Strategic management lesson 05

5 STRATEGY FORMULATION CONTENTS 5.0 Aims and Objectives 5.1 Introduction 5.2 Strategy Formulation 5.3 Generic Strategies 5.3.1 Cost Leadership Strategy 5.3.2 Differentiation Strategy 5.3

UNIT III

5

STRATEGY FORMULATION

CONTENTS

5.0 Aims and Objectives

5.1 Introduction

5.2 Strategy Formulation

5.3 Generic Strategies

5.3.1 Cost Leadership Strategy

5.3.2 Differentiation Strategy

5.3.3 Focus and Niche Strategies

5.4 Grand Strategies

5.5 Let us Sum up

5.6 Lesson End Activity

5.7 Keywords

5.8 Questions for Discussion

5.9 Suggested Readings

5.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to:

l Understand the generic strategies

l Learn about grand strategies

l Know about strategies of different Indian Companies

5.1 INTRODUCTION

Formulating competitive strategy involves the consideration of four key factors These are shown in Figure 5.1 These factors determine what a company can successfully accomplish The factors that are internal to the organization are its strengths and weaknesses and the values of its key personnel; the factors that are external to the organization are the industry opportunities and threats and societal expectations These factors combine to provide the basis and limits to the competitive strategy a company can successfully adopt The appropriateness of the competitive strategy can be determined

by testing the proposed objectives and policies for consistency

Strategic Management These broad considerations in an effective competitive strategy can be extended into a

generalized approach to the formulation of strategy In order to do this, the organization must be in a position to answer the following questions:

l What is the current strategy, implicit or explicit?

l What assumptions have to hold for the current strategy to be viable?

l What is happening in the industry, with our competitors, and in general?

l What are our growth, size, and profitability goals?

l What products and services will we offer?

l To what customers or users?

l How will the selling/buying decisions be made?

l How will we distribute our products and services?

l What technologies will we employ?

l What capabilities and capacities will we require?

l Which ones are core?

l What will we make, what will we buy, and what will we acquire through alliance?

l What are our options?

l On what basis will we compete?

Although the process may seem intuitively clear, answering these questions involves a great deal of penetrating analysis It is in answering these questions that the organization finds its competitive strategy

Competitive Strategy

Personal values

of Key implementers

Societal Expectations

Industry opportunities &

threats

Company Strengths &

Weaknesses

Factors External to the Company

Factors Internal

to the Company

Figure 5.1: Formulation of Strategy

5.2 STRATEGY FORMULATION

In a tidy logical world, any process of choice could be rational Identifying and choosing options would be done purely analytically This is not necessarily true Identifying and evaluating options and then exercising it for strategy formation is a complex process Actually, it may be difficult to identify all possible options with equal clarity, or at the same time

131 Strategy Formulation The future may evolve differently from any of the options Unexpected events can

create new opportunities, destroy foreseen opportunities, or alter the balance of advantage

between opportunities The results may eventually depend as much on chance and

opportunity as on the deliberate choice Good fortune and inspiration play a large role in

organization success and failure, too No one yet knows enough about effective strategic

management to model it fully (Mintzberg, 1994), making it more art than science

The evolution of strategic choice is driven by many different forces Ideas and practices

emerge from collaborative contacts between organizations Firms cannot avoid learning

and borrowing when they trade and work together The evolution of strategy is also

pushed along by competition and confrontation New ideas and practices arise when

managers try to outwit or beat back powerful rivals New strategies are often a recasting

of the old In a sense, old strategic ideas never disappear entirely; they infiltrate new

practices covertly, like the blending of old and new malt whiskies Finally, strategy is

pushed along by the sheer creativity of managers, because they explore new ways of

doing things

Figure 5.2: The Strategic Choice Process

The nuts and bolts of strategy start with the selection process Strategy selection is

based on the vision of the organization It blends into the missions and goals of the

organization Through strategies, organizations align their internal resources with

environmental demands to ensure long-term effectiveness A workable strategy is built

on these outputs

The relationship of strategy selection with the strategic intent and the strategic assessment

process is shown in Figure 5.2 In the figure, strategic intent, strategic assessment and

available options are shown as three circles To some extent, strategic choice shapes

and even limits the goals a company can reasonably pursue The logically viable strategy

emerges where the three logical elements overlap Where all three circles overlap, the

differing requirements of intent and assessment are most fully met

The common ground between any two circles is of some interest This is explained in

Figure 5.3 Where any two circles overlap are areas where feasible options may exist

which are not aligned to strategic intent This may raise the question of whether the

strategic intent should be changed Options that are not feasible may seem highly attractive

and may have powerful supporters, so the reasons why they are not feasible may need

to be carefully argued with clear evidence in support

Strategic Management

Figure 5.3: The Strategic Choice Process Explained

Another case may be that they are aligned but have not been found feasible In this case also, it will be necessary to faithfully document all the assumptions and analysis of why the option was found not to be feasible Choices of what not to do may sometimes be as important as choosing what to do

5.3 GENERIC STRATEGIES

The objective of the organization is to yield a superior rate of return on the investment for the organization The principle to meet this objective is that organizations achieve competitive advantage by providing their customers with what they want, or need, better

or more effectively than competitors and in ways the competitors find difficult to imitate The best strategy for the organization, therefore, is ultimately unique, reflecting the particular circumstances it faces

In order to succeed in this, organizations have found many offensive and defensive actions to defend their position in the industry and cope with the five competitive forces

A firm's relative position within its industry determines whether a firm's profitability is above or below the industry average The fundamental basis of above average profitability

in the long run is sustainable competitive advantage There are two basic types of competitive advantage a firm can possess: low cost or differentiation The two basic types of competitive advantage combined with the scope of activities by which a firm seeks to achieve them, lead to three internally consistent generic competitive strategies that can be used by the organization to outperform competition and defend its position in the industry These strategies are:

l Cost Leadership

l Differentiation, and

l Focus and Niche Strategies

Figure 5.4: Generic Strategies

2 Differentiation

Competitive Advantage

1 Cost Leadership

3 Cost Focus 4 Differentiation

Focus

Broad Target

Narrow Target

Lower Cost Differentiation

133 Strategy Formulation

The focus strategy has two variants, cost focus and differentiation focus This is shown

in Figure 5.4

These strategies are explained below Effectively implementing any of the generic

competitive strategies usually requires total commitment and determined organizational

support This happens when there is compatibility between corporate level strategy and

the strategy at the business level

5.3.1 Cost Leadership Strategy

A firm pursuing a cost-leadership strategy attempts to gain a competitive advantage

primarily by reducing its economic costs below its competitors This policy once achieved

provides high margins and a superior return on investments

The skills and resources required to be successful in this strategy are sustained capital

investment and access to capital; superior process engineering skills; good supervision

and motivation of its labour force; product designed for ease in manufacturing; low-cost

distribution system The organization attempts to exploit economies of scale by aggressive

construction of efficient economies of scale through:

l Volume of production and specialized machines

l Volume of production and cost of plant and equipment

l Volume of production and employees’ specialization

l Volume of production and minimised overhead costs

This strategy requires tight cost control This is often done by using a full costing method

or activity based costing with frequent and detailed control reports The structure of the

organization should be clear-cut and responsibilities clearly laid out Organizations often

provide incentives based on meeting strict quantitative targets, etc

In order to remain a cost leader, the firm attempts to avoid those factors that can cause

the economies of scale to be affected It has to work within the physical limits to efficient

size; worker motivation; and focus on markets and suppliers, sometimes, in restricted

geographical areas Firms that are known to have successfully used this strategy in a

number of their businesses include Black and Decker, Texas Instruments, and DuPont

The low-cost producer strategy works best when buyers are large and have significant

bargaining power; price competition among rival sellers is a dominant competitive force;

the industry's product is a standard item readily available from a variety of sellers; there

are not many ways to achieve product differentiation that have value to the buyer;

buyers incur low switching costs in changing from one seller to another and are prone to

shop for the best price

A low-cost leader is in the strongest position to set the floor on market price and this

strategy provides attractive defences against competitive forces Its cost position gives

it a defence from competitors because its lower costs mean that it can still earn returns

after its competitors have competed away their profits through rivalry It is protected

from powerful buyers because buyers can exert power only to lower prices, and this will

be possible only with next most efficient competitor Lower cost provides protection

against suppliers because there is more flexibility in the organization to cope with input

cost increases Any new entrant will find it difficult to overcome entry barriers because

of required economies of scale, and also because the activities taken to achieve low

costs are both rare and costly to imitate

Finally, it places the organization in a favourable position when pitted against substitutes

compared to competitors in the industry

Strategic Management Cost leadership is valuable if:

l Buyers do not value differentiation very much

l Buyers are price-sensitive

l Competitors will not immediately match lower prices

l there are no changes in:

v consumer tastes

v technology

v exogenous prices/costs There are a number of risks in using this strategy These risks relate to the fast changing business environment The most serious risk to cost leadership is technological change that nullifies past investment or learning of the organization Sometimes the inability of the management to see or anticipate the changes required in the product or market change, is a grave handicap The organization's advantage can also be neutralized if there is low cost learning by industry newcomers or inflation in costs of supplies or processes that provide the organization a competitive advantage

5.3.2 Differentiation Strategy

In a differentiation strategy, a firm seeks to be unique in its industry along some dimensions that are widely valued by buyers It selects one or more attributes that many buyers in an industry perceive as important, and uniquely positions itself to meet those needs Differentiation will cause buyers to prefer the company's product/service over the brands

of rivals An organization pursuing such a strategy can expect higher revenues/margins and enhanced economic performance

The challenge is finding ways to differentiate that create value for buyers and that are not easily copied or matched by rivals Anything a company can do to create value for buyers represents a potential basis for differentiation Ways to differentiate products / services include:

l Product features

l Linkage between functions

l Timing

l Location/convenience

l Product mix

l Links with other firms

l Customisation

l Product complexity/sophistication

l Marketing (image, etc)

l Service and support Successful differentiation creates lines of defense against the five competitive forces It provides insulation against competitive rivalry because of brand loyalty of customers and hence lower sensitivity to price The customer loyalty also provides a disincentive for new entrants who will have to overcome the uniqueness of the product or service Competitors are not likely to follow a similar approach if buyers value the differentiated

135 Strategy Formulation products and services If they do, this will lead to a lose - lose situation for them The

higher returns of the strategy, provides a higher margin to deal with supplier power

Buyer power is mitigated as there are no comparable alternatives Finally a company

that has differentiated itself to achieve customer loyalty should be better placed to compete

with substitutes than its competitors Some successful examples of this strategy are

DaimlerChrysler in Automobiles, Bose in Audio Systems, and Caterpillar in construction

equipment

Competitive advantage through differentiation is sustainable if the activities taken to

achieve differentiation are rare and costly to imitate The most appealing types of

differentiation strategies are those least subject to quick or inexpensive imitation

Differentiation is most likely to produce an attractive, long-lasting competitive edge when

it is based on technical superiority, quality, giving customers more support services, and

on the core competencies of the organization

Differentiation requires the organization to have some of these skills and resources:

l Strong marketing abilities

l Product engineering

l Creative flair

l Corporate reputation for quality or technological leadership

l Strong cooperation from channels

l Strong coordination among functions

l Amenities to attract highly skilled labor, scientists, or creative people

Differentiation strategy works best when there are many ways to differentiate the product/

service and these differences are perceived by buyers to have value or when buyer

needs and uses of the item are diverse The strategy is more effective when not many

rivals are following a similar type of differentiation approach There are risks in this

strategy when the cost of differentiation becomes too great or when buyers become

more sophisticated and need for differentiation falls

Check Your Progress 1

Fill in the blanks:

1 emerge from collaborative contacts between

organizations

2 The objective of the organization is to yield a superior

on the investment for the organization

3 The low-cost producer strategy works best when buyers are and

have significant bargaining power

5.3.3 Focus and Niche Strategies

The generic strategy of focus rests on the choice of a narrow competitive scope within

an industry The focuser selects a segment or group of segments in the industry, or buyer

groups, or a geographical market and tailors its strategy to serving them to the exclusion

of others The attention of the organization is concentrated on a narrow section of the

total market with an objective to do a better job serving buyers in the target market niche

than the rivals Each functional policy of the organization is built with this in mind

Strategic Management There are two aspects to this strategy, the cost focus and the differentiation focus In

cost focus a firm seeks a cost advantage in its target market The objective is to achieve lower costs than competitors in serving the market - this is a low cost producer strategy focused on the target market only This requires the organization to identify buyer segments with needs/preferences that are less costly to satisfy as compared to the rest of the market Differentiation focus offers niche buyers something different from other competitors The firm seeks product differentiation in its target market

Both variants of the focus strategy rest on differences between a focuser's target market and other markets in the industry The target markets must either have buyers with unusual needs or else the production and delivery system that best serves the target market must differ from that of other industry segments Cost focus exploits differences

in cost behaviour in some markets, while differentiation focus exploits the special needs

of buyers in certain markets A focuser may do both to earn a sustainable competitive advantage though this is difficult Examples of focus strategies are Rolls-Royce in luxury automobiles; Apple Computer in Desktop publishing

Focus strategy is successful if the organization can choose a market niche where buyers have distinctive preferences, special requirements, or unique needs and then developing

a unique ability to serve the needs of the target buyer segment Even though the focus strategy does not achieve low cost or differentiation from the perspective of the market

as a whole, it does achieve this in its narrow target However, the market segment has to

be big enough to be profitable and it has growth potential The organization has to identify

a buyer group or segment of a product line that demands unique product attributes Alternatively, it has to identify a geographical region where it can make such offerings Focusing organizations develop the skills and resources to serve the market effectively They defend themselves against challengers via the customer goodwill they have built

up and their superior ability to serve buyers in the market The competitive power of a focus strategy is greatest when the industry has fast-growing segments that are big enough to be profitable but small enough to be of secondary interest to large competitors and no other rivals are concentrating on the segment Their position is strengthened as the buyers in the segment require specialized expertise or customized product attributes

A focuser's specialized ability to serve the target market niche builds a defence against competitive forces Its focus means that either the organization has a low cost position

as its strategic target, high differentiation, or both! The logic that has been laid out earlier for cost leadership and differentiation also is applicable here

Some of the situations and conditions where a focus strategy works best are:

l When it is costly or difficult for multi-segment rivals to serve the specialized needs

of the target market niche;

l When no other rivals are concentrating on the same target segment;

l When a firm's resources do not permit it to go after a wider portion of the market;

l When the industry has many different segments, creating more focusing opportunities and allowing a focuser to pick out an attractive segment suited to its strengths and capabilities

A focus strategist must beware of events that could impact the target market This can happen when broad-line, multi-segment competitors may find effective ways to match the focused firm in serving the narrow target market, or the segment may become so appealing that it is soon crowded with eager, aggressive rivals, causing segment profits

to be split Often the niche buyer's preferences and needs drift more and more towards