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Some Fundamental Premises for Strategy Formulation

- Costs (and prices) always decline. Prices follow costs. Good managers know and apply the experience curve correctly.
- Your competitive position largely determines your strategic options. Good managers know their strategic position and the possibilities and constraints it creates.
- Customers, Competitors and Profits are always shifting. Good managers anticipate shifts and plan accordingly.
- Simplicity is preferred over complexity. Too many products and options drive up costs.

The Benefits in Low costs

Original Price

New Price

Cost 2

Company 2

New Margins

Cost1

Company 1

Note that because of Co. 1’s lower costs, the drop in price affects

Co. 1’s margins proportionately less than co.2’s (approximately

1/3 vs. ½ in diagrams).

R.O.I

Low

Low

Mkt. Share

High

Assumed causal relationships:

High Market Share

Causes

High Accumulated Volumes of Production

Causes

Low per Unit Costs

High Profits

Then 20th unit = $100 * .85 =$85

Then 40th unit = $85*.85 = $72.25

An 85% Experience Curve120

110

A

100

Deflated Direct cost per Unit

90

B

80

C

D

70

60

E

50

40

30

20

10

0

10

20

30

40

50

60

70

80

90

100

120

130

Accumulated Vol. Of Production (units)

The Learning Effect

n

Y = 2X

Where y = the no.(cost) of direct labor hrs required

to produce the xth unit

a = the no.(cost) of direct labor hrs required

to produce the first unit

x = the cumulative unit no.

n = the learning index = (log 0)/(log 2)

0 = the learning rate

1-0 = the progress ration

1.0

Direct Labor hrs/unit

10 % progress (0 =90)

.1

20% progress(0=80%)

.01

30% progress (0=70%)

.001

10

1000

100

Cumulative units as plotted logarithmetrically

Paper Airplane Exercise Results on Linear Scale

$5

Trial 1

4

Cost Per Airplane

3

Trial 2

2

Trial 3

1

9

6

12

0

3

Accumulative Experience (Number of Planes)

Paper Airplane Exercise Results on Log Scale

$10

Slope = 74%

R2 = 1.00

5

Trial 1

Cost Per Airplane

Trial 2

Trial 3

2

1

5

10

15

0

2

Accumulative Experience (Number of Planes)

Example Using Traditional Linear Programming

Maximize : TT = $33X1 + $39X2 +$59X3

Subject to: 10X1 +15X2 +12X3 < or = 14,400 labor hours

Production

Constrain 24X1 + 20X2 + 14X3 < 0R = 5,900 machine hours

Here, our optimal solution would be to produce:

0 units of X1

0 units of X2

361 units of X3 With resulting contribution margin of:

$59 (361) = $21,299

This would yield optimal solution if there are no learning effects present. If, however, workers learn, machines are used more efficiently, and materials usage is optimized, then we would have to modify our linear programming formula. For example, that learning occurs such that there is a 90% experience curve effect. Then, if we were to only produce X the constraints on production change:

Using logs 12X3.848 < or = 14,400 labor hrs 14X3.848 < or = 5,920 machine time

We obtain 36X 3.848 < or = 13,026 materials

Yields an optimal solution of $59 (1,040X) = $61,360

Experience Curve for Price of Brokerage Services

30¢

Slope = 64%

R2 = 099

1990

20

EXECUTION

REVENUE

PER SHARE

TRADED

(intuitional: 1996 Dollars

10

5

2003

3

300

500

5,000

10,000B

1,000

2,000

CUMMULATIVE SHARES TRADED

$0.97

Full Price

$1.00

Profit 8.1%

Costs:

91.9%

Profit 5.1%

Costs: 91.9%

The Perils of a Price Cut- An innocent little 3% price cut by the average S&P 1000 knocks the profits down from 8.1% to 5.1% or a whopping 37%

Incremental Breakeven Analysis

Δ q = Δp – (1-cm) Δ c

cm- Δp + (1-cm) Δc

Definitions:

Δq---the breakeven sales increase in percentage;

Δp---the magnitude of a price cut;

Cm---the contribution margin in percentage (before the price cut);

Δc---the reduction in marginal costs in percentage due to the price cut.

Incremental Breakeven Analysis

Δ q = Δp – (1-cm) Δ c

cm- Δp + (1-cm) Δc

Definitions: using Galanz example

Δq---the breakeven sales increase in percentage = 90.5%;

Δp---the magnitude of a price cut = 20%;

Cm---the contribution margin in percentage (before the price cut) or (price – marginal cost) = 40%;

Δc---the reduction in marginal costs in percentage due to the price cut = 35%

Circumstances for a Price War

- High growth markets
- Heterogeneous firms with a wide distribution of cost efficiencies
- New technologies with significant scale economies

Source of the Experience Effect

- Labor efficiency
- New processes and improved methods
- Product redesign
- Product standardization
- Scale effect
- Substitution in the product

Practical Considerations

- Cost-time relationship
- High-volume effect
- Shared experience
- Product Definition
- Cost data
- Marginal vs. average cost
- Inflation
- Planning horizon
- External influences
- Market instability

Steps in A Typical Value-Added Chain:

Product R & D

Process R & D

Purchasing of Raw Materials

Transportation of Raw Materials

Mfg. Of Parts and Components

Assembly

Testing and Quality Control

Marketing

Sales to intermediaries

Wholesale Distribution

Retailing

After sales Service

The Generic Value Chain

Firm Infrastructure

Human Resource Management

Support Activities

Technology Development

Procurement

Operations

Marketing & Sales

Inbound

Logistics

Outbound

Logistics

Service

Margin

Upstream Value Activities

Downstream Value Activities

Primary Activities

Economies of Scale Dominate

Economies of Scope Dominate

Effects of accumulated experience over the cost accrued

in different stages of value added

Purchasing and

Mfg of parts &

Components

R& D

Subassembly

Marketing

Distribution

Retail

Deflated direct cost per unit

95%

75%

70%

90%

85%

95%

Accumulated Volume of production in each stage (in units)

R& D

Manufacture

Assembly

Marketing

Distribution

Retail

2%

20%

15%

30%

25%

8%

Accumulated Costs in each stage

Mkt. Leader is A w/rel. mkt share of 4 to 1 over B. Conceptualize value-added in 2 stage mfg and dist. In mfg. Stage A has the 4 to 1 advantage over B but in dist. Stage B has 3 to 1 advantage in terms of mkt share, because this is just one of many others that share the same system of dist. If we assume that experience in both stages has the same impact over costs, and that each stage contributes half the final value of the product, we could use a normalized mkt share to determine the relative standing of the 2 firms in the business.

Two firm ex. W/value added as manufacturing and distribution for firm A:

Market Share = (Mfg. Share x Mfg. Value-Added) + (Distribution Market Share x Distribution Value-Added)

= [(4 to 1 or 4/5)] + [(1 to 3 or I/4) x (0.5)]

= 0.525

Similarly for firm B

Market Share = 0.475

The relative market share of firm A over firm B using this weighted measure of experience in only 0.525/0.475 = 1.10 times, for smaller than the observed to 4 to 1 product ratio in the final market.

Gillette Razor Blades

Industry

Life cycle

Sales

Business

Life Cycle

Waves of Product life cycle

Wave of Profit

Stainless

Steel

Blue

Blades

Super

Chromium

Platinum

plus

Time

a less developed country

a newly industrialized country

a fully developed country

Sales

$

Time

Costs – Sales – Profit Relationships by Stages of life Cycle

Total Sales

Costs/Unit

Price/Unit

Profit

loss

Loss

Maturity

Rapid

Growth

Introduction

Decline

22%

20 %

Mkt. Growth Rate

18%

16%

14%

12%

10%

8%

6%

4%

2%

10X

4X

1.5X

1.0X

0.5X

0.1X

Relative Competitor Position

Industry growth (Total Ind. Sales 2009) – (Total Ind. Sales 2008)

Rate (2009) = Total Ind. Sales 2008

Relative Industry Your business unit’s sales

Share = Leading competitor’s sales

Circle Size = Your business unit’s sales

Total corp. sales

4 ways to separate high-low growth

- Avg. industry growth –single industry
- Overall economic growth – multiple industry
- Weighted average growth
- Corporate growth target

Ideal Movement of Products and cash in the Portfolio

Market

Growth

Relative Competitive Position

= Cash Movement = Product movement

Using the Matrix to Guide Strategy

The process consists of 3 steps:

- Developing matrices for ones’ own firm.
- Developing matrices for ones’ competitors.
- Making strategic comparisons and generating strategies.

Each step may be further subdivided:

1.a. Identify the products and the business sectors.

1.b. Selecting and ranking the criteria for assessing the Bus. Pos. and Ind. Attractiveness.

1.c. Gathering the data.

1.d. Quantifying each product’s position.

1.e. Drawing the matrices; past, present, and future.

1.f Assessing the implications of each product’s position in the matrix.

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