Strategy Consulting Archives - Global Advisors | Quantified Strategy Consulting

Strategy Tools: ‘Price-Volume-Profit’ Part 1 – A strategic take on cost-volume-profit analysis

By Eric van Heeswijk and Marc Wilson
Eric is an analyst and Marc is a partner at Global Advisors. Both are based in Johannesburg, South Africa.

Almost every person who has studied financial or management accounting at school or university is probably familiar with cost-volume-profit (CVP) analysis. It should be the basis of financial planning in most companies. However, in our experience, most managers do not apply the analysis and get it wrong in its most basic form (e.g. planning for similar / increased volumes together with price increases). The outcome? At best: results that fail to meet budgets. At worst: firms trigger the “margin-price-volume death spiral”. Whether you are a production manager or a CEO, you should understand how CVP analysis applies to your firm. Your business’s survival may be at stake.

Strategy Tools: The Growth-Share Matrix

The Growth-Share Matrix was introduced almost 50 years ago by Bruce Henderson and the Boston Consulting Group (BCG). It is considered one of the most iconic strategic planning techniques.

The Growth-Share Matrix is a framework first developed in the 1960s to help companies think about the priority (and resources) that they should give to their different businesses. At the height of its success, in the late 1970s and early 1980s, the Growth-Share Matrix (or approaches based on it) was used by about half of all Fortune 500 companies, according to estimates.

The need which prompted The Growth-Share idea was, indeed, that of managing cash-flow. It was reasoned that one of the main indicators of cash generation was relative market share, and one which pointed to cash usage was that of market growth rate:

“To be successful, a company should have a portfolio of products with different growth rates and different market shares. The portfolio composition is a function of the balance between cash flows. High growth products require cash inputs to grow. Low growth products should generate excess cash. Both kinds are needed simultaneously.”—Bruce Henderson.

The two axes of the matrix are relative market share (or the ability to generate cash) and growth (or the need for cash).

For each product or service, the “area” of the circle represents the value of its sales. The growth–share matrix thus offers a “map” of the organization’s product (or service) strengths and weaknesses, at least in terms of current profitability, as well as the likely cashflows.

The matrix puts each of a firm’s businesses into one of four categories. The categories were all given memorable names – cash cow, star, dog and question mark – which helped to push them into the collective consciousness of managers all over the world.

Strategy Tools: Profit from the Core

Extensive research conducted by Chris Zook and James Allen has shown that many companies have failed to deliver on their growth strategies because they have strayed too far from their core business. Successful companies operate in areas where they have established the “right to win”. The core business is that set of products, capabilities, customers, channels and geographies that maximises their ability to build a right to win. The pursuit of growth in new and exciting often leads companies into products, customers, geographies and channels that are distant from the core. Not only do the non-core areas of the business often suffer in their own right, they distract management from the core business.

Profit from the Core is a back-to-basics strategy which says that developing a strong, well-defined core is the foundation of sustainable, profitable growth. Any new growth should leverage and strengthen the core.

Management following the core methodology should evaluate and prioritise growth along three cyclical steps:

Focus – reach full potential in the core

Define the core boundaries
Strengthen core differentiation at the customer
Drive for superior cost economics
Mine full potential operating profit from the core
Discourage competitive investment in the core

For some companies the definition of the core will be obvious, while for others much debate will be required. Executives can ask directive questions to guide the discussion:

What are the business’ natural economic boundaries defined by customer needs and basic economics?
What products, customers, channels and competitors do these boundaries encompass?
What are the core skills and assets needed to compete effectively within that competitive arena?
What is the core business as defined by those customers, products, technologies and channels through which the company can earn a return today and compete effectively with current resources?
What is the key differentiating factor that makes the company unique to its core customers?
What are the adjacent areas around the core?
Are the definitions of the business and industry likely to shift resulting in a change of the competitive and customer landscape?

Expand – grow through adjacencies

Protect and extend strengths
Expand into related adjacencies
Push the core boundaries out
Pursue a repeatable growth formula

Companies should expand in a measured basis, pursuing growth opportunities in immediate and sensible adjacencies to the core. A useful tool for evaluating opportunities is the adjacency map, which is constructed by identifying the key core descriptors and mapping opportunities based on their proximity to the core along each descriptor. An example adjacency map is presented below:

Redefine – evaluate if the core definition should be changed

Pursue profit pools of the future
Redefine around new and robust differentiation
Strengthen the operating platform before redefining strategy
Fully value the power of leadership economics
Invest heavily in new capabilities

Executives should ask guiding questions to determine whether the core definition is still relevant.

Is the core business confronted with a radically improved business model for servicing its customers’ needs?
Are the original boundaries and structure of the core business changing in complicated ways?
Is there significant turbulence in the industry that may result in the current core definition becoming redundant?

The questions can help identify whether the company should redefine their core and if so, what type of redefinition is required:

The core methodology should be followed and reviewed on an on-going basis. Management must perform the difficult balancing act of ensuring they are constantly striving to grow and reach full potential within the core, looking for new adjacencies which strengthen and leverage the core and being alert and ready for the possibility of redefining the core.

Source: 1 Zook, C – 2001 – “Profit From The Core” – Cambridge, M.A. – Harvard Business School Press
2 Van den Berg, G; Pietersma, P – 2014 – “25 need-to-know strategy tools” – Harlow – FT Publishing

Strategy Tools: Opportunity/vulnerability matrix – “The Bananagram”

Logic suggests that high relative market share (RMS) should translate into higher profitability (unless the firm was not using its potential advantages or pricing to penetrate the market further). This suggests that a “normative curve / band” exists to describe this phenomenon i.e. the expected profitability of the average business segment in a particular industry according to normal expectations conditional on the segment’s relative market share. This normative band is shown in the figure below as the area between the two curves.

The Opportunity / Vulnerability Matrix

The curve is best explained using data / businesses that have been correctly segmented. In practice such data can only be obtained after analysing the organisation and having a good understanding of any relationships. The band used to be shown coloured yellow, hence the chart became known as a “bananagram”.

The implication of the curve is that high relative market share positions, correctly segmented, are valuable segments / businesses. Managers should therefore strive to achieve / participate in these segments / businesses.

Another implication, in some ways obscured focusing primarily on the growth share matrix (especially where “dogs” are concerned), is that it is useful to improve relative market share in a business segment whatever the starting position. The bananagram enables one to calculate a rough estimate of the equilibrium profitability to be expected from any particular position (relative market share). Therefore it is possible to estimate the potential benefit of moving any particular segment position against the cost of doing so – extra marketing spend, product development or lower prices. This allows one to quantitatively assess whether it is worth trying to raise RMS and which segment / business investments give the best return to shareholders.

Empirical evidence suggests that the majority of observations would fall between the two curved lines and it would be unusual for businesses to fall outside this band. There are two possible positions where a business segment can find itself outside of the two curved lines – this is depicted in the figure below.

The Opportunity / Vulnerability Matrix – Example

Business A is earning (for example) 45 per cent return on net capital employed, a good return, but is in a weak relative market share position (say 0,5x, or only half the size of the segment leader). The theory and empirical data from the matrix suggests that the combination of these two positions is at best anomalous, and probably unsustainable. Business A is therefore in the “vulnerability” part of the matrix. The expectation must be that in the medium term, either the business must improve its relative market share position to sustain its profitability (the dotted arrow moving left), or that it will decline in profitability (to about break-even). Why should this happen? Well, the banana indicates that the market leader in this business may well be earning 40 percent or even more ROCE in the segment. What may be happening is that the leader is holding a price umbrella over the market, that is, is pricing unsustainably high, so that even the competitors with weak market share are protected from normal competition (especially where pricing is concerned). What happens if the market leader suddenly cuts prices by 20 percent? They will still earn a good return, but the weaker competitors will not. The leader may opt to provide extra product benefits or services, instead of lowering prices, but the effect would still be a margin cut. It is as well to know that business A is vulnerable. If relative market share cannot be improved, it is sensible to sell it before the profitability declines.

Now let’s look at business B. This is a business in a strong relative market share position – the leader in its segment, five times larger than its nearest rival. It is earning 2 percent ROCE. This is a wonderful business to find. The theory and practical data suggest that such a business should be making 40 percent ROCE, not 2 percent. Nine times out of ten when such businesses are found, it is possible to make them very much more profitable, usually by radical cost reduction (often involving restructure), but sometimes through radical improvement of service and product offering to the customer at a low extra cost to the supplier, but enabling a large price hike to be made. Managements of particular businesses very often become complacent with historical returns and think it is impossible to raise profits in a step function to three, four or five times their current level. The bananagram challenges that thinking for leadership segment positions, and usually the bananagram is proved right. After all, high relative market share implies huge potential advantages; but these must be earned and exploited, as they do not automatically disgorge huge profits.

Source: Koch, R – “Financial Times Guides Strategy” – Fourth edition – Prentice Hall – page 313-316

Strategy Tools: The Ansoff Matrix

The Ansoff Matrix is a strategic-planning tool that provides a framework to help executives, senior managers, and marketers devise strategies for future growth. It is named after Russian American Igor Ansoff, who came up with the concept. Ansoff suggested that there were effectively only two approaches to developing a growth strategy; through varying what is sold (product growth) and who it is sold to (market growth).

“When we are in peak, we make a ton of money, as soon as we make a ton of money, we are desperately looking for ways to spend it. And we diversify into areas that, frankly, we don’t know how to run very well,” mused Bill Ford, great grandson of Henry. Ford’s story is neither unique nor new and companies often choose sub-optimal growth paths.

Igor Ansoff created the product / market matrix to illustrate the inherent risks in four generic growth strategies:

Market penetration / consumption – the firm seeks to achieve growth with existing products in their current market segments, aiming to increase market share.
Market development – the firm seeks growth by pushing its existing products into new market segments.
Product development – the firm develops new products targeted to its existing market segments.
Diversification – the firm grows by developing new products for new markets.

Ansoff’s Matrix

Selecting a Product-Market growth strategy

Market penetration / consumption

Market penetration and consumption covers products that are existent in an existing market. In this strategy, there can be further exploitation of the products without necessarily changing the product or the outlook of the product. This will be possible through the use of promotional methods, putting various pricing policies that may attract more clientele, or one can make the distribution more extensive.

Market penetration or consumption can also be increased is by coming up with various initiatives that will encourage increased usage of the product. A good example is the usage of toothpaste. Research has shown that the toothbrush head influences the amount of toothpaste that one will use. Thus if the head of the toothbrush is bigger it will mean that more toothpaste will be used thus promoting the usage of the toothpaste and eventually leading to more purchase of the toothpaste.

In market penetration / consumption, the risk involved is usually the least since the products are already familiar to the consumers and so is the established market.

Market development

In this strategy, the business sells its existing products to new markets. This can be made possible through further market segmentation to aid in identifying a new clientele base. This strategy assumes that the existing markets have been fully exploited thus the need to venture into new markets. There are various approaches to this strategy, which include: new geographical markets, new distribution channels, new product packaging, and different pricing policies.

Going into new geographies could involve launching the product in a completely different market. A good example is Guinness. This beer had originally been made to be sold in countries that have a colder climate, but now it is also being sold in African countries.

New distribution channels could entail selling the products via e-commerce or mail order. Selling through e-commerce may capture a larger clientele base since we are in a digital era where most people access the internet often. In new product packaging, it means repacking the product in another method or dimension. That way it may attract a different customer base. In different pricing policies, the business could change its prices so as to attract a different customer base or create a new market segment.

Product development

With a product-development growth strategy, a new product is introduced into existing markets. Product development can be from the introduction of a new product in an existing market or it can involve the modification of an existing product. By modifying the product one could change its outlook or presentation, increase the product’s performance or quality. By doing so, it can be more appealing to the existing market. A good example is car manufacturers who offer a range of car parts so as to target the car owners in purchasing additional products.

Diversification

This growth strategy involves an organisation marketing or selling new products to new markets at the same time. It is the most risky strategy as it involves two unknowns:

New products are being created and the business does not know the development problems that may occur in the process.
There is also the fact that there is a new market being targeted, which will bring the problem of having unknown characteristics.

For a business to take a step into diversification, they need to have their facts right regarding what it expects to gain from the strategy and have a clear assessment of the risks involved. There are two types of diversification – related diversification and unrelated diversification.

In related diversification, the business remains in the same industry in which it is currently operating. For example, a cake manufacturer diversifies into fresh-juice manufacturing. This diversification is within the food industry.

In unrelated diversification, there are usually no previous industry relations or market experiences. One can diversify from a food industry into the personal-care industry. A good example of the unrelated diversification is Richard Branson. He took advantage of the Virgin brand and diversified into various fields such as entertainment, air and rail travel, foods, etc.

Conclusion

The Ansoff matrix gives managers a framework for surveying all the initiatives the business has under way – how many are being pursued in each realm and how much investment is going to each type, and also allows managers to understand the risks and thus probability of success of each initiative.

To use the tool effectively, a company may take its sales initiatives for the next 3-5 years and place them in each of the quadrants in the matrix and analyse which quadrant shows the greatest uplift in sales. If it is in existing products to existing or new markets, or new products to existing products, there should be no cause for alarm. If it is in the new products to new markets quadrant, then this will require a greater effort at greater risk.

Companies that focus on the three quadrants other than diversification find more success as these strategies are built on familiar skills in production, purchasing, sales and marketing. An HBR study found that companies that invested 70% of their resources in core operations i.e. the market penetration quadrant, out-performed those that did not.

A diversification strategy operates in a higher plane of risk than the other three strategies. Superficially attractive and practiced by many companies, it is distracting and absorbs a disproportionately high proportion of managerial and engineering resources due to the lack of familiarity with the new venture.

Sources

Evans, V – “25 need-to-know strategy tools” – FT Publishing – 2014
Anonymous – “Ansoff Matrix” – Strategic Management – Quick MBA – http://www.quickmba.com/strategy/matrix/ansoff/
Anonymous – “What is the Ansoff matrix?” – http://www.ansoffmatrix.com/
https://en.wikipedia.org/wiki/Ansoff_Matrix
Nagji, B; Tuff, G – “Managing Your Innovation Portfolio” – Harvard Business Review – 2012 – https://hbr.org/2012/05/managing-your-innovation-portfolio

Strategy Tools: Pareto (80/20) analysis

Pareto (80/20) analysis - illustrative example

Pareto Analysis is a statistical technique for decision making that is used for selecting a number of tasks that produce significant overall effect.¹ It is based on the Pareto Principle (the 80/20 rule) which states that by doing 20% of the work you can generate 80% of the benefit of doing the whole job. The Pareto Analysis is named after Vilfredo Pareto, an Italian economist who lived in the late 19th and early 20th centuries. In 1897, he presented a formula that showed that income was distributed unevenly, with about 80% of the wealth in the hands of about 20% of the people.²

The figures 80 and 20 are illustrative; the Pareto Principle illustrates the lack of symmetry that often appears between work put in and results achieved. For example, 13% of work could generate 87% of returns. Or 70% of problems could be resolved by dealing with 30% of the causes. The sum of the two numbers does not need to add up to 100 all the time.

The following conclusions are illustrative of potential Pareto outcomes²:

80% of customer complaints arise from 20% of your products or services.
80% of delays in schedule arise from 20% of the possible causes of the delays.
20% of your products or services account for 80% of your profit.
20% of your sales-force produces 80% of your company revenues.
20% of a system’s defects cause 80% of its problems.

Strategy Tools: The GE Matrix

The GE matrix is a nine cell portfolio matrix first developed by General Electric in the 1970s which was used as a tool for screening large portfolios of business units or product lines. It is based on the idea that determining an appropriate level of investment for a business depends on both the attractiveness of the market and the businesses current capability in that market. Industry attractiveness and business unit strength are calculated by identifying a number of criteria and applying a weighting to each to come to a combined figure for its positioning on the graph. It is similar to the growth-share matrix in that it maps the strategic business units relative to their position within the industry. The axes of industry attractiveness and business unit strength are comparable to the market growth and market share axes of the growth-share matrix. The tool could be used to decide what products or business units should be added to or removed from a portfolio or which markets to exit/enter, and as a result how investment should be prioritised across the business.

Strategy Tools: SWOT analysis

SWOT analysis is a simple but useful framework for analysing an organization or individual’s strengths and weaknesses, and identifying the opportunities and threats that are faced1. As such, the tool can be used in both a business and a personal context. Fundamental to this tool is the analysis of both internal and external factors. For example, while strengths and weaknesses are often internal to and organisation, opportunities and threats tend to relate to external factors such as competitors’ actions and changing market dynamics.

Global Advisors | Quantified Strategy Consulting

Strategy Tools: ‘Price-Volume-Profit’ Part 1 – A strategic take on cost-volume-profit analysis