an increase in capital spending (16.3%). Net income for the Standard & Poor’s firms has increased by 22.7%. These are very dramatic indicators which are a sign that the U .S. economy is now in a growth mode. 54 However, it must be remembered that Europe is still in the recession and growth in China is slowing. 55 While we may be beyond the global economy recession, turbulent times will come again. Changing economic conditio ns can occur all the time. In order to stay ahead of changing and/or turbulent environments, Figure 1.1 provides a guide to growing within changing times. Figure 1.1 is also applicable during transition from weak to strong economies. 28 Figure 1.1: Growth Within Changing or Turbulent Environments ECONOMIC CHANGE/TURBULENCE Identification of Evolving Strategic Industry Factors Development of Resources to Meet Strategic Industry Factors Development of New or Reconfigured Resources to Grow in the Direction Dictated by Customers Capitalize Upon Errors of Competitors Achieving a Series of Temporary Advantage Environmental Scanning Flexibility which is built into Resources Resource Reconfiguration to Capitalize Upon Competitors Weaknesses Learning Knowledge Base to Developing in Times of Economic Chaos F I R M D E C I S I O N S 29 First, firms must develop the capability to scan the changing environment to identify how a specific industry is changing and why it is changing in this direction. For several years, Caterpillar has been experiencing record profits and record growth. However, its most profitable division, mining equipment, cannot achieve profitability under cur rent economic conditions (2009 -2010). Its mining trucks are used to extract oil from sand. If the price of oil is greater than $40/barrel, these mining processes are profitable. If the price is below $40/barrel, the processes are not profitable. Knowing this fact, Caterpillar is developing mining equipment which could be profitably used at prices less than $40/barrel. During 2010, the global mining industry became very profitable throughout the world. Caterpillar now (2011) has an 18 month back log on its mining trucks. In 2010 and 2011, Caterpillar generated records in terms of revenues and profits. Second, during times of economic turbulence, firms must be able to analyze industries to determine strategic industry factors 56. Strategic industry fact ors are factors which dictate consumer buying decisions. What the firm needs to do is to identify the current customer needs while developing the capacity to identify emerging customer needs 57. Cell phone manufacturers have sequentially added features as the industry has evolved to require additional technology capabilities. Third, in an economic crisis, firms need to develop resources which have flexibility. Resource flexibility is crucial for growth 58. In many cases, the direction a firm will grow is not known before the fact. For example, Toyota has been successful because its production processes are designed to support different models of cars with minimal modification. Fourth, a firm needs resources that can be developed to address current strateg ic industry factors. In an effort to reduce costs, many universities have developed distance learning or online courses. This approach is also beneficial to students because they do not need to incur additional expenses, such as gas or time commuting to a centralized location. Fifth, during times of turbulence a firm’s resources need to be combined and reconfigured to meet the needs of significant environmental change 59. As this happens firms develop new resources which have the capability to create new and/or improved products. As the price of oil continues to climb, global auto manufacturers have responded by developing alternative forms of fuel which are not dependent upon oil. The significant point with respect to the creation of new resources is th at they make existing and/or related resources better from a differentiation perspective. The new resources should be put to their most productive use by developing capabilities which add value (e.g. process and product R & D). The firms that experience the highest growth rates are able to develop a sequence of temporary advantages that are linked over time to provide long -term growth. The pharmaceutical industry is an example of an industry which requires firms to continuously develop new products to re place existing products which are coming off patent protection (e.g. Lipitor). Fundamentally a firm must grow with its customer base over time. It is of critical importance that the firm stays close to the customer to ascertain how strategic industry fact ors change over time. This is becoming increasingly difficult as email and fax become routine modes of communication. To fully understand the evolutionary needs of its customer base, the firm must keep in close, personal contact with them. If they do no t, its competitors may develop goods and services which meet customers’ needs and take significant revenues from the initial firm. This is what happened to the U.S. auto industry as European and Asian auto manufacturers entered and established strong posi tions 30 within the U.S. These international firms maintained these positions over time by continuously developing new automobiles which addressed current consumer needs. Sixth, take advantage of the strategic errors of competitors. The crux of strategy is to gain a position of advantage and then sustain that position over time 60. Established business models may not work. The deregulation of the trucking industry was one case. During the initial phase of the deregulation of the U.S. trucking industry, t rucking firms attempted to move into related industries before they had fully developed their operational infrastructure; all these firms went out of business. From a trucking prospective, if a firm’s infrastructure is not fully developed, it is difficult to meet the needs of a customer base which is expanding geographically. In this industry a fully developed infrastructure is a prerequisite for growth. In the trucking industry, those firms which established this complete infrastructure grew after the i ndustry was deregulated. Those firms which did not went out of business. The fast food industry provides another example of firms taking share from competitors. Some customers now prefer fast food restaurants to provide meals which are low in calories a nd fat. McDonalds has recognized this need and has developed several options for its customers seeking healthy options. Hardees’ is a fast food restaurant which has not. As these firms continue to grow learning becomes important. Learning from other fir ms can be an important factor. The airfreight firms learned from the telephone companies the benefits of a hub and spoke network. They learned that they could significantly reduce transit time and overall costs by developing an integrated air -ground, hub -and -spoke operating system. By developing global hub -and -spoke operating systems, carriers provide shippers with total global coverage. This learning provides a knowledge base for firms to make better strategic decisions during periods of significant ec onomic change. The role of alliances is becoming increasingly important in the twenty -first century. Many firms that have grown in volatile environments have developed strategic alliance networks that provide for global coverage. The Star , One World, and SkyTeam alliances have provided airlines throughout the world with global coverage. These alliances permit access to market positions without significant incremental costs being incurred. Airlines who are members of these international alliances obtain a global coverage advantage over carriers that have not engaged in international airline alliances. As firms begin to grow within domestic environments, alliances provide firms with the capability to grow over time in changing environments. As they move into international markets, as a result of these alliances, firms continue to learn how to grow in different types of international environments. This new knowledge base allows firms to grow based upon what has been learned. The lessons learned in the 20 07 -2010 recession provide valuable insights for future recessions. 31 Discussion Questions 1. Explain how the current economic recession differs from the depression in the 1930’s. 2. Why has the U.S. Government taken a significant ($787 billion) role in the current economic recession? 3. What led to the collapse of the economic environment within the U.S.? Answer the same question from an international perspective. 4. What can we learn from Table 1.2? 5. Why has Mexico encountered such a significant collapse fr om an economic perspective? 6. For a firm of your choice, explain how this firm can grow within turbulent environments using Figure 1. 7. What is one of the single most important factors to judge whether a country is recovering from the global economic recession? 32 References 1. _______ “Business Cycle Expansion and Contractions.” National Bureau of Economic Research 2010. 2. Ibid 3. Ibid 4. J. Lahart, “How a Modern Depression Might Look if the U.S. Gets There,” Wall Street Journal , March 30, 2009 . 5. Ibid 6. F. Moseley, “The U.S. Economic Crisis; Causes and Solutions,” International Economic Review , March -April 2009. 7.____________ “Strategic Planning in a Crisis,” McKinsey Quarterly , 2009. 8. Moseley, 2009 9. Ibid 10. Ibid 11. Ibid 12. H. Stern, “Bankruptcies have Banner Year in 2008,” Wall Street Journal , February 26, 2009. 13. Ibid 14. E. Andrews and S. Labarion, “Bai lout Plan: $2.5 trillion and a s trong U.S. Hand,” Wall Street Journal , February 10, 2009. 15. Ibid 16. Ibid 17. Ibid 18. J. Hahart, “Gauging the Economy’s Engine as it Sputters Again,” Wall Street Journal , May 19, 2009. 19. Ibid 20. Ibid 33 21. Ibid 22. Ibid 23. __________ “6.7 Million Americans Unemployed: Highest Since 1967,” New York Times , May 19, 2009. 24. N. King and J. Stoll, “Government Forces Out Wagner at G.M.,” Wall Street Journal , March 30, 2009. 25. Ibid 26. N. King and S. Terlep, “G.M. Collapses into Government Arms,” Wall Street Journal , June 2, 2009. 27. ____ “U.S. Treasury Lends $15.4 billion to G.M.,” Wall Street Journal , April 25, 2009. 28. S. Tercep and N. Shirouzu, “G.M. Gets $4 billion in New U.S. Funds,” Wall Street Journal , May 23, 2009 29. ____ “Pontiac, 21,000 Workers to be cut in G.M. Plan,” New York Times , April 28, 2009 30. S. Tercep, “G.M. to Close 1,100 Dealerships,” Wall Street Journal , May 16, 2009. 31. J. Bennett and A. Kellogg, “New Day for Chrylser as Fiat Arrives,” Wall Street Journal , June 12, 2009. 32. Ibid 33. Ibid 34. Ibid 35. N. Bunkley, “Fiat Acquires 35% Stake in Chrysler,” New York Times , January 20, 2009. 36. Ibid . 37. V. Bajaj, “Stocks are Hurt by Latest Fear: Declining Prices,” New York Times , November 20, 2008. 38. B. Davis, “World Economies Plummet,” Wall Street Journal , May 21, 2009. 39. Ibid 34 40. L. Bryan and D. Farrell, “Leading through Uncertainty,” McKinsey Quarterly , December 2008. 41. D. Luhnow and A. Harrup, “Mexico’s Economy Slumps, Dragged Down by the U.S.” Wall Street Journal , May 21, 2 009. 42. Ibid 43. Tanneau, 2009. 44. ___ “Financial Crisis of 2007 -2009,” www.en.wikipedia.org/wiki/financialcrisis 45. Ibid 46. R. Paul. “Audit of the Federal Reserve Reveal 16 Trillion in Secret Bailouts,” 2012. 47. Ibid 48. Wagner, Daniel, “Dow closes above 13,000, first time since crises”, The Boston Globe, February 29, 2012 49. The Herald -Dispatch, “Nasdaq Cracks 3000, but stocks fall”, 03/01/2012, http://www.herald -dispatch.com/business/x1744743793/Nasdaq -cracks -3-000 -but -stocks - fall 50. Ibid 51.Mullaney, Tim, “Jobless Rate Falling Faster than Many Predicted”, The USA Today, 03/06/2012, http://www.usatoday.com/mone y/economy/story/2012 -01 -30/cutting - the -jobless -rate/53390626/1 52.Thurm,S, “U.S. Firms Emerge Stronger,” Wall Street Journal, April 9, 2012 53. Ibid 54.Thurm,S, “For Big Companies, Life is Good,” Wall Street Journal, April 9, 2012 55. Ibid 56. R. Amit and P. Schumacher, “Strategic Assets and Organizational Rent,” Strategic Management Journal , 1993, 14: 33 -46. 57. B. Wernerfelt, “A Resource -Based View of the Firm,” Strategic Management Journal , 1984, 5: 171 -180. 58. R. Sanchez, “Strategic F lexibility in Product Competition,” Strategic Management Journal , 16: 135 -159. 35 59. P. Moran and S. Ghosphal, “Markets, Firms, and the Process of Economic Development,” Academy of Management Review, 1999, 24: 390 -412. 60. R. Rumelt, D. Schendel, and D. Teece, “Strategic Management and Economics,” Strategic Management Journal , 1991, 12: 5 -29. 36 Harvard Business Cases for Chapter 1 Toyota: The Accelerator Crisis Product Number TB0243 Google’s Andriod: Will it shake up the wireless industry in 2009 and beyond? Product Number SM176 Professor Case for Chapter 1 General Motors (G.M.) Discussion Question: Explain G.M.’s strategy as it exited Chapter 11 bankruptcy protection. Has this been a viable strategy? Explain why or why n ot. 37 Chapter 2 Industry Analysis and Industry Evolution for the 21 st Century 38 Learning and Assessment Goals 1. Understand the challenges of the 21 st century. 2. Obtain the ability to conduct an industry analysis. 3. Determine at what stage firms are in from an industry evolution perspective. 4. Understand the relationship between industry analysis and industry evolution. 5. Understand how Porter’s (1980) 5 forces model changes as a firm moves from one stage of industry evolution to the ne xt. 39 Firms need to have a very clear objective. This objective is referred to as the mission statement. All stakeholders of the organization should understand the mission statement. For example, Southwest Airlines mission statement is “dedicated to the highest quality of customer service delivered with a sense of warmth, friendliness, individual pride, and company spirit.” In an era of cost -oriented airlines, Southwest wishes to become the airline that provides its customers the highest quality of airline transportation service. This mission may be one reason Southwest Airlines is the only airline that has been profitable every year since the airline industry was deregulated in 1978. While the mission statement is what the firm wishes to become, the statement of strategic intent is how a firm is to accomplish its mission. Strategic intent identifies how the firm uses its resources to achieve advantage within a competitive environment. The competitive environment of the 21 st century differs significantly from the competitive environment of the 1990’s. The Competitive Environment in the 21 st Century Some believe that the 21 st century will bri ng significant change. Gary Hamel (co - author of The Future of Management ) believes that strategic leaders will need to greatly change how they manage. The 20 th century model of designing and managing companies, which emphasized hierarchy and the importan ce of labor and capital inputs, is no longer applicable 1. Forward -looking executives will respond to this challenge by developing new ways to bring innovative products and services to the marketplace 2. New approaches to managing employees and organizing talent to maximize wealth creation may provide companies with a competitive advantage. As companies change the direction of the firm, they will have to balance revolutionary thinking with practical experience 3. Scholars believe that the management of tec hnology will be crucial for success within the first few decades of this century. There are three reasons why technology will be important in the current and future environment 4. As Lowell (author of Mobilizing Minds ) says, first is the impact of new tech nology. Technology provides the availability of powerful new tools for coordinating human effort. Second, increasing global demand for goods and services will require companies to be adaptable and innovative 5. Third, technology can be used to identify un met consumer needs much more quickly than in the past (e.g., iPhone) 6. Lowell believes that strategic leadership must include innovation. The scarce resources in any company today are discretionary spending, talent, and knowledge. The issue isn’t just in novation, but being able to implement the innovation throughout the company. Bryan believes that the ideas on how to run firms in the 21 st century have now reached a stage of maturity which will require managers to consciously innovate. Bryan believes th at we may be entering an area of new technology innovation which will cause managers to adapt to new environments. This will lead to a continued importance of developing innovative as a result of increases in intellectual capital. If innovation can be re alized, firms will participate in the new products environment. Otherwise, these other firms will not. A firm’s competitive environment will consist of firms within its industry and may consist of firms in other industries. As such, it is important to identify industry boundaries. 40 Industry Structure From an industry analysis perspective, the structure of an industry can take many forms which impact competition in different ways. Table 2.1 shows a number of structures an industry may take. Table 2.1 Selected Industry Structures Type of Structure Number of Competitors Ease of Entry into Market Product Monopoly One Many barriers Almost no substitutes Oligopoly Few Some barriers Homogeneous or differentiated (with real or perceived differences) Monopolistic competition Many Few barriers Product differentiation, with many substitutes Pure competition Unlimited No barriers Homogeneous products Monopoly A competitive structure in which an organization offers a product that has no close substitutes, making that organization the sole source of supply. The United States Postal Service (USPS) is the only entity that can deliver first class mail. Oligopoly A competitive structure in which a few sellers control substantial market shares. The worldwide steel industry would be an example of an industry which would be an oligopoly. Three firms dominate the industry: ArcelorMittal, Nippon (Japan), and Posco (So uth Korea). Monopolistic competition A competitive structure in which a firm has many potential competitors and tries to develop a marketing strategy to differentiate its product. A good example of monopolistic competition would be the auto industry. Th e number of global auto manufacturers is quite large. Pure competition A market structure characterized by an extremely large number of sellers, none strong enough to significantly influence price or supply. Bottled water firms would be an example of pur e competition. No one firm can influence price or supply. Industry Classification The U.S. government has developed a classification system to group firms into industries. This system, the Standard Industrial Classification (SIC) System , groups firms that produce similar goods and/or services. This system is being replaced by the North American Industry Classification System (NAICS). The newer system is a result of the North American Free Trade Agreement (NAFTA) that reduced trade barriers between the United States, Canada, and Mexico. This system classifies firms in the U.S., Canada, and Mexico into industries. The NAICS 41 is based upon the International Standard Industrial Classification (ISIC) System, which is used to classify firms into industry groups throughout the world. Table 2.2 Comparison of SIC and NAICS SIC code sequence for chewing gum, bubble gum manufacturers SIC Code Type of Code Description 20 Sector Food and kindred products 206 3 digit sub -sector Sugar and confectionary product manufacturing 2067 4 digit sub -sector Chewing gum, bubble gum, and chewing gum base NAICS code sequence for chewing gum, bubble gum manufacturers NAICS Code Type of Code Description 1997 Value of Product Shipments ($1,000) 311 3 digit sub - sector Food manufacturing 423,262,220 3113 4 digit sub - sector Sugar and confectionary product manufacturing 24,301,957 311340 U.S. Industry Code Non -chocolate confectionary manufacturing 5,080,263 3113404 Product Class Chewing gum, bubble gum, and chewing gum base 1,310,938 Source: Adapted with the permission of Prentice Hall, from Strategic management by Stephen Porth, 108. 2003. As shown in Table 2.2, the NAICS provides more detailed information than the SIC system. Once industries have been classified, a process needs to be developed to examine the differences between industries. 42 Porter’s Five Forces Michael Porter at Harvard University has developed a framework for analyzing industries 7. His five forces model is illustrated in Figure 2.1. Figure 2.1 Porter’s Model of Industry Competition Source: Adapted with the permission of the Free Press from Competitive advantage: creating and sustaining superior performance by Michael Porter, 5. 1985 The figure identifies 5 key structural features that determine the degree of competition within an industry. Each element of the figure will now be discussed. Potential Entrants (Threat of New Entrants) This force addresses the likelihood that firms, which are currently outside an industry, will enter the industry 8. If firms within the industry have significant economies Potential Entrants  Economies of scale  Absolute cost advantage  Brand identity  Access t o distribution  Switching costs  Government policy Degree of Rivalry  Number of competitors  Industry growth  Asset intensity  Product differentiation  Exit barriers Substitutes  Functional similarity  Price performance trend  Product brand Recognition Suppliers  Supplier concentration  Number of buyers  Switching costs  Availability of substitute raw materials  Threat of forward integration Buyers  Buyer concentration  Number of suppliers  Switching costs  Substitute products  Threat of backward integration Threat of new entrants Bargaining power of buyers Bargaining power of suppliers Threat of substitute products or services 43 of scale, these scale economies act as a deterrent to entry. For example, firms are not likely to enter the ground transportation shipping industry in the U.S. because United Parcel Service (UPS), FedEx, and DHL deliver millions of shipments each day. Brand name can also deter firms from ent ering an industry. Coke and Pepsi have such strong brands in the soft drink industry that it would be difficult for new entrants to compete in the beverage industry. Even if entrants attempted to enter a segment (such as bottled water) firms of the indus try, they would be likely to face significant competition. For example, Coke has acquired Dasani and Pepsi has acquired Aquafina. Making sure certain goods and services are available to customers requires establishing an inbound and outbound transportat ion system. A fully developed distribution infrastructure provides customers easy access to a firm’s products/services. Building infrastructure is expensive and time consuming. In addition, new entrants would need to offer a product and/or service that induces the consumer to switch brands. For example, a firm would be unlikely to enter the P.C. industry in the U.S. due to the extensive infrastructure and brand name that Dell has created. The P.C. industry is comprised of large -scale players who primar ily compete on price. These industry conditions make it difficult for new entrants to establish a viable position within this industry. Government policy may also impact a firm’s entry into an industry. For example, the United States Postal Service (USP S) is a monopoly with respect to delivery of government mail. As such, competitors are not permitted to enter this segment of the industry. Bargaining Power of Suppliers This force addresses the degree to which inputs into the industry affect the rela tionship between sellers and buyers 9. If pilots decided not to fly, the airline industry would not function. By having large capital resources (e.g. aircraft) not being utilized, the airlines would be losing even more money than they are currently. The g reater the degree of concentrations of suppliers, the greater the power these suppliers can impact an industry. The OPEC cartel is one reason that gasoline prices are high in 2011. Because final consumers have very few options with respect to travel by car (e.g. train), the suppliers have a significant impact upon the industry. While auto manufacturers are introducing alternative types of cars (e.g. electric), the vast majority of vehicles are still dependent upon oil for fuel. Bargaining Power of Buy ers This force addresses how much influence customers have within the industry 10. Where switching costs are low, consumers exert significant power. Switching costs determine how easy it is for consumers to change products/services. Within the auto and brewing industries, consumers have many options; thus, consumers have significant power as to what products/services are manufactured. On the other hand, the pharmaceutical industry has significant control over buyers because drugs a re protected by 17 years of patent protection. Threat of Substitutes This force addresses how products/services are perceived from the customer’s perspective 11. The more options that the final consumer has, the greater the threat of substitute products . With respect to cell phone manufacturers, consumers have a broad selection. As such, price becomes an elastic variable. Because the functionality is 44 primarily the same, the only option for manufacturers is to compete on price. For industries which do not have brand equity and which have products with similar functionality, price becomes a key variable. Commodity industries such as mining and steel manufacturing tend to be price sensitive markets. On the other hand, the fashion industry is relatively inelastic with respect to price due to branding (e.g. Gucci). The same brand perception applies to service industries: the Mayo Clinic has one of the best brand reputations for h ealthcare in the world. To a lesser degree, some management -consulting firms have excellent brand reputations (e.g. McKinsey). Degree of Rivalry This issue addresses how much rivalry exists within an industry 12. The degree of rivalry within an industry is determined by several factors. The first factor is the number of competitors. In general, the greater the number of competitors within an industry, the greater is the rivalry. When little product differentiation exists, firms compete intensely on price. The U.S. airline and trucking industries are two examples. For industries where significant product differentiation exists (e.g. the apparel industry), competition is less intense and focuses on value (or brand) as opposed to price. For example, brand loyalty in the cosmetics industry is approximately 70 percent 13. If an industry requires high expenses to acquire and maintain its assets, the rivalry among firms tends to be less. Because of the capital needed to fund R&D, the pharmaceutical ind ustry has only a few large competitors. While these competitors engage in rivalry, the rivalry is focused more on value added products as opposed to pure price. Figure 2.2 represents a five focus analysis of the LTL (Less Than Truckload) Trucking Industry. This industry involves the movement of shipments above 50 pounds and under 10,000 pounds. The Interstate Commerce Commission (ICC) defines LTL carriers as those motor carriers who transport freight by placing in their t railers multiple shipments from multiple shippers destined for multiple customers. While each individual shipment represents less than a full truckload of freight, the accumulation of multiple shipments results in fully loaded trailers. This industry is q uite homogeneous in its operating structure and market environment, but it is different from the operating structure faced by other segments of the trucking industry. Within this segment, the majority of the carriers utilize a hub -and - spoke operating syst em that is distinct from the rail, pipeline, and, to a certain extent, the TL (truckload) industry. The threat of new entrants will be discussed first. 45 Bargaining power of buyers – significant Industry Analysis Using Porter’s Five Forces Model Figure 2.2 A Five Forces Analysis of the L TL Trucking Industry (2011) Potential Entrants  High barriers to entry  Economies of scale  No brand identity  Low switching costs  Deregulated  National Hub and Spoke operating network is required Degree of Rivalry - Significant  4 competitors  Minimal industry growth  Little product differentiation  High exit barriers  Rigid assets Buyers  Low switching costs  Many types of buyers  Buyers are dispersed geographically Suppliers  Suppliers are concentrated  Unionized  Few buyers Substitutes  Carriers provide similar service  Carriers compete primarily on price Threat of new entrants – minimal Bargaining power of suppliers – moderate Threat of substitute product/services – significant 46 Before the industry was deregulated in 1980, there were over 100 LTL carriers. As of 2011, 4 major carriers exist. The LTL industry is very capital intensive. As such, this industry has high barriers to entry. Because there i s little brand equity, the trucking firms must generate profits as a result of economies of scale. The trucking firm’s primary customers are multi -national corporations. These firms do not view one trucking firm as providing a better service than the oth ers. As such, the firms compete on price. Therefore, the threat of new entrants, from firms entering from outside the industry is minimal . The bargaining power of suppliers will be discussed next. The workforce of this industry is all unionized. While there is a very large pool of available workers, unionization puts constraints on trucking operations. While there are many suppliers of parts, the manufacturer of trucks and trailers are provided by a small number of firms. As such, these firms exert su bstantial influence upon the industry. Because of the power of the labor unions and small number of providers of trucks and trailers, the bargaining power of suppliers is moderate . The bargaining power of buyers will be discussed next. Because customers have very low switching costs (firms are substitutable) between firms, the existence of substitutes is significant. Carriers have the accessibility to service all points within the U.S. because they have extension hub and spoke operating networks. Becaus e customers are dispersed throughout the U.S., the trucking firms have an advantage compared to rail and air freight modes of transportation. Still, buyers have significant bargaining power . The threat of substitute products will be discussed next. Becau se trucking firms provide similar service, these firms must compete aggressively on price for business. This is one reason why costs must be minimized. Therefore, the threat of substitute products or services is significant . The degree of rivalry will b e discussed next. The LTL industry is comprised of a small number of large -scale players who compete in an industry with little product differentiation. Because the assets are rigid (trucks, trailers), alternative uses of assets are minimal. The way that many trucking firms have been competing is to form strategic alliances with ocean shipping firms and rail firms. Because all major firms have alliances with railroads and ocean shipping firms, the trucking firms cannot differentiate their services. With substitutes available, trucking firms cannot achieve significant product differentiation. Without product differentiation, cost becomes important. However, the bargaining power of suppliers, especially labor unions, tends to prevent significant cost red uctions. With assets that cannot be re -deployed to generate alternative revenue streams, the degree of rivalry within the industry is significant . The 5 forces industry analysis of the LTL trucking industry would lead to the conclusion that this is a diff icult industry in which to remain profitable. This is a very mature industry. In 1980, there were over 100 firms. As of 2011, there are 4 major firms. As of 2011 the largest firm in the industry, YRC, is close to entering Chapter 11 bankruptcy protecti on. This firm has lost over $2.5 billion in the past 5 years. The other three firms in the industry are experiencing minimal (if any) profitability. Industry Evolution Porter’s 5 forces model provides a perspective for industry analysis at a specific point in time. However, industries evolve over time. Generally, industries move through a life cycle that consists of introduction (embryonic), growth, maturity, and decline stages 14. Each of these life cycle stages will be discussed. 47 Introduction Stage Innovating and creativity dominate the introduction stage. Creativity may be in the form of technology that changes the way we do business. Broad new technologies tend initially to be brought into practice in crude form, representing a bundle of potent ial resources. The automobile, the airplane, the transistor, the computer, and the laser – were introduced as new technologies that could be utilized in many industries 15. However, these innovations required considerable refin ing before they became use ful. It took significant investment before these new technologies became major contributors to economic growth 16. During the introduction stage, products are developed and commercialized for the first time. 17 Advertising plays a key role b ecause potential consumers must be made aware of new products/services created as a result of these innovations. Distribution channels need to be developed to provide infrastructure for the transportation of raw materials into manufacturing facilities and to provide a network to move finished goods to final consumers. Operational processes need to be developed to manufacture products. Financial investments are needed to support high initial investments and initial losses. Because one firm may be supplyi ng the entire market, building a credible image is important. Growth Stage As products begin to be accepted within the industry, demand begins to increase significantly. With the increase in demand comes competition. Firms begin to design, manufacture, and distribute similar types of products/services to compete against the initial firm. Channels of distribution are expanded because of the increase in demand. As firms begin to design and manufacture substitutes, the firm that developed the original innovation may develop value added products to remain ahead of competitors. Firms begin to establish long -term relationships with customers to generate repeat purchases. If the incumbent firm has developed a significant market share, prices may be slightly reduced to act as a barrier to entry for competition. New competitors must not only manufacture and distribute the new product/service; they must spend significant R&D to create the new products/services. If potential entrants become aware of the innovati ng firm adding additional value to its new products, they may choose to enter other industries. During this stage, firms may begin to expand via exporting to international markets. Maturity Stage While the introduction phase is dominated by innovation, firms attempt to achieve efficiencies in the maturity stage. With significantly more firms in the industry, firms with the largest market share can obtain efficiencies through higher levels of production or through automation. As scale becomes important, firms may engage in process R&D . Process R&D attempts to achieve efficiencies through Total Quality Management (TQM) initiatives. Investments in capital to achieve large -scale production are importa nt. Products may be viewed as more commodity based: as such, advertising, which attempts to create perceived or real customer benefits, may be more heavily utilized. During the maturity stage, firms may engage in mergers and acquisitions to build larger s cale. As a result of mergers and acquisitions, a small number of large -scale players may dominate the industry. International markets are more fully developed through acquisitions, strategic alliances, or foreign direct entry (FDI). 48 Decline Stage Durin g the decline stage, demand tends to be significantly reduced as products/services become obsolete. Very little is invested in product or process R&D because firms allocate investments toward more attractive industries. Production is reduced as facilities are utilized to produce products/services for more attractive industries. Customers begin to reduce purchases and buy products/services that address new unmet needs. Investments in marketing and sales are reallocated to products/servi ces that generate higher returns. As price continues to decline, firms that do not have alternative revenue streams begin to have difficulty with profitability. Some firms may enter Chapter 11 bankruptcy or go out of business (e.g. U.S. airline industry). Firms with positions in multiple industries may attempt to sell off their position in the declining industry. Firms will utilize the funds to support investments in more attractive industries. Because of a lack of demand, t he profit potential within the industry declines. 49 Table 2.3 Porter’s Five Forces and Industry Evolution An Analysis of Industry Forces as Firms Move through the Industry Life Cycle Introduction Growth Maturity Decline Bargaining Power of Suppliers Significant: No prior relationships may exist Moderate:

Distribution channels become larger and more extensive Moderate: Firms will attempt to lock suppliers into long term contracts to reduce costs Minimal: Firms use existing channels Bargaining Power of Buyers Significant: No revenues without customers Significant:

Customer acceptance is crucial to generate large revenues Significant:

Customers put pressure on manufacturers to reduce price Significant: Customers pu rchase other goods/services Threat of Substitute Products/ Services None: Substitutes do not exist Significant: Firms are entering the industry: Initial firms may begin to add additional product/service benefits Significant:

Products/ Services are perceiv ed to be homogeneous.

Customers search for lowest priced provider Minimal: Competitors utilize funds and resources to grow within other industries Threat of New Entrants Minimal: Firm with the innovation dominates Significant: Firms enter the industry with similar products/ Services Minimal: Price becomes a significant buying factor for customers. Potential entrants look for more attractive industries Minimal: Firm growth is declining as is firm profitability Degree of Rivalry Minimal: One firm dominat es the industry Moderate: Firms enter industry with similar products/ services. Incumbent firms attempt to grow by expanding into new markets or adding value to existing products/ services Significant: Because price is a key buying factor, firms must expan d to generate significant revenues to offset shrinking margins Minimal: Firms are exiting the industry As firms move through an industry’s life cycle, industry forces change. Table 2.3 provides an overview of Porter’s five forces as an industry evolves. 50 Industry Forces During Introduction Stage One of the most significant industry forces during the introduction stage of the industry cycle is the bargaining power of suppliers. Because the industry is new, these relationships may not exist. The firm mus t develop ways of obtaining raw materials and transporting them to an operating/manufacturing facility. Without suppliers, the firm has nothing to manufacture. Once manufacturing has been completed, the firm needs to establish distribution channels so th at finished goods can reach customers. Customers are extremely important. They generate revenue that is needed to pay variable costs and make some contribution to fixed costs (e.g. plant and equipment). Without buyers, the industry cannot evolve. In ad dition, customers provide revenue to help fund expansion. The firm must also hire and train all employees. Advertising agencies become important because the benefits of products/services must be communicated to potential customers. Threat of substitutes does not exist during the introduction stage because competitors do not exist. As such, the threat of new entrants is minimal. For a majority of the introduction stage, potential competitors are waiting to ascertain customer acceptance. In addition, be cause the industry is in its beginning, other firms may not have the knowledge and/or resources to compete in the new industry. Firms are more likely to continue to build positions within their existing industries rather than venturing into a new industry that may or may not be profitable. Firms considering entry may have difficulty utilizing their existing assets within the new industry. As a result, the degree of rivalry is minimal. Industry Forces During Growth Stage The industry moves into the grow th stage once competition begins to enter. As competitors enter the industry, they may pose significant threats to the incumbent firm by developing products/services that are close substitutes. Because customers have choices, the threat of substitute pro ducts is significant. The incumbent firm may both expand scale of operations and add value to existing products/services. By adding value, the incumbent firm can attempt to create differentiation. By increasing scale of operations, the initial firm may develop a scale advantage over new entrants. Degree of rivalry tends to be moderate because industry demand is growing. If demand grows in excess of supply, competition is less severe. Firms may attempt to use excess production capacity to expand into ne w markets or export into international markets. Bargaining power of suppliers tends to become less significant as the incumbent firm obtains greater utilization of its existing infrastructure. Distribution channels are more fully developed and effort is expended into building long -term relationships with suppliers. Because buyers have choices, they play a significant role in terms of which firms grow in the industry and which firms do not. The incumbent firm will attempt to obtain brand loyalty by focus ing upon benefits (perceived or real) via advertising or other forms of promotion. If customers require differentiated products/services, they can exert influence on firms to provide additional value. New firms will need to recover costs of R&D and imple mentation. Therefore, they may be more rigid from a price perspective than the incumbent firm. 51 Industry Forces During Maturity Stage When firms begin to compete on price, rather than value added, they have entered the maturity stage of the industry. Du ring this stage, firms compete vigorously against one another. Because there is a downward pressure on price, firms must achieve a much larger scale to generate acceptable profit margins. Firms may add significant production capacity to reduce costs. Ho wever, firms must be careful with plant expansion because industry growth rates will tend to be lower than in the growth stage. Degree of rivalry during this stage is significant because industry growth rates have declined and there are a number of compet itors within the industry. Firms that invest quickly in plant expansion or TQM (Total Quality Management ) may have a cost advantage. Also, firms may either outsource elements of production or relocate to markets where labor rates are more attractive (e.g. Mexico, Southeast Asia). Buyers have substantial power because they desire products with value added features in addition to lower priced products/services. In general, buyers have significant choices with respect wh ich firm’s products/services they purchase. Because repeat business is crucial, customers have significant input into which firms remain profitable within the industry. Customer’s needs may change. If firms have developed relationships with customers, they may be able to develop goods and services that offer differentiation from competitors. In this case, these firms may enjoy the benefits discussed in the growth stage. During the maturity stage, firms will attempt to lock suppliers into long -term co ntracts so the distribution infrastructure remains intact. In addition, the bargaining power of suppliers may impact the degree to which manufacturing and assembly can be outsourced to low cost markets. Further, automation may be necessary to remain comp etitive. If the workforce is unionized, firms within the industry must have good relationships with labor unions. Because the threat of substitute products/services is significant, customers tend to treat products and services as commodities. Because th is threat is very significant, firms within the industry, have no choice but to expand scale to achieve economies. It is much more difficult to differentiate products/services in this stage of the life cycle because firms have the capability to quickly ma tch competitor’s offerings. In addition, because efficiency is important, firms may not invest in product R&D to the extent that was incurred during the introduction and growth stage of the industry. The R&D that is employed during this stage is focused upon process R&D . In general, process R&D attempts to create greater efficiencies. During the maturity stage of the life cycle, new entrants are minimal. Many of the existing firms have developed large -scale operati ons. This should provide a cost advantage over new entrants. Firms that are not in the industry will look to other more attractive industries to invest in. Industry Forces During Decline Stage Firms have entered the decline stage when some firms go o ut of business. The level of firm expenditures is reduced significantly as firms transfer their resources to more attractive industries. The degree of rivalry between firms is low because firms are exiting the industry. The decision is not “how should t he firm compete” but “should the firm be in this industry?” 52 The threat of new entrants is very low because new firms do not perceive the industry as attractive. In addition, firms that had resources to effectively compete in this industry would have ente red in one of the earlier stages. Bargaining power of buyers is significant because they will need incentives to remain brand loyal. Since products are viewed as commodities, the firms’ only option is to further reduce price. This action may lead to ver y low or negative profit margins because prices have already been significantly reduced during the maturity stage. Bargaining power of suppliers is low because the firm has no financial incentive to further develop the industry. Firms utilize their exist ing infrastructure with minimal, if any, modifications. Bargaining power of suppliers is further reduced because firms are exiting the industry. Firms may reduce the number of suppliers in an attempt to reduce costs. Because product R&D and process R&D are minimal, if they exist at all, threat of substitute products is low. The firms’ resources have been shifted to other industries that have more attractive profit potential. The Upside of Declining Industries In general, most firms will not, and should not, compete in industries that are in the decline stage. However, a specific industry may be at a different stage of industry evolution in international markets. For example, the Smartphone industry is at an ear lier stage in developing countries than it is in the United States and Japan. As such, Apple may be able to s ell existing products (iPhone ) in developing markets. Because GDP/capita is lower than in fully industrialized countries, manufacturing facilities may need to be constructed in these markets to reduce costs. Another possibility exists within declining markets: that technological change will occur. For years, the airline industry has suffered from the classica l traits of a declining industry. Some firms are, or have been, in Chapter 11 bankruptcy protection, and many other large airlines are close to entering bankruptcy. Some airlines have gone out of business (Pan Am, Eastern, Wes tern). With the exception of Southwest and JetBlue, most airlines have not been profitable for many years. This industry may be in for a shock. Richard Branson and Paul Allen have developed an aircraft that can reach an altitude of 62 miles above the ea rth. Customers are initially willing to pay $200,000 per seat. The current plans call for commercialization in 2012. By taking advantage of the curvature of the earth and no atmosphere, transit times to Asia and Europe could be dramatically reduced. Wh ile this technology may not be commercially feasible at this point, it could revolutionize air transportation in the future. If successful, the airline industry may move from a mature stage industry to an introduction or growth stage industry. 53 Discus sion Questions 1. Explain how industries are classified within the United States. 2. Identify Porter’s 5 forces. What is the primary purpose of these forces? 3. Identify the stages of industry evolution. 4. Why is it important to understand what stage an industry is in? 5. How do firms compete within the different industry life cycle stages? 6. Explain how industry analysis and industry evolution impact firm level strategy. 7. Which force of industry analysis is most important for the Capstone Simulation industry? 8. Why will innovation be crucial as we move further into the 21 st century? 54 References 1. Hamel G. and Green B. 2007. The future of management. Harvard Business School Press. Cambridge, MA. 2. Ibid 3. Ibid 4. Lowell B. and Joyce C. 2007. Mobilizing minds: creating wealth from talent in the 21 st century organization. McGraw Hill: New York. 5. Ibid 6. Helfat C., Finkelstein S., Mitchell W., Peteraf M., Singh H., Teece D. and Winter S. 2007. Executives, Dynamic Capabilities, and Strategic Change. Indynamic capabilities: understanding strategic change in organizations. Blackwell Publishing: Malden, MA. 7. Porter, M. 1980. Competitive advantage . Free Press. New York, NY. 8. Ibid 9. Ibid 10. Ibid 11. Ibid 12. Ibid 13. Peter, J. and Olson, J. 2002. Consumer behavior and marketing strategy . McGraw -Hill Irwin. Boston, MA. 14. Ibid 15. Grant, R. 2005. Contemporary strategy analysis . Blackwell Publishing. Australia. 16. Ibid 17. Agarwal, R., Sarkar, M., and Echambadi, R. 2002. The conditioning effect of time on firm survival: an industry life cy cle approach. Academy of Management Journal . 45:971 -994. 55 Intel Mini Case Intel is one of the largest semiconductor manufacturers in the world. Intel reported its best financial results ever in 2010. Intel controls approximately 80 percent of the market share of the industry. AMD controls a significant portion of the remaining market share (Table 1). Intel’s revenue grew from $37.6 billion in 2008 to $43.6 billion in 2010. Net income increased to $11.46 billion in 2010 from $5.29 billion in 2008 (Table 1). Earnings per share increased from $.92 in 2008 to $2.01 in 2010 (Table 1). Intel’s primary growth is driven by the increase in P.C. sales. Over 1 million P.C.’s are sold worldwide each day. Many households have more than one P.C. In additi on, P.C. growth has grown at an increasing rate in emerging markets. Growth from Intel’s Asian business has increased from 26 percent of revenues in 2000 to 57 percent of revenue in 2010 (Table 2). The competitive landscape is changing. New categories o f products such as smart phones, smart TVs, tablets, in -vehicle systems, and more are connecting to the Internet and becoming more intelligent. Intel is aggressively pursuing opportunities to expand in these new product categories. In addition, the Inte l brand is consistently ranked as one of the most recognizable and valuable brands in the world. In 2010, the Intel brand ranked 5 th in the world and had a brand value of $35.6 billion. Intel believes that its brand represents its commitment to moving te chnology forward. As the world leader in computing innovation, Intel designs and builds the technologies that serve as the foundation for the world’s computing devices. Intel believes that it is transforming from a company with a primary focus on the des ign and manufacture of semiconductor chips for P.C.’s and servers to a computing company that delivers complete solutions in the form of hardware and software platforms and supporting services. Table 1 Intel Financial Results 2008 2009 2010 Revenues ($ Billions) 37.6 35.1 43.6 Net Income ($ Billions) 5.29 4.36 11.46 Earnings per Share .92 .77 2.01 Table 2 identifies the distribution of its revenues from a geographic perspective. Table 2 Geographic Dispersion of Revenues (Percent) 2000 2005 2010 Japan 9 10 10 Europe 24 21 13 North America 41 19 20 Asia 26 50 57 Intel’s manufacturing process technology enables it to build processors with increased energy -efficient performance at low cost. Intel has been shipping products 56 built using 32 nanometer (nm) process technology since 2009. By the end of 2010, Intel’s competition had not shipped any. PC shipments grew by double -digit percentages in 2010, but computing is no longer confined to computers. Thousands of other devic es powered by Intel technology – cars, cell phones, homes, hospitals, offices, and factories – are other examples. These additional uses may increase Intel’s revenue significantly. Intel believes it has the financial position to grow into these additiona l businesses. Discussion Question: 1. How well is Intel positioned for future growth? 57 Harvard Business Cases for Chapter 2 The Canadian Telecommunications Industry and Regulation Product Number W11013 The Global oil and Gas Industry: 2010 Product Number TB0223 Professor Case for Chapter 2 Global Steel 58 59 Chapter 3 Utilizing Internal Analysis to Build Competitive Advantage Over Rivals 60 Learning and Assessment Goals 1. Understand what value chain activities should not be outsourced. 2. Understand how firms can utilize value analysis to obtain competitive advantage. 3. Understand how firms can utilize value analysis to maintain competitive advantage. 4. Understand the key role that technology plays in positioning firms for advantage. 5. Understand how value chain analysis can be used in the Capstone Simulation. 61 As discussed in Chapter 1, understanding a firm’s external environment is critical if the firm is to capitalize upon opportunities or neutralize threats. However, the firm must also conduct an internal analysis to build strengths to exploit competitors’ weaknesses. This building of strengths is based upon how a firm develops its resources to achieve positions that are superior to rivals. The Resource -Based View Edith Penrose originally developed this perspective in her seminal book, A Theory of the Gro wth of the Firm . To Penrose, resources represented “unused productive services 1.” Resources are stocks of assets that are controlled by the firm 2. These assets can be either tangible or intangible. Examples of tangible assets would be plant, equipment, trucks, airplanes, and cars. Intangible resources cannot be seen, felt, or otherwise observed. They are deeply rooted in a firm’s history. Intangible assets would include brand name , reputation, company culture, and intellectual capita l. Intellectual capital represents the collective knowledge of the management team. This resource is extremely important to firm growth and competitive advantage. As such, Chapter 11 is totally devoted to this issue. For resources to be productive, the y must be utilized. Capabilities represent the processes by which resources are utilized 3. These processes are very important because they can help a firm differentiate itself from rivals. Examples of capabilities would be the ability to transform techn ology into new products, the development of low cost logistic networks, effective promotion of products, and miniaturization of components and products. Core competencies are combinations of resources that are linked by capabilities that serve as a source of competitive advantage over rivals. Coke’s global branding, Intel’s chip technology, and Gillette’s technology in men and women’s razors are examples of core competencies. It is not the resources or capabilities that provide competitive advantage; it is how the firm uses these resources and capabilities to generate core competencies 4. Core competencies emerge over time as firms continually add value to their stock of resources and develop innovative ways of using their resources. Dell Direct is a c ore competence. This capability allows Dell to charge lower prices because the intermediary network of wholesalers and retailers is eliminated. Caterpillar’s dealer network represents a core competence because it allows for worldwide distribution. Cri teria for Competitive Advantage For capabilities to be judged as core competencies, they must meet four criteria. They must be (1) valuable (2) rare (3) costly to imitate and (4) nonsubstitutable 5. Valuable capabilities allow the firm to exploit opportunities or neutralize threats in its external environment. By effectively using capabilities to exploit opportunities, a firm creates value for customers. The continuous technological evolution of Intel chips and Microsof t’s operating systems are capabilities that customers view as valuable. Lean manufacturing and Just In Time (JIT) inventory are examples of capabilities that have fueled growth for automakers and manufacturing firms. Rare capabili ties are capabilities that few, if any, competitors possess. A key question to be answered when evaluating this criterion is, “How many rival firms possess these capabilities?” Rare capabilities would include the development of new drugs by pharmaceutica l firms. These drugs have 17 years of patent protection in the United 62 States. The managerial capability to accurately forecast conditions in any emerging industry (e.g. nanotechnology) would be another example of a rare capability. Costly to imitate cap abilities are capabilities that other firms cannot easily develop. For example, the ground/air hub and spoke -operating network that has been developed by Fed Ex and UPS over several decades, is very costly for competitors to imitate. The distribution net work that Wal -Mart has developed is costly for competitors to imitate. Highly competent management teams are developed over time. As such, they also represent a capability that is costly to imitate. Non -substitutable capabilities are capabilities that d o not have strategic equivalents. Trust between strategic alliance partners or manages industry knowledge are capabilities that do not have strategic equivalents by competitors. Brand loyalty is another capability that is non -substitutable. As firms develop more of these capabilities, they increase the probability of generating competitive advantage 6. Disney’s theme parks are an example that may meet all of the above criteria. The theme p arks are valuable because they are important to children and parents who have children. Mickey Mouse, Donald Duck, and the Magic Kingdom are part of the Disney culture. The Disney culture is rare because it is unique. Although competitors have attempted to duplicate, (e.g. Six Flags), the Disney experience has been built over decades. As such, it is very costly to imitate. The construction of Disneyland, Disney World, Epcot, and the other specialized parks provide for an experience that competitors hav e difficulty developing substitutes for. To help identify how internal firm activities can be transformed into core competencies, value chain analysis is conducted. 63 Figure 3.1 Value Chain Analysis Source: Adapted with the permission of the Free Press, from Competitive advantage: creating and sustaining superior performance , by Michael Porter, 39 -40, 1985. As shown in Figure 3.1, value chain analysis is an internal analysis. Porter 7 originally devel oped value chain analysis . To Porter, the firm could be divided to segments, each of which could create value. Primary activities are involved with a product’s physical creation, its sale and distribution to buyers, and its service after the sale. Primar y activities follow the product development process beginning with sourcing of raw materials and ending with after sale service. Support activities provide the assistance necessary for the primary activities to take place. Either type of activity has the potential to create advantage over rivals. Definitions for each activity are discussed in Table 3.1 and Table 3.2. Firm Infrastructure Human Resource Manageme nt Technological Development Procurement Inbound Logistics Operations Outbound Logistics Marketing & Sales Service Primary Activities Support Activities 64 Table 3.1 Examining the Value -Creating Potential of Primary Activities Inbound Logistics Activities, such as materials handling, warehousing, and inventory control, used to receive, store, and disseminate inputs to a product. Operations Activities necessary to convert the inputs provided by inbound logistics into final product form. Machining, packaging, assembly, and equipment maintenance are examples of operations activities Outbound Logistics Activities involved with collecting, storing, and physically distributing the final product to customers. Examples of these activities include finished goods warehousing, materials handling, and order processing. Marketing and Sales Activities completed to provide means through which customers can purchase products and to induce them to do so. To effectively market and sell products, firms develop advertising and promot ional campaigns, select appropriate distribution channels, and price products to be competitive. Service Activities designed to enhance or maintain a product’s value. Firms engage in a range of service Jrelated activities, including installation, repairI training, and adjustmentK Source: Adapted with the permission of the Free Press, from Competitive advantage: creating and sustaining superior performance, by M. Porter, 40 -43, 1985. 65 Table 3.2 Examining the Value -Creating Potential of Support Activities Technological Development Technological development takes many forms, such as manufacturing processes, basic research, product design, and servicing procedures. Activities by which a firm’s products and/or processes are improved. Human Resource Management Activities involved with recruiting, hiring, training, developing, and compensating all personnel. Firm Infrastructure Firm infrastructure includes activities such as general management, planning, finance, accounting, legal support, and governmental relations that are required to support the work of the entire value chain. Through its infrastructure, the firm strives to effect ively and consistently identify external opportunities and threats, and to identify resources and capabilities that can be developed into core competencies. Procurement Activities completed to purchase the inputs needed to produce a firm’s products. Purc hased inputs include items utilized during the manufacture of products (e.g., raw materials and supplies, as well as fixed assets — machinery, laboratory equipment, office equipment, and buildings Source: Adapted with the permission of the Free Press, from Competitive advantage: creating and sustaining superior performance, by M. Porter, 40 -43, 1985. 66 It is expected that the role of technology may transform many value chain activities in the fu ture to further lower costs or create differentiation. Technological development consists of activities that result in improvement in a firm’s products and/or the processes used to manufacture them. Product R&D consists of concentrating on ways of making products better. Table 3.3 is a value chain analysis of Berkshire Hathaway’s 2009 acquisition of BNSF. Warren Buffett is the CEO of Berkshire Hathaway. Table 3.3 Value Chain Benefits Resulting from Berkshire Hathaway’s 2009 Acquisition of BNSF Primary Activities Value Chain Activity BNSF Position Inbound Logistics  Largest hauler of food products (e.g.

corn, coal for electricity)  Hauls goods imported from Asia Operations  One train can haul the equivalent of 280 fully loaded trucks Outbound Logistics  Large exporter of goods to Asia  Distributor for Berkshire Hathaway’s products to final consumers Marketing and Sales  Access to Powder River Basin provides a high quality of coal  Greater efficiencies result in lower prices Service  Reduction in greenhouse emissions Support Activities Value Chain Activity BNSF Position Technology Development  Improvements in the manufacturing in locomotives and freight cars  Development of information systems  Electronic fuel injection  Remote control technology Human Resource Management  Maintaining the existing BNSF management team Firm Infrastructure  2nd largest railroad in North America  Extensive existing network west of the Mississippi River Procurement  Coal is used for supplying Mid - American Energy Holdings Co. for Berkshire Hathaway business 67 Warren Buffett acquired the Burlington Northern Santa Fe (BNSF) for $34 billion. BNSF is the 2 nd largest North American railroad which has extensive coverage west of the Mississippi River . From a value chain perspective, this acquisition provides several value chain benefits. One of the most important benefits that the acquisition will provide is human resource management . Matt Rose, CEO of BNSF and his entire management team has been m aintained. Matt Rose and his management team have decades of experience in the rail industry. Buffett has acquired a firm that can be utilized to provide substantial inbound and outbound logistics capabilities . BNSF is the biggest hauler of food produ cts like corn, and coal for electricity, making it an indicator of the country’s economic health. The railroad also ships a large amount of consumer goods – including items imported from Asia. This transpacific logistic capability is of crucial importanc e because of the growth of China. From an inbound logistical perspective , BNSF has established positions within the Powder River Basin, which has the highest quantity of coal deposits in the world. In addition, from an inbound logistical perspective Berk shire Hathaway own major utilities that rely on coal for its Mid -American Energy Holdings Co. Rail is a much cheaper mode of transportation than truck. As stated earlier, one train can haul the equivalent of 280 fully loaded trucks. From an infrastructu re perspective, railroads have major cost and environmental advantages over trucking firms, their main competitor. Last year BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That’s three times more fuel -effi cient than trucking. Rail firms also provide sustainability benefits because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits. This acquisition also provided service benefits. Porte r defines service as “activities designed to enhance or maintain a product’s value.” In a broad sense, efficiency and reducing greenhouse emissions would provide service benefits not only for rail customers but for society as a whole. BNSF was the first railroad to utilize technology to provide operational benefits via technological innovations to improve the manufacture and repair of locomotives and freight cars, develop the maintenance of right -of-way, and the quality of information systems. Locomotiv es were emerging with electronic fuel injection and increased fuel efficiency. BNSF was also the first railroad to develop remote control technology utilizing a portable transmitter, called the operator control unit, to communicate with a computer, or rec eiver, in the cab of the locomotive. An on -board computer operates the locomotive based on the signals received from the employee on the ground. 68 Value Chain Analysis and Capstone Simulation Value chain analysis is important because it can be applied to all primary and support activities. Table 3.4 illustrates how value chain analysis can be utilized within the simulation. Table 3.4 Value Chain Analysis Via Simulation Value Chain Activity Simulation Component Support Activities Technology Development  Creating new products  Repositioning established products  Reducing R&D cycle times Human Resource Management  Recruiting, training, and compensating employees  Labor Negotiations Firm Infrastructure  Financial analysis  Sources and uses of funds Procurement  Purchase / sale of plant and equipment Primary Activities Inbound Logistics  Implement total quality management (TQM) initiatives Operations  Implement automation  Implement TQM Outbound Logistics  Developing distributor network Marketing & Sales  Developing promotion budget  Developing sales budget  Developing sales forecasting  Developing price positioning Service  Improving Performance: Mean Time Before Failure (MTBF) Technology Development The simulation incorporates both product and process R&D . The R & D spreadsheet of the simulation allows firms to examine the cost trade -offs of creating new products versus improving exi sting products. In general, the more extensive a product needs to be modified, the more desirable it may be to develop a new product. However, new products may take longer to reach the market. The R&D spreadsheet allows for examination as to when produc ts would be released versus the time to redesign existing products. The cost versus time to market trade -off should be the criteria by which firms decide whether to revise existing products or introduce new ones. The R & D spreadsheet allows an examinati on of this trade -off for all products in all segments. 69 Some of the Total Quality Management (TQM) initiatives result in a reduction in R&D cycle time . TQM is an optional module of the Capstone Simulation. Human Resource Management As discussed by Porter, human resource management is activities involved with recruiting, training, developing and compensating personnel 9. The simulation addresses human resource management as a separate module of the production spreadsheet. The human resource module of the simulation allows for recruiting, training, and compensating employees. Human resources that are better trained will result in more effective decision -making. This is because human resources “learn by doing 10.” As human resources “learn by doing,” they become better and/or more efficient with the performances of their duties. As employees become better at performing their responsibilities, they develop the capability to teach others. Part of Chapter 11, Stra tegic Leadership Decision Making, is devoted to this topic. Human resource management also encompasses labor relations and negotiations. Labor negotiations are a separate module of the simulation. Firm Infrastructure To Porter, firm infrastructure includes activities such as general management, planning, finance, accounting, legal support, and governmental relations that are required to support the work of the entire value chain 11. Through its infrastructure, the firm strives to effectively and con sistently identify external opportunities and threats, and develop resources and capabilities to capitalize on these opportunities and neutralize threats. A firm’s ability to capitalize on opportunities and minimize threats is dependent upon the firm havi ng the financial resources to fund growth. An understanding of a firm’s growth options is achieved by analyzing a firm’s income statement, balance sheet, and statement of cash flows. A complete analysis of financial statements will be addressed in Chapte r 12, Wealth Creation. Investments in plant and equipment and sale of plant and equipment are addressed as part of the finance spreadsheet of the simulation. Thus, the finance spreadsheet allows for different capital budgeting alternatives to be evaluated. Capital budgeting is the analyzing and ranking of possible investments in fixed assets such as land, buildings, and equipment in terms of the additional outlays that will result from each investment. Firms prepare capital budgets and rank them on the basis of some accepted criteria or hurdle rate (for example, years to pay back investment, rate of return, or time to break -even point) for the purpose of strategic decision making 12. The finance spreadsh eet allows for different types of vehicles to finance investments. Firms may issue common stock and/or acquire long or short term debt financing to fund expansion activities. Procurement To Porter, procurement consists of activities completed to purchase the inputs needed to produce a firm’s products 13. Purchased inputs include items fully consumed during the manufacture of products (e.g. raw materials and supplies), as well as the purchase of fixed assets — machinery, laboratory equipment, office equipmen t, and buildings. The purchasing and selling of plant and equipment is performed within the production spreadsheet of the simulation. Purchasing plant and equipment is important for generating economies of scale. Economies o f scale are efficiency gains that result from larger firm size. 70 Inbound and Outbound Logistics To Porter, logistics involves both the transportation of raw materials to manufacturing facilities and the transportation of finished g oods to final consumers 14. The logistics component of Porter’s value chain is addressed within the Total Quality Management (TQM) initiatives of the simulation. Inbound logistics is addressed by the Just -In-Time (JIT) initiative. JIT is an integrated set of activities designed to achieve high volume production using minimal inventories of raw materials, work -in-process, and finished goods. JIT helps to reduce material costs by having only the needed materials available for manuf acturing processes. CCE (Concurrent Engineering) and CPI (Continuous Process Improvement) represent two of the TQM initiatives the simulation uses to reduce material costs. CCE could be utilized to ascertain which ven dors are either more efficient or better qualified to source raw materials. CPI can be utilized to ascertain whether a firm should continue to outsource its inbound transportation network versus the firm developing its own transportation network for obtai ning raw materials. Outbound logistics is a critical element of a firm’s distribution network 15. Distribution is addressed within the advanced marketing module of the simulation. This module allows for increasing or dec reasing the number of distributors. Increasing the number of distributors improves infrastructure. An advanced distribution system allows products to reach final consumers earlier and to increase the service area offered by the firm. Operations To Porte r, operations are activities needed to convert the inputs provided by inbound logistics into final product form 16. The objective is to create an efficient operations system. The operations aspect of Porter’s value chain is addressed in the production spr eadsheet. The simulation allows for production to be scheduled by product line. For some lines, efficiency is important. These product lines normally are for products that are more price sensitive than others. For price sensitive products, production c an be set at high levels of automation to increase efficiency. However, as automation is implemented, production processes tend to become more rigid. As they become more rigid, firms are less able to respond to changing customer needs. Several of the Total Quality Management (TQM) initiatives allow for the creation of efficiency. The key is to obtain lower costs than competitors. Production efficiencies lower variable costs that allow firms to reduce price and still maintain profit ma rgins on these products. Marketing and Sales To Porter marketing and sales are activities to induce consumers to purchase the firm’s products/services 17. The ability to forecast sales is a critical aspect of marketing and sales. Correct sales forecasts (Chapter 5: Analysis of Markets and Positioning) are crucial because they allow senior management to allocate resources to meet demand and minimize inventory -carrying costs. To effectively market and sell products, firms develop advertising and promotional campaigns, select appropriate distribution channels, and change the composition of their sales force. Within the simulation, advertising and promotion are addressed as an advanced marketing module that is linked to the marketing spreadsheet . The optional marketing module allows for the selection of different types of promotion (print media, direct mail, web media, email, and trade show) that is applied to different 71 types of products. The objective is to increase customer aw areness. This module also allows for the allocation of outside and inside sales employees to specific product lines. Firms that have new products may want to increase the number of outside sales employees to build customer awareness. Increasing the numb er of inside sales employees tends to assist in establishing longer -term relationships with existing customers. Maintaining these relationships is important because the firm can identify changing consumer preferences more quickly than competitors who have not invested in these relationships. The marketing spreadsheet allows for price changes on a product -by -product basis. For products that are price sensitive, price needs to be set at levels that are acceptable to customers but which permit the firm to make a profit. As discussed above, for price sensitive products, automation needs to be considered because automation improves efficiency and reduces per unit variable costs. Service To Porter, service consists of activities designed to enhance or maintain a product’s value 18. Many automotive and tire manufacturers provide warranties which guarantee certain levels of service performance. Service is critical because it has a direct impact upon a firm’s reputation. Bridgestone / Firest one is an example of reputation having a significant negative impact upon firm sales and profitability. Light bulbs that last two years or more are an example of a positive service attribute. Some firms attempt to differentiate from a service perspective (e.g. Maytag, Otis Elevator). Service is addressed in the R & D spreadsheet. The simulation views service as Mean Time Before Failure (MTBF) . MTBF measures how long a product is expected to last before it fails. As more funds are allocated to MTBF, the life of the product increases. The R & D spreadsheet permits MTBF to be adjusted on a product -by -product basis. Costs for changing MTBF are calculated on the R & D spreadsheet. As MTBF is increased, the product w ill last longer. This aspect of durability is a critical factor for products in the performance segment of the simulation. As discussed above, the simulation addresses all aspects of Porter’s value chain. The key to value chain analysis is to create va lue and/or efficiencies from each activity in the chain. The creation of value may generate differentiation from competitors. The creation of efficiencies allows firms to compete favorably in price sensitive segments. In this way, firms can generate adv antage by performing value chain activities superior to competitors. Global Outsourcing At times it may not be advisable to perform all primary and support value chain activities within the firm . In some cases, outsourcing may be a viable alternative. Outsourcing is based upon the principle that a third party may be better at a specific value chain activity than the firm. For example, most of the major rail (e.g. CSX) and airfreight (e.g. Fed Ex) firms have extensive logistics services that provide distribution to customers worldwide. Firms such as Komatsu outsource sub assembly manufacturing to Southeast Asian markets due to the difference in labor rates and insurance coverage between Japan a nd these markets. The key to outsourcing is to select only value chain activities that are not core competencies of the firm. Outsourcing activities that are not core competencies may allow the firm to fully concentrate on those activities that are core competencies. Outsourcing core competencies could provide competition with the knowledge to build similar competencies. 72 Outsourcing must be done with care. For example, within the U.S. an increasing number of jobs are lost each year as a result of outso urcing. Firms need to be fully aware of the significant labor relations’ issues that can result from outsourcing. While not a solution to the problem of displaced workers, technology is transforming many areas that had previously been outsourced. The cr eation of robotic sub assembly processes is one such transformation. Global outsourcing saves corporations time and money. Outsourcing has grown by 4% in 2010, and has sustained an average annual growth of 9.7% since 2005. 19 The outsourcing outlook fo r the coming years looks promising. As the world emerges out of the global recession, outsourcing should return to higher growth rates. According to Datamonitor, the market will grow at 7.2% in 2011 with $660 billion in revenue by the end of 2011. By 20 14 it is expected that the market value will be around $875 billion with 10% growth. 20 A great majority of firms have experienced declines in market growth due to the 2007 -2010 global recession. Because of the significant savings that outsourcing offers, companies are able to stay in business by outsourcing more. 21 Outsourcing helps to save money and improve the bottom line. U.S. Sourcing Line, a global data base firm, has compiled the most comprehensive online database of outsourcing country statistic s to aid managers in their outsourcing decisions. 22 Each country has been scored across dozens of key statistics which fall into three broad areas of (1) Cost Competitiveness, (2) Resources & Skills, and (3) Business & Economic Environment. 23Based on their (Sourcing Line) research, the top outsourcing destinations are identified in Table 3.5. Table 3.5 Post Recession Most Popular Outsourcing Locations (2011) World Rank Country 1 India 2 Malaysia 3 China 4 Brazil 5 Russia 6 Ukraine 7 Philippines 8 Indonesia 9 Thailand 10 Mexico 11 Chile 12 Argentina 13 Czech Republic 14 South Korea 15 United States 16 Canada The presence of developing markets dominates this list. The emerging markets (BRIC) ranked 1, 3, 4, and 5 are the most popular outsourcing locations in 2011. Malaysia is ranked as the number 2 outsourcing location. Malaysia (#2) is an emerging 73 market where English is a second language. Fully developed markets such as the U.S.

and Canada are ranked 15 and 16. Western European m arkets are not listed in the top 16 countries. 74 Discussion Questions 1. Explain the difference between a resource, a capability, and a core competence. Which is more important for developing competitive advantage? 2. Explain how a firm of your choosing can meet all of the criteria for obtaining competitive advantage. 3. Explain the fundamental difference between primary and support activities in Porter’s value chain. Which are more important? 4. With respect to the perceptual map example, would positioning a t the intersection of the vertical and horizontal be recommended? Explain why or why not. 5. With respect to the simulation, which value chain activities should be focused upon price sensitive products? Explain. 6. What specific value chain activities are im portant to the performance market segment of the simulation? How should these activities be developed? 7. Which elements of Porter’s value chain were not acquired as result of Buffett’s acquisition of BNSF? 75 References 1. Penrose, E. 1959. A theory of the growth of the firm . John Wiley & Sons. New York, NY. 2.Amit, R. and Shoemaker, P. 1993. Strategic assets and organizational rent. Strategic Management Journal . 14:33 -46. 3. Nelson, R. and Winter, S. 1982. An evolutionary theory of econom ic change . Belknap Press of Harvard University Press. Cambridge, MA. 4. Barney J., 1991. Firm resources and sustained competitive advantage. Journal of Management . 17:99 -120. 5. Ibid 6. Ibid 7. Porter M. 1985, Competitive advantage . Free Press, New York, NY. 8. Ibid 9. Ibid 10. Nelson and Winter. An evolutionary theory of economic change. 11. Porter. Competitive advantage . 12.Brealey R., Myers S., and Marcus A. 2004. Corporate finance . McGraw -Hill Irwin: Boston, MA. 13. Porter. Competitive advantage 14. Porter. Competitive advantage 15. Pride W. and Ferrell O. 2003. Marketing . Houghin Mifflin: Boston, MA. 16. Porter. Competitive advantage . 17. Ibid 18. Ibid 19. A. Kaushik, “Offshore Outsourcing and Economic Recessions: Impact on Global, Indian, and European Outsourcers,” U.S. News Digital Weekly, November 1, 2010. 20. Ibid 21. Ibid 76 22. Ibid 23. Ibid 77 Ryder Mini Case Ryder is an American -based provider of transportation and supply chain management solutions with global operations. Ryder specializes in (1) fleet management, (2) supply chain management (SCS and (3) dedicated contract carriage. Ryder operates in North A merica, the United Kingdom, and Asia. Ryder’s fleet management business segments is its largest business segment. This segment consist primarily of contract based full service leasing, contract maintenance, commercial rental and fleet support services. Ryder’s Supply Chain Management (SCS) segment is where Ryder owns and maintains the trucks and the customer decides where they go. These solutions are logistics management services designed to optimize a customer’s supply chain. Ryder’s dedicated con tract carriage is a combination of services. In this segment, Ryder combines full service leasing and supply chain management. Ryder provides service to a large number of industries: automotive, electronics, transportation, grocery, wood products, food s ervice, and home furnishing. Ryder’s finances over the last 5 years are as follows: Table 1 Ryder Financial Data 2006 2007 2008 2009 2010 Revenue ($ billions) 6.30 6.56 6.20 4.88 5.13 Net Income ($ millions) 249 254 200 62 118 Earnings/Share 4.09 4.24 3.52 1.11 2.25 During the recession (2007 -2010), Ryder has lost significant revenue and net income and earnings per share has also been negatively affected. Discussion Questions: 1. What activity(s) of Porter’s value chain does Ryder perform? 2. What areas of its business should Ryder focus upon? 78 Harvard Business Cases for Chapter 3 United Cereal: Lora Brill’s Eurobrand Challenge Product Number 4269 The Dutch Flower Cluster Product Number 711507 Professor Case for Chapter 3 Airbus A380 vs. Boeing 787 79 Chapter 4 Business Level Strategy 80 Learning and Assessment Goals 1. Understand the concept of business level strategy. 2. Understand how to make decisions to achieve competitive advantage. Understand what decisions need to be made to maintain competitive advantage. 3. Understand how competitive dynamics can be utilized to maintain competitive advantage. 4. Understand how SWOT analysis can be utilized to capitalize upon competitors’ weaknesses. In addition, understand how SWOT analysis can be utilized to convert opportunities into strengths. 81 Key Success Factors This chapter examines business level strategies. Business level strategies are focused on how a firm achieves competitive advantage within an industry. Key success factors and initial conditions dictate a firm’s initial business level strategy. Key success factors are the set of criteria t hat determine buying decisions 1. Developing a business level strategy to meet key success factors enables a firm to gain competitive advantage. To maintain competitive advantage, a firm will modify its business level strategy based upon changes in key success factors and competitive dynamics. Competitive dynamics are actions and reactions of firms within an industry over time. This general relationship is illustrated in Figure 4.1. Figure 4.1 Using Business Level Strategies to Gain and Maintain Compe titiveness Key success factors differ on an industry -by -industry basis. For example, taste is a key success factor within the soft drink industry, whereas durability is a key success factor within the athletic shoe industry. Determining key success factors (r eferred to as key buying criteria in the simulation) is an important component of firm growth. Knowledge of key success factors can help a firm position itself better with respect to competition 2. An important element of growth is the ability of a firm’s managers to identify key success factors and to develop resources and capabilities to adapt to these factors as they change over time. Determining Key Success Factors Various stakeholders need to be contacted to effectively determine key success factors. One place to start is with the senior management team. It is the responsibility of the senior management team to identify key success factors in the current time period and to develop resources and capabilities to meet these factors. It is also the resp onsibility of senior management to monitor key success factors over time. As such, the perspective of senior management is crucial if firms are to utilize H L Time Competitive Advantage Key Success Factors Initial Competitive Position Business Level Strategy T1 Change in Key Success Factors Business Level Strategy Tx Competitive Dynamics 82 key success factors to grow. In many cases, senior managers have substantial industry experience. Therefore, these senior managers cannot only identify the existing set of key success factors but also provide a perspective for how they have changed over time within a specific industry. They have keen insights into how these factors may change in the f uture. The sales force is an important source of information concerning key success factors. The sales force has responsibility for direct customer contact. They provide the best source, within the firm, of information on customer needs and wants. They are an excellent source of information not only of existing key success factors but also of factors that may be emerging, as consumer needs change. The sales force can also provide an understanding of which factors are more important from the customer’s p erspective. The sales force may also obtain information from customers as to which firms are better at satisfying specific key success factors. Utilizing Key Success Factors over Time In order to grow over time, a firm must develop resources and capabili ties to meet the key success factors in the current time period and continuously develop new resources and capabilities based upon the direction in which the key success factors evolve over time. Key success factors must be viewed from a longitudinal per spective. A successful stream of strategy decisions over time must be founded on the ability to identify changes in key success factors. Changes in key success factors require the firm to make adjustments in its strategy. Revising a firm’s strategy to f ocus upon changing key success factors may allow the firm to gain an advantage over rivals. An understanding of the evolution of key success factors over time can provide the basis for an “emergent strategy ”3. To capitalize upon changing environmental opportunities, the firm must have the flexibility to develop its resource base to respond to emerging key success factors. This identification and development ability is as important for the future as it is in the current time perio d. The greater the ability of the firm’s managers to identify the future key success factors better than its competitors, the quicker the firm can develop resources and capabilities to meet these emerging key success factors before its competitors. There are several generic business level strategies that firms can develop to become competitive. Generic Business Level Strategies Business level strategies consist of an integrated set of actions that allow firms to become and remain competitive within an industry 4. Porter’s framework provides a foundational matrix for identifying how firms can achieve advantage within an industry. The matrix identifies two primary sources by which firms can achieve advantage: (1) low cost and (2) uniqueness. The matrix is illustrated in Figure 4.2. 83 Figure 4.2: Generic Business Strategies Competitive Advantage Cost Uniqueness Broad Target Cost Leadership Differentiation Competitive Scope Narrow Target Focused Low Cost Focused Differentiation Source: Adapted with the permission of The Free Press, an imprint of Simon & Schuster Adult Publishing Group, from Competitive advantage: creating and sustaining superior performance by Michael Porter, 12. 1985. Cost leadership Cost leadership is based o n high -volume sales of low -margin items. High volume products are usually no -frills items. However, they must be of acceptable quality and have features that meet consumers’ needs. Superior advantage in a cost leadership position comes from creating a s ignificant and sustainable cost gap, relative to competitors, by managing costs to achieve economies of scale. This cost gap translates into superior margins when the firm maintains prices at or near industry averages. UPS (United Parcel Service) and Wal -Mart are two firms that are the lowest cost producers within their respective industries. These firms would fall into the cost leadership position because their target markets (customers served) are international in scope. Focused low cost Firms that se rvice a narrow target market achieve a focused low cost position. Examples of focused low cost would be Boone’s Farm, Dollar General, and online brokerage firms. Boone’s Farm’s target market consists primarily of those individuals who have little disposa ble income and enjoy drinking wine. Dollar General focuses upon target markets in selected cities that prefer to shop at small discount stores. Online brokerage firms focus on investors that are heavy users of the Internet. These firms meet the needs of specific target markets. Differentiation A position of uniqueness is based on sales of high -margin items. Customers are willing to pay a premium price for a differentiated product or service because the item satisfies some specialized need. Uniqueness can be achieved through design or brand image, technological features, customer service, specialized dealer networks, product innovations, and a high level of quality, and/or better relations with suppliers than competitors. The key to a successful diffe rentiation strategy is to offer a broad range of customers something for which they are willing to pay substantially more than the cost incurred by the firm creating it. Microsoft and Intel are examples of firms that utilize 84 differentiation strategies. T hese firms are multinational firms servicing very broad target markets with superior quality products. Focused differentiation Firms that follow a focused differentiation strategy primarily rely on brand image . Rolex, Gucci, and Rolls Royce are examples of firms that follow focused differentiation strategies. These firms focus on special segments of an industry. This strategy is oriented toward providing superior quality to those customers that value uniqueness. The question arises a s to whether a firm can occupy a position at the center of the matrix. Porter would view this approach as likely to lead to a “stuck in the middle” position. Such a position may prevent the firm from establishing a distinct advantage over rivals. The re sources that are needed to support a cost position (orientation toward efficiency) and a uniqueness position (orientation toward differentiation ) are quite different. In addition, different strategies may be needed for broad and narrow markets. These gene ric strategies help firms to gain competitive advantage. Maintaining the position is as important as gaining an initial position of advantage. Competitive advantage results from gaining a position of superiority versus rivals and maintaining that position over time 5. Figure 4.3 is an example of the application of generic business level strategies to the Capstone Simulation. Figure 4.3 Business Level Strategy and Capstone Simulation Competitive Advantage Cost Uniqueness Broad Target Competitive Scope Narrow Target L = Low end (39% of industry) T = Traditional (32% of industry) H= High End (11% of industry) P = Performance (9% of industry) S = Size (9% of industry) The low -end segment (L) is a cost leadership market representing 39 percent of units produced within the industry. The most important key success factor for the low - L T H S P P H 85 end market is price. To maintain a position of advantage over time, the firm must implement activities that are efficiency -based. The implementation of Total Quality Management (TQM) is one such activity. The implementation of several TQM initiatives will help drive down costs. This action is crucial for success in the low -end market. The traditional segment of the indust ry is another broad segment of the industry because it represents 32 percent of the industry demand. The key success factors for this segment include both cost and uniqueness criteria oriented to a broad target market. The business level strategy for thi s segment must include a low cost position coupled with a uniqueness component. One approach to obtaining this position is through the implementation of flexible manufacturing systems. A flexible manufacturing system is a computer -controlled process used to produce a variety of products in moderate, flexible quantities with a minimum of manual intervention. The high end, performance, and size segments are positioned to follow a focused differentiation strategy. Each segment will not be developed with th e same focused differentiation strategy. Each segment places different importance on key success factors to maintain advantage. An important key success factor of the high -end segment is new product development. Durability is important to the performanc e market. Market positioning is a key success factor for the size market. As such, a distinct business level strategy must be developed for each segment. Porter’s generic business strategy model has been challenged because it provides a static perspect ive 6. The incorporation of key success factors introduces a dynamic component into Porter’s generic business strategies. An understanding of the evolution of key success factors over time will allow the firm to be able to continuously meet key success fa ctors as they change. As such, the firm can develop a dynamic strategy to maintain advantage over time. By incorporating the time dimension, firms can alter their positions in response to changing market conditions (e.g. key success factors). By understa nding how each market evolves over time, the firm can maintain competitive advantage over rivals. A firm’s business level strategy must take into consideration the action and reaction of competitors. As such, an understanding of competitive dynamics is i mportant for sustaining a firm’s strategy over time. How firms grow over time is important. Walmart’s Expansion Walmart is a firm which has primarily grown by internal development. In the 1960’s Walmart grew by more fully developing its U.S. customer b ase. The U.S. customer base included all 50 states by 1993. However, this was not Walmart’s primary focus during the mid 1970’s to late 1980’s. This time period was utilized primarily for product development. As shown in Table 4.1, Walmart engaged in a period of new product development. In 1975, Walmart introduced Walmart pharmacy, auto service, and jewelry divisions within its store. These divisions provide Walmart with new products to Walmart customers which generated higher return than Walmart’s tr aditional business. These businesses also led Walmart to its primary focus of one -stop shopping. From 1991 to 2010, Walmart expanded into international markets. As can be shown from Table 4.1, Walmart has established a significant international presence . 86 Table 4.1 Walmart’s Expansion Year Results 1962 1st store opened in Rogers, AK 1971 U.S. geographic expansion 1975 Introduced Wal -mart pharmacy, auto service, and jewelry divisions 1983 1 hour photo lab 1987 Developed and introduced satellite communication system 1988 First superstore opened in Washington, MO Introduced bar code scanning 1991 Expansion into Mexico 1993 Stores opened in all 50 states 1994 Opened stores in Hong Kong 1995 Opened stores in Argentina 1996 Opened stores in China 1997 Opened stores in Germany and Korea Early 2000’s Increased international presence 2005 Commitment to environmental sustainability: Created experimental stores that save energy, conserve natural resources and reduce pollution 2006 Opened store s in Japan 2007 Opened stores in Brazil 2009 Significant international expansion 2010 Further international expansion into Brazil, China, and Mexico 87 Has this internal development expansion all been successful? Let us examine Walmart’s current financial data (2010): Table 4.2 Walmart’s Financial Data (2006 -2010) Year 2006 2007 2008 2009 2010 Revenue ($ Billions) 308 344 373 401 405 Net Income ($ Billions) 11.38 12.19 12.86 13.25 13.25 Earnings/Share 2.72 2.92 3.16 3.35 3.73 The approach seems to have worked. Revenue has increased from $308 billion in 2006 to $405 billion in 2010. Net income has risen from $11.38 billion in 2006 to $13.25 billion in 2010. Earnings per share have increased from $2.72 in 2006 to $3.73 in 2010. These financial results have occurred primarily through internal development. Competitive Dynamics Winning positions can result from a successful stream of strategic decisions over time or they can result from an exploitation of competitive weaknesses. O ne technique that is utilized to understand a firm’s position with respect to competition is SWOT analysis. SWOT Analysis SWOT refers to strengths, weaknesses, opportunities, and threats. As shown in Figure 4.4, firms attempt to utilize strengths to ca pitalize on competitors’ weaknesses and build opportunities into strengths. Figure 4.4: Strengths Strengths refer to capabilities that give the firm an advantage in meeting the needs of its target markets. An analysis of company strengths should be cust omer focused 88 because strengths are meaningful only when they assist the firm in meeting customer needs. Pfizer’s strength in research and development resulted in the creation and release of Lipitor. Lipitor is a cholesterol -reducing drug that has become the largest selling pharmaceutical drug in history 7. Toyota’s strength in lean manufacturing helps to maintain its leadership position in the automotive industry. Weaknesses Weaknesses refer to any limitations that a company faces in developing or implementing a strategy. Weaknesses should also be examined from a customer perspective because customers often perceive weaknesses that a company cannot see. Apple’s operating system became a weakness when the computer industry went to a Windows standar d. Until recently, McDonald’s faced a weakness in that the majority of its menu items contain high levels of fat . Today’s society is focusing on more healthy eating alternatives. Opportunities Opportunities refer to favorable conditions in the environm ent that could produce rewards for the organization if acted on properly. Caterpillar’s capabilities in heavy moving equipment lead to it establishing a leadership position in the reconstruction of Iraq. Dell’s strategy of selling direct to consumers sho rtened its distribution cycle and reduced costs. Threats Threats refer to conditions or barriers that may prevent the firm from reaching its objectives. For instance, Barnes & Noble’s launching of a website to sell books represented a threat to Amazon.c om. New regulations may be threats. Many emerging markets (e.g. India, Brazil) are privatizing many industries. This action can lead to new entrants establishing significant positions within these markets. In many cases, the firms that are entering a de regulated market may have had more experience being successful in deregulated industries. As such, these firms pose significant threats to incumbent firms.

A firm’s strategy should determine how threats could be minimized or eliminated. The threat of Joh nson and Johnson losing market share as a result of the cyanide poisoning of Tylenol capsules in the 1980’s posed a significant threat. Johnson and Johnson responded to the threat by introducing safety seals; these seals are now industry standards. A SWO T analysis of two U.S. airlines will now be discussed. 89 SWOT Analysis of American Airlines vs. Southwest Airlines (2010) Figure 4.5 depicts a SWOT analysis of American Airlines and Southwe st Airlin es as of 2010 . American Airlines was one of the founding members of the OneW orld alliances. These global airline strategic alliances provided global coverage to its members . Through its membership the OneW orld network it has total global coverage. On the other hand, Southwest is not a partner of any of the three global airline alliances which limits its coverage to North America. American’s debt load is $8.77 billion. In 2010, American Airlines had revenues o f $22.17 billion and lost $471 million. American has been losing money for several years, this airline has been too highly leveraged. It has problems from a cash flow perspective. Its high debt load limits its expansion capacity. Southwest Airlines has minimal debt and has been profitable, every year, since the industry was deregulated in 1978. Southwest generated $12.1 billion in revenues and $459 million in net income in 2010. In addition, Southwest is exploiting American new baggage charges through its advertising. Southwest has a fleet composed of all 737 aircraft. These aircrafts are very fuel efficient. In addition, Southwest has fuel prices hedged until 2015. American’s has one of the largest aircraft fleet of all airlines. However, some of these models (e.g. 747) are not fuel efficient. In addition, American does not have jet fuel prices hedged. During the current time period (2010, 2011) jet fuel prices have skyrocketed. These high prices significantly impact American financial statemen ts because jet fuel is a major cost factor for any airline. Southwest can compete more favorably because of its lower fuel costs. American has a small portion of the revenues (less than 5 percent which are generated from its air cargo operations). This business is more profitable than its commercial passenger revenues. Since many of Southwest flights are less than 500 90 miles, Southwest faces more significant competition from other modes (e.g. cars) than does American. Pacific Rim markets are expected to grow significantly over the next few years. American has transpacific and transatlantic capabilities which could positively impact American’s bottom line. On the other hand, Southwest’s aircraft does not have transatlantic or transpacific capabilities. Competitive dynamics over time The achievement of competitive advantage over time will be discussed within the pharmaceutical industry. Firms launch a product (e.g., a new drug) that has been developed through product R&D and then explo it it for as long as possible while the product is shielded from competition. Within the pharmaceutical industry , firms launch new products and these products are protected for seventeen years by patents. Eventually, competi tors respond to the action with a counterattack. Within the pharmaceutical industry, this counterattack commonly occurs as patents expire. This creates the need for another product launch by the initial firm to maintain its advantage. Figure 4.6 illustr ates this process over time. Figure 4.6 Achieving Competitive Advantage Over Time Source: Adapted with permission of the Academy of Management Executive by I. MacMillan from Controlling competitive dynamics by taking strategic initiatives , 112. 1988 As patents are about to expire, competition enters from generic drug firms. The brand name drug firm would then launch a second product that would be protected by a second seventeen years of patent protection. As this sequence is repeated over time, firm s can build a sustainable advantage based upon a series of temporary advantages. The above scenario assumes that the initial firm continues to make a series of successful products sequentially. Most of the time, firms make both good and bad decisions. In addition, Figure 4.6 assumes that the sustaining of advantages occurs for exactly the time period. While this may be true of the pharmaceutical industry, which have specific time parameters (e.g. patents last for exactly the same time period), this assum ption is not true for ma ny other industries. In actuality, a firm’s ability to sustain competitive advantage may be a function of successful new products which are initiated by competitors for different time periods.

(e.g. iPad) The actual evolution of ind ustries may be more similar to Figure 4.7. ROILaunch ExploitationFirm has alreadyadvanced to Advantage No. 2 TimeCounterattack Low High 91 Figure 4.7 Competitive Dynamics Over Time Firm 1 develops an initial advantage. Firm 2 develops a similar product which is viewed as more acceptable to the customer base. This is why it has a longer period of maintaining high R OI. Firm 1 then tries to develop another product but this product fails in the market place. Firm 2 learns from Firm 1 and then offers a product which is well received by the customer base. Therefore, it has a longer period of sustainable ROI. Firm 3 the n enters the industry with a product which appears to be successful. This process then continues over time. A scenario within an industry is more likely to look as depicted in the following table (Table 4.3) taken from Capstone Stimulation for Years 1 through 3. Table 4.3 Performance on ROE (Percentage Change) Team Year 1 Year 2 Year 3 Andrews (5.7) (10.1) (14.7) Baldwin 4.3 6.7 9.1 Chester (3.3) (4.6) 1.2 Digby (2.3) 3.1 (4.6) Erie 6.1 (2.9) (6.8) Ferris (7.2) (1.4) 5.9 Assume that the teams in the simulation industry achieved the results in Table 4.1. Andrews does not appear to have a business level strategy because returns are steadily declining. This competitor may not have a clear understanding of key buying criteria. This is a weakness that your firm may be able to exploit. Baldwin does appear to have a business level strategy that is working on a year - to-year basis. What is Baldwin’s business year strategy on a segment -by -segment basis? Will Baldwin be able to sustain this strategy over time? The key to strategy is to have a ROI Launch Time FIRM Low H i g h 1 2 1 Negative 2 3 1 Exploitation Counterattack 92 long -term strate gy and properly execute the strategy over time. Does Baldwin appear to have a viable long -term strategy? How can your firm successfully position against Baldwin for long -term success? Examine the statement of cash flows to ascertain if Baldwin is invest ing in plant improvements. If not, what does this tell your firm? How should your firm position itself in the short and long term with respect to Team Baldwin? Team Chester may not be in as unfavorable a position as it appears for the long term. This t eam may have heavily invested in plant improvements, automation, or TQM initiatives. These benefits may be realized in subsequent years. Refer to the cash flows statement of the simulation for changes in plant improvements, the production analysis for ch anges in automation, and the TQM summary for investments in quality improvements. It is quite possible that Team Chester will accrue higher benefits in subsequent years. It would appear as if Team Digby does not have a short -term business level strategy. This team may have accumulated inventory -carrying costs during Year 1 and Year 3. How are this team’s products positioned on a segment -by -segment basis on key buying criteria? This may be a team that your team can take market share from. Develop a sho rt-term strategy to capitalize upon this competitor’s weaknesses. Team Erie appeared to have a solid year 1 and has since had difficulty. What changed for Team Erie? Why were they successful in year 1 and not subsequent years? Did other firms develo p strategic changes to capitalize upon Team Erie? If so, what team and what was the action? Erie’s strategy may not have enough flexibility to respond to changing market conditions or to changes in other firm’s strategy that are aimed at exploiting their weaknesses. Similar to team Chester, Ferris may be a team that invested heavily in year 1 (check the cash flow statement, production analysis, and TQM summary). It also appears as if these investments are beginning to pay rewards. How is this competi tor positioned on key buying criteria on a segment -by -segment basis? What can your firm do to neutralize Ferris? What is Ferris’ generic business strategy on a segment -by -segment basis? Where are their weaknesses? How can these weaknesses be exploited? While each team should develop a long -term business level strategy for each segment, that strategy must be flexible enough to capitalize upon competitor’s weakness over time. Competitive dynamics requires that firms have enough flexibility to respond to competitors’ threats. The key to competitor analysis is to evaluate each competitor on a segment -by -segment basis. How well is each competitor meeting the key buying criteria? What is each firm’s business level strategy on a segment -by -segment basis? W ith this information your firm should be able to develop a strategy to gain and sustain competitiveness. 93 Discussion Questions 1. Explain what business level strategy your firm should pursue in the Capstone Simulation on a segment -by -segment basis. Explain why. 2. Which firm would have a more sustainable advantage in the Capstone Simulation:

one that concentrates on cost leadership or focused differentiation? Explain why. 3. Why do key success factors need to be viewed over time? What happens if they are not? Provide an example of a firm that has viewed these factors over time and one that has not. 4. Explain why and when SWOT analysis needs to be performed. 5. Explain sustainable competitive advantage. How is this advantage achieved in the Capstone Simulation? 6. Explain the difference between competitive dynamics and business level strategy. Explain why each is important. 7. Explain how one of the teams in your industry has been successful from a competitive dynamics perspective. Explain why teams have not been successful. What would you recommend for this unsuccessful team? Explain. 8. Why has Wal -Mart been successful both before the global economic recession and during the global economic recession (2007 -2010)? 94 References 1. Ohmae, K. 1982. The mind of the strategist . McGraw Hill. New York, NY. 2. Vasconcellos, J. and Hambrick D. 1989. Key success factors: Test of a general framework in the mature industrial – product sector. Strategic Management Journal , 10: 367 -382. 3. Mintzberg, H. 1978. Patterns in strategy formation. Management Science , 24: 934 - 948. 4. Porter, M. 1985. Competitive advantage: creating and sustaining superior performance . Free Press. New York, NY. 5. Rumelt, R. and Schendel, D. and Teece, D. 1991. Strategic management and economics. Strategic Management Journal . 12 (winter): 5 -29. 6. D’Aveni, R. Hypercompetition . 1994. New York, NY. 7. Jain S. 2004. Marketing Planning and Strategy . Thomson. Mason, OH. 95 Dell Mini Case Dell is a te chnology company. They offer a broad range of product categories, including mobility products, desktop PCs, software and peripherals, servers and networking, and storage. In addition, their services include a broad range of configurable IT and business r elated services, including infrastructure technology, consulting and applications, and business process services. Competition Dell operates in an industry in which there are rapid technological advances in hardware, software, and service offerings. They compete based on their ability to offer profitable and competitive solutions to its customer base. Dell attempts to build long - term relationships with customers. These relationships may allow them to recognize changing customer needs faster than their c ompetitors. Dell attempts to balance their mix of products and services to optimize profitability, liquidity, and growth. Dell believes this strategy will lead to competitive advantage. Dell has four primary business segments: (1) large enterprises, (2 ) public sector, (3) small and medium size business, and (4) commercial consumers. Large enterprises consist of multi -national firms would have very broad information technology (IT) needs. Public customers are educational institutions, government, healt h care, and law enforcement agencies. Small and medium businesses have basic IT needs. Commercial customers are individual customers. Table 1 provides Dell’s financial results from 2006 to 2010. Table 1 Fiscal Year Ended 2010 2009 2008 2007 2006 Revenue ($ Billions) 52.9 61.1 61.1 57.4 55.7 Net Income ($ Billions) 1.4 2.4 2.9 2.5 3.6 Earnings/Share .73 1.25 1.33 1.15 1.50 From Table 1, Dell’s revenues have fluctuated from 2006 to 2010. However, Dell net income has been reduced from $3.6 billion in 2006 to $1.4 billion in 2010. In addition, earnings per share have decreased from $1.50 per share in 2006 to 73 cents in 2010. Discussion Question 1. Why has Dell’s financials decreased significantly over time? 96 Harvard Business Cases for Chapter 4 Cola Wars Continue: Coke and Pepsi in 2010 Product Number 711462 Philips Versus Matsushita: The Competitive Battle Continues Product Number 910410 Professor Case for Chapter 4 Dis ney 97 Chapter 5 Analysis of Markets and Positioning 98 Learning and Assessment Goals 1. Understand the various sales forecasting techniques and when to employ each. 2. Understand how markets can be segmented. 3. Understand the relationship between market segmentation, key buying criteria, and sales forecasting. 4. Understand the trade -offs (e.g. inventory carrying costs) that are made as a result of inaccurate sales forecasting. Understand how to improve sales forecasting. 5. Develop the ability to achieve successful competitive advantage in multiple market segments. 99 Marketing is based upon the fundamental concept of exchange. A seller engages in a relationship with a customer by providing a good or service in exchange for payment, which is usually money. The primary focus of marketing is outside the firm. A seller must provide a good or service to a customer that meets the customer’s needs at the right place, at the right price, in the right form, in the righ t quantity, and at the right time. If one or more of these conditions is not met, the exchange will not occur. Market Segmentation In order for firms to meet all of the above criteria, they develop a marketing mix, which consists of an integration of pro duct, price, promotion, and distribution that is targeted toward identifiable market segments. Market segments consist of consumers who have very similar needs. A market segment is a group of people who, as individuals or as organizations, have needs for products in a product class and have the ability, willingness, and authority to purchase such products 1. In general use, the term market sometimes refers to the total population, or mass market, that buys products. However, our definition is more specific ; it refers to persons seeking products in a specific product category. A market segment is defined by key success factors. Remember from Chapter 4, these are factors that are important to customers and upon which customers make buying decisions. Within an industry, key success factors can be used to define segments. For example, the key success factors within the automotive industry are significantly different than those within the telecommunications industry. Key success factors, referred to as custome r buying criteria in the Capstone Simulation, form distinct market segments. The simulation has five market segments: low end, traditional, high end, performance, and size. While the factors are the same for each segment, their importance varies on a seg ment -by -segment basis. For example, price is the most important key buying criteria in the low end, while positioning is the most important in the high end. Because customers place different importance on key buying criteria or have different key buying criteria, the firm must develop a separate marketing mix for each segment. A firm generates value by providing a better marketing mix than its competitors. 2 An example is illustrated in Figure 5.1. Market Segmentation and the Airline Industry The airlin e industry can be segmented into commercial and airfreight segments. 3The commercial segment can be further segmented into business and leisure travelers. The airfreight segment can be further segmented into next day freight and defe rred freight. Deferred freight has a service requirement beyond next day. Each of these segments has different customer buying criteria, or each segment places different importance on the same buying criteria. For example, the most important criterion t o the business traveler is on -time reliability. To the leisure traveler the most important criterion is price. For the next day air freight segment, the most important criterion is an integrated air/ground hub and 100 Figure 5.1 Market Segmentation of the Airline Industry Marketing Mix = Airline Industry Air Freight Commercial Business Traveler Leisure Traveler Next Day Deferred Customer Buying Criteria 1. On -Time Reliability 2. …….. 3. …….. X. …….. 1. Price 2. …….. 3. …….. X. …….. 1. Shipment Tracking 2. …….. 3. …….. X. …….. 1.Air/Ground Network 2. …….. 3. …….. X. …….. Marketing Mix – Business Traveler Marketing Mix – Leisure Traveler Marketing Mix – Next Day Marketing Mix – Deferred Airline Product Price Promotion Distribution 101 spoke operating network. For the deferred airfreight market, the most important criterion is shipment tracking. While some criteria, such as price, are common to all segments, each segment needs to be treated as a separate market. To properly service a segment, the firm must know the specific buying criteria in order of importance. Members of each segment view the same buying criteria in the same order of importance. The goal of the firm is to develop a series of separate marketing mixes to meet the n eeds of distinct customer segments superior to competitors. Customer buying criteria change over time. The telecommunications industry has undergone significant change since it was deregulated in 1984. The focus of the telephone industry in 1984 was to provide point -to-point communication. This focus was greatly expanded during the 1990’s with heavy influence from Internet variables such as; packet switching, Internet Protocol (IP), and the World Wide Web. 4 These newl y created influences served as a launch pad for the industry’s metamorphosis from “the Telecoms Industry to the Infocommunications Industry”. 5 In 2012, with the explosion of smartphones, mobile operating systems (such as Apple’s iOS) and voice command per sonal assistant applications such as Apple’s Siri 6, the infocommunication industry is rapidly creating the way we communicate. As such, it is important for the firm to know the new set of key buying criteria at a point in time and have enough flexibility t o change the capabilities of the firm to meet new key buying criteria as they evolve over time. Thus, developing relationships with customers over time is of critical importance. Since the sales staff has direct customer contact, the firm needs to develop a communication infrastructure for moving information on customer needs and expectations from sales employees to senior management. With this information the firm can determine the trade -offs its customers are willing to make. Not only must the firm be k nowledgeable of the changing key success factors on a segment -by -segment basis, the firm must be able to forecast demand on a segment -by - segment basis. Several methods exist for forecasting. Product Positioning The key to marketing is to develop products that are better than competitors on dimensions that are important to customers. Figure 5.2 provides a depiction of the global automobile industry. We call this depiction a perceptual map. 102 Figure 5.2 Perceptual Map for Autos In this perceptual map, auto brands are compared on two key buying criteria (price and traditional versus sporty). This map shows some interesting facts. If you will remember from the G.M. case, it eliminated the Oldsmobile line. The perceptual map shows that Oldsmobile and Buick compete for the same customers: customers that desire a reasonable priced car which has traditional product features (e.g., GPS positioning). Competing for the same customer base can take sales away from one or both brands. As s uch, G.M. decided to eliminate the Oldsmobile line and keep the Buick line. In addition, there does not appear to be a significant market for autos which are traditional and have functional features. There are a number of brands which are close to the c enter of the perceptual map. This is a sign of a mature industry. Many firms compete for the exact same customer base: moderately priced cars which do not differentiate in terms of traditional vs. sporty criteria. Since this perceptual map has the capab ility to evaluate only two key buying criteria, additional criteria must be considered. Currently (2011) the price of oil is at all time highs. As such, the price of gasoline is quite high. This criteria affects all makes of cars. Developing new source s of propulsion (e.g. electric) may provide the first mover with a significant advantage. In addition, electric propulsion provides sustainability benefits which gasoline does not. In addition, electricity may eventually be cheaper than gasoline. Further, it would appear that Acura and Infiniti compete for the same general customers. This is a much more competitive section of the segment that the customers who buy Porsche (very high price, very sporty). The task for the manufacturers of Acura and Infiniti is to develop a point of differentiation from each other to provide a competitive advantage. Luxurious Functional Sporty Traditional Mercedes Cadillac Lincoln Chrysler Buick Oldsmobile Lexus Porsche BMW Acura Infiniti Mercury Ford Dodge Kia Chevrolet Nissan Toyota Honda Saturn VW 103 Sales Forecasting Sales Forecasting Methods At times, a company may forecast sales chiefly on the basis of executive judgment . Executive judgment may work reasonably well when product demand is relatively stable and the management team has many years of industry experience. A disadvantage of executive judgment is that the views of customers are not obtained. As key success factors in the industry change, executives must be aware of these changes. It is important for executives to continuously communicate with the sales force. The sales force has direct customer contact and may be more knowledg eable than senior management with respect to changing conditions. Naïve methods are another type of forecasting method. Forecasts are developed based on last year’s sales and growth rate. Naïve methods are best util ized when industries are in their maturity stage. During the maturity stage of an industry’s life cycle, entry of firms outside the industry is minimal because all market segments have been addressed. The tobacco industry would fal l into these general parameters. Growth rates in these industries tend to be relatively stable and do not change significantly from year to year. In addition, market share within these industries tends not to change much over time because of the stage (m aturity) of industry evolution. The utilization of multiple years of sales data can be very helpful when attempting to forecast future sales. One technique that uses multiple years of sales data is exponential smoothing . Exponential smoothing consists of projecting the next period’s sales by combining an average of past sales and most recent sales giving more weight to the latter. A simple exponential smoothing method requires less data than more advanced techniques but does not adjust for seasonality. More sophisticated methods (e.g., Winter’s smoothing) are needed if seasonality is present. The Delphi technique is a method of making forecasts based on expert opin ion. 7 The Delphi technique is gradually becoming more important for predicting sales. 8 Many large corporations use this technique for long -range forecasting. This technique is based upon the judgment of “experts.” The Delphi approach was developed to d eal with situations where experts are in remote locations. The basic approach involves asking each individual to provide forecasts. In round one, the experts are surveyed via questionnaire, and the results are then summarized. In the second round, the res pondents are given the same questionnaire, along with a summary of the results from the first round. Results are once again compiled and third round is conducted. This process of repeating rounds can be continued until there is agreement between the expe rts. With time series analysis , the forecaster uses the firm’s historical sales data to attempt to discover a pattern or patterns in the firm’s sales over time. If a pattern is found, it can be used to forec ast sales. This forecasting method assumes that past sales patterns will continue in the future. In an industry where entry barriers are low, firms may enter more easily, as opposed to industries where entry barriers are high. With the entry and exit of firms, the pattern of historical sales may not be an accurate predictor of future sales. In a time series analysis, a forecaster usually performs several types of analyses: trend, seasonal, and random factor. Trend analysis focuses on annual sales data spanning many years to determine if a general sales pattern can be observed. Seasonal analysis is performed to ascertain if sales follow a pattern within a given year. For example, around Christmas consumer goods have significantly higher sales than other times throughout 104 the year. With random factor analysis, the forecaster attempts to determine the impact of environmental conditions on sales that are beyond the firm’s control. Hurricane Katrina would be an example of an environmental factor that had a significant impact on the price of gas. After performing each of these analyses, the forecaster combines the results to develop the sales forecast. Like time series analysis , regression analysis requires the use of historical sales data. In regression analysis, the forecaster seeks to find a relationship between past sales (the dependent variable) and one or more independent variables, such as population, per capita income, or gross domestic product. Simple regression analysis uses one independent variable, whereas multiple regression analysis includes two or more independent variables. An accurate forecast depends on a specific relationship between the dependent and independent variables. Regression analys is is not recommended when faced with changing environmental conditions. An increase in unemployment, recession, inflation, and advances in technology may change the relationship between the dependent and independent variables over time. Changing industr y conditions, such as the entry of a large competitor (e.g. Microsoft entering the gaming industry) may also change the relationship between dependent and independent variables. Because of changing conditions, it is important to remember that forecasting sales should not be a specific value. By developing a range, the firm can build in flexibility to accommodate broad sets of conditions (e.g. firms exiting a specific segment). Scenario analysis is a tool used to g enerate strategic alternatives based on varying assumptions about the future. A scenario is a possible set of environmental circumstances concerning what the environment may look like in the future. It depicts potential actions and events in a likely orde r of occurrence, beginning with a set of conditions that describe the current situation. Scenario analysis can factor in predicted competitive actions. Sales Forecasting and Capstone Simulation Table 5.1 summarizes the size market segment information. Section a of Table 5.1 identifies size and growth of the segment and the customer buying criteria. Within the segment, positioning and age dominate the buying criteria. Re -positioning of existing products is quite important because positioning is 43 perce nt of the customer buying criteria. An additional benefit of repositioning is age is cut in half. Section a also identifies the segment demand (4596 units) and the growth rate (18.3 percent) for the current year. The actual units sold met the segment de mand for this year. If the competitors had not met the demand, actual units sold would be less than the total industry demand (4596 units). Section b of Table 5.1 summarizes the activity that has taken place within the segment for the year. No products w ith significant market share sold out. Several products were not positioned well (Egg, Buddy) and incurred significant inventory carrying costs. This section of the table is very helpful because it provides a competitive analysis on a product -by -product b asis. This data is useful in decision -making for the next round. Section c is the production schedule. This portion of the table identifies the production capacity on a product -by -product basis. A product’s production capacity needs to be adjusted base d upon inventory that was not sold from this year. The three sections of this table allow for an analysis of decisions that need to be made for the next year within the size segment from an R&D, marketing, and production perspective. Let us begin with an estimation of sales. 105 The technique utilized to forecast segment demand in the Capstone Simulation is a naïve method. The sales forecast for the segment is the segment demand (4596) times the growth rate (18.3 percent). Thus, the segment demand for the next year is 5437 units. Sales forecasting of firm demand is much more complex. If each competitor offers exactly the same product, each competitor would be expected to receive 1/7 of the segment demand (777 units). All teams except Baldwin and Ferris h ave one product in the segment; Baldwin has two products in the segment and Ferris has no products in the segment. Forecasting production capacity within this segment for each competitor is important. Based upon the production schedule (Section c), there is a total capacity of 3241 units generated by first shift production for the next round . In addition, the production summary provides ending inventory levels. The inventory remaining at the end of the year is 1289 units. This represents a total capacit y of 4530 (3241 + 1289) units for the next round. If all firms operate at the capacity levels they are at now (Section c) and sell the remaining inventory, there will be 907 (5437 – 4530) units of unmet demand. The production capacity for next year (secti on c) will now be discussed. Table 5.1 Size Market Segment Analysis Section a Size Statistics Total Industry Unit Demand 4,596 Actual Industry Unit Sales 4,596 Segment % of Total Industry 11.0% Growth Rates 18.3% Customer Buying Criteria Criteria Expectations Importance 1. Ideal Position Pfmn 7.5 Size 5.6 43% 2. Age Ideal Age = 1.5 29% 3. Reliability MTBF 16000 -21000 19% 4. Price $22.50 – 32.5M 9% Section b Products in Size Segment Top Products in Segment Name Market Share Revision Date Inve - ntory Level Pfmn Cord Size Cord List Price MTBF Age Dec.

31 Promo Budget Sales Budget Customer Awareness Dec. Customer Survey Cure 21% 26 -Sep -14 66 7.5 5.4 $32.90 19000 1.3 $1,100 $1,441 66% 41 Egg 19% 21 -Apr -14 341 6.7 6.8 $32.50 18500 2.1 $800 $3,650 87% 28 Agape 18% 26 -May -14 182 7.5 5.6 $32.50 19000 2.4 $1,300 $1,904 90% 51 Buddy 14% 12 -Apr -13 511 6.1 6.8 $31.99 19000 2.5 $1,200 $591 89% 14 Dune 13% 5-Nov -14 189 7.3 5.6 $32.50 20000 1.5 $480 $1,021 65% 55 Best 9% 28 -Jun -13 YES 6.8 6.6 $32.49 24000 1.5 $1,200 $521 39% 26 Ditty 6% 9-June -14 YES 7.5 5.6 $32.50 20000 1.1 $1,021 $480 36% 44 106 Section c Size Production Schedule Firm Sales (Units) Inventory (Units) Capacity Next Round (Units) Plant Utilization Cure 943 66 500 149 Egg 863 341 341 194 Agape 839 182 600 149 Buddy 654 511 600 184 Dune 603 189 600 132 Best 396 Sold out 400 99 Dity 297 Sold out 200 149 Total 1289 3241 Cure is the best -positioned product in the segment (inventory level of 66) and 21 percent market share (section c). Its positioning coordinates (performance at 7.5 and size at 5.4) (section a) are very close to the ideal position (performance at 7.5 and size at 5. 6) (section a). Cure needs to be R & D’ed to position at the ideal coordinates for the next round. This action will also cut Cure’s age in half. This is significant because positioning is 43 percent of the buying criteria and age is 29 percent (section a). For the current round Cure’s revision date is September 26. This is too late in the year and needs to come out earlier next year. One way of achieving an earlier revision date is to allocate funds to the TQM initiatives, which reduce cycle time. Egg has significant inventory. It sold 863 units and had an inventory of 341 units (section c). In many cases, this is a result of poor product positioning. Positioning is the most important customer buying criteria, which accounts for 43 percent of the customer’s decision. Egg is relatively poorly positioned (performance – 6.7, size – 6.8) when compared to its primary competitors: in this case, Cure and Agape (section c). Egg’s age (2.1 years) is much higher than Cure (1.3 years) with the ideal age at 1.5 years. E gg is running at 94 percent overtime (section c). In essence, Egg is running overtime on its production lines to produce product, which is inferior to competitors. In addition, Egg’s promotion budget is $800, which may lead to the fact that its December cu stomer survey is 28. Cure and Agape are both significantly higher. Egg’s production capacity for next year is 341 units. By selling the 341 in inventory and producing its first shift capacity of 341 units, Egg can significantly reduce 107 its inventory. Also, Egg needs to spend R&D to get closer to the ideal position for next year. Agape has made a commitment to be a major player in the industry. It sold 839 units and inventoried 182 units with production capacity of 600 units for next year.

Agape plans to sta y as a major product in this segment. No firm has greater production capacity planned for this segment. Buddy and Dune also have 600 units of capacity next round. From a positioning perspective, Agape is right on the ideal point ( Table 5.1 section a & b). It must R&D this product to remain on the ideal point for the next round and cut its age in half. Its age (2.4 years) was a little high for this segment this year. Buddy is in a difficult situation because it has made a significant commitment to this segme nt (600 units of capacity for next round, section c) but has 511 units in inventory (section c). This is the highest level of inventory experienced by any product in the segment. Buddy has very poor product positioning. Its performance coordinate is 6.1 an d its size coordinate is 6.8 (section b). T he ideal position is performance at 7.5 and size at 5.6. Buddy is going to have to spend a significant amount of R&D to reposition the product closer to the ideal position. Due to the extens ive amount of R&D neede d, Buddy may have a late revision date. Buddy will have trouble selling product until this revision date is reached. As such, investments in TQM to reduce R&D cycle time would be required. In addition, Buddy is running at 84 percent overtime. In essence, i t is paying overtime to inventory product. Buddy may be better served to exit the segment and use the funds for more profitable opportunities. Dune is in a situation that is not optimal either. For the year, Dune sold 603 units and inventoried 189 units. D une is very near the optimal position coordinates (7.3 for performance and 5.6 for size). However, this positioning was not obtained until November 5 (section b). Virtually Dune’s entire inventory was accumulated prior to November 4 (section b). Dune also is at the optimal age of 1.5. Dune and Cure have the strongest products in the segment. Dune has 600 units of capacity next year. It should sell as many products (1200 units) as it can by running a second shift at 100 percent. Dune should be able to sell a ll 1200 units at the top of the price range ($32.00 next round) and its entire inventory. D une should consider adding a second shift based upon segment growth rate of 18.3 percent . It also needs to be pointed out that it has the highest December customer survey (55) (section b). Best needs to be discussed. Best only has a 9 percent market share. However, it is not positioned well (performance 6.8, size 6.6) (section b). In addition, Best has an age of 1.5, which is the ideal age for the segment (section a) . Its production capacity for next year is 400 units. If Best is to grow its market share, it will need t o invest in R&D to reposition closer to the ideal position. In addition, its customer awareness is 39 percent and its December customer survey is 26 (s ection b). Its investment in sales budget ($521 – section b) needs to be increased significantly. Best’s plant utilization is 99 percent: as such, it is not incurring overtime. All other products are incurring over time in this segment. Best should maximize the utilization of overtime . This action may give it a cost advantage within the segment. Best is at the age of 1.5 years, Best has an advantage over all other products except Dune (Dune is also at the ideal age (1.5 years) (section b). Ditty is a very strong product in this segment. It is positioned at the ideal position (performance 7.5, size 5.6) and its age is at 1.1. Ditty needs to run its production line at 100 percent overtime . Its December customer survey is 44: this is second hig hest within 108 the segment. Significant increases in the sales budget are needed. It is currently allocating only $480 to its promotion budget. Table 5.2 provides an assessment of each product in this segment and also provides recommendations on a product -by -product basis. One issue that needs to be discussed is the relationship between increasing plant ca pacity and overtime. The trade -off is as follows: overtime costs a 50 percent wage premium. However, running a second shift may be more profitable. If t he teams only run first shift, it already has paid all of the period costs – things like depreciation, R&D, promotion and sales budgets. But if period costs are already paid for, second shift only has to pay for the 50% premium on the labor. In high grow th markets, firms may need to run at 200 percent capacity and add plant. 109 Table 5.2 Product Analysis Summary Product Assessment Recommendations Cure  Good positioning  Minimal inventory  Late revision date (September)  Highest market share in segment  1st shift capacity is 500 units  R&D to remain at, or close to, sweet spot for next year  R&D will cut age to 1.3 (optimal is 1.5)  Invest in TQM to reduce R&D cycle time  Increase December customer survey  Add capacity to increa se market share  Run production line at 200 percent  Increase MTBF to 21,000 Egg  Poorly positioned relative to other competitors (e.g. Cure)  Age is too high (2.1 years): ideal age is 1.5 years  Produce at capacity (341 units) for next years  Production line needs to be producing at 100 capacity  Promotion budget needs to be increased  December customer survey needs to increase  If product line profitability is negative, consider eliminating product  Increase MTBF to 21,000 Agape  Must remain in segment (600 units capacity) next year  Age must be reduced  Production capacity needs to be increased because Ferris is out of segment and other competitors are not well positioned  R&D to remain at, or close to, sweet spot for next year  R&D will cut age to 2.4  Invest heavily in TQM initiatives to reduce R&D cycle time  Continue to invest heavily in promotion and sales budget  Increase MTBF to 21,000 Buddy  Not well positioned (43 percent of customer buying criteria)  Age is too old (2.5 years)  Running at 84 percent overtime and producing significant inventory  Buddy should exit this segment and use funds to better position itself in other markets Dune  Significant inventory  Revision date is late (November) in year  Once revision date is reached, Dune will be a strong product  Promotion budget needs to be increased significantly  R&D to move closer to ideal position  Invest heavily in TQM to reduce R&D cycle time and keep product at optimal age (1.5 years)  Add capacity and produce at 100 percent overtime  Increasing MTBF to 21,000 would be advised Best  Not incurring overtime  MBTF at 24,000, which is 3,000 over range  Best is at optimal age (1.5 years)  December customer survey is 26  Utilize overtime  MTBF needs to be reduced to 21,000  R&D product to move closer to ideal positioning and to maintain ideal age (1.5 years)  Significantly increase sales budget Ditty  Incurring no inventory  Additional market shares can be taken once R&D has occurred (June)  Age at 1.1 years is positive  R&D to maintain optimal positioning and 1.1 age  Invest in TQM to decrease R&D cycle time  Utilize a second shift  Run prod uction line at 100 percent over time  Increase MTBF to 21,000  Increase sales budget to parity with other competition 110 Marketing Mix Variables As key buying criteria change, the firm must make changes to its marketing mix. As discussed earlier, a marketing mix consists of an integration of product, price, promotion, and distribution. Product Variable A product is anything tangible or intangible which is obtained as a result of an exchange re lationship between buyer and seller. Products must meet the key buying criteria of each segment. Within the Capstone Simulation, each firm must make decisions as to whether to revise existing products through increased spending on R&D or engage in new pr oduct development. Consider the following matrix: Figure 5.3 Product Decisions If the market potential for the product is high and if it requires high investment in R&D, it may make sense to engage in new product development. Some competitors will attempt to R&D existing products. However, if the gap between existing products and desired products is significant, developing new products may provide the firm with a competitive advantage. For example, pharmaceutical firms focus upon new products to cure diseases (e.g. AIDS). For other types of products, where R&D investments are low, it may be more beneficial to R&D existing products. This is also the case if both R&D investments and market potential are moderate. To R&D exist ing products normally requires a shorter time to market and is less expensive than new product development. If the market potential is high and investment in R&D is low, revising existing products will usually be more beneficial. If the market potential for the product is low or moderate and R&D investment is high, the firm should focus its resources on other products. Also if the market potential is low and the R&D investment is moderate, the firm should not further serve this segment. R&DInvestmentHighModerateLow LowModerateHigh Do NotServeRepositionExistingProducts New ProductDevelopment Market Potential 111 Price Variabl e The role of price in the marketing mix needs to be discussed. Price is significantly different than all other marketing mix variables. Price is the only variable that generates sales; all other marketing mix variables generate costs. In addition, pric e is easily changed; as such, it is more flexible than other marketing mix variables. Price must be able to cover variable operating expenses and must be competitively appealing to customers when evaluating alternative products of competitors. The more i mportant price is viewed, as a significant key buying criterion, the greater the focus the firm must place upon it. Price is quite important in commodity -based markets. Figure 5.4 Price and Generic Business Strategies Cost Unique For products in the shaded area, price is very important. To remain profitable in these segments, the firm must be a low cost provider. That does not translate into spending less on marketing. If acceptable products are not offered to the customer base, they will not be purchased at any price. In addition, if products are not promoted, the customer may not be aware that products exist. Further, if the distribution network is not fully developed, customers will have no option other tha n to purchase competitors’ products. If price is a significant key buying criteria and there are several competitors in a given segment, there may be substantial pressure to lower price. What is the lower bound on price: an analysis of the income statements must be conducted. Product line profitability can be utilized to determine th e lowest acceptable price. This is especially true if price is expected to be a significant key -buying criterion in the future. Under this scenario, it makes sense to attempt to lower production costs or reallocate resources to higher margin segments. Promotion Variable Just as the marketing mix has four principal components, the promotion mix also has four components: advertising , personal selling , sales promotion , and public relations . Advertising is a paid form of nonpersonal communication transmitt ed through mass media, such as television, radio, the Internet, newspapers, magazines, direct mail, Broad Narrow 112 outdoor displays, and signs on mass transit vehicles. Organizations use advertising to reach a variety of audiences ranging from small groups to large popu lations. Advertising can be used to build up a long -term image for a product (ex. Coke). It can also efficiently reach geographically dispersed buyers. Certain forms of advertising (TV) require a large budget, whereas other forms (local newspaper) do no t. Personal selling is paid personal communication that attempts to inform customers and persuade them to purchase products in a face -to-face setting. Personal selling is normally utilized for customers who generate a large volume of sales. For exampl e, Boeing had 33 customers who generated 90 percent of its 2010 revenue. As such, Boeing utilizes sales teams for each customer. Personal selling is unique among the promotion elements in that it is the only element that permits real -time customer feedba ck. This feedback is not confined to a customer’s existing products. Personal selling allows sales people to probe customers concerning competitors and competitors’ products. Personal selling can also be used to obtain information from customers with respect to future needs. This is why maintaining relationships with customers over time are so critical. Feedback from sales people can be utilized to develop new products that focus upon unmet needs of customers. Sales promotions are direct inducements to the consumer to make a purchase. More money is spent on sales promotions than any other promotional mix element in the United States. Sales promotion consists of coupons, contests, rebates, and other incentives designed to generate sales. The focus of sales promotion is to generate sales in the near term. Auto dealers offering rebates and 0 percent financing during the fall months are examples of sales promotion. Retail stores offering discounts after Christmas is another example. Public relations are a broad set of communication efforts used to create and maintain favorable relationships between an organization and its stakeholders. An organization communicates with various stakeholders, both internal and external, and public relations efforts can b e directed toward any or all of these. A firm’s stakeholders include customers, suppliers, stockholders, the media, educators, potential inventors, government officials, and society in general. Public relations is a marketing communications function that deals with the public issues encountered by firms across a wide range of situations. An important component of public relations is publicity — news media coverage of events related to a firm’s products or activities. Publicity presents both challenges, (a s GM learned with its schedule of heavy annual layoffs ending in 2010 and most recently PepsiCo’s 2012 announcement of a 3 year plan for global layoffs 9) and opportunities (e.g. electric cars). News reports about problems, such as those Bridgestone/Firest one had to deal with, represent challenges. Large investments in facilities, which generate jobs or new product discoveries, represent opportunities for positive publicity (e.g. Caterpillar building a new plant in North Carolina in 2011 created many new j obs). The Capstone Simulation incorporates promotion decisions into the marketing spreadsheet. Promotion expenditures create product awareness. Awareness is critical because the customer base must be aware that products exist. Table 5.3 is a summary of the promotion media that can be targeted to the simulation segments. 10 113 Table 5.3 Summary – Promotion Budget SEGMENT PRINT MEDIA DIRECT MAIL WEBMEDIA EMAIL TRADE SHOWS Traditional Good Good Poor Poor Fair Low End Good Good Poor Poor Fair High End Poor Fair Fair Fair Good Performance Poor Poor Good Good Fair Size Fair Poor Good Good Poor Diminishing Returns Beyond $700,000/ Product $800,000 Product $500,000/ Product $600,000/ Product $300,000/ Product The key to successful promotion is to obtain maximum return on resources expended. Table 5.3 clarifies the point at which diminishing returns will occur for the various forms of sales promotions. Benefits may also accrue by deploying sales force resour ces properly. A firm’s inside sales force may economically maintain existing products. Firms, which pursue a cost leadership strategy in price -sensitive segments, may not want to allocate additional resources to the outside sales force. On the other han d, for segments that are based upon differentiation, it may be beneficial to increase the outside sales force to communicate the unique advantages of a firm’s new or repositioned products to the customer base. Distribution Variable Distribution refers to the channels by which goods are moved to customers. Types of activities include order processing , inventory management , materials handling, warehousing , and transportation . Planning an efficient physical distribution system is crucial to developing an ef fective marketing strategy because it can decrease costs and increase customer satisfaction. Speed of delivery, service, and dependability are often as important to customers as price 11. An integrated distribution channel can reduce cycle time: the time period from completion of manufacturing to delivery to customers. Order processing is the receipt and transmission of sales order information. Computerized order processing provides a database for all supply chain members to increase their productivity. When carried out quickly and accurately, order processing contributes to customer satisfaction, decreases costs and cycle time, and increases profits.

Many companies use electronic data interchange (EDI) to integra te order processing with production, inventory, accounting, and transportation. Within the supply chain, EDI functions as an information system that links marketing channel members and outsourcing firms together. Inventory management involves having the right goods in stock to satisfy customer demand without creating excessive inventory levels. Many firms utilize a Just in Time (JIT) approach to inventory management. When using JIT, companies maintain low inventory levels and pu rchase products and materials in small quantities whenever they need them. Just In Time inventory management requires a high level of coordination between producers and suppliers, but it eliminates waste and reduces inventory costs significantly. 12 114 Materials handling involves the physical handling of products. Efficient procedures and techniques for materials handling minimizes inventory costs, reduces the number of times a good is handled, improves customer service, and increases customer satisfact ion. Systems for packaging, labeling, loading, and movement must be coordinated to maximize cost reduction and customer satisfaction. Organizations gain considerable efficiencies in materials handling through the use of technologically advanced electroni c equipment. Warehousing represents the storage of goods before shipment to consumers. Over the past 20 years, warehousing has been radically transformed. The warehouses of today are single story facilities that are operated by computer systems. These s ystems are based upon heavy utilization of robotics. The use of robotics tends to reduce costs and create greater efficiencies. Transportation represents the physical movement of goods. This is the most expensive aspect of distribution. The various mod es of transportation include truck, rail, barge, air, ocean shipping, and pipelines. The choice of mode is dependent upon the service requirements of the customer and type of shipment that is being transported. Recently, transportation firms have become multi -modal carriers. Multi -modal carriers utilize more than one mode (e.g. rail, trucking) for transportation of products. Union Pacific, a major U.S. railroad, has strategic alliances with trucking firms, airfreight forwarders, ocean shipping firms, and international railroads. 13 The success of a firm’s distribution function depends upon the degree to which all aspects are integrated. An integrated network provides for an efficient system that meets customer needs better than competitors. Within the Capstone Simulation, increasing the number of distributors increases the firm’s network to provide for an efficient network to meet consumer demand. Each distributor costs $100,000 with diminishing returns beyond 50. The TQM (total quality management) mo dule of the simulation also captures distribution elements. Channel Support Systems increase demand by adding valuable tools for the sales force. Just in Time (JIT) and Continuous Process Improvement (CPI) tend to reduce costs as sociated with distribution. 115 Discussion Questions 1. Explain why it is necessary to segment markets. What happens to firms if they do not? 2. Why is it important to sustain relationships with customers over time? 3. What are the ramifications of sales forecasts that are too high? Too low? Explain using the Capstone Simulation. 4. Explain the fundamental relationship between key buying criteria, competition, and your Capstone firm. 5. Using the Capstone Simulation, explain when new product developm ent is recommended versus R&D of existing products. 6. From the perspective of the simulation, what determines customer awareness? Infrastructure? 7. Identify market segments within an industry of your choice. Identify the key buying criteria of each segment . 8. What method of forecasting does the simulation utilize? Explain. 9. Assume your firm is entering a new market segment. What approach is recommended for forecasting sales? 10. What are the primary weaknesses of using perceptual mapping? 116 References 1. Kotler P. 2003. Marketing management. Prentice -Hall: Upper Saddle River, N.J. 2. Jain S. 2004. Marketing planning and strategy . Thomson: Mason, Ohio. 3. Pettus M. 2003. Growth from chaos . Praeger: Westport, Ct. 4. Fransman, Martin, Evolution of the Telecommunications Industry Into the Internet Age, 03/25/12, http://www.telecomvisions.com/articles/pdf/FransmanTelecomsHistory. pdf 5. Ibid 6. Apple.com, 2012 7. Sudharshan D. 1998. Marketing strategy. Prentice -Hall. Upper Sale River, NJ 8. Ibid 9. Rueters, 02/09/2012, The New York Times, 03/25/2012 http://www.nytimes.com/2012/02/10/business/pepsico -to-cut -8700 -jobs -in-a- revamping.html?_r=1&ref=indraknooyi 10. Ibid 11. _____ 2010 . Mar keting Module. Capstone simulation . 12. Lambert, D. and Stock, J. 1994. Strategic logistic management. McGraw -Hill Irwin. Boston, MA. 13. Pettus, 2003 117 Proctor and Gamble (P&G) Mini Case Proctor and Gamble’s (P&G) business model is based upon developing bil lion dollar brands. In 2010, P&G had 23 billion dollar brands and another 18 brands which had sales between $500 million and $1 billion. P&G billion dollar brands are listed in Table 1. Table 1 P&G’s Billion Dollar Brands (2010) Ariel Gain Bounty Gillette Braun Head and Shoulders CoverGirl Olay Crest/Oral B Oral -B Dawn/Fairy Pampers Downy/Lenor Pantene Duracell Tide Fusion Wella In addition, P&G has a substantial portion of international revenue. Table 2 identifies sales by geographic region (as of 2010): Table 2 P&G Global Market Presence (2010) Market Percent of Sales North America 42 Western Europe 21 C.I.S., Middle East, and Africa 13 Latin America 9 Asia 15 Total 100 P&G business segments are focused upon 3 primary areas: (1) beauty and grooming, (2) health and well -being, (3) household care. Table 3 shows the dispersion of sales and earnings for each business segment as of 2010. 118 Table 3 Revenue and Earnings by Business Segment ( 2010) Business Segment Reportable Segment % of Net Sales % of Net Earnings Beauty and Grooming Beauty 24 23 Grooming 10 13 Health and Well - Being Health Care 14 16 Snacks and Pet Care 4 3 Household Care Fabric Care and Home Care 30 28 Baby Care and Family Care 18 17 In 2010, Proctor and Gamble’s sales and earnings were quite balanced (e.g. beauty and grooming accounting for 24 percent of the sales and 23 percent of the earnings). Discussion Question 1. How should P&G grow its business? 119 Harvard Business Cases for Chapter 5 The NFL’s Digital Media Strategy Product Number 511055 Yum! China Product Number 511040 Professor Case for Chapter 5 JetBlue 120 121 Chapter 6 Growth by Internal Development 122 Learning and Assessment Goals 1. Understand how a firm can grow using internal development. 2. Understand when a firm should grow by internal development as opposed to acquisitions or strategic alliances. 3. Understand how a firm can identify new markets and develop products/services to meet these new markets. 4. Understand the role of competition as it impacts a firm’s internal development decisions. 5. Determine how to allocate resources to maximize opportunities for internal devel opment. 123 Firms have choices with respect to growth. Internal development, acquisitions, and strategic alliances represent alternative modes of growth 1, 2, 3 . This chapter will focus upon the opportunities where internal development is utilized. Inte rnal development is based upon the firm developing products/services that are sold in markets with its own resources. Acquisitions and strategic alliances will be discussed in the next two chapters. Internal Development Strategies Ansoff 4 was one of the first scholars to address how product/market positions are internally developed over time. Ansoff’s original matrix is contained in Figure 6.1. Figure 6.1 Growth Matrix Product Development Diversification Market Penetration Market Development To Ansoff, firms would initially attempt to more fully develop existing products within existing markets (market penetration). Next, firms would utilize existing products in new markets (market development). Third, firms would develop new products for existing markets (product development). Finally, firms would develop new products for new markets (diversification). Market penetration will be discussed first. Market Penetration A firm’s first growth option is to more fully develop existing markets with existing resources. Growth is driven by the utilization of excess capacity 5. Normally, excess capacity refers to excess production capacity 6. Thus, firms would initially utilize excess capacity to more fully develop existing markets (market penetration). This excess capaci ty may provide the firm with a scale advantage in its existing markets. Market penetration consists of an interrelated set of conditions. A market penetration model is presented in Figure 6.2. New Existing Products Existing New Markets Source: Adapted with permission from the Harvard Business Review from Strategies for diversification by I. Ansoff. January - February. 41. 1957. 124 Figure 6.2 Market Penetration Process Market penetration attempts to target customers who are members of the firm’s target market segment but not aware the firm’s products exist. These customers have the same key buying criteria as existing customers. One way firms increase market Advertising Intensive Distribution Fuller Utilization Of Excess Capacity Economies of Scale Lower Prices Increase in Market Share Lower Variable Operating Costs Investment in plant and equipment Increase in Profit Margins 125 penetration is to advertise. Advertising communicates the potential advantages of a good or service to customers who may be unaware that these products/services exist. This is one reason why billions of dollars are spent on advertising existing products. Another way of developing greater market penetration for a firm’s existing products is through more intensive distribution. Intensive distribution is used when firms utilize multiple channels to provide easily accessible products to consumers. Coke is an example of a firm that utilizes intensive distribution. The primary focus of market penetration is increasing the size of a firm’s existing market segment. Firms will more fully utilize production facilities to achieve economies of scale . One reason economies of scale are generated is because of experience curve effects. Experience curve effects allow firms to “learn by doing ”7. As firms gain experience, processes can be more fine ly tuned to generate substantial variable cost savings. As cost savings are generated, firms may pass these savings along to consumers in the form of lower prices. For price sensitive markets, decreases in price may result in an increase in market share. As firms obtain additional market share, variable costs may be reduced and profit margins increased. Higher margins may result in additional funds to increase production facilities via investment in plant capacity. The cycle then repeats: the addition al production capacity that is purchased may not be totally utilized. As such, the firm will engage in advertising to further increase market share. As the firm more fully develops its distribution infrastructure, the products become more accessible and excess capacity is more fully utilized. This process results in greater economies of scale. The firm then lowers price to achieve greater market share and lower variable costs. As profit margins increase, the funds are utilized to purchase more plant an d equipment. The cycle then repeats indefinitely. As shown in Figure 6.2, this process will provide the firm with a continuous scale advantage within existing markets. Market Development After the firm has fully developed its products in one market, fi rms can enter new markets from a position of strength 8. As domestic markets become more mature, firms expand into international markets to generate growth. As firms expand into additional markets, they can begin to generate global economies of scale. Af ter Gillette fully developed the United States market, it developed positions in many international markets for razors and blades. Initially, Coors was a beer that was distributed in the Rocky Mountain States. Coors now has substantial international mark et presence. In general, the more related the new market is to the firm’s core market, the greater the firm can reduce entry costs by internal development. After United Parcel Service (UPS) had fully developed its ground infrastructure within the United States, it expanded into Europe. Initially, UPS expanded into Europe via direct investment rather than by acquisition. This decision looked to be based on the understanding that acquisitions may not be wise because they are likely to entail the purchase of redundant assets 9. Walmart would be an example of a firm which has grown internationally via market development. In addition, the Harry Potter books and movies have been translated into over 70 languages. Additionally, over 135 million individuals h ave seen “The Phantom of the Opera”. 10The key is to grow into those markets that demand a firm’s existing products. As firms establish positions in international markets, they may begin production in these markets. In this way, firms eliminate the addit ional costs associated with 126 distribution from a domestic market to international markets. To position against international competitors, firms may eventually move production to low cost markets. Sony has production facilities all over the world that reduc es operating costs for the production of electronics and gaming products. In this way, the firm can maximize profit margins. Once a firm’s international infrastructure is in place, firms can move various products through this network. The expansion of firms into international markets tends to create global economies of scale . Not only can firms generate economies of scale from a production perspective; firms can also generate economies from a distribution perspective. The abov e discussion assumes that customers in international markets require the same products as domestic customers. International Strategies, Chapter 10, addresses this issue. Which new markets to develop first will depend upon the overall attractiveness of the market and competitive positioning? This relationship is illustrated in Figure 6.3. Figure 6.3 Assessment of Market Attractiveness and Competitive Positions Do Not Invest Analyze Analyze Market Development Market attractiveness can be evaluated based on various factors. Some factors to consider include overall market size, growth rate, availability of raw materials, scope of the distribution infrastructure, and the position of government with respect to exp ansion. Competitive position is evaluated based on a different set of factors. Some factors to consider include competitors’ core capabilities, price competitiveness, strength of position on key success factors versus competition, capacity to reduce cos ts, and size of market share. For a complete analysis of market attractiveness and a firm’s business strengths, refer to Chapter 7, Corporate Level Strategy and Restructuring. For those markets where competitors hold dominant or moderate positions relati ve to your firm, market expansion is not recommended. Dell’s position in the P.C. market is an example. In many cases, funds should be shifted to markets that are more attractive or to markets where competition has a weaker position. Market development High Weak Weak Moderate High Market Attractiveness Strength of Competitor’s Position Moderate 127 should be analyzed in highly attractive markets where competition is strong. Microsoft’s entry into the gaming industry would be an example. For unattractive markets, the firm should expand elsewhere. For example, the low -end retail market in the U.S. is dominated by Wal -Mart. For markets that are moderately attractive and have a moderate degree of competition, the firm should analyze. Entry into the health conscious fast food market is an example. Market development should be undertaken if the markets are highly attractive and competitors do not have a strong position. Gillette’s expansion into Japan would be an example. Levi’s expansion into markets such as India, which has an emerging middle class, would be another example. With Apple’s iPhone and iPad series of products, the company’s overall industry dominance is common knowledge. This current market presence provides the best example of having the ability to focus on market development within the emerging markets as the competition in these area s would be considered weak to moderate at best. For markets which are moderately attractive and in which competitors have a weaker position relative to your firm, market development should occur. FedEx’s expansion of its air network is an example. Produ ct Development After a firm has fully developed its markets, the firm will develop new products for existing customers 11. New products are necessary for achieving longer -term competitive advantage. These products may add value to existing products. Int el’s improvements in chip technology increase the capabilities of PC’s and cell phones. Multi -player social gaming using such software as PlayPhone, with devices including the Android and iOS 12, appears to be the next generation of gaming As new product features are integrated into existing products, the firm creates new sources of value. The cell phone can now be utilized to store data, take pictures, provide access to the Internet, and transmit video. As such, these cell phones incorporate new product s that add value to the existing cell phones. These new products provide new, value added benefits to customers. The development of ethanol as an alternative fuel source is another example. New processes can also be developed to manufacture new products . One type of process is flexible manufacturing facilities. Because consumers have different needs, flexible manufacturing helps to reduce the time and expense of assembling new products. Automotive and motorcycle manufactur ers utilize a great deal of flexible manufacturing. Because these processes are specific to a firm, these assets are developed via internal development. By internally developing new processes, the firm can begin to build a barrier to entry for competitor s. Product development can also be utilized to meet emerging consumer needs. After the trucking industry was deregulated in 1980, firms began to develop information systems to track shipments in transit. These systems improved the capability of the firm to meet emerging customer needs. The utilization of robots in assembly lines is a process that reduces costs and improves product consistency. By the firm internally developing products and processes, the firm does not need to engage in costly acquisiti ons or risk technology transfer that may occur with strategic alliances. The degree to which products need to be changed will determine whether a product is improved or a new product should be developed. This decision is based upon R&D expenditures and the profitability of the product line. Figure 6.4 illustrates this relationship. 128 Figure 6.4 Products and R&D Investments Product Line Profitability Low Moderate High High Moderate Low The firm should consider eliminating marginally profitable products. Investments could then be made in product lines that are more profitable. The key is to utilize investments to generate the highest returns possible. For products that have high profit potential and high R&D investments, it may be wise to create new products. For example, some diseases have no cures. As such, new products need to be developed. These types of products normally require significant R&D investments. For products that require moderate or low R&D expenditures and generate moderate to high profitability, revision of existing products is normally the strategy to utilize. Videophones have high profit potential and require a moderate level of R&D (e.g. modification of existing cell phone technology). Products suc h as online courses have a relatively low level of R&D expenditures and have moderate profit potential. For products that require high R&D expenditures and which are moderately profitable, the firm must analyze the expense in R&D with respect to other alt ernatives for the funds. Ways of reducing R&D expenditures should also be analyzed. With the expense of bringing a new drug to market now exceeding $1 billion, pharmaceutical companies are increasingly searching for low -cost alternatives. China is becomi ng a market for firms to conduct R&D at greatly reduced costs. Novartis AG has recently formed a partnership with the government -run Shanghai Institute for MateriaMedica. Scientists will identify compounds derived from traditional Chinese medicine that N ovartis scientists may be able to develop into new drugs 13. Roche Ltd. has built a research -and -development center in Shanghai, which will employ 40 local scientists. Pfizer is spending $175 million on establishing a new regional headquarters in Shanghai 12. This office will oversee existing manufacturing and marketing operations. Pfizer is considering building its own R&D center in China. Analyze New Product Development Consider Product Elimination Revise Products Revise Products R&D Expenditures 129 Firms can hire lower cost Chinese scientists because about 80% of pharmaceutical R&D costs go toward scientists’ sala ries 14. The key point is to utilize R&D investments to maximize the returns on revised or new products. New product development means that the firm must innovate. Innovation is crucial for firm growth. Innovation may be the only true source of differe ntiation that can distinguish one firm from another. The rapid change and diffusion of new technology, along with substantial competition in domestic and international markets, has placed increasing importance on firms’ ability to innovate and to introduc e new innovations into the marketplace. In fact, innovation may be required to maintain or achieve competitive parity in many global markets 15. Innovation (whether developed internally or acquired) is a source of value creation and competitive advantage for individual firms 16. However, learning how to manage the research and development activities that permit innovation on a global scale is challenging 17. Thus, in both domestic and international economies, innovation increasingly is recognized as a key l ink to the firm’s strategic competitiveness 18. Moreover, because it challenges the firm to be continuously devoted to strong product lines and taking actions that will cause the goods in those lines to be improved constantly, innovation is a factor that d ifferentiates companies from competitors 19. Although difficult and challenging, effective innovation is a critical part of the skill set that firms need to participate successfully in markets. Evidence of a relationship between high innovative propensity and sustained superior profitability for U.S. pharmaceutical companies can be interpreted as fairly strong support of the decision to allocate resources to innovation 20. If pharmaceutical firms do not innovate, they do not stay in business. Eli Lilly & Co. is ready to launch Prasugres, an anti -clotting drug designed to prevent recurring heart attack and strokes 21. Novartis and other pharmaceutical firms are looking to genemapping to develop new drugs and vaccines because bestsellers like Dicvan (the mark et leader) and Zometa are coming off patent protection soon 22. Diversification To Ansoff, diversification resulted from the development of new products utilized in new markets. This definition differs from the classical use of the term diversification. Diversification is a corporate level strategy concept. Corporate level strategy is discussed in Chapter 7. Ansoff uses the term from a business level strategy perspective. A simple way to understand this concept is to view it as combining market develop ment with product development. By utilizing new products in new markets, the firm can increase its growth. An assumption is applied using this logic: it assumes that new products can be sold in new markets. In other words, products are standardized acros s markets. In many countries, product adaptation is required. This issue is more fully developed in Chapter 10, International Strategies. Whether firms use market penetration, market development, product development, and/or dive rsification, competition must be evaluated. Competition For the most part, the growth decisions that have been discussed have not factored in competition. Decisions that respond to competitor’s actions (e.g. new products) are required. Products must meet the customer’s key buying criteria superior to competition. As customers’ needs change, firms need to develop new products or re -position existing products to maintain competitive superiority. If they don’t, they may lose market share. Firms can be suc cessful as second movers but they need to respond before the first mover has an established customer base. If your firm can anticipate competitors’ 130 moves, actions can be taken to respond to these decisions quickly. Speed of implementation is important. T he quicker the decisions are implemented, the sooner the firm can begin to accrue benefits. The first step is to determine whether or not your firm desires to change based upon competitors’ actions. Not all competitors’ actions are beneficial. For exampl e, investing significant R&D funds in a price sensitive market may not be beneficial. In addition, if competitors make unwise decisions, your firm may be able to capitalize upon these weaknesses. For example, assume that a competitor exits a market segme nt that is profitable and a growth market for your firm. Increasing production will create greater demand for your firm because there will be a smaller number of firms in that segment. The Capstone Simulation can be utilized to ascertain how firms can gr ow in a competitive environment. Internal Development and Capstone Simulation The primary mode of growth that the Capstone Simulation utilizes is internal development. In order to grow, the firm must determine direction of growth. As discussed in Chapter 5, Analysis of Markets and Positioning, direction of growth is determined by a firm’s initial conditions, the size and growth rate of each segment, the key buying criteria , and competitor’s positioning. Market penetration using the Capstone Simulation will be discussed first. Growth by Market Penetration As is shown in Table 6.1, Section a, under Traditional Statistics, the segment demand (11,471 units) was not met. Firms could have sold an additional 1117 (11,471 - 10 ,354) units if they had produced more. Referring to the production analysis (Section b), we can calculate the production capacity for this segment by examining the capacity next round for each product. Table 6.1 Market Penetration Section a Traditional Market Segment Analysis Traditional Statistics Total Industry Unit Demand 11,471 Actual Industry Unit Sales 10,354 Segment % of Total Industry 29.4% Growth Rates 1.092% Traditional Customer Buying Criteria Criteria Expectations Importance 1. Age Ideal Age = 2.0 47% 2. Price $17.50 – 27.50 23% 3. Ideal Position Pfmn 8.5 Size 11.5 21% 4. Reliability MTBF 14000 -19000 9% 131 Section b Production Capacity and Plant Utilization Product Capacity Next Round (Units) Plant Utilization (Percentage) Adam 1200 198 Chunt 500 198 Daze 1800 65 Duwaa 600 68 Eat 1300 190 Total 5400 Total first shift capacity for the next round is 5400 units. Because demand is growing at 9.2 percent (section a), demand for next year is (11,471) (1.092) =12,526 units. Firms will need to add capacity to meet the increased demand. Since demand was not met, Daze and Duwaa need to increase producti on. To utilize excess capacity Daze’s plant utilization is 65 percent and Duwaa’s utilization is 68 percent. With demand at 12,526 units next year and 1 st shift capacity at 5400 units, all firms that remain in this segment should be producing at 100 percen t overtime. For next year, the price range will be between $17 and $27. Since demand cannot be met with both 1 st and 2 nd shift capacity of products within this segment, all firms should price at $27. Growth by Market Development At the beginning of the si mulation, all firms had one product in each segment. Upon examination of section b, Baldwin and Ferris no longer have products in the Traditional Segment. This is surprising because the Traditional Segment represents 32.4 percent of all segments’ units in year 1 and 24.5 percent of all units in year 8. This is a segment in which all firms need to have products in. In Chapter 5, we discussed that positive results can occur as a consequence of poor decisions by competitors. This is such a case: Baldwin and Fe rris have withdrawn products from this segment which will allow all remaining well positioned firms in the segment to achieve maximum margins by pricing at the highest level ($27) (section a).

The remaining segments are identified on the next page. 132 Tabl e 6.2 Market Development Section a Low End Market Segment Analysis Low End Statistics Total Industry Unit Demand 15.581 Actual Industry Unit Sales 14,399 Segment % of Total Industry 37.3% Growth Rates 11.7% Traditional Customer Buying Criteria Criteria Expectations Importance 1. Price $12.50 – 22.50 53% 2. Age Ideal Age = 7.0 24% 3. Ideal Position Pfmn 4.2 Size 15.8 16% 4. Reliability MTBF 12000 -17000 7% Demand with the low -end segment was not met. Segment demand was 15,581 units and actual sales were 14,399 units. If we take $15 (range is $12.50 - $22.50) (section a) as a price per unit, the lost sales of 1412 units (15,811 – 14,399) accounted for approxi mately $21,180. Table 6.3 Market Development Section a High End Market Segment Analysis High End Statistics Total Industry Unit Demand 5.410 Actual Industry Unit Sales 5,410 Segment % of Total Industry 13.0% Growth Rates 16.2% Traditional Customer Buying Criteria Criteria Expectations Importance 1. Ideal Position Pfmn 13.4 Size 6.6 43% 2. Age Ideal Age = 0.0 29% 3. Reliability MTBF 20000 -25000 19% 4. Price $27.50 – 37.5M 9% The demand in the High End Segment (5410 units) was met. As such, some firms had inventory. This will be discussed in the “Growth of Product Development” section. 133 Table 6.4 Market Development Section a Performance Market Segment Analysis Performance Statistics Total Industry Unit Demand 4,726 Actual Industry Unit Sales 4,479 Segment % of Total Industry 11.3% Growth Rates 19.8% Performance Customer Buying Criteria Criteria Expectations Importance 1. Reliability MTBF 22000 -27000 43% 2. Ideal Position Pfmn 14.4 Size 12.5 29% 3. Price $22.50 – 32.50 19% 4. Age Ideal Age = 1.0 9% In the Performance Segment, industry demand was 4726 units and industry sales were 4479 units. Sales of 247 units (4726 – 4479) were not met. Taking an average price of $25 per unit, $6175 of demand was not met. Table 6.5 Market Development Section a Size Market Segment Analysis Total Industry Unit Demand 4,596 Actual Industry Unit Sales 4,596 Segment % of Total Industry 11.0% Growth Rates 18.3% Customer Buying Criteria Criteria Expectations Importance 1. Ideal Position Pfmn 7.5 Size 5.6 43% 2. Age Ideal Age = 1.5 29% 3. Reliability MTBF 16000 -21000 19% 4. Price $22.50 – 32.5M 9% The demand in the Size Segment (4596) was met. As with the high Jend segment, some firms had inventory. This will also be discussed in the “Growth by Product Development” section. Growth by Product Development To discuss growth by product development, the production spreadsheet needs to be reviewed. Digby’s products will be used as an example. 134 Product Development Name Primary Segment Units Sold Units in Inventory Daze Trad 1,388 0 Dell Low 1,593 0 Dixie High 433 206 Dot Pfmn 1,090 0 Dune Size 603 189 Duke High 594 0 Ditty Size 297 0 Duwaa Trad 1,009 0 The placement of Daze (Traditional), Duwaa (Traditional), Dot (Performance), Dell (Low End), and Ditty (Size) are well positioned (0 inventory). However, Dixie (High End) and Dune (Size) are not competitive products within each segment. Dixie has 206 units in inventory. Dune has 189 units in inventory. Dixie – High End Segment Units Sold 433 Units Inventoried 206 Revision Date Sept. 15 Performance 12.3 Size 7.0 List Price $37.50 MTBF 23,500 Age 1.7 Positioning in this high -end segment accounts for 43 percent of the customer buying criteria (Table 6.3). Dixie’s performance (12.3) and size (7.0) positioning are quite a distance from the segment’s ideal spot (performance 13.4, size 6.6 ) (Table 6.3 section a). In addition, the Dixie product had a late revision date (Sept. 15). Within the segment, several other products were positioned closer to the ideal spot and had earlier revision dates. If Dixie is to be competitive in this high end segment, it must be positioned closer to the ideal spot. The Dune product in the size segment had significant inventory (189 units). Let us discuss this product. 135 Dune – Size Segment Units Sold 603 Units Inventoried 189 Revision Date Nov. 5 Performance 7.3 Size 5.6 List Price $32.50 MTBF 20,000 Age 1.5 Forty -three percent of this segment’s buying criteria is based upon positioning. The ideal position is 7.5 (performance) and 5.6 (size) (section a). The Dune product is very close: 7.3 (performance), 5.6 (size). However, the revision date of Nov. 5 is much too late. Dune did not achieve this ideal position until November 5. Revision date is a crucial statistic in any segment. Investments in TQM initiatives to reduce R&D cycle time are ne eded. Growth by Diversification New products that have been developed for one segment may be attractive to other segments over time. If new products are developed for the high -end market, they will age over time. As these products become older, they may be sold in other segments. Because these new products had originally been sold in the high -end segment, they may sell in the traditional and then low end segments if these products are not repositioned. 136 Discussion Questions 1. Explain the difference bet ween market penetration, market development, and product development. 2. What does market penetration assume? 3. What action should your firm take for markets that are highly attractive and moderately competitive? Why? 4. Under what conditions should a firm und ertake new product development as opposed to re -positioning products? Explain. 5. What primary mode of growth does the simulation utilize? Explain. 6. Explain how competition affects a firm’s internal development decisions. 7. What internal development strateg y should be undertaken for the High End segment of the simulation? Explain. 137 References 1. Yip, G. 1982. Diversification entry: internal development versus acquisition. Strategic Management Journal . 3(4), 331 -345. 2. Chatterjee, S. 1990. Excess resources, utilization costs, and mode of entry. Academy of Management Journal . 33: 780 -800. 3. Chang, S. and Singh, H. 1999. The impact of modes of entry and resource fit on modes of exit by multi -business firms. Strategic Management Journal. 20: 1019 - 1035. 4. Ansoff, I. 1957. Strategies for diversification. Harvard Business Review . September -October: 113 -119. 5. Penrose, E. 1959. A theory of the growth of the firm . John Wiley & Sons. New York, NY. 6. Ibid 7. Nelson, R. and W inter, S. 1982 . An evolutionary theory of economic change . Harvard University Press. Cambridge, MA. 8. Wernerfelt, B. 1984. A resource based view of the firm. Strategic Management Journal . 5: 171 -180. 9. Chatterjee. Excess resources, utiliza tion costs , and mode of entry. 10. ____________________, Wall Street Journal. April 19, 2012 11. Ansoff. I. 1957. Strategies for diversification. Wall Street Journal . 12. Takahashi, Dean, PlayPhone enables instant multiplayer across android and iOs devices, 03/19/2012, http://www.ajc.com/business/ups -pushes -logistics -to- 1397277.html 13. Santini, L. 2004. Drug companies look at China for cheap R&D. Wall Street Journal. November 24. 14. Ibid 15. Buckler, S. 1997. The spiritual nature of innovation. Research -Technology Management , March -April: 43 -47. 16. Nobel, R. and Birkinshaw, J. 1998. Innovation in multinational corporations: Control and communication patterns in international R& D operations. Strategic Management Journal , 19: 479 -496. 138 17. James, A.; Georghiou, L.; and Metcalfe, J. 1998. Integrating technology into merger and acquisition decision making. Technovation , 18 (8/9): 563 -573. 18. Meyer, J. 1997. Revitalize your product lines through continuous platform renewal. Research -Technology Management , March -April: 17 -28. 19. Roberts, P. 1999. Product innovation, product -market competition and persistent profitability in the U.S. Pharmaceutical industry. Strategic Management Jou rnal , 20: 655 -670. 20. Winslow, R. and Johnson, A. 2007. New blood thinner drugs on line. Wall Street Journal . December 10. 21. Ibid 22. Ibid 139 Starbucks Mini Case Starbucks is one of the largest specialty coffee shops in the world. In 1982, after returning from a trip to coffee bar in Milan, Italy (with its 1,500 coffee bars), Howard Schultz recognized an opportunity to develop a similar retail coffee -bar culture. Starbucks has now grown into a large multi -national firm. Starbucks initiativ es for 2011 and beyond are as follows: 1. Build an international model that will achieve substantial economies of scale and grow profitability. 2. Lead the premium, specialty coffee segment of the industry 3. Build its Consumer Products Group (CPG) business 4. Acceler ate growth in China 5. Reach new customers 6. Optimize and grow its U.S. retail business These are quite lofty goals. However, Starbucks has a strong financial position. Revenues have increased from $7.8 billion in 2006 to $10.7 billion in 2010. Operating inc ome has increased from $894 million in 2006 to $1.47 billion in 2010. Earnings per share have increased from 71 cents per share in 2006 to $1.28 per share in 2010. In 2010, 73 percent of Starbucks operating income was generated by U.S. sales while 27 per cent came from international sales. Starbucks believes it has the potential to build a portfolio of $1 billion brands. Sourcing, roasting and serving high -quality coffee will remain its core business, but it will be pursuing sustainable, profitable growt h with a more diversified, multi -channel and multi -brand business model. In the near term, they are focusing on Starbucks VIA Ready Brew, Frappuccino beverages and the Tazo tea brand. These brands generate more than $2 billion in sales. It has experienc ed significant growth in its Seattle’s Best Coffee brand. Starbucks (2010) has now 10 times more locations U.S. domestically and internationally than in 2009. Discussion Questions: 1. Illustrate Starbucks position on Porter’s generic business strategy matr ix. 2. Will Starbucks be successful in achieving some or all of its strategic initiatives? 140 Harvard Business Cases for Chapter 6 Corporate Strategy at Berkshire Partners Product Number 710414 Havells India: The Sylvania Acquisition Product Number 909M89 Professor Case for Chapter 6 Louis Vuitton Moet Hennessy 141 Chapter 7 Corporate Level Strategies and Restructuring 142 Learning and Assessment Goals 1. Understand the general relationship between types of diversification and performance. 2. Understand why senior managers and shareholders have different risk profiles from a diversification perspective. 3. Utilize industry analysis and firm business strengths assessment to determine a firm’s competitive position. 4. Develop an understanding of where and how resources are allocated based upon different diversification scenarios. 143 Corporate level strategy and restructuring will be discussed in this chapter. Corporate level strategy examines what industries a firm should invest in and what industries a firm sho uld not invest in. In Chapter 2 , Industry Analysis, we discussed how industries are classified. Certain industries are more attractive than others. For example, a firm that is not cur rently in the tobacco or airline industry would not want to move into either of these industries. On the other hand, the pharmaceutical industry has higher profitability and growth potential 1. However, the pharmaceutical industry may be unattractive because of high barriers to entry. While corporate level strategy is concerned with identifying attractive and unattractive industries, diversification is a process by which firms actually achieve positions within industries. Diversification One way to classify firms is based upon their level of diversification. A firm’s level of diversification is based on the types of industries entered 2. Diversification decisions can be classified into three types: low level, moderate to h igh, and very high levels. The SIC system can be utilized to determine level of diversification. Low levels of diversification would consist of firms that diversify primarily into the same 4 -digit SIC code 3,4,5 . Moderate to high levels of diversificatio n would consist of firms that diversify into the same 2 -digit SIC code 6, 7, 8 . Very high levels of diversification would consist of firms that diversify into different 2 -digit SIC codes 9,10,11 . Low levels of diversification are defined as businesses tha t have 70 percent or more of their revenues coming from a single business 12. Firms that have a low level of diversification tend to grow within the same 4 -digit SIC. Consolidated Freightways would be an example of a firm with low levels of diversification because trucking represents the majority of sales. Many firms that have low levels of diversification are only in one specific industry (e.g. airline industry, utility industry). One way to determine the level of diversification is to examine the number of industries that a firm competes in from a review of industry reports, annual reports and 10 -K reports. Moderate to high levels of diversification represent firms that generate less than 70 percent of revenues from a firm’s core business but there are linkages between businesses 13. Hewlett Packard would be a firm that exhibits moderate to high levels of diversification. Some linkages exist between their imaging and printing business and the P.C. business. Hewlett Packard utilizes the same distributi on channels for their various businesses. Very high levels of diversification represent firms that generate less than 70 percent of their revenues from a core business and there are no linkages between firms 14. General Electric is a firm that has grown by investing in many different industries. For our purposes, firms that diversify within the same 4 -digit SIC are referred to as same business. Firms that diversify within the same 2 -digit SIC are referred to as related. Firms which diversify within di fferent 2 -digit SIC are referred to as unrelated. The performance consequences of alternative diversification strategies will now be discussed. Diversification and Performance Much of the strategic management literature examines level of diversification and performance 15. The general relationship is illustrated in Figure 7.1: 144 Figure 7.1 Diversification and Performance Consequences Type of Diversification SOURCE: Adapted with the permission of Southwestern Publishing: A division of Thomson Publishing from Strategic management by M. Hitt, R. Ireland and R. Hoskisson, 312. 2005. Performances tend to increase as firms move beyond their core business (same 4 - digit SIC) and expand into related businesses (same 2 -digit SIC) 16. As firms move beyond their 2 -digit SIC and expand into unrelated industries, performance tends to decline 17. There are sever al reasons why this general relationship exists. By remaining in the same business, firms may not be able to fully utilize the excess capacity of their resource base. By diversifying into related businesses, firms may create value by sharing resources and transferring skills from business to business 18. Firms are likely to perform better by diversifying into a related business because the firm may have resources that can be effectively utilized within related businesses 19. This process of resource sharin g may create synergies that could not have occurred without venturing into related businesses. An acquisition example of this form of resource sharing and diversification by expansion into a related industry is InBev’s 2008 acquisition of Anheuser -Busch. Synergies represent cost savings that are created as a result of economies of scale or economies of scope . Economies of scale exist when cost savings are incurred as a result of greater utilization of a firm’s resource base within its core business. More fully utilizing production capacity is an example of economies of scale. Economies of scale generally r esult in lower variable operating expenses. Economies of scope are cost savings that are created by leveraging a firm’s resources in related businesses. Economies of scope can be achieved by using the resources of the acquiring firm within the target firm’s businesses. By diversifying into related businesses, a firm generates multiple revenue streams. When Boeing acquired McDonnell Douglas, it established a position in military aircraft manufacturing. With the commercial airc raft industry experiencing substantial cyclicality, the military aircraft business provides a more stable cash flow. Risk Same Business Related Business Unrelated Business H igh L ow High Low Shareholders Senior Mgmt. 145 From Figure 7.1, firms that diversify into related industries tend to experience higher profit than do firms that acquire same industry or unrelated industry targets. Table 7.1 explains why this general relationship exists from a value chain perspective. The primary activities will be discussed first. Diversification and Value Chain Analysis Table 7.1 Value Chain Analysis by Type of Diversification Same Related Unrelated Primary Activities Inbound Logistics May provide redundant sources of locating and extracting raw materials New network for existing products Totally different networks Operations May be unable to generate economies of scale or scope May generate additional economies of scale and scope May need new production processes Out bound Logistics May provide redundant networks for moving products to final consumers New network for existing products Totally different networks Marketing & Sales May not need the target firm’s sales person who has the same experience and contacts as the acquiring firm’s sales team Ability to sell products/services of both firms May be no overlap of customer base Service Products of target’s firm may have the same type of guarantees as the acquiring firm Value added ways of providing service Different products/markets may require new processes Support Activities Firm Infrastructure Target firm may have a total network which is very similar to that of the acquiring firm Possible expansion of existing network (good for acquirer and target) May be to tally different products/markets H.R. Redundant human resources New human resources which may find new sources of value Problems with dominant logic R&D Target firm may have the same basic R&D capabilities as the acquiring firm New capabilities (different ways of using resources) May not be able to leverage R&D capabilities Procurement Target firm may have a similar network for locating either lower cost or higher quality materials Target may have systems in place which could be leveraged Differ ent sources of raw material sourcing 146 Same Industry Diversification From an inbound logistics perspective, the acquiring and target firm may utilize the same type of network for sourcing raw materials. The BHP Billiton’s proposed (mining) $125 billion acquisition of Rio Tinto (mining) will not increase BHP Billiton’s access to raw materials such as iron ore, copper, and uranium 20. From an operations perspective, the target firm may not provide the acquiring firm with either economies of scale and/or ec onomies of scope. Occidential Petroleum and OMV AG have invested $2.5 billion in the Libyan National Oil Co. to increase the output of Libya’s oil fields 21. This investment will be matched by Libyan National Oil Co. and will increase oil production in Li bya from 100,000 barrels a day to 300,000 barrels a day 22. However, Occidential Petroleum will only increase its capacity by 24,500 barrels a day due to government restrictions 23. From an outbound logistical perspective, the target firm may not have larger networks in place to move finished goods to customers. Arcelor Mittal has increased its ownership of China Oriental Group (steelmaker) from 28 percent to 73 percent 24. However, this acquisition does not allow Arcelor Mittal access to any more of C hina Oriental’s infrastructure. Versasun’s (ethanol producer) acquisition of U.S. Bioenergy will combine the number 2 and 3 ethanol producers behind Archer Daniels Midland (ADM) 25. However, these two firms have redundant outbound logistics networks. Whe n an acquiring firm acquires a same industry target, sales and marketing personnel may overlap because products and services may be the same. As such, it may be necessary to lay off some of the target firm’s sales and marketing staff due to this overlap. After Cerberus Capital Management’s acquisition of Chrysler, hundreds of Chrysler’s management team were laid off after Chrysler posted a $1.4 billion loss in 2006 26. A same industry acquisition may result in additional service personnel who are no longe r needed. When American Airlines acquired TWA, it acquired aircraft, some of which it did not need. In addition, American Airlines did not need all of the TWA mechanics. Redundant infrastructure becomes costly to maintain. Since U.S. Airways acquired America West, integrating the carriers infrastructure has been difficult 27. Revenue in 2007 has decreased, profit has continued to fall, and the stock price has fallen $62 at the time of the acquisition (2006) to $16 in late December 2007 28. A similar situation of layoffs, redundant personnel, and organization restructuring was experienced during the months after Oracle reached a firm agreement with Sun Microsystems in April of 2009. Within same industry acquisitions, managerial capabilities are very sim ilar to those of the acquiring firm. As such, the combined firms do not venture into related types of acquisitions which may generate more profitable firms. In addition, there are risks in staying in the same industry (e.g. tobacco industry). From a hum an resources perspective, R&D capabilities between the acquiring firm and the target may tend to be similar. As such, opportunities to capitalize on new or related products/ services may not be undertaken. Even with a same industry acquisition, human res ources may not be able to run the combined firms profitably. In 2006, Sprint acquired Nextel for $35 billion. In 2007, Sprint’s COO was fired 29. In addition, the CEO was forced to retire. The combined firms have been unable to combine their cellular ne tworks and management teams to effectively run the combined firms 30. At the time of the acquisition, the combined firms’ stock price was $24; in August of 2007, the stock price was $16 31. As of 2012, the stock has been trading at less than $5.00 per shar e. 147 Firms may acquire targets which have the same network for procuring either lower cost or higher quality materials. Transocean Inc.’s 2007 acquisition of Global SantaFe Corp. for $18 billion did not provide Transocean any more offshore oil sites 32. Re lated Industry Diversification From an inbound logistics perspective, related acquisitions allow firms closer access to raw materials. Port and railway networks in China can be merged to allow firms access to raw materials which they previously did not h ave. BHP’s acquisition of Rio Tinto integrates port and railway infrastructures to create an inbound logistics network to give both firms greater access to copper, coal, and iron ore reserves. From an operations perspective, related acquisitions allow fi rms to utilize assets to achieve economies of scale or scope. The $10.1 billion related acquisition of Trane by Ingersoll Rand allows for the more economical production of refrigerated trucks and transportation cooling systems for several modes of transpo rtation 33. From an outbound logistics perspective, related acquisitions provide new access for existing products and new products. Proctor and Gamble’s acquisition of Gillette provided Proctor and Gamble access to international networks (e.g. Europe, Sou th America) where it previously had a minimally developed network compared to its primary competitor, Unilever. From a marketing and sales perspective, related acquisitions allow firms to differentiate their products from competitors. Microsoft’s entry i nto the software mapping industry through the acquisition of Multimap allows Microsoft to effectively utilize its capabilities in related industries where it previously did not have a position 34. From an infrastructure perspective, related acquisitions al low firms greater access to similar industries. Many of these acquisitions have been made by Chinese firms. Aluminum Corp. of China acquisition of Canada’s Peru Copper and China Metallorgical Construction Group’s acquisition of Australia’s Balmoral Iron Holdings are two examples which allow the acquiring firms access to related businesses. From a human resource perspective, the acquisition of intellectual capital from related industries provides new perspectives on how to achieve greater competitive adva ntage for both the acquiring and target firm. Cisco’s John Chambers ability to integrate the various related acquisitions of Cisco has allowed Cisco to maintain its domestic position within core and related industries. Ping An (China) acquisition of Fort is NV (Dutch) has allowed Ping An to enter the life insurance industry 35. This acquisition will help Ping An to develop its own insurance based banking network in China 36. From a research and development (R&D) perspective, the ability to combine the capa bilities of both firms to develop new products to service related industries allows firms to maintain competitive advantage. Johnson & Johnson, Merck, Pfizer, Bristol Meyers, Lilly and Astrazeneca are all examples of pharmaceutical firms which have made r ecent related acquisitions of bio tech firms because several brands of these firms are losing patent protection in the upcoming years (e.g. Lipitor (2011) – Pfizer, Fosamax (2008) – Merck) 37. From a procurement perspective, related acquisitions have systems and procedures in place to find lower cost or higher quality products. Naspers (South Africa) acquired Tradus (London) to gain access to Eastern European markets for pay -television, internet, and print media assets 38. This acquisition provides th e capability to obtain these related assets at lower costs. 148 Unrelated Industry Diversification From an inbound logistics perspective, unrelated firms usually have totally different logistics networks because they are designed for different products/servic es. The acquiring firm may not be able to utilize the target’s infrastructure and vice versa. The same is true from an outbound logistics perspective because the acquiring and target firms may have different customer bases. Campbell Soup Co.’s acquisiti on of Godiva Chocolatier for $850 million required Campbell’s to maintain two different inbound and outbound logistical networks 39. Unrelated acquisition targets may have different types of operational facilities. As such, it may be difficult to achieve either economies of scope or economies of scale from an operations perspective. This situation makes it very difficult to achieve cost savings because synergies may be difficult to achieve. For example, Olympus, a camera maker, has acquired Gyrus Group, a United Kingdom Medical -instruments firm for $1.89 billion. Since these firms have totally different operational processes, it may be difficult to achieve any type of synergies or cost savings. Japan Tobacco’s acquisition of Katokichi, a frozen foods ma ker, did not provide any operational synergies 40. One aspect of unrelated acquisitions is that the sales, marketing, and service resources of the target firm may need to be maintained because they serve two totally different industries and customer bases. Different customer bases have different needs; training will need to be focused upon two discreet sales and marketing plans. Recently, Beer Brewer Kirin has acquired Australian Dairy and Soft Drink National Foods Company for $2.6 billion. These two fir ms maintain two distinct customer bases. The human resource functions of both the acquiring and target firm will need to be maintained and any differences in terms of salaries and benefits need to be resolved before the acquisition is completed. If there is a significant difference between acquiring and target firm’s compensation, this could cause problems with the workforce of the combined firms. In addition, if one workforce is unionized and the other is not, these major human resource issues will need to be resolved. The Warren Buffett Berkshire Hathaway 2009 acquisition of the BNSF Railroad is an elaborate example of various human resource and management related challenges that needed to be addressed. As is common in an unrelated industry acquisitio n, Buffett maintained the management team of the BNSF. In addition, the $1.91 billion acquisition of Tradus PLC, an internet auction firm, by media conglomerate Naspers Inc., required totally different managerial capabilities. As such, both management te ams needed to be maintained. Due to the unrelated nature of the acquisition, the acquiring firm may need to obtain two distinct R&D functions. These functions are likely to have minimal to no overlap. As such, two different budgets will need to be maint ained. In addition, the two R&D functions will compete for resources. Unless the management team of the target firm is maintained, maximizing the return on R&D expenditures may be difficult. CIE FinanciereRioyemont’s acquisition of British American Toba cco required R&D capabilities in luxury goods and tobacco 41. As such, R&D capabilities of the acquiring firm could not be leveraged. Diversification and Risk As firms move from related to unrelated businesses, returns tend to decline. One explanation fo r this is because of managerial risk motives. This risk relationship between managers and shareholders is different for different levels of diversification. Shareholders’ risk is minimized by the firm engaging in related diversification. As discussed abo ve, related diversification is likely to result in economies of scale and/or 149 economies of scope. These cost savings generally result in higher margins and lower levels of risk for shareholders. However, as firms engage in unrelated diversification, firms tend to develop a portfolio of businesses that have different risk profiles and differing levels of cash flow. As such, risk is minimized for the senior management team by engaging in unrelated diversification. Shareholders do not need to minimize their risk because they can diversify their portfolios among many different firms. However, investments in unrelated diversification can result in managerial problems associated with dominant logic 42. Managers’ knowledge is best applied to industries with which they are familiar. Venturing into “uncharted waters” may stretch a firm’s managerial team beyond their capabilities. As firms move further away from their core industry into more unrelated industries, issues such as competition, cus tomer preferences, stage of industry life cycle, and demand for product/services may be distinctly different. In addition, a firm’s resources in its primary industry may not be able to be utilized to create economies of scale or scope in unrelated industr ies. The relationship between a firm’s business strength and industry attractiveness is of critical importance. Business Strengths and Industry Attractiveness In order for a firm to profitably diversify, the firm must be able to determine the relative att ractiveness of industries. In addition, the firm must make some judgment in terms of its own strengths. One approach to examining both issues is the General Electric (G.E.) matrix. A modified G.E. matrix is illustrated in Figure 7.2. Figu re 7.2 G.E. Matrix Figure 7.2 identifies what actions a firm should take based upon the level of industry attractiveness and the firm’s business strengths. Figure 7.2 illustrates that firms would invest in highly attractive industries in which they have strong business posi tions (1). Investments in highly attractive industries in which the firm has moderate business strength is also recommended (2). Investments are needed in moderately attractive industries in which the firm has a strong business strength position (3). (7) Invest (2) Invest (1) Divest (5) Analyze (8) Invest (3) Divest (4) Divest (6) (9) Moderate Industry Attractiveness High Moderate Weak Strong Low Firms’ Business Strength 150 Fir ms should divest businesses in which they have a weak business strength position and the industry attractiveness is low (4). Divestment should also occur in cells (5) and (6). The funds and resources made available through the divestment of (4), (5), and (6) should be focused upon moving firms in cell (2) and (3) into cell (1). A portion of the funds and resources made available through the investment of positions in (4), (5), and (6) should be used to research cells (7), (8) and (9). The remaining fund s should be allocated to whichever segment provides the firm with the greater potential advantage. Determining which industry(s) a firm should enter and assessing a firm’s business strength within these industries are crucial decisions. Determining industr y attractiveness should be conducted first. Table 7.2 Determining Industry Attractiveness Criteria Weight* Score** (Value)*** Industry 1 Industry 2 Industry 3 Industry 4 1. Market Size 2. Industry Growth Rate 3. Cumulative Industry Profitability 4. Favorable Industry Structure 5. Role of Technology 6. Presence of multi -national firms 7. Cumulative free cash flow 8. Lack of Industry Competitiveness 9. Market Capitalization .10 .10 .25 .05 .10 .05 .05 .25 .05 8(.8) 8(.8) 9(2.25) 8(.4) 9(.9) 2(.1) 5(.25) 8(2) 8(.4) 4(.4) 6(.6) 8(2) 6(.3) 9(.9) 2(.1) 4(.2) 4(1) 6(.3) 3(.3) 7(.7) 4(1) 7(.35) 4(.4) 3(.15) 6(.3) 8(2) 4(.2) 6(.6) 2(.2) 5(1.25) 4(.2) 2(.2) 2(.1) 7(.35) 9(2.25) 4(.2) Total 1.00 7.90 5.80 5.40 5.35 *Weights are assigned by senior management based upon how important one criterion is when compared to others. **Scores are based upon a 1 to 10 scale where 1 is poor and 10 is excellent. ***Value consists of the weight of each factor multiplied by the firm’s score. Industry Attractiveness Industry attractiveness (Table 7.2) is measured based upon numerous factors: some factors which are important are (1) market size, (2) industry growth rate, (3) cumulative industry profitability, (4) favorable indus try structure, (5) role of technology, (6) presence of multi -national firms, (7) cumulative free cash flow, (8) lack of industry competitiveness, and (9) market capitalization of firms within the industry. A hypothetical industry attractiveness analysis is conducted in Table 2. Cumulative industry profitability (criteria 3) and lack of industry competitiveness (criteria 8) are the most important factors for determining industry attractiveness.

Cumulative industry profitability is marginally greater for In dustry 1 compared to Industry 2. Industry 1 has significantly higher cumulative profitability when compared to industries 3 and 4. 151 All industries, with the exception of Industry 2, are not experiencing a high level of competition. Based upon higher cum ulative profitability and lower industry competitiveness, Industry 1 would be the most attractive industry to enter. Overall, this industry is more attractive (7.90) than Industry 2 (5.80), Industry 3 (5.40) and Industry 4 (5.35). Determining a firm’s bu siness strength within Industry 1 will now be discussed. Business Strength To determine firm business strengths the same general process would be utilized as was used for determining industry attractiveness. A firm’s business strength is measured based o n an evaluation of numerous factors: some factors which are important are (1) market share, (2) firm growth rate, (3) depth and breadth of product lines, (4) distribution infrastructure, (5) price competitiveness, (6) promotion coverage, (7) productivity, (8) access to raw materials, (9) quality/price tradeoff, and (10) product and process R&D. A business strength analysis should be performed for your firm and all competitors within each industry. Assume that Industry 1 has 4 existing competitor firms (A,B ,C,D). Table 7.3 is an example. Table 7.3 Business Strength Assessment : Industry 1 Criteria Weight* Score** (Value)*** Firm A Firm B Firm C Firm D 1. Market Share 2. Firm Growth Rate 3. Depth and Breadth of Product Lines 4. Distribution Infrastructure 5. Price Competitiveness 6. Promotion Coverage 7. Productivity 8. Access to Raw Materials 9. Quality/Price Tradeoff 10. Product and Process R&D .10 .10 .05 .10 .10 .05 .10 .05 .15 .20 7(.7) 8(.8) 6(.3) 9(.9) 9(.9) 8(.4) 9(.9) 9(.45) 9(1.35) 9(1.8) 8(.8) 9(.9) 4(.2) 8(.8) 7(.7) 7(.35) 7(.7) 4(.2) 8(1.2) 6(1.2) 6(.6) 4(.4) 7(.35) 4(.4) 5(.5) 6(.3) 4(.4) 3(.15) 7(1.05) 7(1.4) 4(.4) 2(.2) 3(.15) 5(.5) 2(.2) 5(.25) 6(.6) 2(.1) 5(.75) 3(.6) Total 1.00 8.50 7.05 5.55 3.75 *Weights are assigned by senior management based upon how important one criterion is when compared to others. **Scores are based upon a 1 to 10 scale where 1 is poor and 10 is excellent. ***Value consists of the weight of each factor multiplied by the firm’s score. Firm A would have the strongest business strength (8.50) in Industry 1. Firm A has the highest total score of all 4 firms. Within this industry, the most important criteria is product and process R&D (criteria 10). Firm A’s superiority in product R&D may allow it to sustain a superior position with respect to competitors. The second most important criteria is quality/price trade -off (criteria 9). Firm A has a better quality/price 152 tradeoff than other competitors . Future investments in product R&D may create new products to provide differentiation for other competitors. Investments in process R&D may improve efficiency and productivity. These investments may allow Firm A to charge lower prices. Currently, Firm A is very competitively priced (Criteria 5) with respect to other firms. These lower prices may increase market share and generate economies of scale. Firms C and D should exit Industry 1 because Firms A and B (Table 7.3) have stronger overall business strength positions. Firms C and D should determine their relative business strengths in industries 2, 3, and 4. Following an analysis similar to that in Table 2, firms C and D may have much stronger business strength positions in industries 2, 3, and/or 4. Firm B’s approach is less clear. Industry 1 has the highest industry attractiveness (Table 6.2). If Firm C or D exits, Firm B may be able to increase its market size within Industry 1. Firm 2 should conduct the business strength assessment to determ ine its relative business strength in Industry 2, 3, and 4. Firm 2 should allocate more funds to whichever industry it has the strongest position in. Because this approach evaluates competitors within industries based upon their business strengths, it i s an excellent planning tool. However, some assumptions have been made: (1) all industries are privatized (2) industry competitiveness is assumed for a specific point in time and (3) each industry is assumed to have high barriers to entry. If firms deci de to invest in new industries, they may need to restructure industries they are currently in to obtain the necessary funds. Restructuring Restructuring is changing the set of businesses that a firm focuses upon. Three primary vehicles accomplish restruc turing: downsizing, downscoping and realignment. Downsizing will be addressed first. Downsizing Downsizing is a planned reduction in the number of employees. The primary objective of downsizing is to reduce costs. If a firm is unprofit able, the first decision a firm may make is to implement a reduction in payroll across all businesses. This reduction is normally accomplished by laying off employees. By engaging in across the board cuts, firms are not identifying which businesses are more profitable than others. Payroll reductions are an internal firm process. Very little is analyzed concerning the impact upon suppliers, customers, and competition. Care must be taken to engage in reductions while still meeting the needs of all the f irm’s stakeholders. Extensive cost cutting can result in low employee morale. Employees may be concerned that additional layoffs may eliminate them. Therefore, the remaining employees may decrease productivity because their primary focus may be upon fin ding another job. The U.S. airline industry is a good example of downsizing. The more extensive the cuts, the more unprofitable the airlines become. Virtually all of the U.S. based airlines, with the exception of Southwest and Jet Blue, have had very s ignificant manpower reductions. With rising fuel prices continuing into 2012, these reductions have continued. Downsizing occurs in many industries. On May 5, 2005 IBM reduced its workforce by between 10,000 and 13,000 employees 43. With slow sales in Europe, IBM plans to realign its operating structure in Europe to reduce overhead. 153 The automotive industry continued to be hit hard by downsizing throughout the late 90’s and in to the next decade. General Motors steadily reduced i ts workforce by eliminating thousands of jobs since 1995. Chrysler did not fare much better after the company’s announcement to downsize beginning in 2007. The company announced an immediate plan to cut 13,000 jobs impacting multiple U.S. plants in an at tempt to return to profitability in 2008. 44 A number of company downsizing initiatives have occurred throughout the last several years both within the United States as well as globally. These include: Lowe’s 2011 report to close multiple stores within the U.S. impacting 1,950 jobs and 20 stores across the country, 45 Verso Paper’s 2011 report to downsize, reduce production, and cut 300 jobs citing the cost of rising raw materials and low industry demand, 46 and most recently, Blockbuster and PepsiCo. Blockb uster continues to flirt with financial issues into 2012 and made About.coms list of worst retail news in 2009 after cutting more than 10,000 retail jobs and closing 960 stores. 47 PepsiCo issued news in February 2012 that it would be cutting 8,700 jobs, in dicating higher raw materials as one of the determining factors in the company’s move toward a cost cutting strategy. 48 Additional downsizing events include STMicro, a Swiss chipmaker, laid off 9 percent of its employees in 2004 49. This reduction is a res ult of a declining demand for its products. Unilever, the primary competitor of Proctor & Gamble, plans to downsize its workforce by 20,000 workers by 2009 50. Unilever’s revenue is $50 billion compared to $77 billion for Proctor & Gamble. In addition, Un ilever employs 179,000 workers which Proctor & Gamble employs 138,000 workers 51. In addition, Pfizer is closing its R&D operations in the U.S. and cutting 2100 workers 52. It will continue to outsource its R&D to Pacific Rim countries. Downscoping is an other form of restructuring. Downscoping Downscoping refers to the elimination of business units that are either unprofitable or not related to a firm’s core competencies. Phillip Morris’ divestment of Miller Brewing is an example. Phi llip Morris’ core business is tobacco. For some time, South African Brewers had desired to establish a position within North America. Their acquisition of Miller achieved this objective and allowed Phillip Morris to concentrate upon its core business of tobacco. At times, a firm will attempt to downscope because a specific product line may not be generating acceptable returns. For example, Proctor & Gamble may sell off the Oral B division of Gillette because the division represents 15 percent of sales and 3 percent of net income. In addition, tooth care is not an area of strength for Gillette: its expertise is in blades and razors. Blades and razors account for 41 percent of the sales of Gillette and 68 percent of the profit. Royal Dutch Shell is sell ing its Intergen NV power plant business to American International Group and Ontario Teachers ’ Pension Plan for $1.75 billion 53. Shell is refocusing its business upon developing oil reserves. Adidas -Salomon is selling its sporting goods division to Amer Sports (Finland) for $624 million 54. Adidas is re - focusing its attention to concentrate on sport shoes and apparel segments of the industry. Emmis Communications is selling its 16 television stations, which are valued at approximately $1 billion 55. Emmi s plans to use the funds to reduce debt and buy back stock. General Electric is selling its self -storage business to Prudential Financial and Extra Space Storage for $2.5 billion 56. General Electric will use the funds from this sale to focus on its highe r margin business segments. 154 The U.S. airlines have also engaged in downscoping. American Airlines has recently spun off its regional carrier, American Eagle 57. This follows similar actions at Delta, Continental, Northwest and United of selling off regional carriers. The airlines logic is that they can contract the same flights and services at lower cost 58. Fujitsu has spun off its manufacturing of LSI chips as it exits the semiconductor business 59. While Fujitsu makes hardware products including P C’s, network equipment and components, the majority of its profits come from its software and consulting services 60. Realignment Realignment refers to a substantial change in a firms’ organizational structure. After reaching an agreemen t to acquire Compaq in September 2001, Hewlett Packard continued to experience organizational changes into 2005 when HP separated its PC business from other parts of the firm. Also in June 2005, Viacom decided to split into two firms. The split separated the company’s cable channels and film studio from its broadcast television and radio operations. Viacom Inc. includes cable networks and entertainment (e.g. movies). CBS Corp. includes television, radio, outdoor advertising and one cable network (Showtime ). Ford Motors Inc. has agreed to restructure its former partner, the auto parts maker Visteon, by spending between $1.6 and $1.8 billion to appeal to a more diverse customer base. Aon Corp., the world’s largest insurance broker has sold off two of its businesses. Its Combine Insurance Co. of America has been sold to Ace Limited for $2.4 billion 61. Also, its Munich Re AG was sold for $352 million to Sterling Life Insurance. Aon believes these moves will allow it to re -focus on its brokerage and consu lting business 62. In 2008, Philip Morris created PMI as a stan dalone business from Philip Morris 63. This move would free Philip Morris from litigation within the U.S. which has hindered growth. PMI would operate as an independent firm. It would be able to focus upon the growth markets within the tobacco industry: Brazil, Russia, India, and China 64. Restructuring and the Capstone Simulation Andrews has one product in each segment. All products with the exception of the high end product have positive net margins (Table 7.4 : section b). Andrews’ high end product has a negative net margin (46). Adam is only using 33 percent of its production cap acity on its high end product (Table 7 .6). This product is generating 97 units of inventory. Andrews may want to sell 900 units of first shift capacity of Adam’s production capacity and use the funds to increase the capacity of its new product (Ate).

Ate c ould be a successful new product in the high end segment. Andrews’ size product (Agape) is only producing 62 percent of its capacity (Table 7 .6). This product is well positioned within the size segment (inventory of 8 units) (Table 7 .6). Andrews’ tradition al product (Able) and its low end product (Acre) are Andrews’ m ost profitable products (Table 7 .4: section b). These products are generating minimal inventory (Table 7.6). As such, capacity should be bought and automation should be increased. Baldwin has one product in the traditional, low end, and size segments. It has two products in the high end segment and no products in the performance segment. Its traditional, low end, and one of its high end products are profitable. Baldwin is incurring minimal loss es on its second high end product and its size product (Table 7 .4: section b). Baldwin’s low end product, Bead, has a strong position in the low end segment: minimal (150 units) of inventory. Since this is a price sensitive segment, Baldwin needs to increa se its automation and add capacity after plant capacity exceeds 150 percent . The 155 low end product is Baldwin’s most profitable product (Table 7.4 : section b). Baker (traditional product) is Baldwin’s next most profitable product. Currently, Baker is running at 84 percent of production capacity. Baker is generating 217 units in inventory. Part of the reason may be because of its late revision date (Dec. 5). Baldwin needs to increase automation on this product line. Baldwin has two high end products (Bid, Bold ). Bid is making money ($4502) and Bold is losing money ($351) (Table 7 .4: section b). Bid product is generating inventory (114 units) and running its production line at 176 percent. Part of its problem with the inventory may be due to its revision date (D ec. 18). Bold has a much better position from a positioning perspective (89 units of inventory).

This product is onl y running at 58 percent (Table 7 .6). Capacity on this line needs to be increased. Baldwin’s size product (Buddy) is losing money ($791) and generating significant inventory (103 units). In addition, this production line is only running at 50 percent. Baldwin should sell off this line and use the funds to focus upon the Baker, Bead, and Bid lines. As discussed above, all of these lines are prof itable. Chester has one product in each segment. All of its products are profitable. However, its traditional (Cake) and low end (Cedar) account for significantly greater profitability than do its high end (Cid) and size (Cure) products. Cid and Cure are significantly more profitable than its performance (Coat) product. Due to the relatively low inventory levels on all products, Chester may choose to increase the utilization of overtime on all lines . In order to increase capacity, Chester may want to sell off its performance production line. This is needed to increase automation on its traditional and low end product lines. Digby has one product in each segment. All of Digby’s products are profitable (Table 7 .4: section b). Digby’s traditional and low end account for most of the profit. Digby’s traditional product, Daze, and its low end product, Dell, are well positioned in each segment as can be seen from the relatively low inventory levels on both products (Table 7 .6). The Daze and Dell products are runni ng at 24 percent and 31 percent overtime. Another reason to add capacity is because both of these segments are price sensitive. As such, achieving economies of scale is important. Along the same line, increasing automation on both lines will result in addi tional efficiencies. Capacity also needs to be added to the high end, performance, and size products to service market growth. Segment growth rates for the high end (16.2%), performance (19.8%) and size (18.3%) are significant (Table 7 .5). Production capac ity for Doom needs to be increased. Erie has two products in the traditional segment, one product in the low end segment, and one product performance and size. Erie has no product in the high end segment. Erie has sold off its production capacity in the p erformance segment. Erie has put itself in a vulnerable position. Erie is exiting the \ market (Table 7 .6) and is losing money on its si ze product (Table 7 .4: section b). Erie is profitable on both of its traditional products and its low end product. Howev er, Andrew s, Baldwin, Chester, Ferris, and Digby are generating greater profitability on their low end lines (Table 7 .4: section b). In the traditional line, Erie is generating sales of $39,095 and $32,050 (Table 7.4: section a). In addition, within the tr aditional and low end segments, Erie is generating relatively low inventory of these products (Eat, Echo, Ebb). This is not the case with respect to its size product (Egg). This product is losing money ($2776) and is poorly positioned. Erie must sell off i ts production capacity on this line. The funds need to be used to buy additional capacity in both the low and traditional lines. Erie needs to continue t o buy capacity in both the Eat and Ebb lines. In addition, it is of crucial importance for Erie to tota lly automate both its traditional and low end production lines. 156 Erie must dominate both the traditional and low end market segments if it is going to stay as a viable competitor. Speed of decision making is crucial for Erie. Ferris has one product in each segment. Ferris is makin g money on all products (Table 7 .4: section b). As evidenced by minimal invento ry on all product lines (Table 7.6), Ferris should remain in all segments. Ferris’ capacity on the traditional and low end lines is too small. Ferris ne eds substantial increases in capacity in the traditional and low end lines. Since both of these lines support price sensitive products, it is crucial that Ferris increases this capacity to the level of Erie’s traditional and low end lines. Ferris has a sig nificant problem with its traditional line: this line is only automated to a level of 4. This will not provide sufficient cost efficiencies in trying to compete with all other firms in this line. Although Ferris has an automation level of 6 on its low end (Feat) line, this is comparable to the other firms in the industry. However, the low end product is very cost sensitive. As such, automation needs to be increased significantly and as quickly as possible. Ferris’ existing high end product, Fist, has a str ong market position. Fox has the potential to take market share from Bid, and/or Dixie, and/o r Cid. From Table 7 .4: section b, we see that Andrews’ high end product, Adam, is losing money. The second high end product of Baldwin(Bold) is losing money, and Erie has no product in the high end. All of Fox’s 500 units of capacity should go into it in the high end. Table 7.7 summarizes the restructuring decisions for each team. Table 7.4 Product Analysis Section a Sales ($) Segment/Firm Traditional Low End High End Performance Size Andrews 39,758 32,270 11,727 15,986 8701 Baldwin 28,382 42,936 30,611, 10,402 None 8547 Chester 35,123 43,478 25,655 23,067 23,891 Digby 41,180 38,540 26,828 24,298 24,412 Erie 39,075 32,050 40,803 None 2639 2657 Ferris 32,401 32,454 26,835 23,434 25,153 Section b Net Margin ($) Segment/Firm Traditional Low End High End Performance Size Andrews 8330 7836 (46) 2525 1314 Baldwin 4779 8469 4502, (351) None (791) Chester 5848 8984 3996 513 2596 Digby 8118 8029 3910 1484 2917 Erie 7762, 3023 7666 None 98 (2776) Ferris 6496 4914 4192 1995 4050 157 Table 7.5 Market Segment Analysis Traditional Market Segment Traditional Statistics Total Industry Unit Demand Actual Industry Unit Sales Segment % of Total Industry Growth Rate 8809 8809 30.4% 9.2% Low End Market Segment Low End Statistics Total Industry Unit Demand Actual Industry Unit Sales Segment % of Total Industry Growth Rate 11,180 11,180 38.6% 11.7% High End Market Segment High End Statistics Total Industry Unit Demand Actual Industry Unit Sales Segment % of Total Industry Growth Rate 3448 3448 11.9% 16.2% Performance Market Segment Performance Statistics Total Industry Unit Demand Actual Industry Unit Sales Segment % of Total Industry Growth Rate 2749 2749 9.5% 19.8% Size Market Segment Size Statistics Total Industry Unit Demand Actual Industry Unit Sales Segment % of Total Industry Growth Rate 2776 2776 9.6% 18.3% 158 Table 7.6 PRODUCTION INORMATION Name Primary Segment Units Sold Units Inventory Revision Date Age Dec. 31 2nd Shift & Overtime Automation Next Round Capacity Next Round Plant Utiliz. Able Trad 1,446 69 5/7/2013 2.0 20% 5.0 1,200 120% Acre Low 1,501 104 1/29/2012 6.6 3% 7.0 1,400 103% Adam High 313 97 7/7/2013 1.6 0% 7.0 900 33% Aft Pfmn 477 7 3/3/2013 2.0 14% 4.0 400 114% Agape Ate Size 260 0 8 0 11/28/2013 2.0 0.1 0% 0% 4.0 7.0 400 400 62% 0% Baker Trad 979 217 12/5/2013 1.8 0% 5.0 1,300 84% Bead Low 2,035 150 5/25/2007 6.6 45% 7.0 1,400 145% Bid High 785 114 12/18/2013 1.2 76% 3.0 600 176% Bold Buddy High Size 306 251 89 103 7/27/2013 9/18/2013 1.7 1.6 0% 0% 3.0 3.0 600 650 58% 50% Cake Trad 1,325 171 8/26/2013 1.9 39% 5.5 1,000 139% Cedar Low 2,230 172 1/29/2012 6.6 59% 7.5 1,450 159% Cid High 684 86 11/15/2013 1.3 7% 3.0 600 107% Coat Cure Pfmn Size 710 735 46 66 11/3/2013 9/10/2013 1.5 1.6 16% 24% 4.0 4.0 600 600 116% 124% Daze Trad 1,420 201 8/22/2013 1.8 24% 5.0 1,200 124% Dell Low 1,793 178 5/25/2007 6.6 31% 7.0 1,400 131% Dixie High 688 120 12/3/2013 1.2 39% 3.0 600 139% Dot Pfmn 715 12 11/13/2013 1.5 16% 3.0 600 116% Dune Size 718 73 11/13/2013 1.5 24% 3.0 650 124% Doom Eat Ebb Echo Edge Egg Fast Feat Fist Foam Fume Fox Trad Low High Pfmn Size Trad Low High Pfmn Size 0 1,447 2,092 1,187 78 78 1,117 1,475 688 689 740 0 0 224 148 125 0 60 254 54 91 54 73 0 8/9/2014 4/8/2013 1/15/2013 7/20/2013 6/30/2009 12/24/2013 4/22/2013 7/26/2016 12/22/2013 11/11/2013 11/9/2013 12/12/2013 0.0 2.1 6.6 1.4 4.5 2.3 2.1 6.6 1.2 1.5 1.5 0.0 0% 10% 50% 38% 99% 0% 55% 98% 39% 16% 24% 0% 6.0 7.0 6.0 5.0 3.0 3.0 4.0 6.0 3.0 4.0 4.0 5.5 500 1,400 1,500 900 1 600 800 700 550 600 600 500 0% 110% 149% 138% 198% 8% 155% 198% 139% 116% 124% 0% 159 Table 7.7 Restructuring Decisions Andrews  Sell off 33 percent capacity of Adam to fund growth in Ate (new product) and/or fund growth of its traditional (Able) or low end (Acre). Able and Acre generate the bulk of Andrew’s profitability Baldwin  Sell all the buddy line except one unit of production capacity  Use funds to further develop Baker (traditional) and (low end) Bead Chester  Sell off performance line  Increase overtime utilization on traditional (Cake) and low end (Cedar) lines  Increase automation level on Cake product line  Utilize additional 2 nd shift on traditional (Cake) and low end (Cedar) lines Digby  Increase overtime utilization on traditional (Daze) and low end (Dell) lines  Automation levels on tradi tional and low end lines need to be increased  Additional production line capacity for Doom (new product) needs to be increased Erie  Sell off production capacity on size line  Increase overtime utilization of traditional (Eat) and low end (Ebb ) lines.  Increase automation in low and traditional lines Ferris  Increase overtime utilization on traditional (Fast) line .  Buy additional plan t capacity on low end product (F eat)  Significantly increase automation on traditional and low end lines  Increase capacity on Fox line to establish a larger position in the high end 160 Discussion Questions 1. Explain why performance varies for different types of acquisitions. 2. Do managers and shareholders view the relationship between diversification and risk similarly? Explain. 3. Which financial statement(s) should be examined when engaging in restructuring decisions? Explain. 4. Explain the G.E. matrix: which segments should the firm invest in? Which segments should the firm divest? Why? 5. Which restructuring pr ocess is recommended? Why? 6. How is a business strength assessment conducted? 7. Why is year ending cash flow important? 161 References 1. Grant, R. 2005. Contemporary strategy analysis , Blackwell: Oxford, England. 2. Rumelt, R. 1974. Strategy, structure, and ec onomic performance . Harvard Business School Press. Boston, MA. 3. Ibid 4. Ibid 5. Ibid 6. Ibid 7. Ibid 8. Ibid 9. Ibid 10. Ibid 11. Ibid 12. Ibid 13. Ibid 14. Ibid 15. Chatterjee, S. and Wernerfelt, B. 1991. The link between resources and type of diversification: theory and evidence, Strategic Management Journal . 12(1), 33 -48. 16. Palich, L., Cardinal, L., and Miller, C. 2000. Curvilinearity in the diversification performance linkage: an examination of over three decades of research, Strategic Management Journal. 12, 155 -174. 17. Ibid 18. Port er, M. 1987. From competitive advantage to corporate strategy. Harvard Business Review . 65(3), 43 -59. 19. Chang, S. and Singh, H. 1999. The impact of modes of entry and resource fit on modes of exit by multi -business firms. Strategic Management Journal . 20 : 1019 - 1035 20. Barta, P. 2007. Mine deals to unclog bottlenecks. Wall Street Journal . 162 21. Gold, R. and Chazan, G. 2007. Occidental, OMV cut deal with Libya. Wall Street Journal . November 27. 22. Ibid 23. Ibid 24. Lee Y. 2007. Arcelor seeks control of Chinese steelmaker. Wall Street Journal . December 20. 25. Etter, L. 2007. Verasun -US Bioenergy deal to form ethanol titan. Wall Street Journal . November 11. 26. Chrysler CEO expects $1.6 Billion loss this year. Wall Street Journal . 27. Trottman M. 2007. Can US Airways pass test of time? Wall Street Journal . December 26. 28. Ibid 29. Sharma, A. 2008. After Sprint and Nextel merge, customers and executives leave. Wall Street Journal . December 23. 30. Ibid 31. Ibid 32. ____________ __, Global Santa Fe Acquires Transocean but not any additional oil sites. Wall Street Journal. December 7. 33. ___________ 2007. One cool acquisition. Wall Street Journal . December 7. 34. ___________ 2007. Acquisition to expand Microsoft’s map services. Wall Street Journal . December 6. 35. Santini, L. 2007. Ping An’s Fortis stake brings insurer expertise. Wall Street Journal . December 28. 36. Ibid 37. Martinez, B. and Goldstein, J. 2007. Big pharma faces grim prognosis. Wall Street Journal . December 27. 38. Stewart, R. 2007. South Africa’s Naspers to buy Tradus PLC. Wall Street Journal . December 4. 39. ____________ 2007. Campbell soup, chocolate Godiva. Wall Street Journal . December 4 163 40. Kachi, H. 2007. Japan tobacco, Nissin buy frozen -foods maker. Wall Street Journal . 41. Gelnar, M. 2007. Richemont raises profile with Tobacco -sping Plan. Wall Street Journal. ______ 42. Prahalad, C. &Bettis, R. 1986. The dominant logic: a new linkage between diversity and performance. Strategic Management Journal . 6: 485 -502. 43. Associated Press/MSNBC, 02/16/2007, http://www.msnbc.msn.com/id/17183711/ns/business -autos/t/chrysler -downsizing - affect -midwest -plants/#.T29gvtnNkUo 44. Companies Downsizing for October 2011, The Los Angeles Post, 03/25/2012, http://www.thelosangelespost.org/companies -downsizing -october -2011/ 45. Farfar, Barbara, Blockbuster – Worst Downsizing News and Results in 2009, About.com Retail Industry, 03/25/12, http://retailindustry.about.com/od/americanretailhistory/ig/2009 -Retail -Best -and - Worst/Worst -of-2009 --- Blockbuster.htm 46. Anderson, Mae, PepsiCo Layoffs: World’s Second Largest Food Company Cutting 8,700 Jobs Despite Higher Revenue, Huffington Post, http://www.thelosangelespost.org/companies -downsizing -october -2011/ 47. Forelle, C. 20 05. IBM plans restructuring and job cuts. Wall Street Journal . May 5. 48. Logrotteria, B. 2005. STMicro to cut staff outside Asia. Wall Street Journal . May 17. 49. Ball, D. and Patrick, A. 2007. How a Unilever executive is thinning the ranks. Wall Street Journal . November 27. 50. Ibid 51. Johnson, A. 2007. As drug industry struggles, chemists face layoff wave. Wall Street Journal . December 11. 52. Berman, D. and Singer, J. 2005. Shell is selling Intergen unit to investor duo for $1.75 billion. Wall Street J ournal . April 20. 53. Frey, G. 2005. Dow Jones Newswires. Wall Street Journal . May 3. 54. McBride, S. 2005. Emmis plans to sell 16 TV stations. Wall Street Journal . May 10. 55. Kranhold, K. and Berman, D. 2005. G.E. weighs sale of storage unit for $2.5 billion. Wall Street Journal . April 25. 164 56. Trottman, M. 2007. AMR will shed American Eagle. Wall Street Journal . November 27. 57. Ibid 58. Alabaster, J. 2008. Fujitsu moves to spl it off chip business. Wall Street Journal . January 22. 59. Ibid 60. Kuykendall, L. 2007. AON exits underwriting business in deals with ACE, Munich Re. Wall Street Journal . November 27. 61. Ibid 62. O’Connell, V. 2008. Philip Morris readies aggressive global pu sh. Wall Street Journal. January 29. 63. Ibid 64. Ibid 165 General Electric (G.E.) Mini Case The chapter discussed product portfolio analysis which was developed by G.E. As such, this case will discuss product portfolio analysis of General Electric in 2010. Table 1 identifies G.E.’s revenue, by segment and profitability. Table 1 (2010) Segment Revenue ($ Billions) Segment Profit ($ billions) Energy Infrastructure 37.51 7.27 Technology Infrastructure 37.86 6.31 NBC Universal 16.90 2.26 G.E. Capital 47.04 3.26 Home and Business Solutions 8.64 .45 Total 147.95 19.55 G.E.’s business is classified in 5 business segments: (1) energy infrastructure, (2) technology infrastructure, (3) NBC Universal, (4) G.E. Capital, and (5) Home and Business Solutions. G.E. believes that (1) energy infrastructure and (2) technology infrastructure are growth segments. G.E. believes that (3) NBC Universal and (4) G.E. Capital are segments which have moderate growth and (5) Home and Business Solutions is at the end of its life cycle as a segment of G.E.’s business. Discussion Questions 1. Construct a G.E. product portfolio matrix for G.E.’s business segments. 2. Based upon the matrix, how should G.E. allocate its resources? 166 Harvard Business Cases for Chapter 7 NTT DOMO – Joint Venture with Tata in Indian Mobile Telecom Product Number W10004 UTV and Disney: A Strategic Alliance Product Number 910M43 Professor Case for Chapter 7 Oracle 167 Chapter 8 Growth Via Strategic Alliances 168 Learning and Assessment Goals 1. Understand key factors to consider in strategic alliance formation. 2. Understand how strategic alliances can be modes of domestic and international growth. 3. Understand th e different types of strategic alliances and the benefits each type can generate. 4. Understand the role that joint ventures play in firm growth. 5. Develop an understanding of the downside of strategic alliances. 169 Strategic alliances are agreements among firms in which each commits resources to achieve a common set of objectives. Strategic alliances result when firms agree to share resources for R&D, manufacturing, and/or distribution. Companies may form strategic alliances with a wide variety of p layers: customers, suppliers, universities or divisions of government. Through strategic alliances, companies can improve competitive positioning, gain entry to new markets, supplement critical skills and share the risk or cost of major development projec ts. To form a strategic alliance, companies should: (1) define their business vision and strategy in order to understand how an alliance fits their objectives, (2) evaluate and select potential partners based on the level of synergy and the ability of the firms to work together, (3) develop a working relationship and mutual recognition of opportunities with the prospective partner, (4) negotiate and implement a formal agreement that includes systems to monitor performance 4. Strategic alliances are formed fo r many reasons. Some rationales are to: (1) reduce costs through economies of scale or increase knowledge, (2) increase access to new technology, (3) inhibit competitors, (4) enter new markets, (5) reduce cycle time. One benefit of strategic alliances is that the firm does not need to invest significant capital to engage in them. A second benefit is that strategic alliances may result in quicker growth than internal development. A third benefit is that it is easier to withdraw from alliances as opposed t o acquisitions or internal development. With acquisitions the firm must divest businesses, which can be time -consuming. With internal development, this type of growth may have become an integral part of the firm and may not be divestible. Figure 8.1, on the next page, discusses strategic alliance formations. 170 Figure 8.1 Key Factors to Consider in Strategic Alliance Formation An integrated strategic alliance network is based upon several criteria. Trust is probably the most important. Trust No one firm can create all of its resources to be competitive over time . Pressures from globalization along with changes in regulation and technological factors have resulted in firms reaching out to partners to access their complementary capabilities. A key consideration in alliance formation is the relationship between al liance partners. Trust between partners is fundamental to sustaining alliances 1. In many cases, firms will not enter into alliance relationships unless they feel that they can trust their partners and/or partners have established a reputation of trustwor thiness. In 2006, Capitaland’s alliance with Walmart to open up its new malls in China showed the trust each firm had with the other. These partners have agreed to open up 17 new malls in China in 2007. Assume that Firm A and Firm B enter into an allia nce. The alliance will continue until both firms are receiving benefits which they could not have attained working alone. For example, Firm A may benefit from the distribution infrastructure of Firm B, while Firm B may benefit from economies of scale and /or economies of scope. As Firm A and Firm B develop their alliance over time both firms may be more comfortable sharing other types of resources. Additional alliances between Firm A and Firm B may be easier and quicker to implement. Firm A Firm B Firm C 1. As Firm A learns how to develop and implement its strategic alliances with B, an additional alliance with Firm C should take less time and be easier to implement (assuming all other conditions are held constant) Trusting Relationship Additional Alliance Second Alliance 2. Firm C must have assets or mar ket positions that Firm A view as important 3. Firm C’s risk associated with forming an alliance with Firm A is reduced due to A’s trusting relationship with Firm _ 4. Firm A’s risk of aligning with Firm C is not changed First Alliance 171 Scale of Coverage As firms observe the development of alliances between Firm A and Firm B, Firm C may become interested in obtaining an alliance with Firm A and/or Firm B. As this process occurs over time, firms develop alliance networks which could be beneficial to all me mbers of the network. This network can allow each firm the opportunity to tap into its partners’ resources which may serve as a source of sustained competitive advantage 2. In addition, prior alliance experience is important in being able to build and uti lize routines and mechanisms to build alliance networks 3. A firm’s alliance opportunities are likely to be related to its possession of resources. The number of potential partners that are willing to align with a firm is a function of the firm’s attracti veness to other firms 4. A firm’s attractiveness to potential partners, in turn, depends on the value that it can add to them. The value that a firm can provide to its partners will occur when a firm can make available assets that are difficult for the pa rtners to create on their own. The greater a firm’s stock of resources, the greater the firm’s attractiveness to partners, and the greater the firm’s collaboration opportunities 5. However, firms willing to share their resources are likely to demand asset s from their partners that go beyond the financial assets they can obtain at the going rates from the capital market 6. All alliance partners are linked to other alliance partners within the same network. The position of the network and the quality of its ties with others allows firms to access the resources and capabilities of others within the network 7. Alliances that generate advantage are characterized by: creation of relationship -specific assets, access to complementary capabilities, and substantial flow of knowledge between the partners 8. Research evidence on alliances suggests that such characteristics of partnerships are systematically created by firms not only through careful selection of partners, but also through deliberate investment in these features. Relationship -Specific Assets The term relationship -specific assets refers to the assets of a partner that are customized to the relationship with another partner, so that the combination of assets is idiosyncratic. Such customization would cr eate some barriers to imitation by competitors. Complementary Capabilities Complementary capabilities is similar to the concept of co -specialized assets 9. One example of complementary capabilities is when pharmaceutical firms combine R&D operations. In addition, reputation and prior experience play an important role in partner assessment 10. Interfirm Knowledge Sharing Interfirm knowledge sharing is defined as a regular pattern of firm -level interactions that permit the transfer, recombination, or crea tion of knowledge 11. A firm’s ability to absorb knowledge from a partner depends on prior related knowledge or “absorptive capacity” 12. Cohen and Levinthal (1990) define absorptive capacity as the firm’s ability to recognize and assimilate new knowledge and then apply it to commercial ends. As each firm interfaces more with its partners, greater knowledge is transferred between partners. When American Airlines entered the One World Airline alliance, it 172 made available to all partners its reservation syst em which was viewed as one of the best in the world. There are two general types of strategic alliances. Scale alliances are partnerships in which partners contribute similar resources 13. Link alliances are partnerships in which firms contribute different resources 14. Table 8.1 identifies the possible positive ramifications of alliance formation. Table 8.1 Ramifications of Alliance Formation Scale Alliances Link Alliances  Economics of scale  Expansion into new markets  Expansion into restricted markets  Building international networks  Economics of scope  Developing new products/services  Obtaining new resources  Increase rate of learning  Transfer of technology  Obtaining value chain benefits Scale Alliances Scale alliances will be discussed first . Scale alliances can result in economies of scale . Economies of scale are improvements in efficiency as a result of increasing utilization of assets. Airlines are examples of firms that utilize scale alliances to generate econo mies of scale by increasing the number of passengers per flight. There are three major international airline alliances that provide alliance partners with global coverage. Table 8.2 identifies the partners in the three major airline alliances. 173 Table 8 .2 Global Airline Alliances (2012) Star OneWorld Skyteam Adria American Airlines Aeroflot Aegean British Airways Aeromexico Air Canada Cathay Pacific Air Europa Air China Finnair Air France Air New Zealand Iberia Alitalia ANA Japan Airlines (JAL) China Eastern Asiana Airlines LAN China Southern Austrian Malev Czech Airlines Blue1 Mexicana Delta Airlines British Midland International Qantas Kenya Airways Brussels Airlines Royal Jordanian Tarom Croatia Airlines S7 Airlines Vietnam Airlines Egyptair Airbelin Airlines Korean Airlines LOT Polish Airlines Lufthansa Scandinavian Airlines Singapore Airlines South African Airways Spanair Swiss TAM Tap Portugal Thai Turkish Airlines United/Continental U.S. Airways Ethiopian Airlines These alliances permit partners to expand into new markets . One benefit of alliances of this type is they provide for expansion at minimal costs. Scale alliances can also be utilized to expand into new markets without incurring acquisition costs or the risks associated with foreign direct investment. Anheuser Busch has recently formed an alliance with Tsingtao, China’s leading brewer. This alliance provides Anheuser Busch with access to the second largest (following the United States) beer market in the world. Kansas City Southern Railway has entered into a strategic alliance with Mi -Jack to obtain access to the Panama Canal. This alliance has created an ocean -to-ocean transshipment service between the Atlantic and Pacific oceans on a railway that runs parallel to the Panama Canal 15. This railway serves as an important link between European, North American, and Asian markets. Scale alliances allow firms to enter restricted markets that may not otherwise be accessible. In some markets, acquisitions and direct investment are not permitted. Thus, strategic alliances allow firms to grow into international markets from which they had 174 been previously restricted. Often international acquisitions are restricted because of government policy. Russia’s oil and natural gas industry is state owned. BP PLC (Great Br itain) has an alliance with TNK (Russia), which has permitted BP to develop the oil and gas industry within Russia 16. Another benefit of scale alliances is that international networks can be developed . Caterpillar has formed an alliance with Mitsubishi to manufacture heavy equipment machinery for Pacific Rim markets. The alliance is important because it gives Caterpillar a position in its primary competitor’s (Komatsu) home market. As shown in Table 8.2, airlines can build international networks quickl y. General Motors has strategic alliances with many other global auto manufacturers (Saab, Suzuki, Isuzu, Toyota) to help build its international network 17. Link Alliances Link alliances have many benefits. One benefit is economies of scope . Economies of scope are cost savings that the firm creates by successfully transferring some of its capabilities and competencies that were developed in one of its businesses to its other businesses. Burlington Northern Santa Fe Railroad has an alliance with Swift Transportation (trucking) to offer intermodal services for domestic and international shipments 18. Intermodal services utilize more than one mode of transportation. By utilizing railroads, trucking firms can reduce costs. Rail ca rriers benefit by having greater access to markets. DHL Worldwide and Lufthansa AG (Germany) entered into a strategic alliance to achieve economies of scope. Lufthansa utilized DHL ground infrastructure (e.g. trucks) to provide for pickup and delivery of freight 19. DHL utilized Lufthansa for the air transportation of its shipments 20. At times, firms will enter into alliances to obtain access to new products or services . Roche AG and GlaxoSmithKline PLC have an alliance for the development, marketing, and distribution of a once -a-month osteoporosis pill, Boniva. The global market for this pill is estimated at $5.7 billion 21. Roche developed the drug and entered into the alliance with GlaxoSmithKline to market and distribute the drug. Glaxo’s sales force is much larger and more dispersed worldwide than Roche’s 22. In addition, Glaxo’s sales force has established relationships with doctors who treat osteoporosis. Monsanto Co. has teamed up with Genaissance Pharmaceutical and the U.S. Government to ma p the genetic code of soybeans. The hope is to supply farmers with technology that makes the crops more resistant to disease and drought 23. General Motors and DaimlerChrysler have alliances with the Department of Energy to develop hydrogen fuel cells for cars 24. Novartis AG and Schering have created a strategic alliance to develop a new drug, PTK/XK, which treats colorectal cancer 25. Many cancer drugs kill both cancerous and healthy cells 26. This is one of the few cancer medicines that focus on cancer cells only. Siemens has an alliance with Ejoala AG, a German fashion retailer, to design and market cell phones that are fashionable. This venture is an attempt to differentiate cell phones from a customization perspective 27. Samsung Electronics has al so introduced a fashion cell phone as a result of an alliance with designer Ann Sui 28. Link alliances allow partners access to new resources . Hewlett -Packard has alliances that provide the firm with new resources in software (Microsoft), chip technology ( Intel), and systems integration resources (Accenture, BearingPoint) 29. Emerson’s alliance with Shell Philippines has provided Shell with technology capabilities for extracting natural gas deposits and gives Emerson a market presence along the Pacific Rim 30. 175 By combining different resources, firms can increase their rate of learning . Corning has an alliance with Cisco where it shares its expertise in optics and photonics with Cisco to build Internet -scale optical networks. This learning enables cable and DSL providers to install optical infrastructures faster and cheaper 31. Boeing and Airbus have increased their rate of learning with respect to aircraft manufacturing processes. United Technologies is manufacturing cabin air conditioning and temperature co ntrol systems for the new Airbus A380 and Boeing 787 32. Jamco Corp. of Japan is providing Airbus access to ways of producing key structure elements obtained from advanced composite materials 33. DaimlerChrysler AG has partnered with European Aeronautic De fense and Space Program (an owner of Airbus) to learn new production processes 34. It is possible that unwanted technology transfer could occur from link alliances. The key to preventing technology transfer is to develop long -term relationships with respect to alliance partners. This process is similar to the development of long -term relationships with customers that firms attempt to build. Technology transfer is common in Japan because of the strong partnership relationships that exist among firms within and across industries 35. For example, Japanese aircraft technology has been applied to numerous industries. The process called “spin -off” includes (1) production control technologies for electronic products, (2) design technologi es for ships and automotive vehicles, and (3) manufacturing technologies for industrial products, hydraulic equipment, and electronics 36. The transfer of technology in link alliances implies that one firm may receive greater benefits than its partner(s). In some cases both firms may benefit. The NUMMI alliance between General Motors and Toyota is an example of technology transfer benefiting both partners. General Motors obtained access to Toyota’s manufacturing processes. Toyota learned how to utilize t echnology to run a manufacturing operation in the United States 37. Royal Dutch Shell has an alliance with Kuwait Petroleum to explore opportunities within the downstream value chain 38. Shell provides its technology experience and Kuwait Petroleum supplies oil for refining 39. China is requiring the three bidders for its four nuclear reactors (valued at $2 billion each) to agree to technology transfer before it awards the contract 40. The three bidders --British Nuclear Fuels PLC, Areva SA (France), and Siemen s (Germany) --must agree to assist making China self -sufficient from an energy perspective by transferring technology and teaching China how to make phase 3 plants 41. Phase 3 plants generate more than 1000 megawatts of power. Sometimes alliances are formed to obtain value chain benefits that each firm is lacking. The DHL alliance with the United States Postal Service (USPS) allows DHL to expand its U.S. infrastructure network. This alliance is especially valuable since DHL acquired Airborne in 2003. By e xpanding its infrastructure, DHL is able to compete more effectively on costs with United Parcel Service (UPS) and FedEx. This alliance gives USPS access to DHL’s extensive global infrastructure. Several rental car firms are using large retailers to focus upon distribution of rental cars. Wal -Mart has alliances with Budget, Thrifty, and Enterprise 42. Sears has an alliance with Avis 43. These alliances increase Wal -Mart and Sears’ offering in non - traditional segments. The rental car firms increase coverag e to locations other than airports. 176 Joint Ventures A joint venture is a form of strategic alliance in which two or more firms create a legally independent company to share resources to develop a competitive advantage. Joint ventures provide a way to t emporarily combine the different strengths of partners to achieve an outcome of value to both. Petrochina Co., an oil and natural gas producer, has a joint venture with China National Petroleum Corp. to expand operations outside of China 44. China National Petroleum Corp. has over 30 oil and gas investments outside of China. Las Vegas Sands and Hong Kong’s Regal Hotels International have a joint venture to develop hotel/casinos in the Hong Kong area. Las Vegas Sands will lease and manage the casinos while Regal Hotels will build the complex 45. In 2004, the Virgin Group, headed by Richard Branson, and Mojave Aerospace Ventures, led by Paul Allen, entered into a joint venture to develop and test a reusable space vehicle. During 2004, the vehicle was success fully launched to an altitude of 62 miles 46. The venture, Virgin Galactic, is scheduled to begin business in 2007 to transport tourists into space. Seats on the vehicle are expected to cost between $100,000 and $200,000 each 47. Joint ventures can result in new products. Paris -based retailer GroupeDanone is introducing new products for the Chinese market. Its joint venture with Hangzhou Wanaha Group, China’s largest beverage company, focuses upon introducing healthy beverages targeting urban consumers 48. The new product, Nutri -Express, represents an attempt to change Wahana’s position from a mass producer of beverages for children to target beverages for adults. Sony has formed a joint venture with Toyota Industries Corp., a Japanese machinery maker, t o produce liquid crystals for digital cameras and camcorders 49. This venture, St. Morice Display, is an attempt by Sony to improve its electronics position in Japan 50. Ryder has a joint venture with Toyota Tsusho America, a Toyota group company that prov ides iron, steel, and textiles to automobile manufacturers. The venture, TTR Logistics, has Toyota Tsusho providing the materials and Ryder managing the flow and warehousing of raw materials. Samsung Corning Precise is a joint venture that develops and ma nufactures high quality glass substrates. This joint venture has created several new manufacturing processes 51. In 2000, Transplace.com (TPC) was created. TPC is an Internet -based global transportation logistics company. TPC includes substantially all o f the logistics business of the following transportation carriers: Covenant Transport, Swift Transportation Co, U.S. Xpress Enterprises, and Werner Enterprises 52. In 2002, Sony and Ericsson created a joint venture by merging their mobile phone businesses 53. The new venture, Sony Ericsson Mobile Communications, is equally owned (50 percent) by both partners. Both partners believe that this joint venture will increase their share of the international mobile phone market. In 2005, this joint venture establ ished a partnership with the Women’s Tennis Association (WTA) that made Sony Ericsson Mobile Communications the worldwide title sponsor of the Women’s Tennis Tour. Under the terms of the deal, the WTA Tour will be renamed the Sony Ericsson WTA Tour, and b oth firms will enjoy a significant on -course presence in the hundreds of televised matches around the world. In 2004, Comcast and Microsoft established a joint venture that used Microsoft’s “Foundation” software for digital cable 54. This venture is one of Microsoft’s attempts to enter home entertainment. The Foundation software works like an operating system for 177 set -top boxes in the same way Windows is an operating system for personal computers. Once it is installed, new features can be added to the cabl e box similar to the way software can be added to PCs 55. On March 4, 2005, Hon Hai Precision Industry Co, one of the world’s biggest contract manufacturers of electronics, entered into a joint venture with Hewlett -Packard for new product development 56. Hon Hai is competing against Flextronics International Ltd. to be the world’s biggest producer of electronics goods from a supplier perspective. Hon Hai surpassed Flextronics International Ltd. in 2004 as the world’s biggest contract manufacturer of elect ronics goods. Hon Hai makes computers, mobile phones and other products for companies including Apple Computer Inc. and Sony Corp 57. In 2005, Yahoo and Verizon Communication announced plans to offer an Internet portal service to Verizon customers. The Ve rizon agreement helps further Yahoo’s efforts to generate additional revenue and could attract new users to Yahoo from other rival Internet services 58. The benefit to Verizon is offering value -added services to its customers. With the significant benefits offered by strategic alliances and joint ventures, one would wonder why all firms do not engage in developing alliances. The reason is that some alliances have negative ramifications. The Downside of Strategic Alliances and Joint Ventures One negative a spect of strategic alliances is that some partners have more to lose than others. Novartis AG has provided $375 million to Vectura Group PLC and Arakis Ltd. to develop a drug for smoker’s lung disease 59. Novartis is willing to pay substantial costs to at tempt to develop a new product by combining the technology capabilities of these two firms. Vectura and Arakis will receive royalties if the product is commercialized. If the new drug fails, the firms have no financial commitment to Novartis AG 60. The fu nds represent a sunk cost for Novartis AG. At other times, strategic alliances may lead to an unwanted acquisition. In 2004, TCL Communications Technology Holdings and Alcatel SA formed a joint venture to achieve a stronger position within the cell phone i ndustry. Subsequently, TCL Communications hostilely acquired Alcatel 61. Unwanted technology transfer is another downside of alliances. Broadcom Corporation is suing Qualcomm Inc., Texas Instruments, and Maxim Integration Products, Inc. for patent infring ements. Broadcom specializes in the manufacturing of chips for various segments of the communication industry. Strategic alliances can also result in costs to end an alliance. On February 14, 2005, General Motors agreed to pay Fiat $1.99 billion to end t heir alliance 62. The agreement preserves GM’s access to Fiat technology that GM believes it can use in improving its unprofitable European operations 63. For Fiat, the agreement provides much needed funds. Strategic Alliances and the Recession During the economic recession (2007 -2010) the overall formation of strategic alliances decreased by approximately 40 percent. 64 The focus of many firms during the global recession was survival. The formation of strategic alliances is more oriented toward long term growth opportunities rather than attempting to stay in business. Higher risk may be another factor as to why firms decided not to aggressively pursue strategic alliances. 65 178 As stated by Harbir Singh, Wharton strategy professor, “You would say that alliance and network capability is secondary to the core focus of the firm. …Really, what it comes down to is the tension between creating shared resources versus protecting one’s own resources.” Only a third of the respondents to a recent study conducted by Ernest and Young felt that the recent recession was a good time to attempt to engage in strategic alliances. 66 If firms are to prosper after the global recession, strategic alliances will be part of a firm’s growth strategy. Organizations grapple wit h how to build external networks – what Singh calls “the extended enterprise” -without shifting too much focus away from the core needs of the firm. “In order to be successful in the extended enterprise world, you have to invest in alliances and network ca pabilities,” Singh said. Singh suggest that what firms need are “innovation networks.” An “innovation network” is a web of people, institutions, or companies outside of a firm that helps it solve problems or come up with new ideas. While organizations h ave formed alliances and strategic partnerships for years, experts say this web of connections is becoming increasingly important today. In terms of looking post -recession, executives were pretty evenly split between expanding into new geographies, incr eased use of strategic alliances, acquisitions, speed to market and divesting non -core business. 67 “Companies that maintain a sustainable business model through the current downturn will not only survive the downturn, but will emerge stronger and in the b est position to take advantage of new growth opportunities as the economy improves,” stated a senior consultant of Ernst & Young LLP. From a strategic alliance perspective, opportunities in the areas of energy, agriculture, mining, pharmaceuticals, infras tructure and construction were highlighted as the ones where strategic alliances may be either developed or expanded. At a summit that took place in Brazil in 2010, government representatives from the BRIC (Brazil, Russia, India, China) countries conclud ed that they needed a more closely linked network as the global economic recession was ending (2010). Strategic alliances representative between the BRIC markets, Argentina, Paraguay, and Uruguay were invited to participate in alliance formation with the BRIC markets. The BRIC position indicated that the four countries will coordinate their standpoints, strengthen unity and face financial crisis together to take the lead in economic recovery. As the global recession was ending in 2010, China and India bot h displayed good momentum in economic growth. Russia and Brazil also were recovering fast. 68 These countries are now better positioned to increase the scope and size of strategic alliances as the global recessions ends. Strategic alliances formation may be a crucial link in moving these emerging markets into fully developed markets. The Future of Strategic Alliances Alliances are beginning to account for a significant percent of a firm’s revenue 69. Many senior level executives view strategic alliances as a primary means of growth 70. Alliances provide for a quick way to grow and have the potential to provide firms both cost and differentiation advantages. While scale alliances primarily increase scale of operations, link alliances can provide firms acc ess to new resources and capabilities. As firms learn from alliances, they make better decisions with respect to future alliance partners. Firms will continue to engage in strategic alliances as a primary mode of growth as long as trust exists between pa rtners. Firms that are viewed as trustworthy can obtain an advantage from the perspective of entering into future strategic alliances 71. As firms build an alliance network and engage in trusting behavior, potential alliance partners will perceive these fi rms as good alliance partners. As such, firms that have a 179 reputation of trust will have many more opportunities to engage in additional alliances than firms who do not. In addition, as firms gain experience, they will be viewed more positively because o f their experience with respect to alliance formation. Strategic Alliances and Capstone Simulation While strategic alliances are not currently incorporated into the Capstone simulation they could and this section discusses how they could be incorporated. The discussion assumes that products are somewhat standardized and production lines can manufacture only one product . Table 8.3 Production Schedule Name Primary Segment Units Sold Unit Inventory Revision Date 2nd Shift & Overtime Automation Next Round Capacity Next Round Plant Utiliz. Baker Trad 979 217 12/5/2013 0% 5.0 1,300 84% Bead Low 2,035 150 5/25/2007 46% 7.0 1,400 145% Bid High 785 114 12/18/2013 78% 3.0 600 176% Bold High 306 89 7/27/2013 0% 3.0 600 58% Buddy Size 251 103 9/18/2013 0% 3.0 650 50% Cake Trad 1,325 171 8/26/2013 40% 5.5 1,000 140% Cedar Low 2,230 172 1/29/2012 61% 7.5 1,450 159% Cid High 684 86 11/15/2013 8% 3.0 600 107% Coat Pfmn 710 46 11/3/2013 17% 4.0 600 116% Cure Size 735 66 9/10/2013 25% 4.0 600 125% It may be beneficial for Baldwin and Chester to form an alliance. A scale alliance would benefit both firms. Cure is running 25 percent overtime on this line and Buddy is only utilizing 50 percent of its production capacity. If Cure would run 25 percent of its production on the Buddy line, it would not be incurring any overtime. It would be running at 100 percent. By taking 25 percent of Cure’s size units on its Buddy line, Buddy would increase its utilization from approximately 50 to 75 percent. Buddy woul d be generating lower unit costs because of the increased volume it is producing. Additional scale alliances may also result in lower costs for both firms. Cake (traditional) product line is running at 40 percent overtime. If 16 percent of Cake’s product were running on Baker’s traditional line, Baker could increase its capacity to 100 percent, and Cake’s overtime would be reduced by 16 percent. By both firms’ sharing product lines economies of scale would be resulting for the Baker and Buddy line. Cake an d Cure would reduce the cost of overtime. From a financial perspective, we need to examine product line profitability. Listed in Table 8.4 are the net margins for Baldwin and Chester’s products. 180 By moving 25 percent from the Chester size line (Cure) to the Baldwin size line (Buddy), Buddy may become a profitable product and Chester’s size line (Cure) may generate higher net margin than it currently is ($2596). In addition, both firm’s traditional product lines, Baker and Cake, could be generating higher net margins than they currently are as a result of the scale alliance In addition to scale alliances, the Capstone simulation could incorporate link alliances. Table 8.5 (se ction a) shows the high end statistics; (section b) identifies the high end customer buying criteria; (section c) identifies the top product in the high end segment. Table 8.5 Section a High End Market Segment Analysis High End Statistics Total Industry Unit Demand 3,448 Actual Industry Unit Sales 3,448 Segment % of Total Industry 11.9% Next Year’s Segment Growth Rate 16.2B Table 8.5 Section b High End Customer Buying Criteria Expectations Importance 1. Ideal Position Pfmn 10.7 Size 9.3 43% 2. Age Ideal Age = 0.0 29% 3. Reliability MTBF 20000 -25000 19% 4. Price $29.00 – 39.0M 9% Table 8.4 Net Margin by Product Baldwin Segment Product Net Margin Traditional Baker $4779 Low End Bead $8489 High End Bid $4502 Performance Bold ($351) Size Buddy ($791) Chester Segment Product Net Margin Traditional Cake $5848 Low End Cedar $8984 High End Cid $3996 Performance Coat $513 Size Cure $2596 181 Table 8.5 Section c Top Products in High End Segment Name Market Share Units Sold to Seg Revision Date Stock Out Pfmn Coord Size Coord List Price MTBF Age Dec.

31 Bid 23% 785 12/18/2013 114 10.7 9.3 $39.00 23500 1.19 Fist 20% 688 12/22/2013 91 10.2 9.8 $39.00 25000 1.18 Dixie 20% 688 12/3/2013 120 10.2 9.8 $39.00 24000 1.23 Cid 20% 684 11/15/2013 86 10.2 9.8 $37.50 23000 1.25 Adam 9% 313 7/7/2013 97 8.7 11.3 $37.50 21000 1.60 Bold 6% 195 7/27/2013 89 8.8 13.5 $34.00 22000 1.67 From section a, we see that the industry demand, 3448 units, was met. In most cases this means that some firms generated inventory. This is the case in the example.

Section c shows that all firms had inventory at the end of the year. Only 4 firms have significant shares in the high end segment. From section c, we see that Bid (23 percent), Fist (20 percent), Dixie (20 percent), and Cid (20 percent) are the dominant products in the s egment. Adam (9 percent) and Bold (6 percent) have smaller market shares. An interesting point is that all 4 of the dominant firms had late revision dates (November or December). This is relevant because positioning is 43 percent of the customers’ decision in the segment (section c). This high end segment needs products to be continuously R&D’ed. In order to conduct R&D, money is needed.

An examination of each firms’ year end cash ba lance is identified in Table 8.6 . Table 8.6 Year End Cash Balance ($) Firm Balance ($) Andrews 6855 Baldwin 3862 Chester 13,866 Digby 7236 Erie 8031 Ferris 7774 From Table 8.6, Chester ($13,866) has about 3 times as much money to invest than does Baldwin ($3862). Chester has more cash available at year end than any other firm. One way to dominate this high end segment is to invest heavily in positioning to remain close to the ideal position. Due to positive cash balances Bid could remain the top product in the segment and Cid could also increase its market segment s ize. Baldwin must have funds to R&D Bid. This money would come out of the pooled cash of both firms. The same is true for the Cid product. In essence, a link alliance has been formed where Chester provides the majority of the cash. Bid’s value to Cid is it s positioning. Bid is closer to the ideal position than Cid. By using a portion of Bid’s production line, Cid could sell some products at the ideal position (Table 8.5 section b). 182 From the discussion above, the Capstone simulation could incorporate both s cale and link alliances. 183 Discussion Questions 1. Explain the difference between an alliance and a joint venture. 2. Is the Oneworld airline alliance a scale or link alliance? Why? 3. Is expanding into new markets a benefit of scale or link alliances? Explain. 4. Explain economies of scope. 5. How can technology transfer be minimized? 6. How does the Capstone Simulation incorporate alliances? 7. Will alliances be more or less important in the future? Explain. 8. What is the “extended enterprise”? How is it related to the concept of an “innovation venture”? Briefly explain. 9. At the BRIC summit in 2010, what was concluded? 184 References 1. Zaheer, A., McEvily, W., Perrone, V. 1998. Does trust matter? Exploring the effects of interorganiz ational and interpersonal trust on performance. Organization Science 9(2), 141 -159. 2. Gulati, R., Nohria, N., and Zaheer, A. 2000. Guest editor’s introduction to the special issue: Strategic networks. Strategic Management Journal 21: 199 -201. 3. Kale, P ., Singh, H., and Perlmutter, H. 2000. Learning and protection of proprietary assets in strategic alliances: Building relational capital. Strategic Management Journal 21: 217 -237. 4. Ibid 5. Ibid 6. Ahuja, G. 2000. The Duality of collaboration: Inducemen ts and opportunities in the formation of interfirm linkages. Strategic Management Journal 21: 317 -343. 7. Dyer, D. and Kale, P. 2007. Relational capabilities: drivers and implications in dynamic capabilities . Blackwell Publishing. Malden, MA. 8. Ibid 9. Teece, D.J. 1988. The competitive challenge: strategies for industrial innovation and renewal . Ballinger. Cambridge, MA. 10. Dyer, D. and Kale, P. Relational capabilities: drivers and implications in dynamic capabilities . 11. Grant, R.M. 1996. Toward a knowledge -based theory of the firm. Strategic Management Journal 17 (Winter Special Issue): 109 -122. 12. Cohen, W. and Levinthal, D. 1990. Absorptive capacity: A new perspective on learning and innovation. Administrative Science Quarterly 35: 128 -152. 13. Dussauge P, Garrette B, and Mitchell W. 2004. Asymmetric performance: the market share impact of scale and link alliances in the global auto industry. Strategic Management Journal 25: 701 -711. 14. Dussauge P, Garrette B, and Mitchell W. 2000. Learnin g from competing partners: outcomes and duration of scale and link alliances in Europe, North America, and Asia. Strategic Management Journal . 21: 99 -126. 15. Pettus M. 2003. Growth from chaos . Praeger: Westport, Ct. 185 16. Cummins, C. 2005. BP’s chief says g rowth streak is sustainable. Wall Street Journal. March 8. 17. Dussauge, Garrette, and Mitchell. Asymmetric performance: the market share impact of scale and link alliances in the global auto industry. 18. Pettus. Growth from chaos. 19. Ibid. 20. Ibid. 21. Whalen J. 2005. FDA approves osteoporosis drug for monthly use. Wall Street Journal. March 28. 22. Ibid . 23. _____. 2005. Unlocking the genetic code of soybeans. Wall Street Journal . April 1. 24. _____. 2005. GM and Daimler plan fuel cell cars. Wall Str eet Journal. March 31. 25. Greil A. 2005. Novartis, Schering to delay cancer drug filing. Wall Street Journal . March 22. 26. Ibid. 27. Rhoads C. 2005. Cell phone makers will heed fashion world’s call. Wall Street Journal . March 18 . 28. Ibid. 29. Hewlett -Packard 2004 Annual Report . 30. Emerson 2004 Annual Report. 31. Cisco 2004 Annual Report. 32. Michaels D. and Lunsford J. 2005. Stream -lined plane making. Wall Street Journal . April 1. 33. Ibid. 34. Ibid . 186 35. Friedman D. and Samuels R. 1992. How to succeed without really flying. The Japanese aircraft industry and Japan’s technology ideology . Cornell University Press: Ithaca, N.Y. 36. Ibid. 37. Kale P, Singh H, and Perlmutter H. 2000. Learning and protection of propriety assets in strategic alliances: Building relational capital. Strategic Management Journal. 21(3): 217 -237. 38. ____. 2005. Royal Dutch/Shell Group. Wall Street Journal. March 23. 39. Ibid. 40. Ortolani A. 2005. Technology transfer is critical to winning China reactor job. Wall Street Journal. May 12. 41. Ibid. 42. Johnson A. 2005. Renting a car at Wal -Mart. Wall Street Journal . March 22. 43. Ibid. 44. _____. 2005. Petrochina Co. Wall Street Journal . March 24. 45. _____. 2005. Hotel -Casino project in Macau planned with Las Vegas Sands . Wall Street Journal . March 15. 46. _____. 2004. Virgin Group signs deal with Paul Allen’s Mojave Aerospace. New York Times . September 27. 47. Ibid. 48. ______. 2004. Joint venture will launch healthy beverage in China. Wall Street Journal. November 1. 49. Sony 2010 Annual Report 50. Ibid 51. Corning 2010 Annual Report 52. Pettus. Growth from Chaos 53. Sony 2010 Annual Report 54. Grant P. and Guth R. 2005. Microsoft moves into cable set top boxes. Wall 187 Street Journal . November 11. 55. Ibid 56. ______ 2005. Hon Hai. Wall Street Journal. March 4. 57. Ibid 58. Latour A. an d Delaney K. 2005. Yahoo and Verizon plan to offer co -branded web portal service. Wall Street Journal . January 18. 59. _____. British companies license drug to fight smoker’s lung. 60. Ibid 61. Meyer J. 2005. TCL will unwind handset venture with Alcatel SA. Wall Street Journal . May 18. 62. ______. 2005. GM agrees to pay Fiat $1.99 billion to settle dispute. Wall Street Journal. Feb 14. 63. Ibid 64. ____ “Strategic Alliances,” Bain & Publications, December 2010. 65. Ibid 66. Ibid 67. Ibid 68. ___ “Brazil and India Renew Commitments to Strategic Alliances,” Asia Pacific Journal, April 16, 2010. 69. ___ “Can we Innovate Our Way Out of a Recession,” Forbes, July 1, 2009. 70. ___ “The Depth of the Global Recession Impact has permanently Changed the Rules of the Game,” Ernst & Young Publications, June 15, 2009. 71. Ibid 18 8 OneWorld Airline Strategic Alliance Mini Case Table 1 AMR: Patent of American Airlines Financial Data Year 2008 2009 2010 Total Revenue ($ billions) 23.77 19.92 22.17 Net Income ($ billions) (2.07) (1.47) (.47) AMR, the parent of American Airlines, lost $4.01 billion from 2008 -2010 (Table 1). While size of the loss has decreased from 2008 to 2010, AMR lost $436 million in the first quarter of 2011. American Airlines is one of the largest airlines in the world. As such, it is an integral part of the OneWorld airline alliance because it provides se rvice to the largest consumer market in the world (United States). American Airlines began to offer additional benefits to the OneWorld alliance members and their cu stomer base in 2010. On March 27, American Airlines, British Airways and Iberia (two existing OneWorld carriers) implemented fully coordinated flight schedules. Also in 2011, American Airlines launched new service between the east coast of the U.S. and Budapest, Hungary, Barcelona, and Madrid, Spain. On April 1, American Airlines and Japan Airlines (another OneWorld member) coordinated transpacific service between North America and Asia. American Airlines recently entered into Chapter 11 Bankruptcy on November 29, 2011. Discussion Questions 1. From the perspective of the OneWorld alliance, what would you recommend if American Airlines goes out of business? 2. What markets should the OneWorld alliance establish new positions in? 189 Harvard Business Cases for Chapter 8 Adcock Ingram: Decisions and Motives that Steer Acquisitions Product Number 910C08 Roche’s Acquisition of Genetech Product Number 210040 Professor Case for Chapter 8 Chevron 190 191 Chapter 9 Acquisition Strategies 192 Learning and Assessment Goals 1. Understand the positive and negative ramifications of acquisitions. 2. Understand the process for achieving successful acquisitions. 3. Understand why due diligence is importa nt. 4. Understand why the pace and size of acquisitions has increased recently. 5. Develop an understanding of which type of firm (acquiring or target) results in earnings of above average returns over time. Understand why this relationship exists. 193 Impact of the Global Recession on Merge rs and Acquisitions The Mergers and Acquisitions Journal reported, “Global M&A totals $2.3 trillion (2010), up from $1.9 trillion (2009). The U.S. accounted for 34% of the world’s acquisitions. The energy and powe r industries within the U.S. sector was the most active segment in 2010. 1 M&A activity in energy and power reached $482 billion in 2010, up from 38% in 2009. 2 From a geographic perspective some of the M&A activity seen in 2010 came from the emerging mark ets. For developing markets, M&A’s increased more than 84% over the same period in 2009. That is the largest percentage of growth these markets have ever experienced. 3 Emerging markets tend to be recovering from the global economic crisis faster than ful ly developing markets. 4 The pharmaceutical industry was especially active during the recession (2007 - 2010). The largest acquisition in 2009 was Pfizer’s purchase of Wyeth for $68 billion. 5 Swiss -based Roche acquired U.S. based Genentech for nearly $46.4 3 billion. 6 Merck & Co. (U.S. based) purchased Schering -Plough (U.S. based) for $45.70 billion. 7 These mergers and acquisitions were substantial considering we were in a global recession from 2007 -2010. 194 Table 9.1 shows the level of M&A activity for 2009. Table 9.1 Mergers and Acquisitions (2009) Target Name Target Nation Rank Value (millions of $U.S.) Acquiror Name Acquiror Nation Wyeth United States 68,479.70 Pfizer Inc. United States Rio Tinto PLC - WEA Iron Ore Australia 58,000.00 BHP Billiton - WEA Iron Ore Asts Australia Schering - Plough Corp United States 45,704.40 Merck and Co Inc United States Genentech United States 46,430.00 Roche Switzerland General Motors - Cert Assets United States 42,979.50 Vehicle Acq Holdings LLC United States RBS United Kingdom 41,878.70 HM Treasury United Kingdom XTO Energy Inc United States 40,659.10 Exxon Mobil Corp United States Burlington Northern Santa Fe United States 35,948.00 Berkshire Hathaway Inc United States Citigroup Inc United States 28,078.30 Preferred Shareholders Canada Cenvous Energy Inc Canada 23,312.90 Shareholders Canada Cadbury PLC United Kingdom 19,255.40 Kraft Foods Inc United States Petro -Canada Canada 18,245.80 Suncor Energy Inc Canada Liberty Entertainment Inc United States 14,449.10 DirecTV Group Inc United States NBC Universal Inc United States 14,400.00 Comcast Corp United States Endesa SA Spain 13,470.00 EnelSpA Italy Barclays Global Investors Ltd United States 13,345.20 BlackRockInc United States Source: Thomas Reuters The second largest acquisition was BHP Billiton’s acquisition of Rio Tinto’s for $58 billion (Table 9.1). 8 The largest cross -border transaction was U.S. group Kraft Foods’ purchase of the U.K.’s Cadbury for $19.3 billion (Table 9.1). 195 Table 9.2 shows the level of M&A activity for 2010. Table 9.2 Mergers and Acquisitions (2010) Target Name Rank Value (millions of $U.S.) Acquiror Nation Carso Global Telecom SAB de CV 27,483.40 Mexico Quest Communications 22,170.24 United States American Life Insurance Co Inc 15,543.54 United States British Sky Broadcasting 13,730.42 United States Coca -Cola EntrInc -NA Bus 13,440.65 United States Smith InternationInc 12,223.64 United States Williams Companies 11,750.37 United States Alcon Inc 11,120.36 Switzerland Zain Africa BV 10,7000 India PolyusZoloto 10,261.14 Kazakhstan Brasilcel NV 9,742.79 Spain Allegheny Energy Inc 8,943.94 United States Lihir Gold Ltd 8,577.51 Australia Bancaja SA 8,140.35 Spain Telstra Corp Ltd - Wholesale 7,932.60 Australia Source: Thomas and Reuters One of the first things that the table shows us is the size of acquisitions in 2009 compared to 2010. The top eight largest acquisitions in 2009 were all larger than the largest acquisition in 2010. While 13 of the largest 15 acquisitions in 2009 were done by the U.S., Australia, Canada and the United Kingdom, these countries did not dominate acquisitions in 2010. During 2010, firms from Mexico, Switzerland, Spain, Kazakhstan, and India all made significant acquisitions. Cross -border M&A activity rose to $389 billion in 2010, up from $243 billion in 2009. These ac quisitions accounted for 36.5% of overall worldwide M&A volumes. 9 In the largest transaction by value in 2010, Mexico’s American Movil purchased Carso Global Telecom, which is also based in Mexico, for $27.5 billion (Table 9.2). They are both in the tele communications industry. Also in telecommunications, the second -largest transaction in 2010 was the purchase by U.S. group CenturyLink of Qwest Communications (Table 9.2). The largest cross -border transaction, by value, was the purchase of UK group Briti sh Sky Broadcasting (BSkyB) by media and entertainment powerhouse News Corp, out of the U.S. The transaction was valued at $13.7 billion, according to Thomson Reuters data (Table 9.2). The most active overall sectors for M&A in 2010 were the energy and p ower sectors, followed by financials and telecommunications. However, the largest individual transactions in 2010 were telecommunications. 10 196 It would appear as if the economic recession did not have a significant impact upon merger and acquisition prices . Table 9.3 identifies the premiums by industry for 2010. Table 9.3 2010 U.S. Premiums by Industry Premium Deals Financials 55 34 Industrials 52 15 Telecommunications 51 13 Health Care 47 54 Materials 47 21 High technology 43 62 Media and entertainment 10 9 Consumer products and services 36 18 Energy and power 29 27 Retail 29 10 Consumer staples 26 10 Real Estate 24 3 Source: Thomas and Reuters From Table 9.3, it does not appear that target firms were not acquired as bargains (Table 9.3) Firms in financial, health care and technology were sold at significant premiums (Table 9.3). 197 Table 9.4 identifies the benefits and shortcomings of acquisitions. Table 9.4 Ramifications of Acquisitions Attributes Problems Positive Benefits Negative Ramifications 1. Access to international markets 1. Paying too much 2. Synergies resulting from economies of scale 2. Inability to achieve synergies 3. Synergies resulting from economies of scope 3. Failure to retain key personnel 4. Reduce costs of new product development 4. Too much debt 5. Entry into more attractive industries 5. Invest in mature industries Attributes of Successful Acquisitions Access to International Markets Many times firms will acquire targets to expand into international markets. One example is General Motors’ acquisition of Daewoo. Daewoo has production facilities in China, the Philippines, Vietnam, the Czech Republic, Poland, and Romania. In addition to market positions along the Pacific Rim, this acquisition provides G.M. access to production facilities in Eastern Europe. This is important because G.M. has not made money in Europe since 1999. In 2004, G.M. lost $792 million in Europe. One reason is because its primary European manufact uring facilities are in Germany, which is a very expensive labor market. DHL’s acquisition of Airborne provided DHL with the number 3 (behind Fed Ex and UPS) position in the U.S. air express industry. This network is important because DHL has the most ext ensive international distribution network of all carriers. This provides DHL an advantage over UPS and Fed Ex for international shipments. DHL also benefited by acquiring Airborne’s distribution infrastructure within the U.S. A key benefit of acquisition of firms in international markets is that the acquiring firm obtains access to the target’s customer base. British Petroleum’s acquisition of Amoco provided British Petroleum access to all of Amoco’s U.S. customers. Another related positive benefit of acq uisitions is the creation of synergies. Generic drug company Watson Pharmaceuticals acquired Swiss based Actavis in 2012 for $5.9 billion in an effort to significantly boost its international presence. UPS’ $6.8 billion acquisition of TNT Express in 2012 g ives UPS access to all markets within the European Union. 198 Synergies Resulting from Economies of Scale Synergy exists when the value created by units working together exceeds the value those units could create worki ng independently. Synergy can be created by the efficiencies derived from economies of scale. Firms generate economies of scale by more fully utilizing excess capacity. Acquisitions result, in part, because firms have excess capacity. This excess capa city can be productively utilized to generate economies of scale. Economies of scale can result from a firm acquiring a target within the same 4 -digit industry. Exxon’s acquisition of Mobil created substantial economies of scale as did Yellow’s acquisiti on of Roadway. The latter acquisition combined the second and third largest firms within the LTL (less than truckload) segment of the trucking industry. Economies of scale are important in the trucking industry because the industry is quite mature and th e customer base views price as a key buying criteria. The primary benefit that Yellow obtained as a result of the USF acquisition was economies of scale. Another industry in which economies of scale are important is the telecommunications industry . In February 2004, Cingular Wireless acquired AT&T Wireless. In December 2004, Sprint acquired Nextel. In January 2005, SBC acquired AT&T business and customer divisions. In 2007, AT&T Corp. acquired Bell South 11. The inter national airline industry is another example of acquisitions creating economies of scale. In 2003, Air France acquired KLM. Lufthansa is in the process of acquiring Swiss Airlines. For Swiss Air, the acquisition may provide for su rvival within a consolidating industry. Swiss Air has been unprofitable with a cumulative net loss of nearly two billion francs from 2001 to 2004. They have undertaken a series of restructuring programs and management changes, but losses have continued a s fuel prices have increased. The benefit to Lufthansa is that a European competitor is eliminated. The merger of Xstrata and Glencore in 2012 will create an $80 billion dollar mining firm which should lead to significant economies of scale. Synergies Resulting from Economies of Scope Economies of scope are cost savings that a firm creates by successfully transferring some of its resources and capabilities that were developed in one of its businesses to another of its businesses . Fed Ex’s acquisition of Roadway Package Services (RPS) provided Fed Ex with a ground infrastructure that could be more fully utilized for both air express and ground shipments. Cendant’s (the holding company for Gulliver’s Travel and Octopus Travel Gro up) acquisition of Donvand Ltd. will provide economies of scope as Cendant begins to focus upon the travel and real estate industry. CSX (railroad) has been involved in a number of acquisitions that have provided economies of scope. With the acquisition of Sea -Land Corporation, CSX established a position in the global ocean shipping industry. Boeing’s acquisition of McDonnell Douglas created economies of scope by establishing positions within the military aircraft industry .

Tata M otors’ (India) acquisition of Jaguar (2010) and Land Rover in 2011 allows Tata to more fully utilize its flexible manufacturing operations. Reduce Costs of New Product Development New product development can be costly. As a result, some firms acquire tar gets that are within months of introducing new products. Part of Cisco’s success with acquisitions is because it will only acquire firms that are within 6 months of a new product introduction. Since products are ready to be introduced into the marketplac e, the 199 acquiring firm does not have to invest in R&D. Equally as important, products can be introduced into the market more quickly because the acquiring firm does not need to engage in a new product development process. Sun Microsystems acquired SevenS pace in late 2004. This acquisition allowed Sun access to management services for computers for the first time. SevenSpace has a wide range of hardware and software that assists Sun in developing its service business. In late 2004, Johnson & Johnson acqu ired Guidant Corp. Guidant makes devices that stabilize heart rhythms. Johnson & Johnson already has a 43 percent share of the coated coronary stint products; the acquisition will allow Johnson & Johnson to acquire Guidant’s 38 percent share of heart rhy thm devices 12. In early 2005, Medco Health Solutions acquired Accredo Heath. This transaction marks the entry of a pharmacy benefit manager (Medco) into the specialty pharmacy industry 13. Accredo provides patients with specialty drugs for diseases like multiple sclerosis and hemophilia. Medco views the specialty drug market as having a much higher growth rate than other segments of the pharmaceutical industry 14. Amazon’s $775 million acquisition of Kiva Systems in 2012 give s Amazon an avenue for introducing robotics into its customer fulfillment centers. Entry into More Attractive Industries PenaultPrintempsRedout’s (PPR) acquisition of Gucci provides entry for PPR into the luxury goods industry. PPR’s rationale for the ac quisition was to enter an industry that has higher margins. For Gucci, the acquisition may provide financing to more successfully position itself against the industry leader Louis Vuitton. General Motors’ acquisition of Electronic Data Systems (EDS) and Hughes Aerospace is an attempt to enter more attractive industries. Proctor & Gamble’s acquisition of Gillette provides them with a dominant position in the wet shaving industry. Gillette has a 74 percent worldwide market share in the wet shaving industr y. In addition, Gillette had previously acquired Duracell in the battery industry and Oral -B in the dental care industry. The industries that Gillette has entered have been more profitable than the industries Proctor & Gamble has entered. For 2003, Proc tor & Gamble’s return on sales was 12.6 percent; for the same period, Gillette’s return of sales was 23.3 percent. In an attempt to make its way into an area which has grown significantly in recent years, cloud computing; Oracle Corp. came to an agreemen t in 2012 to acquire online software maker Taleo Corp. for $1.9 billion. Problems with Acquisitions Paying Too Much Many firms simply pay too much for targets 15. Due to the bidding war between Verizon and Quest for MCI, Verizon’s accepted bid represente d a 25 percent premium. Omnicare acquired NeighborCare for $1.45 billion 16. This represented a $150 million premium. In addition, Omnicare assumed approximately $250 million of NeighborCare’s debt 17. As shown in Table 9.3, many firms in many industries paid significant premiums to acquire target firms. Inability to Achieve Synergies Many acquisitions are sold based upon cost savings the acquiring firm hopes to achieve as a result of synergies. Esta blishing synergies between Compaq’s P.C. business 200 and Hewlett Packard’s imaging and printing business were a primary reason for the Compaq acquisition. As a result, Hewlett Packard felt that significant synergies would exist and it could achieve a larger market share in the enterprise computing and P.C. industry. However, in 2004, only Hewlett Packard’s imaging and printing segment remained profitable. Since the merger, H -P has lost market share 18. The Compaq merger hasn’t helped in other areas either. In the 12 months ended in September 2005, IBM and Dell gained share in network servers while H -P declined. H -P’s operating margins in business services have fallen for two consecutive years 19. While Hewlett Packard attempted to cut costs, the cost saving s were never realized. In fact, profit margins have continued to decline, especially in the P.C. business. American Airlines acquisition of TWA created too much excess capacity and the combined airlines were unable to achieve cost savings. This acquis ition, coupled with the aftermath of 9/11, has American Airlines in financial difficulty. U.S Airways’ 2012 attempt to acquire American Airlines would have created a firm which would not be able to obtain synergies from combining two major airlines. Many U.S. airlines have acquired other U.S. airlines in the past (e.g. Northwest, Delta). None of these acquisitions have led to significant synergies. It needs to be noted that U.S. Airways has been to Chapter 11 bankruptcy protection while American Airlines is currently in Chapter 11 bankruptcy. Failure to Retain Key Personnel Entry into industries other than a firm’s core or related industry can cause significant problems. Firms may have difficulty achieving advantages in industries that are unrelated to their primary industry because the acquiring firm’s management team has no experience in the unrelated industry. Phillip Morris’ acquisition of Miller Brewing is an example. After the acquisition of Compaq by Hewlett Packard, Michael Capellas, the CEO of Compaq left to become CEO of MCI. The other members of Compaq’s senior management team also left. Thus, Hewlett Packard was trying to compete against industry leader Dell without managerial resources with substantial industry experience in the P.C. industry. The management team of the target firm has specific knowledge of industry structure, the customer base, the evolution of competition within the industry and knowledge of the target firms’ domestic and international infrastructure network. These issues are of critical importance if the target is in an industry not relate d to the acquiring firm. When PepsiCo acquired Taco Bell, Pizza Hut, and KFC, the logic was that these fast food chains would provide distribution outlets for Pepsi’s many beverages. PepsiCo eliminated critical managerial resources in the target firms. Afterwards, PepsiCo realized that the soft drink and fast food industries are quite different. Thus, PepsiCo spun these firms off as Tri -Con. With the addition of Long John Silver and A&W Root beer, the combined companies are now Wow Brands and totally independent of PepsiCo. Hewlett Packard entered the Smartphone and tablet markets with its $1.2 billion acquisition of Palm in 2010. Hewlett Packard did not retain the Palm management team. HP left this market less than a year later. Too Much Debt Too m uch debt restricts the funds that are available for other expansion options. Dynegy’s acquisition of Illinois Power significantly restricted Dynegy’s ability to further 201 expand in the newly deregulated utility industry. Dynegy finally sold Illinois Power to Ameren in 2004. Quest Communication’s $56 billion acquisition of U.S. West created a firm whose stock has since lost 87 percent of its value. The combined firm now has $17 billion in debt. The antivirus software firm, Symantec, has lost 35 percent of i ts stock value after its $13.5 billion acquisition of Veritas 21. Symantec has not been able to pay down its debt as a result of the acquisition. The $181 billion acquisition of Time Warner by AOL has created substantial long -term debt. Since 2001, the m arket capitalization of AOL/Time Warner has declined in value by $233 billion 20. In addition, the combined firm is struggling to pay down debt as a result of the merger. The $11.5 billion acquisition of Sears by Kmart has created substantial debt. This increase in debt will make it difficult for the combined firms to compete against Wal - Mart. Besides, they are still much smaller than Wal -Mart. Wal -Mart had sales of $256 million in 2004 compared to $55 billion as a result of the Kmart acquisition of Se ars. Caterpillar acquired Bucyrus Mining for $8.6 Billion in 2011. Caterpillar paid a 32% premium and obtained all of Bucyrus’ debt. Invest in Mature Industries As discussed in Chapter 1, Industry Analysis, firms that are in mature industries must foc us upon costs to be successful. During the maturity stage, firms attempt to reduce costs because there is very little product differentiation. The American Airlines acquisition of TWA in 2000 is an example. Even before 9/11, U.S. airlines were only marg inally profitable. As such, American acquired TWA to achieve economies of scale. The acquisition resulted in American Airlines becoming the largest airline in the world. Because American Airlines and TWA both had excess capacity, the combined airline ha d even more excess capacity. Within the U.S. airline industry, Southwest Airlines is the only carrier that has been profitable every year since the U.S. airline industry was deregulated in 1978. Southwest generates profit because its business model is a pplicable to a mature industry. Southwest does not utilize a hub and spoke network. Each lane (pair city) combination must be profitable. If a lane segment is not profitable, it is eliminated. As such, each part of Southwest network is profitable. Bec ause other airlines utilize a hub and spoke business model, lane segment analysis is not performed. In a mature industry, each unit of your firm needs to generate profit. After the railroad industry was deregulated in 1980, rail carriers began to acquir e trucking firms to increase their scope of coverage. These trucking subsidiaries were unprofitable because the trucking industry was a mature industry. One reason was because of excess capacity. The railroads believed that some of their time sensitive freight could travel by truck as opposed to by rail. The railroads were unsuccessful at increasing the utilization of trucks because trucking firms began to lose freight to independent owner operations. These non -union owner operations could carry freigh t at much lower rates. As has been discussed in the text, the trucking industry is a very mature industry. When Yellow Freight acquired Roadway ($1.05 billion) (Trucking) in 2003 and USF Corp ($1.37 billion) (Trucking) in 2005, it established a larger m arket share in its own industry (Trucking). As a result of acquiring firms in the mature trucking industry, Yellow has lost over $2 billion since these acquisitions occurred. 202 Process for Achieving Successful Acquisitions While firms have experienced mixe d results with respect to acquisitions, the process by which acquisition candidates are selected and implemented may make future acquisitions beneficial. Due diligence is a critical part of the process. Due Diligence Due diligence is a comprehensive, complete analysis of an acquisition opportunity. It is a third party’s independent objective view of the value of an acquisition target. The due diligence process should be performed for every acquisition opportunity. Consulting firms an d investment bankers conduct due diligence because they have substantial industry experience. These firms perform many tasks. Some important due diligence functions are (1) determining whether the acquisition will be friendly or hostile (2) what is the m aximum bid that the acquiring firm should offer to make the acquisition opportunity profitable (3) will the acquiring firm have to divest unwanted business sectors of the target firm (4) what realistic cost savings will be realized as a result of the acqu isition (5) what is the likely reaction of Wall Street (6) what has been the financial performance of the target over time (7) what level of funds will be needed to make implementation successful (8) should the management team of the target be retained (9) what type of R&D capability does the target firm have that can be utilized by the acquiring firm and (10) determine the integration process. If effective due diligence is not completed, acquiring firms may pay too much for acquisition targets or inapprop riate targets may be selected. For example, Hewlett Packard may have been wise to conduct due diligence before it spent $19 billion to acquire Compaq. A due diligence fee of $1 million may well have been worth it. In December 2004, Oracle acquired People Soft. The acquisition process started in June 2003. The final offer, $10.3 billion, represents a 25 percent premium over market price 23. The combined firms will still trail SAP in terms of global enterprise resource planning software 24. This was a host ile takeover. This means the target firm had no desire to be acquired. Hostile takeovers create significant implementation problems. This leads to our second criteria for successful acquisitions: engage in friendly acquisitions. Engage in Friendly Acquisitions Hostile acquisitions can cause problems between acquiring and target firms. With hostile takeovers, acquiring firms may end up paying a premium. In many cases, the senior management of the target is removed. If the target is in an unrelated business, the acquiring firm may not have the managerial resources to integrate the combined firms’ resources successfully. Target firms have many anti -takeover amendments that can be passed to further increase the price of the acquisition. Cisco, which has made hundreds of successful acquisitions, will not engage in hostile takeovers. Cisco values the target firm’s human resources. Cisco’s policy is to concentrate on people first and business integration second. Berkshir e Hathaway’ s 2009 acquisition of BNSF Railroad was a friendly acquisition which has generated position results in terms of net income and EPS. Maximize Resource Utilization At times, firms make acquisitions to obtain greater resource utilization. At all times, firms have excess capacity 21. This excess capacity can be utilized to obtain 203 economies of scale or economies of scope. Economies of scale may result from same industry acquisitions. Anheuser Busch’s acquisition of Hardin, a Chinese brewer, allowed Anheuser Busch to achieve economies of scale in China. South African Brewers (SAB) acquisition of Miller created economies of scale and resulted in SAB obtaining a significant position within the U.S. market. UPS’ acquisition o f Overnite Trucking may result in economies of scope by using the same trucks for small package and large freight transportation. Proctor & Gamble’s acquisition of Gillette provides for increased economies of scope by more fully utilizing Proctor & Gamble and Gillette’s extensive international infrastructure. The Air France acquisition of KLM permits Air France to maximize its own utilization of resources due to the increase in international passengers and airfreight traffic. Interbrew’s (Belgium) acquisi tion of Ambev (Brazil) provides both firms with access to each other’s distribution infrastructure. Sometimes, firms will also acquire targets for brand names. Diversify Into Firms That Have Strong Brand Names Proctor & Gamble plans to commit significant resources to grow its own and Gillette’s major brands. Currently, Proctor & Gamble has about $52 billion in sales and 21 billion dollar brands 22. P&G’s largest competitor is Unilever. Unilever has $52 billion in sales and 12 billion dollar brands 23. Wit h the acquisition of Gillette, Proctor & Gamble adds 10 more billion -dollar brands 24. Gillette is the market leader in the wet shaving industry with a 75 percent market share. The acquisition may provide funds for Gillette to fu rther develop these brands domestically and globally. Proctor & Gamble’s acquisition of Gillette gave it strong brands in the wet shaving industry (Mach 3, MP3, Venus Divine), and the health care industry (Oral B). Gillette has one of two strong brands – Duracell – (the other being Energizer) in the global alkaline battery industry 25. In 2003, Gillette purchased the leading battery firm in China. Also in 2003, Gillette had record $1.35 earnings per share 26. Forty one percent of Gillette’s sales have co me from products introduced in the past 5 years 27. Proctor & Gamble already has an established infrastructure in China. Its Rejoice brand has a 25 to 30 percent share of the Chinese market. Gillette has a stronger position in toothpaste and deodorant in developing markets such as Brazil and India. Gillette’s products more effectively compete against Unilever in these markets. P&G should be able to grow Gillette in developing markets quicker and more efficiently. P&G’s sales into emerging markets like R ussia, Mexico, and China grew by 20% in 2003 34. Gillette had declining sales in Russia and Germany, while P&G has increased its position by acquiring Germany’s Wella AG hair care line. This acquisition may help increase Gillette’s position against Unilev er in Germany. P&G has strength in the women’s personal care market with products such as Clairol, Olay, and Tide. P&G can provide Gillette with expertise to help improve the marketing of their products to women. Gillette, on the other hand, will provi de benefits to P&G in the form of its knowledge of marketing to men because of their success with Gillette and Braun products. This acquisition puts the combined firm in an advantageous position for sustainable growth. South African Brewers’ (SAB) acquisi tion of Miller beer is another example of a firm acquiring a strong brand. Before the acquisition, South African Brewers had a small position in the North American beer industry. The Miller acquisition significantly increased SAB’s position within North America. InBev’s 2008 acquisition of Anheuser Busch allowed InBev to acquire a dominant position within North America. Anheuser Busch has the strongest brand name of any beer firm in the U.S. and a growing presence 204 in China. These acquisitions are importa nt because the United States and China are the two largest beer markets in the world 28. In many cases, firms acquire high growth firms. Acquire High Growth Firms In 1997, Sidney Frank Importing introduced Grey Goose Vodka. By 2002, Grey Goose had sale s volume in excess of one million cases 29. In 2004, Grey Goose had a sales volume that was close to the industry leader, Stolichnaya. In 2004, Bacardi acquired Grey Goose for $2 billion 30. In 2000, Topspin Communications was founded. Topspin utilizes i ts equipment to connect PC’s, storage computers, and the computer servers that perform corporate data analysis 31. In 2005, Cisco acquired Topspin for $250 million 32. Cisco believes that Topspin will improve its ability to provide customers with networking technology that lets them build data centers in a flexible, innovative, grid -like fashion. This acquisition follows Cisco’s 2002 acquisition of Andiamo Systems that makes switches that connect data -storage computers 33. Hostile Acquisitions Up to this point, it has been assumed that the target is willing to be acquired. If the target attempts to fight off the potential acquiring firm’s acquisition bid it is referred to as a hostile acquisition attempt. If the acquiring firm completes the acqu isition, it will likely pay a higher price for the target. This is because the target firm can implement anti -takeover amendments. In Figure 9.1, the Louis Vuitton hostile acquisition attempt of Gucci demonstrates several of these actions: Figure 9.1 Lo uis Vuitton Hostile Takeover Attempt of Gucci After Louis Vuitton had acquired more than a 15 percent share of the outstanding stock of Gucci, Gucci contacted Pinault -Printemps -Redoute (a retailer) to act as a white knight. A white knight is a firm that will take an ownership position in a target firm that is normally greater than the position taken by the hostile acquiring firm. In this case, PPR acquired a larger percentage of the outstanding shares of stock than Louis Vuitt on. A white knight may not have an interest in acquiring the target. However in some cases, the target will be acquired. PPR did acquire Gucci. For Louis Vuitton to continue with the acquisition, it would need to acquire additional shares of stock. By PPR obtaining an ownership position in Gucci, Louis Pinault -PrintempsRedoute (PPR) Gucci Louis Vuitton (2) White Knight (3) Poison Pill (4) Golden Parachutes (5) Staggering election of Board of Directors (1) Hostile Acquisition Bid (6) Greenmail 205 Vuitton would need to acquire over 50 percent of Gucci outstanding stock. If PPR was to acquire Gucci, Louis Vuitton would then need to acquire both PPR and Gucci. It may be too costly for Louis Vuitton to continue with the acquisition attempt of both firms. Because PPR is a retailer while Louis Vuitton is a luxury goods conglomerate, most of PPR’s product lines are unrelated to Louis Vuitton’s. Acquiring an unrelated firm by the target firm is a good way to drive the acquiring firm away. Another anti -takeover strategy is referred to as a poison pill. Gucci also took this action. Gucci created an employee stock ownership plan (ESOP) to create a class of stock which was offered for employee purchase. As this stock was acquired, it diluted Louis Vuitton’s initial position because of the creation of additional, new stock. Another anti -takeover strategy is called greenmail. As PPR was in the process of acquiring Gucci, it could have purchased Louis Vui tton’s stock in Gucci for greater than their market value. In return for obtaining a premium on the stock it had purchased, Louis Vuitton would agree not to purchase any additional Gucci shares of stock. A fifth type of anti -takeover amendment is called golden parachutes. Golden parachutes require that the acquiring firm (Louis Vuitton) pay large lumps of payments to the senior management team of the target firm in order to complete the acquisition. Firms can also stagger the election of Board of Direct ors. If a firm has 12 board members, each year 3 will come up for re -election. If an acquiring firm completes a hostile takeover, it will take 12 years to obtain total control due to the staggering pattern of board members. With the number of anti -takeover amendments that can be implemented, the cost of the acquisition continues to increase. In many cases the acquiring firm will search for more friendly target firms. This is exactly what happened with Louis Vuitton. PPR acquired Gucci and Lo uis Vuitton began to look for other options. In some cases, target firms will attempt to create additional value in order to increase the purchase price of the target. Scottish & Newcastle PLC has continued to reject a hostile takeover bid offered jointl y by Heineken NV and Carlsberg A/S 34. Scottish & Newcastle has sold its unprofitable French business and engaged in downsizing to cut costs further 43. Are Acquisitions Beneficial? Evidence suggests that for acquiring firms, acquisition strategies may not always result in desirable outcomes 35. Studies have found that shareholders of target firms often earn above -average returns, while shareholders of acquiring firms’ returns are near zero 36. During the 1990’s, acquiring shareholders lost $216 billion 37. Between 1998 and 2001, 87 of the largest acquisitions lost $134 billion in shareholder wealth 38. There are several reasons for these results. The failure to complete an effective due diligence process often results in the acquiring fi rm paying a premium for the target company. In addition, the entire acquisition process is very time consuming. Typically, substantial managerial time and energy are required to research, acquire and implement acquisitions. Because senior managers are co nsumed with the acquisition process, they may not devote the necessary time to run their existing business. Senior managers must still focus upon the mission of the firm while meeting quarterly financial targets. The acquisition process is an additional re sponsibility to the ongoing duties of senior management. In addition, different stakeholders have different expectations. Communication to various stakeholders is of critical importance. Employees need to understand why acquisitions are being made and wh at the ramifications are for them. If collective bargaining units represent the employees, they 206 will also need to be informed. Everyone inside the firm will need to understand how the integration will take place. Customers also need to be informed. Cu stomers need to be assured that products will not be affected from an availability and distribution perspective. Customers of both the acquiring firm and target need to be informed as to how the acquisition will benefit them (e.g. improvements in distribu tion channels). Shareholders will need to understand why the acquisition was made and they need to be informed how long the integration process will take. Shareholders need to understand how and when the acquisition will result in increases in stock value s. Suppliers, wholesalers, and retailers need to understand how the acquisition will affect inbound and outbound logistics. In many cases, new distribution networks may need to be developed to provide quality service to existing and target firm customers. If the target firm is an international company, domestic and international distribution networks may need to be integrated. The three primary growth modes by which firms grow are (1) internal development, (2) strategic alliances, and (3) acquisitions. Table 9.5 is a comparison of these modes o f growth. Table 9.5 Comparison of Primary Modes of Growth Internal Development Acquisitions Strategic Alliances  Significant time to implement  May be too late to market with new products/services  No partners = no risk of technology transfer  Expensive; cost savings may not be realized  Significant costs and time to integrate target within acquiring firm  Divestment may be difficult  Can generate quick, not necessarily profitable, growth  Risk of technology transfer  Ownership of partners’ assets not obtained  Low to moderate entry and exit barriers In many cases, firms will use all three modes of expansion depending upon the stage of industry life cycle, the nature of competition, the financial strength of the fir m, and the conditions within selected markets. Acquisitions as a Source of Innovation Innovation success is critical to organizational competitiveness in the global economy. Companies that innovate enjoy the first -mover advantages of acquiring a deep knowledge of new markets and developing strong relationships with key stakeholders in those markets. Innovators are also able to solve many of the most challenging problems associated with changing environments. Organizational innovation can result from using skills and capabilities that are inside the firm (internal innovation) or by acquiring innovation skills or innovative products through purchasing other firms. 207 The rapid change and diffusion of new technology, along with substantial competition in d omestic and international markets, has placed increasing importance on firms’ ability to innovate and to introduce new innovations into the marketplace 39. In fact, innovation may be required to maintain or achieve competitive parity within domestic market s, much less achieve a competitive advantage in many global markets 40. Any action that either puts the organization into new strategic domains or significantly alters the way the organization attempts to serve existing customers or constituents is consider ed an innovation 41. Acquisitions assist firms in the innovation process 42. Experiences show that developing innovations internally and introducing them into the marketplace can be expensive 43. In some cases, internal innovation is a high risk activity. In 1985, Fed Ex lost several hundreds of millions of dollars on its Zapmail product innovation. In addition to the loss of money, the amount of resources which were committed to this innovation took away substantial resources that could have been utilize d for international expansion. A failure to innovate may put firms on a path to failure 44. Moreover, significant amounts of time are often required for product innovations to earn a profitable return on the firm’s investment. Even with proper support in terms of resources and time, the knowledge that eight of 10 new products fail commercially demonstrates that internal innovation is risky 45. Acquisitions can be a substitute for innovation. Because of the low probability of success and the length of time required for innovations to satisfy hurdle return rates, some managers believe that internal innovation is a high -risk activity. In these instances, acquisitions may be an attractive alternative because they offer immediate entrance to a market that is n ew for the acquiring firm and/or a larger share of a market the company is serving already. As with internal innovation, external acquisitions are not risk free; however, the outcomes from acquisitions are more certain and can be estimated more accurately compared to internally developed innovation. Firms can innovate by acquiring innovation skills or innovative products through purchasing other firms. Many pharmaceutical firms are making acquisitions to add new drugs to existing product lines (e.g. ch olesterol reducing medicine). For example, Warner -Lambert acquired Agouron Pharmaceuticals Inc. in large part due to Agouron’s research and development expertise in such areas as cancer. Innovation (whether developed internally or acquired) is a source o f value creation and competitiv e advantage for individual firms. Innovation increasingly is recognized as a key link to the firm’s strategic competitiveness. Innovation may be a factor that differentiates successful companies from competitors. Acquisiti ons can become a substitute for innovation in companies actively using an acquisition strategy. 208 Discussion Questions 1. Why has the telecommunications industry consolidated? 2. Is size of target firm related to acquisition success? 3. Identify and explain the attributes of successful acquisitions. 4. Did Oracle follow the recommended approach of achieving acquisition success? Explain. 5. Explain the concept of synergy from an acquisition perspective. 6. Will acquisition of large targets continue? Explain. 7. Explain why hostile acquisitions are not normally recommended. 8. Explain anti -takeover amendments that target firms can implement to fight off hostile takeover attempts. 9. Did the pattern of mergers and acquisitions (M&A) change during the global economic recession (2009 -2010)? 209 References 1. P. Walden, “A Look at 2010’s Mergers & Acquisitions,” Merger & Acquisition Journal, January, 2011. 2. Ibid 3. ____ “Pharmaceutical Companies Seek Biotech Acquisitions to Boost Drug Pipelines,” ICIS Chemical Business, February 12, 2010. 4. Ibid 5. Ibid 6. D. Bedell, “Largest M&A Deals in 2009 and 2010,” Thompson Reuters Mergers and Acquisition Review, 2009, 2010. 7. Ibid 8. Ibid 9. ____ “The Largest Mergers and Acquisitions in History,” Thompson Reuters, Mergers and Acquisitions Review, 2009. 10. _________. 2005. Merger snapshots: who did the big deals. Wall Street Journal . May 15. 11. Schatz, A. and Hughes, S. 2007. Justice department criticized for approving big AT&T deal. Wall Street Journal . November 22. 12. Burton, T., Hensley, S. and Sidel, R. 2004. Behind the J&J Guidant talks: heart implants. Wall Street Journal . December 8. 13. Martinez, B. 2005. Medco to buy Accredo Health in $2.2 billion cash -stock deal. Wall Street Journal . February 22. 14. Ibid . 15. _________. 2005. The rise of the super brands. The Economist , February 5 -11. 16. Ibid. 17. Ibid. 18. Tam, P. 2005. HP’s printer business takes a hit as rivals muscle in. Wall Street Journal . March 10. 19. Ibid 210 20. Berman, D. and Machalaba, D. 2005. Yellow Roadway is in talks to buy USF. Wall Street Journal . February 23. 21. Ibid. 22. __________. 2005. The rise of the super brands. The Economist, February 5 -11. 23. Ibid 24. Steinburg B. and Vranica S. 2005. When beauty met sweaty. Wall Street Journal . January 31. 25. Byrnes, N. and Symonds, W. 2005. Brands lessons from Gillette. Wall Street Journal . February 14. 26. Ibid 27. Ibid 28. _________. 2002. SAB poised to clinch Miller acquisition. Modern Brewery Age . April 22. 29. Lawton, C. 2005. Stolichnaya maker takes shot at ads for Grey Goose . Wall Street Journal . April 15. 30. Ibid 31. _________. 2005. Cisco agrees to buy networking firm for $250 million. Wall Street Journal . April 15. 32. Ibid 33. Ibid 34. Scottish and New Castle rejects takeover bid. 2007. Wall Street Journal . November 21. 35. Ibid 36. Gugler, K., Mueller, D., Yurtoglu, R. and Zulehner, C. 2003. The effects of mergers: An international comparison. International Journal of Industrial Organization . 21: 625 -653. 37. Ibid 38. Cornett, M., Hovakimian, G., Palia, D. and Tehranian, G. 2003. The impact of the manager -shareholder conflict on acquiring firm’s returns. Journal of Banking & Finance . 27: 103 -131. 211 39. Hitt, M., Nixon, R., Hoskisson, R., and Kochhar. 1999. Entrepreneurship and cross - functional fertilization: activation, process and disintegration of a new product design team, Entrepreneurship: Theory & Practice , 23(3): 145 -167. 40. Ibid 41. Hitt, M., Haprison, J., and Ireland, R. 1990. Mergers and acquisitions: a guide to creating value for stakeholders . Oxford University Press. 42. Shank, J.K. and Govindarajan, V. 1992. Strategic cost analysis of technological investments. Sloan Management Review . 34(Fall): 39 -51. 43. Hitt, M., Haprison, J., and Ireland, R. 1990. Mergers and acquisitions: a guide to creating value for stakeholders . Oxford University Press 44. Marcotti, G. 1998. Technology Innovation: Eight out of 10 new products are commercial failures. Financial Times. March 31: 21. 45. Ibid 212 Pfizer Mini Case Pfizer i s the largest pharmaceutical firm in the world. In 2010, it generated approximately $68 billion in sales. However, Pfizer has 4 brand name products which are coming off patent protection in 2011 or 2012. (Table 1) Collectively, these brands generated $1 4.70 billion in sales in 2010. Table 1 Pfizer’s Leading Products and Patent Expiration Purpose Drug Revenue 2010 ($ Billions) Patent Expiration Cholesterol Lowering Lipitor $10.73 2011 Erectile Dysfunction Viagra $1.93 2012 Schizophrenia Geodon/Zeldox $1.01 2012 Overactive Bladder Detrol $1.03 2012 Total $14.70 Table 2 shows the distribution of Pfizer’s sales as of 2010. As shown in Table 2, Pfizer has significant market positions in the U.S., Western European markets, and emerging markets. Sales within the U.S. account for 43 percent of Pfizer’s total sales (Table 2). Western European markets account for 24 percent of total sales (Table 2). Table 2 Pfizer Sales by Market $ Billion % of Total U.S. 29.04 43 Western Europe 16.66 24 Emerging Markets 12.00 18 Less Developed Regions 10.09 15 Total 67.79 100 Discussion Questions: 1. In 2009, Pfizer acquired Wyeth for $68 billion. Was this a good acquisition for Pfizer? 213 Harvard Business Cases for Chapter 9 Grolsch: Growing Globally Product Number PG0002 Foreign Investment in Russia: Challenging the Beal Product Number TB0015 Professor Case for Chapter 9 Caterpillar 214 215 Chapter 10 International Strategies 216 Learning and Assessment Goals 1. Understand the process of international strategy analysis 2. Be able to perform the analysis for determining international country attractiveness. 3. Be able to perform the analysis for identifying attractive international industries. 4. Be able to perform competitive analysis within an international industry. 5. Understand the different modes of entry into international markets. 217 This chapter discusses international strategy. Within the last 3 decades world trade has expanded from $200 billion to $7 trillion 1. U.S. investment in international markets increased from $198 billion in 1990 to $2.03 trillion in 1999 2. With these growth rates, the key question is not “if” a firm should d evelop an international strategy. The key questions are “where” and “how” a firm should establish international strategies. Factors Encouraging International Expansion There are several factors fueling this growth. First, firms generate excess capacity 3. If this excess capacity is excess production capacity, firms may attempt to utilize this extra capacity in international markets 4. Utilization of the excess capacity in international markets may allow a firm to obtain a lower cost position within its d omestic markets by generating economies of scale . In addition, firms generate additional revenue streams from international expansion. Second, firms may be able to enter international industries that are at earlier stages of the i ndustry life cycle. In Chapter 3, Industry Analysis, we learned that homogeneous products characterize the maturity stage of an industry’s life cycle with the advantage to large -scale providers. Within the U.S., many industries are in the maturity stage of the industry life cycle. Examples are the airline, trucking, fast food, and beverage industries. All of these industries have undergone substantial consolidation. Because firms within the maturity stage of the life cycle must compete on price, large scale is required to survive the industry consolidation. As discussed in Chapter 9, the U.S. telecommunications industry is a prime example. Verizon’s $8 billion acquisition of MCI, Sprint’s $35 billion acquisition of Ne xtel and SBC’s $22 billion acquisition of AT&T Wireless have created a small number of very large telecommunications players. If these firms do not expand into international markets, they can only compete on price. International expansion represents the only substantial opportunity for growth within this industry. A third factor that has fueled international growth is the emergence of China as a consumer market. China has an emerging middle class that has 300 million consumers 5. This is approximately equivalent to the entire U.S. population. China is a primary market for outsourcing . Many manufacturing firms have significant positions within China. As China has developed a more complete infrastructure, growth has accelerated. The beer industry is one example of the growth of China. China is the second largest (U.S. is first) beer drinking market in the world 6. This is one reason Anheuser Busch acquired Hardin, a large Chinese brewer, in 2003. In the near future, Anheuser Busch wi ll be increasing its stake to 27 percent in Tsingtao, the largest Chinese brewer 7. A fourth factor that has fueled international growth is the deregulation of many industries in international markets. India is in the process of deregulating several of i ts industries. The passenger airline industry is one example. Air India and Indian Airlines are experiencing competition from Britain’s Virgin Group, Emirates Group, and Jet Airways 8. Jet Airways is a privately owned airline in In dia 9. 218 Table 10.1 shows the difference between regulated and deregulated industries. Table 10.1 Fundamental Differences Between Regulated and Deregulated Industries Condition Existence of Condition Regulated Deregulated : Control on number of firms Yes No : Market share controlled Yes No : Market entry limited Yes No : Price and profitability controlled Yes No : Competition limited Yes No : Scale of operating authority constrained Yes No When industries are regulated or state owned, price and profitability are controlled by the regulatory agency 10. The Russian oil industry is an example of a state owned industry. Industries that are regulated are protected because the government controls industry condition s by limiting competition, controlling market entry, and putting limits on the scale of operations. Because several U.S. industries have been deregulated for some time, firms in the U.S. have more experience growing in deregulated industries. The airline and airfreight industries were deregulated in 1978. The trucking and railroad industries were deregulated in 1980. The telecommunications industry was deregulated in 1984. As these industries have become deregulated, firms have developed strategies to c ompete in a competitive global market. The fifth factor that has fueled international growth is defensive in orientation. If firms do not engage in international expansion, international firms may establish positions within the U.S. Many international f irms have established strong positions in U.S. industries. Toyota (Japan) is profitable within the U.S. auto manufacturing industry. Sony (Japan) has established a dominant position within the electronics and gaming industries in the U.S. Nokia (Finland ) has established a strong position within the U.S. cellular phone industry. Louis Vuitton (France) has established a leadership position in the U.S. luxury goods industries. DeBeers (South Africa) has established a dominant position within the U.S. diam ond industry. Figure 10.1 represents a framework for developing international strategy. 219 Determining Figure 10.1 Development of International Strategy Introduction of product/service innovation in domestic market Expansion of domestic market Firms expand to developing markets to achieve low cost position Competition within international market intensifies Negative Determination of international mode of entry  Exporting  Licensing / Franchising  Strategic Alliances  Acquisitions  Foreign Direct Investment  Negative Positive Positive Adaptation or standardization of product/service Positive Negative International industry attractiveness International country attractiveness Firm’s business strengths 220 Innovation in Domestic Market Figure 10.1 illustrates the stages of evolution as a firm establishes positions within international markets. In most cases, firms will innovate within their domestic marke t. Fast food (McDonalds), chips (Intel), PC’s (Dell), air express (FedEx), and operating systems (Microsoft) were all developed within the U.S. before expanding to other countries. Coke and Pepsi were also developed within the United States before being introduced into international markets. Luxury cars (Mercedes Benz, Jaguar, Volvo) were all developed within their home country before they were sold internationally. L’Oreal products were first introduced within France. Firms will tend to fully develop products/services within domestic markets before expanding internationally 11. Once domestic markets are fully developed, the firm can enter international markets from a position of strength 12. Determining International Country Attractiveness Several fa ctors, shown in Figure 10.2, help firms determine whether or not a certain country is attractive to expand into. Figure 10.2 Determinates of International Country Attractiveness Source: Adapted with the permission of The Free Press, from Competitive advantage of nations , by Michael Porter, 72. 1990. International country attractiveness can be based on 4 factors: (1) factors of production, (2) demand conditions, (3) related and supporting industries and (4) firm strategy, structure, and rivalry 13. Factors of production consist of inputs into an industry 14. The availability of raw materials, the degree tha t infrastructure (e.g. roads) has been developed, the supply of skilled labor to produce a firm’s products, and the development of a communications system are factors which determine a county’s attractiveness to produce and distribute goods to consumers. A quantitative measure to determine a country’s attractiveness is to Factors of production Firm stra tegy, structure, and rivalry Demand conditions Related and supporting industries 221 measure gross domestic product (GDP) per capita . Countries that have higher GDP per capita will, in general, have more consumer income to support a giv en industry. Demand conditions are the second factor. Demand conditions refer to the potential of the market to purchase goods and services within an international market 15. For example, substantial growth rates in a market may signal that demand is suff icient to support additional competitors. A firm must ascertain if the demand is large enough to support large -scale facilities needed to generate economies of scale. One way is to examine the size of competitors’ facilities and revenue streams on a countr y-to-country basis. Annual reports and 10 -Q reports are good sources of this information. Related and supporting industries are the third factor 16. If countries have industries that are related, a firm can generate alternative revenue streams. A firm m ay generate economies of scope by using its resources in related or supporting industries. Within the U.S., most revenue that airlines generate is from passengers. In many international countries, airlines have both significant revenues from passengers a nd freight. These airlines achieve economies of scope by moving both passengers and freight between international markets. Strategy, structure, and rivalry are the last attributes to be evaluated for determining international c ountry attractiveness 17. Being able to adapt a firm’s strategy to conditions within an international market is crucial. Different countries have different competitive conditions. In Japan, collusion is an accepted form of business develo pment. As such, the Japanese have become very good at transferring technology both within and across industries. In Germany, firms must determine strategy by integrating the role of labor within the strategy. This is because labor unions have a seat on the board of directors in large German firms. In general, the more factors that a country meets, the more attractive the country becomes from an international perspective. If firms do not enter international markets, they must continuously invest in R&D within domestic markets to obtain additional revenue streams from new product/service introductions. Development of international markets is crucial because the success of new product ventures is usually less than 10 percent within the U.S. 18. In additi on, international markets may be less mature than domestic markets. Sony believes that developing nations are a good source of growth for its existing PlayStation 2 product. By introducing the new PlayStation 3 product to the U.S. and Japan and the PS2 p roduct to developing markets, Sony can take advantage of less mature gaming markets.

Determining industry attractiveness in international countries is important. Role of Government One possible limitation of the diamond model is that the role of the inter national government is not specifically addressed. While Porter agrees government is important, he does not support its role enough to make it a fifth determinant in the model. Government’s role is to influence the other four points of the diamond and Po rter’s message for firms is to develop the diamond by using government only as an aid but not as a primary force. However, the role of the government can have an impact upon Porter’s determinants. From a demand condition perspective, governments need to establish more jobs to reduce unemployment and increase GDP/capita. One way of doing this is to provide incentives for international firms to establish operations within a specific country such as lowering trade barriers. Stimulating the economy by provi ding opportunities for investment by international firms may reduce high unemployment levels and GDP/capita 222 may increase. By establishing trade relationships with other countries, the firms may be able to use its excess capacity for selling products inter nationally. Related and supporting industries and the role of the government will be discussed next. From a related and supporting industry perspective, using resources in two or more related industries may allow the firm to achieve economies of scope. By the government providing financial incentives for firms to expand into related and supporting industries, a firm’s resource base can be used to support positions within several industries, and it may be able to leverage its resources to expand into additi onal, new international markets. As such, economies of scope can be realized within both domestic and international firms. Japan’s flexible manufacturing systems permit economies of scope to be realized within both its domestic and international markets. Strategy, structure, and rivalry will be discussed next from a government policy perspective. The government may work with other governments to reduce trade barriers with certain markets (e.g. NAFTA, EU). By entering international markets, firms may b e in position to alter competition. By establishing product positions within several countries, the firm may be able to generate additional revenue streams. One reason is because international countries may be at different stages of the industry life cyc le compared to domestic markets. For example, the tobacco industry is moving into the decline stage of its industry life cycle within the U.S. However, within Pacific Rim countries and the Commonwealth of Independent States (CIS), tobacco firms are at ea rlier stages of development in terms of the industry life cycle. The role of government from a factors of production perspective will be discussed next. From a factors of production perspective, the government may need to focus upon building a better in frastructure within its own country. In international markets, the firm may need to develop inbound logistics networks to move raw materials to manufacturing facilities. In addition, firms will need to develop outbound logistics networks to provide the i nfrastructure needed to move products to customers. In many cases, firms will need to develop both inbound and outbound logistical networks to meet customers’ needs in a timely manner. Once these networks are in place, the firm can utilize them for all i ts products. In this manner, firms develop international distribution infrastructures, which can be used for current products and for new products developed in the future. The demand for products and services becomes irrelevant if the network to move prod ucts to consumers does not exist. Without a well -developed infrastructure, firms from other countries will choose other international markets to expand into. In addition, a country’s firms are limited from selling their goods and services to other countr ies because these products cannot reach a rail, highway, and/or an airport. Problems with infrastructure stifle trade within and between countries. The government needs to focus on infrastructure to relieve bottlenecks. Porter’s diamond has stood the test of time in terms of determining which international markets a firm should enter. This discussion adds value to Porter’s model by incorporating the role of the government in which the firm is considering expanding into. International governments can be the brake or accelerator to firm expansion. As shown in Figure 10.3, the government has an impact upon all of Porter’s factors. By understanding the role of the government within each international market, firms can make more intelligent decisions upon which countries to enter and which countries not to enter. 223 Figure 10.3 The Role of Government and International Country Attractiveness Determination of International Industry Attractiveness Several criteria can be utilized to determine international industry attractiveness. Some important factors are as follows: (1) state ownership of industry, (2) government intervention within industries, (3) industry competitiveness, (4) industry profitab ility, (5) degree of product differentiation, (6) presence of large, multi -national firms within the industry, (7) significance of “Not Invented Here” syndrome, and (8) industry growth rates. Each criterion will now be briefly discussed. If the government owns the industry, international firms cannot achieve a position within it. As such, if the industry is state owned no further consideration should occur. The second criterion is government intervention within industries. As discusse d earlier, while firms in an industry may not be state owned, governments can take actions to support existing firms within the industry. Examples of such actions would be import duties, tariffs, or providing financial support for domestic firms. This is also a criterion that could prevent firms from entering an international industry. Porter’s 5 forces model can be used to determine international competitiveness. If entry barriers are high, an international firm may choose an industry that has lower barriers to entry. If buyers have significant bargaining power, a new entrant would need to enter the industry with a value added product or products. These products may require significant product R&D investment. If products are substitutable, customer s within the international industry have no incentive to switch. If suppliers have significant bargaining power, firms entering the industry may have difficulty establishing an inbound Factors of Production Demand Conditions Firm Strategy, Struct ure, and Rivalry Related and Supporting Industries Role of the International Government 224 logistic network. If existing industry rivalry is significant, new en trants may have difficulty competing. Industry profitability is a crucial statistic. Firms are in business to maximize earning so that shareholder wealth can appreciate. Some industries are more profitable than others. For example, firms within the U. S. oil industry are achieving much higher earnings than firms within the U.S. commercial airline industry. The degree to which products of firms within the industry are differentiated implies that the industry may not have reached the maturity stage. F rom Chapter 1, firms that are marketing differentiated products will most likely be in the growth stage of the industry life cycle. The maturity state occurs when competitors compete upon the basis of price as opposed to differentiation. The presence o f large multi -national firms within the international industry may act as a barrier to entry. If multi -national firms are of sufficient size, they may be generating economies of scale that would allow them to reduce price to combat new entrants. These fi rms may have sufficient resources to introduce value added features to existing products within the industry. Industries that do not have multi -national firms may be more attractive to new entrants. If it is important to have products that are manufact ured within the international market, it may require firms to engage in Foreign Direct Investment (FDI) within these markets. Brand name of existing firms may be quite significant. For example, because Harley Davidson motorcycles are “made in America”, i t is difficult for an international firm to compete within the U.S. heavyweight motorcycle market. High industry growth rates may indicate that the international industry is in the growth stage of its life cycle. As such, a new entrant may enter the in dustry and grow as the industry grows. Lower industry growth rates may imply that the industry is in the mature stage. Table 10.2 illustrates how an industry analysis would be conducted within an international country (A). Industry analysis should be conducted for all industries in all countries a firm is considering entering. 225 Table 10.2 International Industry Attractiveness Country A Criteria Weight* Score **(Value)*** Industry 1 Industry 2 Industry 3 Industry 4 1. State Ownership † Yes/No Yes No No No 2. Government intervention† Yes/No Yes No No No 3. Lack of industry competitiveness .25 N/A 5(1.25) 9(2.25) 9(2.25) 4. Industry profitability .20 N/A 6(1.20) 4(.80) 9(1.80) 5. Degree of product differentiation .20 N/A 8(1.60) 5(1.00) 8(1.60) 6. Presence of large, multi -national firms within industry .15 N/A 9(1.35) 6(.90) 6(.90) 7. Lack of “not invented here” syndrome .1M N/A 9(.90) 4(.40) 8(.80) 8. Industry growth rate .10 N/A 3(.30) 6(.60) 6(.60) Total 1.00 6.60 5.95 7.95 * Weights are assigned by senior management based upon how important one criteria is when compared to another **Scores are based upon a 1 to 10 scale where 1 is poor and 10 is excellent ***Value consists of the weight of each factor multiplied by the firm’s score † If yes, this industry should no longer be considered Based upon Table 10.2, Industry 1 is state owned. As such, the international government may not allow international firms to compete within this industry. Industry 1 is eliminated from consid eration. Industries that are subsidized by the international government should also be eliminated from consideration. Industry 4 may be the most attractive industry to target within this country. Industry 4 has higher profitability than industries 2 an d 3. Industry 4 is much less competitive than Industry 2 and has greater product differentiation than Industry 3. The “Not Invented Here” criterion is also much less significant than Industry 3. Industry 4 does not appear to have a significant number of multi -national firms (criteria 6) that could reduce price if a new entrant enters the industry. Industry 2 does have a large number of multi -national firms. These firms may have significant R&D resources that could produce value added products when the new entrant enters the industry. Based upon the above analysis, a new entrant should consider entering Industry 4 within this country. A firm must now assess its relative business strength within Industry 4. 226 Determination of Firms’ Business Strengths Table 10.3 addresses a firm’s business strength within a specific country and industry. A new entrant’s relative business strength versus existing competitors needs to be evaluated before entering the industry. Some of the criteria which impact firm compet itiveness within an industry are: (1) firm’s financial performance, (2) degree of product R&D required, (3) degree to which large scale production facilities are required, (4) significance of brand name, (5) level of process R&D required, (6) expense of de veloping distribution channels, and (7) expense of sourcing raw materials. Each of these criteria will now be discussed. Firms that have strong historical financial performance may be better positioned to negatively impact new entrants. These firms may be able to add value to existing products and/or reduce price while maintaining positive margins. Firms that have significant funds to devote to product R&D expenditures can more easily adapt products within an industry. If products are not standardized, product R&D must be incurred. Product R&D is primarily focused upon the development of new products or the re -positioning of existing products. If the industry requires new products, R&D expenditures may increase significantly. In addition, marketing r esearch is necessary to determine what specific types of products are required. It may be necessary to establish large scale operating facilities within the international markets. If competitors within the industry have already established such facilities , they may be able to reduce price to combat the new entrant while maintaining margins. If existing products have strong brand names it may be difficult to convince customers to purchase products from a new firm. A strong brand name can be a factor in ma intaining repeat customer purchasing and act as a barrier of entry. Promotional expenses could be significant for new entrants if existing customers are brand loyal. In order to sell products within international markets, firms will need to establish a d istribution network to reach customers within the foreign market. The firm will need to develop an inbound logistics network to move raw materials to manufacturing facilities. Both inbound and outbound logistics networks may need to be developed. Once m anufacturing facilities have been constructed, investments in process R&D may be required. Process R&D investments are primarily focused upon efficiency. Automation and six sigma are examples of process R&D expenditures. Competitors may have already inc urred the design and implementation of such initiatives. In addition, many TQM initiatives can be expensive to implement. Table 10.3 illustrates how a business strength assessment can be developed within an international industry. 227 A new entrant may consider entering Industry 4. Based on Table 10.2, we know that this industry has the highest potential of all industries within this country. Table 10.3 Firm Business Strength Assessment Country A Industry 4 Criteria Weight* Score** (value)*** Firm B Firm C Firm D 1. Firm’s financial performance (e.g. ROI, ROE) .25 9(2.25) 6(1.50) 4(1.00) 2. Product R&D expenditures .20 8(1.60) 3(.60) 2(.40) 3. Completion of construction of large scale facilities .15 5(.75) 4(.60) 4(.60) 4. Brand name competitor .15 4(.60) 2(.30) 3(.45) 5. Process R&D spending expenditures .10 3(.30) 4(.40) 4(.40) 6. Developed distribution network .10 3(.30) 4(.40) 7(.70) 7. Developed raw material sourcing network .05 7(.35) 7(.35) 2(.10) Total 1.00 6.15 4.15 3.65 * Weights are assigned by senior management based upon how important one criteria is when compared to another **Scores are based upon a 1 to 10 scale where 1 is poor and 10 is excellent ***Value consists of the weight of each factor multiplied by the firm’ s score This industry (Table 10.3) appears to have one significant competitor (Firm B) and two competitors who have much weaker positions. Firm B has had superior financial results compared to firms C and D. Firm B has invested significant resources to product R&D. The industry appears to be in the growth stage. All firms have not completed construction of large facilities (criteria 3). No firm has a strong brand name position (criteria 4). Distribution network (criteria 6) appears to be under -developed for f irms B and C. If the international firm considering entering Industry 4 has significant funds to engage in R&D expenditures and construction of large -scale facilities, the international firm may be able to develop a superior competitive position with res pect to firms C and D. However, Firm B may be a formidable competitor. The potential new entrant should examine the competitive position of all other industries in all other countries it has targeted before making a major commitment to this industry in this country. 228 Adaptation Versus Standardization A crucial decision that must be made is whether to produce the same products/services for international markets. If adaptation is not necessary, firms can utilize e xcess capacity from their domestic operations. Some types of products do not require adaptation for sale in international markets. Magic markers for use on white boards in classrooms are one example. Levi jeans are another example. Gillette’s blades and razors are a third example. In order to determine whether a firm’s products/services need adaptation, it is important to obtain customer input within the international market. One way to judge customer receptiveness is to perform focus groups within the international markets the firm is considering entering. Focus groups are discussions of products/services and competition with customers. A primary benefit of focus groups is that they can determine whether adaptation of products/service s will be required to meet the needs of each international market. For example, Coke and Pepsi are beverages that require minor adaptation for international markets. Within markets in South America, the formula for Coke and Pepsi is sweeter than in the U .S. Adaptation becomes expensive; however, if products/services do not meet market needs, they will not be consumed. Focus groups can provide a current perspective of a country’s political/legal environment. Understanding the crucial role the governmen t plays with respect to industries is quite important 20. For example, governments may impose import duties on certain goods and services. These duties will tend to raise costs for the importing firm. Governments may also control the type of advertising an international firm can employ. For example, France and Italy have banned advertising for tobacco products 21. The moderator of the focus group can have the participants enter into a discussion concerning competition. The firm considering internation al entry obtains an unbiased qualitative view as to the nature of competitors and their relative strengths and weaknesses. Another benefit of conducting focus groups in international markets is that firms can access the impact of the “Not Invented Here” (NIH) syndrome 22. Some markets may not purchase products simply because they are manufactured in markets other than those in which they are consumed. It is very difficult for international firms to sell heavyweight motorcycles within t he U.S. because Harley Davidson customers are loyal. Firms have different modes in which to enter international markets. Determination of International Modes of Entry International markets can be entered via (1) exporting, (2) licensing or franchising, ( 3) strategic alliances, (4) acquisitions and/or (5) foreign direct investment. Exporting will be discussed first. Exporting After a country has been identified as a viable international market, a firm must determine the best mode of entering that specifi c market. The entry mode with the lowest level of risk is normally exporting. The firm uses its excess domestic production capacity to sell products/services in selected international markets. Because the firm is manufacturing domestically, the internat ional distribution network may have added costs. For example, a U.S. firm that decides to enter China via exporting must develop a network to move products from the U.S. to China. 229 In addition to transporting products to international markets, firms must then develop a distribution infrastructure within the market. In addition, the actual selling process within the international market must be developed. An international sales staf f or agents are normally utilized for selling in international markets. This staff needs to be hired from each country. The primary reason is that sales personnel who are based in international markets are more familiar with the role of the government, t he competition, and the customer base. To facilitate international trade, the formation of agreements between countries has resulted in a reduction of trade barriers. The North American Free Trade Agreement (NAFTA) is one example. NAFTA has greatly reduced the barriers to trade between the United States, Mexico and Canada. NAFTA went into effect in 1994 23. Much of the NAFTA agreement has been centered on trade between the U.S. and Mexico. The value of goods traded between the U.S. and Mexico was $267 billion in 2004 24. Mexico is of critical importance to the U.S. because it is the 2 nd largest exporter of oil to the U.S. 25. Over 1/3 of Mexico’s trade comes from oil exports 26. In 2004, Mexico surpa ssed Saudi Arabia as the 2 nd largest supplier of exported oil. Mexico is also a market that provides favorable labor conditions. Other global developments have provided incentives for exporting. The creation of the European Union (E.U.) has reduced trade barriers between the 27 members. Table 10.4 identifies the members of the E.U. Table 10.4 Members of the European Union Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden United Kingdom These members of the E.U. have a gross domestic product of $38.4 trillion 27. This compares to the gross domestic product of NAFTA of $11.4 trillion 28. These 10 new nations also provide a connection between Western Europe and Russia. Russia is the sixth most populous nation, a nuclear power, and a large player in the global oil industry. Russia’s oil industry is important to all cou ntries. Its oil and gas reserves are greater than Exxon/Mobile, Petro -China, Royal Dutch Shell and Chevron Texaco 29. 230 Licensing/Franchising Firms may also enter international markets by licensing. Licensing occurs when one firm, the licensor, allows ano ther firm, the licensee, to use its intellectual property to generate sales. Intellectual property may include, but is not limited to, product R&D or process technology, other types of technology, brand names and/or trademarks. Licensees pay royalties to licensors. The licensor can gain access to international markets with minimal investment. Licensing may allow the licensor to enter international markets where acquisitions or direct foreign investment are not permitted by the government. Licensing is n ot without risk because technology transfer can occur. Research In Motion (RIM), the maker of Blackberry Wireless e -mail devices, has been sued by NTP Inc. for unwanted technology transfer 30. RIM has agreed to pay $450 million to settle the dispute 31. Li censing is also important because of property rights. Intellectual property rights have affected the international cell phone industry. Nokia, a worldwide leader in cell phones, licenses the intellectual property of 3G technologi es at much lower rates than rivals such as LG Electronics 32. Because Nokia holds many of the intellectual property rights, it holds a cost advantage over rivals. It is possible that Nokia could sell 3G phones for as much as $30 less than rivals 33. One reason Sony entered into a joint venture with Ericsson was to further develop intellectual cell phone property rights. Licensing does not only involve intellectual property rights. Products themselves can also be licensed. Tate & Lyle PLC (London) has a l icensing agreement with Johnson & Johnson to market and distribute Splenda 34. Splenda is a zero calorie sweetener that tastes closer to sugar than rival products. Coke, Pepsi, and Cadbury Schweppes have reformulated most of their diet cola products with Splenda 35. Franchising is a form of licensing in which a company (the franchiser) grants a franchisee the right to market its products/services within an international market. The difference between licensing and franchising concerns operations within th e international market. The franchisee agrees to conduct business in accordance with the franchiser’s standard of operation. Fast food chains utilize a great deal of franchising to develop positions within international markets. In 2005, McDonald’s had franchises in 119 countries 36. Yum Brands, which consists of KFC, Taco Bell, Pizza Hut, A&W Root Beer, and Long John Silvers, has over 13,000 franchises worldwide 37. While franchising has resulted in significant growth for fast food and hotel chains (e.g. Holiday Inn, Marriott), there are significant risks. To prevent opportunistic behavior on the part of the franchisee, the franchiser needs to control the point of differentiation. Otherwise, the franchisee may become a direct competitor of the franchiser. For example, Coke has expanded internationally via franchising. To maintain control of its many franchising firms, Coke exports the syrup. As such, this action prevents the franchisee from becoming a direct competitor. The role of government can also create risks for franchisers. When Venezuelan President Hugo Chavez changed monetary policies, franchisers were not able to collect royalties 38. Such political r isk can create an unfavorable position for franchisers. To assist firms in deciding where to enter into franchising agreements, consulting firms have developed factors that are crucial for franchising success. Factors such as market size, ease of entry a nd government corruption are measured on a country - by -country basis. Countries that provide the best franchising opportunities are fully developed markets such as the United States, Great Britain, Australia, and Germany 39. Developing countries such as Ma laysia, Poland, India, Russia, and Indonesia provide less 231 favorable conditions for franchising opportunities 40. Strategic alliances are another mode of international entry. Strategic Alliances Strategic alliances are partnerships between firms that pool assets to achieve competitive advantage. Strategic alliances can be categorized as either scale or link alliances. Scale alliances allow partners to more fully utilize the excess capacity of their resource base 41. The 3 major global airline alliances, St ar, OneWorld , and Skyteam, allow partners to utilize the aircraft of other partners to increase global coverage and reduce costs. Link alliances consist of firms that contribute different resources 42. Samsung has an alliance with Deutsche Telekom AG to collaborate on mobile digital broadcasting 43. Samsung will provide terrestrial mobile digital broadcasting in return for Deutsche Telekom AG’s assistance in gaining access to the German market 44. Link alliances have been referred to as “Trojan horses” 45. Since firms are contributing different resources, the possibility of technology transfer also exists. In some cases, both firms jointly working on new technology can minimize technology transfer. Boeing and Lockheed Martin are jointly working on a pr oject with the U.S. government to develop new rocket technology 46. This $4 billion project is to develop lower cost rocket launchers for launching military and surveillance aircraft. General Motors and Toyota have an alliance to develop technology that w ill lead to gasoline -electric hybrid cars 47. This technology will benefit both auto manufacturers. Siemens entered into a strategic alliance with the Russian rail monopoly, Russian Railways, to build trains for Russia 48. Siemens provides the technology for building the high -speed trains and Russian Railways provides the infrastructure. In this case, while the technology for building high -speed trains may be transferred to Russian Railways, the risks are not significant because Russian Railways controls all of the rail business in Russia 49. In addition, Russian Railways has no interest in expanding beyond Russia. Strategic alliances do have a down side. Firms that engage in alliances may withdrawal from these partnerships. If firms withdraw, partner s won’t have access to some international markets. For example, if United Airlines goes out of business, its partners in the Star global airline alliance will not have access to United’s extensive U.S.

based operating network. Currently, United Airlines (which acquired Continental Airlines in 2010) is the second largest passenger airline (American Airlines is first) in the world 50. Acquisitions Acquisitions are a mode of international entry by which the acquiring firm buys all or a controlling interest in a target firm. These are referred to as cross border acquisitions. In some cases, acquisitions may result in redundant assets. When Air France acquired KLM, Air France obtained KLM’s fleet; Air France did not need all of KLM’s aircraft 51. When DHL acquired Airborne in 2003, DHL did not need all of Airborne’s operating facilities. Acquisitions do allow firms access to new markets and may create financial incentives. General Electric’s acquisition of Bombardier’s (Canada) sports and recreational vehi cle finance division allowed G.E. to expand its commercial finance division 52. For Bombardier, the acquisition calls for G.E. to assume $1 billion in debt and provides $3.35 232 billion for Bombardier to pay short -term debt and provide financing for new airpl ane ventures 53. Acquisitions can also provide firms with access to high growth markets. The South American beer industry has attracted several international firms. Interbrew’s (Belgium) acquisition of AmBev (Brazil) gives Interbrew access to most South American markets. South African Brewers $6 billion acquisition of Colombian Brewer GrupoEmpresarial provides similar access for South African Brewers. With an international acquisition the acquiring firm has access to all of the target’s resources. Mo st important are knowledge -based resources with respect to competition, government relations, raw materials, distributors, financial resources, and customers within international markets. Acquisitions also have downsides. For example, international gove rnment regulations may not permit firms from establishing a position within their markets via acquisition. For example, the Russian oil and power industries are totally controlled by the Russian government. Only Russian firms have significant market shar es 54. The top 6 producers are all Russian firms: Lukiol, Rosneft, TNK, Surutneftegnz, Sibmept, and Yokos. Foreign Direct Investment Foreign direct investment (F.D.I.) is an entry strategy in which a firm establishes a position within a country without partners. Foreign direct investment may be a necessary strategy to compete effectively within some international markets. Foreign direct investment eliminates product entry costs that may be imposed by international governments. Foreign direct investment can lead to higher levels of employment within international markets. Many U.S. based firms are outsourcing management information system jobs to India. Pharmaceutical firms are outsourcing some aspects of R&D operations to China 55. Due to the extensiv e outsourcing by firms into China, Chinese ports are very congested. With trade between China and the U.S. expected to double by 2020, the U.S. may assist in building new Chinese ports to support the increased trade. In addition, manufacturing firms are outsourcing many assembly operations to Mexico. As outsourcing employment presents opportunities within international markets, the foreign country’s economy may improve. The downside is that many thousands of U.S. jobs, formerly performed within the U.S. , are lost each year. On the other hand, firms that utilize foreign direct investment into the United States create employment opportunities for U.S. citizens. Foreign direct investment is a mode of entry that contains significant risk. Firms that utili ze foreign direct investment may be affected by very volatile economic conditions within many markets. Foreign direct investment is effected by political and international government policy. The Gulf Wars have created uncertainty with respect to investin g in Middle Eastern markets. South American markets are also volatile. In 1994, the Mexican peso was devalued. In 1999, the Brazil real was devalued. In 2001, Argentina was struck by a financial crisis. In 2005, both Mexico and Brazil were experiencin g high inflation. 233 Competition within International Markets Intensifies As firms invest within international markets, a more competitive international environment is created. The industry life cycle and international life cycle literature explains that as a competitive environment becomes more saturated, firms begin to focus upon price as opposed to differentiation. This focus implies that the lowest cost provider will have an advantage. As firms compete on price, profit margins tend to be reduced. Costs saving measures such as increasing scale, implementing TQM initiatives, and/or increasing automation are all processes that are available to all competitors who have funds to invest. These approaches will tend to create highly efficient firms. As co mpetition on price intensifies, firms will need to determine additional ways of reducing costs. Relocate to Low Cost Markets Firms, to reduce costs further, may need to move production to less developed countries. While the variable costs (e.g. labor) are significantly less in developing countries, firms may still need to invest in plant and equipment. In addition, firms must develop inbound logistic networks to provide an infrastructure for raw materials to reach the new plant. Firms will also need t o develop outbound logistics to coordinate movement of products to consumers in a timely matter. In the long run, this network may provide for overall lower costs. However, the fixed costs and distribution infrastructure that must be developed are expens ive. Also, if unions represent your employees, the transition to a developing country for manufacturing and distribution activities may not be easily implemented. If firms successfully produce in low cost marke ts, the economy may grow to the point where customers in the low cost market may have obtained sufficient buying power to consume your products/services. As low cost markets become more developed, the infrastructure will tend to become more extensive. Wi th improvements in distribution, firms may learn to develop distribution infrastructures in additional global markets quicker and cheaper. New Innovation in Home Markets The international life cycle starts with innovation in the firm’s home market and ends with firms producing in low cost markets. Firms begin with products/services that are differentiated and end trying to obtain a cost advantage. To facilitate further growth, the firm will need to develop a new innovation in its domestic market that m ay result in a second international life cycle. If firms do establish international positions, they may more fully leverage their assets to generate returns from countries that are at different stages of the international life cycle. This relationship b etween stages of industry evolution and the international life cycle is illustrated in Table 10.5. 234 Table 10.5 International Life Cycle and Industry Evolution Stage of Industry Evolution International Life Cycle Stage Introduction Innovation in home market Growth Expand to total obtain coverage of domestic market Growth Exporting, licensing, strategic alliances, acquisitions, and/or foreign direct investment to enter international markets Maturity Competition within international markets inte nsifies Maturity/ Decline Relocation to developing markets to achieve low cost position If firms do not develop international markets, firms must continuously engage in new product R& D. Establishing positions in international markets allows the firm to obtain returns at all stages along the life cycle. Further, once an international infrastructure has been developed, it may be utilized for all subsequent products/services. 235 Discussion Questions 1. Explain why international expansion is necessary. 2. What factors encourage international expansion? 3. Explain the difference between regulated and deregulated industries. 4. Discuss Porter’s determinates of international country attra ctiveness. 5. Explain the modes of international entry. 6. Explain the risks with respect to foreign direct investment (FDI). 7. Explain what happens when a firm does not expand into international markets. 8. Explain the role of government with respect to Porter’s determinants of international country attractiveness. 9. What will be the most popular outsourcing locations in 2011? 236 References 1. Cateora, P. and Graham, J. 1999. International marketing . Boston, MA. McGraw -Hill Irwin. 2. Czinkota, M. and Ronkainen, I. 2004. International marketing . Mason, Ohio: Southwestern. 3. Penrose, E. 1959. A theory of the growth of the firm . New York: John Wiley & Sons. 4. Wernerfelt, B. 1984. A resource -based view of the firm. Stra tegic ManagementJournal . 5: 171 -180. 5. _____. 2005. Stake in large Chinese brewer increases to 27 percent. Wall Street Journal . 6. Ibid 7. Ibid 8. Larkin, J. 2005.Growth revolutionizes Indian air travel. Wall Street Journal . March 7. 9. Ibid 10. Mahon, J. and Murray, E. 1981. Strategic planning for regulated companies. Strategic Management Journal . 2: 251 -262. 11. Wernerfelt. A resource -based view of the firm. 12. Ibid 13. Porter, M. 1990. The competitive advantage of nations . New York, NY. The Free Press. 14. Ibid 15. Ibid 16. Ibid 17. Ibid 18. Jain, S. 2004. Marketing: planning and strategy . Mason, OH. Thompson Custom Publishing. 19. Ankli, Robert E. 1992. Michael Porter’s competitive advantage and business history. Business and economic history , Second Series. Volume 21. William J. Hausman, Editor Williamsburg, VA. Business History Conference Publisher 237 20. Cateora and Graham. International marketing . 21. Ibid 22. Ibid 23. Ibid 24. ____________. 2005. Mexican heritage celebration. New York Times . May 5. 25. Luhnow, D. 2005. Pemex chief says Mexican oil patch needs investors. Wall Street Journal . May 6. 26. Ibid 27. Miller, S., Grow, B., and Bilefsky, S. 2004. European Union gets ready to grow. Wall Street Journal . March 15. 28. Ibid 29. White, G. 2004. Latest move seals Gazprom’s role as energy giant. Wall Street Journal . December 24. 30. Heinzl, M. 2005. Blackberry maker asks court to enforce patent settlement. Wall Street Journal . June 15. 31. Ibid 32. Pringle, D. 2005. Dial time: hidden assets could let Nokia capitalize on boom for 3G phones. Wall Street Journal . March 10. 33. Ibid 34. Rashidi, E. and Ball, D. 2005. Tate & Lyle is in a sticky spot. Wall Street Journal . March 19. 35. Ibid 36. ____________. 2005. McD onald’s at 50. New York Times . April 15. 37. Kilman, S. and Gray, S. 2005. Fast food seeks influence in WTO. Wall Street Journal . April 19. 38. Bennett, J. 2005. A franchiser’s path to international success is often paved with pitfalls. Wall Street Journal . Apri l 7. 39. Ibid 238 40. Ibid 41. Dussauge, P., Garrette, B., and Mitchell, W. 2004. Asymmetric performance: the market share impact of scale and link alliances in the global auto industry. Strategic Management Journal. 25: 701 -711. 42. Dussauge, Garrette, and Mitchell. 2000. Learning from competing partners:

outcomes and duration of scale and link alliances in Europe, North America, and Asia. Strategic Management Journal. 21: 99 -126 43. _____. 2005. Samsung Electronics. Wall Street Journa l. April 11. 44. Ibid 45. Dussauge, Garrette, and Mitchell. Asymmetric performance: the market share impact of scale and link alliances in the global auto industry. 46. Pasztor, A., Karp, J., and Lunsford, J. 2005. Lockheed Martin, Boeing to form rocket venture . Wall Street Journal . May 3. 47. Shirouzu, N. and Sapsford, J. 2005. GM, Toyota weighs a bid to share hybrid expertise. Wall Street Journal . May 9. 48. White, G. and Chazan, G. 2005. BP Russia venture faces more taxes. Wall Street Journal. April 11. 49. Ibid 50. __ ________. 2005. Boeing 2010 passenger aircraft forecast. Boeing . Seattle, WA. 51. Keller, G. 2004. Air France acquires KLM. Wall Street Journal . September 1. 52. Kranhold, K. 2005. G.E. to purchase Bombardier arm for $1.4 billion. Wall Street Journal . May 3. 53. Ibid 54. White, G. and Singer, J. 2005. Gazprom, Rosneft each seek Sibneft. Wall Street Journal . May 26. 55. Santini, L. 2004. Drug companies look at China for cheap R&D. Wall Street Journal. November 24. 239 IKEA Mini Case IKEA primarily manufactures unassembled furniture. Because of this fact, IKEA is able to keep prices low. The customer pays for shipment of the furniture from point of sale to the customer’s final destination. This approach allows IKEA to follow a cost leadership strategy. IKEA v ision statement maintains that “IKEA will offer a wide range of well -design, functional, home furniture products at prices so low that as many people as possible can afford them.” IKEA offers prices that are 30 to 50 percent lower than fully assembled com peting products. This is a result of large -quantity purchasing, low - cost logistics, store location in suburban areas, and the do -it-yourself approach. IKEA’s prices do vary from market to market, largely because of fluctuations in exchange rates and diff erences in taxation, but price positioning is a key point IKEA markets. IKEA targets its products to “young people of all ages.” From a promotion perspective, IKEA primarily utilizes catalogs. IKEA utilizes a global distribution network so that the manu facturing locations in Table 2 can meet the needs of its customer base, which is identified in Table 1. Table 1 shows sales per region. The Nordic counties (Finland, Sweden, Norway, and Denmark), other Western European markets, and Eastern European count ries account for 73 percent of IKEA revenue. North America accounts for 15 percent while Asia and Australia account for 5 percent of sales. Table 2 s hows manufacturing per region. While Western Europe (including Nordic countries) account for 49 percent, Asia (30 percent) and Eastern Europe (18 percent) account for substantial manufacturing capacity. Table 1 Sales Per Region Sales Per Region Percent Nordic Countries (Finland, Sweden, Norway, Denmark) 33 Other Western European Countries 30 Eastern Europe 13 North America 15 Asia and Australia 5 Other 4 Total 100 Table 2 Manufacturing Per Region Manufacturing Per Region Percent Western Europe (Including Nordic Countries) 49 Asia 30 Eastern Europe 18 North America 3 Total 100 240 Discussion Questions 1. How and where should IKEA expand in the future? 241 L’Oreal Mini Case L’Oreal is one of the largest luxury cosmetic firms in the world. L’Oreal has 5 distinct product lines: (1) consumer products, (2) professional products, (3) luxury products, (4) active cosmetics, and (5) the body shop. Distribution of revenues by segment is identified in Table 1. The body shop accounts for minimal revenue. Consumer products are L’Oreal’s largest busi ness segment. It accounts for $9.52 billion of total revenues. L’Oreal defines consumer products as “the best in cosmetic innovation at accessible prices in mass -market retail channels.” Luxury products are L’Oreal’s 2 nd largest business segment. This segment focuses mainly on three business segments: skincare, make -up, and fragrances. This segment accounts for $4.50 billion of total sales. Professional products are L’Oreal’s 3 rd largest business segment. This segment “distributes its products in hai r salons all over the world.” This segment accounts for $2.71 billion of total sales. Active cosmetics are L’Oreal’s 4 th largest business segment. This segment addresses “all consumers’ health and skincare needs.” These products are sold through pharmac ies, drugstores, spas, and dermatologists. The segment accounts for $1.38 billion of total sales. Table 1 Distribution of Segment by Revenue Business Segment Revenues ($ billions) Segment Revenues of a Percent Total Consumer Products 9.52 52 Luxury Products 4.50 25 Professional Products 2.71 15 Active Cosmetics 1.38 8 Total 18.11 100 Table 2 shows L’Oreal’s revenues by geographic market (2010). Table 2 Revenues by Geographic Market Market Revenues ($ billions) Percent of Total Western Europe 7.74 43 North America 3.98 22 New Markets 3.09 17 Rest of World 3.30 18 Total 18.11 100 242 Table 3 identifies L’Oreal’s distribution of operating profit by geographic region. Table 3 Breakdown by Operating Profit (2010) Market Profit ($ Billions) Percent of Total Western Europe 1.55 46 North America .70 21 New Markets* 1.12 33 Rest of World Minimal 0 Total 3.37 100 *New markets include Australia, India, New Zealand, and Pacific Rim markets. Discussion Questions 1. Where (what countries) should L’Oreal expand? 243 Harvard Business Cases for Chapter 10 Worldcom Inc.: What Went Wrong? Product Number 905M43 Re -Thinking Think: The Electronic Car Company Product Number 810105 Professor Case for Chapter 10 McDonalds 244 245 Chapter 11 Strategic Leadership Decision Making 246 Learning and Assessment Goals 1. Determine how strategic leaders make decisions which meet the needs of the firm’s various stakeholders. 2. Determine how strategic leaders make decisions at both corporate and business levels. 3. Determine how strategic leaders make decisions over time within multiple industries. 4. Understand how strategic leaders evaluate competition. 5. Understand what strategic leader ship decisions need to be made in difference stages of an industry’s life cycle. 6. Determine why some strategic leaders have made or not made ethical decisions 247 “Apple has lost a visionary and creative genius, and the world has lost an amazing human bei ng. Those of us who have been fortunate enough to know and work with Steve have lost a dear friend and an inspiring mentor. Steve leaves behind a company that only he could have built, and his spirit will forever be the foundation of Apple”. (Apple News R elease 2011 ) Strategy has been defined as the ability to gain and sustain competitive advantage 1. In essence, firms must be able to identify trends within the environment and develop resources and capabilities to capitalize on these trends to increase sh areholder wealth. Leadership has been defined as the process of transforming organizations from what they are to what the leader would have them become 2. Therefore, strategic leadership is the ability to transform organizations to meet the needs of vario us stakeholders over time. Strategic Leadership Strategic leadership encompasses a number of attributes: developing human capital, exploiting and maintaining core competencies, sustaining an effective organizational culture, emphasizing ethical practice s, and establishing balanced organizational controls 3. Each of these elements will be briefly discussed. Developing human capital is, by far, the most important. In the long run, the growth of any firm is based upon the quality of human capital 4. Human capital may be the source of competitive advantage now and in the future because it is non -substitutable. In addition, human capital drives the development of all other attributes listed above. Therefore, human capital allows the firm to gain competitive advantage 5. The development of human capital at all levels of management allows the firm to sustain competitive advantage. Fred Smith, founder of Fed Ex, believes that people are more important than products or services. He believes that if you hire, tr ain, and retain good people they provide superior service. By providing superior service, the firm will be able to sustain continued profitability. Exploiting and maintaining core capabilities is a second attribute which is crucial for strategic leadershi p to be effective. Core competencies are the resources and capabilities that give a firm a competitive advantage over its rivals. In the 21 st century, an ability to develop and exploit core competencies will be linked even more positively and significant ly with the firm’s success. Only the combinations of a firm’s resources and capabilities that are valuable, rare, costly to imitate, and for which there are no equivalent strategic substitutes can be rightly identified as core competencies. 6 The relativel y unstable market conditions resulting from innovations, diversity of competitors, and array of revolutionary technological changes occurring in the new competitive landscape have caused core competencies rather than served markets to become “the basis upo n which firms establish their long -term strategies.” 7 As firms continue to globalize, developing core competencies becomes even more important. Once a firm has achieved advantage within its domestic markets, it can enter international markets from a posi tion of strength. 8A firm that can build competencies to profitably develop domestic markets and exploit international markets will have multiple sources of advantage over competitors which may be unable to achieve this expansion. An excellent way of obtaining and sustaining an effective organizational culture is to provide incentives (stock and/or money) based upon the financial success of the firm 248 on a year -to-year basis. This simple principle has led UPS to be one of the largest firms in the world. Caterpillar and Archer Daniels Midland (ADM) are also examples of firms which reward senior managers based upon the profitability of the firm. Both of these firms have been experiencing record growth and profit. Providing an environ ment that supports ethical practices is another aspect of effective strategic leadership. 9 Strategic leader’s commitment to serve stakeholders’ claims will contribute to the establishment and continuation of an ethical organizational culture. This conditi on applies both to domestic and international markets which a firm services. This is one reason the Sarbanes -Oxley Act (SOX) of 2002 was created. This act was implemented in 2002 with the effects coming into play in 2003 and 2004. The Sarbanes -Oxley Act , “Introduced a new era of corporate governance, including requirements for auditor independence, the restriction of firms engaging in accounting from both auditing and consulting services, independence of firms board committees, management assessment of i nternal controls and personal certification of financial reports by CEO’s and CFO’s. 10 These are important reasons why establishing and maintaining ethical practices are important. Unethical practices take away both managerial time and resources which sho uld have been allocated to running a successful firm to maximize shareholder wealth. Because firms are global in nature, establishing balanced organizational controls is a crucial aspect of effective strategic leadership. 11 Defined as the “formal, inform ation -based…procedures used by managers to maintain or alter patterns in organizational activities,” controls help strategic leaders build credibility, demonstrate the value of strategies to the firm’s stakeholders, and promote and support strategic change .12 Controls provide the parameters within which strategies are to be implemented, as well as corrective actions to be taken. 13 Strategic leadership’s impact upon both corporate and business level strategy will now be discussed. The chief executive offi cer (CEO) and the senior management team normally have strategic leadership responsibilities within firms. The stakeholders of strategic leaders are illustrated in Figure 11.1. 249 Figure 11.1 The Stakeholders for Strategic Leaders Shareholders Customers Investment Strategic Leaders Community Employees Board of Directors Collective Bargaining Organizations Customers One group of stakeholders that must be addressed is the customers. Without customers, the firm has no revenue. In order to meet the needs of customers, strategic leaders must identify key success factors within each industry. Key success factors are the set of conditions that customers deem as important, and upon which customers make buying decisions 14. The simulation identifies these conditions as key buying criteria. Firms that meet key buyin g criteria better than competitors may achieve competitive advantage. The simulation addresses four key buying criteria. For each segment, the key buying criteria are (1) positioning, (2) price, (3) age, and (4) performance (mean time before failure). These key buying criteria are weighted differently for each segment. Table 11.1 identifies the set of key buying criteria within the low end and high -end segments of the simulation. 250 Table 11.1 Key Buying Criteria High -End Segment Low -End Segment Criteria % of Buying Decision Criteria % of Buying Decision Positioning 43 Price 53 Age: 0 Years 29 Age: 7 Years 24 MTBF: 20,000 - 25,000 19 Positioning 16 Price 9 MTBF: 12,000 - 17,000 7 Within the high -end segment, the most important key buying criteria is positioning. Positioning is best met utilizing new product R&D. Within the high -end segment, customers want new products (age = 0) that are durable (MTBF mean time before failure = 20 ,000 -25,000). To meet these key -buying criteria, firms must continuously engage in new product R&D. As products age, the firm may sell some existing products in other segments. From Table 11.1, the low -end segment’s key buying criteria is dominated by price. As products age, the products that were sold within the high -end segment may meet customer needs in the traditional, and eventually, in the low -end segment. The funds generated from sales of these products may be re -invested within the firm to R&D new products for the high -end segment. In this manner, firms can meet the needs of additional market segments over time. By understanding how these criteria evolve over time, the firm may be able to obtain a superior position with respect to competition. Employees are the second group of stakeholders that strategic leaders must satisfy. Employees Employees have access to information concerning how well current products meet the needs of customers. Sales employees obtain feedback from customers about the firm and competitors’ products. Senior management uses this information to make revisions on existing products or develop new products. In addition, sales employees can provide senior management with information concerning how key buying criteria evo lve over time. By identifying how these criteria change, senior management can allocate resources, normally funds for product R&D, to meet the changing needs of customers as they arise. M anagerial resources are a key group of stakeholders. Managerial r esources create value by using resources to create new productive services that the firm can employ to generate growth faster than competitors 15. Managerial resources are responsible for developing, implementing, and measuring a firm’s strategy. Managers dictate how resources will be allocated within the firm. Without sound decisions by the management team, sustained competitive advantage is not likely. Not only are managerial resources responsible for making strategy decisions, they have the responsibi lity of implementing them. This is why it is crucial that all employees have input into the development of a firm’s strategy. If open communication exists between all employees and senior management, strategy adjustments become easier to implement. If em ployees have some degree of ownership, it will also make the implementation of the 251 strategy easier. The implemented strategy, not the designed strategy, is what determines competitive advantage. Because of these responsibilities, strategic leaders must accomplish two primary objectives: (1) maximize quarterly firm performance and (2) maximize long -run shareholder value. The second objective must be the result of a well thought out and properly implemented strategic plan. Becaus e strategic leadership involves transforming organizations, significant expenses may need to be incurred. Some of the expenses are related to product and/or process R&D, implementation of TQM initiatives, investments in promotion and infrastructure, and d evelopment of domestic and global markets. As John Skelly, former CEO of Apple, stated: “The best way to compete in the future is to create it”. Managerial resources create growth potential for the firm. As multi -national firms expand, the importance of understanding and competing in international markets becomes important. One reason why Paul Mullehom, former president of Archer, Daniels, Midland, obtained his job was because of his international experience. Knowledge of international markets allows fi rms to re -deploy resources to obtain maximum returns. As discussed in Chapter 10, International Strategies, international markets represent significant growth potential. In addition, the development of international markets may reduce spending needed on new product R&D. The firm may not need to be continuously focused on innovations in domestic markets. International markets allow for expansion of existing or adapted products. International expansion allows firms to grow within the firm’s core business. If the management team does not have international experience, the firm may soon be reacting to international competitors as opposed to leading change. The U.S. auto industry is an example of firms that have engaged in a reactive strategy. Effective st rategic leadership identifies not only where the firm needs to grow but also how and when this growth can occur. Collective Bargaining Organizations If employees are members of collective bargaining organizations, these organizations may moderate what actions a firm can take. Labor unions may reduce a firm’s flexibility. Firms with strong collective bargaining units may have less flexibility to participate in outsourcing programs. Faced with rapid g lobal expansion, leaders of the world’s top unions are forming cross -border alliances to share strategies for contract negotiations and to develop international safety and workers -rights standards 16. These moves could make collective bargaining stronger. This focus on global labor unions comes at a time when union membership, as a percentage of the total work force, has been declining in the U.S., most of Western Europe, and Australia. Shareholders Leadership decisions can lead to “d estruction” for shareholders. One only needs to pick up the paper. Corruption and greed have occurred with alarming regularity among CEOs entrusted with strategic leadership responsibilities. Enron, WorldCom, Arthur Andersen, Tyco, and AIG all had CEOs who attempted to utilize their leadership positions for personal gain at the expense of shareholders. One of the reasons why these CEOs engaged in opportunistic behavior is because of risk. One type of risk that has different consequences for shareholder s and CEOs (including senior management) concerns acquisitions. Figure 11.2 illustrates these different risk profiles. 252 Figure 11.2 Shareholder & CEO Risk Profile High Risk Low Same Related Unrelated Business Business Business Levels of Diversification Source: Adopted with the permission of Thompson Learning from Strategic management by M. Hitt, R. Ireland, and R. Hoskisson. 312.2005. Shareholder risk is minimized with more related acquisitions. Shareholders can diversify their risk by creating a portfolio of stocks with different risk profiles. The CEO and senior management cannot . Therefore, they may be more focused on engaging in unrelated acquisitions to reduce employment risk. Unrelated acquisitions may result in a portfolio of different businesses that may lead to more stable cash flows. This stability of cash flows tends to reduce CEO and senior management risk. However, firms that acquire related businesses tend to generate higher returns than unrelated acquisitions. As discussed before, to solve the risk difference between shareholders and senior management, firms are beg inning to compensate senior managers based on the financial performance of the firm. Executive compensation is the responsibility of the board of directors. Boards of directors are an important stakeholder group because they represent the interest of sha reholders. Board of Directors The board of directors has two primary responsibilities: (1) maximize shareholder value and (2) hire and fire the CEO . Boards of directors have become more involved in developing a firm’s strategy. Historically, boards of directors have utilized the CEO as the primary information source with respect to firm actions and reactions 17. More recently, boards of directors have become more proactive in terms of ut ilizing multiple sources for information and becoming more active in firm decision -making 18. Shareholders Senior Management 253 The Sarbanes -Oxley Corporate Reform Law of 2002 requires CEOs and chief financial officers (CFOs) to sign their financial reports certifying the reports’ accurac y. The CEO and CFO are threatened with criminal prosecution if they knowingly certify false documents. This act is another way of reducing the risk difference that may exist between senior management and shareholders. Because most firms cannot fund grow th entirely through internal funds, the investment community becomes important. Investment Community Firms need to have good relationships with investment bankers. Investment bankers provide capital to fund a firm’s expansion. Whether a firm is expandin g via acquisition, development of international markets, or other major expansion programs, firms are not normally able to fund significant expansion programs entirely from cash from ongoing operations. For the firm to grow and create additional value fo r shareholders, the firm needs to develop long -term relationships with the investment community. In addition, the investment community attempts to provide an independent objective view of a firm’s future performance. Wall Street’s “point of view” may pos itively or negatively impact a firm’s stock price. Strategic leadership has implications for both corporate and business level strategy. The relationship between strategic leadership and growth will be discussed. Table 11.2 Senior Managers and Ethic s Shareholder Ethical Unethical Shareholders Investment maximized Increase to shareholder wealth not obtained Employees Investment in profit sharing not maximized Higher turnover Board of directors Maximizing shareholder wealth Senior managers maximizing their own wealth Collective bargaining organizations Capability to work together with collective bargaining organizations Minimal interest in bargaining to provide for firm growth and/or profitable returns Investment community Long term relat ionships with investors maintained Hesitant to provide funding needed for growth due to prior negative relationships Customers Meeting evolutionary needs of customers Time devoted to unethical behavior: needs of customers may not be met Senior Managers and Ethical Decision Making Senior managers have many stakeholders which must be satisfied. Table 11.2 provides a discussion of senior managers and ethics. Shareholders will be discussed first. 254 A primary role of senior managers is to provide for increas ing shareholder wealth . Ethical decision makers will work to make decisions which will maximize the returns to shareholders. They will not engage in risky decision making which could reduce shareholder wealth. From a diversification perspective, senior man agers will most likely engage in related diversification because, in general, these types of actions will increase shareholder wealth (Figure 7.1: Chapter 7). In addition, unethical decision makers will normally decrease shareholder wealth. Unethical deci sion makers can have a negative impact upon employees. Employees model behavior of their superiors. If employees are aware of unethical senior manager actions, employees may take the position that unethical decision making is fine and act accordingly (in t his case, unethically). If employees are ethical, they may change jobs to more ethical firms who have ethical senior managers. In this case, the unethical firms will need to incur significant time and money to hire and educate new employees.

The employees who have moved to ethical firms take institutional knowledge about their former firm, its position in the industry, and knowledge of the industry and customer base they have acquired during their employment with the unethical firm. If senior managers are unethical, boards of directors must fire them. In addition, boards of directors must then conduct a search to replace them. In the meantime, the unethical firm may lose some of its market positions because no one in the unethical firm can make superior dec isions in the firm’s best interest. As a result, shareholder wealth may decline. With declines in shareholder wealth, firms may have difficulty obtaining needed funds from investment banks which are needed for growth. In fact, investment banks may be more inclined to provide funds to competitors because the value of shareholder wealth with unethical decision makers has declined and will continue to decline. In order to meet the needs of customers, the needs of collective bargaining organizations must be m et. If firms do not deal ethically with collective bargaining units, firms may be forced to deal with labor strikes. Trust is of crucial importance when dealing with labor unions. Strikes do not allow firms to meet the needs of the marketplace (e.g. custom ers). If a firm goes on strike, competitors may benefit from obtaining customer revenues from customer bases of the unethical firm. In addition, if the competitor has good relationships with its collective bargaining unit, it knows that product supply will be met when needed. In addition, once customers move to competitors of the unethical firm, there is no guarantee that the customers will return to the initial firm once the strike is over. This takes revenue from the firm that is engaged in the strike and this revenue immediately goes to competitors. This diversion of revenue could affect the domestic and international customer base of the firm that is engaged in the strike. One overarching theme that can be stated is that unethical senior managers are limited from a conceptual perspective. Visionary senior managers do not need to be unethical because they create industries: Steve Jobs (Apple), Bill Gates (Microsoft), Jim Casey (UPS), Fred Smith (FedEx), Ray Kroc (McDonald’s) and Larry Ellison (Oracle).

Th e above list is not all inclusive but shows that industries can be created by ethical, visionary, senior managers. I am not aware of any industries which have been created by unethical decision makers. Visionary leaders are too busy developing new industri es; they do not have the time or the interest of engaging in unethical behavior. 255 Strategic Leadership and Growth In the long run, the competitiveness and growth of any firm is directly related to decisions made by the senior management team. Managerial resources which have different capabilities may provide the firm with different performance consequences. Figure 11.3 implies that the accumulation of managers from related industries will generate higher growth than hiring managers from the same or unre lated industries. Figure 11.3 Hiring of Senior Managers and Performance Consequences High Growth Low Same Related Unrelated Business Business Business Source of Hired New Senior Managers This relationship is similar to the relationship which we discussed in Chapter 7, Corporate Level Strategy and Restructuring. Firms which hire managers from the same industry may not have the performance potential as opposed to firms which hire managers from r elated industries. Firms which have hired managers from the same industry limit growth because they have the same experience as existing managers. Many of the U.S.’s airline acquisitions have not been profitable because the target’s managerial resources do not, in most cases, have experience outside the U.S. commercial airline industry. 256 Table 11.3 shows the major U.S. airline acquisitions since 2001. Table 11.3 U.S. Airline Acquisitions Since 2001 Combined Airline Acquisition Date Acquiring Firm American Airlines/TWA 4/9/2001 American Airlines US Airways/America West Airlines 9/27/2005 US Airways Delta Airlines/Northwest Airlines 12/31/2009 Delta Airlines United Airlines/Continental Airlines 10/1/2010 United Airlines Southwest Airlines/AirTran Airways 5/2/2011 Southwest Airlines As shown in the table, the major U.S. airlines have had a tendency to acquire another airlines. These types of acquisitions limit the growth potential of the acquiring firm because the acquiring firms are obtaining managerial resources from other U.S. airlines who have similar knowledge. American Airlines has lost $4.22 billion since 2008. U.S. Airways/America West Airlines has lost $2.95 billion since 2007. Delta Airlines lost $1.24 billion in 2009. It is too early to have financial results from the United Airlines/Continental Airlines merger or the 2011 of Airtran Airways by Southwest Airlines. This data points to the fact that top managers who have spent their careers in one industry or fir m, they will have a limited knowledge base from which to conduct a strategic search for new opportunities and would not be likely to pursue new ideas outside this limited knowledge base. 19 A firm’s managerial resources are of crucial importance in times o f change. 20 Top management teams must possess experience outside the firm’s core business during periods of significant change. Under conditions of environmental change, firms must pursue senior managers with new capabilities. 21 Those senior managers pr ovide skills that are particularly scarce relative to their competitors, and being relevant in the particular competitive context, have the potential to generate rents. 22 This is especially true because these skills cannot be imitated quickly by other top executives in other firms. Senior managers from unrelated industries have different perceptions of the environment, the customer base, the nature of competition, and differential speeds of learning. In addition, managers from unrelated industries may no t have knowledge of strategic industry factors of the industry they are entering. Strategic industry factors dictate buying decisions. In the industry in which they are moving to, managerial resources drive the development of firm specific capabilities w hich in turn will determine what productive services the firm is capable of offering. Without knowledge of strategic industry factors managers may not make good business decisions. One of the primary assumptions of the theory of the growth of the firm is that “history matters.” 23 Growth is essentially an evolutionary process and based on the accumulation of collective knowledge. 24 Penrose (1959) states that, “the growing experience of management, its knowledge of other resources of the firm and of the 257 potential for using them in different ways, create incentives for further expansion as the firm searches for ways of using the services of its resources more profitably. This is especially true in industries with turbulent environments. The air freight an d airline industries were deregulated in 1978 while the trucking and railroad industries were deregulation in 1980. Many firms did not survive the consolidation of these industries. The transportation firms which are successful today are multi -modal carr iers. These firms have become total transportation firms which provide all modes of transportation worldwide. These firms offer trucking, rail, air freight, ocean shipping, and logistical services worldwide. Managers with superior knowledge of a firm’s capabilities and industry context are more likely to design strategies that create value by being more effective than rivals at bundling and deploying resources in new ways. This perspective of the firm as being able to dictate environmental change exten ds the traditional position of the firm from responding to environmental change after the fact. By the management team acquiring new capabilities, the firm has the potential to create environmental change that alters the competitive environment in the fir m’s favor to provide for long -term growth. As such, through the integration of related industry managerial resources with the firm’s existing management team, the firm may be able to “creatively construct” its environment to the point where the firm can d ictate the path of environmental change. Firms which have not incorporated new managerial resources from related industries may not have the capacity to grow through “creative construction.” Scandals and Strategic Leadership Throughout the first part of the new century, corporate scandals have played a central role within many U.S. corporations. The WorldCom scandal resulted in negative consequences for the firm’s board of directors. Eleven of the former board members agreed to pay $20.2 million to set tle a lawsuit concerning the firm’s accounting fraud 25. In March 2005, Bernard Ebbers, former WorldCom CEO, was convicted of fraud and conspiracy and sentenced to 25 years in prison. Many other senior executives face situations similar to that confrontin g Bernard Ebbers 26. Others who have been convicted are Kenneth Lay (former chairman of Enron), and Jeffery Skilling (former CEO of Enron). Kenneth Lay has died and Jeffery Skilling is serving 25 to life. The senior management team at AIG Inc., the world ’s largest insurance firm, admitted to a broad range of accounting frauds that reduced the firm’s net worth by $1.7 billion 27. In addition, Michael Eisner (Disney) stepped down as CEO after considerable pressure from the board of directors. Carly Fiorina , former CEO of Hewlett Packard, resigned as a result of the Compaq acquisition. In many cases, individuals attempted to maximize their own personal financial gains instead of trying to increase shareholder wealth. What is alarming is that CEO bonuses r ose 46 percent at 100 of the largest U.S. companies in 2004 28. Many of these firms did not experience similar increases in shareholder wealth 29. Due to the fact that many individuals conspired together (e.g. WorldCom senior management), the amount of ti me to engage in these illegal actions was considerable. This time reduced the focus and commitment the senior management teams needed to devote to maximizing shareholder wealth. Strategic leadership should be focused on gaining and sustaining competitive advantage for shareholders. Strategic leadership is not eliminating or significantly reducing shareholder wealth. Acts of fraud are focused 258 within the firm. Strategic leadership needs to be focused on making decisions based on external factors such as customers, competition, and industry transformation. Industry Evolution and Strategic Leadership In Chapter 2, Industry Analysis, the relationship between industry analysis and industry evolution was discussed. A similar framework can be utilized to address what strategic decisions need to be made at different points of industry evolution. The framework is illustrated in Table 11.4. Table 11.4 Strategic Leadership Decisions Across the Industry Life Cycle Stage of Industry Life Cycle Strategic Leade rship Decisions Introduction (1) relationship building, raising capital (2) establish suppliers (3) recruit, hire, and train employees (4) build inbound and outbound distribution infrastructure (5) develop communication infrastructure Growth (1) develop pricing strategy (2) conduct competitive analysis (3) develop lower cost or differentiation positioning (4) continue relationship building (5) design expansion strategy (including international) Maturity (1) achieve economies of scale and economies of scope (2) implement automation (3) implement total quality management (TQM) initiatives (4) implement international strategy Decline (1) conduct product line profitability and eliminate unprofitable lines (2) focus resources on more attractive industries (3) decision -making should be focused on the development of innovat ions to begin the second life cycle process Introduction Strategic leaders must obtain capital to fund the new business. Venture capitalists provide funding, but expect high returns. Because the risk is substantial, the venture capitalists must be convinced that the venture is solid. One of the best ways of a ttracting investors is to have a well -developed business plan. One way of accomplishing this is to hire individuals who have been successful at starting new businesses. Strategic leadership during the introduction stage of an industry’s life cycle is focused on relationship building. The leader must develop relationships with suppliers because none may exist. A network needs to be established that allows for raw materials 259 to be transported to manufacturing/operating facilities and then to customers in a timely manner. Leaders must hire employees to manufacture raw materials into finished goods. Leaders must instill in employees a sense of pride and commitment. One of the best ways of doing this is to make your employees shareholders. When their comp ensation is partially rewarded based on the profitability of the firm, employees will be more highly motivated to perform at peak efficiency. A commitment to the firm from sales people during this stage is crucial because the firm is offering new goods/se rvices to new customers. The firm’s existence is dependent upon the sales force converting prospects into customers. Compensation programs that provide high incentives to generate sales quickly are crucial at this point. Since the firm is offering new products/services to new customers, customer acceptance is crucial. The leader must make certain that feedback with respect to products/services, competition, and changing key buying criteria reaches senior level management in a timely manner. A communic ation infrastructure must be developed to permit timely information to flow throughout the firm and especially to customers. This infrastructure needs to facilitate the building of long -term relationships with employees and customers. Growth When compe titors have entered the industry, the growth stage of the life cycle has begun. A well -developed pricing strategy is crucial as the firm enters the growth stage. Low prices by the incumbent firm may act as a barrier to entry. Potential entrants may choo se to enter other industries that offer more favorable margins. When competition does enter the industry, strategic leaders can follow one of two approaches. First, as competitors enter the industry with similar products/services, the initial firm may r educe price. Because competitors have start -up costs to recover, price reductions will make this recovery process longer. Second, the initial firm’s leaders may decide to improve the quality of existing products by adding value -based features. The attem pt with the second option is to create differentiation from competitors. If margins are sufficient, strategic leaders may engage in both approaches. By creating differentiation from competition and offering consumers lower prices, the firm can maximize g rowth. It is the leaders’ responsibility to anticipate actions by competitors, and quickly implement strategic responses to competitors’ actions. Leaders must be aware of the strengths and weaknesses of their firm and of competitors. Strategic leaders will design and implement programs to capitalize upon competitors’ weaknesses. Strategic leaders will also implement an expansion strategy to penetrate international markets. Maturity When price becomes more of an elastic variable, the industry has enter ed the maturity stage of the life cycle. Strategic leaders need to design and implement programs that allow for economies of scale to be obtained. As the industry moves further into the maturity stage, price becomes an important key buying criterion. In addition to actions that achieve scale economies, strategic leaders need to design and implement total quality management (TQM) initiatives that reduce costs. While a firm’s domestic market may be mature, the firm may be able to obtain higher margins in international markets within the same industry. International markets 260 may be at earlier stages of the industry life cycle than the firm’s domestic market. As such, firms may enjoy the benefits of the growth stage of i ndustry evolution in some international markets. This expansion may permit strategic leaders to obtain additional funds to expand into other international markets. Decline As firms begin to exit the industry and/or go out of business, the industry has reached the decline stage. This stage is characterized by decreasing sales and margins. Product line profitability studies need to be continually reviewed. Unprofitable lines need to be eliminated. Strategic leaders need to determine the best allocation of resources. Leaders may reallocate resources to developing international markets that are at earlier stages of the life cycle. This process of industry and international expansion is what sustains firms in the long run. Strategic leaders may allocate resources to create new industries; this begins a new industry life cycle. The entire process will then follow a new life cycle. 261 Discussion Questions 1. Define strategic leadership. 2. Identify the primary stakeholders of strategic leaders. 3. Why have some strategic leaders engaged in greed and corruption? 4. Explain how strategic leaders analyze competition. 5. What should strategic leaders do when their firm enters the maturity stage of the industry’s life cycle? Why? 6. Explain what decisions strategic leaders need to make at each stage of the industry life cycle. 7. Explain why strategic leaders need to develop long -term relationships. 262 References 1. Rumelt, R., Schendel, D. and Teece, D. 1991. Strategic management and economics. Strategic Management Journal . 12(winter): 5 -29. 2. Dess, G., Lumpkin, G., and Eisner, A. 2005. Strategic management . McGraw -Hill Irwin. Boston, MA. 3. Ireland R. and Hitt M. 2005. Achieving and maintaining strategic competit iveness in the 21 st century: the role of strategic leadership. Academy of Management Executive , 13: 63 -77. 4. Penrose E. 1959. A theory of growth of the firm . John Wiley & Sons: New York. 5. Ireland R. and Hitt M. 2005. 6. Barney J. 1991. Firm resources and sustained competitive advantage. Journal of Management , 17: 99 -120. 7. Ireland R. and Hitt M. 2005. 8. Wernerfelt B. 1984. A resource based view of the firm. Strategic Management Journal , 5: 171 -180. 9. Thompson A., Strickland A., and Gamble J. 2007. Crafting and executing strategy; the quest for competitive advantage. 14 th edition. McGraw -Hill Irwin: New York 10. Dalton D. & Dalton C. 2005. Sarbanes -Oxley legislation and the private company: If not a m arriage, then certainly an engagement. Journal of Business Strategy , 26(2): 7 -8. 11. Ireland R. and Hitt M. 2005. 12. Laverty K.J. 1996. Economic “short termism”: The debate, the unresolved issues, and the implications for management practice and research, Ac ademy of Management Review. 13. ibid 14. Amit, R. and Shoemaker, P. 1003. Strategic assets and organizational rent. Strategic Management Journal . 17: 33 -46. 15. Moran, P. and Ghoshal, S. 1999. Firms and the process of economic development.

Academy of Management Rev iew . 24: 390 -412. 16. Glader, P. and Maher, K. 2005. Mining and unions seek to form cross -border alliances. Wall Street Journal . May 6. 263 17. ____2004. The view from the boardroom. Wall Street Journal. November 11. 18. Young, S. 2005. Ex -WorldCom directors reach pa ct. Wall Street Journal . March 24. 19. Hambrick, D. and Mason, P., (1984). Upper echelons: The organization as a reflection of its top managers. Academy of Management Review , 9: 193 -206. 20. Adner, R. and Helfat, C., (2003). Corporate effects and dynamic manage rial capabilities. Strategic Management Journal , 24: 1011 -1025. 21. Holcomb, T., Holmes. R., and Connelly, B., (2009). Making the most of what you have: Managerial ability as a source of resource value creation. Strategic Management Journal , 30: 457 -486. 22. Castanias, R.P. and Helfat, C.E. (2001). The managerial rents model: Theory and empirical analysis. Journal of Management , 27: 661 -678. 23. Teece, D., Pisano, G., and Shuen, A., (1997). Dynamic capabilities and strategic management. Strategic Management Journ al, 18: 509 -533. 24. Penrose, E., (1995). Forward in Penrose, E. The Theory of the Growth of the Firm . Oxford: Basil Blackwell. 25. Pulliam, S. 2005. At center of fraud, WorldCom officials see life unravel. Wall Street Journal . March 24. 26. Ibid 27. McDonald, I., Francis, T., and Solomon, M. 2005. AIG admits improper accounting. Wall Street Journal . March 31. 28. Lublin, J. 2005. CEO bonuses rose 46.4% at 100 big firms in 2004. Wall Street Journal . February 25. 29. Ibid 264 Hershey Mini Case The Hershey Company is the largest producer of quality chocolate in North America and a global leader in chocolate and sugar confectionery. This firm has continued to grow from a sales and profit perspective in light of the fact that many of its products are not view ed positively by health conscious consumers. Revenues have increased from $5.13 billion in 2008 to $5.67 billion in 2010. In addition, net income has increased from $311 million in 2008 to $509 billion in 2010. Further, earnings per share have increased from $1.41/share in 2008 to $2.29/share in 2010. Hershey has substantial international operations (in addition to the U.S.) in Canada, Mexico, Brazil, Asia, the Middle East, and Africa. Some of these international markets are a source of growth because many of these countries are currently not focused upon the concerns of healthy chocolate products. While some products, may need minimal adaptation, the consumers in general, are focused more on taste than upon health. From this perspective, Hershey is f ocusing u pon Mexico and the Pacific Rim markets as two of its growth markets. Hershey’s International group is responsible for building global brands, developing growth platforms, brand positioning and portfolio strategy. This group also develops market -specific insights, strategies and innovation for Hershey International. In international markets, one of Hershey’s strategic goals is to deliver sustainable innovation to improve their position in these key growth areas. Hershey believes that this appr oach would strengthen their position globally in sugar confections, building a competitive position in the premium and value confectionery segments and supporting health and wellness product offerings. The “supporting health and wellness product offerings ” are one key to profitable growth in fully developed markets which are focused upon healthy choice options (e.g., U.S.). Hershey has a goal of being a socially responsibility corporate citizen. Discussion Questions 1. Explain how Hershey has designed it s strategy to meet the needs of a health conscious society. 2. Explain how Hershey is focusing upon corporate social responsibility. 265 Harvard Business Cases for Chapter 11 Hocol Product Number SKE141 Volkswagen to Brazil: Driving Strategy with the Balanced Scorecard Product Number 111049 Professor Case for Chapter 11 AB Inb ev 266 267 Chapter 12 Wealth Creation 268 Learning and Assessment Goals 1. Understand what wealth creation is and how it is achieved. 2. Understand how the balanced scorecard can be utilized to provide a framework for assessing wealth creation. 3. Develop an understanding of financial ratios and how they are used. 4. Understand the concepts of economic value added (EVA) and market va lue added (MVA). 269 In Chapter 11, we identified several groups of stakeholders: customers, shareholders, employees, and investment bankers as important groups for whom the firm needs to create wealth. Many stakeholders and firms utilize financial data to judge wealth. Balanced Scorecard and Wealth Creation While financial data can provide a wealth of information concerning a firm’s historical performance, financial data does not predict future performance. In addition, fin ancial measures are based on one firm alone with no competitive or industry data assessment. These limitations can be resolved by using the balanced scorecard. The balanced scorecard is illustrated in Figure 12.1. Figure 12.1 Balanced Scorecard Source : Adapted from Kaplan, R. S., and D.P. Norton, “The Balanced Scorecard – Measures That Drive Performance,” Harvard Business Review 72.1992. The purpose of the balanced scorecard is to identify and monitor the key elements of a firm’s strategy. Two of the four elements are oriented toward the future: (1) customer perspective and (2) future perspective. The balanced scorecard can be expanded to determine wealth creation. Figure 12.2 provides a model of wealth creation using the balanced scorecard. Financial Perspective Customer Perspective Future Perspective Internal Perspective 270 Figure 12.2 A Balanced Scorecard for Wealth Creation Financial perspectives from Figure 12.1 have been replaced with shareholder wealth in Figure 12.2. Shareholder wealth is a key success factor 1. The firm must design its strategy to maximize shareholder wealth. The internal perspective from Figure 12.1 has been replaced with employee wealth in Figure 12.2. In the long run, employees represent the only true source of wealth creation 2. Employees represent intellectual capital. Intellectual capital can be rare, valuable, non -imitable, an d non -substitutable 3. Employees are integral components of wealth creation because they design and implement strategic and tactical actions which may add or detract wealth from the firm. Shareholder Wealth  Debt management ratios  Asset management ratios  Profitability ratios  Liquidity ratios  Economic Value Added (EVA)  Market Value Added (MVA)  Yearly change in cumulative profit  Yearly change in market capitalization  Yearly change in stock price  Yearly change in free cash flow Customer Wealth  Number of industries in which firm has superior performance based upon customer surveys  Number of industries in which firm does not have superior performance based on customer surveys  Number of new products introduced in last 3 years  Revenue from products 3 years old or less  Profit from products 3 years old or less  Number of products introduced in international markets  Revenue and profit from products introduced in international markets Positioning for Future Wealth  Number of func tional departments who have implemented success ion planning  Number of functional departments who have not implemented succession planning  Number of acquisitions  Price of acquisitions  Anticipated synergy benefits ($)  Actual synergy benefits ($)  Number of sc ale alliances  Number of link alliances  Revenue per year from alliances  Percentage of senior management time on tactical issues  Percentage of senior management time on strategic issues  Restructuring costs/benefits Employee Wealth  Customer satisfaction surveys  Time to recruit and train new employees  Expense of recruiting and training new employees  Turnover per year per department  Number of employees hired per department per year  Stock incentives per employee per year Wealth Creation 271 The customer perspective has been modified to include data that c an be measured to create customer wealth. The future perspective of the balanced scorecard has been expanded to focus upon positioning for wealth creation over time. The key to wealth creation is to meet or exceed stakeholders’ expectations over time. Each aspect of wealth creation will now be discussed. We will begin with customers. Customer Wealth Creating wealth for consumers is critical for success. Increasing customer wealth is dependent upon how much better the firm meets the key buying criteria within each industry compared to competition. Firms may have multiple sources of revenue because they may have positioning in multiple industries. The first step is to identify what industries a firm is competing within. Ind ustries can be defined by the Standard Industrial Classification (SIC), for U.S. domestic firms. The North American Industry Classification System (NAICS) is used for classifying firms within North America. The International Standard Industrial Classificat ion (ISIC) is used to classify international firms outside North America. These classification systems were discussed in Chapter 1, Industry Analysis. Once industry boundaries have been identified, it is important to ascertain a firm’s performance withi n each industry. Chapter 4, Business Level Strategy, fully developed this issue, and explained how a firm can achieve competitive advantage. Chapter 5, Analysis of Markets and Positioning, examined the process by which firms can evaluate their position v ersus competitors on an industry -by -industry basis. A crucial component of this analysis is obtaining feedback from customers through the sales force. Chapter 11, Strategic Leadership Decision Making, discussed how firms could obtain such feedback. Exam ining the results of customer surveys is one approach that was discussed. A crucial point that has been addressed throughout the book is the sales force developing long -term relationships with customers. If these relationships exist, the sales force can communicate to senior leaders how the firm and competitors are positioned within each industry. Based on this feedback from customers, the firm can judge where resources should be reallocated to maximize firm performance. Without this assessment on an ind ustry -by -industry basis, the firm is more likely to engage in reactive as opposed to proactive decision -making. The industry analysis may determine that in some industries, the firm is not meeting the key buying criteria. If key buying criteria are not b eing met, the firm may need to develop new products that do meet key buying criteria. Therefore, one wealth -creating statistic would be the number of new products introduced per year. Wealth can be determined by measuring the revenue and profit these ne w products generate. Another measure of wealth creation would consist of how much revenue and profits these new products have generated over time. The success of new products is dependent upon the degree of benefit that customers obtain as opposed to the benefits obtained from competitors’ products/services 5. One way to measure this benefit is to determine the number of products competitors introduced per year and the revenue and profitability of those products. In many cases, product line profitability data is available in competitors’ annual reports and 10 -K reports. 272 However, superior products/services do not necessarily result in higher sales. Customers incur significant costs in terms of new product purchases. Figure 12.3 identifies the costs that c onsumers incur with respect to purchase of a product. Figure 12.3 Consumer Purchasing Costs = + = + = Source : Adapted with permission of McGraw -Hill Irwin from Consumer behavior and marketing strategy by Peter J. and Olson J. 459. 2005. Consumer Costs Money is the usually what is exchanged when purchasing a product. However, customers can incur significant no n-monetary costs. One such cost is time. Time can be divided into two primary elements (1) amount of time consumers spend on learning about a product/service (cognitive activity) and (2) the physical time it takes consumers to stop what they are doing a nd purchase the product/service (behavioral effort) 6. The perceived customer benefits plus the consumer costs will determine the price the consumer is willing to pay for the product/service. If the sales price is higher than the sum of consumer costs an d customer benefits, the consumer will not engage in the transaction. Reducing customer costs results in additional benefits created for customers and increases the likelihood of engaging in continuous transactions with customers. Firm Costs The firm must make a profit on the products/services that it sells. Selling price is the refection of a number of key costs. One cost firms incur is R&D. R&D has two cost components: product R&D and process R&D . Product R&D is the costs that are incurred by developing new products. With respect to product R&D, new products must be designed before they are implemented. Ideas for new product development can come from several sources. One way of obtaining new product ideas is from marketing research. Marketing research may entail approaches such as focus groups and customer surveys. The same results from Consumer Costs Money Time Cognitive activity Behavior effort Customer Benefits Price willing to pay Firm Costs R&D Marketing Production Investments Profit Price willing to sell 273 multiple techniques will tend to create a more accurate picture for identifying customers’ changing needs. New products may generate additional costs. New product introduction may create changes in both inbound and outbound logistics. An infrastructure may need to be developed to move materials into manufacturing operations. In addition, an evaluation needs to be conduc ted to determine if existing outbound logistics are sufficient for moving new products to consumers on time. If the firm is introducing products into new international markets, an infrastructure may need to be developed. Investments in plant and/or equipm ent to generate economies of scale and/or economies of scope may be substantial. Further, if the product is new to the firm, an international sales staff that has sold similar products may need to be hired. Introducing new products does not necessarily increase wealth creation. Customer wealth may result from re -positioning existing products. As products age, they may become more attractive to other segments. An example would be the Play Station 2 (PS2) from Sony. The newer version, Play Station 3 (P S3) will be initially sold in the United States and Japan. However, production facilitates still exist for manufacturing PS2. To more fully utilize this capacity, Sony could sell PS2 products in developing markets. Because GDP per capita is significantly lower in developing countries, potential customers may not be able to afford new PS3’s. The selling of PS2’s in developing countries may begin to develop a new customer base for Sony. As these customers begin to earn higher GDP per capi ta in the future, they may be able to afford PS3’s. Sony may be able to create wealth by offering new products to existing customers and offering existing products to new customers. Firms can incur significant production costs manufacturing new products. Existing processes may need to be changed significantly for new product creation. These process R&D costs are changes in manufacturing that may need to be implemented to improve efficiencies. Examples include automation, flexible manufacturing , and six sigma . Process R&D initiatives, such as quality function deployment efforts, may also reduce R&D cycle time and/or increase demand. As these costs increase, the firm needs to determine revenue, costs, and prof its. To conduct this profit/cost trade -off, many firms utilize test markets. Test markets are beneficial because they can be used to determine actual sales and actual costs. This analysis will determine what price the firm needs to se ll products/services. If this price is equal to or lower than customer costs and expected benefits, a transaction will occur. If not, no transaction will occur. Shareholder Wealth Most firms are in business to increase shareholder wealth. In other word s, the price of the firm’s stock needs to appreciate. There is a good reason for increasing the wealth of shareholders. If wealth is not created, shareholders will invest in other firms. Because increasing shareholder wealth is important, more firms are beginning to compensate senior management based upon firm performance. Cisco compensates all of its senior management team based upon changes in shareholder wealth. This approach to compensating senior management tends to reduce agency problems between senior management and shareholders. Several firms have implemented processes for measuring shareholder wealth. Caterpillar initiated a new style of management reporting in 2004. Called Transparent 274 Financial Reporting, it aligns the company’s internal m anagement reporting system more closely with shareholders’ returns. “It’s much more ‘live’ in terms of what’s actually happening as a shareholder would see it,” stated Mr. Doug Oberhelman, the group president of Caterpillar who has oversight responsibilit y of the finance operation 7. Procter & Gamble uses a model for calculating shareholder wealth called Total Shareholder Return (TSR). This model evaluates management performance by calculating bonus payments for senior managers based on firm performance 8. One measure of shareholder wealth is obtained by examining financial ratios. Financial ratios are important because they measure a firm’s current and historical performance. Financial ratios can be classified into the following groups: (1) liquidity ratios, (2) asset management ratios, (3) debt management ratios, and (4) profitability ratios 9. Liquidity ratios measure the firm’s ability to converting assets into cash quickly and at low cost. Some of the important liquidity ratios are the following: Liquidity Ratios a. Current ratio: current assets current liabilities b. Quick ratio: current assets – inventory current liabilities c. Inventory to net working capital: inventory current assets – current liabilities (net working capitalF The current ratio is a measure of the firm’s ability to pay short -term liabilities from short -term assets. It measures the firm’s potential cash reservoir. Decreases in this ratio over time are a signal the firm may have difficulty paying current expense s. The quick ratio measures the ability of the firm to meet its short -term obligations from current assets (not including inventory). The inventory to net working capital ratio refers to the degree to which the firm’s working capital is tied up in invent ory. Asset Management Ratios a. Inventory turnover: sales inventory b. Fixed -asset turnover: sales fixed assets c. Average collection period: accounts receivables average daily sales Asset management ratios measure a firm’s effectiveness at managing its assets. Inventory turnover measures the number of times that average inventory was turned over during the year. Fixed -asset turnover measures how much revenue is generated by each 275 dol lar of fixed assets. Average collection period is the amount of time required to receive payment after sales. Debt Management Ratios a. Debt -to-assets ratio: total debt total assets b. Debt -to-equity ratio: total debt total equity c. Long -term debt -to-equity ratio: long -term debt total equity These ratios measure the extent to which a firms uses debt financing. If the firm earns more on investments financed with borrowed funds than it pays in interest, then its shareholders’ returns are magnified, or “leveraged.” Debt management ratio s reflect financing of operations. The total debt to total assets ratios measures the extent to which borrowed funds have been used to finance the firm’s assets. The debt to equity ratio represents the ratio comparing funds provided by creditors to funds provided by stockholders. The long -term debt to total equity measures the balance between debt and equity. Profitability Ratios a. Gross profit margin: Sales – cost of goods sold sales b. Net profit margin: profits after taxes sales c. Return on assets: earnings before interest and taxes (EBIT) total assets d. Return on equity: profits after taxes total equity Profitability ratios represent how well a firm is allocating its resources. Gross profit margin represents the total margin available to cover operating expenses and generate a profit. Net profit margin ratio reflects how much profit is generated by each sales dollar. Return on assets (ROA) measures the return on total investments from stockholders and creditors. Return on equity (ROE) measures the rate of return on the book value of shareholders total investment in the firm. Economic Value Added (EV A) and Market Value Added (MVA) While ratio analysis is beneficial for determining a firm’s current performance, these financial measures cannot be utilized to determine a firm’s future wealth. What 276 shareholders desire are increases in wealth. Because shareholder wealth is based upon the future stream of cash flows, it is not calculated based upon historical performance. Shareholder wealth can be defined as the present value of the anticipated stream of cash flows added to the liquidation value of the company. As long as the returns f rom the firm exceed its cost of capital, the firm will add to shareholder wealth. In addition, most profitability ratios only focus on the cost of debt, not the cost of equity. Economic value added (EVA) focuses on debt and equity. EVA is an estima te of a firm’s economic profit for a specific year. EVA represents the income after the cost of debt and the cost of equity have been deducted. It measures the extent to which the firm has added to shareholder wealth 10. EVA is calculated as follows: EVA = Net operating profit after taxes – After tax dollar cost of capital used to support operations. One benefit of EVA is that it is a single performance statistic. It also tends to align the interests of shareholders and management because it reflects how effectively management uses capital. Market value added (MVA) is another statistic which helps to align both shareholder and management interests. MVA is equal to market value less capital invested 11. Shareholder wealth is increased by maximizing t he difference between the market value of the firm’s stock and the amount of equity capital that was supplied by shareholders. MVA is calculated as follows: MVA= Total market value – total capital = (Shares outstanding) (Stock price) – Total equity. EVA and MVA have distinct differences. EVA is used to measure managerial wealth creation because its value can be calculated on a year -to-year basis. MVA is an indication of the wealth that has been created by the firm since its beginning. Employee W ealth A third group of stakeholders are the employees. The firm wishes to retain employees because of two primary reasons. The first reason is economic. If an employee leaves, the firm will spend time and money to recruit and train a replacement. Since your firm has already trained the employee, a competitor does not incur training costs. The second reason is knowledge transfer. If employees do not perceive that wealth is being created for them, they may decide to leave the firm and work for a competit or. All experience and knowledge that has occurred within your firm will now be available to competitors. This is important because employees build relationships with customers over time, and these customers may switch to the firm that the employee is mo ving to. In this case, the revenue that is lost to your firm goes immediately to the firm the employee moves to. The firm the employee is moving to may generate additional revenue at minimal cost. Creation of employee wealth is also crucial for other rea sons. Employees will dictate the long -run performance of the firm. Therefore, it is of critical importance that a firm generates wealth for employees. Employee satisfaction surveys, which should be distributed and scored without reference to specific e mployees, can be a measure of employee satisfaction. Employee turnover by department needs to be closely analyzed. In general, turnover should be approximately the same for each 277 functional group. If it is not, a closer analysis of those departments gene rating higher turnover is required. One of the best ways of retaining employees is to make them shareholders. Each year, United Parcel Service (UPS) rewards employees based upon how well the firm has performed during the year. Because these rewards are s tocks, employees have an incentive to maximize shareholder wealth. This reward system links the compensation of employees to stock price changes because all employees are rewarded for stock appreciation. If the company has a bad year, all employees withi n the firm aggressively search to find the source of the stock decline and implement corrective action quickly. These actions increase wealth for the shareholders, the firm’s senior management, and all other managers within the firm. Positioning for Fu ture Wealth For the firm to create future wealth, it must design and implement its strategic plan. Some of the issues that need to be addressed are (1) expansion within domestic and international markets, (2) acquisitions and mergers, (3) costs and antici pated benefits of acquisitions, (4) restructuring, (5) resource utilization (6) implementation of strategic plan, (7) creation of strategic alliances, and (8) succession planning Because employees represent the most important asset of any firm, succession plans must be developed to retain high performing employees. Most employees in firms want to advance. Many times, succession planning only addresses the CEO and senior management team. The plan should include general parameters for all employees. If employees are unaware of how they can advance within a firm, they may leave and join competitors that have more fully developed succession plans. Succession planning affects many levels within a firm. Assume a new CEO is chosen from within the firm. Fur ther assume that the former job of the new CEO was chief operating officer (COO) and the new COO was the chief financial officer (CFO). Assume that the new CFO was vice president of North American operations. The selection of an internal CEO puts in plac e a domino effect that impacts the entire organization. Positioning for future wealth creation is due, in part, to identifying, acquiring, and implementing acquisitions. The price paid for each target firm needs to be evaluated versus the actual benefit s (e.g. cost savings) realized. Chapter 9 covers acquisitions in depth. To determine changes in wealth, the wealth of the firm before the acquisition is compared to the wealth created after the target is totally integrated within the acquiring firm. In order to engage in acquisitions, a firm may need to restructure existing businesses. The wealth created, as a result of the acquisition, needs to be compared to any restructuring that was needed to fund the acquisition. In general, acquisitions should add wealth to the firm, while restructuring should not result in decreases in wealth. The number of strategic alliances a firm has entered into can also measure future wealth. Alliances may allow firms to generate increases in future wealth more quickly than other modes of growth (e.g. internal development). Scale alliances allow firms to combine similar resources to lower costs by increasing utilization of assets. Scale alliances allow firms to combine similar resources to grow quickly 12. Scale allian ces are also less expensive than acquisitions. In general, costs may be reduced because the firm is using the resources of partners. 278 Link alliances are formed by firms combining different resources to create new products/services 13. Because firms are com bining different resources, new sources of wealth may be created because they generate new resources for the firm. New resources, or new combinations of existing resources, provide new productive services, which creates wealth for the firm 14. The relati onship between tactical and strategic issues needs to be discussed. Tactical issues are internal firm issues such as under -producing employees or more fully utilizing manufacturing facilities. Tactical issues will usually not have a significant impact upo n financial performance. Lower levels of management are responsible for identifying and correcting tactical issues. This will allow time for senior management to be focused on creating shareholder wealth from a strategic perspective. It is the responsibil ity of the CEOs and senior managers to be focused on long -term wealth creation. Many firms do not approach decision -making in this manner. Many CEOs and senior managers become immersed in tactical issues inside the firm. Tactical issues need to be dealt with by the function that is most closely affected. Lower levels of management have much greater knowledge than senior management as to the cause and solution of tactical issues. Resolving tactical issues is one reason why these managers are compensated . CEOs and senior management are paid to create a strategic vision and implement that vision to achieve long -term wealth creation. An internal focus is not oriented toward strategic issues (e.g. changes in industry structure, customers, competition, and/ or domestic or international expansion). Positioning for future wealth cannot be done if senior level executives are focused on tactical issues. For example, while Hewlett Packard was trying to integrate the Compaq acquisition, Dell’s strategy of aggress ively building international market positions increased shareholder wealth. Hewlett Packard’s acquisition of Compaq resulted in decreases in shareholder wealth: HP lost 66% of the value of its stock between the date the acquisition was announced to the t ime the CEO resigned. One quick way of creating greater wealth is to capitalize upon competitor’s mistakes. Downsizing may be a weakness of many firms. By focusing on downsizing, as opposed to downscoping, firms are onl y addressing internal cost measures. By General Motors eliminating approximately 25,000 jobs per year, the firm is not addressing changing consumer needs. In many cases, downsizing results in reduction of human resources. This reduction in resources may create a situation where wealth is reduced because of loss in intellectual capital. By reducing wealth, firms may have less revenue. With less revenue the firm may cut additional resources. The cycle can continue indefinitely. Downscoping, on the othe r hand, does address changing consumer needs because it focuses resources on the profit generating segments of a firm’s businesses. All elements of the scorecard are interrelated. A firm’s financial performance is a result of meeting consumer needs over time. Employees create wealth by building long - term relationships with customers and suppliers. By understanding how consumer needs change over time, the firm’s senior managers can design and implement new strategies to improve financial performance. A s a result of increases in financial performance, increases in cash flow may occur. The firm’s CEO and senior management may then have sufficient funds to begin to generate additional sources of wealth for the firm. As the firm successfully positions for the future, customer, shareholder and employee wealth should all increase. It is the interconnectedness of these elements that provide for increases in wealth creation over time. 279 Figure 12.4: Apple Wealth Creation (2012) Date Stock Price 1985 ( Steven Jobs ousted) $1.98 1996 ( Steven Jobs returns) $5.88 2011 ( Steven Jobs resigns) $376.18 March 13, 2012 $568.10 Shareholder Wealth Wealth Creation Positioning for Future Wealth :  Release new products which Steven Jobs developed before he died  Introducing Apple products into BRIC Markets with some price modifications Customer Wealth :  Ability to create consumer needs  Acquisition of intellectual capital Employee Wealth :  Stock options for lower level managers  Employee payment for new products which are successful in the market place  Succession planning 280 Capstone Simulation Measures of Wealth Creation The Capstone Simulation uses three measures to calculate wealth creation. The first measure is free cash flow . Free cash flow is defined as the amount of funds that can be utilized for investments without any negative ramifications for the firm. One reason the simulation uses cumulative cash flow is to account for changes in inventory. In any one -year, inventor y-carrying costs can have a substantial impact on cash flow. A cumulative value of cash flow will tend to stabilize the value of cash flow over time. The second component of wealth creation the simulation uses is cumulative profit . Profit is a general statistic that is viewed as wealth creating. Profit is significantly impacted by a firm's investments. Large capital expenditures may significantly affect profit negatively for the year the investments are incurred. As with cum ulative cash flow, cumulative profits are a better indication of wealth creation over time because investments usually stabilize over time. However, profits do not measure a firm’s potential for generating wealth in the future. Shareholders only generate wealth as a result of stock appreciation or dividends. A third component of wealth creation the simulation uses is market capitalization . Market capitalization is the stock price times the number of shares outstanding 15. Table 12.1 Capstone Simulation Measures of Wealth Creation Firm 1 Firm 2 Stock Price $50 / share $50 / share Market Capitalization $50 million $100 million Stock Issue No Yes A complete analysis of wealth creation should contain a detailed analysis of all factors in Figure 12.2. However, utilizing the Capstone criteria, Table 12.1 can be used to explain market capitalization. If two firms have the same stock price (e.g. $50/share) and firm 1 has a market capitalization of $50 million and f irm 2 has a market capitalization of $100 million, firm 2 has generated more wealth 16. Because firm 2 issued stock to fund investments, its stock price has been diluted. Since both firms have the same ending stock price, firm 2 would create more wealth b ecause it has acquired more shares of stock while maintaining the same stock price 17. 281 Discussion Questions 1. What are the limitations of using only financial ratios to measure wealth creation? 2. Explain the concept of the balanced scorecard. 3. Why is empl oyee wealth creation important? 4. What is economic value added (EVA)? How does it differ from market value added (MVA)? 5. Explain the difference between liquidity, asset management, debt management, and profitability ratios. 6. Explain “positioning for the fu ture.” 7. Explain how the Capstone Simulation measures wealth creation. 282 References 1. Norton, R. 2005. CFO thought leaders . Booz, Allen, Hamilton. New York, NY. 2. Penrose, E. 1959. A theory of the growth of the firm . John Wiley. New York, NY. 3. Barney, J. 1991. Firm resources and sustained competitive advantage. Journal of Management . 17: 99 -120. 4. Peteraf, M. and Bergen, M. 2003. Scanning dynamic competitive landscapes: a market -based and resource -based framework. Strategic Management Journal . 24 : 1024 -1042. 5. Peter, J. and Olson, J., 2005. Consumer behavior and marketing strategy. McGraw - Hill Irwin. New York, NY. 6. Ibid 7. Norton. CFO thought leaders. 8. Ibid 9. Brealey, R., Myers S., and Marcus, A. 2004. Fundamentals of corporate finance . McGraw -Hill Irwin. New York, NY. 10. Leach, J. and Melicher, R. 2003. Entrepreneurial finance . Thomson. Mason, OH. 11. Ibid 12. Dussauge, P., Garrette, B., and Mitchell, W. 2004. Asymmetric performance: the market share impact of scale and link alliances in the global auto industry. Strategic Management Journal. 25: 701 -711. 13. Ibid 14. Penrose. A theory of the growth of the firm . 15. _____ 2011 . Capstone simulation . 16. Ibid 17. Ibid 283 Chapter 13 Conducting Case Analysis: An Exercise in Wealth Creation 284 The case method has been a proven mode of facilitating learning for decades. One reason is because cases represent firms that are in business today. As such, information and data with respect to current decision -makin g is available. Because of the Sarbanes -Oxley Act, financial statements must accurately reflect the performance consequences of firms’ decision makers. Therefore, a firm’s annual report and 10 -K report provide accurate, current data with respect to curre nt year decision -making. A second reason why case analysis is an excellent learning vehicle is because it conveys how historical decisions have impacted a firm’s performance. Historical decisions may constrain future decision -making. Firms that have ha d difficult relationships with large collective bargaining organizations (e.g. UPS) may be less flexible. The decision to outsource may be more difficult to implement for firms represented by collective bargaining organizations. Sometimes a firm’s historical decisions dictate what the firm can do in the future. Airbus is expecting the long haul (e.g. trans -pacific, trans -Atlantic) passenger business to represent the highest rate of growth. The A380 is the newes t long haul aircraft in Airbus’ fleet. If the long -haul market does not exhibit strong growth rates in the future, Airbus may not be able to respond to Boeing’s new 787. The 787 is a short to medium range aircraft that can be used in developing markets ( e.g. intra - China). If the long haul market does exhibit strong growth, Boeing already has the 777 long haul aircraft. A third reason that cases are used is to exhibit questionable or sound decision - making and the consequences of these decisions. Oracle’s acquisition of PeopleSoft was accepted because it represented a 75 percent share increase over market value. Proctor & Gamble’s acquisition of Gillette represents the acquisition of the worldwide industry leader in the wet shaving industry . Unfortunately, there is no model for a good case study. The primary reason is that professors have diverse perspectives on what constitutes a good case study. This may not be all bad. Students should feel free to ask professors w hat they perceive a good case analysis should include. Professors may provide you with examples of good case analysis. In addition, professors may offer examples of poor case study analysis. Remember, in this course, there is only one stakeholder (the p rofessor). It is important that the parameters be clear. In other words, what format does the professor prefer (e.g. history → situational analysis → recommendations)? An example may be helpful. Assume that we have been given the following case assignm ent. Should a firm, not in the Capstone industry, enter the sensor industry? Explain why or why not from a wealth creation perspective . One aspect of a case analysis that can begin to answer this issue is a review of the existing state of affairs. This is referred to as a situational analysis. 285 Figure 13.1 Case Study Analysis Figure 13.1 is only one example of how a case could be analyzed. The situational analysis is driven by corporate and business level strategy. The corporate level component can be addressed by Porter’s 5 forces model. This model exami nes the structural characteristics of an industry. To address business level strategy, competitive dynamics is utilized. The benefit of competitive dynamics is that it examines decision making over time. Based on the structural traits of the industry a nd the competitive dynamics that exist within it, it is possible to measure the amount of wealth that has been created or Situational Analysis Corporate Level Strategy Overview Industry Structure  Bargaining power of buyers  Bargaining power of suppliers  Threat of new entrants  Industry rivalry  Threat of substitute products Business Level Strategy Overview Competitive Dynamics  The analysis of moves and reactions of competitors within an industry over time Conclusions  Comparison of firms to industry average  Comparison of firms to each other Wealth Creation  Cumulative profit  Cumulative cash flow  Market capitalization Recommendations 286 destroyed by each firm within the Capstone Simulation industry. These measures of wealth can be compared to other firms within the in dustry and to historical industry averages. A recommendation is then developed based on a complete analysis of these factors. We will begin with an analysis of industry structure. Let us assume that we h ave segment profiles for a firm for a round of a si mulation game. Industry Structure Industry structure consists of five critical elements: 1) Threats of new entrants 2) Threats of substitute products 3) Industry rivalry 4) Bargaining power of buyers 5) Bargaining power of suppliers Table 13.1 Segment Profiles Section a Traditional Statistics Total Industry Unit Demand 10,351 Actual Industry Unit Sales 10,351 Segment % of Total Industry 28.4% Growth Rate 9.2% Section b Low End Statistics Total Industry Unit Demand 14,290 Actual Industry Unit Sales 14,290 Segment % of Total Industry 37.8% Growth Rate 11.7% Section c High End Statistics Total Industry Unit Demand 4,512 Actual Industry Unit Sales 4,512 Segment % of Total Industry 12.6% Growth Rate 16.2% 287 Table 13.1 (Continued) Section d Performance Statistics Total Industry Unit Demand 3,9 38 Actual Industry Unit Sales 3,938 Segment % of Total Industry 10.7% Growth Rate 19.8% Section e Size Statistics Total Industry Unit Demand 3,848 Actual Industry Unit Sales 3,848 Segment % of Total Industry 10.5% Growth Rate 18.3% Each segment of the industry is summarized in Table 13.1 . By comparing each segment’s demands and unit sales we see that d emand for each segment has been met. Table 13.2 shows the production information for each firm. 288 Table 13.2 Production Information Name Primary Segment Units Sold Unit Inventory 2nd Shift & Overtime Automation Next Round Capacity Next Round Plant Utiliz. Able Trad 991 322 0% 6.0 1,000 99% Acre Low 1,732 378 36% 8.0 1,400 134% Adam Trad 1,010 86 11% 8.0 900 110% Aft Pfmn 32 0 99% 4.0 1 198% Agape Size 52 27 99% 4.0 1 198% Ate High 691 177 100% 8.0 500 198% Baker Trad 1,081 215 0% 6.0 1,100 99% Bead Low 2,157 317 53% 8.0 1,500 152% Bid High 749 127 0% 4.0 850 87% Bold Trad 1,304 0 100% 5.0 1,000 198% Buddy Trad 1,225 70 85% 5.0 1,000 183% Cake Trad 1,077 133 0% 6.0 1,000 99% Cedar Low 2,378 349 59% 8.0 1,700 158% Cid High 637 94 0% 3.0 750 79% Coat Pfmn 1,055 45 12% 4.5 1,000 111% Cure Size 1,270 117 44% 4.5 1,050 143% Daze Trad 1,102 179 5% 5.5 1,000 104% Dell Low 1,927 352 50% 7.5 1,450 149% Dixie High 640 130 0% 3.0 800 80% Dot Pfmn 970 59 0% 4.0 1,000 99% Dune Size 1,411 136 53% 4.0 1,200 151% Doom Pfmn 862 38 70% 6.0 600 168% Eat Low 1,028 168 0% 8.0 1,400 67% Ebb Low 2,708 239 84% 8.0 1,650 182% Echo Trad 1,268 131 30% 6.5 1,000 129% Egg Trad 1,293 0 100% 5.0 1,000 198% Fast Low 596 79 0% 4.0 500 89% Feat Low 1,764 167 77% 6.0 1,150 176% Fist High 813 125 7% 3.0 750 106% Foam Pfmn 1,019 54 13% 5.0 850 111% Fume Size 1,115 180 28% 5.0 1,000 127% Fox High 982 92 100% 5.5 1,000 198% The fact that many firms have positions in multiple segments is an indication that the industry is competitive both in terms of meeting demand in each segment (Table 13.1) and firms have multiple products in each segment (Table 13.2). As such, threats of new entrants would be minimal . From Table 13.2, many firms have significant inventory. A plausible option is that firms may have overproduced because their sales forecasts are too high. In addition, products do not appear to be substitutable because of the se high inventory levels . Having 289 varying levels of inventory for products within a market segment is an indication that products are not substitutable . Based upon the significant inventory levels, it would appear that firms do not have an understanding of key buying criteria on a segment by segment basis. Since the firm is not meeting key buying criteria, customers have no choice but to buy whatever products are available. Therefore, bargaining power of buyers is low . Table 13.2 shows that all firms are pr oducing in excess first shift plant capacity (plant utilization) on most production lines. Some firms are incurring substantial overtime. Firms may be able to reduce costs by adding a 2 nd shift. This issue will need to be reviewed with the firms’ collecti ve bargaining organization (e.g. unions). Based on these factors, it would appear that firms are not having problems sourcing raw materials. The above factors would lead to the conclusion that bargaining power of suppliers is moderate. The degree of rivalry in this industry is quite competitive. Firms are not meeting the needs of the customer. However, as can be seen from Table 13.2, virtually all firms are running their production lines with substantial overtime. Firms are competing aggressively with each other: demand for each segment is being met (Table 13.1). Even with significant growth rates in the high end (16.2 percent), performance (19.8 percent), and size segment (18.3 percent), firms are still running significant overtime. Most firms have su bstantial capacity in the traditional and low end products (Table 13.2). In addition, it can be seen from Table 13.2, many firms have high automation levels on their low end product lines. In addition, firms (Chester, Digby, and Ferris) have significant ca pacity in performance and size markets. Further, Baldwin and Erie have eliminated their performance and size products. Collectively, all of these decisions lead us to the conclusion that the industry rivalry is high . Competitive Dynamics for the Capstone Simulation From Chapter 4, Business Level Strategy, it is important to understand how firms have grown. A crucial aspect of growth is competitive dynamics. Competitive dynamics addresses firms’ actions and reactions to competitors’ actions and reactions. Competitors’ actions and reactions can be examined from an analysis of production.

Table 13.2 is a complete review of the producti on summary for all firms . The production summary identifies opportunities that a new competitor may be able to capitalize upo n. Refer to the 2 nd Shift & Overtime column. Bead, Cedar, Dell, and Ebb are generating substantial overtime charges. Firms are under -producing because their sales forecasts are too conservative. Most firms are generating significant levels of overtime on many production li nes. Since firms have ending inventory they should not expand capacity. All firms, with the exception of Ferris, have significant automation of their low end products . Higher levels of automation increase efficiencies and lower costs . Investing in TQM initiatives is another way of reducing costs and reducing R&D cycle time . In general, firms may not be making enough investments to reduce costs of production (e.g. additional plant capacity, automation ). 290 Table 13.3 provides financial data for each firm. Based upon Table 13.3, the firm’s leverage range is from 1.00 to 1.44 percent. Firms are financing most of their expansion from equity. In general, firms have not utilized enough debt to obtain financial leverage. The balanced scorecard section of the simulation recommends a value between 1.8 to 2.8 for leverage. Leverage is important for two reasons: (1) by raising funds through debt, stockholders can maintain control of a firm without increasing their investment, and (2) if the firm earns more on investments financed with borrowed funds than it pays in interest, then its shareholders’ returns , as measured by ROE, are magnified or “leveraged.” With minimal debt financing, firms are restricted in terms of growth. Wealth Creation Measures Wealth creation could be measured from two primary factors: 1) Cumulative Profit 2) Market Capitalization Table 13.4 Wealth Creation Team Cumulative Free Cash Flow ($Millions) Cumulative Profit ($ Millions) Stock Price ($) Share Outstanding Market Capitalization ($ Millions) Andrews 38 40 70.46 1,820,931 128 Baldwin 25 34 53.84 2,134,410 115 Chester 32 35 61.25 2,069,366 127 Digby 37 39 66.42 2,064,739 137 Erie 16 24 43.76 2,234,181 98 Ferris 42 38 57.87 2,113,626 122 Industry Averages 32 35 59.93 2,072,288 121 Five teams (all except Erie) have cumulative profit which ranges from $34 million to $40 million (Table 13.4). The market capitalization for these firms ranges from $115 Table 13.3 Financial Leverage Firm Firm Leverage = Total Assets Total Equity ROA ROE Andrews 1.31 10.2 % 13.1 % Baldwin 1.44 11.2 % 15.8 % Chester 1.03 9.8 % 9.2 % Digby 1.11 12.9 % 13.3 % Erie 1.11 9.6 % 10.8 % Ferris 1.00 11.8 % 11.1 % 291 million to $137 million. Erie’s low cumulative profit ($24 million) and market capitalization of $98, put it in position to be exploited by other firms. In addition, Erie has the least ($16 million) free cash flow. This restricts its ability to increase its value. Andrews and Ferris have much higher levels of free cash flo w for investment purposes. Conclusion Figure 13.2 illustrates the results for this industry at the end of Round 8. From a corporate level strategy perspective the industry appears to be in the growth stage. The industry structure will permit new entrant s. As far as competitive dynamics are concerned, firms do not appear to have well -developed strategies to maximize performance. Issues such as automation to reduce costs have not been implemented by most teams. Each teams’ forecasting is not accurate and results in significant inventory levels . These mistakes are amplified by examining the wealth creation statistics. Firms are performing below industry averages on most factors (e.g. cumulative profitability). 292 Figure 13.2 Case Study Ass essment Situational Analysis Corporate Level Strategy Overview  Bargaining power of buyers: low  Bargaining power of suppliers:

moderate  Threat of new entrants: moderate  Threat of substitute products: low  Industry rivalry: high Business Level Strategy Overview A new entrant could enter and take advantage of the following: 1) Baldwin has a product (Bead) which is not positioned well 2) Production facilities have significant overtime in low end market which may make the lines unprofitable without the inclusion of a second shift. 3) Excess ending inventory may be a result of sales forecasts which are too high. 4) Firms need to have adequate au tomation levels. Conclusion  Industry structure provides for new entrants  Firms within the industry do not understand competitive dynamics  Firms within the industry are not creating as much wealth as “average” firms Wealth Creation  Cumulative profit: all firms below industry average  Cumulative cash flow: all firms below industry average  Market capitalization: except for Erie, all firms below industry average Recommendations 1) Enter industry as new entrant 2) By using greater debt, firms can leverage themselves versus competition 3) Use excess funds to implement TQM initiatives 4) Increasing promotion budget to communicate products to customers and increase sales budget to build infrastructure 5) Develop a plan to outperform other firms’ products within each segment. 6) Capitali ze on each segment’s demand growth 7) Automate price sensitive product lines 293 Recommendations This review of corporate level strategy, competitive dynamics, and wealth creation leads to the conclusion that a firm should enter this industry and could be quite successful. Higher levels of financial leverage will allow the new firm(s) to grow at much faster rates than competitors. More accurate sales forecasting will allow the new entrant to capitalize on unmet demand. Investing significantly in TQM i nitiatives will create efficiencies and/or reduce R&D cycle time. This new entrant could develop a strategy for achieving a leadership position within each segment. 294 295 Chapter 14 Comp -XM® 296 Comp -XM: Example 1 Up until this point, many of your decisions with respect to the Capstone simulation have been made in groups by committee. Comp -XM provides an opportunity for you to make all the decisions over a several year time window. I will give you some po inters about what to look for and then we will go through a round of Comp -XM together. The first point concerns scale of operation. If you have market segments that are price sensitive (such as the low end in Capstone), it is important to increase scale of operations. Investments in plant improvement provide for economies of scale, which will tend to reduce costs . As you invest in plant improvement, additional economies of scale will result. There is another way of obtaining efficiencies in price sensitiv e markets. Automation will tend to increase efficiency and provide for additional economies of scale. However, you must be careful with automation. Automation makes it more difficult to reposition products because automation does not allow for flexible manufacturing processes. The following approach may be helpful. Increase plant capacity first and then automate in price sensitive market segments. As you invest in plant improvement, you can reposition products easier than if you had automated first. Eff iciencies can also be obtained as a result of some of the TQM initiatives: (1) continuous process improvements will reduce both material and labor costs, (2) JIT will reduce administrative costs, (3) quality initiative training will reduce labor costs, (4) benchmarking will reduce administration and inventory carrying costs, (5) concurrent engineering will reduce material and labor costs. Positioning is also a crucial element. While Comp -XM uses the same key buying criteria as Capstone, the weights on each criterion are different. For example, the thrift market segment has 55 percent of the customer buying criteria as price. This should be treated as a cost leadership segment.

The elite segment should be treated as a differentiation segment because 34 perce nt of the customer buying criteria is based upon an age = 0. With age = 0, it is necessary to invest in new product development. Positioning accounts for 22 percent of the customer buying criteria. The key to positioning is to have your product positioned superior to competitors on the customer buying criteria. Another key element is forecasting. The basic trade -off is between running out of cash and running out of inventory. Forecasting too high leads to inventory carrying costs and forecasting too low m eans not obtaining sales that would have been available if forecasting had been more optimistic. Because of this trade -off, it is important to forecast a range and then adjust the estimates based upon how well your products meet the customer buying criteri a. As in capstone, forecasts are obtained by taking the segment demand and multiplying by the segment growth rate. If you divide by 6 (assuming there are 6 firms in the segment), you are estimating that you will gain 1/6 of the segment. Let us use an example. 297 Table 14.1 a Size Market Segment Analysis Size Statistics Total Industry Unit Demand 3,885 Actual Industry Unit Sales 3,885 Segment % of Total Industry 10.5% Next Year’s Segment Growth Rate 18.3B Table 14.1b Size Customer Buying Criteria Expectations Importance 1. Ideal Position Pfmn 6.8 Size 6.6 43% 2. Age Ideal Age = 1.5 29% 3. Reliability MTBF 16000 -21000 19% 4. Price $23.00 – 33.0M 9% The segment demand for next year is the segment demand times the growth rates. For the size segment next year demand is (3885)(1.183) = 4595 units. One word of caution is needed. In the real world, demand cannot be predicted with certainty. As such, it is important to obtain a forecast range. For illustrative purposes, refer to Chapter 5, Analysis of Markets and Positioning, for way s of foreca sting a range. For purposes of this example, we will use the 4595 units from here forward as the demand for the segment. A calculation that is somewhat helpful is to not only calculate the demand for the segment but also calculate the capacity of each firm for the next year. From Table 14.2 we can calculate the production capacity for each firm for next year. Table 14.1c Top Products in Size Segment Name Market Share Units Sold to Seg Revision Date Units in invent -troy Pfmn Coord Size Coord List Price MTB F Age Dec.

31 Promo Budget Cust.

Awar eness Sales Budget Cust.

Access ibility Dec.

Cust.

Survey Dune 36% 1,411 9/25/2015 136 7.2 6.4 $33.50 19000 1.30 $1,200 74% $1,586 44% 37 Cure 33% 1,270 9/21/2015 117 6.8 6.6 $32.00 17000 1.35 $1,150 66% $1,591 43% 37 Fume 29% 1,115 11/11/2015 180 6.8 6.0 $33.00 17000 1.19 $1,300 74% $1,278 37% 30 298 Table 14.2 Capacity and Net Margin Analysis Size Segment Product 1st Shift Capacity Next Round (units) Plant Utilization This Year (Percent) Net Margin ($) Dune 1200 151 7771 Cure 1050 143 6868 Fume 1000 198 6003 3250 From the capacity analysis, we see that next year’s 1 st shift capacity (3250) is not sufficient to me et the demand for next year (4595 units). Currently, Dune is operating its Dune line at 151 percent (Table 14.2 ). It is also generating 136 units of inventory (Table 14.1c ). We need to examine Dune’s profitability. From a product line profitability perspective, the productivity of each line is obtained from the income statement. This report shows that Dune is the 2 nd most profitable product that Digby produces. Dell (low end) is the most profitab le product for Digby (Table 14.3 ). Table 14.3 Product Line Profitability –Digby Segment Product Net Margin Traditional Daze 5438 Low End Dell 11,456 High End Dixie 2558 Performance Dot 2727 Size Dune 7771 Since this is a high margin product for Digby we need to determine why Dune is generating inventory. Dune has the greatest market share (36 percent) of all products in the size segment (Table 14.1c ). Positioning is 43 percent of the customer buying criteria table 14.1b . Withi n the segment, Cure is at the optimal position (6.8 performance, 6.6 size). Dune needs to R&D its product to the optimal coordinates for next year. By R&Ding the Dune product, its new age will be different based on its release date at its release date the age will be cut in half ). There is a criterion that all these products do not meet. Products in this segment can move reliability up to 21,000. This criterion for all firms is below 21,000. This is 19 percent of the decision: Dune will be more attractive if it increases its MTBF. As stated in the 2012 team member guide, “A product’s demand is driven by its customer survey score.” Since Cure’s customer survey score is 37, there is ample opportunity to increase the score significantly . 299 Comp -XM: Example 2 Based upon the selected statistics (Table 14.4), your firm (Andrews), had an emergency loan of $21,076,058. We need to understand what caused this loan. One place to start is with the cash flow statement (Table 14.6). Andrews invested $20,000 in plant improvement. Investments in plant improvements are wise because the thrift segment is growing at 11 percent (Table 14.8a), the core segment at 10 percent (Table 14.9a), the nano segment at 14 percent (Table 14.10a), and the elite segment at 16 percent (Tabl e 14.11a). However, from the cash flow statement (Table 14.6), Andrews also retired $42,201 of current debt. These investments were financed by the issuing of $5,000 in common stock. No long term debt was issued to finance the long term investments. The cause of the emergency loan resulted from the retirement of $42,201 of current debt plus the $20,000 in plant investment. Andrews had $36,125 in net cash from operations (Table 14.6) and the issuance of $5,000 in common. By not funding these investments wi th long term sources (e.g. long term debt), Andrews’ decision resulted in an emergency loan of $21,076,058. With respect to the impact of Andrews’ decisions, the stock market summary shows that the stock price rose by $4.92 to close at $52.63 for the yea r. The majority of this increase was due to the earnings/share ratio of $6.77 (Table 14.5). Remember that changes in stock price are due to changes in earnings per share, book value, and dividend policy. The production information (Table 14.7) illustrate s how well products are positioned within the four market segments. The Aft product had an inventory of 387 units. By examining the nano market segment (Table 14.10a), the industry demand of 4741 units was met. As such, firms are likely to have inventory b uilt up. Let us examine the top products in the segment to determine why Aft had an inventory of 387 units. Within the nano segment (Table 14.10a), positioning is the most important key criteria at 35 percent while price is 27 percent of the customer buy ing criteria. Let us examine price first. The Aft product has the highest price ($38.00) of any product in the segment (Table 14.10b). Since the price range is $28 - $40, products that are priced at $38 need to be very well positioned. For Aft, the size co ordinate needed to be closer to the ideal size coordinate (5.3) to generate more sales. Positioning closer to the ideal size coordinate and reducing price would have significantly reduced Aft’s inventory in this segment. Let us examine the Agape product. Referring back to the production information (Table 14.7), the Agape product in the elite segment has 665 units in inventory. The total unit demand for the elite segment was 4,678 units (Table 14.11a). This segment’s demand was met which means that some firms had inventory. The two most important customer buying criteria in this segment were age (34 percent) and price (24 percent) (Table 14.11a). Positioning is also important (22 percent). Agape’s age is 1.6 years, which is higher than the Beetle age of 1.2 years and the Deft age of 1.1 years (Table 14.11b). The ideal age for this segment is zero (0). Agape’s price ($42.00) is also higher than any other product in the segment. $42 is also at the top of the price range for this segment. The Agape product is not price competitive in this segment: price is 24 percent of decision. If Agape is to be competitive in this segment, it either needs to reduce its price and/or engage in new product devel opment. New product 300 development is important in this segment because the ideal age is 0 and age represents 34 percent of the customer buying criteria. Let us examine the Abby product. Referring back to the pr oduction information ( Table 14. 2), the Abby pro duct in the thrift segment has 304 units in inventory. Referring to the customer buying criteria for the thrift segment (Table 14.8a ), the unit demand of 6,285 units was met. The two dominant customer buying criteria for this segment are price ( 27 percent) and MTBF (20 percent). Referring to the top products in the segment (Table 14.8b), the Abby product has a price of $20, which is higher than all other competitors within this segment. Since price is 27 percent of the decision (Table 14.8a), Abby has inventory because it is not priced competitively. This thrift market is very price sensitive and Abby is going to have to reduce its price. To maintain its margins on the product, Andrews has two options (1) buy capacity on this line and/or (2) increa se automation. Buying capacity before automating will have a tendency to reduce cost s and provide for economies of scale. Increasing automation will increase efficiency. Let us examine the Alan product. Referring back to the production information (Table 14.7), the Alan product in the core segment has 0 inventory. The core segment had a segment demand of 8078 (Table 14.9a). The segment demand was met. The four competitors had no inventory in this segment. Alan’s price ($26) is a little higher than Cent ($2 5) and Cake ($25). It is significantly higher than the industry leader Dune ($20). Alan’s age of 3 is significantly higher than Cent (1.1), Cake (1.1), and Dim (.8). Since the ideal age for this segment is 2.0, Alan will need to R&D this product to remain competitive for next year. From the production information (Table 14.7), Alan has a 5.5 level of automation in the core segment. Both of Chester’s core products and Digby’s Dune product have higher automation levels. At higher levels of automation, firms create greater efficiencies. It also would be wise to add plant capacity for the next year because Alan has 1,320 units of capacity next year while Chester has 2,428 units of capacity: 1,139 from Cake and 1,289 units from Cent (Table 14 .7). The capacity in this segment for next year can be determined by adding the capacity for next year and doubling that number to arrive at both first and second shift capacity. Capacity = 2 (1,320 + 1,139 + 1,289 + 1,040 + 1,800) (Table 14.7). Total capacity for this co re segment is 9,576 units. Total core segment demand (Table 14.9a) is the number of units sold this year (8,078) times (1.10), which is equal to 8,886 units. If all firms run at 100 percent of both first and second shift capacity, the segment will have i nventory. Make certain your products meet the customer buying criteria (Table 14.9a) to avoid having inventory in this segment. From the production information (Table 14.7), it can be seen that Andrews has a new product, (A -Elit), which will be introduce d in the next round. Thrift and core would not be markets for new products because they are cost based segments (Table 14.8a, Table 14 .10a). Nano is a segment for products that need to be repositioned. Positioning is 35 percent of the customer buying crite ria. Ideal age = 1 (Table 14.10a). The elite segment is for new products because the segment has ideal age = 0, which is 34 percent of the customer buying criteria (Table 14.11a). As Agape ages, A - Elit should be positioned within the elite segment. All o ther products will be older in this segment (Table 14.11b). In addition, Chester has exited this segment. This elite segment also has the highest growth rate (16 percent) of all segments. Table 14. 12 is a summary of decisions for team Andrews for the next round. 301 Balanced Scorecard The balanced scorecard is the assessment vehicle by which Comp -XM is measured. The balanced scorecard has both quantitative and qualitative measures for the primary assessment goals of financial, internal business process, custom er criteria, and learning and growth. The factors that are included in each category are listed in Table 14.13 . Based upon the results of the balanced scorecard, each firm will know what aspects of the balanced scorecard are strong and which needs improvem ent. We will briefly review some aspects of the balanced scorecard for team Andrews. Let us begin with some of the financial measures. Financial Stock price during the round grew by $4.92 (Table 14.5). Profits increased by $14,613,055 (Table 14.4). From a financial perspective, Andrews ranks 2 based on the 4 teams. We will briefly review the customer criteria. Customer Andrews is having difficulty meeting the customer buying criteria: Aft has 387 units in inventory, Agape has 665 units in inventory, and Abby has 304 units in inventory (Table 14.7). Andrews is poorly positioned in 3 of the 4 segments. These products need to be re -positioned and/or new products need to be developed. A -Elit should be positioned in the elite segment. Andrews needs to make the changes identified in Table 14.12 if it is to meet the customer factors of the balanced scorecard. The internal business processes will be briefly reviewed. Internal Business Process Contribution margin is 32.8 percent, which is similar to the other tea ms (Table 14.4). Andrews is making good plant utilization on its Aft, Agape, and Abby products.

However, Alan has a plant utilization of 68 percent (Table 14.7). The core segment has no inventory (Table 14.9b ). However, Alan has the poorest position on the customer buying criteria (Table 14.9a). Repositioning of this product is required if Andrews is planning on increasing its plant utilization of 68 percent (Table 14.7). Because Aft, Apage, and Abby have significant levels of inventory, each of these produ cts will generate significant inventory carrying costs. The learning and growth criteria of the balanced scorecard cannot be measured because the human resources and TQM modules have not been activated. HR and TQM are the primary factors which impact the learning and growth segment of the balanced scorecard. Refer to Chapter 3, Utilizing Internal Assessment to Build Competitive Advantage Over Rivals, for a complete review of all TQM initiatives. Let us conduct a complete review of this example. 302 Table 14.4 SELECTED FINANCIAL STATISTICS Andrews Baldwin Chester Digby ROS 8.2% 9.6% -6.8% -0.8% Turnover 1.21 1.33 .70 .74 ROA 9.9% 12.8% -4.8% -0.6% Leverage 1.9 1.9 3.9 2.7 ROE 18.6% 24.8% -18.6% -1.5% Emergency Loan $21,076,058 $0 $3,900,058 $0 Sales $179,117,651 $176,393,832 $134,384,005 $136,815,960 EBIT $31,206,059 $32,620,563 $3,305,202 $11,850,467 Profits $14,613,055 $16,915,956 ($9,158,582) ($1,041,356) Cumulative Profit $20,476,056 $31,039,832 ($13,317,625) $3,557,192 SG&A % Sales 7.5% 7.0% 10.3% 12.9% Contrib. Margin % 32.8% 34.0% 30.5% 33.8% Table 14.5 STOCK MARKET SUMMARY Company Close Change Shares Book Value EPS Dividend Andrews $52.63 $4.92 2,159,875 $36.38 $6.77 $0.00 Baldwin $75.52 $7.92 2,061,420 $33.02 $8.21 $0.87 Chester $7.16 ($7.75) 3,432,012 $14.33 ($2.67) $0.00 Digby $28.83 ($12.50) 2,634,377 $25.92 ($0.40) $0.00 Table 14.6 CASH FLOW STATEMENT Net cash from operations $36,125 $25,423 $12,314 $13,100 Cash flows from investing activities Plant improvements (net) ($20,000) ($35,100) ($54,101) ($63,960) Cash flows from financing activities Dividends paid $0 ($1,787) $0 $0 Sales of common stock $5,000 $0 $8,530 $16,227 Purchase of common stock $0 $0 $0 $0 Cash from long term debt issued $0 $17,994 $29,958 $33,585 Early retirement of long term debt $0 $0 $0 $0 Retirement of current debt ($42,201) ($5,400) ($14,573) ($7,772) Cash from current debt borrowing $0 $7,620 $13,972 $9,216 Cash from emergency loan $21,076 $0 $3,900 $0 Net cash from financing activities ($16,125) $18,427 $41,787 $51,255 Net change in cash position $0 $8,751 $0 $395 Balance Sheet Survey Andrews Baldwin Chester Digby Cash $0 $13,343 $0 $6,245 303 Table 14.7 PRODUCTION INORMATION Name Primary Segment Units Sold Units in Inventory Age Dec. 31 Automation Next Round Capacity Next Round Plant Utiliz. Aft Nano 1,443 387 1.6 4.5 1,190 115% Agape Elite 1,027 665 1.6 4.5 1,080 119% Abby Thrift 2,095 304 3.4 6.5 1,700 105% Alan Core 1,508 0 3.0 5.5 1,320 68% A-Elit 0 0 0.0 3.5 1,000 0% Bold Nano 1,669 121 1.3 6.0 1,250 160% Buddy Elite 812 314 2.4 6.5 1,000 124% Bat Nano 1,289 70 1.2 6.0 1,100 134% Beetle Elite 1,202 64 1.2 6.0 1,050 124% Coat Thrift 2,063 318 2.8 8.9 1,935 124% Cure Thrift 1,955 506 2.7 8.9 1,996 128% Cake Core 1,349 0 1.1 8.0 1,139 123% Cent Core 1,533 0 1.1 8.0 1,289 124% Dot Thrift 1,079 437 3.5 9.5 1,400 88% Dune Core 2,178 0 2.1 8.0 1,800 132% Dart Nano 1,045 43 1.0 6.0 900 141% Deft Elite 790 49 1.0 6.0 700 122% Dim Core 743 0 0.8 7.0 1,040 149% Don 0 0 0.0 7.0 600 0% Thrift Customer Buying Criteria Expectations Importance 1. Ideal Position Pfmn 12.1 Size 5.3 35% 2. Price $28.00 – 40.00 27% 3. Age Ideal Age = 1.0 20% 4. Reliability 18000 – 24000 18% Table 14.8a Statistics Total Industry Unit Demand 6,285 Actual Industry Unit Sales 6,285 Segment % of Total Industry 26.4% Growth Rate 11.0% 304 Table 14.8b TOP PRODUCTS IN SEGMENT Name Market Share Units Sold to Seg. Units in Inventory PfmnCoord. Size Coord. List Price MTBF Age Dec.

31 Cure 26% 1,644 8.0 12.0 $15.00 17000 2.7 Abby 25% 1,561 6.8 13.1 $20.00 20000 3.4 Coat 24% 1,520 7.8 12.2 $16.00 17000 2.8 Dot 14% 876 7.0 13.0 $18.00 14000 3.5 Core Customer Buying Criteria Expectations Importance 1. Price $20.00 – 32.00 46% 2. Age Ideal Age = 2.0 20% 3. Reliability MTBF 16000 -22000 18% 4. Ideal Position Pfmn 10.2 Size 9.8 16% Table 14.9b TOP PRODUCTS IN SEGMENT Name Market Share Units Sold to Seg. Stock Out Pfmn Coord. Size Coord. List Price MTBF Age Dec. 31 Dune 23% 1,862 YES 9.4 10.6 $20.00 16000 2.1 Cent 16% 1,323 YES 11.6 9.0 $25.00 20000 1.1 Alan 14% 1,164 YES 8.6 11.4 $26.00 22000 3.0 Cake 14% 1,156 YES 10.9 8.5 $25.00 18000 1.1 Dim 9% 721 YES 10.0 10.0 $21.00 16000 0.8 Table 14.9a Statistics Total Industry Unit Demand 8,078 Actual Industry Unit Sales 8,078 Segment % of Total Industry 34.0% Growth Rate 10.0% 305 Nano Customer Buying Criteria 14.10a Expectations Importance 1. Ideal Position Pfmn 12.1 Size 5.3 35% 2. Price $28.00 - $40.00 27% 3. Age Ideal Age = 1.0 20% 4. Reliability MTBF 18000 -24000 18% Table 14.10b TOP PRODUCTS IN SEGMENT Name Market Share Units Sold to Seg. Stock Out PfmnCoord. Size Coord. List Price MTBF Age Dec.

31 Bat 24% 1,130 13.1 4.8 $37.00 23000 1.2 Aft 22% 1,042 11.6 6.4 $38.00 24000 1.6 Bold 21% 1,009 12.0 6.0 $32.00 23000 1.4 Dart 18% 868 12.1 5.5 $30.00 18000 1.0 Elite Table 14.10a Statistics Total Industry Unit Demand 4,741 Actual Industry Unit Sales 4,741 Segment % of Total Industry 19.9% Growth Rate 14.0% Table 14.11a Statistics Total Industry Unit Demand 4,678 Actual Industry Unit Sales 4,678 Segment % of Total Industry 19.7% Growth Rate 16.0% 306 Customer Buying Criteria Expectations Importance 1. Age Ideal Age = 0.0 34% 2. Price $30.00 - $42.00 24% 3. Ideal Position Pfmn 14.7 Size 7.9 22% 4. Reliability MTBF 20000 -26000 20% Table 14.11b TOP PRODUCTS IN SEGMENT Name Market Share Units Sold to Seg. Stock Out PfmnCoord. Size Coord. List Price MTBF Age Dec.

31 Beetle 23% 1,054 15.0 7.0 $39.00 25000 1.2 Agape 21% 982 14.5 8.2 $42.00 26000 1.6 Buddy 17% 812 15.2 7.5 $35.00 25000 2.5 Deft 13% 618 14.9 7.7 $34.00 20000 1.1 Table 14.12 SUMMARY OF DECISIONS FOR ANDREWS PRODUCT RECOMMENDATIONS Aft Reduce price R&D performance and size coordinate Increase MTBF to 24,000 Agape Buy capacity Introduce new product in this segment Reduce Agape price R&D performance and size coordinate for Agape Abby Reduce price Increase capacity and/or invest in automation Alan Add capacity Increase capacity and/or invest in automation A-Elit Introduce this new product into Elite segment Add capacity 307 Table 14.13 BALANCED SCORECARD Financial Internal Business Process Stock Price Contribution Margin Profits Plant Utilization Leverage Days of Working Capital Stock -out Costs Inventory Carrying Costs Customer Learning and Growth Customer Buying Criteria Employee Turnover Rate Customer Awareness Employee Productivity Customer Accessibility TQM Material Reduction Product Count TQM R&D Reduction SG&A Expense TQM Admin Cost Reduction TQM Demand Increase 308 As CEO of your own firm (Andrews), you will be called to answer questions generated from your Board of Directors. These questions can be focused upon any aspect of your firm, the competition, and the position your firm occupies within its industry(s). Board inquiry questions will be focused upon how your firm can gain and maintain competitive over rivals. Several board inquiry questions are provided. Board Query Questions 1. What primary error did Andrews make which led to their emergency loan? a) Did not automate its products sooner b) Did not finance long term investments with long term debt c) Borrowed by issuing sale of common stock d) Did not purchase enough short term debt 2. Why is Chester losing money? a) Significant inventory in Coat and Cure products b) Weak position in Nano segment c) Has exited Nan o and Elite segments d) Has no long term sources of debt to finance plant improvements 3. Which firm(s) may drive Chester out of business? a) Andrews b) Baldwin c) Digby d) Andrews and Baldwin 4. What should Baldwin do to maintain its strong profit position? a) Reposition Bold and Buddy b) Increase automation on Buddy c) Introduce a new product in Elite d) Exit Nano segment e) a, b, c f) a, c g) All 5. What actions should be taken to increase market share in the thrift segment? a) Reduce price b) Increase reliability to 20,000 c) New product creation d) Sell product below $14 e) a, b f) a, b, c g) c, d 6. What type of generic business strategy is Chester following? a) Cost leadership b) Focus differentiation c) Differentiation d) None of the above 309 7. Which of Porter’s five forces model are relevant to this industry? a) Barriers to entry are high b) Firms follow a combination of cost leadership and differentiation c) Bargaining power of customers is high d) Industry rivalry is low e) a, c f) a, b, c 8. Why didn’t firms within the Core segment generate inventory? a) Accurate forecasting b) Chester has two products in the segment c) Core is a price sensitive market: firms sold products at lower end of price range d) Low segment growth rate 9. What segment should the Don product be positioned in? a) Nano b) Elite c) Thrift d) Core e) A case could be made for each segment 10. Which segment(s) focuses upon cost leadership and differentiation? a) Nano b) Elite c) Thrift d) Core e) a, b, d f) a, b, c g) All 11. Why is Chester’s stock price so low? a) Too much use of issuing shares to fund growth b) EPS is lower than other competitors c) Book value is too low when compared to other firms d) All of the above e) A, B f) C, D 12. Why did Digby lose money this year? a) New product introduction b) Too much overtime c) Too much inventory d) Entering new segments which it currently did not have positions 13. What does Baldwin need to do to continue to generate more profit than Andrews next round? 310 a) Increase automation on core product line b) R&D Buddy product c) Develop new product for core segment d) R&D Bat product e) a, b f) a, b, c g) All of the above 14. What can Chester do to improve its EPS? a) Must have favorable price position in thrift segment b) Needs to R&D Core product c) Sell off capacity in Coat product to reduce inventory d) Buy back stock while still maintaining positive free cash flow e) a, b f) b, c g) a, d 15. Why did Digby’s stock price go down this specific year? a) It has too many shares outstanding b) It is not meeting customer buying criteria in Core market segment c) Digby did not utilize enough long term funds to finance Don d) It is not meeting key buying criteria on thrift market segment e) a, b, c f) c, d g) b, c 16. What type of generic business strategy is Andrews using? a) Cost leadership b) Differentiation c) Value chain analysis d) Scenario analysis 17. What type of generic business strategy is Baldwin using? a) Cost leadership b) Differentiation c) Value chain analysis d) Scenario analysis 18. Why does Andrews have so much inventory? a) Positioning coordinates are not close enou gh to ideal on Aft product b) Forecast is too high on Elite product c) Price is too high on Abby product d) Age is too old on Agape product e) All of the above f) a, b, c g) a, d h) c, d 19. Which segment would a new firm be most likely to enter? a) Nano 311 b) Elite c) Thrift d) Core e) A case could be made for all f) None 20. What firm has not properly financed its long term investments? a) Andrews b) Baldwin c) Chester d) Digby 312 313 Appendix U.S. Domestic Data Sources Source Contents Annual Reports and 10 -K reports Standard Industrial Classification (SIC)manual North American System Industry Classification (NAICS) Hoover Online Directory (www.hoovers.com ) Million Dollar Directory Standard &Poors Corporate Directory Security & Exchange Commission (www.sec.gov ) Dun & Bradstreet (http://smallbusiness.dnb.com ) Business Source Elite Hoovers Company and Industry database Lexis Nexis Small Business Center Valueline Valueline Investment First Research Industry Database Detailed firm level data Classifies firms into industries Classifies firms in the U.S., Canada, and Mexico into industries Current financial data on firms Classifies firms into industries and provides both qualitative and quantitative information on firms Provides firm level data Provides firm level data Provides annual firm level data for public and private companies Includes some full -text. Business related topics, including detailed company profiles (covers 1985 – present) Comprehensive collection of corporate, industry, news and financial information Full -text company news and financial information. Company needs for small businesses www.infotrac.galegroup.com Both firm and industry level which is updated every 3 months An investment information service that covers some 1,700 equity issues. Contains industry, news and financial information 314 International Data Sources Source Contents Statistical Yearbook (published by the United Nations) World Atlas (published by World Bank: www.worldbank.com ) World Trade Organization (www.wto.org ) EuropeanUnion (www.europa.eu.int ) UN publications (http://unp.un.org ) LANIC (www.lanic.utexas.edu ) Asia -Pacific Economic Cooperation (www.apecsec.org.sg ) International Standard of Industry Classification (ISIC) manual International Trade Commission International Monetary Fund (IMF) ABI/INFORM ISI Emerging Markets International trade data on imports at the country level Country data containing population, growth trends, and GNP statistics Annual trade data by member countries Annual data on member countries Extensive data on member countries Data on Latin and South American countries Data on Pacific Rim countries Data on international firms and ind ustries Provides data on trade between member countries Provides current information on the world economic outlook  Source of international information and data which is sourced from the Wall Street Journal and over 7000 current annual reports for over 1000 North American firms  Tracks the economic, political and market developments around the world with country reports. Has over 190,000 reports from 195 countries, providing concise analysis of market conditions worldwide Follows 80 emerging markets thr oughout the world. Contains financial statements and firm level data on firms within these 80 markets. 315 Glossary A Acquisition A strategy through which one firm buys a controlling (over 50 percent) interest in another firm with the intent of making the acquired firm a subsidiary business. Automation The degree to which manufacturing processes do not involve manual labor. B Balanced Scorecard Multidimensional approach of measuring corporate performance through financial and non -financial factors. Board o f Directors A group of elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling a corporation’s top -level executives. The board of directors has ultimate responsibility for increasing shareh older wealth. Business level strategy How a firm competes in a given product/market. C Capabilities The skills and routines that allow the company to exploit its resources in ways that are valuable and difficult for other firms to imitate. Competencies Links key resources and capabilities to satisfy customer needs and provides access to new markets; these capabilities may be very hard for competitors to imitate. Competitive advantage occurs when a firm implements a strategy that competitors are unable to duplicate or find too costly to try to imitate. Concurrent Engineering (CCE) A TQM initiative utilized to ascertain which vendors are either more efficient or better qualified to source raw materials. Continuous Process Improvement (CPI) A TQM initiative utilized to ascertain whether a firm should continue to outsource its inbound transportation network versus the firm developing its own transportation network for obtaining raw materials. Core Competencies Capabilities that serve as a source of competiti ve advantage for a firm over its rivals (e.g. Dell Direct). Corporate -level strategy Actions a firm takes to gain a competitive advantage by selecting and managing a group of different businesses competing in different industries. D Dominant Logic The deg ree to which the management team understands the customers, key buying criteria, and competition within its various industries. The management team needs to have sufficient knowledge within industries in which it has market positions. Downscoping Divestur e, spin -off, or some other means of eliminating businesses that are unrelated to a firm’s core businesses. Downsizing A reduction in the number of a firm’s employees and, sometimes, in the number of its operating units. Due diligence Process through which a potential acquirer evaluates a target firm for a potential acquisition. 31 6 E Earnings Per Share (EPS) Calculated by dividing net profit into the number of shares outstanding. Economic Value Added (EVA) Income after the cost of debt and the cost of equity has been deducted. Measures the extent to which the firm has increased shareholder wealth. Economies of scale Potential cost savings from processes in which an increase in the size of the firm causes a decrease in the long run average cost of each unit. Economies of scope Potential cost savings from combining the production of dis parate products provided that they rely on the same management structure, administration systems, marketing departments, and R&D. F Financial Ratios Liquidity Ratios Current Ratio measures the firm’s ability to pay short -term liabilities from short -term assets Quick Ratio measures the ability of the firm to meet its short -term obligations from current assets (not including inventory). Asset Management Ratios measure a firm’s effectiveness at managing its assets Asset Turnover Sales, generated in a part icular year, divided by the value of total assets for the same period. Inventory Turnover measures the number of times that average inventory was turned over during the year. Fixed -Asset Turnover measures how much revenue is generated by each dollar of fixed assets. Average Collection Period the amount of time required to receive payment after sales. Debt Management Ratios measure the extent to which a firm uses debt financing. If the firm earns more on investments financed with borrowed funds than it does in interest, then its shareholders’ returns are magnified, or “leveraged”. Debt -to-Assets Ratio measures the extent to which borrowed funds have been used to finance the firm’s assets. Debt -to-Equity Ratio compares the funds provided by creditors to funds provided by stockholders. Long -term Debt -to-Equity Ratio measures the balance between debt and equity. Profitability Ratios represent how well a firm is allocating its resources. Gross Profit M argin represents the total margin available to cover operating expenses and generate a profit. Net Profit Margin reflects how much profit is generated by each sales dollar. Return on Assets (ROA) - Net profit, generated each year, divided by the value of total assets for the same period. Return on Equity (ROE) - Net profit, generated each year, divided by the value of owner’s equity for that year. Return on Sales (ROS) - Net profit, generated each year, divided by total sales for the same period. 317 Flexibl e Manufacturing A computer -controlled process used to produce a variety of products in moderate, flexible quantities with a minimum of manual intervention. Free Cash Flow The money left after investment that a company could either put in the bank or give t o shareholders as dividends. G G.E. Matrix A framework for identifying a firm’s position(s) on factors related to industry attractiveness and the firm’s own business strengths. H Hostile Takeover Special type of acquisition strategy wherein the target fi rm does not wish to be acquired. I Industry analysis An assessment of the attractiveness of an industry based on (Porter’s 1980) five forces - the bargaining power of buyers, the bargaining power of suppliers, degree of rivalry, threat of new entrants and threat of substitute products. Industry Life Cycle In troduction stage This stage is dominated by the marketing of an innovation for the first time. Competition is minimal (if any). The firm becomes a first mover.

Returns during this stage are not positive because the first mover must recover costs of produc t development, advertising, and manufacturing. Growth stage The stage of the industry life cycle when profits rise; product reliability increases as does the competition. Firms differentiate based upon value/quality. Maturity stage Sales tend to be the hi ghest during this period. The industry faces significant price pressure because customers view a firm’s offering as homogeneous. Margins are negatively impacted because price becomes the dominant key buying criteria. Decline stage Revenues and profits are reduced significantly during this stage. Firms may choose to allocate resources to products/markets which are at earlier stages of the life cycle. Innovation Putting an invention or other important discoveries into widespread use (e.g. laser) Internationa l Strategy A strategy through which a firm sells its goods or services outside its domestic market. Typical modes of international entry are exporting, licensing, franchising, strategic alliances, acquisitions, mergers and foreign direct investment (FDI). J Joint Venture A strategic alliance in which two or more firms create a legally independent company to share some of their resources and capabilities to develop a competitive advantage. Just in time (JIT) Inventory management approach in which a compan y products only what the customer wants, in the quantities the customer actually requires, and when the customer needs it. 318 K Key buying criteria Factors that dictate the purchase of a product/service. L Leverage Total assets at the end of the period divi ded by owner’s equity for the same period. Licensing A legal arrangement whereby one company permits another firm to produce and sell the company’s products for royalties. M Market Capitalization (from the perspective of the Simulation) This statistic is measured by multiplying the stock price per share times the number of shares outstanding. Market Value Added (MVA) Market value less capital invested. Mean Time Before Failure (MTBF) Reliability of product, expresses in hours. Merger A strategy through whi ch two firms agree to integrate their operations on a relatively coequal basis. Mission Specifies the business or businesses in which the firm intends to compete and the customers it intends to serve. N Net Income Value of profits as calculated on the Inc ome Statement Net Margin Value of total sales less variable and period costs Net Profit Earnings left after all expenses are paid. Net profit can only be allocated to one of two directions. It is either paid out to the owners of the business, in the form o f a dividend or it is retained in the business to grow the company and is thus added to the Retained Earnings of the business. P P/E Ratio The closing stock price divided by the earnings per share (EPS). The P/E is sometimes referred to as the earnings multiple or simply the multiple. Porter’s Five Forces See Industry Analysis R Resources An organization’s basic financial, physical, and human capital assets. Restructuring A strategy through which a firm changes its set of businesses or its financial structure. Retained Earnings Total of all company profits and losses over the life of the company, less any dividends paid out. The monies ar e captured in the assets of the company. This may be cash but it may just as easily be in the form of plant or even accounts receivable. S Sales Forecasting Delphi Technique An iterative process of forecasting a future event based upon experts who are dispersed geographically 319 Executive Judgment The senior level executives within a firm, based upon their judgment, predict sales forecasts at the industry and product market level. Exponential Smoothing Projects next year’s sales by combining an average of past sales and more recent sales giving more weight to the latter. Naïve Method Developed based upon historical (usually last year’s) sales and growth rates. Regression Analysis This technique requires the use of historical sales data. The forecaster seeks to find a relationship between past sales (the dependent variable) and one or more independent variables, such as population, per capita income, or gross domestic product. An accurate forecast depends upon identifying a specific relationship between the depende nt and independent variables. Scenario Analysis This technique is used to generate strategic alternatives based on varying assumptions about the future. A scenario is a possible set of environmental circumstances concerning what the environment may look like in the future. It depicts potential actions and events in a likely order of occurrence, beginning with a set of conditions that describe the current situation. Test Market Study Actually selling the product in a number of specific markets. Ac tual cost and revenue data can be gathered from each market. Time Series Analysis The forecaster uses the firm’s historical sales data to attempt to discover a pattern or patterns in the firm’s sales over time. If a pattern is found, it can be used to fore cast future sales. This forecasting method assumes that past sales patterns will continue in the future. Stakeholders Those who affect and are affected by a company’s actions and results. Strategic Leaders People located in different parts of a firm who u se the strategic management process to help the firm reach its vision and mission. SWOT Analysis Strengths, weaknesses, opportunities and threats analysis; examining the internal strengths and weaknesses of a firm, comparing them with external opportunit ies and threats, and matching the two in order to choose a strategy based on the analysis. SWOT can also be used to determine the position of competitors. Synergy When the value created by business units working together exceeds the value that those same u nits create working independently. T Total Quality Management (TQM) Initiatives Activities designed to achieve enhanced productivity and increase quality at the same time; Benchmarking reduces administrative costs. Channel Support Systems (Sales Force support) Increases demand. Concurrent Engineering (CCE) Reduces R&D cycle time. Continuous Process Improvement (CPI) Reduces material and labor costs Quality Function Deployment Effort reduces R&D cycle time and increas es demand. Quality Initiative Training (QIT) reduces labor costs. 6 Sigma Training reduces material and labor costs. Vendor/Just -In -Time (JIT) Reduces material costs and administrative overhead. 320 V Value Chain The primary and support activities a firm undertakes to deliver products and services to customers; each element in the value chain can be broken down to determine how profitable it is. Consists of primary activities which examine the product from source o f raw material to after sales service. Secondary activities (e.g. technology) provide support for the primary activities. Vertical Integration Corporate structure in which a company combines production, distribution, and/or sales within its organization . Vision A picture of what a firm wanted to be and, in broad terms, what it wants to ultimately achieve. 321 Index Adaptation, 215 Advanced marketing module, 55 Auto Industry (U.S), 20 Automation, 53, 55, 56, 290, 291 Balanced Scorecard, 253, 254 BNSF Railroad Acquisition, 67, 68, 69 Board of Directors, 237 Brand  equity, 27  image, 69  loyalty, 47  name, 46 BRIC (Brazil, Russia, India, China), 18, 23, 179, 241 Capital budgeting, 54 Cash flow. See Free cash flow Chapter 11 bankruptcy, 31, 35 Chief Executive Officer (CEO), 233, 237 Collective bargaining organizations, 220, 235, 285 Collusion, 208 Concurrent Engineering (CCE), 116, 142, 164 Continuous Process Improvement (CPI), 142, 164 Continuous Process Improvements (CPI), 116 Cumulative profit, 262, 291 Data Sources (U.S. Domestic), 311 Data Sources (International), 312 Depression (1930s), 22, 24, 29 Dominant logic, 132 Dow Jones, 25 Downscoping, 137, 261 Downsizing, 136, 261 Due diligence, 189, 192 Economic value added (EVA), 258 Economies of scale, 29, 55, 106, 107, 115, 127, 156, 181, 185, 189, 204 Economies of scope, 127, 158, 186, 208 Electronic data interchange (EDI), 95 Emergent strategy, 67 European Union, 216, 228, 235, 24 1 Experience curve, 106 Finance spreadsheet, 54 Financial Ratios  Asset Management Ratios, 257  Debt Management Ratios, 258  Liquidity Ratios, 257  Profitability Ratios, 258 Flexible manufacturing, 108, 256 Free cash flow, 262, 291 G.E. Matrix, 133 Global Outs ourcing, 240 Government Stimulus Plan ($787 Billion), 24 Great Depression (1930s), 17, 19 Gross Domestic Product (GDP), 35, 208, 256 Housing Prices, 23, 26 Hostile acquisitions, 189 Industry  aircraft, 186  airline, 82, 185, 204  cell phone, 217  evolution, 47  fashion, 27  mining and steel, 27  pharmaceutical, 27, 73, 126, 186  railroad, 29  telecommunications, 84, 181, 185, 204  tobacco, 84  wet shaving, 190, 285 Innovation, 30 International Monetary Fund (IMF), 27 International Standard Industrial Clas sification System, 23 Interstate Commerce Commission (ICC), 45 Just in time (JIT), 46, 55, 95, 96, 116, 164 Key buying criteria, 57, 86, 93, 111 Learn by doing, 54, 106 LTL (Less Than Truck) Trucking Industry, 45, 46, 47 Market capitalization, 262 Market value added (MVA), 258 Marketing spreadsheet, 56 Mean Time Before Failure (MTBF), 56 Mission statement, 22 Monopolistic Competition, 41 Monopoly, 41 322 NASDAQ, 25 North American Free Trade Agreement (NAFTA), 23, 216 North American Industry Classification System (NAICS), 23, 41, 42, 228, 235 Not Invented Here, 215 Oligopoly, 41 OPEC Cartel, 44 Organization for Economic Co -operation and Development (OECD), 28 Outsourcing, 57, 204 Perceptual Map, 100, 101 Product  adaptation, 110  line profitability, 243 Production spreadsheet, 55 Quality/price tradeoff, 135 R&D  cycle time, 54, 116, 290  investments, 92, 116  process, 31, 34, 35, 53, 182, 255  product, 31, 34, 35, 51, 52, 53, 73, 221, 255 Realignment, 137 Sabbanes -Oxley of 2002, 255 Sales forecasting  Delphi technique, 85  executive judgment, 84  exponential smoothing, 84  naïve methods, 84  regression analysis, 85  scenario analysis, 85  time series analysis, 85 Scale economies. See Economies of scale Senior management. See Strategic leader s Shareholders, 236 Six sigma, 256 Standard and Poor's, 25 Standard Industrial Classification System (SIC), 23, 41, 42 Standardization, 215 Strategic leaders, 233, 235 Switching costs, 26 Synergies, 185 Technology transfer, 159 Test markets, 256 Total Qua lity Management (TQM), 31, 34, 55, 112, 116, 138, 243 U.S. Bankruptcy Filings, 18, 19 U.S. Economic Conditions, 16, 24, 25 U.S. Government Bailout Plan, 20 U.S. Government Stimulus Plan, 20 U.S. Housing Market, 18, 22, 24 Walmart Expansion, 84, 85