Posted by: hmchang | December 14, 2007

Business: Lessons on How to Manage and Plan Strategically

Tradeoffs are essential to strategy. They create the need for choice and purposefully limit what a company offers. –Michael E. Porter [1]

Mr. Porter was not the first one who identified the importance of strategy, but many of his articles on strategy and management have profound impact on how people view strategy nowadays. As he pointed out, strategy is about trade-off – a company determines which market they want to participate in and how they plan to win the market. Understanding what are the existing tradeoffs help sharpen the strategy a company should take. Once a strategy is clearly identified, the management activities and daily operations follow strategy. As the company grows and the market evolves, the company’s strategy may change accordingly. This article explains the essentials of planning a strategy and the management activities to support the strategy.

Two General Strategies: Cost leadership and Differentiation

There are two general strategies that one can take: cost leadership and differentiation. Cost leadership competes in the mass market by providing low priced products. In order to maintain sufficient profit margin, the cost per product is minimized. This is usually achieved by providing mainstream products that require low investment on production and development. Such products would not decrease a lot on customers’ willingness to pay. The volume of the sales is expected to be large to achieve economies of scale.

On the other hand, a differentiation strategy competes in the niche market by providing products to the “sweet spot” of a targeted customer. Through investing on product development to increase customers’ willingness to pay, these products can be priced at a premium. The production volume may be smaller due to the high price but the significant profit margin can still accumulate to have good overall profits.

Driving Business Activities with Strategy

Business activities should comply with the general strategy. The value chain of a company, for example, starting from the research and development, production, packaging, and then marketing should be developed around the strategy. For example, when a differentiation strategy is taken, the marketing activities are centered on understanding the requirement of specific groups of people. The product specification will then drive the development procedure to create the best fitted products. Production schedules will then depend on the demand estimated. Seasonal variations should be considered during demand forecasting to have a reasonable inventory at hand. Finally, the packaging should comply with the marketing image and the pricing. As a real world example, luxury goods providers such as Tiffany and Coach shape their high-end images by having elegant product designs, store settings, services and even packaging.

Whichever strategy one takes, understanding the cost structure of each product based on all the business activities is necessary. Costs of producing a product can be usually broken down into the development costs, production costs, marketing costs and administrative costs. Production cost is comprised of material cost, labor cost, packaging cost, depreciation, and inventory cost. In the marketing cost, expenditure on promotion activities, sales force and advertisement should be calculated. Summing all the costs up and dividing it by the units sold would be a unit cost for the product. The difference of the selling price and the cost is the profit margin for the product.

To be competitive in the market, it is useful to compare the cost structure of each product to the competing products in the market. Such relative cost analysis framework is useful to benchmark the overall profitability in the marketing and also give a sense of what strategy one should take. For example, commodity markets are usually characterized by few innovations and consumers are not willing to pay a premium. Thus, using a differentiation strategy in such market may lead to low profit margin due to high cost but low price. On the other hand, high technology markets have more diverse audiences and it is possible to find a niche to compete in. The relative cost structure in that sense will show a good margin even though the volume of sales is low.

In fact, relative cost analysis should be performed periodically to understand how the market evolves. If the whole market has shrinking profit margins but no further cost reduction can be performed, it may be a sign of commoditized products. However, if the whole market maintains good profit margins but our own profit margin is shirking, this is a warning signal in the cost structure of that product. Managers should analyze the breakdown of the cost structure to see if any costs are significantly higher than the competitors. Typical mistakes in the cost structure are having high labor in a cost leadership competition or the wrong pricing in a differentiation game.

Understanding the cost structure of our products is one thing, how to price them is another. Depending on the different stage of the product, the pricing strategy can be different. To compete in the main street, for example, a competitive pricing strategy can be used [2]. Another method of pricing is to analyze the consumer willingness to pay [3]. Although a general rule says that customers are willing to pay higher prices for better performance products, it is really hard to precisely estimate how much a customer is really willing to pay. Market survey and analysis could become handy in terms of pricing. The final price of a product should give sufficient margin for company operation. Pricing at a negative profit to gain market share may be useful in a short term and can only be played by companies with deep pocket. In that case, finding alternate profit source may be itself a differentiation strategy.

Marketing activities should also demonstrate a strong support to the strategy. When a differentiation strategy is used, advertisements are usually sent to toward a specific group of people through channels such as through tradeshows, specialized magazines or emails. On the contrary, a cost leadership strategy would require advertisement through printed media, general magazine or TV commercials to target broader audience. The return on marketing expenses is usually hard to evaluate but the higher awareness of your product, the better chance you can sell.

Finally, all the above mentioned activities will not work without solid financial support. Three financial statements – the balance sheet, income statement, and statement of cash flows can clearly indicate the healthiness of a company. Moreover, benchmarking important financial ratios with a company in the same industry sector will give you a sense of management effectiveness. For example, the Return on Equity, Return on Sales and Return on Assets are all good indicators on the profitability of a company.

Although growth is good, it should be sustainable. Having insufficient cash to support growth may lead a company into bankruptcy. Pro Forma analysis and net present value are useful tools to get a sense of whether a project would worth investing. Do not be afraid of getting loans as long as it is well planned and supported by promising future income. Although acquiring debt may hurt the short term financial statement, it should pay off in the long run. As a famous business quote says, “You have to break a few eggs to make a cake.”

Endnote
[1] Michael E. Porter, “What is Strategy?” Harvard Business Review, Nov-Dec 1996.
[2] Geoffrey Moore, “Crossing the Chasm: Marketing and Selling High-Tech Products to Mainstream Customers,” HarperBusiness, July 1999
[3] Pankaj Ghemawat and Jan W. Rivkin, “Creating Competitive Advantage”, Harvard Business School Case Study, 9-798-062, Revised February 25, 2006

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