MCS-06 Strategic Planning

Syllabus Requirement:

6. Long Range Planning - Converting corporate vision into a long-range plan - Input Output Relationship

 Explain different organizational goals. Comment on goal of shareholder value maximization in particular.

Goals

Although we often refer to the goals of a corporation, a corporation does not have goals; it is an artificial being with no mind or decision-making ability of its own. Corporate goals are deter-mined by the chief executive officer (CEO) of the corporation, with the advice of other members of senior management, and they are usually ratified by the board of directors. In many corpo-rations, the goals originally set by the founder persist for generations. Examples are Henry Ford, Ford Motor Company; Alfred P. Sloan, General Motors Corporation; Walt Disney, Walt Disney Company; George Eastman, Eastman Kodak; and Sam Walton, Wal-Mart.

Economic Goals

Shareholder's value, Earning per share and Market value, all relate to maximizing shareholder's value, which is not a desirable goal, because what is 'maximum' is difficult to determine. Although optimizing shareholder value may be one goal, but there are other stakeholders in the business also such as customers, employees, creditors, community and so on. Again, shareholder value is usually equated with the market value of the company's stock. But market value is not an accurate measure of the worth of shareholders' investments. Besides, such value can be obtained only when the share is traded in the stock exchange.

It is interesting to note that Henry Ford's operating philosophy was 'satisfactory profit', not 'maximum profit'. He said, "A reasonable profit is right, but not too much. So, it has been my policy to force the price of the car down as fast as production would permit and give the benefit to the user and laborers, with resulting surprisingly enormous benefit to ourselves"

Other goals such as adding new products, or product-line or new business actually indicate normal organizational growth.

Social Goals

However, every organization has its share of responsibility towards the local community where it is situated, and the public at large. It is very difficult to incorporate in Management Control System such goals as taking pride in an organization which cares for the society and renders service to the public. Of course, any concrete structural programme indicating its operational expenses, methods of providing service, personnel involved in rendering service and the nature of the service in details can, however, be mentioned through an appropriate system.

Profitability

In a business, profitability is usually the most important goal.

Return on investment can be found by simply dividing profit (i.e., revenues minus expenses) by investment, but this method does not draw attention to the two principal components: profit margin and investment turnover.

In the basic form of this equation, "investment" refers to the shareholders' investment, which consists of proceeds from the issuance of stock, plus retained earnings.

One of management's responsibilities is to arrive at the right balance between the two main sources of financing: debt and equity. The shareholders' investment (i.e., equity) is the amount of financing that was not obtained by debt, that is, by borrowing. For many purposes, the source of financing is not relevant; "investment" thus means the total of debt capital and equity capital.

"Profitability" refers to profits in the long run, rather than in the current quarter or year. Many current expenditure (e.g., amounts spent on advertising or research and development) reduce current profits but increase profits over time.

Some CEOs stress only part of the profitability equation. Jack Welch, former CEO of General Electric Company, explicitly focused on revenue; he stated that General Electric should not be in any business in which its sales revenues were not the largest or the second largest of any company in that business. This does not imply that Welch neglected the other componentsof  the equation; rather, it suggests that in his mind there was a close correlation between market share and return on investment.

Other CEOs, however, emphasize revenues for a different reason: For them, company size is a goal. Such a priority can lead to problems. If expenses are too high, the profit margin will not give shareholders a good return on their investment. Even if the profit margin is satisfactory, the organization may still not earn a good return if the investment is too large. Some CEOs focus on profit either as a monetary amount or as a percentage of revenue. This focus does not recognize the simple fact that if additional profits are obtained by a greater than proportional increase in investment, each dollar of investment has earned less.

Maximizing Shareholder Value

In the 1980s and 1990s the term shareholder value appeared frequently in the business literature. This concept is that the appropriate goal of a for-profit corporation is to maximize shareholder value. Although the meaning of this term was not always clear, it probably refers to the market price of the corporation's stock. We believe, however, that achieving satisfactory profit is a better way of stating a corporation's goal, for two reasons.

First, "maximizing" implies that there is a way of finding the maximum amount that a company can earn. This is not the case. In deciding between two courses of action, management usually selects the one it believes will increase profitability the most. But management rarely, if ever, identifies all the possible alternatives and their respective effects on profitability. Furthermore, profit maximization requires that marginal costs and a demand curve be calculated, and managers usually do not know what these are. If maximization were the goal, managers would spend every working hour (and many sleepless nights) thinking about endless alternatives for increasing profitability; life is generally considered to be too short to warrant such an effort.

Second, although optimizing shareholder value may be a major goal, it is by no means the only goal for most organizations. Certainly a business that does not earn a profit at least equal to its cost of capital is not doing its job; unless it does so, it cannot discharge any other responsibilities. But economic performance is not the sole responsibility of a business, nor is shareholder value. Most managers want to behave ethically, and most feel an obligation to other stakeholders in the organization in addition to shareholders.

Example: Henry Ford's operating philosophy was satisfactory profit, not maximum profit. He wrote let me say right here that I do not believe that we should make such an awful profit on our cars. A reasonable profit is right, but not too much. So it has been my policy to force the price of the car down as fast as production would permit, and give the benefits to the users and labourers with resulting surprisingly enormous benefits to ourselves.

By rejecting the maximization concept, we do not mean to question the validity of certain ob-vious principles. A course of action that decreases expenses without affecting another element, such as market share, is sound. So is a course of action that increases expenses with a greater than proportional increase in revenues, such as expanding the advertising budget. So, too, are actions that increase profit with a less than proportional increase in shareholder investment (or, of course, with no such increase at all), such as purchasing a cost-saving machine. These principles assume, in all cases, that the course of action is ethical and consistent with the corporation's other goals.

An organization's pursuit of profitability is affected by management's willingness to take risks. The degree of risk-taking varies with the personalities of individual managers. Nevertheless there is always an upper limit; some organizations explicitly state that management's primary responsibility is to preserve the company's assets, with profitability considered a secondary goal. The Asian .financial crisis during 1996-1998 is traceable, in large part, to the fact that banks in Asia's emerging markets made what appeared to be highly profitable loans without paying adequate attention to the level of risk involved.

Multiple Stakeholder Approach

Organizations participate in three markets: the capital market, the product market, and the factor market. A firm raises funds in the capital market, and the public stockholders are therefore an important constituency. The firm sells its goods and services in the product market, and customers form a key constituency. It competes for resources such as human capital and raw materials in the factor market and the prime constituencies are the company's employees and suppliers and the various communities in which the resources and the company's operations are located.

The firm has a responsibility to all these multiple stakeholders-shareholders, customers, employees, suppliers, and communities. Ideally, its management control system should identify the goals for each of these groups and develop scorecards to track performance.

Example: In 2005, the Acer Group, headquartered in Taiwan, was one of the largest computer companies The Company subscribed to the multiple stakeholder approach and managed its internal operations to satisfy the needs of several constituencies. To quote Stan 'Shih,-the founder, "The customer is number 1, the employee is number 2, the shareholder is number 3. I keep this message consistent with all my colleagues. I even consider the company's banks, suppliers, and others we do business with are our stakeholders; even society is stakeholder. I do my best to run the company that way."

Lincoln Electric Company is well known for its philosophy that employee satisfaction was more important than shareholder value. James Lincoln wrote: "The last group to be considered is the stockholders who own stock because they think it will be more profitable than investing more in any other way. The absentee stockholder is not' of any value to the customer or to the worker, since he has no knowledge of nor interest in the company other than greater dividends and ad-vance in the price of his stock." Donald F. Hastings, chairman and chief executive officer, emphasized that this was still the company's philosophy in 1996.

What are different types of Strategic Missions at SBU level? How do these missions affect Strategic Planning process and Budgeting at SBU Level?

Different Types of Strategic Missions:

Business Unit Mission:

In a diversified firm one of the important tasks of senior management is resource deployment, that is, make decisions regarding the use of the cash generated from some business units to finance growth in other business units. Several planning models have been developed to help corporate level managers of diversified firms to effectively allocate resources. These models suggest that a firm has business units in several categories, identified by their mission; the appropriate strategies for each category differ. Together, the several units make up a portfolio, the components of which differ as to their risk/reward characteristics just as the components of an investment portfolio differ. Both the corporate 'office and the business unit general manager are involved in identifying the missions of individual business units. Of the many planning models, two of the most widely used are Boston Consulting Group's two-by-two growth-share matrix and General Electric Company/McKinsey & Company's three-by-three industry attractiveness-business strength matrix. While these models differ in the methodologies they use to develop the most appropriate missions for the various business units, they have the same set of missions from which to choose: build, hold, harvest, and divest.

 Build: This mission implies an objective of increased market share, even at the expense of short-term earnings and cash flow (e.g., Merck's bio-technology, Black and Decker's handheld electric tools).

 Hold: This strategic mission is geared to the protection of the business unit's market share and competitive position (e.g.: IBM's mainframe computers).

 Harvest: This mission has the objective of maximizing short-term earnings and cash flow, even at the expense of market share (e.g., American Brands' tobacco products, General Electric's and Sylvania's light bulbs)

 Divest: This mission indicates a decision to withdraw from the business either through a process of slow liquidation or outright sale. While the planning models can aid in the formulation of missions, they are not cook books. A business unit's position on a planning grid should not be the sole basis for deciding its mission.

 Business Unit Competitive Advantage: Every business unit should develop a competitive advantage in order to accomplish its mission. Three interrelated questions have to be considered in developing the business unit's competitive advantage. First, what is the structure of the industry in which the business unit operates? Second, how should the business unit exploit the industry's structure? Third, what will be the basis of the business unit's competitive advantage?

 Industry Analysis: Research has highlighted the important role industry conditions play in the performance of individual firms. Studies have shown that average industry profitability is, by far, the most significant predictor of firm performance. According to Porter, the structure of an industry should be analyzed in terms of the collective strength of five competitive forces.

1. The intensity of rivalry among existing competitors. Factors affecting direct rivalry are industry growth, product differentiability, number and diversity of competitors, level of fixed costs, intermittent overcapacity, and exit barriers.

2. The bargaining power of customers. Factors affecting buyer power are number of buyers, buyer's switching costs, buyer's ability to integrate backward, impact of the business unit's product on buyer's total costs, impact of the business unit's product on buyer's product quality/ performance, and significance of the business unit's volume to buyers.

3. The bargaining power of suppliers. Factors affecting supplier power are number of suppliers, supplier's ability to integrate forward, presence of substitute inputs, and importance of the business unit's volume to suppliers.

4. Threat from substitutes. Factors affecting substitute threat are relative price/performance of substitutes, buyer's switching costs, and buyer's propensity to substitute.

5. The threat of new entry. Factors affecting entry barriers are capital requirements, access to distribution channels, economies of scale, product differentiation, technological complexity of product or process, expected retaliation from existing firms, and government policy.

Three observations are inevitable with regard to the industry analysis:

1. The more powerful the five forces are, the less profitable an industry is likely to be. In industries where average profitability is high (such as soft drinks and pharmaceuticals), the five forces are weak (e.g., in the soft drink industry, entry barriers are high). In industries where the average profitability is low (such as steel and coal), the five forces are strong (e.g., in the steel industry, threat from substitutes is high).

2. Depending on the relative strength of the five forces, the key strategic issues facing the business unit will differ from one industry to another.

3. Understanding the nature of each force helps the firm to formulate effective strategies. Supplier selection (a strategic issue) is aided by the analysis of the relative power of several supplier groups; the business unit should link with the supplier group for which it has the best competitive advantage. Similarly, analyzing the relative bargaining power of several buyer groups will facilitate selection of target customer segments.

 Generic Competitive Advantage:

The five-force analysis is the starting point for developing a competitive advantage since it helps to identify the opportunities and threats in the external environment. With this understanding, Porter claims that the business unit has two generic ways of responding to the opportunities in the external environment and developing a sustainable competitive advantage: low cost and differentiation.

 Low Cost: Cost leadership can be achieved through such approaches as economies of scale in production; experience curve effects, tight cost control, and cost minimization (in such areas as research and development, service, sales force, or advertising). Some firms following this strategy include Charles Schwab in discount brokerage, Wal-Mart in discount retailing, Texas Instruments in consumer electronics, Emerson Electric in electric motors, Hyundai in automobiles, Dell in computers, Black and Decker in machine tools, Nucor in steel, Lincoln Electric in arc welding equipment, and BIC in pens.

Differentiation:The primary focus of this strategy is to differentiate the product offering of the business unit, creating something that is perceived by customers as being unique. Approaches to product differentiation include brand loyalty (Coca-Cola and Pepsi Cola in soft drinks), superior customer service (Nordstrom in retailing), dealer network (Caterpillar Tractors in construction equipment), product design and product features (Hewlett-Packard in electronics), and technology (Cisco in communications infrastructure). Other examples of firms following a differentiation strategy include BMW in automobiles; Stouffer's in frozen foods, Neiman-Marcus in retailing, Mont Blanc in pens, and Rolex in wristwatches.

Business units can develop competitive advantage based on low cost, differentiation, or both. The most attractive competitive position is to achieve cost-cum-differentiation.