CMA Professional Programme 2018 – 2022
Strategic Level
SL 3: Business Strategy & Risk Management
(BSR)
Institute of Certified Management Accountants of Sri Lanka (CMA)
The National Professional Management Accounting Institution in Sri Lanka
ISBN: 978-955-0926-28-2
The Governing Council of CMA reserves the right to make any amendments it deems
necessary during the period covered herein.
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A Word to the Students
This text is designed as a guide to lead Level 4 (Strategic Level)
students in the study of Business Strategy (70%) & Risk Management
(30%) - BSR examination paper. It is carefully prepared to cover the
Syllabus content, giving comprehensive explanations in each section
including exposure in answering questions.
Note that examination success will depend not only on your
knowledge, but also on your ability to present what you have learnt, in
response to the given questions, within the specified time period.
Make every effort to understand the subject and develop the skills to
apply your knowledge. Knowledge is the theoretical and practical
understanding of a subject. Application is the ability to use knowledge
in a given relevant situation. This is the ability to select the
appropriate principles and/or techniques and apply them to relevant
information from a range of data.
We wish you success at the examination.
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Business Strategy – 70%
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Table of Contents
Contents
Page No.
Chapter – 01: Introduction to Strategic Management
06 - 11
Chapter – 02: Strategic Analysis
12 - 46
Chapter – 03: Strategic Direction
47 - 54
Chapter – 04: Strategic Choice and Strategy Formulation
55 - 81
Chapter – 05: Strategy Implementation
82 - 111
Chapter – 06: Strategic Review & Control
112 - 128
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Chapter 1
Introduction to Strategic Management
Learning Objectives
After studying this chapter, you should be able to:
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Describe the concept of strategy and ‘strategic management’, in the context of
management in organisations.
Identify and explain the nature of strategic decisions, the advantages and some concerns
of a formal planning system.
Explain the ‘levels of strategy’ and their main areas of focus.
Appreciate the logic of Henry Mintzberg’s perspectives of strategy
What is strategic management?
Strategic Management is the term applied to describe those activities of an organization that
enable it to meet the challenges of a constantly changing environment. Even though the
terminology surrounding strategic management practices has become increasingly common over
the past decade, the development of the discipline has its roots in the work of a number of
strategy writers from fields of both management and even from the military environment.
The American Heritage dictionary defines strategy as the “Science and art of military command
as applied to the overall planning and conduct of large scale combat operations”. This theme
remains an important component of most management definitions of strategy.
Strategic management as it exists today has evolved over many years and continues to evolve in
response to the changes in organizations and their environments. The essence of all these is that a
critical aspect of the management of organization’s today involves matching organizational
competences with the opportunities and threats in their environment in ways that will be both
effective and efficient over the time such resources are deployed.
The basic characteristics of a match an organization achieves with its environment is called its
strategy and the concept of strategy is used by today’s managers as one of the major tools for
coping with the internal and external changes
What is an organization?
“Organization is a group of people working together for achieving a common
objective.”According to above definition, three major elements can be identified in an
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organization, namely a group of people, common objectives and interaction among people
Organizations as open systems
Organisations are open systems and could influence and are influenced by the environment in
which they operate. This leads to a state of dynamic (changing) equilibrium between an
organisation and its environment and health of an organisation is dependent on being able to
match its pace of change in line with the rate of change with its environment. Characteristics of
Open Systems:
The concept of strategy
In its simplest form strategy is a course of action designed to achieve specific objectives.
Strategy in an organization is the long term, large scale, scope and direction which enables it to
achieve a competitive advantage through deployment its configuration of resources within a
changing environment to meet the needs of markets that it targets to serve, and to fulfill some
desirable stakeholder expectations.
Characteristics of strategic decisions
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Strategic decisions are likely to be concerned with or affect the long term direction of the
organization.
Strategic decisions are normally about trying to achieve some advantage for the
organization.
Strategic decisions are likely to be concerned with the scope of an organization’s activities.
Strategic decisions involve matching the activities of an organization to the environment in
which it operates.
Strategic decision also involves building on or stretching an organizational resources and
competencies to create opportunities or to capitalize on them.
Strategic Decisions involve major resource changes for an organization.
Strategic decisions affect operational decisions.
Strategic decisions are affected by the values and expectations of those who have power in
and around the organization.
Advantages and some possible disadvantages of a formal system of Strategic Planning
Advantages
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Identifies risks-Strategic planning helps in managing these risks.
Forces managers to think strategically -Strategic planning can encourage creativity and
initiative by harnessing the ideas of the management team in improving the company’s
strategic competitiveness.
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Forces decision making-organizations cannot remain static-they have to cope with changes
in the environment. The strategic planning process draws attention to the need to change
and adapt with the changing dynamics of the competitive environment.
Better Control-Management Control can be better exercised if targets are explicit.
Enforces consistency across all time horizons, namely consistency between the long-term,
medium-term and short-term objectives, strategies and controls.
Co-ordinates- different types of activities and brings the need to harmonize different
functions of the business by being directed towards a common goal.
Allocate Responsibility- The plan clearly demarcates and indicate organizational members
where they fit in and their respective roles in a cohesive master action plan for the
organization.
Brings about heightened motivation and inspiration of the members of the organization
towards achieving the organization’s strategic intent.
Addresses the expectations of the organization’s key stakeholders as a strategic plan
necessarily entails establishing a desirable and a balanced set of corporate objectives.
Some possible disadvantages of a formal strategic planning system
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Could be both costly and time consuming.
Possibility of being prescriptive in nature as there is a tendency for excessive formalization
in the process that could undermine the creativity of some members.
Lack of flexibility to cope with unexpected changes.
May undermine the importance in implementation if those who formulate are not
adequately connected with the implementation.
(These factors point to the importance of ‘strategic thinking’ and all planning processes need to
encourage this aspect without too much emphasis on rigid planning frameworks).
The scope of strategic management
The strategic management is the term that collectively describes the four main types of inter
connected and intergraded set of activities that constitute the process of managing an
organisation from a strategic standpoint. These are:
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Strategic Analysis
Strategy Formulation
Strategy Implementation and
Strategic Review and Control
A very brief description of these distinct phases is given below and will be subject to detailed
discussions in the chapters that follow.
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First and foremost a typical strategic management process begins with a searching appraisal of a
company’s external as well as its internal environments. An external analysis of the many layers
of a company’s external environment will bring about salient issues that are strategically relevant
to an organisation’s future course. These are termed ‘opportunities’ and ‘threats’ while the
pertinent factors that arise form an appraisal of the organisation’s internal environment are
popularly referred to as ‘strengths’ and ‘weaknesses’.
The second major step in the process is the strategy formulation stage that will try to come up
with a set of long term objectives and proposals how the organisation could achieve a
‘competitive advantage’ in the competitive environment, taking in to account the opportunities,
threats strengths and weaknesses that were identified and evaluated in the preceding section of
strategic appraisal.
Strategy implementation is the phase that follows strategy formulation and will concentrate how
formulated strategic options could be operationalised to realise the set long term objectives. It is
relevant to note in this
initial discussion itself that, in the practical business world
implementation is much more difficult to achieve than we may imagine.
The final phase in the process is exercising strategic review and control that will increase the
possibility of realising the strategic objectives that were carefully planned and agreed at the stage
of strategy formulation. Closely resembling to the typical ‘control function’ in management,
strategic review and control have a more strategic emphasis and endowed with techniques and
methodologies that are clearly strategic in complexion.
Levels of strategy in an organisation
All business needs to grow and to achieve such continual growth it may be necessary to diversify
in to different types of business activities. When such expansion takes place to bring about
orderliness in conducting such different types of business activities, usually establishment of
strategic business units (SBUs) become the mechanism to manage such complexity. Hence in
large businesses consisting of many strategic business units (SBUs) we can identify three levels
of strategy: Corporate, Business and Functional/Operational. In such multi-business unit
environments, the distinction between corporate level and business level strategy arises because
of the distinct nature of the scope of such business units, usually grouped on the basis of their
product/market scope, and such a structure demands a level beyond each such SBU that
integrates and manages such different businesses as a portfolio of investments at this corporate
level, that will look after the interests of the shareholders.
1) Corporate Level strategy
Corporate strategy is concerned with what types of businesses the organisation is in and
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generally sets the scope and direction for the different business units that comprise the
corporate level.
2) Business Level strategy
Business strategy’s primary scope is how an organisation approaches to build and sustain
the competitive advantage of an SBU, given its particular product- market scope.
3) Functional strategies
Functional strategies deal with each respective functional/ specialised area of a particular
SBU and may typically include functions such as Marketing, Operations, Human Resources
and Finance.
CORPORATE LEVEL
SBU 1
SBU 2
SBU 3
BUSINESS LEVEL
MARKETING
OPERATIONAL
FUNCTIONAL LEVEL
HR
FINANCE
Figure 1.1: Levels of Strategy
Five Ps for Strategy
The term strategy is being used implicitly in different ways and hence it will be interesting for us
to examine a ‘five P’s classification popularized by Henry Mintzberg, a prolific author on the
subject of strategic management.
Strategy is a plan - As some sort of consciously intended course of action or a set of guidelines
to deal with a situation.
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Strategy is a ploy – As a plan, a strategy can be a ploy too where some maneuvering intended to
outwit an opponent or competitor.
Strategy is a pattern - This thinking implies strategy is consistency in behavior whether intended
or not.
Strategy is position - This line of thinking means locating an organization in an environment
there by implying and arriving at some match between the internal and external context.
Strategy is a perspective - Here the emphasis is not just of a chosen position but of an ingrained
way of perceiving the world. A good example here is McDonalds, a company that has become
famous for its emphasis on “quality, service, cleanliness and value”. Strategy in this respect is to
an organization what personality is to an individual.
Chapter Summary
This opening chapter introduces the concept of strategy in a business context recognizing that
organizations are ‘open systems’. The characteristics of strategic decisions further elaborate the
complexion and significance of decisions considered strategic. The advantages of adopting
strategic planning in the contemporary business world are discussed.
The organizational strategy is considered at corporate, business, and functional levels. Strategies
are operationalised under functional heads and are coordinated and harmonized to achieve
business level objectives and strategies. Henry Mintzberg’s interesting analysis of perspectives
of strategy under the popular ‘five Ps of strategy’ is outlined.
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Chapter 02
Strategic analysis
Learning Objectives
After studying this chapter, you should be able to:
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Understand the structure adopted in this chapter, in analyzing, comprehending and
conducting a strategic analysis in an organizational setting.
Explain and analyze the constituent variables/factors and some key models and
frameworks in each of the layers of a company’s external environment, that primarily
constitute Macro, Industry and Operating level analyses.
Identify the salient strategic factors/issues properly classified under ‘threats’ and
‘opportunities’, after the external analysis as conducted above
Understand the constitution, the relevant factors/stages and analyze a company’s Internal
environment using appropriate methods and models.
Identify the salient strategic factors/issues properly classified under ‘strengths’ and
‘weaknesses’ after the internal analysis as conducted above
Conduct a SWOT analysis that will lay the foundation for an informed strategy
formulation
Appreciate concepts such as ‘corporate social responsibility’, ‘triple bottom line’
philosophy, ‘agency theory’, ‘stake holder satisfaction’ and ‘corporate governance’ all
that impact future sustainability of the corporation and the world of business, from a
broader perspective.
Part A: ‘External’ Environmental Analysis
What is external environment?
An external environment from the point of view of a strategic analysis in an organization refers
to forces and institutions outside the organization that can potentially affect performance of the
organization. Ideally at conclusion of a comprehensive analysis of a company’s external
environment the analysts hope to identify the strategically relevant ‘Threats’ and ‘Opportunities’.
For an easier and a practical strategic analysis, the external environment can be further
subdivided in to three elements;
•
Macro Environment
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Industry Level Environment
Operating Environment
Macro Environment
Industry/ Market
environment
Operating Environment
Company
S
2
S
1
S1 – Strategy Group 1
S2 - Strategy Group 2
Figure 2.1: Layers of External Environment
Macro environment comprises the broad forces in the environment that affects all industries in
the economy. The industry or the market environment basically refers to a company’s
competitive environment and the Operating environment relates to the factors that influence most
immediate situation such as customers, suppliers and the labor market.
Macro Environmental Analysis
PEST analysis is the main model that is widely used to analyze the strategically relevant impact
of the macro environment, when conducting a strategic analysis.
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PEST analysis
PEST is an acronym for the popular classification of the macro environmental factors comprising
Political, Economic, Social and Technological forces.
Political/Legal Factors
The political arena has a profound influence on businesses as political power will enable the
government in power to influence the economic environment as well regulatory framework of
businesses and the legal environment. The likely considerations here are:
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How stable is the political environment?
Will government policy influence laws that regulate or taxation of businesses?
What is the government's position on marketing ethics?
What is the government's policy on the economy?
Does the government have a view on culture and religion?
Is the government involved in trading agreements such as SAFTA, NAFTA, ASEAN, or
others?
Economic Factors
Economic factors, being so connected with businesses are amongst the most influential set of
forces that could impact a company’s strategic agenda and need to consider the relevant variables
in conducting a strategic analysis. Amongst these are:
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The GDP growth rate as well as the long-term GDP growth prospects for the economy
Economic stability
Interest rates.
The levels of inflation
Unemployment
Exchange rate
Balance of payments
Socio-Cultural and Demographic Factors
The norms, values, attitudes, behavior patterns and characteristics of the population structure of a
society could also impact the strategic prospects of organizations and hence have emerged as a
major force in a company’s macro environmental analysis.
Technological Factors
Technology and related developments have now emerged as vital contributory factors in the
pursuit of improving competitive advantage in the modern organization and is also a major
driver of globalization. In the context of strategic management, technology doses not really mean
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embracing high-tech technologies that multiply around us with increasing rapidity but more
importantly, to explore and adapt technological advances that could impact a company’s
competitive advantage by increasing benefits to our customers or say those developments that
could improve productivity and will favorably impact a company’s unit costs. Consider the
following questions as some potential areas of application.
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Does technology allow for products and services to be made more cheaply and to a better
standard of quality?
Do the technologies offer consumers and businesses more innovative products and services
such as Internet banking, new generation mobile telephones, etc?
How is distribution changed by new technologies e.g. books via the Internet, flight tickets,
auctions, etc?
Does technology offer companies a new way to communicate with consumers e.g. banners,
Customer Relationship Management (CRM), etc?
The improvements that could improve the designing or accelerate production processes.
Industry level analysis and the Porter’s Five Forces Model
The industry environment
All industries in an economy exist in the same macro environment and depending on the nature,
dynamics and complexion of different industries, industry level competition will vary. Hence
factors that directly influence a firm’s prospects originate in the industry in which the firm
operates.
What constitute an Industry?
Economic theory defines an industry as ‘a group of firms producing the same principal products
or, more broadly, ‘a group of firms producing products that are close substitutes for each other’.
From a strategic management perspective it is useful for managers in any organization to
understand the competitive forces in their industry or sector since these will more intently
determine the attractiveness in terms of the competitive intensity as industry level competitive
dynamics can have a profound impact on the likely success or failure.
Five Forces Model
As per this landmark model the competitive intensity in an industry, and therefore the relative
attractiveness or otherwise in that particular industry, will be dependent upon the collective and
simultaneous operation of five forces as given below.
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These ‘Five competitive forces’ together influence the state of competition in an industry and
hence collectively determine the profit (i.e. long-run return on capital) potential of the industry as
a whole. These are:
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The threat of new entrants to the industry
The threat of substitute products or services
The bargaining power of customers
The bargaining power of suppliers
The rivalry amongst current competitors in the industry
Figure 2.2: Porter’s Five Forces Model to analyse the intensity of the industry
competitiveness.
The threat of new entrants (and barriers to entry)
A new entrant into an industry will bring extra capacity and more competition. The strength of
this threat is likely to vary from industry to industry and depends on two things.
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The strength of the barriers to entry. Barriers to entry discourage new entrants.
The likely response of existing competitors to the new entrant.
Barriers to entry
(a)
Scale economies - High fixed costs often imply a high breakeven point, and a high
breakeven point depends on a large volume of sales. If the market as a whole is not
growing, the new entrant has to capture a large slice of the market from existing
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competitors. This is expensive (although Japanese companies have done this in some
cases).
(b)
Product differentiation - Existing firms in an industry may have built up a good brand
image and strong customer loyalty over a long period of time. A few firms may promote a
large number of brands to crowd out the competition.
(c) Capital requirements - When capital investment requirements are high, the barrier against
new entrants will be strong, particularly when the investment would possibly be high-risk.
(d) Switching costs - Switching costs refer to the costs (time, money, convenience) that a
customer would have to incur by switching from one supplier's products to another's.
Although it might cost a consumer nothing to switch from one brand of frozen peas to
another, the potential costs for the retailer or distributor might be high.
(e)
Access to distribution channels - Distribution channels carry a manufacturer's products to
the end-buyer. New distribution channels are difficult to establish and existing distribution
channels hard to gain access to.
(f)
Cost advantages of existing producers, independent of economies of scale include:
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Patent rights
Experience and know-how (the learning curve)
Government subsidies and regulations
Favoured access to raw materials
Entry barriers might be lowered by the impact of change.
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Changes in the environment
Technological changes
Novel distribution channels for products or services
The threat from substitute products
A substitute product is a good or service produced by another industry which satisfies the
same customer needs.
• Buyer propensity to substitute
• Buyer ‘switching’ costs
• Number of substitute products available in the market
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The bargaining power of customers
Customers want better quality products and services at a lower price. Satisfying this want might
force down the profitability of suppliers in the industry. Just how strong the position of
customers will depend on a number of factors.
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How much the customer buys?
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How critical the product is to the customer's own business?
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Switching costs (i.e. the cost of switching supplier).
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Whether the products are standard items (hence easily copied) or specialised.
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The customer's own profitability: a customer who makes low profits will be forced to
insist on low prices from suppliers.
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Customer's ability to bypass the supplier (or take over the supplier).
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The skills of the customer purchasing staff, or the price-awareness of consumers.
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When product quality is important to the customer, the customer is less likely to be pricesensitive, and so the industry might be more profitable as a consequence.
The bargaining power of suppliers
Suppliers can exert pressure for higher prices. The ability of suppliers to get higher prices
depends on several factors.
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Whether there are just one or two dominant suppliers to the industry, able to charge
monopoly or oligopoly prices.
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The threat of new entrants or substitute products to the supplier's industry.
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Whether the suppliers have other customers outside the industry, and do not rely on the
industry for the majority of their sales.
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The importance of the supplier's product to the customer's business.
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Whether the supplier has a differentiated product which buyers need to obtain.
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Whether switching costs for customers would be high.
The rivalry amongst current competitors in the industry
The intensity of competitive rivalry within an industry will affect the profitability of the
industry as a whole. Competitive actions might take the form of price competition, advertising
battles, sales promotion campaigns, introducing new products for the market, improving after
sales service or providing guarantees or warranties. Competition can stimulate demand,
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expanding the market, or it can leave demand unchanged, in which case individual competitors
will make less money, unless they are able to cut costs.
Factors determining the intensity of competition
(a) Market growth - Rivalry is intensified when firms are competing for a greater market share
in a total market where growth is slow or stagnant.
(b) Cost structure - High fixed costs are a tempt for to compete on price, as in the short run any
contribution from sales is better than none at all.
(c) Switching - Suppliers will compete if buyers switch easily (eg Coke vs Pepsi).
(d) Capacity- A supplier might need to achieve a substantial increase in output capacity, in order
to obtain reductions in unit costs.
(e) Uncertainty - When one firm is not sure what another is up to, there is a tendency to respond
to the uncertainty by formulating a more competitive strategy.
(f) Strategic importance - If success is a prime strategic objective, firms will be likely to act
very competitively to meet their targets.
(g) Exit barriers make it difficult for an existing supplier to leave the industry. These can take
many forms.
(i)
Fixed assets with a low break-up value (e.g. there may be no other use for them, or
they may be old).
(ii)
The cost of redundancy payments to employees.
(iii) If the firm is a division or subsidiary of a larger enterprise, the effect of withdrawal on
the other operations within the group.
(iv) The reluctance of managers to admit defeat, their loyalty to employees and their fear
for their own jobs.
(v)
Government pressures on major employers not to shut down operations, especially
when competition comes from foreign producers rather than other domestic producers.
It is opportune to provide a word of caution in trying to first understand, study and in
application of this model. First and foremost, never attempt to by heart this model as it is too
complex for such a mechanistic approach. The better approach is to understand and appreciate
how some of the variables under each major force will impact your business, if you are one of
the existing players amongst many industry competitors.
The Concept of ‘Strategic Groups’
As we have shown in the figure 2.1 ‘strategic groups’ can be discerned within an industry and
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can be considered as an important variable in the context of an organizational strategic analysis.
A Strategic group consists of a group of organizations operating within a particular industry that
seem to be following somewhat similar strategies, of similar strategic characteristics such as
similar size and most importantly competing on similar bases of competitive advantage. Hence
it is advised to pay a closer to attention of the ‘strategic groups’ within an industry that an
organization exists.
Operating environment
The most immediate environment to a company’s own internal environment is the ‘operating
environment’ and interestingly this layer is occupied by one of the most important and powerful
stakeholder groups, namely ‘customers’. A strategically oriented organization will carefully
analyze this environmental sector in to relevant market segments and understand the repertoire of
the customer motivations of the segments that the company wishes to target as strategic success
largely depends on its capabilities in creating a competitively superior customer value. At this
juncture students are advised to refresh their knowledge from the course unit ‘Marketing’ on the
concepts of segmentation, targeting and positioning s popularly referred to as STP strategies.
Part B - Internal Environmental Analysis (or Internal Analysis)
At the commencement of the foregoing analysis, the importance of the role of the external
environment was mentioned in shaping strategic thinking and related decision-making.
The external environment in which a business operates can create opportunities which a business
can exploit, as well as threats which could damage a business. However, to be in a position to
exploit opportunities or respond to threats, a business needs to have the right resources and
capabilities in place.
Hence an important part of business strategy is concerned with ensuring that these resources and
competencies are understood and evaluated - a process that is often known as internal
environment analysis or at time referred to as a ‘strategic audit’.
The process of conducting a strategic audit can be summarized into the following stages:
a) Resource Audit /Functional analysis
Resources are the instruments through which a company implements its strategy to achieve its
goals and objectives. The bundle of resources that a company possesses can be categorized under
‘tangible (assets and money), ‘human’ and ‘intangibles’ such as brands, corporate reputation and
even the systems and processes. As resource deployment in an organization usually takes place
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under different functional disciplines it is customary for a resource analysis or a strategic audit to
be conducted under different functional areas comprising Marketing, Operations, Finance, and
Human resources as the functional disciplines common to most commercial organizations.
Appendix 1 at the end of this chapter lists several of such variables that are likely to be
applicable to a wide spectrum of organizations. However, strategic analysts of different
organizations will have to creatively identify the applicable internal factors that are pertinent and
have strategic relevance in their own contexts.
b) Value Chain Analysis
To better understand the activities through which a firm develops a competitive advantage and
creates customer value, it is useful to separate the business system into a series of valuegenerating activities referred to as the value chain. In his 1985 land mark title Competitive
Advantage, Michael Porter introduced a generic value chain model that comprises a sequence of
activities found to be common to a wide range of firms.
Value Chain Analysis describes in a strategically relevant manner, the different types of
activities that take place in a business to produce and deliver customer requirements where it is
possible to compare with those of the competitors and hence considered a valuable tool in a
strategic analysis. Influential work by Michael Porter who pioneered this framework suggested
that the activities of a business could be grouped under two headings: (i) Primary Activities those that are directly concerned with creating and delivering a product (e.g. component
assembly); and (ii) Support Activities, which whilst they are not directly involved in production,
may increase effectiveness or efficiency (e.g. human resource management). Value Chain
Analysis is also one way of identifying which activities are best undertaken by a business and
which could be best provided by others ("outsourced").
Value chain has many advantages in a strategic analysis and one such attribute is that it has a
structure that could enlighten the analysts as to how the firm manages its ‘cost structure’, cost
being such a vital strategic variable.
Porter identified primary and support activities as shown in the following diagram:
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Figure 2.3: ‘Value Chain’ Framework of Michael Porter (1985)
The primary value chain activities are:
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Inbound Logistics: the receiving and warehousing of raw materials and their distribution to
manufacturing as they are required.
Operations: the processes of transforming inputs into finished products and services.
Outbound Logistics: the warehousing and distribution of finished goods.
Marketing & Sales: the identification of customer needs and the generation of sales.
Service: the support of customers after the products and services are sold to them.
These primary activities are supported by:
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The infrastructure of the firm: organizational structure, control systems, company culture,
etc.
Human resource management: employee recruiting, hiring, training, development, and
compensation.
Technology development: technologies to support value-creating activities.
Procurement: purchasing inputs such as materials, supplies, and equipment.
The margin is the excess the customer is prepared to pay over the cost to the firm of
obtaining resource inputs and providing value activities. It represents the value created by
the value activities themselves and by the management of the linkages between them.
The firm's margin or profit then depends on its effectiveness in performing these activities
efficiently, so that the amount that the customer is willing to pay for the products exceeds the
cost of the activities in the value chain. It is in these activities that a firm has the opportunity to
generate superior value. A competitive advantage may be achieved by reconfiguring the value
chain to provide lower cost or better differentiation.
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•
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Cost advantage: by better understanding costs and squeezing them out of the value-adding
activities.
Differentiation: by focusing on those activities associated with core competencies and
capabilities in order to perform them better than do competitors.
Linkages between Value Chain Activities
Value chain activities are not isolated from one another. Rather, one value chain activity often
affects the cost or performance of other ones. Linkages may exist between primary activities and
also between primary and support activities.
Consider the case in which the design of a product is changed in order to reduce manufacturing
costs. Suppose that inadvertently the new product design results in increased service costs; the
cost reduction could be less than anticipated and even worse, there could be a net cost increase.
c) Core Competence Analysis
Core competencies are those unique capabilities that are critical to a business in a particular
market and are considered important achieving competitive advantage. The starting point for
analyzing core competencies is recognizing that competition between businesses is as much a
race for mastery of competencies that could create better customer value that could contribute to
improve market position and market power.
Core Competences and the concept of Critical Success Factors/CSFs
The prolific British authors on strategy Johnson & Scholes divide competences into two types.
An organization must achieve at least a threshold level of competence in everything it does,
basically to be in business in a competitive world of business. The organization’s core
competences are those where it outperforms competitors and that are difficult to imitate. Core
competencies are the most significant value creating skills within a corporation and key areas of
expertise which are distinctive to your company and critical to the company's long term growth.
A company's core competencies are the things that you can do better than your competitors in the
critical, central areas of the company where the most value is added to its products. These areas
of expertise may be in any area such as say for example in product development and even in
areas such as employee dedication and commitment to service excellence. Strategic
competitiveness depends on unique resources or core competences.
Prahalad and Hamel suggest three factors to help identify core competencies in any business:
23
What does the
Core Competence
Achieve?
Comments / Examples
Provides potential The key core competencies here are those that enable the creation of
access to a wide new products and services.
variety of markets
Example: Why has Saga established such a strong leadership in
supplying financial services (e.g. insurance) and holidays to the older
generation?
Core Competencies enable Saga to enter apparently different markets:
- Clear distinctive brand proposition that focuses solely on a closelydefined customer group
- Leading direct marketing skills - database management; directmailing campaigns; call centre sales conversion
- Skills in customer relationship management
Makes a significant
contribution to the
perceived customer
benefits of the end
product
Core competencies are the skills that enable a business to deliver a
fundamental customer benefit - in other words: what is it that causes
customers to choose one product over another? To identify core
competencies in a particular market, ask questions such as "why is the
customer willing to pay more or less for one product or service than
another?" "What is a customer actually paying for?
Example: Why have Tesco been so successful in capturing leadership
of the market for online grocery shopping?
Core competencies that result in customers value the Tesco.com
experience so highly:
- Designing and implementing supply systems that effectively link
existing shops with the Tesco.com web site
- Ability to design and deliver a "customer interface" that personalizes
online shopping and makes it more efficient
- Reliable and efficient delivery infrastructure (product picking,
distribution,
customer
satisfaction
handling)
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Difficult
competitors
imitate
for A core competence should be "competitively unique": In many
to industries, most skills can be considered a prerequisite for participation
and do not provide any significant competitor differentiation. To
qualify as "core", a competence should be something that other
competitors wish they had within their own business.
Example: Why does Dell have such a strong position in the personal
computer market?
Core competencies that are difficult for the competition to imitate:
- Online customer "bespeaking" of each computer built
- Minimization of working capital in the production process
- High manufacturing and distribution quality - reliable products at
competitive prices
Critical Success Factors
Competences can be related to critical success factors (CSFs).
Critical success factors (CSFs) 'are those factors that are relatively few but critical for strategic
success in a given market and hence are fundamentally important considerations in formulating a
company’s strategy.
•
Some C`SFs are generic to the whole industry, others to a particular firm. The critical
success factor to run a successful mail order business is speedy delivery.
•
A CSF of a parcel delivery service is that it must be quicker than the normal post.
•
Underpinning critical success factors are key tasks. If customer care is a CSF, then a key
task, and hence a measure of performance, would include responding to enquires within a
given time period. There may be a number of key tasks - but some might be more
important than others, or must come first and needs to be prioritised.
Relationship between competences and CSFs
•
•
A competence is what an organisation has or is able to do.
A CSF is what is necessary to achieve an objective in a given market.
Competences thus fulfil the CSF. In the examples quoted, a competence of faster delivery
supports a CSF that a courier service must be faster than a competitor.
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Relation to Key Performance Indicators (KPIs)
A critical success factor is not a key performance indicator (KPI). Critical success factors are
elements that are vital for a strategy to be successful. KPIs are measures that quantify
management and enable the measurement of strategic performance. A critical success factor is
what drives the company forward, it is what makes the company or breaks the company. As staff
must ask themselves everyday 'Why would customers choose us?' and they will find the answer
is the critical success factors.
Example
•
•
KPI = Number of new customers.
CSF = Installation of a call center for providing quotations
(d) Performance Analysis
The resource audit, value chain analysis and core competence analysis help to define the
strategic capabilities of a business. After completing such analysis, questions that can be asked
that evaluate the overall performance of the business. These questions include:
•
•
•
•
How have the resources deployed in the business changed over time; this is "historical
analysis"
How do the resources and capabilities of the business compare with others in the industry
“industry norm analysis”.
How do the resources and capabilities of the business compare with "best-in-class" wherever that is to be found-benchmarking.
How has the financial performance of the business changed over time and how does it
compare with key competitors and the industry as a whole? – the popular ‘ratio analysis’
is a technique that is widely applied during this stage.
(e) Portfolio Analysis
Portfolio Analysis analyses the overall balance of the strategic business units (SBUs) of a
business. Most large businesses have operations in more than one market segment, and often in
different geographical markets supplying diverse range of products types. Larger, diversified
groups often have several divisions (each containing many business units) operating in quite
distinct industries.
An important objective of this part of this strategic audit is to ensure that the business portfolio is
strong and that business units requiring investment and management attention are highlighted.
This is important - a business should always consider which markets are most attractive and
which business units have the potential to achieve advantage in the most attractive markets.
26
Traditionally, two analytical models have been widely used to undertake portfolio analysis:
•
•
The Boston Consulting Group Portfolio Matrix (the "Boston Box");
The McKinsey/General Electric Growth Share Matrix
Levels of Portfolio analysis
A portfolio means a ‘collection’. In this context it means a collection of strategic business units.
In relation to a strategic analysis, management seek to visualize their operations as a collection of
income-yielding assets. This approach is based on an approach used in financial strategy and is
intended to give guidance on where to invest additional funds and what are the strategies to
apply.
i) A product portfolio - A business unit may provide a range of products to its customers. For
examples, a life insurance firm may offer a number of products such as pensions,
endowments, whole life, critical illness and guaranteed income policies.
ii) A business (or corporate) portfolio - This is the business as seen from the corporate level of
a business. Here the strategic business units (SBUs) are being seen as a collective whole.
Product Portfolio Analysis
The concept of a product life cycle
Many firms make a number of different products or services. Each product or service has its own
financial, marketing and risk characteristics. The combination of products or services influences
the attractiveness and profitability of the firm.
The profitability and sales of a product can be expected to change over time. The Product Life
Cycle is an attempt to recognise distinct stages in a product's sales history.
Like human beings, products also have life-cycle. From birth to death human beings pass
through various stages e.g. birth, growth, maturity, decline and death. A similar life-cycle is seen
in the case of products. The product life cycle goes through multiple phases, involves many
professional disciplines, and requires many skills, tools and processes. Product life cycle (PLC)
has to do with the life of a product in the market with respect to business/commercial costs and
sales measures.
27
Figure 2.4: Concept of Product Life Cycle (PLC)
Introduction - This is a new product and hence will be unfamiliar to the market. The firm will
need to invest considerable resources in developing and launching the product (Including
promotion, Stock-building, staff training).
•
A new product takes time to find acceptance by would-be purchasers and there is a slow
growth in sales. Unit costs are high because of low output and expensive sales promotion.
•
There may be early teething troubles with production technology.
•
The product for the time being is a loss-maker.
Growth - Rapidly increasing sales due to acceptance of the product. Substantial investment
needed to keep up with demand.
•
•
If the new product gains market acceptance, sales will eventually rise more sharply and the
product will start to make profits.
Competitors are attracted. As sales and production rise, unit costs fall.
Maturity - The rate of sales growth slows down and the product reaches a period of maturity
which is probably the longest period of a successful product's life. Most products on the market
will be at the mature stage of their life. Profits are good.
Decline - Eventually, sales will begin to decline so that there is over-capacity of production in
the industry. Severe competition occurs, profits fall and some producers leave the market. The
remaining producers seek means of prolonging the product life by modifying it and searching for
28
new market segments. Many producers are reluctant to leave the market, although some
inevitably do because of falling profits.
Summary of the strategic characteristics of different stages of the life cycle
Stage
Market
introduction
stage
Growth stage
Characteristics
•
•
•
•
•
•
•
•
•
•
•
•
•
Mature stage
•
•
•
•
•
Saturation and
decline stage
•
•
•
•
costs are high
slow sales volumes to start
little or no competition - competitive manufacturers watch for
acceptance/segment growth losses
demand has to be created
customers have to be prompted to try the product
makes no money at this stage
costs reduced due to economies of scale
sales volume increases significantly
profitability begins to rise
public awareness increases
competition begins to increase with a few new players in establishing
market
increased competition leads to price decreases
costs are lowered as a result of production volumes increasing and
experience curve effects
sales volume peaks and market saturation is reached
increase in competitors entering the market
prices tend to drop due to the proliferation of competing products
brand differentiation and feature diversification is emphasized to
maintain or increase market share
Industrial profits go down
costs become counter-optimal
sales volume decline or stabilize
prices, profitability diminish
profit becomes more a challenge of production/distribution efficiency
than increased sales
29
The relevance of the product life cycle to strategic planning
In reviewing outputs, planners should assess products in three ways.
(a) The stage of its life cycle that any product has reached.
(b) The product's remaining life, i.e. how much longer the product will contribute to profits.
(c) How urgent is the need to innovate, to develop new and improved products?
BCG analysis / the BCG Matrix
For each product or service, the 'area' of the circle represents the value of its sales.
Figure 2.5: Boston Consultancy Group (BCG) Matrix
The Boston Consulting Group (BCG) developed a matrix based on empirical research that
assesses a company's products / SBUs in terms of potential cash generation and cash expenditure
requirements. Products or SBUs are categorised in terms of market growth rate and relative
market share.
30
(a) Assessing rate of market growth as high or low depends on the conditions in the market. No
single percentage rate can be set, since new markets may grow explosively while mature
ones grow hardly at all.
(b) Relative market share - is assessed as a ratio: it is market share compared with the market
share of the largest competitor. Thus a relative market share greater than unity indicates that
the product or SBU is the market leader.
(a) Stars - Stars have high market share in high-growth markets. Stars generate large cash flows
for the business, but also require large infusions of money to sustain their growth. Stars are
often the targets of large expenditures for advertising and research and development to
improve the product and to enable it to establish a dominant position in the industry. In the
short term, these require capital expenditure in excess of the cash they generate, in order to
maintain their market position, but promise high returns in the future. Strategy: build.
(b) In due course, stars will become cash cows. Cash cows are business units that have high
market share in a low-growth market. These are often products in the maturity stage of the
product life cycle. They are usually well-established products with wide consumer
acceptance, so sales revenues are usually high. Cash cows need very little capital expenditure
and generate high levels of cash income. Cash cows can be used to finance the stars.
Strategy: hold or harvest if weak.
(c) Question marks (also known as problem child) - Do the products justify considerable
capital expenditure in the hope of increasing their market share, or should they be allowed to
die quietly as they are squeezed out of the expanding market by rival products? Strategy:
build or harvest.
(d) Dogs - They may be ex-cash cows that have now fallen on hard times. Although they will
show only a modest net cash outflow, or even a modest net cash inflow, they are cash traps
which tie up funds and provide a poor return on investment. However, they may have a
useful role, either to complete a product range or to keep competitors out. Strategy: divest or
hold.
Market share: One entity's sale of a product or service in a specified market expressed as a
percentage of total sales by all entities offering that product or service.
Thus, this will help to determine whether company is having a balanced port-folio or not.
For example, The Company has just one cash cow, three question marks, and no stars. The cash
base of the company is inadequate and cannot support the question marks. The company may
allocate available cash among all question marks in equal proportion. Dogs may also be given
occasional cash nourishment. If the company continues its current strategy, it may find itself in a
dangerous position in five years, particularly when the cash cow moves closer to becoming a
dog. To take corrective action, the company must face the fact that it cannot support all its
31
question marks. It must choose one or maybe two of its three question marks and fund them
adequately to make them stars. In addition, disbursement of cash in dogs should be totally
prohibited. In brief, the strategic choice for the company, considered in portfolio terms, is
obvious. It cannot fund all question marks and dogs equally. The portfolio matrix focuses on the
real fundamentals of businesses and their relationships to each other within the portfolio. It is not
possible to develop effective strategy in a multiproduct, multimarket company without
considering the mutual relationships of different businesses.
Limitations of the Boston Consulting Group Matrix
The BCG matrix provides a framework for allocating resources among different business units
and allows one to compare many business units at a glance. However, the approach has received
some negative criticism for the following reasons:
•
•
•
•
•
•
The link between market share and profitability is questionable since increasing market
share can be very expensive.
The approach may overemphasize high growth, since it ignores the potential of declining
markets.
The model considers market growth rate to be a given. In practice the firm may be able to
grow the market.
High market share is not the only success factor
Market growth is not the only indicator for attractiveness of a market
Sometimes Dogs can earn even more cash as Cash Cows
The General Electric Business Screen
The approach of the GE Business Screen (GEBS) is similar to that of the BCG matrix. The
GEBS includes a broader range of company and market factors. A typical example of the GE
matrix is provided below. This matrix classifies products (or businesses) according to industry
attractiveness and company strengths. The approach aims to consider a variety of factors
which contribute to both these variables.
32
Figure 2.6: General Electric Matrix (GE) Business Screen
Factors that Affect Market Attractiveness
Whilst any assessment of market attractiveness is necessarily subjective, there are several factors
which can help determine attractiveness. These are listed below:
-
Market Size
Market growth
Market profitability
Pricing trends
Competitive intensity / rivalry
Overall risk of returns in the industry
Opportunity to differentiate products and services
-
Segmentation
Factors that Affect Competitive Strength
Factors to consider include:
-
Relative market share
Strength of assets and competencies
Relative brand strength
Financially solid position
Customer loyalty
Relative cost position (cost structure compared with competitors)
Distribution strength
Record of technological or other innovation
Access to financial and other investment resources
33
The broader approach of the GE matrix emphasizes the attempt to match competences within the
company to conditions within the market place. Difficulties associated with measurement and
classification mean that again the results of such an exercise must be interpreted with care.
Improvements in GE matrix compared to BCG matrix
•
BCG matrix considers two external variables. It ignores internal aspect of a business.GE
matrix considers both internal aspect (business strength) and External aspect (Market
attractiveness).
•
BCG matrix considers two narrative variables. However GE matrix considers two broad
variables. (There are so many factors that determine the business strength and market
attractive as discussed earlier).
•
BCG Matrix has four options and GE matrix have nine options.
Stakeholder Analysis
The concept of ‘Stakeholders’
Groups or individuals those who may be internal or external to an organisation and whose
interests are directly affected or impacted by the activities of a firm or organisation and
whose interests and actions also could influence what an organisation is trying to accomplish.
Stakeholders can be divided in to two main groups:
•
Internal Stakeholders-People who are staying inside of an organisation and interest about
organisational activities.
E.g: Employees, Share holders
•
External Stakeholders- People who are staying outside of an organisation and interest about
organisational activities
E.g: Governmental organisations, Media, Community, Potential investors, Competitors,
Customers, suppliers, Banks and Financial institutions and even public at large.
Conflict between Stakeholders
Stakeholder groups can exert influence on strategy. The greater the power of a stakeholder
group, the greater its influence will be. The complexity of stakeholder management is because
each stakeholder group has different expectations about what it wants, and often
the
expectations of the various groups will be in conflict. For example the employee group will
expect higher salaries and bonuses while such expectations will be in conflict with higher
dividend expectations with the powerful shareholder group. Similarly increasingly advancing
34
customer expectations for better quality at affordable prices could be in conflict with the profit
targets of the employees that could determine their benefits and bonuses.
Additionally, there will be differences between the objectives of members of the same
stakeholder group. Two examples are particularly important;
•
Differences between shareholders
Some needs more dividends and another is happy for profits to be retained to promote
capital growth.
•
Differences between managers
Objectives of managers and the departments they lead, may have the potential for conflict
such as in the case of ‘Finance’ function pursuing aggressive cost management while the
HR function will push for additional expenditures in the from staff training across all
levels.
Stakeholder management – Stakeholder mapping
Level of interest
Low
High
Low
Minimal
Effort
Keep
Informed
Keep
Satisfied
Manage
Closely
Power
High
Figure 2.7: Mendelow’s Stakeholder Matrix
35
Mendelow (1991) proposed the following diagram as per the figure 3.1 that could provide a
possible approach to manage the expectations of the major stakeholder groups when confronted
with issues of different levels of complexity. For example in relation to an issue that is of high
level of interest to a stakeholder group with immense power, such a situation needs to be
‘managed closely’.
Agency Theory
Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely defined)
between resource holders. An agency relationship arises whenever one or more individuals,
called principals, hire one or more other individuals, called agents, to perform some service and
then delegate decision-making authority to the agents. The primary agency relationships in
business are those (1) between stockholders and managers and (2) between debt holders and
stockholders. These relationships are not necessarily harmonious; indeed, agency theory is
concerned with so-called agency conflicts, or conflicts of interest between agents and principals.
This has implications for, among other things, corporate governance and business ethics. When
agency occurs it also tends to give rise to agency costs, which are expenses incurred in order to
sustain an effective agency relationship (e.g., offering management performance bonuses to
encourage managers to act in the shareholders' interests). Accordingly, agency theory has
emerged as a dominant model in the financial economics literature, and is widely discussed in
business ethics texts.
Conflicts between Managers and Shareholders
Agency theory raises a fundamental problem in organization self-interested behavior. A
corporation's managers may have personal goals that compete with the owner's goal of
maximization of shareholder wealth. Since the shareholders authorize managers to administer the
firm's assets, a potential conflict of interest exists between the two groups.
Self- interested behavior
Agency theory suggests that, in imperfect labor and capital markets, managers will seek to
maximize their own utility at the expense of corporate shareholders. Agents have the ability to
operate in their own self-interest rather than in the best interests of the firm because of
asymmetric information (e.g., managers know better than shareholders whether they are capable
of meeting the shareholders' objectives) and uncertainty (e.g., myriad factors contribute to final
outcomes, and it may not be evident whether the agent directly caused a given outcome, positive
or negative). Evidence of self-interested managerial behavior includes the consumption of some
corporate resources in the form of perquisites and the avoidance of optimal risk positions,
whereby risk-averse managers bypass profitable opportunities in which the firm's shareholders
would prefer they invest. Outside investors recognize that the firm will make decisions contrary
36
to their best interests. Accordingly, investors will discount the prices they are willing to pay for
the firm's securities.
In the majority of large publicly traded corporations, agency conflicts are potentially quite
significant because the firm's managers generally own only a small percentage of the common
stock. Therefore, shareholder wealth maximization could be subordinated to an assortment of
other managerial goals.
Managers can be encouraged to act in the stockholders' best interests through incentives,
constraints, and punishments. These methods, however, are effective only if shareholders can
observe all of the actions taken by managers. A moral hazard problem, whereby agents take
unobserved actions in their own self-interests, originates because it is infeasible for shareholders
to monitor all managerial actions. To reduce the moral hazard problem, stockholders must incur
agency costs.
Stockholders Vs. Creditors: A Second Agency Conflict
In addition to the agency conflict between stockholders and managers, there is a second class of
agency conflicts those between creditors and stockholders. Creditors have the primary claim on
part of the firm's earnings in the form of interest and principal payments on the debt as well as a
claim on the firm's assets in the event of bankruptcy. The stockholders, however, maintain
control of the operating decisions (through the firm's managers) that affect the firm's cash flows
and their corresponding risks. Creditors lend capital to the firm at rates that are based on the
riskiness of the firm's existing assets and on the firm's existing capital structure of debt and
equity financing, as well as on expectations concerning changes in the riskiness of these two
variables.
Corporate Governance
Closely aligned with the concept of ‘agency’, governance is important because of the power
given to the ‘directors’ to run the organization on behalf of the shareholders and the hence the
directors are entrusted with responsibility for the organization as a whole.
Corporate governance is mainly concerned with the selection and the conduct of the directors
and their relationship with other stakeholders.
One of the key aspects of governance is the availability of good quality information. As some
information cannot be shared easily given their degree of high commercial sensitivity and
strategic significance stakeholders rely on such things as independent external audits and nonexecutive directors to act as checks on the behavior of the executive directors. Statutorily
imposed governance mechanisms such as ‘audit’, ‘related party’ and ‘remuneration’ committees
under the leadership of non-executive directors are becoming increasingly relevant in today’s
corporate world from a governance perspective.
37
Corporate Social Responsibility (CSR)
The idea here is that the management of organizations when making business decisions in pursuit
of formulating and implementing strategies to realize the strategic objectives, need to take in to
account the impact of such decisions on the interests of the society at large as well, than just the
immediate interest of the shareholders and the organization. The Corporate Social Responsibility
hence, is the continuing commitment by businesses to behave ethically and contribute to
economic development while improving the quality of life of the workforce and their families as
well as of the local community and even society at large. Therefore it takes a broader view
extending relationships beyond its immediate structure and examines its role in the society and
the broader environment.
Issues commonly associated with social responsibility:
•
•
•
•
•
•
•
•
•
Environmental pollution from production or consumption of products
Standards of factory & product safety
Non-discrimination in employment and marketing practices
Avoidance of the use of non-renewable products
Non-Production of socially undesirable goods
Production of non-gradable packaging or products
Taking bribes
Unfair competitive moves
Non-payment of taxes
Relationship between Business Ethics and Corporate Social Responsibility (CSR)
Definition of Business Ethics
Business Ethics is concerned with issues of moral righteousness
and actions taken in conducting the business.
and wrongness of decisions
They have distinct meaning although the two are often used interchangeably. Business ethics
comprises principles and standards that govern behavior in the world of business. Hence business
ethics could also be considered as one important dimension of a socially responsible
organization.
Issues commonly associated with Ethics:
•
•
•
•
Honesty in advertising of jobs or products
Fairness in setting pay & working conditions
Non-Exploitation of countries or peoples
Effects of customers of consuming products
38
•
•
Dealing with oppressive governments
Management of Closures of redundancies
Dimensions of CSR
CSR has been defined as having four dimensions: Economic, legal, ethical and philanthropic.
Figure 2.8: Carroll’s CSR Pyramid
Archie B Carroll has identified four types of social responsibilities.
a) Economic Responsibilities
Financial stability, Effective utilization of limited resources is few examples for economic
responsibilities. However profitability becomes the key in here.
b) Legal responsibilities
Compliances to the rules & regulations imposed by the governments, local bodies and
professional institutions etc.
E.g. EPF. ETF, Shop & Office Ordinance, Gratuity Act
c) Ethical Responsibilities
Ethics are written or unwritten rules about right and wrong or good and bad perceived by
particular society or group of people.
E.g. Honesty in advertising of jobs or products, Fairness in setting pay & working conditions
d) Philanthropic Responsibilities
Philanthropy encompasses those corporate actions that are in response to society's expectation
39
that businesses be good corporate citizens. This includes actively engaging in acts or
programs to promote human welfare or goodwill. Examples of philanthropy include business
contributions of financial resources or executive time, such as contributions to the arts, health,
education, or the community.
As the CSR Pyramid illustrates, businesses have a primary economic responsibility to “be
profitable.” Resting on this foundational responsibility are three additional responsibilities: the
legal responsibility to obey the law, the ethical responsibility to do what’s right and avoid harm,
and the philanthropic responsibility to improve welfare of the society.
Sustainability and the concept of ‘the triple bottom line’
The phrase triple bottom line was first coined in 1994 by John Elkington the founder of a British
consulting company called ‘SustainAbilty’. The concept popularized by him was that companies
should be ideally preparing for three quite three different bottom lines, yet within a harmonious
relationship. One is the traditional measure of ‘corporate profit’ bottom line in the form of a
‘profit and loss account’. The second is the bottom line of a company’s ‘people account’ a
measure of how socially responsible an organization has been throughout its operations and in
pursuit of its mission, goals and objectives. Such an organization is expected to be committed to
fair and beneficial business practices towards, employees and even towards the community and
the region that it conducts the business. The third is the bottom line of the company’s ‘planet’
account, a measure of how environmentally responsible it has been in the course of conducting
the business by adopting sustainable environmental practices such as keeping off ecologically
disruptive practices. An interesting example can be quoted here. A long standing, respected
organization operating in the non banking financial sector(NBFI sector) is committed to a
specified number of ‘trees’ being planted with every vehicle lease being offered to a customer,
as a mechanism to balance off the effects of harmful environmental emissions consequent such
vehicle usage-perhaps a novel approach to put in to practice environmental responsibility, given
the very nature of one its principal product categories.
40
Bearability
People
Planet
Sustainability
Profit
Viability
Equitability
Figure 2.9: The concept of Triple Bottom Line
Part C: Strategic analysis - SWOT Analysis
A complete awareness of the organisation’s external environment and its internal capacities is
necessary for a rational consideration of future strategy, but it is not sufficient. The threads must
be drawn together so that potential strategies may be developed and assessed. The most common
way of doing this is to analyse the factors into strengths, weaknesses, opportunities and
threats. Strengths and weaknesses are diagnosed by the internal environmental analysis,
opportunities and threats by the External environmental analysis. This phase was discussed at
length in chapter 2. The findings of this comprehensive analysis will unearth the relevant and key
strengths and weakness on the one hand and the opportunities and threats confronting the
organisation on the other.
Referred to by the popular acronym SWOT it is a critical assessment of the key strengths and
weaknesses, opportunities and threats in relation to the internal and external environmental
factors affecting the entity, in order to establish its condition prior to the preparation of a longterm plan.
Strengths: Internal attributes of the organization those are helpful to achieving the objective.
Weaknesses: Internal attributes of the organization those are constraining achievement of the
objective.
Opportunities: external conditions those are helpful or positive towards achieving the objectives.
Threats: external conditions which could act negatively or damage to the business's performance.
41
For example: strength could be:
- Your specialist marketing expertise.
- A new, innovative product or service.
- Location of your business.
- Quality processes and procedures.
- Any other aspect of your business that adds value to your product or service.
A weakness could be:
- Lack of marketing expertise.
- Undifferentiated products or services (i.e. in relation to your competitors).
- Location of your business.
- Poor quality goods or services.
- Damaged reputation due to a defect in product quality
An opportunity could be:
- A developing market such as the Internet.
- Possibility of a strategic alliance.
- Moving into new market segments that offer improved profits.
- A new international market.
- A market vacated by an ineffective competitor.
A threat could be:
- A new, powerful competitor in your home market.
- Price wars with competitors.
- A competitor has a new, innovative product or service.
- Competitors have superior access to channels of distribution.
- Taxation being introduced in to the market of the company’s product or service
At this juncture it is quite relevant to point out that the analyst need to exercise caution not to get
to much immersed with all possible SWOT factors because in the contemporary, complex
business world there could be several strengths, weaknesses opportunities and threats that one
might come across during a strategic analysis. The skill here is to identify the relevant and key
SWOT factors and once identified under the respective categories, to rank them in order of their
relative importance. This would enable the strategist to work with few but the most pertinent
SWOT factors so that the strategy would be built on key and salient strategic issues of the
organization. Such is the creativity that is demanded when formulating strategy. Strategic issues
being multi faceted and multi functional in composition, this analysis need to be performed
preferably by a cross-functional team or a task force that represents a broad range of
organizational dimensions. For example, a SWOT team may include a marketing specialist, the
head of manufacturing/operations and a financial expert thereby representing the capability of
42
integrating many vital perspectives in formulating a strategy. After all a strategy is cohesive plan
of action for the entire origination and must guide unify all functions towards an achievement of
its strategic and financial objectives.
The finalized SWOT consisting of the summary of key Strengths, Weaknesses, Opportunities
and Threats can now be used to guide strategy formulation.
Equipped with this summary of key SWOT factors the team may address many aspects in the
creative phase of strategy formulation such as:
How can we utilize key a strength such as a core competence to strategic advantage and
what are ways we can manage a key identified weakness without allowing it to be a
disadvantage in the company’s strategy? Further how can we exploit a key opportunity such as
emerging societal trend or how can we defend against an emerging environmental threat that
could harm our strategic advantages.
The popular TOWS matrix as shown below is an approach used by some strategists to illustrate
how the key opportunities and threats facing an organization can be matched with the key
internal strengths and weaknesses that could result possible strategic alternatives.
Figure 2.10: TOWS Matrix
Example
Match Strengths with market Opportunities
Strengths which do not match any available opportunity are of limited use while opportunities
which do not have any matching strengths are of little immediate value.
43
Or alternatively it could be to generate strategies that deploy the strengths to avoid some critical
threats facing the organisation.
However, TOWS matrix is only one approach to guide generating alternative strategic options
and it is necessary to understand that formulating a competitive strategy is such a creative and a
complex process that should ideally be predominated with ‘strategic thinking’ synthesizing
many key strategically relevant variables, as opposed to model based somewhat mechanistic
approaches.
Appendix 1
Internal Factors/Functional analysis – Potential
Strengths and Weaknesses
(Some usual examples)
Marketing
-
Degree of market orientation
Effectiveness in product line, product mix, PLC of key products
Product portfolio balance
Availability of required channels of distribution
Effective sales organization
Product quality as intended
Pricing strategy
Brand image and brand equity
Promotional effectiveness
After sales effectiveness
Operations/ Manufacturing
-
Raw materials cost and availability and supplier relationships.
Inventory control systems; inventory turnover.
Location of facilities; layout and utilization of facilities.
Economies of scale.
Technical efficiency of facilities and utilization of capacity.
Effective use of sub-contracting.
Degree of vertical integration; value added and profit margin.
Production facilities and technology conforming to modern standards
44
-
Effective operation control procedures: design, scheduling, purchasing, quality control,
and efficiency.
Costs and technological competencies relative to industry and competitors.
Research and development/technology/innovation.
Human Resources /Personnel
-
Management competencies at all levels.
Employees’ knowledge, skills, morale and experience.
Cordial employee relations.
Effective personnel policies including compensation, rewards, promotional and practices
driving increased motivation.
Effective use of incentives to motivate performance and promote creativity.
Effective management training and development practices.
Employee turnover and absenteeism.
Specialized skills supporting competitive strategy.
Ability to develop core competencies.
Progressive diversity and succession management policies.
Finance and Accounting
-
Ability to raise short-term capital.
Ability to raise long-term capital: debt/equity.
Corporate - level resources (in a multi- business firm).
Cost of capital relative to industry and competitors.
Tax planning and management.
Relations with owners, investors, and stockholders.
Price - Earnings ratio.
Sound Working Capital management.
A sound Capital structure, financing policies (Leverage/Gearing position consistent with
acceptable levels of financial risk).
Good relations with financial markets.
Dividend policy.
Effective cost controls; ability to reduce cost.
Efficient and effective accounting systems to support and facilitate business processes
and also in cost, budget, and profit planning .
Sound financial control systems covering all spheres of organizational activities.
Organization and General Management
-
An appropriate Organizational Structure supporting effective strategy implementation.
45
-
Firm’s corporate image and brand positioning.
Firm’s record for achieving objectives.
Effective communication and management information systems.
Appropriate organizational control systems and governance mechanisms.
A healthy Organizational climate and culture.
Use of systematic procedures and techniques in decision making.
Top- management’s competencies skills, capabilities and interest.
Intra- organizational synergy (multi-business firms).
Strategic management and thinking skills at all managerial levels.
A sound and an effective enterprise wide risk management framework.
Top management succession policies.
Chapter Summary
Setting a strategic direction for the organization takes place with an intimate understanding of the
salient features that was identified in the strategy analysis stage and summarized through a
SWOT analysis template. Formulation of a mission to guide the scope of the business and the
role of the vision as an inspirational and an ultimate goal were discussed. The hierarchy of a
company’s desired end results are further expressed through goals and objectives. When an
organization formulates goals and objectives, companies take a more appropriate ‘stakeholder’
perspective extending beyond the traditional and narrow shareholder interests. Social and ethical
responsibilities are imperatives and even responsibility towards our broader environment is to be
preferably considered when formulating the desired end results and strategy, in the present
context where organizations strive towards sustainability.
46
Chapter 03
Strategic Direction
Learning Objectives
After studying this chapter, you should be able to:
•
•
•
•
Differentiate the terms and concepts of strategic planning and strategic thinking
Understand the different approaches to strategy formulation.
Explain the concept of mission as a critical component of strategy and advice how to
develop mission with correct balance practical relevance for a given corporate situation.
Understand the success factors in formulating company objectives, the multi-faceted
complexion of objectives and the importance of right balance and linkages between
financial and strategic objectives.
Strategic Thinking Vs Strategic Planning
When we mention about ‘planning’, such a process basically encompass elements such as
setting objectives, deciding and formulating means of achieving such objectives and making
available the required resources. The planning process that occurs at the top management level in
an organization is typically referred to as ‘strategic planning’. Such a process comprises setting
objectives; means of achieving such objectives popularly termed ‘strategy’ and resource
deployment, for the organization as a whole.
Strategic thinking and strategic planning are two interwoven concepts that reinforce the
effectiveness of one another. The term strategic planning is more used in the context of a process
that takes place at the ‘top’ with a view to formalize some method to come in to terms with the
complex and changing environment and formulate strategies and achieve corporate objectives.
Strategic thinking brings about the creative ways of ‘thinking’ about essential strategic
imperatives such as the future trajectories of an industry, customer needs and wants , the likely
changes to the bases of competitive advantage that will change the complexion of the
competitive strategy and such critical thinking will undoubtedly enrich the strategic flavor of the
strategic planning process.
The real essence of a strategy lies on the way a company plans to achieve a strategic advantage
in the competitive world. Over time, different schools of such strategic thought have evolved and
two of such prominent approaches are termed ‘market based-view’ and ‘resource-based view’ of
strategy. In a nutshell the market based view is primarily attributed to Michael Porter who has
47
advocated the importance of an organization finding a suitable industry and create a relatively
superior position within that industry. This implies the route to competitive advantage is to
achieve a proper strategic –fit between the organization and an attractive industry. Alternatively,
the resource based view holds the view that in pursuit of competitive advantage an organization
needs to leverage its resources and create a strategic intent to overcome competitive rivalry and
achieve superior profitability and other strategic objectives. Hence interestingly the former view
is an outside-in view while the second is an inside-out approach. The contemporary thinking is
that both views have distinct advantages and a combined approach can yield better results.
‘Mission’ formulation
Once the stages of the strategic analysis is completed by conducting an external and an internal
analyses and thereafter followed up with a systematic SWOT the group of analysts will be
quite familiar with the relevant and key internal ‘strengths and weaknesses’ as well as the
existing and potential ‘threats and opportunities’ that will confront an organization. With such
strategic awareness, the next stage in the planning as well as in the strategic thinking process is
to critically examine the stage of mission formulation and in case of an existing organization to
consider whether the company needs to contemplate a re-formulation of its strategic mission
with the objective of better aligning with key strategic variables impacting the organization.
The concept of mission in relation to an organization attempts
understanding of some of its key business fundamentals such as;
•
•
•
to deal with a focused
Its reason for existence and the fundamental and preferably the unique societal purpose
the organization aims to accomplish.
A company’s mission statement is typically focused on its description of present business
scope in terms of the products and services it produces/markets, the market segments as
well as the technology and the method of sale that the company is adopting and even the
scope in terms of its geographical presence.
Principal values that a company is committed to or in other words, what does the company
stands for?
Coming up with a strategically meaningful and a potent company mission is not as simple as one
might imagine. For example “Is Coca Cola in the soft-drink business (in which case
management’s strategic attention can be concentrated on outselling and out competing Pepsi,
7ups, Creamsoda, Necto) or is it in the beverage business (In which case, management also needs
to think strategically about positioning Coca-Cola products to compete against fruit juices, ready
to drink teas, bottled water, sports drink, milk & coffee)”?. Hence not only that eventually
coming up with an appropriate mission is vitally important as it sets the parameters of the
strategic course for an organization, but one of the roles of a mission statement is also to give
the organization its own special strategic identity.
48
Boundaries may be set in terms of a combination of geography, market, technology, product or
any other parameter that defines the nature of the organization.
Values are the basic, perhaps unstated beliefs of the people who work in the organization. The
values of the business as a social entity must be ingrained by the organizational members as
collectively as possible and deeply committed to same. It’s also relevant to note that such values
must be in harmony with sound ethical principles that socially responsible organizations espouse
at all times.
Mission Statements
Mission Statements are formal statements of an organization’s mission. They might be
reproduced in a number of places (e.g. at the commencement of an organization’s annual report,
on publicity materials, in the chairman’s office etc.) There is no standard format, but they should
posses certain characteristic;
-
Brevity-easy to understand and remember.
Flexibility-To accommodate change.
Distinctiveness-to make the firm stand out and be strategically powerful.
Mission formulation –The difference between a ‘broad’ or a ‘narrow’ views of organizational
mission.
Example:
Narrow definition
Broad definition
Show film
Entertainment of Customers
Following are some other examples for this.
We are in the business of:
Board definition
Narrow definition
Furniture business
Telecommunication business
Beverage business
Global mail delivery business
Steel outdoor furniture business
Long-distance telephone service business
Soft drink business
Overnight package delivery business
The risks of making an overly broad mission statement are lack of business focus and dilution of
effort. Few businesses fail because they are focused on sharply targeted market opportunities but
many fail or do badly because management’s attention is divided and resources are scattered
across too many areas.
49
On the other hand taking a too narrow, product centric view of the scope of a business can make
a business less market oriented and legendary writers like Philip Kotler has advised that a
business must be viewed as a ‘need satisfying’ process as opposed to taking a narrow, myopic
view as a ‘product producing’ process. Hence the advice for the business strategists is that they
need to be creative in conceptualizing a mission for a business by avoiding taking a too narrow
or a broad view of the scope of a business and instead look to take a more market oriented view
that is consonant with the distinctive capabilities and competencies of the organization.
Some practical examples for Mission statements.
Seylan Bank
"To exceed customer expectations by providing competitively priced superior services through
speedy and multiple delivery channels, whilst rewarding staff through recognition and
empowerment; being a responsible corporate citizen; adopting environmental friendly
practices and adding superior value to shareholders".
Commercial Bank
Providing reliable, innovative, customer friendly financial services, utilizing cutting edge
technology and focusing continuously on productivity improvement whilst developing our staff
and acquiring necessary expertise to expand locally and regionally".
A strategic Vision of an organization
A strategic vision aims to project the broadest and the most desirable, the long- term aspirations
for the organization and its business.
The idea of positioning the stage of vision formulation after the initial phase of deciding a
mission for the organization is because of the view that, the vision is a long term inspirational
end and ideally be within the framework of a definitive scope for the business, that mission is
supposed to define.
Communicating a clear strategic vision can be a hugely motivating tool for the entire
organization and could arouse organization wide commitment towards the strategic intent spelt
out in the vision.
Features of vision
• Foresight or “ power of seeing”
• Focus on future (see the future and prepare for it).
• Serves as a concrete foundation for the organization.
• Seldom can change but it be improved.
E. g. Microsoft organization
50
For years, one vision drove what Microsoft did “A computer on every desk and in every home
using great software as an empowering tool”. But the emergence of the internet and non-Pc
devices like handheld computers and TV-set –top boxes as increasingly integral parts of
everyday a change was incorporated to its vision to “ empower people through great software
anytime, anyplace , and on any device”. Bill Gates observes “we see a world where people can
use any computing device to do whatever they want to anytime, anywhere. The PC will continue
to have a central role. But it will be joined by an incredibly rich variety of digital devices
accessing the power of internet”.
Which comes first? The mission statement or the vision statement? As mentioned earlier the
text has positioned mission as the starting point of the strategic direction process. However, there
are alternative possibilities in practice. For instance in case of a new start up business, new
program or plan to re engineer current services, it could be that the vision will guide the
mission statement and the rest of the strategic plan. On the other hand in case of an established
business where the mission is already established, mission guides the vision statement and the
rest of the strategic plan. Either way, it is relevant to note that it’s important for the strategic
thinkers are cognizant of the fundamental purpose - the mission, a company’s current situation
in terms of internal resources and capabilities (strengths and/or weaknesses) and external
conditions (opportunities and/or threats), and where the company want to go - the vision for the
future. It's important that a business keep the end or desired result in sight from the start.
Some practical examples of vision statements.
Seylan Bank
“To be the leading financial solutions provider that delivers exceptional value to stakeholders"
{Compare with the previously discussed ‘mission’ of the same institution -"To exceed customer
expectations by providing competitively priced superior services through speedy and multiple
delivery channels, whilst rewarding staff through recognition and empowerment; being a
responsible corporate citizen; adopting environmental friendly practices and adding superior
value to shareholders".
Commercial bank
"To be the most technologically advanced, innovative and customer friendly financial services
organization in Sri Lanka, poised for further expansion in South Asia".
{Compare with the previously discussed ‘mission’ of the same institution - Providing reliable,
innovative, customer friendly financial services, utilizing cutting edge technology and focusing
continuously on productivity improvement whilst developing our staff and acquiring necessary
expertise to expand locally and regionally"}.
51
Establishing Goals and Objectives
The terms Goals and Objectives are often used interchangeably. However some writers identify
differences between goals and objectives.
Goals – are relatively long-term and less specific targets that a company wants to accomplish.
Objectives – are relatively short-term and more specific targets that the want to accomplish.
The role of goals/objectives:
•
•
•
Setting goals/objectives help converting the strategic Vision into specific performance
targets
Unless an organization’s long-term direction is translated into specific performance targets
and managers are pressured to show progress in reaching these targets, Vision and Mission
statements are likely to end up as nice words, window dressing, and unrealized dreams
For objectives to function as yardsticks of organizational performance and progress they
must be stated in quantifiable, or measurable, terms and they must contain time lines for
achievement. They have to spell out how much of what kind of performance by when. This
means avoiding generalities like “maximize profits”, “Reduce cost”.
Types of objectives
They are two types of objectives:
•
•
Strategic Objectives
Financial Objectives
Strategic objectives
“Those related to strategic performance”.
Need to be customer oriented, competitor-focused, and process centric, often aiming at creating a
superior competitive position in the industry and pursuing customer satisfaction as a vehicle for
financial success.
Examples:
-
A bigger market share
Innovations quickly than rivalry
Higher product quality than rivals
Lower cost costs relatives to key competitors
A stronger brand name than rivals
52
Financial Objectives
“Those related to financial Performance”
Examples:
-
Growth in revenue
Growth in earnings
Bigger profits margin
Higher returns on invested capital
Attractive economic value added performance
Stronger cash flows
A rising stock price
It is generally considered good objectives need to conform to the commonly used acronym
SMART criteria. The SMART criteria (an important concept that you should try to remember
and apply in examinations) are summarized below:
•
Specific - the objective should state exactly what is to be achieved.
•
Measurable - an objective should be capable of measurement – so that it is possible to
determine whether (or how far) it has been achieved.
•
Achievable - the objective should be realistic given the circumstances in which it is set and
the resources available to the business.
•
Relevant - Congruent with the mission.
•
Time Bound - objectives should be set with a time-frame in mind. These deadlines also
need to be realistic.
The need for Long-Range (Goals) and short-Range (Objectives)
•
Organizations need to establish both long-range goals and short-range objectives.
•
A strong commitment to achieving long-range objectives forces managers to begin taking
actions now to reach desired performance levels later. A company that has set itself a goal of
doubling its sales within five years cannot wait until the third or fourth year of its five-year
strategic plan to begin growing its sales and customer base. It need to support such long term
goals by establishing say realistic, challenging annual objectives that form milestones of the
journey towards the realization of the goals.
•
Objectives are needed at all organizational levels Objective setting does not stop when
company performance targets agreed on. Company objectives must be broken down in to
performance targets for each of the organization’s separate businesses, product lines,
functional areas, and departments need for top-down objective setting.
53
•
A top-down process of setting companywide performance targets first and then insisting that
the financial and strategic performance targets established for business units, divisions,
functional departments and operating units.
Chapter Summary
Setting a strategic direction for the organization takes place with an intimate understanding of the
salient features that was identified in the strategy analysis stage and summarized through a
SWOT analysis template. Formulation of a mission to guide the scope of the business and the
role of the vision as an inspirational and an ultimate goal were discussed. The hierarchy of a
company’s desired end results are further expressed through goals and objectives. When an
organization formulates goals and objectives, companies take a more appropriate ‘stakeholder’
perspective extending beyond the traditional and narrow shareholder interests. Social and ethical
responsibilities are imperatives and even responsibility towards our broader environment is to be
preferably considered when formulating the desired end results and strategy, in the present
context where organizations strive towards sustainability.
54
Chapter 4
Strategic Choice and Strategy Formulation
Learning Objectives
After studying this chapter, you should be able to:
•
Understand the relevance between the differences of strategy formulation at corporate
and business levels.
•
Explain the application of Porter’s generic strategy, being the main model of competitive
strategy within the ambit of ‘market- based’ approach.
•
Understand and apply ‘strategy clock’ as a mechanism of expanding of business level
strategic choices.
•
Explain the scope of corporate level strategy and application of BCG/GE matrixes to
understand the composition and characteristics of SBUs that constitute the corporate level
of a multi-business unit situation.
•
Advise the pursuit of growth through the application of Ansoff’s growth matrix including
the initiatives for diversification.
•
Understand the difference between ‘organic’ and ‘M&A’ growth and relevance of a range
of methods available for achieving growth and explain their relative advantages and
possible drawbacks.
•
Understand the different approaches between the strategies for market leaders and
followers.
•
Understand the value of ‘Blue Ocean’ thinking approach for making more innovative and
creative strategy making.
•
Understand the practical relevance of Henry Mintzberg’s concept of emergent strategy.
Strategy formulation at different ‘levels’
As we have discussed in the opening chapter, the strategy is to be considered at different levels
and in case of a multi- business environment with several business units, clearly we can discern
strategies at ‘business’ level and ‘corporate’ level. Hence when studying strategy formulation
we need to differentiate strategy making at these different levels.
55
Formulating Business Level Strategies
Business level strategy is usually referred to as ‘competitive strategy’ because this refers to a
strategy in a particular SBU and as product market scope for the business is already determined
the emphasis is how best the business can get and sustain advantage over the competitors.
As before formulating a strategy, a critical analysis is an essential prerequisite, students will have
to bear in mind the importance of a good strategic analysis. In chapter 2 this subject was
discussed in detail and the findings of such an analysis culminate with what we usually refer to
as a SWOT analysis. For student convenience part of this section is reproduced below to enable
continuity of the subject matter.
SWOT Analysis
A complete awareness of the organisation’s external environment and its internal capacities is
necessary for a rational consideration of future strategy, but it is not sufficient. The threads must
be drawn together so that potential strategies may be developed and assessed. The most common
way of doing this is to analyse the factors into strengths, weaknesses, opportunities and
threats. Strengths and weaknesses are diagnosed by the internal environmental analysis,
opportunities and threats by the External environmental analysis. This phase was discussed at
length in chapter 2.The findings of this comprehensive analysis will unearth the relevant and key
strengths and weakness on the one hand and the opportunities and threats confronting the
organisation on the other.
Referred to by the popular acronym SWOT it 'a critical assessment of the key strengths and
weaknesses, opportunities and threats in relation to the internal and External environmental
factors affecting the entity, in order to establish its condition prior to the preparation of a longterm plan.
Strengths: Internal attributes of the organization those are helpful to achieving the objective.
Weaknesses: Internal attributes of the organization those are constraining achievement of the
objective.
Opportunities: external conditions those are helpful or positive towards achieving the objectives.
Threats: external conditions which could act negatively or damage to the business's performance.
At this juncture it is quite relevant to point out that the analyst need to exercise caution not to get
to much immersed with all possible SWOT factors because in the contemporary, complex
business world there could be several strengths, weaknesses opportunities and threats that one
might come across during a strategic analysis. The skill here is to identify the relevant and key
SWOT factors and once identified under the respective categories, to rank them in order of their
relative importance. This would enable the strategist to work with few but the most pertinent
SWOT factors so that the strategy would be built on key and salient strategic issues of the
56
organization. Such is the creativity that is demanded when formulating strategy. Strategic issues
being multi faceted and multi functional in composition, this analysis need to be performed
preferably by a cross-functional team or a task force that represents a broad range of
organizational dimensions. For example, a SWOT team may include a marketing specialist, the
head of manufacturing/operations and a financial expert thereby representing the capability of
integrating many vital perspectives in formulating a strategy. After all a strategy is cohesive plan
of action for the entire origination and must guide unify all functions towards a achievement of
its strategic and financial objectives.
The finalized SWOT consisting of the summary of key Strengths, Weaknesses, Opportunities
and Threats can now be used to guide strategy formulation.
Equipped with this summary of key SWOT factors the team may address many aspects in the
creative phase of strategy formulation such as;
How can we utilize key a strength such as a core competence to strategic advantage and
what are ways we can manage a key identified weakness without allowing it to be a
disadvantage in the company’s strategy? Further how can we exploit a key opportunity such as
emerging societal trend or how can we defend against an emerging environmental threat that
could harm our strategic advantages.
The popular TOWS matrix as shown below is an approach used by some strategists to illustrate
how the key opportunities and threats facing an organization can be matched with the key
internal strengths and weaknesses that could result possible strategic alternatives.
Figure 4.1: TOWS Matrix
57
Example
Match Strengths with market Opportunities
Strengths which do not match any available opportunity are of limited use while opportunities
which do not have any matching strengths are of little immediate value.
Or alternatively it could be to generate strategies that deploy the strengths to avoid some critical
threats facing the organisation.
However TOWS matrix is only one approach to guide generating alternative strategic options
and it is necessary to understand that formulating a competitive strategy is such a creative and a
complex process that should ideally be predominated with ‘strategic thinking’ synthesizing
many key strategically relevant variables, as opposed to limiting and constraining such effort
through model based somewhat mechanistic approaches.
Competitive advantage is anything which gives one organisation an edge over its rivals. Michael
Porter an eminent authority in the field of strategy argues that a firm should adopt a competitive
strategy which is intended to achieve some form of competitive advantage for the firm.
Competitive strategy means taking offensive or defensive actions to create a dependable
position in an industry, to cope successfully with the competitive forces and thereby yield a
superior return on investment for the firm. Firms have discovered many different approaches to
this end, and the best strategy for a given firm is ultimately a unique construction reflecting its
particular circumstances'. (Porter 1980).
The choice of competitive strategy
A firm positions itself by leveraging its strengths. Michael Porter has argued that a firm's
strengths ultimately fall into one of two headings: cost advantage and differentiation. By
applying these strengths in either a broad or narrow scope, three generic strategies result: cost
leadership, differentiation, and focus. These strategies are applied at the business unit level.
They are called generic strategies because they are not firm or industry dependent.
Cost leadership means adopting a business strategy striving to become the lowest cost
producer and a presence over a larger scope in the market or the industry.
Differentiation is a business strategy in pursuit to create uniqueness that is valued by the
customers in a particular market and when applied over a larger scope of the market/industry
Focus involves a restriction of activities to only a narrow scope of the market (a segment) by
either
58
•
•
Providing goods and/or services at lower cost (Cost-focus).
Providing a unique product or service (Differentiation-focus).
The following table illustrates Porter's generic strategies:
Competitive
Advantage
Product
Uniqueness
Low Cost
Target
Scope
Broad
(Industry Wide)
Cost
Strategy
Narrow
(Market Segment)
Focus
Strategy
(low cost)
Leadership
Differentiation
Strategy
Focus
Strategy
(differentiation)
Figure 4.2-Porter’s Generic Strategies
Cost leadership and differentiation are industry-wide strategies. Focus involves segmentation but
involves pursuing, within the segment only, a strategy of Cost Leadership or Differentiation.
Cost leadership
A cost leadership strategy seeks to achieve the position of lowest-cost producer in the industry
as a whole. By producing at the lowest cost, the manufacturer can effectively compete on price
with every other producers in the industry, and earn superior profits.
59
In the event of a price war, the firm can maintain some profitability while the competition suffers
losses. Even without a price war, as the industry matures and prices decline, the firms that can
produce more cheaply will remain profitable for a longer period of time. The cost leadership
strategy usually targets a broad market.
Possible avenues to achieve overall Cost Leadership
•
Set up production facilities to obtain economies of scale.
•
Use the latest technology to reduce costs and/or enhance productivity (or use cheap
labour if available).
•
In high technology industries, and in industries depending on labour skills for product
design and production methods, exploit the learning curve effect. By producing more
items than any other competitor, a firm can benefit more from the learning curve, and
achieve lower average costs.
•
Concentrate on improving productivity.
•
Minimise overhead costs.
•
•
Get favourable access to sources of supply.
Efficient distribution channels
Each generic strategy has its risks, including the low-cost strategy. For example, other firms may
be able to lower their costs as well. As technology improves, the competition may be able to
leapfrog the production capabilities, thus eliminating the competitive advantage.
Differentiation
A differentiation strategy calls for the development of a product or service that offers unique
attributes that are valued by customers and that customers perceive to be better than or different
from the products of the competition. The value added by the uniqueness of the product may
allow the firm to charge a premium price for it. The firm hopes that the higher price will more
than cover the extra costs incurred in offering the unique product. Because of the product's
unique attributes, if suppliers increase their prices the firm may be able to pass along the costs to
its customers who cannot find substitute products easily.
Firms that succeed in a differentiation strategy often have the following internal strengths:
•
•
•
•
Access to leading scientific research.
Highly skilled and creative product development team.
Strong sales team with the ability to successfully communicate the perceived strengths of
the product.
Corporate reputation for quality and innovation.
60
Focus (or niche) strategy
In a focus strategy, a firm concentrates its attention on one or more particular segments or
niches of the market, and does not try to serve the entire market with a single product. The
premise is that the needs of the group can be better serviced by focusing entirely on it. A firm
using a focus strategy often enjoys a high degree of customer loyalty, and this entrenched loyalty
discourages other firms from competing directly.
A cost-focus strategy: aim to be a cost leader for a particular segment.
A differentiation-focus strategy: pursue differentiation for a chosen segment. Luxurious goods
with extremely unique attributes are the prime examples of such a strategy.
Advantages
•
•
A niche is more secure and a firm can insulate itself from competition.
The firm does not spread itself too thinly.
Drawbacks of a focus strategy
•
•
•
The firm sacrifices economies of scale which would be gained by serving a wider market.
Competitors can move into the segment, with increased resources (e.g. the Japanese moved
into the US luxury car market, to compete with Mercedes and BMW).
The segment's needs may eventually become less distinct from the main market.
Which strategy?
A Combination of Generic Strategies
Stuck in the Middle?
These generic strategies are not necessarily compatible with one another. If a firm attempts to
achieve an advantage on all fronts, in this attempt it may achieve no advantage at all. For
example, if a firm differentiates itself by supplying very high quality products, it risks
undermining that quality if it seeks to become a cost leader. Even if the quality did not suffer, the
firm would risk projecting a confusing image. For this reason, Michael Porter argued that to be
successful over the long-term, a firm must select only one of these three generic strategies.
Otherwise, with more than one single generic strategy the firm will be "stuck in the middle" and
will not achieve a competitive advantage.
Porter argued that firms that are able to succeed at multiple strategies often do so by creating
separate business units for each strategy. By separating the strategies into different units having
different policies and even different cultures, a corporation is less likely to become "stuck in the
middle".
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However, there exists a viewpoint that a single generic strategy is not always best because within
the same product customers often seek multi-dimensional satisfactions such as a combination of
quality, style, convenience, and price. There have been cases in which high quality producers
faithfully followed a single strategy and then suffered greatly when another firm entered the
market with a lower-quality product that better met the overall needs of the customers.
The strategy clock
Porter's basic concept of generic strategies has been the subject of further discussion. Johnson
and Scholes, quoting Bowman, describe the strategic options on the strategy clock.
Figure 4.3: The Strategy Clock
Price-based strategies
Strategies 1 and 2 are price-based strategies.
(a) A no frills strategy is aimed at the most price-conscious and can only succeed if this segment
of the market is sufficiently large. This strategy may be used for market entry, to gain
experience and build volume. This was done by Japanese car manufacturers in the 1960s.
(b) A low price strategy offers better value than competitors. This can lead to price war and
reduced margins for all. Porter's generic strategy of cost leadership is appropriate to a firm
adopting this strategy.
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Differentiation strategies
Strategies 3, 4 and 5 are all differentiation strategies. Each one represents a different trade-off
between market share (with its cost advantages) and margin (with its direct impact on profit).
Differentiation can be created in three ways.
•
•
•
Product features
Marketing, including powerful brand promotion
Core competences
The pursuit of any differentiation strategy requires detailed and accurate market intelligence. The
customers and their preferences must be clearly identified, as must the competition and their
likely responses. The chosen bases for differentiation should be inherently difficult to imitate,
and will probably need to be developed over time.
The hybrid strategy seeks both differentiation and a lower price than competitors. The cost base
must be low enough to permit reduced prices and reinvestment to maintain differentiation. This
strategy may be more advantageous than differentiation alone under certain circumstances.
•
•
•
•
If it leads to growth in market share.
If differentiation rests on core competences and costs can be reduced elsewhere.
If a low price approach is suited to a particular market segment.
Where it is used as a market entry strategy.
The basic differentiation strategy comes in two variants, depending on whether a price premium
is charged or a competitive price is accepted in order to build market share.
Strategy of focussed differentiation seeks a high price premium in return for a high degree of
differentiation. This implies concentration on a well defined and probably quite restricted market
segment.
Failure strategies
Combinations 6, 7 and 8 are likely to result in failure.
Option six - increased price/standard
• Higher margins if competitors do not value follow/risk of losing market share.
Option seven - increased price/low values
• Only feasible in a monopoly situation.
Option eight - low value/standard price
• Loss of market share.
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Corporate Level Strategy
Corporate Level strategy, as mentioned earlier is applicable in a multi-business unit scenario and
the type and the scope of the decisions and matters dealt with include;
•
•
•
•
•
•
The overall corporate mission and objectives.
The analysis of the portfolio of businesses to understand their relative attractiveness
The growth, stability or reduction/close of different business units or their levels of
exposure towards corporate portfolio.
The performance analysis and management.
Transfer of resources, co-ordination between the different business units and promote
synergistic advantages for the group as a whole such as by building core competencies in
areas such as say IT development, as an example of such an initiative
Whether the group will expand in to related or unrelated areas of business as well as
whether the growth will be achieved by methods such as ‘organic’ growth or M & A route
to growth.
Strategy analysis at the corporate level
Previously discussed the BCG Growth Share Matrix (BCG) and its more improved version The
General Electric Business Screen (GEBS) greatly assist the strategic managers at the corporate
level to understand the strategic characteristics of different SBUs comprising the corporate level.
Such understanding gained through these analytical models are quite useful in relevant decision
making at this top level such as in allocating the limited corporate resources among the needs
of different SBUs constituting the corporate portfolio.
Product-Market Strategies, Direction of Growth and Ansoff’s Growth Matrix
Product-Market is a commonly used term that denotes the products/services a firm markets
and the market (segments) that it sells them to.
Ansoff’s Product – Market matrix
In 1960’s Ansoff drew up a growth- vector matrix that became to be one of the most widely
used analytical frameworks in marketing and strategy. The diagram simply charts the scope of a
firm's activities in terms of ‘existing ’ and ‘new’ markets in one axis and ‘existing’ and ‘new’
products in the other. The value of this chart is that it can indicate the potential avenues that it
can pursue growth and hence how a firm can approach growth.
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Ansoff’s Product – Market matrix
Existing
Market
Penetration
Market
Development
Product
New
Product
Development
Diversificatio
n
Existing
New
Market
Products/ Markets
Related
Unrelated
Figure 4.4: Ansoff’s Growth Matrix
Technically as per this matrix a firm could envisage possible growth options under the following
categories.
Current products and current markets: market penetration
Market penetration - The firm seeks to do four things.
(a) Maintain or to increase its share of current markets with current products, eg through
competitive pricing, advertising, sales promotion.
(b) Secure dominance of growth markets.
(c) Restructure a mature market by driving out competitors.
(d) Increase usage by existing customers (eg air miles, loyalty cards).
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This is a relatively low risk strategy since it requires no capital investment. As such it is
attractive to the unadventurous type of company.
Present products and new markets: market development
Market development is the process by which the firm seeks new markets for its current products.
There are many possible approaches. Here are some examples.
(a) New geographical areas and export markets (e.g. a radio station building a new
transmitter to reach a new audience).
(b) Different package sizes for food and other domestic items so that both those who buy in
bulk and those who buy in small quantities are catered for.
(c) New distribution channels to attract new customers (e.g. organic food sold in
supermarkets not just specialist shops
(d) Differential pricing policies to attract different types of customer and create new market
segments. For example, travel companies have developed a market for cheap long-stay
winter breaks in warmer countries for retired couples.
This approach to strategy is also low in risk since it also requires little capital investment.
New products and present markets: product development
Product development is the launch of new products to existing markets. This has several
advantages.
(a) The company can exploit its existing marketing arrangements such as promotional methods
and distribution channels at low cost.
(b) The company should already have good knowledge of its customers and their wants and
habits.
(c) Competitors will be forced to respond.
(d) The cost of entry to the market will go up.
This strategy is riskier than both market penetration and market development since it is likely to
require major investment in the new product development process and, for physical products, in
suitable production facilities.
New products: new markets (diversification)
Diversification occurs when a company decides to make new products for new markets. It
should have a clear idea about what it expects to gain from diversification.
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(a) Growth. New products and new markets should be selected which offer prospects for
growth which the existing product-market mix does not.
(b) Investing surplus funds not required for other expansion needs, bearing in mind that the
funds could be returned to shareholders. Diversification is a high risk strategy, having
many of the characteristics of a new business start-up. It is likely to require the deployment
of new competences.
Related diversification
Related diversification is 'development beyond the present product market, but still
within the broad confines of the industry ... [it] ... therefore builds on the assets or
activities which the firm has developed' (Johnson and Scholes). It takes the form of
vertical or horizontal integration.
Horizontal integration is to development into activities which are competitive with or directly
complementary to a company's present activities.
Vertical integration occurs when a company seeks to gain ownership of its supply or input
sources or in its output/distribution. One such option under vertical integration is backward
integration which would occur where a milk processing business acquires its own dairy farms
rather than buying raw milk from independent farmers. If a manufacturer of synthetic yarn began
to produce shirts from the yarn instead of selling it to other shirt manufacturers, such a growth
option could be described as forward integration. Vertical integration has its greatest potential
for success when the final customer's needs are not being properly satisfied. For example if there
is potential for improving the satisfaction of the end user by improving the links in the value
system, them an integration strategy may succeed. Examples would be where there is a premium
on speed, as in the marketing of fresh foodstuffs, or when complex technical features require
great attention to quality procedures.
Advantages of vertical integration
•
•
•
•
•
A secure supply of components or materials, hence lower supplier bargaining power.
Stronger relationships through better co-ordination with the final consumer of the
product e.g. improved scheduling ensuring steady supply of products in time as well as
better quality control of final output achieved, when backwardly integrated.
A share of the profits at all stages of the value chain.
More effective pursuit of a differentiation strategy.
Creation of barriers to entry.
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Disadvantages of vertical integration
(a) Overconcentration. A company places 'more eggs in the same end-market basket'
(Ansoff). Such a policy is fairly inflexible, more sensitive to instabilities and increases the
firm's dependence on a particular aspect of economic demand.
(b) Reduced flexibility to change partners. This occurs when the vertically integrated
enterprise does not perform well as the firm will not be able to easily change partners there
by introducing some rigidity.
(c) If the firm fails to benefit from any economies of scale or technical advances in the
industry into which it has diversified.
(d) Possible disadvantages when integrated into industries where technology could change
rapidly.
Unrelated diversification
Unrelated (or conglomerate) diversification 'is development beyond the present
industry into products/ markets which, at face value, may bear no close relation to the
present product/market.'
Conglomerate diversification can be observed in practice. It has been a key strategy for
companies in Asia, particularly South Korea.
Advantages of conglomerate diversification
(a)
Risk-spreading. Entering new products into new markets offers protection against the
failure of current products and markets.
(b)
High profit opportunities. An improvement of the overall profitability and flexibility
of the firm through acquisition in industries which have better economic characteristics
than those of the acquiring firms.
(c) Better access to capital markets.
(d) Use surplus cash.
(e) Exploit under-utilised resources.
(h) Other possible financial advantages (such as accumulated tax losses).
(i) Use a company's image and reputation in one market to develop into another where
corporate image and reputation could be vital ingredients for success.
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Disadvantages of conglomerate diversification
(a)
The dilution of shareholders' earnings if diversification is into growth industries with
high P/E ratios.
(b)
Lack of a common identity and purpose in a conglomerate organisation. A
conglomerate will only be successful if it has a high quality of management and financial
ability at central headquarters, where the diverse operations are brought together.
(c)
Failure in one of the businesses will drag down the rest, as it will eat up resources.
(d)
Lack of management experience. Japanese steel companies have diversified into areas
completely unrelated to steel such as personal computers, with limited success.
(e)
Poor for shareholders. Shareholders can spread risk quite easily, simply by buying a
diverse portfolio of shares. They do not need management to do it for them.
Diversification and synergy
Concept of Synergy often expressed as the 2+2=5 effect, means combined results produce a
better rate of return than would be achieved by the same resources used independently. Synergy
is often used to justify diversification.
Obtaining synergy
(a) Marketing synergy: use of common marketing facilities such as distribution channels,
sales staff and administration, and warehousing. For example the AA offers loans to
customers as well as breakdown services.
(b) Operating synergy: arises from the better use of operational facilities and personnel,
bulk purchasing, a greater spread of fixed costs whereby the firm's competence can be
transferred to making new products. For example, although there is very little in common
between sausages and ice cream, both depend on a competence of refrigeration.
(c) Investment synergy: The wider use of a common investment in fixed assets, working
capital or research, such as the joint use of plant, common raw material stocks and
transfer of research and development from one product to another
(d) Management synergy: the advantage to be gained where management skills concerning
current operations are easily transferred to new operations because of the similarity of
problems in the two industries.
Strategies
Methods of Strategy Development
Having discussed and concerned with the strategic choices at business and corporate levels
within this broad steer , we discussed the number of different options concerning the direction
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of such strategic options (products and markets) assisted by the famous Ansoff’s growth matrix.
It is now necessary to discuss the methods ( such as through ‘Organic’ growth or M& A options
such as joint ventures or franchising for example) of developing specific strategies.
Alternative Growth Strategies (Methods of growth)
•
Organic growth (Internal Development).
•
•
•
•
Building up new businesses from scratch and developing them.
Acquiring already existing businesses from their current owners.
Merger of two or more separate businesses.
Alliances
Strategic alliances
Joint ventures
Consortia
Licensing Agreement
Subcontracting
Franchising
Organic growth
Organic growth (sometimes referred to as internal development or internal expansion) is the
primary method of growth for many organisations, for a number of reasons. Organic growth is
achieved through the development of internal resources such as retention of earnings or rising of
new finance (equity and/ or debt) to fund growth.
Reasons for pursuing organic growth
(a)
Learning. The process of developing a new product gives the firm the best understanding
of the market and the product.
(b)
Innovation. It might be the only sensible way to pursue genuine technological
innovations, and exploit them. (Compact disk technology was developed by Philips and
Sony, who earn royalties from other manufacturers licensed to use it.)
(c)
There is no suitable target for acquisition.
(d)
Organic growth can be planned more meticulously and offers little disruption.
(e)
It is often more convenient for managers, as organic growth can be financed easily from
the company's current cash flows, without having to raise extra money.
(f)
The same style of management and corporate culture can be maintained.
(g)
Hidden or unforeseen losses are less likely with organic growth than with acquisitions.
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(h)
Economies of scale can be achieved from more efficient use of central head office
functions such as finance, purchasing, personnel, management services etc.
Problems with organic growth
(a)
Time - sometimes it takes a long time to descend a learning curve.
(b)
Barriers to entry (e.g. distribution networks) are harder to overcome: for example a
brand image may have to be build up from scratch.
(c)
The firm will have to acquire the resources independently.
(d)
Organic growth may be too slow for the dynamics of the market.
Organic growth is probably ideal for market penetration, and suitable for product or market
development, but it might be a problem with extensive diversification projects.
Mergers and Acquisitions (M & As)
Although often used synonymously, the terms merger and acquisition mean slightly different
things. When one company takes over another and clearly establishes itself as the new owner, the
purchase is called an ‘acquisition’. From a legal point of view, the target company ceases to
exist, the buyer "swallows" the business and the buyer's stock continues to be traded.
A merger happens when two firms agree to go forward as a single new company rather than
remain separately owned and operated. This kind of action is more precisely referred to as a
"merger of equals" as the firms are often of about the same size. Both companies' stocks are
surrendered and new company stock is issued in its place. For example, in the 1999 merger of
Glaxo Welcome and SmithKline Beecham, both firms ceased to exist when they merged, and a
new company, GlaxoSmithKline, was created.
E.g. Cargill’s acquisition of Kotmale
Sri Lankan Government Acquisition of Shell gas
Sri Lanka Telecom acquisition of Mobitel
Hayley’s’ acquisition of Ceylon Intercontinental Hotel/Amaya Resort/ Hunas
Falls hotel
Mergers- e.g.: Bank Merger -Sri Lanka's six regional development banks merge in to one
development Bank (Sabaragamuwa Development Bank (SDB), The Uva Development Bank,
Rajarata Development Bank, Ruhuna Development Bank, Wayamba Development Bank and
Kandurata Development Bank).
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The Reasons behind M& A s
(a) Marketing advantages
•
•
•
•
Buy in a new product range
Buy a market presence (especially true if acquiring a company overseas)
Unify sales departments or to rationalise distribution and advertising
Eliminate competition or to protect an existing market
(b) Production advantages
•
•
•
•
•
Gain a higher utilisation of production facilities
'Buy in' technology and skills
Obtain greater production capacity
Safeguard future supplies of raw materials
Improve purchasing by buying in bulk
(c) Finance and management
•
•
•
•
Buy a high quality management team, which exists in the acquired company
Obtain cash resources where the acquired company is very liquid
Gain undervalued assets or surplus assets that can be sold off
Obtain tax advantages (e.g. purchase of a tax loss company)
(d) Risk-spreading
(e) Independence. A company threatened by a take-over might take over another company, just
to make itself bigger and so a more expensive target for the predator company.
(f) Overcome barriers to entry
Many acquisitions do have logic, and the acquired company can be improved with the
extra resources and better management. Furthermore, much of the criticisms of takeovers
have been directed more against the notion of conglomerate diversification as a strategy
rather than takeover as a method of growth.
Problems with Acquisitions and Mergers
(a)
Cost. They might be too expensive, especially if resisted by the directors of the target
company. Proposed acquisitions might be referred to the government under the terms of
anti-monopoly legislation.
(b)
Customers of the target company might resent a sudden takeover and consider going to
other suppliers for their goods.
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(c)
Incompatibility. In general, the problems of assimilating new products, customers,
suppliers, markets, employees and different systems of operating might create 'indigestion'
and management overload in the acquiring company. The difficulty of integrating separate
organisational cultures has resulted in serious problems in several mergers.
(d) Driven by the personal goals of the acquiring company's managers, as a form of sport,
perhaps.
(e)
Corporate financiers and banks have a stake in the acquisitions process as they can
charge fees for advice.
(f)
Poor success record of acquisitions. Takeovers benefit the shareholders of the acquired
company often more than the acquirer.
(g)
Firms may not adequate attention of non-financial factors.
Joint development methods
Alliances - Two or more organizations share resources and activities to pursue strategies. There
are different forms of alliances. Some which dependent on formalized inter organizational
relationship and others which are much looser arrangements and informal networks between
organizations.
Examples:
i)
ii)
iii)
iv)
v)
vi)
Strategic alliances
Joint ventures
Consortia
Licensing Agreement
Subcontracting
Franchising
Strategic Alliances
Strategic Alliance is a cooperative agreement between actual or potential competitors.
Examples
Mercantile Merchant Bank (Ltd.) (MMBL), has formed a new strategic alliance with the Aitken
Spence Group by selling them a fifty percent stake in its subsidiary, MMBL Money Transfer
(Pvt) Ltd.
A strategic alliance between Lake House Printers and Publishers Plc (LHPPP), a leading security
printer in Sri Lanka and Manipal Press Ltd, India’s largest private sector printing company
Reasons for developing alliances by companies:
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•
•
•
•
Strategic alliances may facilitate entry into a foreign market.
Strategic alliances allow companies to share the fixed costs and associated risks that arise
from the development of new products or processes.
Alliances bring together complementary skills and assets that neither company could
develop on its own.
Alliances help companies to set technological standards for their industry.
Possible sources of drawbacks of strategic Alliances
• Company risks giving away technological know- how to the competitor and the competitor
gets a low-cost route to acquiring new technology.
• A potential competitor gets a low-cost route to gaining market access.
Factors contributing to success of a strategic alliance
•
•
•
•
•
The need to do a careful selection of the alliance partner paying close attention to its
reputation.
Need to build trust and informal communication networks between partners.
The partner must be able to help the company achieve its strategic goals through the
possession of capabilities that the company lacks but values.
Need to take pro-active steps to learn from alliance partners.
It is necessary to structure the alliance so as to avoid an unintended transfer of technical
know-how. The Alliance must be structured in a way that reduces the risks of a company
giving too much away to its alliance partner, without getting anything in return.
Joint Ventures
Which involve two or more organizations setting up a newly created organization and the
sponsoring organizations remains independent. Each has a share in both the equity and the
management of the business. This form of alliance is often used where organization want to enter
new markets.
E.g: stretch line-is a three way joint venture between Stretchline (U.K), MAS Holdings Sri
Lanka and Brandot international Ltd U.S.A.
Advantages of Joint ventures
(a)
Share costs -As the capital outlay is shared, joint ventures are especially attractive to
smaller or risk-averse firms, or where very expensive new technologies are being
researched and developed (such is the civil aerospace industry).
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(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
Reduce risk -A joint venture can reduce the risk of government intervention if a local
firm is involved.
Participating enterprises benefit from all sources of profit.
Close control over marketing and other operations.
Overseas joint ventures provide local knowledge, quickly.
Synergies. One firm's production expertise can be supplemented by the other's marketing
and distribution facility.
Learning. Alliances can also be a 'learning' exercise in which each partner tries to learn
as much as possible from the other.
Technology. New technology offers many uncertainties and many opportunities. Such
alliances provide funds for expensive research projects, spreading risk.
The alliance itself can generate innovations.
The alliance can involve 'testing' the firm's core competence in different conditions,
which can suggest ways to improve it.
Disadvantages of joint ventures
(a)
Conflicts of interest between the different parties.
(b)
Disagreements may arise over profit shares, amounts invested, the management of the
joint venture, and the marketing strategy.
(c)
One partner may wish to withdraw from the arrangement.
Consortia
Is a short-term legal entity and will usually be focused on projects with sunk cost from each of
the partner and which terminate at the end of the project.
E.g. A deal to build a container terminal in an expanded Colombo port -a China and Sri Lanka
consortium.
A Licensing agreement is a commercial contract whereby the licenser gives something of value
to the licensee in exchange for certain performances and payments.
(a)
The licenser may provide rights to produce a patented product or to use a patented process
or trademark as well as advice and assistance on marketing and technical issues.
(b)
The licenser receives a royalty.
Subcontracting is also a type of alliance. Co-operative arrangements also feature in supply
chain management, JIT and quality programmes.
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Franchising is a method of expanding the business on less capital than would otherwise be
possible. For suitable businesses, it is an alternative business strategy to raising extra capital
for growth. Franchisers include, Express Dairy, Holiday Inn, KFC, even McDonald's. The
franchiser and franchisee each provide different inputs to the business.
(a) The franchiser
•
•
•
Name, and presumably enormous brand image and goodwill associated with it.
Systems and business methods.
Support services, such as advertising, training and help with site decoration.
(b) The franchisee
•
Capital, personal involvement and local market knowledge.
•
Payment to the franchiser for rights and for support services.
•
Responsibility for the day-to-day running within and maintaining the standard operating
procedures of the business model and the ultimate profitability of the franchise.
Disadvantages of franchising
•
The search for competent candidates is both costly and time consuming where the
franchiser requires many outlets requiring large capital and resource commitments (e.g.
McDonald's in the UK).
•
Control over franchisees (McDonald's franchises in New York recently refused to cooperate in a marketing campaign).
Strategy and Market Position
So far in this chapter we have considered the broader aspects of strategy as they affect the overall
stance of the organisation. In this section we will examine some of the options that apply most
appropriately to the strategic management of individual products or brands. An appreciation of
scale is important when considering strategy.
Strategies for market leaders
PIMS research has revealed the advantages of being the market leader. A company in this
position may try to do three things.
(a)
Expand the total market by seeking increased usage levels; and new uses and users.
These aims correspond to market penetration and market development.
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(b)
Protect the current market share. The most common way of doing this is by means of
continuous product innovation, reducing costs and selling price.
(c)
Expand market share. This may be pursued by enhancing the attractiveness of the
product offering in almost any way, including increased promotion, aggressive pricing and
improved distribution.
Strategies for market challengers
The market challenger seeks to build market share in the hope of eventually overtaking the
existing leader. However, this does not necessarily mean attacking the market leader head-on.
This is a risky strategy in any case, because of the leader’s resources in cash, promotion and
innovation. Instead, the challenger may attack smaller regional firms or companies of similar
size to itself that are vulnerable through lack of resources or poor management. They can use
following strategies;
•
•
•
•
•
•
•
Manufacturing cost reduction strategy: A Company can use its lower costs to price more
aggressively.
Product Innovation Strategy: By continuously introducing innovations, a company can
attack the leader’s position.
Product proliferation strategy: The challenger can attack the leader by offering a wider
product range thereby giving customers a wider choice.
Improved service strategy.
Distribution innovation Strategy: On line purchasing system of Keells Super markets.
Intensive advertising/Promotion.
Pricing strategy: A market challenger can launch a higher-quality product and charge a
higher price than the leader.
Strategies for market followers
The market follower accepts the status quo and thus avoids the cost and risk associated with
innovation in product, price or distribution strategy. Such a me-too strategy is based on the
leader’s approach. This can be both profitable and stable. However, to be consistently successful,
such a strategy must not simply imitate. The follower should compete in the most appropriate
segments, maintain its customer base and ensure that its turnover grows in line with the general
expansion of the market. It should be aware that it may constitute an attractive target for market
challengers. The follower must therefore control its costs and exploit appropriate opportunities.
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Strategies for market nichers
Avoiding competition by focusing on a niche is a profitable strategy for small firms generally
and for larger organisations where competition is intense. The key to a successful niche is
specialisation, but there are other considerations.
(a)
The chosen market must have some growth potential while being uninteresting to major
competitors.
(b)
The firm must be able to serve its customers sufficiently well to build up sufficient
goodwill to fend off any attacks.
It must be possible to build up sufficient size to be profitable and purchase efficiently.
(c)
Serving a single niche can be risky: a sudden change in the market can lead to rapid decline.
Multiple nicheing can overcome this problem.
Offensive and Defensive Strategies
Offensive strategies involve strategic moves that improve the firm's position relative to that of
rival firms in the industry. Following are some ways of using offensive strategies.
1) Frontal attack– This is the direct, head on attack meeting competitors with the same product
line, price, promotion, etc. Because attack is on the enemy’s strengths rather than weakness it
is considered the most risky and least advised strategy.
2) Flanking attack – The aim here is to engage competitors in those products markets where
they are weak or have no presence at all. Its overreaching goal is to build a position from
which to launch, an attack on the battlefield later.
3) Encirclement attack – Multi pronged attack aimed at diluting the defenders ability to
retaliate in strength. The attacker stands ready to block the competitor no matter which way
he turns the product market. Product proliferation supplying different types of the same
product to the market. Market encirclement consists of expanding the products into all
segments and distribution channels.
4) Bypass attack – This is the most indirect form of competitive strategy as it avoids
confrontation by moving into new and as yet uncontested fields. Three type of bypass are
possible; develop new products, diversify into unrelated products or diversify into new
geographical markets.
5) Guerrilla warfare – Less ambitious in scope, this involves making small attacks in different
locations whilst remaining mobile. Such attacks take several forms. The aim is to destabilize
the competitor by small attacks.
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Defensive strategies are those moves that reduce the ability of rival firm strategies to threaten the
firm's competitive strength or organizational resources. Following are some ways of using
defensive strategies.
1. Position defense – static defense of a current position, retaining current product markets by
consolidating resources within existing areas. Exclusive reliance on a position defense
effectively means that a business is a sitting target for competition.
2. Mobile defense – A high degree of mobility prevents the attackers’ chances of localizing the
defense and accumulating its forces for a decisive battle. A business should seek market
development, product development and diversification to create a stronger base.
3. Pre-emptive defense – Attack is the best form of defense. Pre-emptive defense is launched
in a segment where an attack is anticipated instead of moving into related or new segments.
4. Flank position defense – This is used to occupy a position of potential future importance in
order to deny that position to an opponent. Leaders need to develop and hold secondary
markets to prevent competitors from using them as a spring board into the primary market.
5. Counter offensive defense – This is attacking where the company is being attacked. This
requires immediate response to any competitor entering a segment or initiating new moves.
6. Strategic withdrawal- It might be the right decision to cease producing a product and/ or to
pull out of a market completely. This is a hard decision for managers to take if they have
invested or if the decision involves redundancies.
Blue Ocean and Red Ocean Strategies
Red Oceans are all the industries in existence today - the known market space. In the red oceans,
industry boundaries are defined and accepted, and the competitive rules of the game are known.
Here companies try to outperform their rivals to grab a greater share of product or service
demand. As the market space gets crowded, prospects for profits and growth are reduced.
Blue oceans, in contrast, denote all the industries not in existence today—the unknown market
space, untainted by competition. In blue oceans, demand is created rather than fought over. There
is ample opportunity for growth that is both profitable and rapid. In blue oceans, competition is
irrelevant because the rules of the game are waiting to be set. Blue Ocean is an analogy to
describe the wider, deeper potential of market space that is not yet explored.
The corner-stone of Blue Ocean Strategy is 'Value Innovation'. A blue ocean is created when a
company achieves value innovation that creates value simultaneously for both the buyer and the
company. The innovation (in product, service, or delivery) must raise and create value for the
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market, while simultaneously reducing or eliminating features or services that are less valued by
the current or future market.
Red Ocean Strategy
( Focus on Existing Customers)
Compete in Existing Market
Blue Ocean Strategy
( Focus on Non-Customers)
Create uncontested market to serve
Beat the Competition
Make the competition irrelevant
Exploit Exiting Demand
Create and Capture New Demand
Intended, Deliberate, Realized, and Emergent Strategies
Henry Mintzberg the prolific writer on strategy and his colleagues at McGill University
distinguish intended, deliberate, realized, and emergent strategies. The strategy conceived of by
the management team and the impetus for initial strategy implementation is referred to as
‘intended’ strategy. Even here, rationality is limited and the intended strategy is the result of a
process of negotiation, bargaining, and compromise, involving many individuals and groups
within the organization. However, ‘realized’ strategy is the he actual strategy that is implemented
and comes to fruition as a consequence of implementation and other internal and external factors
is only partly related to that which was intended.
Hence intended strategy is the desired strategic direction deliberately formulated or planned by
the managers or by the strategic leaders. The realized strategy is the strategy that is actually
being followed by an organization in practice. In practice strategic direction may emerge from
actions taken by the middle management and organizational routines rather than by strategy as
designed by the top management.
The primary determinant of realized strategy is what Henry Mintzberg terms emergent strategyA pattern of action that develops over time in an organization or in addition to what was
conceived of in the intended and deliberate strategies- the decisions that emerge from the
complex processes in which individual managers interpret the intended strategy and adapt to
changing external circumstances. Thus, the realized strategy is a consequence of deliberate
strategy. A plan of action, flowing from the intended strategy that an organization chooses and
implements to support its vision, mission, and goals.
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Deliberate Strategy
Intended Strategy
NonRealizedStrat
egies
Realized Strategy
Emergent
Strategies
Figure 4.5: Intended, Deliberate, Realised and Emergent Strategies
Chapter Summary
In the preceding chapter we discussed the structure and approach in conducting a ‘strategic
analysis’ for a given organizational situation. Such an analysis is broadly carried out under the
two main sections namely an ‘external’ and an ‘internal’ analysis. The idea is to get a
comprehensive and a systematic understanding of the pertinent variables that can impact possible
strategic courses of action. The key variables from such an analysis is summarized that is
typically referred to as a SWOT analysis and eventually form the basis on which a company will
proceed to make their strategic choices.
The section first discusses the strategic choices available at the ‘business level’ with a detailed
analysis of Prof Michael Porter’s generic strategy framework .The growth strategies are at the
centre stage of the ‘corporate level’ strategy discussion. The popular Ansoff’s growth share
matrix provides us with the necessary guidance to chart the variety of growth options including
the area of diversification. Various methods to implement growth are also discussed in this
section.
The concept of ‘Blue Ocean’ strategy is an area created heightened attention in strategy parlors
since introduction some years back. This innovative concept promotes creative strategic thinking
contrary to traditional thinking that effective strategy necessary entails countering intense
competition. Strategies for ‘market leaders’ and ‘market followers’ as much as offensive and
defensive strategies, are customary discussions in strategy domain being areas of immense
practical significance. The chapter concludes with a brief discussion on Henry Mintzberg’s
concept of emergent strategy.
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Chapter 05
Strategy Implementation
Learning Objectives
After studying this chapter, you should be able to:
•
•
•
•
•
•
•
•
•
•
Understand the term strategy implementation and the practical importance and difficulties
of strategy implementation.
Explain the composition and describe the host of the strategy implementation variables
discussed in the popular Mc Kinsey’s 7 S Framework.
Understand the importance of change management in an organisational setting and advice
on the conditions and challenges to successfully implementing and managing resistance
to such change.
Describe the role of organisational structure as an important strategy implementation
imperative and discuss the different structural options dictated by given organisational
situations.
Discuss the role of organisational culture as such a pervasive influencing factor in
implementing strategy.
Appreciate the role of policies, procedures and discuss the value of properly balanced
rewards in implementing strategy.
Explain the role and value of good leadership leading implementation and understand the
differences between a strategic leader and a manager.
Understand the value of benchmarking in the domain of strategy that could become
particularly handy in improving efficiencies when implementing strategy and applying
such knowledge of best practices in development of standards and processes.
Understand and explain the concept of re-engineering in a business context and the
rationale of business process re-engineering in implementing strategy and understand the
the principal steps involved in a re-engineering initiative.
Explain the role of IT/IS in improving strategy implementation capability in a variety of
ways and application of such knowledge through the some Porters models on strategy.
5.1 Introduction
Strategy implementation is the translation of chosen strategy into organizational action so as to
achieve strategic goals and objectives. Strategy implementation can also be described as the
manner in which an organization should develop, utilize, and amalgamate organizational
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structure, control systems, and culture to follow strategies that lead to competitive advantage and
a better performance.
Once the creative and analytical aspects of strategy formulation have been settled, the managerial
priority is one of converting the strategy into operationally effective action. Indeed, a strategy is
never complete, even as formulation until it gains a commitment of the organization’s resources
and becomes embodied in organizational activities. Therefore, to bring the result, the strategy
should be put to action because the choice of even the soundest strategy will not affect
organizational activities and achievement of its objectives. Therefore, effective implementation
of strategy is a must for the organization.
To successfully implement strategy, an organization needs to be equipped with a number of
variables, conditions and most importantly a competent, motivated and a well rewarded work
force. Amongst such factors are a facilitative organizational structure, a conducive culture,
coordinating mechanisms, systems and processes, reward mechanisms and a host of other
implementation variables.
Organizational structure provides the structural foundation for implementation by developing
tasks and roles to the employees and states how these tasks and roles can be correlated and
coordinated so as to maximize efficiency, quality, customer satisfaction and even innovation
and creativity.-the pillars of competitive advantage. A proposed strategy has to be implemented
under existing organizational structure and culture. Strategy- structure match is of vital
importance for an effective strategy implementation and as famously quoted by Alfred Chandler
‘structure follows strategy’ underscores the need for this congruence. When it is felt that a
strategy cannot be implemented successfully with the existing structure the structure should be
changed to match with proposed strategy. However, as we may see later such change should be
introduced carefully.
5.2 The McKinsey’s 7S Model
McKinsey’s 7S model can be used to better understand strategy implementation. This model was
developed in the 1980's by Robert Waterman, Tom Peters whilst working for McKinsey & Co, a
leading management consulting firm.
The basic premise of the model is that there are seven internal aspects of an organization that
need to be carefully aligned and in harmony if it is to be successful. The 7S model can be used in
a wide variety of situations and particularly to assist in strategy implementation and will provide
advantages such as:
Improve the performance of a company.
•
Examine the likely effects of future changes within a company.
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•
•
Align departments and processes during a merger or acquisition.
Determine how best to implement a proposed strategy.
The McKinsey 7S model can be applied to elements of a team or a project as well where
alignment of different variables is necessary for successful implementation.
The Seven Elements
The McKinsey 7S model involves seven interdependent factors which are categorized as either
"hard" or "soft" elements:
Hard Elements
Soft Elements
Strategy
Shared Values
Structure
Skills
Systems
Style
Staff
"Hard" elements are easier to define or identify and management can directly influence them:
These consists of elements such as strategy statements, organization structure assisted by
proper charts and clear reporting lines, market oriented work processes and a range of effective
systems including IT/IS, planning and control systems.
"Soft" elements, on the other hand, can be more difficult to describe, and are less tangible and
more influenced by culture. However, these soft elements are as important as the hard elements
if the organization is going to be successful.
The way the model is presented below depicts the interdependency of the elements and indicates
how a change in one affects all the others.
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Figure 5.1: Mckinsey’s 7 S Model
Let’s consider each of the elements specifically:
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•
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Strategy: the plan devised to maintain and build competitive advantage over the
competition.
Structure: the way the organization is structured and who reports to whom.
Systems: Inter connection of the different parts, functions and daily activities and
procedures that staff members collectively engage in, to get the jobs done and achieve
organizational objectives.
Shared Values: called ‘super ordinate goals’ when the model was first developed, these
are the core values of the company that are evidenced in the corporate culture and the
general work ethic.
Style: the style of leadership adopted.
Staff: the employees and their general capabilities.
Skills: the actual skills and competencies of the employees working for the company.
Placing Shared Values in the middle of the model emphasizes that these values are central to the
development of all the other critical elements. The company's structure, strategy, systems, style,
staff and skills all stem from why the organization was originally created, and what it stands for.
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The original vision of the company was formed from the values of the creators. As the values
change, so do all the other elements.
5.3 Managing Change
Change is an essential requirement in the strategy implementation.
What is change?
A change is simply defined as making things different or as something new.
Change options: What should be changed?
1. Structure
- Degree of specialization
- Departmentalization
- Chain of command
- Span of management
- Centralization Decentralization
- Co-ordination
2. Technology
- Machine, Equipment and tools
- Operating methods and procedures
- Job design
3. Physical settings
- The layout of work space
- Space Configuration
- Interior Design
- Equipment space
4. People
- Changing knowledge skills and attitudes of people
- Changing group processes such as communication decision making’
- Problem solving, leadership
- Changing culture
Resistance to change
When change is implemented, the emergence of opposing forces is natural and it can come from
two sources.
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Sources of Resistance
1. Individual Variables
2. Organizational variables
Individual Variables
Employees can resist on change based on following reasons.
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Feelings of economic insecurity
Adjustment problems
Threats of Social Relationships/Loss of social Rewards
Fear of unknown
Group norms and values
Habitual Resistance
Inaccurate Perceptions on the outcome of change
Failure to recognize need for change
Organizational Variables
Following can be identified as organizational reasons.
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Structural Issues-the organizational forces acting on employees encouraging them to
perform their job in certain ways.
Work Group Issues-Strong Social norms within groups to perform in specific way impose
formidable barriers to change.
Threats to existing balance of power-Those units that now control resources have the
expertise and power may fear losing their advantageous positions.
Cost involved in change.
Previously unsuccessful efforts.
Models of the change process
A systematic approach should be established, for planning and implementing changes.
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Steps
1
Determine need or desire for change in a particular area.
2
Prepare a tentative plan
Brainstorming sessions a good idea, since alternatives for change should be
considered (Lippitt 1981).
3
Analyse probable reactions to the change.
4
Make a final decision from the choice of alternative options
Decision taken either by group problem-solving (participative) or by manager
on his own (coercive).
5
Establish a timetable for change
'Coerced' changes can probably be implemented faster, without time for
discussions.
Speed of implementation that is achievable will depend on the likely reactions
of the people affected (all in favour, half in favour, all against etc).
Identify those in favour of the change, and perhaps set up a pilot programme
involving them. Talk with the others who resist the change.
6
Communicate the plan for change
This is really a continuous process, beginning at Step 1 and going through to
Step 7.
7
Implement the change. Review the change
Continuous evaluation and modifications.
The change process ( Lewin /Schein’s three stage approach)-Another Model for change
In the words of John Hunt (Managing People at Work): 'Learning also involves re-learning - not
merely learning something new but trying to unlearn what is already known.' This is, in a
nutshell, the thinking behind Lewin/Schein's three stage approach to changing human behaviour,
which may be depicted as follows.
UNFREEZE
existing
behaviour
¾®
Attitudinal/
behavioural
change
¾®
REFREEZE
new
behaviour
Step 1: Unfreeze is the most difficult stage of the process, concerned mainly with 'selling'
the change, with giving individuals or groups a motive for changing their
attitudes, values, behaviour, systems or structures.
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(a) If the need for change is immediate, clear and necessary for the survival of
the individual or group, the unfreeze stage will be greatly accelerated.
(b) Routine changes may be harder to sell if they are perceived to be unimportant
and not survival-based.
(c) Unfreezing processes need four things
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A trigger (e.g.: a crisis).
Someone to challenge and expose the existing behaviour pattern.
The involvement of outsiders.
Alterations to power structure.
Step 2: Change is mainly concerned with identifying what the new, desirable behaviour
should be, communicating it and encouraging individuals and groups to adopt it.
The new ideas must be shown to work.
Step 3: Refreeze is the final stage, implying consolidation or reinforcement of the new
behaviour. Positive reinforcement (praise, reward) or negative reinforcement
(sanctions applied to those who deviate from the new behaviour) may be used.
Overcoming Resistance to Change
Six tactics have been suggested for use by change agents in dealing with resistance to change.
Let's review them briefly.
1. Education & communication
Resistance can be reduced through communicating with employees to help them see the logic of a
change. This tactic basically assumes that the source of resistance lies in misinformation or poor
communication: If employees receive the full facts and get any misunderstandings cleared up,
resistance will subside. Communication can be achieved through one-on-one discussions, memos,
group presentations, or reports.
2. Participation & Involvement
It's difficult for individuals to resist a change decision in which they participated. Prior to making
a change, those opposed can be brought into the decision process. Assuming that the participants
have the expertise to make a meaningful contribution, their involvement can reduce resistance,
obtain commitment, and increase the quality of the change decision. However, against these
advantages are the negatives: potential for a poor solution and great time consumption.
3. Facilitation & Support
Change agents can offer a range of supportive efforts to reduce resistance. When employee fear
and anxiety are high, employee counseling and therapy, new-skills training, or a short paid leave
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of absence may facilitate adjustment. The drawback of this tactic is that, as with the others, it is
time-consuming. Additionally, it is expensive, and its implementation offers no assurance of
success.
4. Negotiation & Agreement
Another way for the change agent to deal with potential resistance to change is to exchange
something of value for a lessening of the resistance. For instance, if the resistance is centered in a
few powerful individuals, a specific reward package can be negotiated that will meet their
individual needs. Negotiation as a tactic may be necessary when resistance comes from a
powerful source. Yet one cannot ignore its potentially high costs. Additionally, there is the risk
that, once a change agent negotiates with one party to avoid resistance, he or she is open to the
possibility of being blackmailed by other individuals in positions of power.
5. Manipulation & Co-optation
Manipulation refers to covert influence attempts. Twisting and distorting facts to make them
appear more attractive, withholding undesirable information, and creating false rumors to get
employees to accept a change are all examples of manipulation. If corporate management
threatens to close down a particular manufacturing plant if that plant's employees fail to accept an
across-the-board pay cut, and if the threat is actually untrue, management is using manipulation.
6. Implicit and Explicit Coercion
Last on the list of tactics is coercion; that is, the application of direct threats or force upon the
resisters. If the corporate management mentioned in the previous discussion really is determined
to close a manufacturing plant if employees don't acquiesce to a pay cut, then coercion would be
the label attached to its change tactic. Other examples of coercion are threats of transfer, loss of
promotions, negative performance evaluations, and a poor letter of recommendation. The
advantages and drawbacks of coercion are approximately the same as those mentioned for
manipulation and cooptation.
5.4 Organizational Structure and Strategy implementation
Organizational structure is the way that the work, resources and authority of an organization
have been divided among its members so that the strategy can be implemented efficiently and in
an orderly manner so that the objectives can be realized. An effective organizational structuring
includes decisions in connection with the following variables:
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Level of specialization
Departmentalization
Chain of command
Span of management
Delegation
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•
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Formalization
Co-ordination
Different types of Organizational Structure
Functional Structure
Group people together because they hold similar positions in an organization, perform a similar
set of tasks, or use the same kind of skills.
This division of labor and specialization allows an organization to become more effective.
Advantages of a Functional Structure
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Easy communication among specialists - People grouped together according to similarities
in their positions can easily communicate and share information with each other.
Quick decisions - People who approach problems from the same perspective can often
make decisions more quickly and effectively than can people whose perspectives differ.
Learning - Makes it easier for people to learn from one another's experiences. Thus a
functional structure helps employees improve their skills and abilities and thereby enhances
individual and organizational performance.
Disadvantages of a Functional Structure
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Serving needs of all products - When the range of products or services that a company
produces increases, the various functions can have difficulty efficiently servicing the needs
of the wide range of products. Imagine the coordination problems that would arise, for
example, if a company started to make cars, then went into computers, and then went into
clothing but used the same sales force to sell all three products. Most salespeople would not
be able to learn enough about all three products to provide good customer service.
•
Coordination - As organizations attract customer with different needs, they may find it hard
to service these different needs by using a single set of functions.
•
Serving needs of all regions - As companies grow, they often expand their operations
nationally, and servicing the needs of different regional customers by using a single set of
manufacturing, sales, or purchasing functions becomes very difficult.
Divisional Structures: Product, Market, and Geographic
A divisional structure that overlays functional groupings allow an organization to coordinate
intergroup relationships more effectively than does a functional structure.
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Product Structure
Each product division contains the functions necessary to that service the specific goods or
services it produces.
What are the advantages of a product structure?
Increases the division of labor so that the number of similar products can be increased (such as a
wider variety of appliances like stoves, or ovens) expands into new markets and produce totally
new kinds of products (such as when an appliance maker starts to produce computers or air
planes).
Market Structure
Grouping functions into divisions that can be responsive to the needs of particular types of
customers.
Geographic Structure
An organization facing the problem of controlling its activities on a national or international
level is likely to use a geographic structure and group functions into regional divisions to service
customers in different geographic areas.
Each geographic division has access to a full set of the functions it needs to provide its goods and
services.
Advantages of Divisional Structures
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Quality products and customer service - Functions are able to focus their activities on a
specific kind of good, service, or customer. This narrow focus helps a division to create
high-quality products and provide high-quality customer service.
Facilitates communication - between functions improve decision making, thereby
increasing performance.
Customized management and problem solving - A geographic structure puts managers
closer to the scene of operations than are managers at central headquarters. Regional
managers are well positioned to be responsive to local situations such as the needs of
regional customers and to fluctuations in resources. Thus regional divisions are often able
to find solutions to region-specific problems and to use available resources more
effectively than are managers at corporate headquarters.
Facilitates teamwork - People are sometimes able to pool their skills and knowledge and
brainstorm new ideas for products or improved customer service.
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•
Facilitates decision making - As divisions develop a common identity and approach to
solving problems, their cohesiveness in- creases, and the result is improved decision
making.
Disadvantages of a Divisional Structure
•
•
•
High operating and managing costs - because each division has its own set of functions,
operating costs- the costs associated with managing an organization-increase. The number
of managers in an organization, for example, increases, because each division has its own
set of sales managers, manufacturing managers, and so on. There is also a completely new
level of management, the corporate level, to pay for.
Poor communication between divisions - Divisional structures normally have more
managers and more levels of management than functional structures have, communications
problems can arise as various managers at various levels in various divisions attempt to
coordinate their activities.
Conflicts among divisions - divisions may start to compete for organizational resources and
may start to pursue divisional goals and objectives at the expense of organizational ones.
Matrix Structure
A complex form of organization that some companies use to control their activities results in the
matrix structure, which simultaneously groups people in two ways- the staff are assigned both to
a functional area as well as to a product team which means it provides dual channels of authority,
performance responsibility, evaluation and control. Hence in practice In practice, the employees
in a matrix structure have two bosses-a functional boss and a product boss.
•
•
•
•
•
•
Facilitates rapid product development
Maximizes communication and cooperation between team members
Facilitates innovation and creativity
Facilitates face-to-face problem solving (through teams)
Provides a work setting in which managers with different functional expertise can
cooperate to solve non-programmed decision-making problems.
Facilitates frequent changes of membership in product teams
Disadvantages of a Matrix Structure
•
Increase role conflict and role ambiguity - Two bosses making conflicting demands on a
two-boss employee cause role conflict. Reporting relationships in the matrix makes
employees vulnerable to role ambiguity.
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•
•
High levels of work stress - Conflict and ambiguity can increase feelings of stress.
Difficulty employees have in demonstrating their personal contributions to team
performance because they move so often from one team to another.
Limited opportunities for promotion - because most movement is lateral, from team to
team, not vertical to upper management positions.
5.5 Culture and Strategy
There are many definitions of culture. Simply it can be defined as ‘socially established structures
of meaning’. Edgar Schein an authority on culture defines organizational culture more
specifically as the ‘basic assumptions and beliefs that are shared by members of an organization,
that operate unconsciously and defined in a basic taken-for-granted fashion an organization’s
view of itself and its environment’. Related to this are taken-for-granted ways of doing things,
the routines that accumulate over time. In other words, culture is about that which is taken for
granted but none the less contributes to how groups of people respond and behave in relation to
issues they face. It therefore has important influences on the development and change of
organizational strategy.
In fact cultural influences exist at four multiple levels (National and Regional Cultures, The
organizational field, Organizational Culture, organizational sub-cultures/Functional).
1. National and regional cultures
Attitudes to work, authority, equality and other important factors differ from one country to
another. Such differences have been shaped by powerful cultural forces concerned with history,
religion and even climate over many centuries. Organizations that operate internationally need to
understand and cope with such differences that can manifest themselves in terms of different
standards, values and expectations in the various countries in which they operate.
For example, attitudes to some aspects of employment and supplier relationships may differ at a
regional level even in a relatively small and cohesive country like the UK, and quite markedly
elsewhere in Europe (for example, between northern and southern Italy). There may also be
differences between urban and rural locations.
2. The organizational field
The culture of an organization is also shaped by ‘work-based’ groupings such as an industry (or
sector), a profession or what is sometimes known as an organizational field, which is a
community of organizations that interact more frequently with one another than with those
outside the field and that have developed a shared meaning system. Such organizations may
share a common technology, set of regulations or education and training. In turn this can mean
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that they tend to cohere around a recipe: a set of assumptions, norms and routines held in
common within an organizational field about organizational purposes and a ‘shared wisdom’ on
how to manage organizations. For example, there are many organizations in the organizational
field of ‘justice’, such as lawyers, police, courts, prisons and probation services. The roles of
each are different and their detailed prescriptions as to how justice should be achieved differ.
However, they are all committed to the principle that justice is a good thing which is worth
striving for, they interact frequently on this issue, have developed shared ways of understanding
and debating issues that arise and operate common routines or readily accommodate the routines
of others in the field.
3. Organizational culture
The culture of an organization is often conceived as consisting of four layers
Figure 5.2: Layers of organizational culture
● Values may be easy to identify in an organization, and are often written down as statements
about an organization’s mission, objectives or strategies. However, they can be vague, such as
‘service to the community ‘, ‘honoring equal employment opportunities’ or commitment to a
‘triple bottom line philosophy’.
● Beliefs are more specific, but again they can typically be discerned in how people talk about
issues the organization faces; for example, a belief that the company should not trade with
particular countries or that professional staff should not have their professional actions
appraised by managers. With regard to both values and beliefs it is important to remember
that in relation to culture, the concern is with the collective rather than individuals’ values and
beliefs.
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● Behaviors are the day-to-day way in which an organization operates and can be seen by people
both inside and outside the organization. This includes the work routines, how the
organization is structured and controlled and ‘softer’ issues around symbolic behaviors.
● Taken-for-granted assumptions are the core of an organization’s culture. They are the aspects
of organizational life which people find difficult to identify and explain. Here they are
referred to as the organizational paradigm. The paradigm is the set of assumptions held in
common and taken for granted in an organization. For an organization to operate effectively
there is bound to be such a generally accepted set of assumptions. As mentioned above, these
assumptions represent collective experience without which people would have to ‘reinvent
their world’ for different circumstances that they face. The paradigm can underpin successful
strategies by providing a basis of common understanding in an organization, but can also be a
major problem, for example when major strategic change is needed or when organizations try
to merge and find they are incompatible.
4. Organizational subcultures
In seeking to understand the relationship between culture and an organization’s strategies, it may
be possible to identify some aspects of culture that pervade the whole organization. However,
there may also be important subcultures within organizations. These may relate directly to the
structure of the organization: for example, the differences between geographical divisions in a
multinational company, or between functional groups such as finance, marketing and operations.
Differences between divisions may be particularly evident in organizations that have grown
through acquisition. Also different divisions may be pursuing different types of strategy and
these different market positioning require or foster different cultures. Indeed, aligning strategic
positioning and organizational culture is a critical feature of successful organizations.
Differences between business functions also can relate to the different nature of work in different
functions.
Culture’s influence on strategy
The taken-for-granted nature of culture is what makes it centrally important in relation to
strategy and the management of strategy. There are two primary reasons for this:
● Managing culture - Because it is difficult to observe, identify and control that which is taken
for granted, it is difficult to manage. This is why having a way to analyze culture so as to
make it more evident is important.
● Culture as a driver of strategy - Organizations can be ‘captured’ by their culture and find it
very difficult to change their strategy outside the bounds of that culture. Managers, faced with
a changing business environment, are more likely to attempt to deal with the situation by
searching for what they can understand and cope with in terms of the existing culture. The
result is likely to be incremental strategic change with the risk of eventual strategic drift.
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Culture is, in effect, an unintended driver of strategy. The effect of culture on strategy faced
with a stimulus for action, such as declining performance, managers first try to improve the
implementation of existing strategy.
Advantages of strong culture
•
•
•
•
•
A strong culture engages people. People want to be engaged in their work. Your culture
can engage people. Engagement creates greater productivity, which can impact
profitability.
A strong culture creates energy and momentum. Build a culture that is vibrant and allows
people to be valued and express themselves and you will create a very real energy. That
positive energy will permeate the organization and create a new momentum for success.
Energy is contagious and will build on itself, reinforcing the culture and the attractiveness
of the organization.
A strong culture changes the view of "work." Most people have a negative connotation of
the word work. When you create a culture that is attractive, people's view of "going to
work" will change
A strong culture creates greater synergy. A strong culture brings people together. When
people have the opportunity to (and are expected to) communicate and get to know each
other better, they will find new connections. These connections will lead to new ideas and
greater productivity - in other words, you will be creating synergy. Literally, 1 + 1 + right
culture = more than 2.
A strong culture makes everyone more successful. Not only is creating a better culture a
good thing to do for the human capital in the business, it makes good business sense too.
Analyzing culture: the cultural web
In order to understand both the existing culture and its effects it is important to be able to analyze
culture. The cultural web is a means of doing this. The cultural web shows the behavioral,
physical and symbolic manifestations of a culture that inform and are informed by the taken-forgranted assumptions, or paradigm, of an organization. The Cultural Web, developed by Gerry
Johnson and Kevan Scholes in 1992. The Cultural Web identifies six interrelated elements that
help to make up what Johnson and Scholes call the "paradigm" – the pattern or model – of the
work environment. By analyzing the factors in each, you can begin to see the bigger picture of
your culture: what is working, what isn't working, and what needs to be changed. The six
elements are:
1. Stories – The past events and people talked about inside and outside the company. Who
and what the company chooses to immortalize says a great deal about what it values, and
perceives as great behavior.
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2. Rituals and Routines – The daily behavior and actions of people that signal acceptable
behavior. This determines what is expected to happen in given situations, and what is
valued by management.
3. Symbols – The visual representations of the company including logos, how plush the
offices are, and the formal or informal dress codes.
4. Organizational Structure - This includes both the structure defined by the organization
chart, and the unwritten lines of power and influence that indicate whose contributions are
most valued.
5. Control Systems - The ways that the organization is controlled. These include financial
systems, quality systems, and rewards (including the way they are measured and distributed
within the organization.)
6. Power Structures - The pockets of real power in the company. This may involve one or
two key senior executives, a whole group of executives, or even a department. The key is
that these people have the greatest amount of influence on decisions, operations, and
strategic direction.
These elements are represented graphically as six semi-overlapping circles (see Figure below),
which together influence the cultural paradigm.
Figure 5.3: Cultural paradigm
5.6 Role of Policies & Procedures under Strategy Implementation
Policies are guides to action and facilitate operations greatly. As policies are pre determined
decisions being made at the top, these can guide managerial decision making particularly in
situations requiring repetitive decision making. As the organizational members are quite certain
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how to act in given situations being guided by the policies that are set at higher levels, such can
expedite decision making and ensure organizational wide consistency. Set carefully and wisely,
policies and procedures help channel actions, behavior, decisions and practices that expedite
implementation of strategy. When policies and procedures are not strategy-supportive they
become a barrier to implementation and need to be re assessed and reformulated.
Organization must review existing policies and procedures whenever they modify their strategy.
They must ensure company’s employees understand what is expected of them especially when
you change strategies. It is also important when formulating policies such do not necessarily
stifle creativity as well as introduce inflexibility that could bring about operational constraints in
implementation.
5.7 Role of effective Leadership under strategy implementation
Leaders should give their fullest support when strategy implementation is going on. Every
manager should try to become a leader under this. Manager should be identified as a leader by
employees in order to consider him as a leader. Managers should develop leadership skills such
as Honesty and integrity, Fairness, Clear defined Vision, ability to face problems, patience in
order to become leaders. Following differences can be identified between a manager and a
leader.
Manager
Leader
Coping with complexity
Coping with inevitable change
Allocate resources and responsibility
Align people, inspire and motivate people
Expect respect
Automatically receive the respect
Try to maintain the present situation
Try to achieve the long-term vision
Use Positional power sources such as Use personal power sources that revolve
Legitimate/Reward/Coercive powers
around Expert power
It is important to give guidelines for members by leaders under strategy implementation. Thus
they should clearly communicate the changes taking place in the organization and they should
support employees to adjust in to new system.
5.8 Role of proper Reward systems as an important element of strategy implementation
It is important for both organization departments and employees to be enthusiastic about the
strategy implementation. Organization will never be able to successfully implement any strategy
without the cooperation of their employees. To get employees’ undivided commitment to the
strategy, Organization has to be resourceful in designing both monetary and non-monetary
motivational incentives. Understanding what motivates each employee can help organization
design such systems that will earn their commitment to organization. One of the biggest
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challenges to strategy implementation is to employ motivational techniques that build employee
commitment.
The role of a reward system is to align employee commitment to the organizational strategy.
Successful strategy implementers inspire and challenge employees to do their best. They get their
employees buy-in and structure individual efforts into teams. It is no secret that team-work is
essential for organizational success. One another advantage is that when an organization resorts
to teams, they substitute peer-based control for hierarchical control. Isn’t that great?
Nevertheless, many small businesses still overly rely on the hierarchical reporting system of
work. Peer control is so powerful that organizations using this control methodology find they can
reduce costs by removing some layers of management hierarchy.
The most dependable way to keep employees focused on organizational objectives and their
performance targets is to generously reward and recognize individuals and teams who have
achieved their targets. A properly designed rewards structure is organization’s most powerful
tool for mobilizing organizational commitment for strategy execution. Company’s incentive
system is the vehicle by which their strategy is emotionally ratified in the form of their employee
commitment. Strategy driven performance objectives must be established for every employee,
manager, and team and even for the CEO. If organization’s strategy is going to be low-cost
provider, they must reward performances that helps reduce costs. If they are a niche player, they
must reward low customer complaints, speedy order delivery.
Another point to watch out for is to reward results and not performing assigned functions. In any
job performing assigned tasks is not the same as achieving outstanding results. Once the reward
system has been designed, it is important to communicate it to all employees and make sure they
understand. Pressure for performance must be accompanied with meaningful rewards. The
payoffs have to be high. If it is only marginal, then there is not enough motivation and the system
breaks down.
Hence the message here is that it is advisable for commercial organizations to carefully arrive at
an optimum combination of fixed and variable, performance based pay taking in to account a
host of relevant factors such as the nature of the business, quality considerations, quality of
supervision, competitor practices etc. For example in a financial institution, formulation and
implementation of an incentive based reward system for the marketing staff could be more
difficult than in case of a pure marketing organization, as the credit quality in case of the former
is not as easily established as in case of the latter.
5.9 Benchmarking
Benchmarking is the process of comparing one's business processes and performance metrics to
industry bests and/or best practices from other industries. Dimensions typically measured are
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quality, time and cost. Improvements from learning mean doing things better, faster, and
cheaper.
Benchmarking involves management identifying the best firms in their industry, or any other
industry where similar processes exist, and comparing the results and processes of those
studied (the "targets") to one's own results and processes to learn how well the targets perform
and, more importantly, how they do it.
The term benchmarking was first used by cobblers to measure people's feet for shoes. They
would place someone's foot on a "bench" and mark it out to make the pattern for the shoes.
Benchmarking is mostly used to measure performance using a specific indicator (cost per unit of
measure, productivity per unit of measure, cycle time of x per unit of measure or defects per unit
of measure) resulting in a metric of performance that is then compared to others.
Procedure
There is no single benchmarking process that has been universally adopted.
The following is an example of a typical benchmarking methodology:
1. Identify your problem areas - Because benchmarking can be applied to any business
process or function, a range of research techniques may be required. They include:
informal conversations with customers, employees, or suppliers; exploratory research
techniques such as focus groups; or in-depth marketing research, quantitative research,
surveys, questionnaires, re-engineering analysis, process mapping, quality control
variance reports, or financial ratio analysis. Before embarking on comparison with other
organizations it is essential that you know your own organization's function, processes;
base lining performance provides a point against which improvement effort can be
measured.
2. Identify other industries that have similar processes - For instance if one were
interested in customer care service in a bank he/she would try to identify other fields that
also have customer care service. These could include insurance, finance Companies,
telecommunication and so more.
3. Identify organizations that are leaders in these areas - Look for the very best in any
industry and in any country. Consult customers, suppliers, financial analysts, trade
associations, and magazines to determine which companies are worthy of study.
4. Survey companies for measures and practices - Companies target specific business
processes using detailed surveys of measures and practices used to identify business
process alternatives and leading companies. Surveys are typically masked to protect
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confidential data by neutral associations and consultants.
5. Visit the "best practice" companies to identify leading edge practices - Companies
typically agree to mutually exchange information beneficial to all parties in a
benchmarking group and share the results within the group.
6. Implement new and improved business practices - Take the leading edge practices and
develop implementation plans which include identification of specific opportunities,
funding the project and selling the ideas to the organization for the purpose of gaining
demonstrated value from the process.
Types of benchmarking
•
Internal Benchmarking- involves benchmarking businesses or operations from within
the same organization (e.g. business units in different countries). The main advantages
of internal benchmarking are that access to sensitive data and information is easier;
standardized data is often readily available; and, usually less time and resources are
needed. There may be fewer barriers to implementation as practices may be relatively
easy to transfer across the same organization.
•
Functional Benchmarking-Internal functions (Production, HRM, Finance & Marketing)
are compared with those of the best external practitioners of those functions, regardless of
the industry they are in. Objective of this is to improve the operation of that particular
function.
•
Performance/Competitive benchmarking - allows the initiator firm to assess their
competitive position by comparing products and services with those of target firms.
Businesses consider their position in relation to performance characteristics of key
products and services. Benchmarking partners are drawn from the same sector.
Performance benchmarking focuses on assessing competitive positions through
comparing the
products and services of other competitors. When dealing with
performance benchmarking, organizations want to look at where their product or services
are in relation to competitors on the basis of things such as reliability, quality, speed, and
other product or service characteristics.
•
Process/Activity Benchmarking- Process benchmarking focuses on the day-to-day
operations of the organization. It is the task of improving the way processes performed
every day. Some examples of work processes that could utilize process benchmarking are
the customer complaint process, the billing process, the order fulfillment process, and the
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recruitment process.
•
Strategic benchmarking - involves observing how others compete. This type is usually
not industry specific, meaning it is best to look at other industries. Strategic
benchmarking deals with top management. It deals with long-term results. Strategic
benchmarking focuses on how companies compete. This form of benchmarking looks at
what strategies the organizations are using to make them successful.
The above five are most common types of benchmarking. In addition to that following
two methods can also be used occasionally in practice.
•
Financial benchmarking - performing a financial analysis and comparing the results in
an effort to assess your overall competitiveness and productivity.
•
Benchmarking from an investor perspective- extending the benchmarking universe to
also compare to peer companies that can be considered alternative investment
opportunities from the perspective of an investor.
Advantages of Benchmarking
The main benefits of benchmarking are:
1. It helps to improve organizational performance
- Increased customer satisfaction
- Reduced waste and costs of poor quality
- Reduced overhead through business simplification
- Transmission of best practice between divisions
2. It can assist in overcoming complacency and drive organizational change.
3. It provides a way to monitor the conduct of competitive position.
4. it provides advance warning of deteriorating competitive position.
5. It improves management understanding of the value-adding processes of the business.
The possible drawbacks of benchmarking
1. It increases the diversity of information which must be monitored by management this
increases the potential for information overload.
2. It may reduce managerial motivation if they are compared with a better resourced rival
3. There is a danger that confidentiality of data will be compromised.
4. It encourages management to focus on increasing the efficiency of their existing business
instead of developing new lines of business. As one writer put it: Benchmarking is the
refuge of the manager who’s afraid of the future.
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5. Successful benchmarking firms may find that they are later overloaded with requests for
information from much less able firms whom they can learn little.
5.10 Business Process Re-engineering (BPR)
In today’s constantly changing business world organizations need to always be receptive to re
assess and introspect the internal working mechanisms inside the firm. Business success in the
contemporary environment is increasingly driven by the ability of the business to be customer
oriented as well as be competitor focused, at all times. The mid nineties observed some
successful business corporations in the world seem to have hit upon an incredible solution,
popularly referred to as Business Process Reengineering (BPR).
What is reengineering?
“Reengineering is the fundamental rethinking and radical redesign of business processes to
achieve dramatic improvements in critical, contemporary measures of performance such as cost,
quality, service and speed.”
It encompasses the envisioning of new work strategies, the actual process design activity, and
the implementation of the change in all its complex technological, human, and organizational
dimensions.
BPR advocates that enterprises go back to the basics and reexamine their very roots of their
business processes and more specifically those that are critical to success. It doesn’t believe in
small improvements. Rather it aims at total reinvention. As for results: BPR is clearly not for
companies who want a 10% improvement. It is for the ones that aspire quantum improvements.
The key word that underlies this concept of BPR is the word-‘process.’ BPR focuses on
processes or work steps and not on tasks, jobs or people. It endeavors to redesign the strategic
and value added processes that transcend organizational boundaries.
What to reengineer?
According to many in the BPR field reengineering should focus on processes and not be limited
to thinking about the organizations. After all the organization is only as effective as its processes.
So, what is a process? “A business process is a series of steps designed to produce a product or a
service. It includes all the activities that deliver particular results for a given customer (external
or internal). Processes are customarily invisible and people are that conscious because they are
accustomed to think about the individual departments more often than the process with which all
of them are involved. So companies that are currently used to talking in terms of departments
such as marketing and manufacturing must switch to giving names to the processes that they do
such that they express the beginning and end states. These names should imply all the work that
gets done between the start and finish. For example, order fulfillment can be called order to
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payment process.
Talking about the importance of processes just as companies have organization charts, they
should also have what are called process maps to give a picture of how work flows through the
company. Process mapping provides tools and a proven methodology for identifying your
current ‘As-Is’ business processes and can be used to provide a ‘To-Be’ roadmap for
reengineering your product and service business enterprise functions. It is the critical link that
your reengineering team can apply to better understand and significantly improve your business
processes and bottom-line performance.
Having identified and mapped the processes, deciding which ones need to be reengineered and in
what order is the million-dollar question. No company can take up the unenviable task of
reengineering all the processes simultaneously. Generally they make their choices based on three
criteria:
Dysfunction: which processes are functioning the worst?
Importance: which are the most critical and influential in terms of customer satisfaction?
Feasibility: which are the processes that are most likely to be successfully reengineered?
How to reengineer?
There is no single worldwide accepted methodology. Given below is one such common
methodology that can be applied that consists of a five step activity process.
• Prepare for reengineering,
• Map and analyze ‘ As-Is’ process,
• Design ‘To-Be’ process,
• Implement reengineered process and
• Improve continuously.
Advantages of BPR
•
•
•
•
•
Inefficiencies can be identified and it can be minimized
Potential for possible cost reductions.
Quality of products and services can be improved resulting greater customer satisfaction
Improved Competitive advantage because of process efficiencies
There are usually some advantages for the bottom line through the quick wins which can
be identified. Also advantages for the business, in the form of clearer objectives, and better
systems to achieve those objectives.
Criticisms of BPR
•
Re-engineering implementers sometimes assumes the need to start the process of
performance improvement with a "clean slate," i.e. totally disregard the status quo.
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•
•
•
•
•
•
•
Lack of management support for the initiative and thus poor acceptance in the organization.
Exaggerated expectations regarding the potential benefits from a BPR initiative and
consequently failure to achieve the expected results.
Underestimation of the resistance to change within the organization.
Implementation of generic so-called best-practice processes that do not fit specific
company needs.
Over trust in technology solutions.
Performing BPR as a one-off project with limited strategy alignment and long-term
perspective.
Poor project management.
5.9 Strategic implications of IT
Information System strategies that could assist with generic competitive strategies
•
Cost Leadership
Use information systems to achieve the lowest operational costs and the lower prices.
E.g.: Wal-Mart uses inventory replenishment system to lower the cost. System integrates
suppliers and customers. So, Wal-Mart doesn’t require to maintain large inventories.
•
Product Differentiation
Use information systems to enable new products and services, or greatly change the
customer convenience in using a company’s existing products and services.
E.g: - Google-continuously introduces new and unique search services on its web-site.
- Amazon.com-One-Click Shopping-Amazon holds a patent on one-click shop in that
it licenses to other retailers.
- Paypal.Com –online person to person payment enables transfer of money between
individual bank accounts and between bank accounts and credit card accounts.
•
Focus on Market Niche
Use information systems to enable a specific market focus, and serve this narrow target
market better than competitors. Information Systems support this strategy by producing and
analyzing data for finely tuned sales and marketing techniques. Information systems enable
companies to analyze customer buying patterns, tastes, and preferences closely so that they
efficiently pitch advertising and marketing campaigns to smaller and smaller target
markets.
The data comes from a range of sources-Credit card transactions, demographic data,
purchase data from checkout counter scanners at supermarkets and retail stores, and data
collected when people access and interact with web sites. Sophisticated software tools find
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patterns in these large pools of data and infer rules from them to guide decision making.
Analyses of such data drives one-to-one marketing that creates personal messages based on
individualized preferences.
E.g.: Hilton hotels use a customer information system called On Q which contains detailed
data about active guests in every property across the eight hotel brands owned by Hilton.
Employees at the front desk tapping into the system instantly search through 180 million
records to find out the preferences of customers checking in and their past experiences with
Hilton so they can give these guests exactly what they want.
Information Technology and the Porter’s Five Forces Model
Given below are some instances of how IT/IS can impact strategic competitiveness.
Figure 5.4: Porter’s five forces model
1) Barriers to entry and IT
(a) IT can raise entry barriers by increasing economies of scale, raising the capital cost of
entry (by requiring a similar investment in IT) or effectively colonising distribution
channels by tying customers and suppliers into the supply chain or distribution chain.
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(b) IT can surmount entry barriers. An example is the use of telephone banking, which
sometimes obviates the need to establish a branch network.
2) Bargaining power of suppliers and IT
(a) Increasing the number of accessible suppliers. Supplier power in the past can derive
from various factors such as geographical proximity and the fact that the organisation
requires goods of a certain standard in a certain time. IT enhances supplier information
available to customers.
(b) Closer supplier relationships. Suppliers' power can be shared. CAD can be used to
design components in tandem with suppliers. Such relationships might be developed with
a few key suppliers. The supplier and the organisation both benefit from performance
improvement, but the relations are closer.
(c) Switching costs. Suppliers can be integrated with the firm's administrative operations, by
a system of electronic data interchange.
3) Bargaining power of customers. IT can lock customers in.
(a) IT can raise switching costs.
(b) Customer information systems can enable a thorough analysis of marketing information
so that products and services can be tailored to the needs of certain segments.
4) Threat of Substitutes. In many respects, IT itself is the substitute product. Here are some
examples.
(a) Video-conferencing systems might substitute for air transport in providing a means by
which managers from all over the world can get together in a meeting.
(b) IT is the basis for new leisure activities (e.g. computer games) which substitute for TV or
other pursuits.
(c) E-mail might substitute for some postal deliveries.
5) IT and the state of Competitive Rivalry.
(a) IT can be used in support of a firm's competitive strategy of cost leadership,
differentiation or focus. These were discussed earlier.
(b) IT can be used in a collaborative venture, perhaps to set up new communications networks.
Some competitors in the financial services industry share the same ATM networks.
The impact of information technology on Value Chain
IT can be used to better insights to gain competitive Advantage in Value chain. Diagram 5.5
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depicts how IT can be made to impact on each such activity in the value chain, from a
competitive advantage perspective.
Firm infrastructure
HR Management
Technology development
Procurement
Planning models
Automated personnel scheduling
Computer-aided design / electronic market research
On-line procurement of parts
Automated Flexible
Automated TeleRemote
warehouse manufacturing order
marketing servicing
processing Remotes
Computer
sales
scheduling
terminals
of repairs
Figure 5.5: How IT impacts Value Chain Activities
Linkages with suppliers or customers (Value Web)
Porter is also clear that a firm’s value chain does not exist in isolation and is part of a ‘value
system’ that links it to the value chains of customers and suppliers. By modeling the value
system of the industry, an organization would be able to identify and assess opportunities to
integrate their information system with those of customers and suppliers. Such linkages are likely
to deter customers and suppliers from dealing with the organization’s rivals, thus providing a
competitive advantage.
Enhancing Core Competencies
Yet another way to use information systems for competitive advantage is to think about ways
that IT systems could be used to generate and enhance core competencies. A Core competency is
a unique combination of skills and competencies and information technology can play a vital role
in development of core competencies. Any information system that encourages the sharing of
knowledge across different functional disciplines and business units enhance core competencies
thereby providing necessary integration and co-ordination between the capabilities of such
functions and also between SBUs in case of multi-business scenarios. For example in a financial
institution, state of the art IT capability could provide the basis to integrate knowledge between
the different divisions. This capability can take different forms such as ‘Marketing’ function
making faster transmission of customer credit information from the marketing executives in the
field through hand held devices, to the ‘Credit Control’ function that would enable faster
disposal of loan funds directly to their bank accounts.
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5.10 Contingency Planning
A Contingency plan is a plan devised for a specific situation when things could go wrong.
Contingency plans are often devised by governments or businesses who want to be prepared for
anything that could happen. They are sometimes known as "Back-up plans", "Worst-case
scenario plans" or "Plan B".
Contingency plans include specific strategies and actions to deal with specific variances to
assumptions resulting in a particular problem, emergency or state of affairs. They also include a
monitoring process and “triggers” for initiating planned actions. They are required to help
governments, businesses or individuals to recover from serious incidents in the minimum time
with minimum cost and disruption.
Business and government contingency plans need to include planning for marketing to gain
stakeholder support and understanding. Stakeholders need to be kept informed of the reasons for
any changes, the vision of the end result and the proposed plan for getting there. The level of
stakeholders' importance and influence should be considered when determining the amount of
marketing required, the timescales for implementation and completion, and the overall
effectiveness of the plan. If time permits, input and consultation from the most influential
stakeholders should be incorporated into the building of any contingency plan as without
acceptance from these people any plan will at best encounter limited success.
During times of crisis, contingency plans are often developed to explore and prepare for any
eventuality. During the Cold war, many governments made contingency plans to protect
themselves and their citizens from an ‘unlikely’ nuclear attack.
Chapter Summary
There is a tendency amongst some students to imagine strategy formulation is much important as
much as more onerous compared to strategy implementation. However, those exposed to
practical realities understand the fallacy of such thinking and most senior managers concede the
difficulties of successful implementation. As discussed in the study note, those leaders
responsible for implementing strategy at different levels will have to manage many factors and
variables and also master the fine art of delicate balancing.
An enabling organizational structure lays the structural foundation for strategy implementation
by formalizing the levels, roles, reporting relationships and functional specializations. Different
strategic options and action plans require suitable structures that facilitate implementing such
strategies. The need for a matrix structure in some instances is a shining example of the need for
‘structure to follow strategy’. The students will recall the concepts they studied previously such
as coordinating mechanisms, span of control, delegation and communication etc, knowledge of
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which are very much applicable and essential in the process of implementation. The note also
discusses the role of policies and the importance of balanced rewards that will align the human
efforts and endurance with the implementation process. The leadership is the common thread
guiding the process and underscores the significance of managers stepping in to the role of a
‘leader’ to successfully spearhead the resources in this process, including the ‘human’ factor the
most valuable and complex of them all.
Organizational change is discussed at some length being an area that one has to often manage
with care and therefore such competence becomes an imperative in implementation at some
point or the other in this process. Management of systems, processes and a closely aligned
concept to these –the ‘Business Process Reengineering are areas, the knowledge which becomes
vitally important to the profession of finance.
The role of IT/IS in the contemporary business world is so pervasive these can hugely impact
strategy implementation and hence discussed with the aid of Michael Porters models on strategy.
The discussion ends with a brief reference to contingency planning.
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Chapter 06
Strategic Review & Control
Learning Objectives
After studying this chapter, you should be able to:
•
•
•
•
•
•
•
•
Understand the inextricable link between planning and control and the applicability of
same at strategic level too.
Describe and discuss Robert Antony’s levels of planning and control under ‘strategic
planning and control’, management planning and control’ and the ‘operational planning
and control’.
Explain the different control mind-sets when approaching control action.
Describe the more traditional role of budgetary control in the field implementing controls
the attendant limitations.
Understand and describe the modern structure of strategic controls discussed under
‘premise’, ‘strategic surveillance’, ‘special alert’ and ‘implementation’ controls.
Describe the role of ‘balanced score card’ as a modern approach to strategy
implementation and control, its structure and linkages between the constituent
components/perspectives.
Application of balanced score card in a given situation to link strategy implementation
and strategic control.
Understand the role of the contemporary management accountant.
6.1 Introduction
Strategic Control, the next step of an academic discussion of the strategic management process,
monitors, evaluates and guides the implementation towards ensuring the plans of strategic
actions are on course towards realization of the planed strategic objectives. As a strategic
planning process encompasses the full spectrum of activities by the top level that sets the tone for
the entire organization, essentially a strategic control system is all about tracking strategy as it is
being implemented, detecting problems or changes in the underlying premises, assumptions and
making necessary adjustments and swiftly taking corrective actions. It is opportune to make clear
few points of practical relevance. Strategic management is far from being a static, liner process
as being discussed in a management study program positioned within course curriculum; it is
rather a part of an integrated management action plan where analyzing, formulating,
implementing and controlling take place rather interactively in a dynamic business environment.
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6.2 Relationship between ‘Planning’ and ‘Control’
The classical perspective on planning and control views them as two quite distinct, sequential
sets activities under the umbrella of the process of management. Often planning is listed as the
initial management activity and control as the last, possibly even as a post facto activity.
However, it is beneficial for the students to understand at this initial juncture itself, as mentioned
in the previous section as well, the contemporary thinking is that they (i.e. planning and control)
are so closely intertwined and the relationship preferably be symbiotic. Hence, an effective
planning is a pre requisite to a good control function and presence of strong control systems
enhances the value of planning and makes planning more effective by ensuring the likelihood of
achieving the planned results.
6.3 Levels of control
Professor Robert Anthony (1965) of the Harvard Business School, in particular an authority in
the field of ‘control’, identifies three levels of planning control. Often this line of thinking
provides the basis for an academic discussion in the area of strategic control as this reflects the
planning and control practices under the typical organizational hierarchical levels of ‘strategic’
‘management’ and ‘operational’. As a support service, the types of information and controls
provided by the management accounting function will vary according to the level of control
being exercised.
When Anthony refers to “strategic planning” he means ‘strategic planning and control’ and
similarly “management control” embraces both planning control activities and hence implies
‘management planning and control’ and so on.
Strategic Planning and Control
This is the responsibility of the apex of the organisation and in large and complex organisations
that constitutes a multi-business environment, such planning and control also occurs at the top of
the sub units that function as independent businesses. According to Anthony, ‘strategic planning
and control’ that occurs at this level involves the following:
•
•
•
Setting and modifying organisational objectives.
determining the resources that will be committed to accomplishing these objectives.
Defining the organisational policies regarding obtaining and using these resources.
Under this level strategic control occurs in three ways:
•
First strategic planning itself is a control as managerial actions at lower levels in the
hierarchy is circumscribed by the strategic plan e. g product market domain.
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•
•
Key decisions regarding the allocation of resources e.g. the capital budgeting process that
brings about simultaneous planning as well as control.
Management of strategic issues, as they emerge, that may take place due to unanticipated
environmental changes or unexpected internal crises.
From a management accounting perspective:
• Control information will be predominantly environmental such as competitor analysis,
macro environmental and market trends, economic data or calculations of customer and
product profitability.
• The main output at this level of control will be targets, programmes and plans. These will
need to be implemented at management and at operational levels.
• Information will be imprecise and speculative.
• Management accounting will support this level of control through involvement in the
strategic planning and control process.
Management planning and control
Anthony views ‘management planning and control’ as the processes by which;
•
•
Organisational objectives are achieved.
The use of resources is made effective and efficient; It relates to the effective use of the
organisation’s resources, i.e. ensuring the organisational goals are achieved. It examines, as
a secondary concern, the efficiency with which goals are reached such as the quantity of
resources and time used.
Charles Rossotti of the Boston Consulting Group also offers an excellent and a practical
description what he calls “action planning” which involves activities that are typical in intent and
nature of management planning and control. According to him in action planning the prime focus
is improved internal coordination, communication and motivation toward accomplishment of
organisational goals. In this connection he cites a common organisational planning practice of
the cycle of a ‘five year plan’.
The management control is more aimed at ensuring the realisation of time-bound, measurable
goals and related plans of action that have been translated from the organisation’s strategy and
objectives, the domain of the higher level i.e. the strategic level. Hence the focus is concerned
with reaching the targets set through strategic decisions and as per the strategic plan
From a management accounting perspective:
•
•
It tends to identify particular responsibility centres and seeks to control them in order to
develop a control and information system that embraces the whole organisation.
Much of the information may be expressed in financial and volume terms. This gives a key
role to management accounting control information.
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Operational Planning and Control
Anthony views this third category of ‘operational planning and control’ as;
•
•
Focussing on specific, discrete tasks and mainly concerned with the day-to-day
implementation of the action plans of the organisation such as scheduling of manufacturing
operations or distribution activities.
The process of ensuring that the tasks are done effectively and efficiently.
This level of control works at the Operational level such as for example at the factory floor or
even in an accountant’s office or at an assistant HR manager’s office, depending on the
functional specialisation and the type of resources deployed.
From a management accounting perspective:
•
•
•
Information and monitoring will emphasise short-term control information
Information will be very detailed, specific and summarised in terms of quantity, rates and
times rather than a higher level translation through financial figures.
Information gathered will include productivity measures, budgetary measures, labour
statistics (manning level, turnover, and hours) and rates of capacity utilisation.
Management control information is the vital link between strategic and managerial decisions
because it gets things done. Operational control information, in turn, enables managers of
divisions to monitor and control what happens on the factory floor, among the sales team or
whichever functional levels the action is taking place.
6.4 Three Types of Control mind-sets/Approaches
Control can focus on events before, during, or after a process. These controls are formally called
‘feed forward’, ‘concurrent’, and ‘feedback’ respectively, as shown as follows.
Organizational Control Focus
Focus
Focus
Focus
Input
Ongoing
Process
Output
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Feed-forward control: This is approach to ‘control’ that attempts to identify and prevent
deviations from planned results before such deviations occur and importantly, as far as possible,
before commitment of resources. Sometimes referred to as preventive or pro-active controls, it
also focuses on human, material and financial resources that flow into organization. From such a
perspective its purpose is to ensure that input quality is high enough to prevent problems when
the organization performs its tasks. Feed forward controls in the field of selection and hiring of
new employment attempt to improve the likelihood that employees will perform up to standards
by identifying the necessary knowledge, skills and competencies by using tests and other
screening devices to hire people who have those requirements.
Another type of feed forward control is to proactively identify and better manage risks. For
example some large accounting firms have recognized that they can offer value to their clients by
looking and indentifying and management of strategic risks the clients have knowingly or
unknowingly taken on, rather than merely evaluating their financial performance after the events
have taken place. It is important to appreciate the value of feed forward approach when
compared with the traditional feed-back controls, particularly from a management accounting
perspective. An effective functioning of a feed forward control network means better
optimization of precious and scarce organizational resources before being committed to
uneconomical courses of action that could destroy value.
Concurrent Control: Control action that monitors on-going activities to ensure they are
consistent with intended plans and standards is called concurrent control. This control mostly
applied in relation to monitoring employee output against standards set for performance such as
those that revolve around output quality referred to as ‘Quality Assurance’. Concurrent control
assesses current activities as they take place, and based on performance standards, guide
employee tasks and behavior. Its intent is to ensure that work activities produce the correct
results. It could also include self-control where an individual could impose concurrent control on
their own behaviors against preset performance benchmarks.
Feedback Control - This is the traditional approach to control and such feedback control
focuses on the organization’s outputs by comparing actual results versus the planned results and
in case of material deviations action is initiated to rectify the output. An example could be in
relation to the quantity and /or quality of an end product or a service.
An example of feedback control in a manufacturing department is an intensive final inspection
of a car at an assembly plant. At most universities, students provide feedback information on
their views of the value and usefulness of every subject that they take.
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6.5 Performance Measurement and Control
Hopwood (1974) is critical of the notion that organisational control must always involve
measuring things and adds another dimension of controls. He identifies three forms of control:
Administrative controls -These involve the setting up of performance measurement systems and
comparing the outputs of processes with targets set by management. Accounting controls are an
example of this, alongside staff performance management systems and quality systems.
One drawback of administrative controls is that they can be mechanistic. This means that they
stem from a view of the organisation that sees it as a machine with staff being inputs or cogs.
This can lead to demotivating and dehumanising control regimes and also makes the organisation
very resistant to change.
Social controls - These are developed by social interaction and the sharing of common
perspectives. In a hospital or school the major means of control is through the use of skilled staff
that all share the same professional values. These are very powerful in ensuring that a doctor or
nurse is caring for their patient. Modern management innovations such as quality circles and
team working utilise this form of control.
Self-control -These are where the individual modifies their own behaviour. Clearly the
possession of advanced skills and knowledge will influence this, but it can also be harnessed
with a suitable system of incentives. For example, giving a manager a target to reach,
accompanied by promises of rewards if it is reached, will ensure that the manager uses their selfcontrol to reach it.
6.6 The Role of Budgeting/Budgetary Control –A Traditional method of Control
Budgetary control primarily is the process by which financial control is exercised within an
organisation. Budget for income/revenue and expenditure are prepared in advance and then
compared with actual performance to establish any variances. Managers are responsible for
controllable costs within their budgets and are required to take remedial action if the adverse
variances are regarded as excessive.
Problems with relying solely on budgetary control:
(a)
Financial results appear to provide proof that the strategy is working. But it is possible to
overlook important indicators and drivers of strategic success.
b)
Budgetary control, that is primarily a control with a financial flavour, is more a lagging
indicator as opposed to proactive leading indicators. Hence over reliance on such controls
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only, will not be advisable and hence need to be supplemented with controls with non
financial indicators.
(c)
Too much emphasis on budgetary control and short-term profit can disguise strategic
problems.
(d)
Strategic control measures might require complicated trade-offs between current
financial performance and longer-term competitive position aimed at desirable ways of
building competitive strength.
6.7Establishing Strategic Controls
The question of strategic controls have come a long way since the description and the structure
of the ‘strategic planning and control’ framework by Pro Robert Antony, almost fifty years ago
and as was discussed earlier in this chapter. Since then the business world has not only become
fiercely competitive, the environment too is much more volatile with rapid changes taking place
in many a spectrum of both internal and external variables and forces impacting modern day
businesses.
To encourage the measurement of the right things, firms can institute formal or informal systems
of strategic control and these are influenced by;
•
•
•
•
The time-lag between strategic control measures and financial results.
The linkages with the other businesses in a group.
The risks the business faces.
The sources of competitive advantage and the need to be consciously managing same.
Four types of strategic controls are summarized as follows:
Premise control
Every strategic course of action is based on certain assumptions that usually form the basis of
planning and forecasts. For example, most of strategies are formulated taking in to account
relevant macro environmental factors applicable the business under consideration. For example,
a company constructing and marketing ‘apartments’, when planning for long- term strategy will
have made some assumptions in connection with interest rates and inflation as much as in regard
to societal preferences and attitudes in assessing customer preferences for apartments.
Premise control is designed to check systematically and continuously whether the premises on
which the strategy is based still valid. If an important strategy sensitive premise is no longer
valid the key decision makers may have to be carefully considered whether the strategy needs to
be changed. Planning assumptions or premises are mostly in the areas of macro environment,
industry or in relation to the strategic group to which the business belongs to. Even though macro
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environmental factors impact a business as ‘forces’ beyond the control of a business, they exert
considerable influence on the success of a strategy. The industry environment too can
profoundly impact a company’s strategy by introducing product substitutes that can pose a
threat to a company’s’ market share. Hence constant review of likely changes to the strategy
assumptions is important.
Strategic Surveillance
By their nature, the Premise Controls are focused controls that permit the decision makers to
adopt a systematic approach to check and validate any changes taking place in regard to
assumptions in the areas of external and internal environments made during the strategic analysis
and formulation stages of strategy making. Strategic Surveillance however is unfocussed and is
designed to monitor a broad range of events in and outside the firm that are likely to affect the
course of strategy. Also referred to as “environmental scanning” strategic surveillance entails
gathering information from a broad range of sources such as trade magazines, industry
conferences and professional associations.
Special Alert Controls
In this category of strategic controls an attempt is made to assess and be prepared to cope with
any sudden unexpected events. There are many practical examples in the business world such as
say a quality defect of a major product attribute in the like of break system of a particular model
in the in an automobile company, a major loss of one of the principal customers or a sudden
failure of a company that is heavily reliant on its IT system such as in a financial institution.
Alternatively it could be that the company’s leading competitor is acquired by a giant holding
company that will make the company’s competitor extremely strong overnight. These kinds of
situations are being increasingly managed under a type of contingency planning referred to as
‘Business Continuity’ dealing with special types of risks. There are specialized international
institutions that carefully study such risks and offer ‘Business Continuity Management Systems
(BCMS)’ certificates.
Implementation Controls
This category of controls constitutes controls exercised as the strategy implementation unfold
and are more of a diagnostic nature.
Efficiency Controls
A manufacturing organization may be viewed as a transformation system that produces some
valuable output utilizing varying combination of input in the form of resources comprising
materials, labor and overheads. In these situations to control the efficiency the managers must
be able to measure the number of such inputs (e.g. quantity of electricity usage for an operational
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shift and therefore the cost of inputs, as much as the number and the quantity or the number of
output produced. Efficiency hence affects the final cost of the inputs to produce a unit of output
and eventually the final cost of the product. Such product cost is of strategic importance.
Alternatively efficiency controls may also appear in the form controls over defective output that
will impact the final product cost. Such controls may also be in the form of production methods
used in the conversion process and modern strategic control systems will also be exploring better
production methods that will improve ultimate efficiency. Efficiency controls are equally
applicable in service business models, such as say number of files being processed at the ‘back
office’ in the financial services industry.
Quality Controls
In the contemporary business world quality is an effective strategic differentiator as customers
are becoming increasing conscious of quality. Hence controls that revolve around important
attributes of quality is a strategic control. For such controls to be effective it is necessary that
strategy implementation process clearly identifies the relative importance of quality parameters
in the context of the customer segments that the company caters for. It’s also necessary to be able
to practically measure such quality attributes. Controls on ‘service quality’ too constitute a
significant aspect of total quality that will help establish the desired degree of customer
satisfaction and hence control systems will have to incorporate measurement of same.
Control of Customer Responsiveness
Under this category of control the measurements evaluate how well the employees in contact
with a company’s customers perform their duties. Monitoring their behaviors will give an idea
the training needed, if required, to improve desired levels of responsiveness that is considered an
important determinant of strategic success.
Control over Innovation
Traditional control systems sometimes hinder any kind of risk taking and too rigid set of controls
could inhibit creativity. Innovation capabilities such as new product introductions or process
improvements are considered important to strategic competitiveness and strategic controls
that helps to raise and promote such an organizational climate will be of strategic relevance.
Innovation takes place under conditions of right kind of empowerment that helps to unleash
employee creativity. Controls that encourage risk taking within flexible parameters and promote
disciplined creativity is a modern management challenge.
6.8 Modern Control Systems –The concept of the Balanced Score Card (BSC)
The purpose of strategic control systems is to shift management attention away from sole
reliance on financial performance indicators towards longer-term strategic drivers and milestones
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which eventually determine long term financial health, sustainability and performance. The
balanced scorecard is an example of how this might be put into practice. Traditionally the
performance of a company used to be measured predominantly through financial measures and
indicators. Presumably, this is because financial measures such as profitability and liquidity are
of such importance the shareholders the effective owners of an organization, and the
management. Although financial measurements do not capture all the strategic realities of the
business, a failure to attend to the 'numbers' can rapidly lead to a failure of the business, for
example if there is a major liquidity crisis. Nevertheless over-reliance on financial indicators
could lead to some serious limitations because financial results are ascertained after the activities
or events have taken place and hence have the drawback of being somewhat historical. Further,
financial results are at the top of the ice berg and do not reveal any deeper insights of the driving
forces of actual performance. For such understanding one has to examine the key operational
areas and drivers of the ultimate financial results. Faced with multiple objectives, some
companies introduce performance measurement systems which include multiple performance
measures.
Weaknesses of traditional accounting based performance measures, include the following.
•
•
•
•
•
Single factor e.g. profit or turnover or ROI or RI.
Historic. e.g. how have we done compared with last year.
Capable of distortion.
Confusion between measures and objectives.
Little use as a guide to action when implementing strategy as well as in controlling
activities as they unfold.
The Balanced Scorecard (BSC) approach, popularized by two Harvard Business School
professors Kaplan and Nortan (1992) is an attempt to bring about a holistic set of performance
measurement variable going beneath the financial and traditional accounting measures such as
return on investment and EPS. Nevertheless, recognizing the immeasurable value of financial
measures, the methodology of BSC is somewhat a causal link of a mixture of performance
drivers that explains the major categories of performance and how the eventual financial
performances of a company are resulted.
BSC is not really a planning tool but a more practical approach to ‘implement’ as much as
‘control’ strategy.
The approach comprises the following steps:
Identify major stakeholder requirements.
Identify critical success factors that will determine the success of a strategy.
Develop measures-financial and non financial and ensure each level in the
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Organization understands how they relate to the overall strategy.
Set standards.
Monitor performance.
Advantages
What gets measured gets done.
Considers all key stakeholders such as ‘customers’ and even ‘employees’ as an important
internal stakeholder category.
Takes the long-term strategic view.
Less capable of distortion.
The scorecard structure
The scorecard provides a framework for measuring all aspects of the performance of a business.
Typically it is divided into four parts:
•
•
•
•
Financial perspective – how do we look to our shareholders?
Customer perspective – how do customers see us?
Internal business perspective - at what must we excel?
Innovation and learning perspective – can we continue to improve and create value?
Hence, it may be seen that the balanced scorecard is a set of measures that gives top managers a
fast but comprehensive, holistic view of the business. The balanced scorecard includes financial
measures that tell the results of actions already taken as much as complementing the financial
measures with operational measures such as customer satisfaction, internal processes, and the
organisation's learning, innovation and improvement activities. In fact operational measures that
are the drivers of future financial performance.
The reason for using such a system is that 'traditional financial accounting measures like return
on investment and earnings per share can give misleading signals for continuous improvement
and innovation - activities today's competitive environment demands'. The balanced scorecard
allows managers to look at the business from four important perspectives.
•
•
•
•
Customer
Financial
Internal business
Innovation and learning
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Customer perspective
'How do customers see us?' Given that many company mission statements identify customer
satisfaction as a key corporate goal, the balanced scorecard translates this into specific
performance measures. In other words attention here Customer concerns that will help generate
the planned customer value and typically fall into several categories such as;
•
Quality: Quality measures include basic operating characteristics as well as other
complementing attributes such as features, durability etc.
•
Service: How long will it take a problem to be rectified? (If the photocopier breaks down,
how long will it take the maintenance engineer to arrive?).
In order to view the firm's performance through customers' eyes, some firms hire market
researchers to assess how the firm performs. Higher service and quality may cost more at the
outset, but savings can be made in the long term.
•
•
Delivery: Lead time is the time it takes a firm to meet customer needs from receiving an
order to delivering the product.
Price: Includes not only the immediate transaction costs but also the life cycle costs. For
example when a customer selects an automobile, the life cycle costs will come in to effect.
Internal business perspective
The internal business perspective identifies the business processes or work steps that have
the greatest impact on customer satisfaction, such as quality and employee skills.
•
Companies should also attempt to identify and measure their distinctive competence sand
the critical technologies they need to ensure continued leadership. Which processes should
they excel at?
•
To achieve these goals, performance measures must relate to employee behaviour, with
a view to align strategic direction with employee action.
•
An information system is necessary to enable executives to measure performance. An
executive information system enables managers to drill down into lower level
information.
Innovation and learning perspective
The question here is 'Can we continue to improve and create value?' Whilst the customer and
internal process perspectives identify the current parameters for competitive success, the
company needs to learn and to innovate to satisfy future needs.
•
How long does it take to develop new products?
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•
•
•
•
•
How quickly does the firm climb the experience curve to make new products?
What percentage of revenue comes from new products?
How many suggestions are made by staff and are acted upon?
What are staff attitudes, motivation and processes in place for employee training and
development.
The company can identify measures for training and competencies required for and longterm investment growth and investment.
Financial perspective
'How do we appear to shareholders?' Financial performance indicators indicate 'whether the
company's strategies, implementation, and execution are contributing to bottom line
management.'
Financial performance indicators
Measure
For
Against
Profitabilit
y
Return on
investment
(profit/
capital)
Easy to calculate and understand.
Ignores the size of the investment.
Residual
income
Earnings
per share
DCF(cash
flow
related)
Accounting measure: easy to • Ignores risk
calculate and understand. Takes • Easy to manipulate (eg
size of investment into account.
managers
may
postpone
Widely used.
necessary capital investment to
improve ratio)
• What are 'assets'? (eg do
brands count?)
• Only really suited to products
in the maturity phase of the
life cycle, rather than others
which are growing fast.
Head office levies an interest Not related to the size of
charge for the use of asset.
investment except indirectly
Relates the firm's performance to Shareholders are more concerned
needs of its shareholders
about future expectations; ignores
capital growth as a measure of
shareholders' wealth
Relates performance to investment • Practical
difficulties
in
appraisal used to take the
predicting future cash flows of
decision; cash flows rather than
a whole company
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Measure
measures
For
Against
accounting profits are better • Difficulty in separating cash
predictors of shareholder wealth
flows for products which share
resources
Linkages
Disappointing results might result from a failure to view all the measures as a whole. For
example, increasing productivity means that fewer employees are needed for a given level of
output. Excess capacity can be created by quality improvements. However, these improvements
have to be exploited (eg by increasing sales). The financial element of the balanced scorecard
'reminds executives that improved quality, response time, productivity or new products, benefit
the company only when they are translated into improved financial results', or if they enable the
firm to obtain a sustainable competitive advantage.
The balanced scorecard only measures strategy. It does not indicate that the strategy is the
right one. According to Kaplan and Nortan “failure to convert improved operational
performance into improved financial performance should send executives back to their drawing
boards to rethink the company's strategy or its implementation plans”.
Example: The structure of a Balanced Scorecard
Many firms use profit or investment centre organisation to control the performance of different
divisions. A profit centre is where managers are responsible for revenues and costs; an
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investment centre is a profit centre in which managers have some say in investment decisions.
Will be useful to be mindful of the following.
•
•
•
•
6.9
Different divisions may offer different risk/return profiles.
Must be conscious of behavioural consequences and the managers may be driven to take
dysfunctional decisions if inequity is perceived and not supported by equitable reward
systems.
An economically efficient, fair transfer pricing system need to be devised.
There are problems in assessing how shared fixed assets or head office costs should be
charged out.
The role of the management accounting function in the organization
The purpose of management accounting in the organization is to support competitive decision
making by collecting, processing, and communicating information that helps management plan,
control, and evaluate business processes and company strategy. The interesting thing about
management accounting is that, with costs increasingly emerging as a major consideration in
strategic competitiveness, the role of ‘management accounting’ is becoming an important
organizational function.
Generally, in a very large company, each division has a top accountant called the controller, and
much of the management accounting that is done in these divisions comes under the leadership
of the controller. On the other hand, the controller usually reports to the vice president of finance
for the division who, in turn, reports to the division’s president and/or overall chief financial
officer (CFO). All of these individuals are responsible for the flow of good accounting
information that supports the planning, control, and evaluation work that takes place within the
organization.
As should be clear by now, the process of management accounting is the process of creating and
using cost, quality, and time-based information to make effective decisions within the
organization. Many people in the organization play a role in this process. The internal audit
department has the responsibility of ensuring that controls are followed and operations are
efficient. Financial accounting, while providing information to outsiders (such as creditors,
investors, and government agencies), must also provide relevant financial reports to decision
makers within the organization. Systems professionals have the responsibility to process
information so that it is available to management in formats useful for decision making. Tax
department experts make sure that the organization complies with the tax laws and pays no more
than its legally obligated tax liability, but these people also participate in good planning, control,
and evaluation of processes and decisions that will affect future tax expense exposure. Finally,
cost accounting obviously plays a key role in tracking and reporting relevant product and service
costs. Overall, the controller works to bring together all this information as an integral part of
the planning, controlling, evaluating, and decision-making activities that take place throughout
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the organization. Following are some of the functions a Management Accountant perform in an
organization.
•
•
•
•
•
•
•
•
•
•
Breaking down of cost/expenditure into functions and processes to facilitate cost control at
each operational level.
Developing standards for all operating areas and evaluating actual with the standards.
Analyzing overall business and operational data.
Suggesting alternatives to improve productivity.
Identifying areas of wastages, leakages and inefficiencies or invisible losses.
Ensuring optimum utilization of available resources.
Deploying informatics tools for an efficient management information system.
Providing ‘Product’ and ‘Market’ Profitability Analyses and also playing a key role in the
‘Pricing’ decisions.
Assisting in decision-making process at all cadres of management.
An excellent understanding of the business model and providing all strategically relevant
information that will help improving strategic competitiveness of the business.
Chapter Summary
Control function is one of the primary functions of the total management process, along with
planning, organizing and leading, by which managers in organizations try to accomplish their
mission, goals and objectives. Strategic planning that takes place at the top management level
setting the agenda and direction for the entire organization is supplemented by strategic controls
carefully designed to pro actively guard against possible threats and risks of failure.
As it may be seen in the discussion of strategic controls, while retaining the fundamental flavor
of the traditional management control function strategic controls cover a wider spectrum from
the stage of strategic analysis to strategy implementation and is a common thread with a special
emphasis on ensuring realization of planned results and organizational well being. Feed-forward
control mind set is pervasive all along the strategic control cycle reminding us the age old adage
‘an ounce of prevention is worth a pound of correction’.
Professor Robert Antony’s hall mark strategic planning and control concepts was discussed that
will enlighten us with a historical perspective of the academic framework for strategic control
and was followed up with the contemporary dimensions of strategic controls. The ‘premise
controls’ watch over whether the assumptions made in the stage of formulating organizational
plans remain applicable during stages of implementation. ‘Strategic surveillance’ scan multiple
information sources that might reveal strategically relevant information and influences over
broader range, external as well as internal events, that was hither to unanticipated. The concept
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of ‘special alert controls’ prepare the organization for any major crisis events should they happen
to impact, though despite very low likelihood. As the name implies ‘implementation controls’
are more of a diagnostic nature and focusing on planned mile stones and are designed to
safeguard the actual achievements against planned results as implementation unfolds.
The section also highlights the importance of behavioral variables in instituting control structures
such as the value of equitable, progressive and challenging reward systems as a layer of any
control system. The limitations of the traditional control mechanism- budgetary control
endowed with many ‘lagging indicators’ was reviewed in the context of strategic controls that
favor more ‘leading indicators’ enabling feed forward controls as opposed to less valued feedback control action. This chapter in its penultimate section contains a comprehensive analysis
of the all famous ‘Balanced Score Card (BSC)’ concept that lays down a useful, practically
implementable structure linking planning with implementation and control through ‘Key
Performance Indicators (KPIs)’.The contemporary role of a management accountant was
examined that conclude the chapter dedicated to strategic control and review.
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Risk Management – 30%
129
Table of Contents
Contents
Page No.
Chapter 01: Risk Management & Strategy
131 - 141
Chapter 02: Enterprise Risk Management for Strategic Advantages
142 - 152
Chapter 03: Identify and Assess Risk Involved in Strategic Decisions
153 - 172
Chapter 04: Governing, Sensing & Countering the Strategic Risk
173 - 186
Solutions to Review Questions
187 - 193
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Chapter – 01
Risk Management & Strategy
Learning Outcomes
After studying this chapter, you should be able to:
•
•
•
Define and interpret the meaning of risk and Enterprise Risk Management.
Explain the Relationship between Strategic Risk Management (SRM) and Enterprise Risk
Management (ERM).
Compare and contrast different types of risk of an enterprise.
1. Managing risk is an integral part of managing a business
Managing risk is an integral part of managing a business. Irrespective of the type of the business,
industry or the business model, every organization has a mission and a range of objectives to be
accomplished. However, there is no guarantee that these objectives are achieved because future
is uncertain. Unforeseen events could impede or threaten the achievement of objectives.
Oil Price Fluctuation
Rise in prices is generally associated with oil price, which exert pressures on margin of entities
which make significant use of oil in the value creation process. Conversely, when the oil price
crashed to an unprecedentedly lower level, profitability of established entity such as BP (British
Petroleum) and Shell were threatened. This event in turn affected pension funds which have
heavily invested in oil companies. These pension funds have been seen as stable investments and
have traditionally paid out a large annual dividend to their shareholders. Furthermore, Banks
were also at risk from the falling oil prices which might increase the chance of default on the
loans granted to finance exploration of new fields in recent years. While fall in oil prices
represented a negative risk to some businesses, it would have reduced the cost of production of
many machine intensive manufacturing organizations and transport sector presenting them with a
great opportunity to reduce the cost. This example epitomizes two facets of an uncertainty which
can be negative or positive and are fundamental to the definition of “Risk”.
Let’s now examine two authoritative definition of risk:
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•
•
Committee of Sponsoring Organization, (COSO), Enterprise Risk Management Integrated
Framework, defines risk as “Possibility that an event will occur and adversely affect the
achievement of objectives”
ISO 31000 defines risk in terms of “Uncertainty” i.e. “Effect of uncertainty on objectives”,
– positive and negative consequences.
According to COSO ERM Integrated Framework, the underlying premise of enterprise risk
management is that every entity exists to provide value for its stakeholders. All entities face
uncertainty, and the challenge for management is to determine how much uncertainty to accept
as it strives to grow stakeholder value. Uncertainty presents both risk and opportunity, with the
potential to erode or enhance value. Enterprise risk management enables management to
effectively deal with uncertainty and associated risk and opportunity, enhancing the capacity to
build value. Management channels opportunities back to its strategy or objective-setting
processes, formulating plans to seize the opportunities.
In other words, risk management prepares organizations to effectively deal with negative
consequences and to seize opportunities with a positive consequence. However, risks should not
be misunderstood as weaknesses or issues. A weakness is a flaw or a propensity for something to
go wrong while an issue describes something that has gone wrong whereas risk takes into
account future events or uncertainty.
1.1 The Relationship between Strategic Risk Management (SRM) and Enterprise Risk
Management (ERM)
In an article published on strategic risk management by Mark L. Frigo and Richard J. Anderson
in 2011based on the research in the Strategic Risk Management Lab at DePaul University, and
through collaborative research with the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) and other universities and professional organizations, the relationship
between Strategic risk management and Enterprise Risk Management has been articulated and is
summarized. The key point highlighted in this study is that SRM is a critical part of an
organization’s overall ERM process. It is not separate from ERM but is a critical element of it—
and one that has been becoming more important. Therefore, we shall first carefully examine the
concept of enterprise risk management and its components which provide foundation for
strategic risk management.
2. Enterprise Risk Management
Enterprise risk management is a process, effected by an entity’s board of directors, management
and other personnel, applied in strategy setting and across the enterprise, designed to identify
potential events that may affect the entity, and manage risk to be within its risk appetite, to
provide reasonable assurance regarding the achievement of entity objectives.
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According to the definition, enterprise risk management is:
•
•
•
•
•
•
•
A process, ongoing and flowing through an entity;
Effected by people at every level of an organization;
Applied in strategy setting;
Applied across the enterprise, at every level and unit, and includes taking an entity level
portfolio view of risk;
Designed to identify potential events that, if they occur, will affect the entity and to manage
risk within its risk appetite;
Able to provide reasonable assurance to an entity’s management and board of directors; and
Geared to achievement of objectives in one or more separate but overlapping categories.
The above elements of the definition delineate that risk management is not an end instead it is a
process that has to be woven into natural fabric of business strategies, planning, operations,
processes and decisions making at every level. This is because many people do not realize that
day to day decisions they make represent risk.
2.1 Critical link between strategy and risk
Report of the National Association of Corporate Directors Blue Ribbon commission on Risk
Governance states that risk is not merely something to be avoided, mitigated, and minimized;
risk is integral to strategy and essential for a business to succeed. Boards should encourage
management to pursue prudent risk to generate sustainable corporate performance and value. The
report further states that the board’s oversight of risk should begin with assessing the
appropriateness of the company’s strategy and the risk that is inherent in that strategy. This
includes understanding and agreeing on the amount of risk the organization is willing to accept
or retain-its “risk appetite,” Boards need to be clear about (and ultimately approve) the risk
appetite that management is endorsing. Higher risk can mean higher return, but also higher
volatility of earnings and perhaps even a threat to the enterprise. Importantly, the failure to
clarify risk appetite- and to monitor the company’s actions relative to that appetite- also poses a
risk to the enterprise. It is important for the board to recognize that approving the company’s risk
appetite is a fundamental strategic decision.
Therefore, it is clear that risk appetite plays a pivotal role in responding to risk and aligning risk
mitigation plans to manage risk within risk appetite. During the next section, we will examine
the strategic relevance of risk appetite and factors that shape the risk appetite.
2.2 Risk Appetite and Risk tolerance
Every organization is exposed to risk and there is always an acceptable level of risk of doing the
business as the effort to manage the risk may outweigh the benefits. For example, Organization
may allow some level of quality failure which is inherent in the production process. Similarly, it
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may not be practical to make work place accidents free, however, an entity may have zero
tolerance for major accidents representing its lower risk appetite in relation to safety at work
place. When such a lower level of appetite is communicated from the board and clearly
articulated, the organization may allocate its resources on appropriate system, process and people
development to align its strategy with risk appetite. This shows the importance of a welldocumented risk appetite and drilling it down to risk tolerance in relation to specific business
objectives.
We will now examine the definition of risk appetite, risk tolerance and factors that determine the
risk appetite.
2.2.1 Risk Appetite
Risk appetite is the amount of risk, on a broad level, an entity is willing to accept in pursuit
of value. It reflects the entity’s risk management philosophy, and in turn influences the entity’s
culture and operating style.
Risk appetite is graphically represented in the below figure
Figure 1: Forming Risk Appetite
Lo
w
Me
diu
m
Exceeding
Risk Appetite
Im
pa
ct
Hig
h
Within Risk
Appetite
Low
Medium
High
Likelihood
Copyright @2004, Committee of Sponsoring Organizations of the Treadway Commission
(COSO). (Reproduced by permission).
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Below discussion on risk appetite is based on a thought paper issued by COSO in 2012, titled
Understanding and Communicating Risk Appetite. Many entities consider risk appetite
qualitatively, with such categories as high, moderate, or low, while others take a quantitative
approach, reflecting and balancing goals for growth, return, and risk. A company with a higher
risk appetite may be willing to allocate a large portion of its capital to such high-risk areas as
newly emerging markets. In contrast, a company with a low risk appetite might limit its shortterm risk of large losses of capital by investing only in mature, stable markets.
This definition brings out some important considerations about the risk appetite
•
•
•
•
•
•
•
It is strategic and is related to the pursuit of organizational objectives;
It forms an integral part of corporate governance;
It guides the allocation of resources;
It guides an organization’s infrastructure, supporting its activities related to recognizing,
assessing, responding to, and monitoring risks in pursuit of organizational objectives;
It influences the organization’s attitudes towards risk;
It is multi-dimensional, including when applied to the pursuit of value in the short term
and the longer term of the strategic planning cycle; and
It requires effective monitoring of the risk itself and of the organization’s continuing risk
appetite.
Risk appetite is directly related to an entity’s strategy
It is considered in strategy setting, as different strategies expose an entity to different risks.
Enterprise risk management helps management select a strategy that aligns anticipated value
creation with the entity’s risk appetite.
Risk appetite guides resource allocation
Management allocates resources among business units and initiatives with consideration of the
entity’s risk appetite and the unit’s plan for generating desired return on invested resources.
Management considers its risk appetite as it aligns its organization, people, and processes, and
designs infrastructure necessary to effectively respond to and monitor risks.
Risk tolerances relate to the entity’s objectives. Risk tolerance is the acceptable level of
variation relative to achievement of a specific objective, and often is best measured in the same
units as those used to measure the related objective.
In setting risk tolerance, management considers the relative importance of the related objective
and aligns risk tolerances with risk appetite. Operating within risk tolerances helps ensure that
the entity remains within its risk appetite and, in turn, that the entity will achieve its objectives.
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An overview of the considerations affecting risk appetite is shown in figure 2.
Figure 2: Determinants of Risk Appetite
Overview of Considerations Affecting Risk Appetite
Existing
Risk p rofile
The current level and distribution of risks across
the entity and across various risk categories
Risk
Capacity
The amount of risk that the entity is able to
support in pursuit of its objectives
Risk
Tolerance
Acceptable level of variation an entity is willing
to accept regarding the pursuit of its objectives
Attitudes
Towards Risk
The attitudes towards growth, risk, and return
Determination
of
Risk
Appetite
Source: Larry Rittenbergand Frank Martens (2012)
2.2.2 Risk Tolerances
Risk tolerances are the acceptable levels of variation relative to the achievement of objectives.
Risk tolerances can be measured, and often are best measured in the same units as the related
objectives. Performance measures are used to help ensure that actual results will be within
established risk tolerances. For example, a company targets on-time delivery at 98%, with
acceptable variation in the range of 97%–100%.
Risk tolerances guide operating units as they implement risk appetite within their sphere of
operation. Risk tolerances communicate degree of flexibility, while risk appetite sets a limit
beyond which additional risk should not be taken.
Table 1: Examples of Risk appetite and tolerance statements
Risk Appetite
Type I:The organization has a higher risk
appetite related to strategic objectives and
is willing to accept higher losses in the
pursuit of higher returns.
Type II:The organization has a low risk
appetite related to risky ventures and,
therefore, is willing to invest in new
business but with a low appetite for
potential losses.
Risk Tolerance
While we expect a return of 18% on this
investment, we are not willing to take more than a
25% chance that the investment leads to a loss of
more than 50% of our existing capital
We will not accept more than a 5% risk that a
new line of business will reduce our operating
earnings by more than 5% over the next ten years.
Source: Larry Rittenbergand Frank Martens (2012)
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2.3 Risk and Achievement of Objectives
The objective of risk management is to increases the probability of success and reduces both the
probability of failure and the level of uncertainty associated with achieving the objectives of the
organization. This view is also confirmed by an authoritative body on Risk management, Institute of
Risk Management in its risk management standard, AIRMIC, Alarm, IRM. Types of objectives
organization establishes varies from one to another. In COSO ERM Framework 2004, four main
categories of objectives are included as described below:
•
•
•
•
Strategic – high-level goals, aligned with and supporting its mission;
Operations – effective and efficient use of its resources;
Reporting – reliability of reporting; and
Compliance – compliance with applicable laws and regulations.
2.3.1 Relationship of Objectives and Components
There is a direct relationship between objectives, which are what an entity strives to achieve,
and enterprise risk management components, which represent what is needed to achieve them.
• The relationship is depicted in a three-dimensional matrix, in the form of a cube.
•
The four objectives categories – strategic,
operations, reporting, and compliance –
are represented by the vertical columns,
the eight components by horizontal rows,
and an entity’s units by the third
dimension. This depiction portrays the
ability to focus on the entirety of an
entity’s enterprise risk management, or by
objectives category, component, entity
unit, or any subset thereof.
Figure 4 COSO- ERM Framework
TIONS
OMPLIANCE
STRATEGIC
A REPORTING
OPER
C
InternalEnvironment
ObjectiveSetting
EventIdentification
RiskAssessment
RiskResponse
ControlActivities
Information&Communication
E
DI
N
VI
TI
SI
T
O
YN
LE
V
EL
B S
U U
SI B
N SI
E DI
SS A
U R
NI Y
T
Monitoring
Copyright @2004, Committee of Sponsoring Organizations of the Treadway? Commission
(COSO) Reproduced by permission.
COSO framework explains that objectives relating to reliability of reporting and compliance with
laws and regulations are within the entities. Achievement of strategic objectives and operations
objectives is subject to external events not always within the entity’s control. However, there is a
much close relationship among these objectives, when an entity is exposed to a major risk.
Operational risk is frequently defined as loss arising from failed or inadequate procedures,
system or policies such risk may affect day to day business operations. However, major
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operational risk such as product failure may threaten the strategic objective of remaining as
marker leader and may result in non-compliance with laws. Such noncompliance may require
disclosures or provision to be recognized in financial statements affecting the reporting
objective.
3. Enterprise-wide view of Risk
Decisions that affect one risk have a direct impact on risks elsewhere. Let’s consider an example
of a manufacturing entity, when there is a delay in supply of raw material, it will affect the
production targets. When the planned production drops, it will reduce employees’ ability earn
production incentive creating dissatisfaction within the work force. It is argued that the
enterprise-wide view, with its concomitant need to involve the entire organisation, is more
accurate and useful than taking a restricted specific view. The enterprise-wide view allows
managers to see the full complexities of the risks and dependencies that exist within the
organisation and to gain an appreciation of the likely effects or consequences of alternative
decisions (Roberts, Wallace, and McClure 2003).
3.2 Risk Classification System
Figure below shows drivers of risk management Internal and external factors can give rise to
risks. Figure 5 below is based on the FIRM Risk Scorecard risk classification system and it
provides examples of internal and external key risk drivers. Some risk classification systems
have strategic risk as a separate category. However, the FIRM Risk Scorecard approach suggests
that strategic (as well as tactical and operational) risks should be identified under all four
headings.
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Figure 5: Drivers of risk management
Source: AIRMIC, Alarm, IRM, 2010
3.3 Enterprise risk; categorization
There are different ways of categorizing enterprise wide risk. The most obvious initial
classification of risk is to differentiate it in terms of the risk level within the organisation on
which it impacts. The obvious classification in this respect is as listed below.
•
•
•
•
strategic risk;
change or project risk;
operational risk;
Unforeseeable risk.
Over and above this basic classification, risk can also be classified in terms of the specific nature
of the risk, its origin and characteristics, and the extent to which the risk is dependent upon or
linked with other risks.
A second possible classification is listed below.
•
•
Financial and knowledge risk;
Internal and external risks; speculative and static risks; risk interdependency.
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Strategic risk relates to risk at the corporate level, and it affects the development and
implementation of an organization’s strategy. An example is the risk resulting from an incorrect
assessment of future market trends when developing the initial strategy.
(Roberts, Wallace, McClure 2003)
Foreseeable Vs unforeseeable risk
Foreseeable risks are those that are known or (at least) knowable, provided we have good
intelligence. Unforeseeable risks cannot be understood or predicted with any degree of accuracy.
E.g. Business model can be disrupted through a new technology e.g. Kodak was short sighted in
identification of the technological breakthroughs of competitors sacrificing its market leadership
to digital cameras.
Unforeseeable risk is the type of risk that cannot be accurately forecast before it occurs. Some
risks may be reasonably anticipated, such as a change in interest rates over a five-year period. In
developing a strategic plan for an organisation, it will be assumed that there will be some
variation in interest rates and that this variation will be contained within reasonable limits.
Unforeseeable risks can sometimes be allowed for up to a point by the use of contingencies built
into the overall plan. However, these can absorb only so much of the impact, and once they are
consumed, the only option may be for a tactical response using resources from elsewhere within
the system (Roberts, Wallace, McClure 2003).
Risk management under unknowable environmental conditions as it must deal with “Unk unks’
Unk unks refers to unknown unknowns i.e. unforeseeable events the consequence of which
cannot be known beforehand. Nasem Nicolas Taleb (2007) objects to people who think they can
map the future, arguing that they ignore the large deviation and thus failed to take the “Black
Swan” i.e. the abrupt unexpected events with extreme effect, into account.
Nassim Nicholas Taleb’s book, The Black Swan, is an honest attempt to look at randomness and
uncertainty in the world, how we should take risks and where we should minimise that risk so we
are not obliterated by the big potential downsides or negative “black swans” and how we can
benefit from the positive black swans. He uses the black swan as a metaphor for a game changer,
prior to the discovery of a black swan, the statement “swans are white” was simply a truism
because no one had evidence that black swans existed but absence of evidence is not evidence of
absence. This is one of the many lessons Taleb teaches as he considers different realms of the
world (Bill Conerly 2013). Some examples of Black Swan types of risk are given below;
•
•
•
September 11 attacks;
Indian Ocean tsunami of December 2004.
Recent events ranging from credit crunch to BP’s Deepwater Horizon oil spill to the Arab
Spring.
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Chapter Summary
•
Managing risk is an integral part of managing a business. Irrespective of the type of the
business, industry or the business model every organization has a mission and a range of
objectives to be accomplished.
•
Risk can be defined as “Possibility that an event will occur and adversely affect the
achievement of objectives” or Effect of uncertainty on objectives. Risk can be classified in a
number of ways: Business or operational: relating to the activities carried out within an
organization; Financial: relating to the financial operation of a business; Environmental:
relating to changes in the political, economic, social and financial environment; Reputation
risk: caused by failing to address some other risk.
•
Risk management is not an end instead it is a process that has to be woven into natural
fabric of business strategies, planning, operations, processes and decisions making at every
level. This is because many people do not realize that day to day decisions they make
represent risk. .The enterprise-wide view allows managers to see the full complexities of
the risks and dependencies that exist within the organisation and to gain an appreciation of
the likely effects or consequences of alternative decisions.
•
Risk is integral to strategy and essential for a business to succeed. SRM is a critical part of
an organization’s overall ERM process. It is not separate from ERM but is a critical element
of it—and one that has been becoming more important.
•
The board’s oversight of risk should begin with assessing the appropriateness of the
company’s strategy and the risk that is inherent in that strategy. This includes understanding
and agreeing on the amount of risk the organization is willing to accept or retain-its “risk
appetite”.
Review Questions
Question 1
Construct a definition of risk management that could be useful within an organization’s strategic
planning documents. Chapter 01
Question 2
Compare and contrast the view of risk as hazard with the view of risk as opportunity. How do
these different views affect the risk management process?
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Chapter – 02
Enterprise Risk Management for Strategic Advantages
Learning Outcomes
After studying this chapter, you should be able to:
•
•
•
•
Discuss the meaning of strategic risk and strategic risk management.
Describe strategic framework for risk management.
Illustrate the benefits of an effective risk management system.
Explain characteristics of an effective risk management system.
1. The Advent of Strategic Risk Management
A thought paper published by PwC on sharpening strategic risk management, it states that “while
conventional enterprise risk management (ERM) techniques have done a reasonable job in
identifying and mitigating financial and operational risks, research shows that it is the
management of strategic risk factors that will have the greatest impact on ability to realize
strategic objectives. The paper argues that bringing ERM into the forefront of strategic decision
making and execution could thus give decisive edge to a business.
BP
When Tony Hayward became CEO of BP in 2007, he vowed to make safety his top priority.
Among the new rules he instituted were the requirements that all employees use lids on coffee
cups while walking and refrain from texting while driving. Three years later, on Hayward’s
watch, the Deepwater Horizon oil rig exploded in the Gulf of Mexico, causing one of the worst
manmade disasters in history. A U.S. investigation commission attributed the disaster to
management failures that crippled “the ability of individuals involved to identify the risks they
faced and to properly evaluate, communicate, and address them.” Hayward’s story reflects a
common problem. Despite all the rhetoric and money invested in it, risk management is too often
treated as a compliance issue that can be solved by drawing up lots of rules and making sure that
all employees follow them. Many such rules, of course, are sensible and do reduce some risks
that could severely damage a company. But rules-based risk management will not diminish either
the likelihood or the impact of a disaster such as Deepwater Horizon, just as it did not prevent
the failure of many financial institutions during the 2007–2008 credit crisis (Kaplan and Mikes
2012.)
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The key issue presented in the above case is management’s failures to prioritize risk that could
threaten the survival of the company and could have a major impact on its reputation and
competitive position in the industry. Given the business model of BP, safety should have been
considered as a top priority in its decision to transfer the management of Macando oil well which
was subject to the calamity to an outside company.
The disaster, which had been treated as operational or managerial risk by the board, had political
and economic impacts that more than halved the company’s market capitalization and even put
its survival at risk (Tricker 2010).
2. Strategic Risk and Strategic Risk Management
These more significant risk exposures have given rise to a focus on “strategic risks” and
“strategic risk management.” “Strategic risks” are those risks that are most consequential to the
organization’s ability to execute its strategies and achieve its business objectives. These are the
risk exposures that can ultimately affect shareholder value or the viability of the organization.
“Strategic risk management” then can be defined as “the process of identifying, assessing and
managing the risk in the organization’s business strategy—including taking swift action when
risk is actually realized.” Strategic risk management (SRM) is focused on those most
consequential and significant risks to shareholder value, an area that merits the time and attention
of executive management and the board of directors.
(Mark L. Frigo and Richard J Anderson 2012)
A study from the Economist Intelligence Unit concluded:“Strategic risk management remains an
immature activity in many companies.”The Risk and Insurance Management Society (RIMS), a
professional association and standard-setting body, defines SRM as a business discipline that
drives deliberation and action regarding uncertainties and untapped opportunities that affect an
organization's strategy and strategy execution (RIMS, 2011).
Spurred by the banking industry’s success in financial risk management and by Sarbanes Oxley’s
rigorous standards for corporate governance, some firms have been adopting the practice of
“enterprise risk management,” which seeks to integrate available risk management techniques in
a comprehensive, organization-wide approach. Many of these early adopters are at a rudimentary
stage, in which they treat enterprise risk management as an extension of their audit or regulatory
compliance processes. Other companies are at a more advanced stage, in which they quantify
risks and link them to capital allocation and risk transfer decisions. Even among these more
advanced practitioners, however, the focus of enterprise risk management rarely encompasses
more than financial, hazard, and operational risks. Most managers have not yet systematically
addressed the strategic risks that can be a much more serious cause of value destructionSlywotzky and Drzik (2005).
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2.1 Categorization of Strategic Risk
Slywotzky and Drzik (2005) define strategic risks as the array of external events and trends that
can devastate a company’s growth trajectory and shareholder value. Slywotzky and Drzik (2005)
identify seven major classes of strategic risk including industry, technology, brand, competitor,
customer, project, and stagnation, and suggest countermeasures for each class of risk. In a similar
fashion, Andersen and Schroder (2010) list several risk factors related to strategic risks:
competitor moves, new regulations, political events, social changes, changing tastes, and new
technologies.
There is an inclination to associate strategic risk with external factors. However, some strategic
risk may arise from organization’s choice of a strategy and the case below is a good example for
strategic risks which deserve the attention of the board.
Toyota
The Toyota car company had developed a worldwide reputation for growth based on innovation
and quality. The board built up a highly successful company using tight Japan- centered
management oversight and control. Unfortunately, the directors failed to foresee the risks when
they expanded the company’s supply chains and manufacturing locations around the world. The
price they paid was massive product recalls of entire ranges of automobiles with problem brakes,
steering, and electronics. The financial cost to the company was heavy; the effect on its
reputation was worse.
Bob Tricker (2012)
3. Importance of managing strategic risk
Based on PwC thought paper on sharpening strategic risk management, there are four main types
of risk that a business is likely to face: financial risk; operational risk; hazard risk and strategic
risk. According to the paper, financial risks are typically well controlled and are part of the
routine focus of board risk discussions, with strong impetus coming from the increased
regulatory, accounting and financial audit focus; operational risks are typically managed from
within the business and often focus on health and safety issues where industry regulations and
standards require; hazard risks often stem from major exogenous factors, which affect the
environment in which the organisation operates. A focus on the use of insurance and appropriate
contingency planning will help address some of these. However, strategic risks are typically
external or affect the most senior management decisions. as such, they are often missed from
many risk registers. Board has a responsibility to make sure all these types of risks are included
in key strategic discussions. Clearly the potential impact of strategic risks is significant enough
to deserve the attention of the board and its directors as a result risk governance has gained
popularity during the recent past as a key governance consideration.
To sum up the above thoughts from various authors on different facets of strategic risk, strategic
risk management and its importance, following points are relevant.
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•
Strategic risks are the most consequential to the organization’s ability to execute its
strategies and achieve its business objectives. In risk management language, strategic risk
has a high impact and lower likelihood in the short run. However, in the long run, when
such risk unfolds the organization may be out of the business. Consider the Blackberry
phone manufacturer which fails to anticipate ever changing customer preferences and
bold moves of competitors.
•
Risk management system of many organizations deals with predictable risk with formal
risk mitigations such as financial controls, hedging and insurance while paying scant
attention to the identification, assessment and mitigation of strategic risk. Firms can
realize even greater value by taking a disciplined and systematic approach to manage the
strategic risks that can make or break them.
•
Managing strategic risk requires the input from the board that plays a pivotal role in
crafting organizational strategies and governing risk. However, the board may not
receive sufficient information to comprehend and deliberate the impact of strategic risk;
US sub-prime mortgage crisis is a good example which threatened the survival of many
banks and financial institutions which supposedly practiced sophisticated risk
management processes.
4. Strategic Framework for Managing Risk
The Centre for Strategy Development and Implementation at Edinburgh Business School,
Heriot-Watt University, founded by Professor Alex Roberts in 2001 had introduced Strategic
Focus Wheel to focus the efforts and resources of organisations on delivering their intended
strategic objectives, and has four core elements described below.
Strategic Planning
Strategic Risk
Management
Strategy Focus
Wheel
Marketing
Strategies Work
Project Management of
Change
Figure 6: The Strategic Focus Wheel™
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Strategic planning revolves around identifying the options available to an organisation and
selecting the most appropriate. If strategic planning is done poorly, even the best implementation
capability is unlikely to compensate.
Making strategies work is a process for connecting the high-level strategic plan to the day-today activities that are critical to its delivery.
Project management of change ensures completeness and control over the physical realization
of the chosen strategy. Project management provides a comprehensive set of tools and
techniques that enable managers to plan and implement change effectively and increase the
likelihood of achieving the various objectives of the change process. Used effectively project
management is a central element of the wheel in that it makes things happen and delivers results.
Strategic Risk Management
Strategic risk management (SRM) identifies monitors and manages the risk profile of the
organisation. Major changes in this profile can result in the need to revise or change the
elements listed above and, in particular, to devise new strategic plans. Alternatively, changes
may be due to the implementation of a new strategy.
(Roberts, Wallace, McClure 2003)
4.1 Scope of Strategic risk management
Strategic risk management covers four primary risk areas or levels. These are strategic risk,
change or project risk, operational risk and unforeseeable risk (Roberts, Wallace, McClure
2003). These boundaries of strategic risk management are explained below.
Strategic risk includes risk relating to the long-term performance of the organisation. This
includes a range of variables such as the market, corporate governance and stakeholders. The
market is highly variable and can change at relatively short notice, as can the economic
characteristics of the country or countries in which a given organisation is operating The
corporate governance risk of the organisation includes risk relating to the reputation of the
organisation and the ethics with which it operates. Examples include the reputation of the
organisation and its desire to maintain that reputation, perhaps at the expense of innovation or
new developments. Stakeholder risk includes the risk associated with the shareholders, business
partners, customers and suppliers. Shareholder attitudes can change quickly if dividends fall.
Change risk can operate at numerous levels within the organisation. Changes can be imposed by
variations elsewhere either within or outside the organisation. Alternatively, changes can be
planned and engineered by the organisation as a way to achieve objectives. An example of an
imposed change would be the realized requirement to install a new production line in order to
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meet a sudden and unforeseen increase in demand for a product. Alternatively, if this increase in
demand had been foreseen the organisation might have initiated the change itself in order to
ensure that it could meet the increase in demand.
Project risk operates at the programme or project levels. Most organisations evolve and develop
by the use of projects, which are themselves actions for achieving change. An example of a
project risk is the risk of damages becoming payable for late completion.
Assuming that the planned change can be approached as a project, the obvious way to organize
the planning and implementation processes is to use project management. As a discipline, project
management offers a range of tools and techniques for the management and control of time, cost,
quality and any other project objectives that may have been set. In this context, project
management is sometimes referred to as a ‘tool for managing change’.
Operational risk can be defined as ‘the risk of direct or indirect loss, resulting from inadequate
or failed internal processes, people and systems or from external events’. Operational risk also
effectively includes anything that can impact on the overall performance of the organisation and
on the ability of the organisation to create value. Operational risk therefore includes events such
as mistakes or missed opportunities.
(Roberts, Wallace, McClure 2003)
Therefore, effective framework for managing strategic risk should take a holistic approach to
address strategic risk, change or project risk, operational risk and unforeseeable risk. In the next
section, we will examine the roles of the board in shaping risk philosophy and creating a risk
culture to embed risk management in all aspects of the organization including the strategic
planning process.
5. Characteristics of an effective risk management system
According to a thought paper published by PwC on sharpening strategic risk management, there
are three main concerns at boards level in relation to risk management. First, many executives
are worried that the risk frameworks and processes that are currently in place in their
organizations are no longer giving them the level of protection they need. Second, boards are
seeing rapid increases both in the speed with which risk events take place and the contagion with
which they spread across different categories of risk. They are especially concerned about the
escalating impact of ‘catastrophic’ risks, which can threaten an organisation’s very existence and
even undermine entire industries. The third shift is that boards feel they are spending too much
time and money on running their current risk management processes, rather than moving quickly
and flexibly to identify and tackle new risks. As a result, some are not convinced that their return
on spending on ERM is fully justified by the level of protection they gain from it. PwC recently
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conducted a qualitative research study into how various multinational organisations have
responded to these challenges which are explained below.
Checks and balances at the board level are critical
Does the board have people with enough industry expertise to ask tough questions about
executives’ decisions? In many cases the answer is no. Even the most sophisticated approach to
risk can be undermined by a lack of industry insight.
In the Internet age, speed and prejudice are all
Information moves instantaneously around the world, and opinion morphs into accepted ‘fact’.
So corporations must hit the ground running with the right responses delivered at pace. All too
often, they are caught unprepared.
Leadership and culture
There is frequently a gap between what management says about risk and what it does. Are the
CEO and board setting the right behavioral example and risk-aware culture, in line with the
corporation’s strategy? Do rewards encourage risk-based thinking and behavior?
The first point above relates to risk governance, which will be explored in detail during the last
chapter. The second point primarily relates to challenges posed by digital world including social
media. The last point is critical to integrate risk management into the drivers of sustainable
success.
In almost every risk management framework, the role of the board has been highlighted as a
stepping stone for a successful implementation of a risk management programme. E.g. in the
COSO ERM Framework, internal environment has a pervasive impact in setting the tone of an
organization, for how risk is viewed and addressed by an entity’s people.
For organizations that are early in this process, the seven keys to success for improving ERM as
described in COSO (2011) Thought Leadership Paper may be useful, and are applicable in
strategic risk management:
1. Support from the top is a necessity
2. Build ERM using incremental steps
3. Focus initially on a small number of top risks
4. Leverage existing resources
5. Build on existing risk management activities
6. Embed ERM into the business fabric of the organization
7. Provide ongoing ERM updates and continuing education for directors and senior
management
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7. Benefits of an effective risk management system
The below excerpts from an article published in Harvad Business Review by Adrian J.
Slywotzky and John Drzik in 2015 delineate strategic benefits of incorporating strategic risk
management into the overall enterprise risk management framework of a corporation.
“The key to surviving strategic risks is knowing how to assess and respond to them. Devoting the
resources to do this is well worth it. Many companies already commit themselves to
meticulously managing even relatively small risks—for instance, auditing their invoices to
comply with new corporate governance regulations. These firms can realize even greater value
by taking a disciplined and systematic approach to mitigating the strategic risks that can make or
break them. Of course, no company can anticipate all risk events: There will always be
unpreventable surprises that can damage your organization—which makes it all the more
important to manage those risks that can be prevented. When a risk is common to all companies
in an industry, taking early steps to mitigate it can put your business in a much stronger
competitive position. Moreover, many strategic risks mask growth opportunities. By managing
strategic risk, you can position your company as a risk shaper that is both more aggressive and
more prudent in pursuing new growth. Such benefits make strategic-risk management a crucial
capability both for chief financial officers who need to protect the stability of their companies
and for any senior managers looking for sources of sustainable growth”.
More specific benefits of an effective enterprise risk management program are given in the
COSO ERM framework and are outlined below with case examples:
• Aligning risk appetite and strategy– Management considers the entity’s risk appetite in
evaluating strategic alternatives, setting related objectives, and developing mechanisms
to manage related risks.
Case Example:
A pharmaceutical company has a low risk appetite relative to its brand value.
Accordingly, to protect its brand, it maintains extensive protocols to ensure product
safety and regularly invests significant resources in early-stage research and
development to support brand value creation.
• Enhancing risk response decisions – Enterprise risk management provides the rigor to
identify and select among alternative risk responses – risk avoidance, reduction, sharing,
and acceptance.
Case Example:
Management of a company that Uses Company owned and operated vehicles recognizes
risks inherent in its delivery process, including vehicle damage and personal injury costs.
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Available alternatives include reducing the risk through effective driver recruiting and
training, avoiding the risk by outsourcing delivery, sharing the risk via insurance, or
simply accepting the risk. Enterprise risk management provides methodologies and
techniques for making these decisions.
• Reducing operational surprises and losses– Entities gain enhanced capability to identify
potential events and establish responses, reducing surprises and associated costs or
losses.
Case Example:
A manufacturing company tracks production parts and equipment failure rates and
deviation around averages. The company assesses the impact of failures using multiple
criteria, including time to repair, inability to meet customer demand, employee safety,
and cost of scheduled versus unscheduled repairs, and responds by setting maintenance
schedules accordingly.
• Identifying and managing multiple and cross-enterprise risks – Every enterprise faces
a myriad of risks affecting different parts of the organization, and enterprise risk
management facilitates effective response to the interrelated impacts, and integrated
responses to multiple risks.
Case Example:
A bank faces a variety of risks in trading activities across the enterprise, and
management developed an information system that analyzes transaction and market data
from other internal systems, which, together with relevant externally generated
information, provides an aggregate view of risks across all trading activities.
• The information system allows drilldown capability to department, customer or
counterparty, trader, and transaction levels, and quantifies the risks relative to risk
tolerances in established categories. The system enables the bank to bring together
previously disparate data to respond more effectively to risks using aggregated as well as
targeted views.
• Seizing opportunities – By considering a full range of potential events, management is
positioned to identify and proactively realize opportunities.
Case Example:
A food company considered potential events likely to affect its sustainable revenue
growth objective. In evaluating the events, management determined that the company’s
primary consumers are increasingly health conscious and changing their dietary
preferences, indicating a decline in future demand for the company’s current products.
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In determining its response, management identified ways to apply its existing capabilities
to developing new products, enabling the company not only to preserve revenue from
existing customers, but also to create additional revenue by appealing to a broader
consumer base.
• Improving deployment of capital– Obtaining robust risk information allows
management to effectively assess overall capital needs and enhance capital allocation.
Case Example:
A financial institution became subject to new regulatory rules that would increase capital
requirements unless management calculated credit and operational risk levels and related
capital needs with greater specificity. The company assessed the risk in terms of system
development cost versus additional capital costs, and made an informed decision. With
existing, readily modifiable software, the institution developed the more precise
calculations, avoiding a need for additional capital sourcing.
Copyright @2004, Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
(Reproduced by permission)
Chapter Summary
•
Strategic risks are the most consequential to the organization’s ability to execute its
strategies and achieve its business objectives.
•
Risk management system of many organizations deals with predictable risk with formal
risk mitigations while paying scant attention to the identification, assessment and
mitigation of strategic risk. Firms can realize even greater value by taking a disciplined
and systematic approach to mitigating the strategic risks that can make or break them.
•
Managing strategic risk requires the input from board of directors who play a pivotal role
in crafting organizational strategies and governing risk. However, board may not receive
sufficient information to comprehend and deliberate the impact of strategic risk.
•
Strategic Focus Wheel enables an organization focus the efforts and resources of
organisations on delivering their intended strategic objectives, and has four core
elements: strategic planning; making strategies work; project management of change and
strategic risk Management.
•
Strategic risk management covers four primary risk areas or levels. These are strategic
risk, change or project risk, operational risk and unforeseeable risk.
Internal environment has a pervasive impact in setting the tone of an organization, for
how risk is viewed and addressed by an entity’s people. Internal environment plays a
•
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•
major role in developing a risk culture within the organization and in enhancing the risk
maturity of an entity.
Effective implementation of ERM can bring about various benefits: aligning risk appetite
and strategy Enhancing risk response decisions: reducing operational surprises and
losses; identifying and managing multiple and cross-enterprise risks; seizing
opportunities and improving deployment of capital.
Review Case Study
Below facts are provided from an investigation conducted by House Financial Services
Subcommittee on Oversight and Investigations, chaired by Rep. Randy Neugebauer. This
investigation is an autopsy of how MF Global came to its ultimate demise.
MF Global, led by Jon Corzine, the former New Jersey governor and co-head of Goldman Sachs,
has filed for bankruptcy protection after suffering massive losses from wrong way betting on
Eurozone bonds. CEO turning 230-year-old commodities broker into a full-service investment
bank, in order to generate revenue for the transformation company heavily invested in the
sovereign debt of struggling European counties which carried enormous default and liquidity risk
Choices made by Jon Corzine during his tenure as chairman and CEO sealed MF Global’s fate,”
Chairman Neugebauer stated. “Farmers, ranchers and other customers may never get back over
$1 billion of their money as a result of his decisions. Corzine dramatically changed MF Global’s
business model without fully understanding the risks associated with such a radical
transformation.
When MF Global’s chief risk officer disagreed with Corzine about the size of the company’s
European bond portfolio, Corzine directed him to report to Abelow rather than to MF Global’s
board of directors. “This change effectively sidelined the most senior individual charged with
monitoring the company’s risks and deprived the board of an independent assessment of the risks
that Corzine’s trades posed to MF Global, its shareholders and its customers,” the report declares.
The subcommittee’s report reveals that Corzine acted as MF Global’s “de facto chief trader” and
insulated his trading activities from the company’s normal risk management review process.
This enabled Corzine to quickly build the company’s European bond portfolio “well in excess
ofprudent limits without effective resistance.”Rather than hold the European bonds on MF
Global’s books, which could expose the company to earnings volatility, Corzine chose to use
these bonds as collateral in repurchase-to-maturity (RTM) transactions. This permitted the
company to book quick profits while keeping the transactions off its balance sheet. The belated
disclosure of its extensive Repo To Maturity Portfolio- 14% of the total assets, prompted credit
agencies to downgrade the company’s trading to junk bonds.
Outline possible causes for above failure in MF global using risk management concepts and the
ways in which an effective risk management system would have averted the above calamity
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Chapter – 03
Identify and Assess Risk Involved in Strategic Decisions
Learning Outcomes
After studying this chapter, you should be able to:
•
•
•
•
Compare and contrast enterprise risk management and strategic risk management.
Illustrate the link between strategies and risk.
Discuss the critical steps in strategic risk management.
Explain the elements of risk management process including risk assessment; risk response;
key risk indicators; control activities; information and communication for making
awareness on risks.
1. Introduction
In this chapter, we will explore in more detail the language of risk professionals which has to be
the instilled in organization’s culture and integrated to the business. The first logical step in risk
management is to identify range of factors stemming from internal and external environment
which could create uncertainty in achieving entity’s objectives. In certain organization which has
reached some level in its risk maturity, strategic risk events are identified as a part of the LongRange Business Planning and annual budgeting process. E.g. when a budget for a financial year
is presented, a risk registers with key risk which could affect objectives are also presented. Let’s
assume that a labor-intensive manufacturing entity intent to increase revenue by 50%, this may
not be possible if there is a significant attrition due to lucrative incentive scheme introduced by
the competitor. Proactive scanning of the external environment for the identification of such
events could prepare the entity in advance to reduce the impact and likelihood of the event.
However, risk identification cannot be limited to a periodic exercise as explained above as new
risk can emerge from the internal or external environment at any point in time. Similarly, when
an entity crafts new strategies, and initiatives projects, events which could impede the strategy/
project should be identified.
2. From Enterprise Risk Management (ERM) to Strategic Risk Management (SRM)
As discussed in the previous chapter, COSO ERM definition describes a broadest of processes
that apply across the enterprise and involve everyone from the board of directors downwards.
(Note that ERM is directly related to “strategy setting.”)The Integrated Framework provides the
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key principles and components of enterprise risk management and is grounded in the concept of
ERM focusing on the achievement of an entity’s objectives.
The Framework groups entity objectives into four categories: strategic, operations, reporting,
and compliance. A particular objective may overlap certain categories, but the four categories
allow an organization to focus on these separate objectives for purposes of ERM.COSO define
strategic objectives as “high-level goals, aligned with and supporting its mission.” These
strategic objectives are the core of an organization’s strategy. Both internal and external events
and scenarios that can inhibit an organization’s ability to achieve its strategic objectives are
strategic risks, which are the focus of strategic risk management. Accordingly, SRM is a critical
part of an organization’s overall ERM process. It isn’t separate from ERM but is a critical
element of it—and one that has been becoming more important. (Frigo and Anderson 2011).
Accordingly, Frigo and Anderson 2011 have come up with the below definition for strategic risk
management.
Strategic Risk Management is a process for identifying, assessing and managing risks and
uncertainties, affected by internal and external events or scenarios, that could inhibit an
organization’s ability to achieve its strategy and strategic objectives with the ultimate goal of
creating and protecting shareholder and stakeholder value. It is a primary component and
necessary foundation of Enterprise Risk Management (Frigo and Anderson 2011).
This above definition, also incorporates ERM, is based on six principles.
1. It’s a process for identifying, assessing, and managing both internal and external events and
risks that could impede the achievement of strategy and strategic objectives.
2. The ultimate goal is creating and protecting shareholder and stakeholder value.
3. It’s a primary component and necessary foundation of the organization’s overall enterprise
risk management process.
4. As a component of ERM, it is by definition effected by boards of directors, management,
and others.
5. It requires a strategic view of risk and consideration of how external and internal events or
scenarios will affect the ability of the organization to achieve its objectives.
6. It’s a continual process that should be embedded in strategy setting, strategy execution, and
strategy management. Organizations can adapt the definition and principles of SRM in
developing their action plans for strengthening ERM and focusing it on strategic risks.
The above definition and elements delineate that SRM is not separate from ERM but is a critical
element of it. ERM has evolved as a separate profession with risk language and tools to manage
risk. Therefore, before we focus on SRM which is an advanced topic, we must carefully examine
critical steps in ERM process and its close interaction with SRM.
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3. Illustration of the Link between strategies and Risk
When an organization sets its objectives, it makes important strategic choices to achieve
objectives. Given below is a simple illustration of a manufacturing entity which expects to
increase profitability through automation of operations performed by skilled labor and through
the development of new products which outperforms the offering of competitors. Each of the
strategies here has its own risk profile. E.g. Product development may be hindered if critical
talents with technical expertise leave the organization. This is a risk to the chosen strategy. On
the other hand, automation may result in not achieving the same level of product quality
standards. This is an implication of choosing automation as a strategy rather a risk to strategy.
Figure 7: Goals, strategies and risk
There is another facet to strategic risk in this scenario. If we are to assume that the mission of
this organization is to produce phenomenal products with unmatchable quality standards making
the best use of rural labor force, then the automation and resultant layoff may pose a threat to
company’s mission which is detrimental to its unique identity in a competitive business
environment.
This clarifies the importance of aligning strategy with the mission and value drivers and
managing risk in relation to strategies. The emphasis on strategic risk is further witnessed by the
exposure draft issued by COSO on the new Enterprise Risk Management Framework. COSO
Board commissioned and published in 2004 Enterprise Risk Management—Integrated
Framework. Over the past decade, the framework gained much popularity among academics and
risk practitioners. The exposure draft was published in 2016. The new title, Enterprise Risk
Management—Aligning Risk with Strategy and Performance, recognizes the increasing
important connection between strategy and entity performance. Given below is the analysis of
strategy related risk included in exposure draft of COSO new ERM framework.
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Three facets of strategic risk
Once strategy is set, enterprise risk management provides an effective way for a board to fulfill
its risk oversight role by knowing that the organization is attuned to risks that can impact strategy
and is managing them well.
Strategy selection is about making choices and accepting trade-offs. So it makes sense to apply
enterprise risk management, the best approach for untangling the art and science of making wellinformed choices, to strategy. Risk is a consideration in many strategy-setting processes. But risk
is often evaluated primarily in relation to its potential effect on an already-determined strategy.
In other words, the discussions focus on risks to the strategy: “We have a strategy in place,
what could affect the relevance and viability of our strategy?” However, risk to the chosen
strategy is only one aspect of risk to consider.
As this Framework emphasizes, there are two additional aspects to enterprise risk management
that can have far greater effect on an entity’s overall risk profile. Central to decisions that
underlie selection of a strategy, the second aspect is the possibility of strategy not aligning with
an organization’s mission, vision, and core values. Then there is a third aspect. When
management develops a strategy, and works through alternatives with the board, they make
decisions on the trade-offs inherent in the strategy. Each alternative strategy has its own risk
profile—these are the implications from the strategy.
The board of directors and management need to consider how the strategy works in tandem with
the organization’s risk appetite, and how it will help drive the organization to set objectives and
ultimately allocate resources efficiently (COSO 2016).
Figure 8: Enterprise Risk Management- Aligning Risk with Strategy and Performance
Source: COSO 2016
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4. Critical Steps for Strategic Risk Management
Frigo and Anderson (2011) had stated that the exact steps that an organization should take in
managing strategic risk will depend on the level of maturity of its overall ERM processes.
1. Assess the maturity of the organization’s ERM efforts relative to its strategic risks.
Consider whether management and the board feel that they have a good understanding of
the organization’s strategic risks and the related risk management processes. Develop
action plans to move to a high level of ERM maturity.
2. Conduct a strategic risk assessment. Conduct a separate assessment to understand and
prioritize the organization’s strategic risks. Consider both internal and external risks and
events.
3. Review the process for strategy setting, including the identification of related risks.
4. Review the organization’s process for setting and updating its strategies and strategic
objectives. Ensure that the process requires the identification and assessment of the risks
embedded in the strategies.
5. Review the processes to measure and monitor the organization’s performance. Expand
the processes to include the monitoring and reporting of key performance indicators (KPIs)
related to strategic risks. Embed risk monitoring and reporting into the organization’s core
processes for budgeting, business performance monitoring, scorecards, and performance
measurement systems.
6. Develop an ongoing process to periodically update the assessment of strategic risks. Make
the strategic risk assessment process an ongoing one with periodic updating and
reporting.
4.1. Overall Risk Maturity
Effectiveness of risk management function increases when the organization increases its risk
maturity which typically reflects stages of integrating risk into the organization’s overall system
of management. Given below are the levels of risk maturity of an organization. It ranges from
“risk naïve” where there is no formal approach of managing risk to “risk enabled” where risk
management and internal controls are fully embedded to operations.
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Figure 9: Organizations’ risk maturity levels -Source IIA 2005
Whilst the above maturity levels represent overall risk maturity of the organization, it could be
applied to strategic risk in terms of approach, awareness, definition and managing of strategic
risk. At the “risk enabled” stage risk management is integrated to the overall governance
framework of the organization. Given below is a mini case study on Unilever Embedded Risk
Management approach.
Unilever: Embedded Risk Management
“At Unilever, we believe that effective risk management is fundamental to good business
management and that our success as an organization depends on our ability to identify and then
exploit the key risks and opportunities for the business. Successful businesses take/manage risks
and opportunities in a considered, structured, controlled, and effective way. Our risk
management approach is embedded in the normal course of business. It is ‘paper light—
responsibility high.’ Risk management is now part of everyone’s job, every day! It is no longer
managed as a separate standalone activity that is ‘delegated to others”.
—Unilever, one of the world’s leading suppliers of fast-moving consumer goods with operations
in 100 countries and sales in more than 190 countries.
Source - Integrating Governance for Sustainable Success (IFAC 2012).
According to Frigo and Anderson 2011, we noted in the above, critical steps for Strategic Risk
Management. These steps have been captured as two fundamental aspects of strategic risk
management and posted(https://corpgov.law.harvard.edu) by Matteo Tonello, managing director
of corporate leadership at the Conference Board of Harvard Law School. The first step is to
understand an organization’s strategic risks and related risk management processes and the
second step is to integrate strategic risk management into its existing strategy setting and
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performance measurement processes. The section below is an extraction of the post by Matteo
Tonello.
4.2 Understanding an Organization’s Strategic Risks Management Processes
A necessary first step for boards to understand their strategic risks and how management is
managing and monitoring those risks is a strategic risk assessment. A strategic risk assessment
is a systematic and continual process for assessing the most significant risks facing an
enterprise. It is anchored and driven directly by the organization’s core strategies. As noted in a
2011 COSO report, “Linkage of top risks to core strategies helps pinpoint the most relevant
information that might serve as an effective leading indicator of an emerging risk”.
4.2.1 The Strategic Risk Assessment Process
There are seven basic steps for conducting a strategic risk assessment.
Figure 10: Strategic Risk Assessment
Conducting an initial assessment can be a valuable activity and should involve both senior
management and the board of directors. Management should take the lead in conducting the
assessment, but the assessment process should include input from the board members and, as it is
completed, a thorough review and discussion between management and the board. These
dialogues and discussions may be the most beneficial activities of the assessment and afford an
159
opportunity for management and the directors to come to a consensus view of the risks facing the
company, as well any related risk management activities.
Details of each step are given below:
1. Achieve a deep understanding of the strategy of the organization the initial step in the
assessment process is to gain a deep understanding of the key business strategies and objectives
of the organization. Some organizations have well developed strategic plans and objectives,
while others may be much more informal in their articulation and documentation of strategy. In
either case, the assessment must develop an overview of the organization’s key strategies and
business objectives. This step is critical, because without these key data to focus around, an
assessment could result in a long laundry list of potential risks with no way to really prioritize
them. This step also establishes a foundation for integrating risk management with the business
strategy. In conducting this step, a strategy framework could be useful to provide structure to the
activity.
2. Gather views and data on strategic risks
The next step is to gather information and views on the organization’s strategic risks. This can be
accomplished through interviews of key executives and directors, surveys, and the analysis of
information (e.g., financial reports and investor presentations). This data gathering should also
include both internal and external auditors and other personnel who would have views on risks,
such as compliance or safety personnel. Information gathered in Step 1 may be helpful to frame
discussions or surveys and relate them back to core strategies. This is also an opportunity to ask
what these key individuals view as potential emerging risks that should also be considered.
4. Prepare a preliminary strategic risk profile
Combine and analyze the data gathered in the first two steps to develop an initial profile of the
organization’s strategic risks. The level of detail and type of presentation should be tailored to
the culture of the organization. For some organizations, simple lists are adequate, while others
may want more detail as part of the profile. At a minimum, the profile should clearly
communicate a concise list of the top risks and their potential severity or ranking. Color-coded
reports or “heat-maps” may be useful to ensure clarity of communication of this critical
information.
4. Validate and finalize the strategic risk profile
The initial strategic risk profile must be validated, refined, and finalized. Depending on how the
data gathering was accomplished, this step could involve validation with all or a portion of the
key executives and directors. It is critical, however, to gain sufficient validation to prevent major
disagreements on the final risk profile.
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5. Develop a strategic risk management action plan This step should be undertaken in tandem
with Step 4. While significant effort can go into an initial risk assessment and strategic risk
profile, the real product of this effort should be an action plan to enhance risk monitoring or
management actions related to the strategic risks identified. The ultimate value of this process is
helping and enhancing the organization’s ability to manage and monitor its top risks.
6. Communicate the strategic risk profile and strategic risk management action plan
Building or enhancing the organization’s risk culture is a communications effort with two
primary focuses. The first focus is the communication of the organization’s top risks and the
strategic risk management action plan to help build an understanding of the risks and how they
are being managed. This helps focus personnel on what those key risks are and potentially how
significant they might be. A second focus is the communication of management’s expectations
regarding risk to help reinforce the message that the understanding and management of risk is a
core competency and expected role of people across the organization. The risk culture is an
integral part of the overall corporate culture. The assessment of the corporate culture and risk
culture is an initial step in building and nurturing a high performance, high integrity corporate
culture.
7. Implement the strategic risk management action plan
As noted above, the real value resulting from the risk assessment process comes from the
implementation of an action plan for managing and monitoring risk. These steps define a basic,
high-level process and allow for a significant amount of tailoring and customization to reflect the
maturity and capabilities of the organization. As shown by Figure 10 above, strategic risk
assessment is an ongoing process, not just a one-time event. Reflecting the dynamic nature of
risk, these seven steps constitute a circular or closed-loop process that should be ongoing and
continual within the organization.
Source: (https://corpgov.law.harvard.edu).
The below illustration provided in COSO ERM integrated framework is a clear analysis of
interplay between mission, objectives, strategies and risk appetite and risk tolerance of a
producer of premium household products with the strategic objective of to be top quality
product sales for retailers.
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Figure11: Relating Mission, Objectives, Appetite and Tolerance
Mission
To be a leading producer of premium household products in the regions in which we operate
Strategic
Objectives
• To be in the top
quality of product
sales for retailers of
our products
Strategy
Expand production of our
top-five selling retail
products to meet increased
demand
Related Objectives
• Increase production of
Measures
1. Market share
Unit X by 15% in the
next 12 months
• Hire 180 qualified new
staff across all
manufacturing divisions
• Maintain product quality
of 4.0 sigma
• Maintain 22% staff cost
per dollar order
Measures
• Units of production
• Number of staff hired
• Product quality by si gma
Risk Appetite
• Accept that the
•
•
company will consume
large amounts of
capital investing in
new assets, people and
process
Accept that
competition could
increase (e.g., through
predatory pricing, etc.)
as we seek to increase
market share, thereby
reducing profit
margins
We do not accept
erosion of product
quality
Risk Tolerances
•
•
•
•
Measure
Market share
Units of production
Number of staff hired (net)
Product quality index
Target
25th percentile
150,000 units
180 staff
4.0 sigma
Tolerances – Acceptable Range
20% – 30%
-7,500/+10,000
-15/+ 20
4.0 – 4.5 sigma
Copyright @2004, Committee of Sponsoring Organizations of the Treadway Commission
(COSO).
(Reproduced by permission)
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4.2.2 Integrating Strategic Risk Management in Strategy Setting and Performance
Measurement Processes
The second step for an organization is to integrate strategic risk management into its existing
strategy setting and performance measurement processes. As discussed above, there is a clear
link between the organization’s strategies and its related strategic risks. Just as strategic risk
management is an ongoing process, so is the need to establish an ongoing linkage with the
organization’s core processes to set and measure its strategies and performance. This would
include integrating risk management into strategic planning and performance measurement
systems. Again, the maturity and culture of the organization should dictate how this performed.
For some organizations, this may be accomplished through relatively simple processes, such as
adding a page or section to their annual business planning process for the business to discuss the
risks it sees in achieving its business plan and how it will monitor those risks. For organizations
with more developed performance measurement processes, the Kaplan- Norton Strategy
Execution Model described in The Execution Premium may be useful. This model describes six
stages for strategy execution and provides a useful framework for visualizing where strategic risk
management can be embedded into these processes.
Stage 1: Develop the strategy - This stage includes developing the mission, values, and vision;
strategic analysis; and strategy formulation. At this stage, a strategic risk assessment could be
included using the Return Driven Strategy framework to articulate and clarify the strategy and
the Strategic Risk Management framework to identify the organization’s strategic risks.
Stage 2: Translate the strategy - This stage includes developing strategy maps, strategic
themes, objectives, measures, targets, initiatives, and the strategic plan in the form of strategy
maps, balanced scorecards, and strategic expenditures. Here, the strategic risk management
framework would be used to develop risk-based objectives and performance measures for
balanced scorecards and strategy maps, and for analyzing risks related to strategic
expenditures. At this stage, boards may also want to consider developing a risk scorecard that
includes key metrics.
Stage 3: Align the organization - This stage includes aligning business units, support units,
employees, and boards of directors. The Strategic Risk Management Alignment Guide and
Strategic Framework for GRC (Governance, Risk and Compliance) would be useful for aligning
risk and control units toward more effective and efficient risk management and governance, and
for linking this alignment with the strategy of the organization.
Stage 4: Plan operations - This stage includes developing the operating plan, key process
improvements, sales planning, resource capacity planning, and budgeting. In this stage, the
strategic risk management action plan can be reflected in the operating plan and dashboards,
including risk dashboards. One organization we worked with developed a “resources follow risk”
philosophy to make certain that resources were appropriately and efficiently allocated. This
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philosophy focused on ensuring that resources used in risk management are justified
economically based on the relative amount of risk and cost-benefit analysis.
Stage 5: Monitor and learn - This stage includes strategy and operational reviews. “Strategic
risk reviews” would be part of the ongoing strategic risk assessment, which reinforces the
necessary continual, closed-loop approach for effective strategy risk assessment and strategy
execution.
Stage 6: Test and adapt - This stage includes profitability analysis and emerging strategies.
Emerging risks can be considered part of the ongoing strategic risk assessment in this stage. The
strategic risk assessment can complement and leverage the strategy execution processes in an
organization toward improving risk management and governance.
Source: Post by Matteo Tonello (https://corpgov.law.harvard.edu).
5 Risk assessments
Section 4 above dealt with critical steps in strategic risk management. We noted that SRM is not
separate from ERM but is a critical element of it. Therefore, elements of enterprise risk
management process are applicable for strategic risk. This section provides insight into risk
assessment criteria such as impact and likelihood used in risk assessment.
According to COSO ERM framework, Risk assessment allows an entity to consider the extent
to which potential events have an impact on achievement of objectives. Management assesses
events from two perspectives − likelihood and impact− and normally uses a combination of
qualitative and quantitative methods. The positive and negative impacts of potential events
should be examined, individually or by category, across the entity. Risks are assessed on both
an inherent and a residual basis.
5.1 Inherent and Residual Risk
Management considers both inherent and residual risk. Inherent risk is the risk to an entity in the
absence of any actions management might take to alter either the risk’s likelihood or impact (also
referred as “Gross Risk”) to residual risk is the risk that remains after management’s response to
the risk (also referred as “Net Risk”). Risk assessment is applied first to inherent risks. Once
risk responses have been developed, management then considers residual risk.
Figure 12 below illustrates likelihood and impact assessment depicted in a four by four grid. It
shows the risk migration (G to N) from gross (inherent) to net (residual) after applying risk
treatment (mitigation). Scoring system can be developed to prioritize each risk. E.g. If a rating
from 1 to 4 is used for both criteria, maximum risk score will be 16. (Critical 4* Almost certain
4).
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Figure 12: Risk heat map
Source: Annual Report 2014- M&S
At this stage, complete understanding of the risk is required. This understanding would assist in
evaluating the risk and coming up with an appropriate risk treatment. Most challenging task is to
quantify the impact and likelihood of the risk. Impact is not limited to financial impact but
extended to disruption, health and safety and reputational impact. Similarly, likelihood should
consider the probability based on the past experience. This stage necessities gathering more data
about the risk.
6. Risk Response
Most important benefit of risk assessment is the ability to prioritize key risk for risk treatment or
mitigation. According to COSO ERM Framework, risk responses include risk avoidance,
reduction, sharing, and acceptance. In considering its response, management assesses the effect
on risk likelihood and impact, as well as costs and benefits, selecting a response that brings
residual risk within desired risk tolerances. Management identifies any opportunities that might
be available, and takes an entity-wide, or portfolio, view of risk, determining whether overall
residual risk is within the entity’s risk appetite.
ISO 31000 uses the phrase ‘risk treatment’ to include all of the 4Ts included under the heading
risk response’. The scope of risk responses available for hazard risks includes the options of
tolerate, treat, transfer or terminate the risk or the activity that gives rise to the risk. For many
risks, these responses may be applied in combination. For opportunity risks, the range of
available options includes exploiting the risk. Reaction planning includes business continuity
planning and disaster recovery planning (AIRMIC, Alarm, IRM, 2010).
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An important point to note is that traditional risk assessment practices and risk mitigation plans
are not effective in dealing with complex and uncertain environments where outcomes are
unknown. The mounting complexity and dynamic nature of business environments mean that
foresight is more important than hindsight. Therefore, in the next chapter, we will explore
various tools and frameworks such as scenario planning and real option framework to deal with
circumstances that are more uncertain and hard to forecast.
7. Control Activities
Control activities are the policies and procedures that help ensure that management’s risk
responses are carried out. Control activities occur throughout the organization, at all levels and
in all functions. They include a range of activities −as diverse as approvals, authorizations,
verifications, reconciliations, reviews of operating performance, security of assets, and
segregation of duties (COSO ERM 2004).
COSO ERM framework particularly includes control activities as a component in the ERM
framework. Control activities here are closely related to risk response. Once the risk response is
developed control activity is aimed at implementation of a risk response by way of policies and
procedures. E.g. If an entity decides to obtain insurance coverage to safeguard its plant and
machinery above a certain threshold as a response to a natural disaster then entity can
incorporate this requirement in its insurance policy and a control can be implemented to check if
the insurance coverage has been taken in accordance with policy before an asset is capitalized.
Commonly used internal controls include authorization, information processing controls,
business performance reviews, segregation of duties etc.
This brings us to another important point about the role of internal controls in risk management.
As depicted below, internal controls are an integral part of risk management both of which are
critical aspects of governance framework of the entity.
Figure 13: Governance, Risk and Controls
Source: IFAC 2012-Evaluating and Improving Internal Control in Organizations
COSO internal control- integrated framework 2013 is a comprehensive framework that can be
used to strengthen internal controls of an entity.
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8. Information & Communication
Pertinent information is identified, captured, and communicated in a form and timeframe that
enable people to carry out their responsibilities. Information systems use internally generated
data, and information from external sources, providing information for managing risks and
making informed decisions relative to objectives.
Effective communication also occurs, flowing down, across, and up the organization. All
personnel receive a clear message from top management that enterprise risk management
responsibilities must be taken seriously.
They understand their own role in enterprise risk management, as well as how individual
activities relate to the work of others. They must have a means of communicating significant
information upstream. There is also effective communication with external parties, such as
customers, suppliers, regulators, and shareholders (COSO ERM 2004).
Communication should effectively convey:
• The importance and relevance of effective enterprise risk management
• The entity’s objectives
• The entity’s risk appetite and risk tolerances
• A common risk language
• The roles and responsibilities of personnel in effecting and supporting the components of
enterprise risk management (COSO ERM 2004)
8.1 Communication relating to risk identification- Top down and bottom up
In an effective risk management environment, communication relating to risk identification
should be both top down and bottom up. Based on the past experience of being in the business,
an entity may know most of the risk which could affect its objectives and strategies. Similar
events can be categorized based on their source and the impact. E.g. Supply Chain Risk can
capture many risk events such as delay, quality, and safety etc. Having one language and a
broader range of risk facilitate risk identification by the lower level employees. This exercise is
popularly known as defining “Risk Universe”. In the risk universe, risks are grouped into
categories using appropriate classifications. Risk universe can be a powerful tool in
communicating the Board and senior management’s understanding of the risk to the individual
across the organization (top down). New or emerging risks which are identified from the lower
level staff in their divisional/ departmental risk register can be escalated to group level to be
included in the risk universe (bottom up).
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8.2 Importance of effective risk communication- Roads to Ruin Study
Roads to Ruin Study, a Study of Major Risk Events: Their Origins, Impact and Implications
published by Cass Business School on behalf of Airmic highlights the critical role of boards in
the effective oversight of risk management within their organisations. This report investigates the
origins and impact of over twenty major corporate crises of the last decade. According to this
study much broader lessons have also been distilled from the case studies. Several of the firms
studied were destroyed by the crises that struck them. These weaknesses were found to arise
from seven key risk areas that are potentially inherent in all organisations and that can pose an
existential threat to any firm, however substantial, that fails to recognise and manage them.
These risk areas are beyond the scope of insurance and mainly beyond the reach of traditional
risk analysis and management techniques as they have evolved so far. Out of seven risks
included in the study two relate to Information and communication and are included below.
Defective communication – risks arising from the defective flow of important information
within the organisation, including to board-equivalent levels.
Risk ‘Glass Ceilings’ – arising from the inability of risk management and internal audit teams to
report on risks originating from higher levels of their organisation’s hierarchy.
8.3 KPI V KRI
Irrespective of the sophistication in the ERM methodology, right information plays critical role
in making risk responsive decisions. If financial statements or KPI had been distorted board/
regulators may not be able to take appropriate actions. One key point in risk information is they
should provide leading indicators rather than lag information. Lag information is historical
whereas leading information is futuristic. In risk management literature, much emphasis is placed
on Key Risk Indicator (KRI) as opposed to Key Performance Indicators (KPI). KRI provides
“early warning indicator”.
While KPIs are important to the successful management of an organization by identifying
underperforming aspects of the enterprise as well as those aspects of the business that merit
increased resources and energy, senior management and boards also benefit from a set of KRIs
that provide timely leading-indicator information about emerging risks.
Measures of events or trigger points that might signal issues developing internally within the
operations of the organization or potential risks emerging from external events, such as
macroeconomic shifts that affect the demand for the organization’s products or services, may
provide rich information for management and boards to consider as they execute the strategies of
the organization COSO 2010.
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Table 2: KPI V KRI
Objective- Manage the collection of accounts receivable to reduce loss due to write-offs
KPI
KRI
Data about write-offs of accounts in most recent Analysis of reported financial results for the
month, quarter, year.
company’s 25 largest customers or general
collection challenges throughout the industry that
highlight trends signaling future collection
concerns.
Source: COSO How Key Risk Indicators can Sharpen Focus on Emerging Risks-2010
9. Monitoring
Monitoring is an important aspect of risk management process as it is designed to ensure all
other elements of enterprise risk management program continues to operate effectively in
identifying, assessing and mitigating risk to organizational objectives. ISO 31000 refers to
“continual checking, supervising, and critically observing or determining the status,” while
COSO suggests “ongoing monitoring of activities, separate evaluations, or a combination of the
two. Monitoring helps ensure effective risk management processes by:
•
•
Systematically checking risk mitigation plans to ensure controls are in place and working,
while checking for changes to the risk universe.
Reviewing risk management processes to achieve continuous improvement
(Nicholson and Backer 2013)
Enterprise risk management is monitored – assessing the presence and functioning of its
components over time. This is accomplished through ongoing monitoring activities, separate
evaluations, or a combination of the two. Ongoing monitoring occurs in the normal course of
management activities. The scope and frequency of separate evaluations will depend primarily
on an assessment of risks and the effectiveness of ongoing monitoring procedures. Enterprise
risk management deficiencies are reported upstream, with serious matters reported to top
management and the board (COSO ERM 2014).
Ongoing monitoring can be carried out as part of ordinary course of running the business. E.g.
Risk triggers/ exception reports when a credit limit is changed or unusual credit is granted to a
customer. Monitoring can be carried out in form of self-assessments, where persons responsible
for a particular unit or function determine the effectiveness of enterprise risk management for
their activities. However, when monitoring is carried out by an internal audit function as a
separate evaluation, it could give much credible insights by way of an independent assurance to
the board/ audit committee on the overall effectiveness of risk management process. The topic
risk assurance has now become a requirement of certain corporate governance codes and is an
evolving subject.
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Chapter Summary
•
SRM is a critical part of an organization’s overall ERM process. It isn’t separate from
ERM but is a critical element of it—and one that has been becoming more important.
•
Risk is a consideration in many strategy-setting processes. Risk to the chosen strategy is
only one aspect of risk to consider. There are two additional aspects to enterprise risk
management that can have far greater effect on an entity’s overall risk profile, the
second aspect is the possibility of strategy not aligning with an organization’s mission,
vision, and core values. The third aspect relates to the implications from the strategy.
•
There are two fundamental aspects of strategic risk management. The first step is to
understand an Organization’s Strategic Risks and Related Risk Management Processes
and the second step is to integrate strategic risk management into its existing strategy
setting and performance measurement processes.
•
A necessary first step for boards to understand their strategic risks and how
management is managing and monitoring those risks is a strategic risk assessment.
•
Effectiveness of risk management function increases when the organization increases
its risk maturity which typically reflects stages of integrating risk into the
organization’s overall system of management.
•
Wider spectrums of techniques are used for risk identification. The main point behind
these techniques is risk identification requires a robust scanning of internal and external
environment and people at every level should be involved in this exercise. The best
method varies based on the circumstances of each entity. Risk universe can be a
powerful tool in communicating the Board and senior management’s understanding of
the risk to the individual across the organization.
•
Risk assessment allows an entity to consider the extent to which potential events have
an impact on achievement of objectives. Management assesses events from two
perspectives − likelihood and impact− and normally uses a combination of qualitative
and quantitative methods. Risks are assessed on both an inherent and a residual basis.
•
Most important benefit of risk assessment is the ability to prioritize key risk for risk
treatment or mitigation. According to COSO ERM Framework, risk responses include
risk avoidance, reduction, sharing, and acceptance. ISO 31000 uses the phrase ‘risk
treatment’ to include all of the 4Ts included under the heading risk response’. The
scope of risk responses available for hazard risks includes the options of tolerate, treat,
transfer or terminate the risk or the activity that gives rise to the risk.
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•
Control activities are the policies and procedures that help ensure that management’s
risk responses are carried out. Internal controls are an integral part of risk management
both of which are critical aspects of governance framework of the entity. Capturing
pertinent and communicated in a form and timeframe that enable people to carry out
their responsibilities are critical for effective risk management. KRI provides timely
leading-indicator information about emerging risks. Monitoring is an important aspect
of risk management process as it is designed to ensure all other elements of enterprise
risk management program continues to operate effectively in identifying, assessing and
mitigating risk to organizational objectives.
Review Questions & Case Study
Question 1
Identify the key methods involved in identifying, estimating and evaluating risk and the options
available for risk treatment or response.
Question 2
Compare and contrast gross and net risk and identify the significance of residual risk reporting in
relation to risk treatment.
3. BP Case Study
On 20th April 2010, Macando oil well in the Gulf of Mexico blew out causing an explosion on its
oil rig, Deepwater horizon. The rig caught fire and sank, killing 11 people & creating the biggest
oil spill in American history, threatening environmental catastrophe.
Thousands of barrels of oil pouring uncontrollably out of the well. BP blamed Transocean for the
failure in sea-floor blowout preventer, which it alleged was defective. Transocean passed the
blame to Halliburton Inc., claiming that it was in charge of cement work that was being used to
cap the well, sealing it with plugs of cement and drilling mud.
By mid-June, BP plc’s share price had dropped from 655p just before the crisis to 300p. Fitch
downgraded the company to BBB, close to jump bonds. At these prices, commentators raised
spectra of a takeover bid from a foreign competitor.
The outcome
On 28th July 2010, Hayward stepped down as CEO, with golden parachutes of his annual $ 1
million and a $10 million pension pot build during his 28 years with BP. Bob Dudley took over
as new CEO. One of his early project was the creation of new safety division for the group with
sweeping powers. Staff bonuses would also reflect compliance with safety rules.
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In November 2010 a US presidential commission cleared BP of cutting corners to boost profits.
It found no evidence, its report said that BP made conscious decisions to put dollar above safety
at Macando well. However, it did suggest that there were systematic problems in the industry.
Moreover, it identified a failure of management. With better management by BP Haliburton and
Trasocean would almost certainly have prevented the blowout.
Source- Corporate Governance Principles, Policies and Practices by Bob Tricker- Case 8.5 BP
Deepwater Horizon disaster.
Evaluate the nature of strategic risk and the extent to which it should have been considered
in BP’s risk assessment
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Chapter – 04
Governing, Sensing & Countering the Strategic Risk
Learning Outcomes
After studying this chapter, you should be able to:
•
•
•
•
Explain the concept and importance of risk governance.
Describe analytical tools used in strategic risk assessment.
Explain counter measures to deal with strategic risk.
Analyze case studies on strategic risk management.
1. Introduction
In this chapter, the role of governing body of a corporation on risk management is explained as it
has been witnessed in many corporate scandals, the risk oversight of the governing body was
questioned. As it was mentioned in the previous chapter, traditional risk assessment practices and
risk mitigation plans are not effective in dealing with complex and uncertain environments where
outcomes are unknown. The mounting complexity and dynamic nature of business environments
mean that foresight is more important than hindsight thus the term “risk sensing” is used as
opposed to mere identification of risk. We will explore how traditional planning tools including
PESTEL framework, Porter’s five forces model, value chain analysis and the like can be
complimented by scenario planning and real option framework to deal with circumstances that
are more uncertain and hard to forecast.
IFAC (2011), paper on integrating the Business Reporting Supply Chain includes serious flaws
in risk management which had been identified after interviews with 25 key business leaders.
These flaws are listed below.
Serious Flaws in Risk Management
A. Having a compliance-only mentality in covering issues such as formal roles and
responsibilities, prevention and detection of fraud, and compliance with laws and regulations, but
ignoring the need to address both the compliance and performance aspects of risk management.
B. Treating risk as only negative and overlooking the idea that organizations need to take risks
in pursuit of their objectives. Effective risk management enables an organization to exploit
opportunities and take on additional risk while staying in control and, thereby, creating and
preserving value.
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C. Internal control that is overly focused on external financial reporting. Providing control in
relation to financial reporting is important in the detection and prevention of fraud, as well as
ensuring financial reports are accurate, and may be a major focus of corporate regulators.
However, effective controls should address all material organizational risk to help it achieve its
objectives, create value, and avoid loss.
D. Regarding risk management as a separate function or process. Line managers should be
aware that they are managing risk as part of their everyday roles and responsibilities, in line with
the organization’s intentions as expressed in its policies, goals, and objectives. This problem is
exacerbated when line managers are not directly responsible for maintaining risk within
established limits for risk taking but are allowed to choose their own limits for risk taking over
those of the organization.
The first and the third point on the list delineate that some organizations have not truly believed
in risk management instead it had been undertaken as a self-fulfilling function designed to meet
the regulatory requirement. In other words, risk management and internal control have failed to
fulfill its core function. Second point witnesses, common misconception that the risk is negative
and it is a hindrance to achieve business objectives when it is in effect able to enhance
organization’s ability to take more risk in anticipation of more return. Further, such organizations
are not prepared itself to seize opportunities. Addressing the fourth point is critical for effective
risk management as risk management cannot be delegated to a position (risk manager) or to a
risk management department. Every individual in the organization should be a part of value
chain and should have some role in managing risk.
2. Risk Governance
Risk governance sets the organization’s tone, reinforcing the importance of, and establishing
oversight responsibilities for, enterprise risk management (COSO 2016). Sir Adrian Cadbury had
stated that corporate governance yesterday focused on raising standards of board effectiveness
and its today’s focus is on role of the business in the society and corporate governance future
focus is shaped by King Code in South Africa. King code has explicitly addressed risk
governance responsibilities of the board. Risk governance discussed in KING III code also
requires board to seek risk assurance from the management and internal audit on the
effectiveness of risk management and internal controls.
KING III Corporate Governance code of South Africa states that the board should appreciate that
strategy, risk, performance and sustainability are inseparable. Given below are excerpts of Board
responsibilities in relation to strategy, risk, performance and sustainability.
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The Board should:
inform and approve the strategy;
ensure that the strategy is aligned with the purpose of the company, the value drivers of its
business and the legitimate interests and expectations of its stakeholders;
• satisfy itself that the strategy and business plans are not encumbered by risks that have not
been thoroughly examined by management; and
• ensure that the strategy will result in sustainable outcomes taking account of people, planet
and profit.
•
•
3.The Three Line of Defense Model
Establishing a separate risk management division may removes responsibility for the
management of risk from where it primarily belongs. A separate risk management function may
hamper rather than facilitate good decision making and subsequent execution. Managing risk has
to be in the job description of everyone who collectively creates value in the organization’s value
chain. The Three Line of Defense Model is a powerful framework to explain how risk
management roles and responsibilities can be structured in overall governance framework of the
organization.
In the Three Lines of Defense model, management control is the first line of defense in risk
management, the various risk control and compliance oversight functions established by
management are the second line of defense, and independent assurance is the third line of
defense. Each of these three “lines” plays a distinct role within the organization’s wider
governance framework (IIA 2013).
Figure 14: Three lines of defense model
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Although neither governing bodies nor senior management are considered to be among the three
lines” in this model, no discussion of risk management systems could be complete without first
considering the essential roles of both governing bodies (i.e., boards of directors or equivalent
bodies) and senior management. Governing bodies and senior management are the primary
stakeholders served by the “lines,” and they are the parties best positioned to help ensure that the
Three Lines of Defense model is reflected in the organization’s risk management and control
processes (IIA 2013).
4. Analytical tools for strategic risk assessment
The formal strategic management and planning frameworks that incorporates analytical tools
adopt their own terminologies contained within a common strategy language. These tools
provide a valuable insight into the ERM process. ERM brings a common risk management
language that can be applied across the organization (Andersen and Schroder 2010).
Let’s consider the usage of analytical tools and framework in enterprise risk management.
Environmental scanning in a predictable way
Corporations often face environmental changes that seem to come out of thin air. This
accentuates the question of how the corporation can better identify and force events that often
initially as week signals at the corporate periphery where the actual transaction takes place.
Hence, the ability to involve the relevant people in the organization to be observant and sensitive
to changes in the risk environment may enable the recognition of the environmental changes
sooner and allow the firm to react to them in more timely manner (Andersen and Schroder 2010).
Andersen and Schroder 2010 states that environmental scanning can be conceived as
incorporating four modes of viewing the environment and searching for important environmental
developments.
Formal search, where the corporation in a structured way obtains information of relevance to
specific issues as input to the planning process and decision making.
Conditional viewing, where the corporation tracks pre-selected information from particular
sources aimed at identifying the contours of specific evolving issues.
Informal search, where the corporation actively looks for information through unfocused and
unstructured efforts to increase understanding of specific developments to assess potential
impacts and the need for responsive action.
Undirected viewing, where the corporation scans many diverse sources of information without
specific informational needs in mind to sense new trends and enable the corporation to think
about environmental developments in unconventional ways.
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The case below delineates the use of environmental scanning by M&S, one of the UK’s leading
retailers, with1, 382 stores worldwide to sense one of the hardest risk to anticipate and respond.
Company has disclosed 11principal risks that may impact its business and are described as
strategic or operational in nature. Out of 11 risks one risk relates to “Changing consumer
behavior” and below response shows the use of environmental scanning to foresee the changes
that will unfold in future which propels company to redefine its value proposition.
M&S- Environmental scanning
The below is probably the mission statement which is profoundly disclosed in its annual report
“We are committed to delivering sustainable value for our stakeholders and making every
moment special through the high quality, own brand food, clothing and home products we offer
in our stores and online, both in the UK and internationally”
We are operating in changing times, so it is crucial that we listen to our customers and keep a
close eye on global trends. Our Customer Insight Unit (CIU) analyses responses from 60,000
customers per month. By combining their views with detailed market research and customer
analytics, we can identify what is influencing shopping behaviour and ensure we stay relevant to
our customers.
Source: M&S Annual Report 2016- Strategic Report
One logical approach is to begin the environmental scanning from the general environmental
conditions popularly identified as “PESTEL” and then extend the analysis to business condition
specific to industry competitive environment in which the corporate operates and finally to focus
on its own territory i.e. company specific risk.
Company Risk
Industry risk
General
enviornmental
risk
Figure 15: Framework for environmental scanning
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M&S- External Risk
M&S has separately disclosed external risk factors that are the subject of discussion at Group
Board and Audit Committee meetings. Risk report further states that “Whilst these risks are
beyond our direct control, we recognize the importance of operating a business model that has
the potential to flex and adapt to a changing external environment”.
“The first external risk is Sociopolitical Unrest, where ongoing geopolitical uncertainty, social
unrest or the threat of terrorism has the potential to impact consumer confidence and retail
spending on a global scale. Deterioration in Foreign Exchange & Global Economy would not
only affect consumer confidence in terms of the global economy, but the performance of our
International business is also significantly influenced by fluctuations in foreign exchange rates.
As part of these broader risk factors we have specifically considered the implications of Brexit in
terms of the significant economic uncertainty that exists in advance of the upcoming referendum
on Britain’s EU membership”.
Source: M&S Annual Report 2016- Strategic Report
Industry Risk Assessment
Porter’s five forces model is a valuable strategic planning framework which enables evaluating
attractiveness of the industry based on the effect of five key forces, namely; the threat of new
entrants; the bargaining power of buyers; the bargaining power of suppliers; the threat of
substitute product or services and; the intensity of competition in the industry.
Table - 2 below shows the competitive pressures exerted by each force and their impact on
industry profit potential i.e. attractiveness.
Table 2: The impact of Five Forces
Five forces
Examples of Key measures
The threat of new entrants
Industry
Attractiveness
More entry barriers making entry difficult
for a new entrant
The bargaining power of Buyers cannot easily switch to a
buyers
competitor due to higher switching cost
More
The bargaining power of Fewer suppliers with less alternative
suppliers
options
Less
The threat of substitute More substitutes with similar product
product or services
features
Less
More
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Intensity of competition in Industry growth has reduced and
the industry
competition is characterized by a price
war to increase market share by each
player
Less
Key point to note here is that when the industry becomes unattractive with intense pressures
from each forces corporation should redefine its strategies and value proposition. Refer below
case on How M&S has responded to the pressure from industry rivals in its UK food business.
According to the disclosure quality and uniqueness have been the value propositions in an
increasingly homogenized market. Company has also seized the excess demands arising from
various events.
M&S-UK Food Market- Competitive Rivalry
Growth in the UK food market has been sluggish this year due to the highly competitive market,
and the discounters continued to grow market share. However, our Food division had another
strong year, with sales continuing to grow ahead of the market. Our customers told us they love
M&S food for being special and different, and our performance saw our market share strengthen
Customers told us that newness is really important to them and we continued to innovate,
introducing 1,700 lines over the year. In an increasingly homogenized market, our quality and
uniqueness are crucial points of difference. Events remained significant for us, from seasonal
celebrations like Christmas, where we saw record sales in the week leading up to Christmas Day,
and Mother’s Day, where we had record sales, to special occasions like a family barbecue. Last
summer’s Tastes of the British Isles range celebrated our food’s provenance. This resonated with
customers.
Source: M&S Annual Report 2016- Strategic Report
Further, M&S has strategically linked its risk response to the business model and strategic
objectives. It has been disclosed in M&S Strategic Report 2016 that the company has
announced a nationwide unsold food redistribution scheme to connect stores with local charities.
The scheme, now live in all their owned store helping the company to achieve its Plan A target
of reducing like-for-like food waste by 20%by 2020.
Company Risk Assessment
Company risks relate to risk factors that are endogenous to the corporation as they are caused by
organizational process, technological systems. Some common framework and tools that can be
used in the analysis of company’s internal environment include the Mc-Kinsey 7S model, value
chain analysis, the VEIO framework (to assess the sustainability of essential corporate
resources), analysis of core competencies etc. The strategic analysis is typically summarized in a
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SWOT analytical framework where strengths and weaknesses are identified in the internal
corporate environment and opportunities and threats are identified in the external market
environment are compared against each other and prioritized (Andersen and Schroder).
As it appears, the summary of the strategic analysis within the SWOT framework can actually
help to identify important strategic risk factors. However, the SWOT analysis does not explicitly
state the relative importance of the various risk factors. This shortcoming can be circumvented
by completing a risk map, which can be considered the SWOT equivalent within the risk
management field and is elaborated through a more formal approach to rank the various risk
issues. The results from the SWOT analysis can essentially feed into the initial assessment phase
of the risk management process. However, as the SWOT framework normally focuses on
strategic and economic risk factors, the SWOT analysis might be completed with assessments of
operational risk factors and hazards (Andersen and Schroder 2010).
We have previously discussed the risk assessment criteria such as likelihood and impact to
prioritize identified risk. Further, risk interaction charts can be used to further refine the highest
risks assessed. We will further explore other tools which are available to foresee unknown risk.
These include scenario planning, KRIs and real option framework based on “Strategic Risk
Management Practices by Andersen and Schroder 2010.
Scenario Planning- a simple technique in an unpredictable world
Many companies normally develop their strategic plan based on an official picture of the future,
focusing on how key issues can be solved most effectively and there by failing to take other
alternatives into account. In a world of mounting uncertainty, this approach is increasingly
hazardous, as too narrow a focus might result in blind spot, with the risk of surprises arising as a
result. It is a critical flow of most predictable surprises that there is a failure to engage in
adequate scanning of the internal and external environments either due to insufficient attention or
lack of resources necessary to collect information about emerging threats. Scenario planning can
be a useful tool to evaluate weak signals and challenge rooted beliefs (Andersen and Schroder
2010).
Scenarios encourage managers and other employees to think through the diverse pieces of the
puzzle, to organize these fragments into a cohesive pattern in the future business environment
and discuss the implications they may have on the effectiveness of current strategies while
evaluating alternative strategic options. Furthermore, it can help to make blinds pots visible and
uncover areas where further knowledge and insight are needed (Andersen and Schroder 2010).
Use of KRI
With the absence or only moderate existence of unpredictable interactions between risk events,
the nature of the sample space for analysis can be roughly determined in advance. This situation
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is used by many corporations to establish a set of key risk indicators (KRIs) and monitor
significant deviations, so called ‘residual risks’, from the likely outcomes. Appropriate
thresholds for the identified KRIs can then be established to represent upper levels that should
trigger some form response. These responses are formalized in many corporations in numerous
business contingency plans where pre-planned instructions should be followed when the
predetermined contingency situations arise (Andersen and Schroder 2010).
We have already discussed the use of KRI with examples.
Dealing with unknown- Real Option Framework
When unforeseeable uncertainties are present and unknowability becomes a predominant
phenomenon, the planning-based methods discussed in previous sections are insufficient, simply
because it is impossible to plan for something one does not know. Instead of developing a
conventional planning template, the identification of important real options, i.e. strategic options,
and analyzing the corporate ability to maneuver around these may help in assessing the
alternative actions available under uncertain environmental conditions. Such a real options
approach can be sensible way to analyze corporate actions when strategic exposures are
influenced by unknown factors. From this perspective, strategic alternatives will appear as a
portfolio of projects or business opportunities where strategy evolves as various projects are
selected for execution (Andersen and Schroder 2010).
For example, Microsoft was experimenting with several operating systems – Dos, Unix,OS/2 and
windows during the same time period in 1980 because it was unclear which of the operating
systems would become the most successful.
Approach similar to the above real option has been described as “double betting” by Slywotzky
and Drzik (2005).Risks involving technology— for example, the probability that a product will
lose its patent protection or that a manufacturing process will become outdated— can have a
major effect on corporate performance. But when a new technology unexpectedly invades a
marketplace, specific product and service offerings may actually become obsolete in short order.
Think, for example, of the way in which digital imaging has shifted market share away from
film-based photography.
That’s why risk savvy managers faced with an unpredictable situation insure against technology
risk by double betting —that is, investing in two or more versions of a technology
simultaneously so they can thrive no matter which version emerges as the winner Slywotzky and
Drzik (2005).
Intel’s double bet on both RISC and CISC chip architectures improved the firm’s chances of
succeeding in the semiconductor industry. By contrast, Motorola’s failure to pursue both analog
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and digital cellular phone technology opened the door for Nokiato supplant it as the industry
leader Slywotzky and Drzik (2005).
Slywotzky and Drzik (2005) states that companies face an array of strategic risks. Even the most
serious, though, can be mitigated through the use of effective countermeasures. These counter
measures are given in the table below.
Table 3: Strategic Risk and Counter Measures
Case Study 1- J.C.Penney: Was Ron Johnson's Strategy Wrong?
J.C. Penney Co. [JCP], an American chain of mid-range department stores has ousted its CEO,
Ron Johnson, the chief executive who reinvented retail at Apple Inc. [AAPL] and who arrived J
C Penney just 17 months ago. Mr. Johnson had a bold vision for the J C Penney. On joining the
firm, he said, “In the U.S., the department store has a chance to regain its status as the leader in
style, the leader in excitement. It will be a period of true innovation for this company”.
Mr. Johnson abruptly scrapped J C Penney’s dubious pricing policies of marking up prices and
then offering discounts, with heavy promotions, and coupons. He proposed to offer more
interesting products, from lines like Martha Stewart and Joe Fresh, at reasonable prices all the
time.
But the change in pricing occurred with merchandise that was already in stores and that
customers were used to, rather than on brand-new merchandise. The approach didn't fare well
with Penney's customer base of bargain hunters. They rebelled, traffic declined, sales fell and
Penney slowly returned to the prior era of pricing, with lots of promotions, lots of price-focused
ads, and marked-up prices that would be later marked down.
Nor did shoppers respond when Penney started to reintroduce markdowns last year. Sales fell
25% in the year ended Feb. 2, depriving Penney of $4.3 billion in revenue and causing analysts
to ask whether it might run out of cash needed to fund its overhaul.
What went wrong with Ron Johnson's Strategy?
[
Bold vision of MR Johnson the leader in style, the leader in excitement brings radical changes to
business model and the way the company has positioned in the minds of customers. Further,
existing structure, management styles may not support the new strategy. This shows a
misalignment of strategy with mission, vision, and core values instilled over a period of time and
eventually produced disastrous result.
The article has provided further reasons why this strategy became a failure and is given below.
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"One of the big mistakes was perhaps too much change too quickly without adequate testing on
what the impact would be," said Bill Ackman, the principal shareholder of J C Penney’s and the
driving force behind Johnson’s recruitment.
Carol B. Phillips, marketing instructor at the University of Notre Dame’s Mendoza College of
Business, says:
“JCP’s CEO Ron Johnson was … clueless about what makes shopping fun for women. It’s the
thrill of the hunt, not the buying. If it was just about buying, we’d all go to Amazon and take
what was offered… women love to shop and deals are what make the game worth playing.
Customer insights don’t have to be deep and mysterious to be powerful. Sometimes they are as
obvious as ‘shopping is fun.’ It took billions of dollars of lost sales, lost market cap and over a
year of embarrassing performance for Johnson to realize this truth… there is an element to
consumer buying behavior now that is qualitatively different. Bargain hunting is now like
playing a game – and finding deep discounted goods on sale is part of the game”.
Become a leader in style?
The other option is still Ron Johnson’s: make J C Penney a leader in style with good products
and honest business practices. Mr. Johnson was well aware of the mismatch between the strategy
and the existing managers, the culture, the product line, the marketing and sales policies and the
customer base. Mr. Johnson had reinvented retail once before at Apple. Now he set out to do it
again, in a general department store.
It was a bold strategy but execution was poor. Re-positioning a low-end bargain department store
as a high-end high-style store needed careful planning, positioning and execution. Instead,
Johnson rushed in. Within weeks of his January 2012 presentation to investors about the future
of Penney, the company had new advertising, new pricing and a new logo, and was announcing a
new fleet of designers who would be creating collections for it. Mr. Johnson put the plans on
pricing, marketing and merchandise into place without doing any small-scale tests.
A lesson in radical management: iterative development
Mr. Johnson set out to delight his customers, which was good. What wasn’t good was assuming
that he knew what would delight the customers. Delighting customers is tricky. An iterative
approach is always critical. As Peter Drucker noted in 1973, what the manager thinks is value is
never exactly what the customer sees as value. It is only by continual iteration that the manager
can learn what works.
Above all, Mr. Johnson destroyed his existing business model before the new business model
was put in place. As David Cush, Virgin America CEO said this morning on CNBC’s
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Squawkbox: “Don’t destroy your old revenue model before you have proved your new revenue
model. That’s the box that J C Penney has put themselves in”.
Was Johnson’s idea itself flawed? Offering Better product and being more honest with the
consumer. Was it too much too fast? Or was the idea itself ok?
Mr. Cush said, “It was a great idea. But you have this massive structure that you need to support.
Revenue supports your structure. You’ve got to make sure that the new model works before you
destroy the old one’.
Source: Forbes- Contributor Steve Denning
Chapter Summary
Risk Governance sets the organization’s tone, reinforcing the importance of, and establishing
oversight responsibilities for, enterprise risk management. King code has explicitly addressed
risk governance responsibilities of the board. The Three Line of Defense Model is a powerful
framework to explain how risk management roles and responsibilities can be structured in the
overall governance framework of the organization.
Traditional planning tools including PESTEL framework, Porter’s five forces model, value chain
analysis and the like can be used to assess the external and internal environmental context of the
corporation. This may also constitute a useful platform to determine initially some of the most
important risk factors in the predictable and known business environment to be considered in the
corporate risk management forces. These analyses can be complimented by scenario planning
and real option framework to deal with circumstances that are more uncertain and hard to
forecast.
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Review Questions
Question 1
Recommend to a board of directors the main features of an effective risk management framework
or architecture for risk management in an organization.
Question 2
Explain how Three Line of Defenses” model can be used to structure specific duties relating to
risk and control.
3. Case Study Galaxy Note 7 Fires Caused by Battery and Design Flaws, Samsung Says
Koh Dong-jin, president of Samsung mobile communications business, said We are taking
responsibility for our failure to ultimately identify and verify the issues arising out of the battery
design and manufacturing process prior to the launch of the Note 7.
In a news conference that took place on Monday morning in South Korea, Samsung and outside
experts said batteries made by two suppliers contained flaws that allowed the phones to overheat
and in several cases catch fire. But they also cited what they said were flaws in the design of the
phone, including an unusually thin lining between the electrodes of the battery.
The cancellation of the Galaxy Note 7 has been an unprecedented public relations disaster for
Samsung, the world’s largest maker of smart phones. It has also cost the company billions of
dollars and, for some critics in South Korea, even called into question the very business model
that has made Samsung so successful. The way the company handled the recall also angered
regulators and led to confusion as it tried to get back millions of phones around the world.
Part of the problem was that with the Note 7, Samsung had pushed itself to the limit, company
officials said. It rushed the Note 7 to the market before Apple rolled out its iPhone 7. The
accelerated production was also driven by fear; Huawei, Xiaomi and other Chinese cell phone
makers were fast catching up. By packing the Note 7 with new features, like waterproofing and
iris-scanning for added security, Samsung also wanted to prove that it was more than a fast
follower.
Although Samsung mostly pointed to manufacturing failures on Monday, battery scientists say
aggressive design decisions made problems more likely. In the Note 7, Samsung opted for an
exceptionally thin separator in its battery. This critical component, which sits between the two
electrodes in a battery, can cause fires if it breaks down, varies in thickness or is damaged by
outside pressure. Samsung’s choice to push the limits of battery technology left little safety
margin in the event of a problem, like pressure on a Smartphone casing, two battery scientists
said.
The management pushed their engineers to make the battery separator really thin, said Qichao
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Hu, founder of the battery start-up Solid Energy Systems. He added that doing so could increase
the likelihood of fires or explosions in batteries.
When reports of Note 7s catching fire began accumulating, Samsung quickly blamed faulty
batteries from one of its two suppliers, Samsung SDI. In early September, it made a bold
decision to recall 2.5 million devices globally. It continued to ship Note 7s with batteries from
the other supplier, ATL, offering them as safe replacements. But some of those began catching
fire, too.
Officials from the United States Consumer Product Safety Commission were angered; the
commission had approved Samsung initial recall, trusting Samsung assurance that the
replacement model was safe and knowing that Samsung had no other Note 7 battery supplier.
Consumers began ridiculing the Samsung device as the Death Note 7. A video clip quickly
spread online featuring a game character throwing Note 7s as explosives in an urban battle zone.
On Oct. 6, a Southwest Airlines plane was evacuated after a Note 7 began smoking. The decision
to ditch the Note 7 cost Samsung an estimated 7 trillion won, or $6.2 billion.
Source - The New York Times 22 Jan 2017- articles by Paul Mozu
Evaluate the adequacy of considerations of strategic risk in launching Note 7 to the market
and the response to product failure.
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Solutions to Review Questions
Chapter – 01
Solution 1
Risk management is the process by which organizations systematically identify and treat upside
and downside risks across the portfolio of all activities with the goal of achieving organizational
objectives. Risk management increases the probability of success, reduces both the probability of
failure and the uncertainty of achieving the organization’s objectives. The goal of risk
management is to manage, rather than eliminate risk. This is most effectively done through
embedding a risk culture into the organization.
Solution 2
Risk can be understood in a number of different ways: as hazard or threat, as uncertainty and as
opportunity. The Institute of Risk Management and the International Federation of Accountants,
together with the Turnbull report, each recognized risk as opportunity, not just as threat and the
need to manage both upside and downside risk for shareholder value. There is a natural
progression in managing risk: from managing the risk associated with compliance and prevention
(the downside); managing to minimize the risks of uncertainty in respect of operating
performance and managing opportunity risks (the upside) which need to be taken in order to
increase and sustain shareholder value.
Risk as threat or hazard is a concern mainly with negative events. Managing risk as threat or
hazard means using management techniques to reduce the probability of the negative event (the
downside) without undue cost. This is an emphasis on conformance. Risk as uncertainty refers to
the distribution of all possible outcomes, both positive and negative. Managing risk as
uncertainty means reducing the variance between anticipated and actual outcomes. This is an
emphasis on both conformance and performance. Risk as opportunity recognizes the relationship
between risk and return, a necessity for increasing shareholder value. Managing risk as
opportunity means using techniques to maximize the upside while minimizing the downside.
This is an emphasis on performance shows how risk management can reconcile the two
perspectives of conformance and performance.
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Chapter -02: Solution to Review Case Study
It appears that there are several indicators of a weak internal environment which could have had a
pervasive impact on the effectiveness of risk management system of the company.
First, domination by chairman and CEO may have resulted in short sighted decisions without
adequate considerations/ consultation of the views of other Board members. This is evident by
dramatic modification to MF Global’s business model without fully understanding the risks
associated with such a radical transformation.
Second, company does not seem to have defined and considered risk appetite in making major
investment decisions. Heavy investment in the sovereign debt of struggling European counties
which carried enormous default and liquidity risk is a good example for high risk-taking behavior
probably in excess of company’s risk capacity.
Third, Corzine as the key person driving the business and the board, had failed to set the right
tone at the top of the company demonstrating integrity and ethical values. Two supporting facts
given in the case are overriding existing internal business controls by acting as a de-facto chief
trader and circumventing company’s normal risk management review process. Further, it shows
that there had been an attempt to mislead financial information through creative accounting
practices and delaying disclosures i.e. structuring bonds as collateral in repurchase-to-maturity
(RTM).
Finally, the existence of risk glass ceilings and lowering the organization status of Chief Risk
Officer, the most senior individual charged with monitoring the company’s risks. As a result
board together with independent directors would not have received an unbiased view of major
risk that threatened the survival of the company.
In addition to the above elements of internal environment, the company has failed to consider the
strategic risk associated with transformation of business model from commodities broker into a
full-service investment bank and strategic and reputational risk arising from its large exposure to
sovereign debt of struggling European counties.
An effective risk management system would have averted the above calamity because
•
An effective risk management system is built within an internal environment comprising of
ethical values, competence and development of personnel, management’s philosophy for
managing risk, and how it assigns authority and responsibility.
•
The tone set by the board and CEO could create a risk culture where, everyone in the
organization is conscious about various risks which threaten the business objectives and
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follows existing controls and risk mitigation strategies without any exception. Further,
individuals may make risk responsive decisions.
•
Risk governance is fundamental to an effective risk management system where risk
management is considered as a top priority area at the board level. Input from nonexecutive directors and the risk assurance from audit committee may also strengthen the
risk management process.
•
An effective risk management system considers strategic risk that could have the most
significant impact on achieving entity’s business objectives. E.g. reputational risk and
resultant erosion of the market value accelerated the failure in MF global.
Chapter – 03
Solution 1
Risk identification aims to determine an organization’s exposure to uncertainty and tries to
ensure that the risks flowing from all significant activities within the organization have been
identified. Examples of methods of identifying risk include brainstorming, workshops,
stakeholder consultations, benchmarking, checklists, scenario analysis, incident investigation,
auditing and inspection, questionnaires, surveys and interviews.
Risk estimation is used to assess the severity of each risk once they are identified. The methods
of risk estimation can be quantitative, semi-quantitative or qualitative in terms of the likelihood
of occurrence and the possible consequences. Examples include information gathering through
market survey, research and development, etc.; scenario planning; soft systems analysis;
computer simulations, for example, Monte Carlo; decision trees; root cause analysis; FTA/ETA;
sensitivity analysis; cost-benefit and risk-benefit analysis; Delphi method; HAZOP studies and a
range of statistical techniques.
Many of these methods are reductionist and assume simple cause-effect relationships rather than
holistic or whole system relationships. Other methods are subjective and rely on individual
perceptions of risk while other methods are a combination of the two, with subjective judgment
reflected in probabilities. Whichever method of estimating risk is used, the most common way of
assessing those risks is through the likelihood/impact matrix. By considering the consequence
and probability of each of the risks it should be possible for organizations to prioritize the key
risks.
Risk evaluation is concerned with making decisions about the significance of risks to the
organization and whether those risks should be accepted or whether there should be an
appropriate treatment or response.
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Risk response may be action taken to exit the activities giving rise to risk (avoidance); action
taken to reduce the risk likelihood or impact, or both (reduction); action taken to transfer a
portion of the risk through, for example, insurance, hedging or outsourcing (risk sharing) or no
action taken if the risk is acceptable.
Solution 2
Effective risk treatment will enable a consideration of the nature and extent of risks facing the
organization; the risk which the organization considers it as acceptable to bear; the likelihood of
risks materializing and the costs and benefits of risk responses.
Gross risk involves the assessment of risk before the application of any controls, transfer or
management responses, net risk involves the assessment of risk, taking into account the
application of any controls, transfer or management response to the risk under consideration. The
residual risk shows how well the risk treatment techniques have reduced the overall exposure to
the organization or increased the opportunities available to it. A comparison of gross and net risk
enables a review of risk response effectiveness and possible alternative management options.
3. BP Case Study
BP’s failure to prevent this unprecedented environmental catastrophe created a major financial
and reputational impact. It also brings into questions corporate social responsibility of a company
whose operations and business model could threaten the wellbeing of the environment and
society at large. Safety and Environmental risk are fundamental to the business model of BP and
should have been identified as an area with a much lower risk appetite so as to require sufficient
resources allocation to manage the risk.
The most important aspect of the case study is the need to manage third party risk. In this case,
Macando oil well was owned by Transocean and leased to BP. Transocean owned the rig, ran it
and maintained the oil well’s blowout preventer. When a critical business operation is performed
outside the control of the company, there is no assurance that same control measures are
deployed to prevent a disaster such as the explosion on the oil rig. This higher inherent risk
should have been captured in BP’s risk management practices and responded through adequate
risk mitigation such as regular monitoring inspection etc.
BP’s subsequent response to safety risk through creation of a new safety division with sweeping
power and aligning staff bonuses to reflect compliance with safety rule indicates that the focus
on safety before the explosion would have been clearly inadequate.
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Chapter – 04
Solution 1
There needs to be a commitment from the board and top management in relation to risk
management. Organizations need a risk management policy which defines the organization’s
approach to risk management and its attitude to, and appetite for risk.
The risk management policy and framework should be driven by the board through an audit or
risk management committee and managed by an executive corporate risk management group.
Risk management needs to be integrated with strategic planning.
A risk management strategy should include the risk profile of the organization, that is, the level
of risk it finds acceptable; the risk assessment and evaluation processes the organization
practices; the preferred options for risk treatment; the responsibility for risk management and the
reporting and monitoring processes that are required. Resources (money, experience and
information, etc.) need to be allocated to risk management.
Responsibility for risk management needs to be assigned, as appropriate, to the board, or its audit
committee, a risk management group, the chief risk officer, internal audit, external audit, line
managers, and all employees, through the organization’s culture. The ownership of risk
management is the best assigned to the line managers and risk management will be more
effective if it is embedded in the organizational culture. Consequently, communication and
training are essential.
Risk management processes should be adopted to identify and define risk, and risk needs to be
assessed as to both likelihood and impact. Risk assessment comprises the analysis and evaluation
of risk through processes of identification, description and estimation. Risk evaluation is used to
make decisions about the significance of risks to the organization and whether each specific risk
should be accepted or treated.
Risk treatment or response for each significant risk will aim to close the gap between the
organization’s risk profile and its appetite for risk. Risk treatment (also called risk response) is
the process of selecting and implementing measures to modify the risk. This may include risk
control/mitigation, risk avoidance, risk transfer, risk financing (e.g. insurance), etc.
There should also be regular risk management review and reporting. This can take place through
internal reporting to the board and business units; internal audit with reporting to the board on the
effectiveness of control systems and external reporting. Risk reporting needs to assess the control
systems in place for risk management; the processes used to identify and respond to risks; the
methods used to manage significant risks and the monitoring and review system.
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Solution 2
The Three Lines of Defense (the Model) addresses how specific duties related to risk and control
could be assigned and coordinated within an organization, regardless of its size or complexity. Its
underlying premise is that, under the oversight and direction of senior management and the board
of directors, three separate groups (or lines of defense) within the organization are necessary for
effective management of risk and control. Effective application of three line of defense model
requires a corporation to first establish an audit committee which could oversee managing of risk
by three line of defense together with the board and the senior management team.
First Line
Front line operating management should own and manage the risk. This requires creating risk
awareness within the entity so that business and process owners whose activities create risk own
the risk, and they design and execute controls to respond to those risks.
Second Line
The second line is put in place to support management by bringing expertise, process excellence,
and management monitoring alongside the first line to help ensure that risk and control are
effectively managed. Various compliance and control system designed to monitor the
effectiveness of first line of are here. Example, quality, financial controls, safety, etc.
Third line
The third line provides an independent assurance to the board and senior management
concerning the effectiveness of management of risk and control and is usually provided by
internal audit.
Solution 3- Samsung Case Study
According to the case information, Samsung rushed the Note 7 to the market to stay ahead of
competitors who were fast in catching up smart phone markets and to rollout Note 7 before I
Phone 7. Being the marker leader, product quality and safety should have been a top priority of
Samsung with lower risk appetite. According to battery scientists aggressive design decisions
made problems more likely (“to push the limits of battery technology left little safety margin in
the event of a problem, like pressure on a Smartphone casing”). This brings into question
consideration of risk when critical decisions are made on the trade-offs inherent in strategy. This
design consideration would have been motivated to attract customers but failed to consider the
threat to product safety and people’s lives. E.g. Southwest Airlines plane was evacuated after a
Note 7 began smoking. This is in addition to the estimated financial cost of7 trillion won, or $6.2
billion on account of the decision to ditch the Note 7.
The article states that the management pushed their engineers to make the battery separator really
thin, this necessitates the interference by governing body e.g. risk committee to challenge
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management decisions which ignores expert advice and could potentially cause significant
business risk. This is evident by Samsung’s subsequent move to form an outside battery advisory
group and add teams focused on the quality assurance of each core component of the device.
The bold decision to recall 2.5 million devices globally appears to confirm the attributes of a
business which is socially and ethically responsible for the product quality. However, some of
the replaced devices began catching fire which exacerbated the issue and may result in regulatory
action being taken. Above all most damaging risk which cannot be quantified is the risk to
reputation which was intensified through social media. Relating to the discussion on strategic
risk, this case emphasizes all aspects of strategic risk, risk to chosen strategy, and
appropriateness of chosen strategy to mission and values and implication of chosen strategies.
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