Strategic Planning
Understanding the importance of strategic planning:
The average life expectancy of a multinational corporation has been estimated by Arie De Geus, a former Shell executive, a scholar and an expert in strategic planning to be between 40 and 50 years. Most corporations are unable to survive long enough because they are unable to manage risks effectively. De Geus’s research has revealed that enduring organizations excel simultaneously on various fronts. They are sensitive to their environment. They do not hesitate to move into uncharted areas when the situation so demands. They use money in an old fashioned way, keeping enough of it for a rainy day. In other words, long lasting companies manage the risks they face in a flexible way, backed by expertise across functions. As Collins and Porras (who have done some brilliant research on what creates lasting companies, in their book ‘Built to Last’) put it, “Visionary companies display a powerful drive for progress that enables them to change and adapt without compromising their cherished core ideals.” All companies face threats in their environment-new competition, new technology, changes in consumer tastes but only a few of them manage these risks effectively. Those who do so are alert to changes in the environment and are willing to change internally to respond to them. The Swedish company Stora, for instance, has shown a remarkable ability to formulate strategies according to the needs of the hour. It has not hesitated to go outside its core business when the situation has demanded. Once it even fought the king of Sweden to retain its independence. To cope with the changing environment, the company has from time to time moved into new businesses - from copper to forest exploitation to iron smelting, to hydropower and later to paper, wood pulp and chemicals. In the process, the company mastered steam, internal combustion, electricity and ultimately, microchip technologies. Had Stora continued in one business line, it would not have survived. Consider Nokia, one of the most admired companies in the world today. Though Nokia has been in the limelight only in recent times, it is a fairly old company, having been around for more than 100 years. At one point of time, Nokia dealt in wood, pulp and paper. Today, it makes sleek cellular phones loaded with powerful software. The lesson from Nokia and Stora is that strategic planning plays the crucial role of enabling a company to anticipate and deal with risks. In this chapter, we shall try to understand the link between strategic planning and risk management. Strategic planning is all about positioning an organisation to take full advantage of opportunities in the environment while simultaneously reducing the vulnerability to threats. Thus, good strategic planning implies the ability to digest what is happening in the environment and reshape the organisation accordingly. It becomes easier to do this if an organisation is prepared for various eventualities. Then, as events unfold in the environment, it is in a better position to decide which strategy would work best. Strait-jacketed thinking, on the other hand, makes the employees of an organisation impervious to external developments. When changes do occur, they are taken by surprise. A simple example from our daily lives illustrates this point. A man who travels by bus daily to office would not be unduly worried about a prolonged railway strike as it does not affect him. But a man who knows there could be an occasional bus strike which would necessitate travel by train, would follow the strike with great interest. A company which has global expansion as one of its options would closely follow, all developments related to WTO, while an insular company would not. In short, by being open to various possibilities, and examining the possible course of action for each of them, strategic planning can to a large extent keep risks within manageable limits.
Dealing with uncertainty in the environment:
The essence of risk management is to help a firm to survive and grow. When the environment is unfavorable, the firm will concentrate on survival and when it is favorable, it will attempt to exploit new growth opportunities. The speed with which a company adjusts to the environment depends crucially on the ability of its senior managers to observe and understand what is happening outside and respond accordingly. De Geus has argued that strategic planning can accelerate the process of institutional learning provided its aim is not so much to draw up a course of action as to change the mental models in the heads of people. When managers are encouraged to think of various possibilities, they can better absorb and digest information and most importantly, act as the environment changes. This is especially valid during times of radical change. As Clayton Christensen of Harvard Business School puts it1 : “The strategies and plans that managers formulate for confronting disruptive technological change therefore, should be plans for learning and discovery, rather than plans for execution. This is an important point to understand, because managers who believe they know a market’s future will plan and invest very differently from those who recognise the uncertainties of a developing market.” Strategic planning in uncertain situations, must take into account various risks. If the prevailing uncertainty is not properly considered, the firm might end up facing threats it is ill equipped to deal with. At the other extreme, the firm may show too much caution and not exploit opportunities that have the potential to yield excellent returns. Many companies take strategic decisions relying totally on their gut instincts during times of uncertainty. This is obviously a wrong thing to do. Intuition has to be backed with some numbers for strategic planning to be effective. Courtney, Kirkland and Viguerie2 provide a framework for strategic planning during conditions of uncertainty. They refer to the uncertainty which still remains, after a thorough analysis of all the variables in the environment has been done, as residual uncertainty. In a simple situation, strategies can be made on the basis of a single forecast. At the next level of uncertainty, it makes sense to envision a few distinct scenarios. At an even higher level, several scenarios can be identified. In the most uncertain situations, it is difficult to even visualize scenarios, let alone predict the outcome. Where uncertainty is less, companies are typically more worried about their competitive position within the industry. They take the industry structure as given and try to exploit the opportunities available and get ahead of rivals. Where uncertainty is high, firms have two broad strategic options. They can make heavy investments and attempt to control the direction of the market. Alternatively, they can make incremental investments and wait till the environment becomes less uncertain before committing themselves to a strategy. In the intervening period, the firm can collect more information, or form strategic alliances to share risks. In short, a firm has to arrive at an optimum portfolio of investments – heavy risky investments, small risky investments and heavy, not very risky investments 3 . The mix would depend on the degree of uncertainty in the environment.
Discovery-driven planning as a risk mitigation tool:
In highly uncertain situations, conventional planning methods may not be appropriate. Rita Gunther McGrath and Ian C MacMillan4 suggest the use of discovery-driven planning in these situations. In uncertain ventures, many assumptions are usually made. So, as the project progresses, there is a compelling need to incorporate new data and revise these assumptions on an ongoing basis. Take the case of Eurodisney. A key assumption made before the execution of the project was that 50% of the revenues would come from admissions and the remaining 50% from hotels, food and merchandise. After the project was completed, Disney found that ticket prices were less than anticipated and that visitors did not spend as much as expected. So, in spite of reaching a target of 11 million admissions, profitability remained below expectations. Ticket prices had to be lowered due to the recession in Europe. Disney had expected people to stay in the hotel for four days but people spent two days on an average, since there were only 15 rides, compared to 45 at Disney World in the US. Disney had assumed that there would be a steady stream of people visiting the restaurants throughout the day, as in the US and Japan, but the crowds came in only during lunch time. Disney’s inability to seat all of them led to loss of revenue, dissatisfied customers and bad word-of-mouth publicity. Visitors to Euro Disney also purchased a much smaller proportion of high margin items such as T-shirts and hats than expected. McGrath and MacMillan have summarized the mistakes made by companies while planning new projects with a great degree of uncertainty: • Companies do not have precise information, but after a few important decisions are made, proceed as though the assumptions are facts. • Companies have enough hard data, but do not spend adequate time in checking the assumptions made. • Companies have enough data to justify entry into a new business or market, but make inappropriate assumptions about their ability to execute the plans. • Companies have the right data and may make the right assumptions to start with, but fail to notice until it is too late that a key variable in the environment has changed. The discovery-driven planning approach prescribes the use of four different documents, which are updated as events unfold: i) a reverse income statement to capture the basic economics of the business. This statement starts with the required profits and works backward to arrive at revenues and costs. ii) pro forma operations specifications that specify the activities associated with the business including production, sales, delivery and service. iii) a checklist for ensuring that all assumptions are examined and discussed not only before the project starts but even as it is executed. iv) a planning chart which specifies the assumptions to be tested at each project milestone. This allows major resource commitments to be postponed until evidence from the previous milestone event signals that the risk associated with the next step is justified. McGrath and MacMillan have pointed out some of the faulty implicit assumptions made by companies.
1. Customers will buy the product because the company thinks it’s a good product. Harvard Business Review, July-August 1995.
2. Customers run no risk in buying from the company instead of continuing to buy from their past suppliers.
3. The product can be developed on time and within the budget.
4. The product will sell itself.
5. Competitors will respond rationally.
6. The product can be insulated from competition. Many of these assumptions do not turn out to be valid as the project evolves. If cognizance is not taken of this, there could be serious problems at a later date.
Futility of conventional appraisal techniques:
Where uncertainty is high, conventional appraisal techniques such as Net Present Value5 (NPV) are of little use. According to David Sharp6 , “NPV’s effectiveness for investment appraisal is limited; the present value of an investment’s cash flows excludes the valuable options embedded within the investment. These options give the company the ability to take advantage of certain opportunities later. For projects with long-term strategic consequences, the options are frequently the most valuable part of the investment. Since NPV calculations understate value, a selection process driven by NPV will reject more potentially profitable projects.” In other words, when evaluating projects with a very high degree of uncertainty, companies may not take a risk worth taking, due to the use of conservative appraisal techniques. Ultimately, the objective of risk management is to facilitate value adding investments. In the real world, the demand for a product and the price which it can command in the market are uncertain. So, there is considerable uncertainty about the cash flows which will be generated. How do we decide which project is the right one? Like Sharp, Martha Amram and Nalin Kulatilaka7 suggest the use of real options while evaluating a project. Thus, a timing option, in the form of a delayed expansion in capacity could create value in a situation of uncertain demand. Putting up a plant in an overseas market currently fed by exports may generate new growth options. An exit option in the form of a plant closure increases the value of the investment decision. By looking at strategic decisions in terms of options and then using information from financial markets to value these options, risk can be greatly reduced. Oil companies for example can predict the future price of oil through the futures markets. Decision makers will not be able to draw information from the financial markets for all decisions. Some decisions typically involve uncertainties which are insulated from the market mechanism and are specific to a company. Amram and Kulatilaka call these ‘private risks’. But as more and more risks become securitised8 , the options approach may become more and more feasible. Amram and Kulatilaka argue that traditional valuation tools which view business development in terms of a fixed path are of little use in an uncertain environment. In the real world, a new business or a major investment in capacity expansion may result in a variety of outcomes that may demand a range of strategic responses. Plans to change operating or investment decisions later, depending on the actual outcome, must form an integral component of the projections. Thinking of the investment in terms of options, allows uncertainty to be taken into account.
As Amram and Kulatilaka put it: “The real value of real options, we believe, lies not in the output of Black-Scholes or other formulas but in the reshaping of executives’ thinking about strategic investment. By providing objective insight into the uncertainty present in all markets, the real options approach enables executives to think more clearly and more realistically about complex and risky strategic decisions. It brings strategy and shareholder value into harmony.” In any investment appraisal process, managers should identify the embedded options, evaluate the conditions under which they may be exercised and finally judge whether the aggregate value of the options compensates for any shortfall in the present value of the project’s cash flows. However, as Sharp puts it, options are of value only in an uncertain environment. Thus investment decisions, whose primary objective is to acquire options, must be made before uncertainties in the environment are resolved. Sharp says9 , “Unlike cash flows, whose value may be positive or negative, option values can never be less than zero, because they can always be abandoned. Embedded options can therefore, only add to the value of an investment. Options are only valuable under uncertainty: if the future is perfectly predictable, they are worthless”.
Scenario planning:
From time immemorial, man has had to prepare himself for various eventualities. Just to survive, he has had to ask questions like: What if it snows? What if there is a poor harvest? Indeed, it is this type of thinking which made man think of taking various steps, such as storing food, building dams, etc.
Many companies prepare their plans in structured formats using bullet points. 3M, one of the most innovative companies in the world does strategic planning differently. The process it uses, may look unstructured at first sight, but has been highly effective in energising and motivating people to take calculated risks and achieve their goals. 3M, realises that the essence of writing is thinking and developing clarity in the thought process. But regimented formats allow people to skip thinking and also do not incorporate the critical assumptions made while preparing the plan. So 3M uses strategic stories while preparing business plans. It transforms a business plan from a list of bullet points into a compelling narrative that describes the environment, the challenges it faces in trying to achieve its goals and how the company can overcome these obstacles. In the process of writing the narrative, the writer’s hidden assumptions tend to come to the surface. Readers get to know the thought processes of the person preparing the plan. According to a 3M manager10, “If you read just bullet points, you may not get it, but if you read a narrative plan, you will. If there’s a flaw in the logic, it glares right out at you. With bullets, you don’t know if the insight is really there or if the planner has merely given you a shopping list.”
Source: Gordon Shaw, Robert Brown and Philip Bromiley, “Strategic Stories: How 3M is Rewriting Business Planning,” Harvard Business Review, May-June 1998.
Formal scenario planning seems to have emerged to reduce uncertainty during the second world war, when it was used as a part of military strategy. The countries involved in the war had to prepare themselves for different contingencies and accordingly develop plans of action. Since then, the use of scenario planning has become increasingly popular. The US Air Force, for example, has been conducting war-game exercises for many years with the aid of computer simulations. In the late 1960s, Herman Kahn of the Stanford Research Institute modified the scenario planning concept so that businesses could also use it. IBM and GM were among the first companies to adopt scenario planning. Both companies however, failed to use scenario planning effectively. Being industry leaders, they probably had an exaggerated notion of their ability to predict and control the
Sloan Management Review, Summer 1991.
Harvard Business Review, May-June, 1998 .
environment. The scenarios they envisaged essentially reflected their existing paradigms. For example, GM totally overlooked the change in consumer preferences in favor of smaller cars and the threat from Japanese car makers. Similarly, IBM failed to foresee the decline of mainframes and the emergence of smaller, less powerful but more user-friendly computers. On the other hand, Shell seems to have achieved great success in the use of scenario planning. (See Case at the end of the chapter). Today, many leading companies accept that adapting blindly to external events is not desirable. Learning about trends and uncertainties and how they interact with each other enables companies to prepare for different future scenarios. It also helps a company to identify the scenarios for which its strengths and competencies are particularly suited. It is then in a position to understand how it can influence the emerging trends in the environment through a combination of innovations, managerial actions and alliances. By identifying the scenarios for which it is least prepared, it can invest in building the required competencies. In extreme cases, it can even withdraw from businesses, especially those which do not promise strategic benefits in the long run. According to Robin Wood11: “Given this level of change in our environment, the only response is to accelerate our capability to learn and change so as to adapt, which then buys us time to produce a more desirable future state for ourselves. Scenarios are the most powerful technology we have encountered to accelerate learning and provoke change, in both individuals and organizations.”
Surviving an industry shakeout:
Some of the greatest risks which companies face are during times when the industry is witnessing a shake-out. The old paradigm may change, or some players may become very powerful. As a result, many weaker players find the going tough and in extreme cases may even quit the industry. While shake-outs threaten virtually all companies in the industry, those who see it coming can create new opportunities. George S Day12 has provided some useful insights on an industry shake-out. Day refers to two kinds of shake-out syndromes: the boom-and-bust syndrome and the seismic-shift syndrome. The boom-and-bust syndrome typically applies to emerging markets and cyclical businesses. The dot com industry, is a good example. During the boom, many companies entered the industry leading to excess capacity. As competition intensified and prices fell, many players found the going tough. The companies which have succeeded are those with a high degree of operational excellence and those which focused on ruthless cost cutting. The seismic-shift syndrome is more applicable to mature industries. Such industries enjoy prosperity for years in a protected environment where competition is not very intense and margins are decent. This state of affairs is mainly due to market imperfections caused by factors such as patent protection and import barriers. A seismic shift takes place when these factors disappear. Deregulation, globalization and technological discontinuities are some of the factors that cause a seismic shift. This kind of a shift has a disruptive impact on players. A good example is the pharmaceutical industry before the emergence of managed health care. (See case on Merck-Medco at the end of the chapter) In a physician driven environment, price was not an important factor. Physicians did not hesitate to prescribe expensive medicines which drug companies gleefully marketed. The emergence of HMOs has reduced the importance of physicians. HMOs recommend the use of generics wherever possible and control costs wherever they can. Drug companies are struggling to adjust to this new environment.
The Boom-and-Bust syndrome in India:
The Boom and Bust syndrome is quite common in India. The experiences of some Indian industries in recent times offer useful lessons.
Granite
When the granite boom hit the headlines, many companies rushed to excavate mines and buy expensive equipment to cut and polish the stone. However, they could not cope with the complicated web of financial, technical, and bureaucratic intricacies that the granite business threw up. Of the 900 odd registered exporters that existed in the days of the granite boom, only about 160 remained in the middle of 2001 and no more than 60 were profitable. There are several reasons for the downfall of these entrepreneurs. To start with, mining granite was not as easy as entrepreneurs envisaged. Most entrepreneurs became embroiled in court cases over bad leases. Mining operations ravaged the land and antagonised locals. So, in some cases, governments suspended the leases. In other cases, companies, were forced to close down their mines. At the end of the day, the industry also did not see as much growth as expected because of limited markets. There was only so much granite that could be used in monuments, buildings, kitchen, and bathroom counters. The final nail in the coffin was driven by the dependence on the American market, where many orders were executed without letters of credit. Consequently, companies began to reel under big defaults, mainly from NRIs. According to Gautam Chand Jain, the CEO of Pokarna Granites, one of the few survivors in the industry, “We have grown by first learning about the quarry business, selling rough blocks and then acquiring sick, good quality units, which were available at a reasonable price.” Quite clearly Pokarna didn’t try to do everything at one go – or by itself. It was careful in selecting customers in the tricky American market. With 7 per cent of its turnover spent on marketing, Pokarna concentrated on strengthening relationships with customers, either through buyers’ guides or local contacts. For the quarter ended July 31, 2001, Pokarna generated profits of Rs. 2 crore on sales of Rs. 15.2 crore. Encouraged by his success, Jain has been busy implementing a Rs. 10 crore expansion plan.
Aquaculture Easy availability of finance and the lucrative Japanese market prompted many companies to enter theaquaculture business in the early 1990s. They dug up thousands of acres of coastal land, spent heavily on various equipment, feed, and housing. But when the white-spot disease (signalled by white spots on the shrimp) wiped out crops between 1994 and 1996, lending agencies pulled the plug, and funds dried up. Today, there are about 100 aquaculture companies along the coast. About half a dozen export goods worth Rs. 100 - Rs. 200 crore. Many of the others are small and medium players with exports in the region of Rs. 20 to Rs. 25 crore. Most of these companies have learned to spread their risks, by splintering the value chain into separate divisions or entire companies: one for farming, one for processing, one for exports, one for consultancy. A good example is Nekkanti Sea Foods of Visakhapatnam, which sources shrimps from farmers along the coast. Instead of shrimp farming, Nekkanti has focused its energies on processing, packaging and building its brands, Akasaka Star and Akasaka Special, sold in seven countries. According to an industry expert, “each aspect gets the dedication and focus it requires with people having the required skill sets.” Nekkanti has correctly understood that small passionate farmers can manage operations more efficiently than corporate executives with a 9-5 mindset. The experiences of shrimp farmers are an indication of the risks involved in making very heavy early commitments in an emerging industry. The reverses seen by the aquaculture industry also stress the importance of concentrating on a small segment of the value chain.
Floriculture The floriculture boom was sparked off by rising rose prices in the 1990s. As prices peaked worldwide, many entrepreneurs rushed to grow roses. But so did counterparts in other countries, as the great rush began to the great flower auctions in Holland. By the middle of the decade, supply increased significantly while there was a worldwide floriculture downturn. Meanwhile, many Indian floriculturists had spent heavily on imported greenhouses, equipment and consultants. Some had even set up greenhouses in the scorching heat of the north. Many of these companies crumbled under soaring costs. The early players in fact imported green houses at double the price, plant material at three times the present day value, and paid huge technical collaboration fees –Rs. 40 lakh for projects of Rs. 7 to Rs. 10 crore.
Managers need to develop antennae that can sense a shakeout before their competitors do so. They can detect early warning signals by systematically monitoring the rate of entry of new players, the amount of excess capacity in the industry and a fall in price. Scenario planning, discussed earlier, can focus attention on change drivers and force the management team to imagine operating in markets which may bear little resemblance to the present ones. Studying other markets which have already seen a shakeout, which are similar in terms of structure and are susceptible to the same triggers can also be of great help. Examining how the same industry is evolving in other countries and regions can also provide useful insights. Day refers to survivors from a boom and bust shakeout as adaptive survivors and those from a seismic shift syndrome as aggressive amalgamators. Adaptive survivors successfully impose discipline in operations and respond efficiently to customer needs and competitor threats. Dell is a good example of an adaptive survivor. During the initial shakeout in the PC industry in the 1980s, Dell survived due to its lean build-to-order direct selling model. In the early 1990s, Dell stumbled when it entered the retail segment and its notebook computers failed to get customer acceptance. CEO Michael Dell did not hesitate to make sweeping changes in the organisation. He put in place a team of senior industry executives to complement his intuitive and entrepreneurial style of management. Today, Dell is the largest manufacturer of PCs in the world. Quite clearly, it has been an adaptive survivor in an industry, which has seen the exit of several players. Aggressive amalgamators show an uncanny ability to develop the right business model for an evolving industry. They usually make one or more of the following moves: rapidly acquire and absorb smaller rivals, cut operating costs and invest in technologies that increase the minimum scale required for efficient operations. Arrow Electronics, one of the largest electronic components distributors in the US is a good example of an aggressive amalgamator. Between 1980 and 1995, Arrow made more than 25 acquisitions, expanded internationally and cut costs by rationalising its MIS, warehousing, human resources, finance and accounting functions. In the Indian cement industry, Gujarat Ambuja seems to be emerging an aggressive amalgamator. Not only has this company cut energy and freight costs aggressively, but it also has become active in the Mergers & Acquisitions (M&A) arena. For companies which find it difficult to become adaptive survivors or aggressive amalgamators, there are alternative survival strategies. These include operating in a niche market segment, joining hands with other small players through strategic alliances and finally to sell out and get the best price possible. The timing of the sale is crucial. Selling at the right time will maximise revenues. Neither a desperate sale nor excessive procrastination is desirable.
A framework for making strategic moves:
The strategic moves of a company can be broadly classified into three: capacity expansion, vertical integration and diversification. All these moves involve some risk, as they are based on assumptions that may or may not ultimately turn out to be true. A careful understanding of these risks and of how they can be minimized if not eliminated is important. Let us examine each of these strategic decisions.
Managing capacity expansion:
When firms add capacity, they may not be able to utilise their capacity fully. Not adding capacity is also risky as a competitor may do so and gain a large market share. The risk associated with capacity expansion is largely due to uncertainty regarding the following factors:
i) Future demand – quantity and price realisation
ii) Future prices of inputs
iii) Technological advances
iv) Reactions of competitors
v) Impact on industry capacity
Capacity expansion is often narrowly applied to manufacturing. In many businesses, manufacturing is a trivial or non-existing activity. So, capacity needs to be understood in terms of the investments made in the most critical area of the value chain. Thus, in the pharmaceuticals industry, capacity has to be defined in terms of scientific manpower and sales force. In a software development company, capacity has to be understood in terms of the number of programmers employed. Many Indian software industries, which recruited software engineers aggressively during 1999 and 2000, now seem to be in big trouble. Many of these engineers are now on the bench.
Industry over capacity is one of the important risks which companies have to consider while expanding their individual capacity. The risk of excess capacity is particularly high in commodity type businesses. In such industries, since products are not differentiated, firms tend to add capacity to generate economies of scale. Risk is also high when capacity cannot be increased in incremental amounts, but only in big lumps. Over capacity may also happen in industries characterized by significant learning curve advantages and long lead times in adding capacity. When there is a large number of players, when there is no credible market leader, and when firms expand indiscriminately, excess capacity usually results. A pre-emptive capacity expansion strategy, which aims to lock up the market before competitors can do so, is quite risky. This strategy requires heavy investments. The firm should have the capacity to withstand adverse financial results in the short run. If competitors do not back down or demand does not rise as expected, the firm can land in big trouble. A firm adopting this strategy should have a certain degree of credibility. Preemptive expansion of capacity is generally not advisable when competitors have non economic goals, consider the business to be strategic in nature and have substantial staying power. Take the example of the Indian Internet Service Provider (ISP) industry which saw the entry of many players during the dot com boom. According to the Internet Service Providers Association of India, 437 players had applied for licenses but only 120 of them were in business in mid 2001. In April 2001, Delhi had 22 ISPs providing services to 2.5 lakh subscribers. The five leading ISPs - VSNL, Mantra, Satyam, NOW and Dishnet, had most of the market share. The remaining catered to just 2352 subscribers on an average. This is clearly an untenable situation in an industry where the initial investment ranges from Rs. 70 lakhs to Rs. 2.5 crores (to offer about 10,000 connections). At least 30,000 connections are needed to make operations viable. To make the business viable, a national level player needs 500,000 subscribers spread over a few cities. The only realistic way of removing the excess capacity seems to be through a wave of mergers. Only five ISPs are expected to survive in the next 12 – 18 months at the national level. Players like Satyam who have a large customer base spread over many cities are still making losses. Texas Instruments (TI) has a unique way of adding capacity without taking undue risk. As demand is cyclical, excess capacity built during the good times becomes a liability during a recession. At Dallas, TI manufactures a wide range of products – low cost DRAM memory chips, customised and expensive microprocessors and sophisticated integrated circuits. Much of the production process, which involves placing transistors in silicon chips, is common across products. Only in the final stages, do the customised chips undergo refinement. TI runs the plant at full capacity but cuts back on production of cheaper DRAM chips and increases that of more sophisticated items when required. Solectron, a company based in Milpitas, USA, specialises in the manufacture of circuit boards for various customers whose demand can fall or rise from time to time. Solectron uses computer software to manage capacity in a flexible way. By reprogramming robots and other machinery, the Milpitas factory can make different types of circuit boards for different customers on the same production line. The Japanese are masters in the use of flexible manufacturing systems. In 1992, Toyota15 built a new plant in which the entire assembly process could switch to a different model in just a few hours. The plant cost much more than a traditional plant where a switchover would have taken weeks. But Toyota was able to add value and minimize risk by generating more options in the same plant.
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References: 1. Theodore Levitt, “The globalization of markets,” Harvard Business Review, MayJune 1983, pp. 2-11. 2. Shawn Tully and Tricia Welsh, “The modular corporation,” Fortune, February 8, 1993, pp. 106-111. 3. Louis Kraar, “Acer’s Edge: PCs to Go,” Fortune, October 30, 1995, pp. 73-86. 4. George S Yip, “Total Global Strategy,” Prentice Hall Inc., 1995. 5. Karen Barth, Nancy J Karch, Kathleen McLaughlin and Christina Smith Shi, “Global Retailing: Tempting trouble,” The McKinsey Quarterly, 1996, Number 1, pp. 116-125. 6. John Byrd and Kent Hickman, “Diversification – A broader perspective,” Business Horizons, March – April 1997, pp. 40-44. 7. George S Day, “Strategies for surviving a shakeout,” Harvard Business Review, March-April 1997, pp. 92-102. 8. Tarun Khanna and Krishna Palepu, “Why focussed strategies may be wrong for emerging markets,” Harvard Business Review, July – August, 1997. 9. Hugh G Courtney, Jane Kirkland and S Patrick Viguerie, “Strategy under uncertainty,” Harvard Business Review, November – December, 1997. 10. Clayton M Christensen, “Making strategy: Learning by Doing,” Harvard Business Review, November-December 1997. 11. Vijay Govindarajan and Anil Gupta, “How to build a Global Presence,” Financial Times Survey - Mastering Global Business, January 29, 1998. 12. Gordon Shaw, Robert Brown and Philip Bromiley, “Strategic Stories: How 3M is Rewriting Business Planning,” Harvard Business Review, May-June 1998. 13. Jonathan Moore and Peter Burrows, “Stan Shih’s Moment of Truth at Acer,” Business Week, October 12, 1998, p. 23. 14. Kasturi Rangan and Marie Bell, “Merck-Medco: Vertical integration in the pharmaceutical industry,” Harvard Business School Case No. 9-598-091, 1998. 15. Martha Amram and Nalin Kulatilaka, “Disciplined decisions – Aligning strategy with the financial markets,” Harvard Business Review, January – February 1999, pp. 95-104. 39 16. John Hagel III and Marc Singer, “Unbundling the corporation,” Harvard Business Review, March-April 1999, pp. 133-141. 17. Jeremy Kahn, “Wal-Mart goes shopping in Europe,” Fortune, June 7, 1999, pp. 53-56. 18. Heidi Dawley, “Watch out: Here comes Wal-Mart,” Business Week, June 28, 1999, pp. 28-29. 19. Tarun Khanna and Krishna Palepu, “The right way to restructure conglomerates in emerging markets,” Harvard Business Review, July – August 1999, pp. 125-134. 20. Carol Matlack, et al, “En Garde Wal-Mart,” Business Week, September 13, 1999, pp. 28-29. 21. Max Bazerman and James Gillespie, “Betting on the future, “The virtues of contingent contracts,” Harvard Business Review, September-October 1999, pp. 155-160. 22. Chris Lonsdale, “Effectively managing vertical supply relationships: A risk management model for outsourcing,” Supply Chain Management: An International Journal, October 4, 1999 Vol. 4, Issue 4, pp. 176-183. 23. Richard Tomlinson, “Kodak’s $1 Billion Bet,” Fortune, October 11, 1999, pp. 97-102. 24. Denise Incandela, Hathleen McLaughlin and Christina Smith Shi, “Retailers to the World,” The McKinsey Quarterly, 1999, Number 3, pp.84-97. 25. Kerry Cabell, et al, “Wal-Mart’s Not Secret British Weapon,” Business Week, January 24, 2000, p. 22. 26. Bruce Einhorn, Stuart Young and David Rocks, “Acer’s About-Face”, Business Week, April 24, 2000, pp. 18-19. 27. Guido A Krickx, “The relationship between uncertainty and vertical integration,” International Journal of Organizational Analysis, Volume 8, Issue 3, 2000, pp. 309-329. 28. Vinod Mahanta, “Net Impasse,” Business Today, April 6, 2001, pp. 76-78. 29. Debojyoti Chatterjee, etal, “ITC’s Big Bang,” Business Today, June 21, 2001, pp. 34-41. 30. David Champion, “Mastering the value chain: An interview with Mark Levin of Millennium Pharmaceuticals,” Harvard Business Review, June 2001, pp. 109-115. 31. Shelly Singh, “The shakeout begins now,” Business World, July 23, 2001, pp. 24-27. 32. Dibyendu Ganguly, “Cruising along with Pizzazz,” Economic Times Corporate Dossier, August 31, 2001, p. 1. 33. Wendy Zellner, et al, “How well does Wal-Mart travel?” Business Week, September 3, 2001, pp. 61-62. 34. Dibyendu Ganguly, “Great White Hope,” Economic Times Corporate Dossier, September 6, 2001, p. 3. 35. Shailesh Dabhal, “The task of competition,” Business Today, September 30, 2001, pp. 45-53. 36. “The next big surprise,” The Economist, October 13, 2001, p. 60. 37. Robin Wood, “Managing complexity,” Profile Books, 2001. 48. Peter Schwartz, “The official future, self-delusion and the value of scenarios,” Financial Times Mastering Risk, Volume I, 2001, pp. 42-46. 49. Benjamin Gomes Casseres, “Alliances and risk: securing a place in the victory parade,” Financial Times Mastering Risk, Volume I, 2001, pp. 74-79. 50. Jeffrey J Reuer and Michael J Leiblein, “Real options: let the buyers beware,” Financial Times Mastering Risk, Volume I, 2001, pp. 79-85.
The average life expectancy of a multinational corporation has been estimated by Arie De Geus, a former Shell executive, a scholar and an expert in strategic planning to be between 40 and 50 years. Most corporations are unable to survive long enough because they are unable to manage risks effectively. De Geus’s research has revealed that enduring organizations excel simultaneously on various fronts. They are sensitive to their environment. They do not hesitate to move into uncharted areas when the situation so demands. They use money in an old fashioned way, keeping enough of it for a rainy day. In other words, long lasting companies manage the risks they face in a flexible way, backed by expertise across functions. As Collins and Porras (who have done some brilliant research on what creates lasting companies, in their book ‘Built to Last’) put it, “Visionary companies display a powerful drive for progress that enables them to change and adapt without compromising their cherished core ideals.” All companies face threats in their environment-new competition, new technology, changes in consumer tastes but only a few of them manage these risks effectively. Those who do so are alert to changes in the environment and are willing to change internally to respond to them. The Swedish company Stora, for instance, has shown a remarkable ability to formulate strategies according to the needs of the hour. It has not hesitated to go outside its core business when the situation has demanded. Once it even fought the king of Sweden to retain its independence. To cope with the changing environment, the company has from time to time moved into new businesses - from copper to forest exploitation to iron smelting, to hydropower and later to paper, wood pulp and chemicals. In the process, the company mastered steam, internal combustion, electricity and ultimately, microchip technologies. Had Stora continued in one business line, it would not have survived. Consider Nokia, one of the most admired companies in the world today. Though Nokia has been in the limelight only in recent times, it is a fairly old company, having been around for more than 100 years. At one point of time, Nokia dealt in wood, pulp and paper. Today, it makes sleek cellular phones loaded with powerful software. The lesson from Nokia and Stora is that strategic planning plays the crucial role of enabling a company to anticipate and deal with risks. In this chapter, we shall try to understand the link between strategic planning and risk management. Strategic planning is all about positioning an organisation to take full advantage of opportunities in the environment while simultaneously reducing the vulnerability to threats. Thus, good strategic planning implies the ability to digest what is happening in the environment and reshape the organisation accordingly. It becomes easier to do this if an organisation is prepared for various eventualities. Then, as events unfold in the environment, it is in a better position to decide which strategy would work best. Strait-jacketed thinking, on the other hand, makes the employees of an organisation impervious to external developments. When changes do occur, they are taken by surprise. A simple example from our daily lives illustrates this point. A man who travels by bus daily to office would not be unduly worried about a prolonged railway strike as it does not affect him. But a man who knows there could be an occasional bus strike which would necessitate travel by train, would follow the strike with great interest. A company which has global expansion as one of its options would closely follow, all developments related to WTO, while an insular company would not. In short, by being open to various possibilities, and examining the possible course of action for each of them, strategic planning can to a large extent keep risks within manageable limits.
Dealing with uncertainty in the environment:
The essence of risk management is to help a firm to survive and grow. When the environment is unfavorable, the firm will concentrate on survival and when it is favorable, it will attempt to exploit new growth opportunities. The speed with which a company adjusts to the environment depends crucially on the ability of its senior managers to observe and understand what is happening outside and respond accordingly. De Geus has argued that strategic planning can accelerate the process of institutional learning provided its aim is not so much to draw up a course of action as to change the mental models in the heads of people. When managers are encouraged to think of various possibilities, they can better absorb and digest information and most importantly, act as the environment changes. This is especially valid during times of radical change. As Clayton Christensen of Harvard Business School puts it1 : “The strategies and plans that managers formulate for confronting disruptive technological change therefore, should be plans for learning and discovery, rather than plans for execution. This is an important point to understand, because managers who believe they know a market’s future will plan and invest very differently from those who recognise the uncertainties of a developing market.” Strategic planning in uncertain situations, must take into account various risks. If the prevailing uncertainty is not properly considered, the firm might end up facing threats it is ill equipped to deal with. At the other extreme, the firm may show too much caution and not exploit opportunities that have the potential to yield excellent returns. Many companies take strategic decisions relying totally on their gut instincts during times of uncertainty. This is obviously a wrong thing to do. Intuition has to be backed with some numbers for strategic planning to be effective. Courtney, Kirkland and Viguerie2 provide a framework for strategic planning during conditions of uncertainty. They refer to the uncertainty which still remains, after a thorough analysis of all the variables in the environment has been done, as residual uncertainty. In a simple situation, strategies can be made on the basis of a single forecast. At the next level of uncertainty, it makes sense to envision a few distinct scenarios. At an even higher level, several scenarios can be identified. In the most uncertain situations, it is difficult to even visualize scenarios, let alone predict the outcome. Where uncertainty is less, companies are typically more worried about their competitive position within the industry. They take the industry structure as given and try to exploit the opportunities available and get ahead of rivals. Where uncertainty is high, firms have two broad strategic options. They can make heavy investments and attempt to control the direction of the market. Alternatively, they can make incremental investments and wait till the environment becomes less uncertain before committing themselves to a strategy. In the intervening period, the firm can collect more information, or form strategic alliances to share risks. In short, a firm has to arrive at an optimum portfolio of investments – heavy risky investments, small risky investments and heavy, not very risky investments 3 . The mix would depend on the degree of uncertainty in the environment.
Discovery-driven planning as a risk mitigation tool:
In highly uncertain situations, conventional planning methods may not be appropriate. Rita Gunther McGrath and Ian C MacMillan4 suggest the use of discovery-driven planning in these situations. In uncertain ventures, many assumptions are usually made. So, as the project progresses, there is a compelling need to incorporate new data and revise these assumptions on an ongoing basis. Take the case of Eurodisney. A key assumption made before the execution of the project was that 50% of the revenues would come from admissions and the remaining 50% from hotels, food and merchandise. After the project was completed, Disney found that ticket prices were less than anticipated and that visitors did not spend as much as expected. So, in spite of reaching a target of 11 million admissions, profitability remained below expectations. Ticket prices had to be lowered due to the recession in Europe. Disney had expected people to stay in the hotel for four days but people spent two days on an average, since there were only 15 rides, compared to 45 at Disney World in the US. Disney had assumed that there would be a steady stream of people visiting the restaurants throughout the day, as in the US and Japan, but the crowds came in only during lunch time. Disney’s inability to seat all of them led to loss of revenue, dissatisfied customers and bad word-of-mouth publicity. Visitors to Euro Disney also purchased a much smaller proportion of high margin items such as T-shirts and hats than expected. McGrath and MacMillan have summarized the mistakes made by companies while planning new projects with a great degree of uncertainty: • Companies do not have precise information, but after a few important decisions are made, proceed as though the assumptions are facts. • Companies have enough hard data, but do not spend adequate time in checking the assumptions made. • Companies have enough data to justify entry into a new business or market, but make inappropriate assumptions about their ability to execute the plans. • Companies have the right data and may make the right assumptions to start with, but fail to notice until it is too late that a key variable in the environment has changed. The discovery-driven planning approach prescribes the use of four different documents, which are updated as events unfold: i) a reverse income statement to capture the basic economics of the business. This statement starts with the required profits and works backward to arrive at revenues and costs. ii) pro forma operations specifications that specify the activities associated with the business including production, sales, delivery and service. iii) a checklist for ensuring that all assumptions are examined and discussed not only before the project starts but even as it is executed. iv) a planning chart which specifies the assumptions to be tested at each project milestone. This allows major resource commitments to be postponed until evidence from the previous milestone event signals that the risk associated with the next step is justified. McGrath and MacMillan have pointed out some of the faulty implicit assumptions made by companies.
1. Customers will buy the product because the company thinks it’s a good product. Harvard Business Review, July-August 1995.
2. Customers run no risk in buying from the company instead of continuing to buy from their past suppliers.
3. The product can be developed on time and within the budget.
4. The product will sell itself.
5. Competitors will respond rationally.
6. The product can be insulated from competition. Many of these assumptions do not turn out to be valid as the project evolves. If cognizance is not taken of this, there could be serious problems at a later date.
Futility of conventional appraisal techniques:
Where uncertainty is high, conventional appraisal techniques such as Net Present Value5 (NPV) are of little use. According to David Sharp6 , “NPV’s effectiveness for investment appraisal is limited; the present value of an investment’s cash flows excludes the valuable options embedded within the investment. These options give the company the ability to take advantage of certain opportunities later. For projects with long-term strategic consequences, the options are frequently the most valuable part of the investment. Since NPV calculations understate value, a selection process driven by NPV will reject more potentially profitable projects.” In other words, when evaluating projects with a very high degree of uncertainty, companies may not take a risk worth taking, due to the use of conservative appraisal techniques. Ultimately, the objective of risk management is to facilitate value adding investments. In the real world, the demand for a product and the price which it can command in the market are uncertain. So, there is considerable uncertainty about the cash flows which will be generated. How do we decide which project is the right one? Like Sharp, Martha Amram and Nalin Kulatilaka7 suggest the use of real options while evaluating a project. Thus, a timing option, in the form of a delayed expansion in capacity could create value in a situation of uncertain demand. Putting up a plant in an overseas market currently fed by exports may generate new growth options. An exit option in the form of a plant closure increases the value of the investment decision. By looking at strategic decisions in terms of options and then using information from financial markets to value these options, risk can be greatly reduced. Oil companies for example can predict the future price of oil through the futures markets. Decision makers will not be able to draw information from the financial markets for all decisions. Some decisions typically involve uncertainties which are insulated from the market mechanism and are specific to a company. Amram and Kulatilaka call these ‘private risks’. But as more and more risks become securitised8 , the options approach may become more and more feasible. Amram and Kulatilaka argue that traditional valuation tools which view business development in terms of a fixed path are of little use in an uncertain environment. In the real world, a new business or a major investment in capacity expansion may result in a variety of outcomes that may demand a range of strategic responses. Plans to change operating or investment decisions later, depending on the actual outcome, must form an integral component of the projections. Thinking of the investment in terms of options, allows uncertainty to be taken into account.
As Amram and Kulatilaka put it: “The real value of real options, we believe, lies not in the output of Black-Scholes or other formulas but in the reshaping of executives’ thinking about strategic investment. By providing objective insight into the uncertainty present in all markets, the real options approach enables executives to think more clearly and more realistically about complex and risky strategic decisions. It brings strategy and shareholder value into harmony.” In any investment appraisal process, managers should identify the embedded options, evaluate the conditions under which they may be exercised and finally judge whether the aggregate value of the options compensates for any shortfall in the present value of the project’s cash flows. However, as Sharp puts it, options are of value only in an uncertain environment. Thus investment decisions, whose primary objective is to acquire options, must be made before uncertainties in the environment are resolved. Sharp says9 , “Unlike cash flows, whose value may be positive or negative, option values can never be less than zero, because they can always be abandoned. Embedded options can therefore, only add to the value of an investment. Options are only valuable under uncertainty: if the future is perfectly predictable, they are worthless”.
Scenario planning:
From time immemorial, man has had to prepare himself for various eventualities. Just to survive, he has had to ask questions like: What if it snows? What if there is a poor harvest? Indeed, it is this type of thinking which made man think of taking various steps, such as storing food, building dams, etc.
Many companies prepare their plans in structured formats using bullet points. 3M, one of the most innovative companies in the world does strategic planning differently. The process it uses, may look unstructured at first sight, but has been highly effective in energising and motivating people to take calculated risks and achieve their goals. 3M, realises that the essence of writing is thinking and developing clarity in the thought process. But regimented formats allow people to skip thinking and also do not incorporate the critical assumptions made while preparing the plan. So 3M uses strategic stories while preparing business plans. It transforms a business plan from a list of bullet points into a compelling narrative that describes the environment, the challenges it faces in trying to achieve its goals and how the company can overcome these obstacles. In the process of writing the narrative, the writer’s hidden assumptions tend to come to the surface. Readers get to know the thought processes of the person preparing the plan. According to a 3M manager10, “If you read just bullet points, you may not get it, but if you read a narrative plan, you will. If there’s a flaw in the logic, it glares right out at you. With bullets, you don’t know if the insight is really there or if the planner has merely given you a shopping list.”
Source: Gordon Shaw, Robert Brown and Philip Bromiley, “Strategic Stories: How 3M is Rewriting Business Planning,” Harvard Business Review, May-June 1998.
Formal scenario planning seems to have emerged to reduce uncertainty during the second world war, when it was used as a part of military strategy. The countries involved in the war had to prepare themselves for different contingencies and accordingly develop plans of action. Since then, the use of scenario planning has become increasingly popular. The US Air Force, for example, has been conducting war-game exercises for many years with the aid of computer simulations. In the late 1960s, Herman Kahn of the Stanford Research Institute modified the scenario planning concept so that businesses could also use it. IBM and GM were among the first companies to adopt scenario planning. Both companies however, failed to use scenario planning effectively. Being industry leaders, they probably had an exaggerated notion of their ability to predict and control the
Sloan Management Review, Summer 1991.
Harvard Business Review, May-June, 1998 .
environment. The scenarios they envisaged essentially reflected their existing paradigms. For example, GM totally overlooked the change in consumer preferences in favor of smaller cars and the threat from Japanese car makers. Similarly, IBM failed to foresee the decline of mainframes and the emergence of smaller, less powerful but more user-friendly computers. On the other hand, Shell seems to have achieved great success in the use of scenario planning. (See Case at the end of the chapter). Today, many leading companies accept that adapting blindly to external events is not desirable. Learning about trends and uncertainties and how they interact with each other enables companies to prepare for different future scenarios. It also helps a company to identify the scenarios for which its strengths and competencies are particularly suited. It is then in a position to understand how it can influence the emerging trends in the environment through a combination of innovations, managerial actions and alliances. By identifying the scenarios for which it is least prepared, it can invest in building the required competencies. In extreme cases, it can even withdraw from businesses, especially those which do not promise strategic benefits in the long run. According to Robin Wood11: “Given this level of change in our environment, the only response is to accelerate our capability to learn and change so as to adapt, which then buys us time to produce a more desirable future state for ourselves. Scenarios are the most powerful technology we have encountered to accelerate learning and provoke change, in both individuals and organizations.”
Surviving an industry shakeout:
Some of the greatest risks which companies face are during times when the industry is witnessing a shake-out. The old paradigm may change, or some players may become very powerful. As a result, many weaker players find the going tough and in extreme cases may even quit the industry. While shake-outs threaten virtually all companies in the industry, those who see it coming can create new opportunities. George S Day12 has provided some useful insights on an industry shake-out. Day refers to two kinds of shake-out syndromes: the boom-and-bust syndrome and the seismic-shift syndrome. The boom-and-bust syndrome typically applies to emerging markets and cyclical businesses. The dot com industry, is a good example. During the boom, many companies entered the industry leading to excess capacity. As competition intensified and prices fell, many players found the going tough. The companies which have succeeded are those with a high degree of operational excellence and those which focused on ruthless cost cutting. The seismic-shift syndrome is more applicable to mature industries. Such industries enjoy prosperity for years in a protected environment where competition is not very intense and margins are decent. This state of affairs is mainly due to market imperfections caused by factors such as patent protection and import barriers. A seismic shift takes place when these factors disappear. Deregulation, globalization and technological discontinuities are some of the factors that cause a seismic shift. This kind of a shift has a disruptive impact on players. A good example is the pharmaceutical industry before the emergence of managed health care. (See case on Merck-Medco at the end of the chapter) In a physician driven environment, price was not an important factor. Physicians did not hesitate to prescribe expensive medicines which drug companies gleefully marketed. The emergence of HMOs has reduced the importance of physicians. HMOs recommend the use of generics wherever possible and control costs wherever they can. Drug companies are struggling to adjust to this new environment.
The Boom-and-Bust syndrome in India:
The Boom and Bust syndrome is quite common in India. The experiences of some Indian industries in recent times offer useful lessons.
Granite
When the granite boom hit the headlines, many companies rushed to excavate mines and buy expensive equipment to cut and polish the stone. However, they could not cope with the complicated web of financial, technical, and bureaucratic intricacies that the granite business threw up. Of the 900 odd registered exporters that existed in the days of the granite boom, only about 160 remained in the middle of 2001 and no more than 60 were profitable. There are several reasons for the downfall of these entrepreneurs. To start with, mining granite was not as easy as entrepreneurs envisaged. Most entrepreneurs became embroiled in court cases over bad leases. Mining operations ravaged the land and antagonised locals. So, in some cases, governments suspended the leases. In other cases, companies, were forced to close down their mines. At the end of the day, the industry also did not see as much growth as expected because of limited markets. There was only so much granite that could be used in monuments, buildings, kitchen, and bathroom counters. The final nail in the coffin was driven by the dependence on the American market, where many orders were executed without letters of credit. Consequently, companies began to reel under big defaults, mainly from NRIs. According to Gautam Chand Jain, the CEO of Pokarna Granites, one of the few survivors in the industry, “We have grown by first learning about the quarry business, selling rough blocks and then acquiring sick, good quality units, which were available at a reasonable price.” Quite clearly Pokarna didn’t try to do everything at one go – or by itself. It was careful in selecting customers in the tricky American market. With 7 per cent of its turnover spent on marketing, Pokarna concentrated on strengthening relationships with customers, either through buyers’ guides or local contacts. For the quarter ended July 31, 2001, Pokarna generated profits of Rs. 2 crore on sales of Rs. 15.2 crore. Encouraged by his success, Jain has been busy implementing a Rs. 10 crore expansion plan.
Aquaculture Easy availability of finance and the lucrative Japanese market prompted many companies to enter theaquaculture business in the early 1990s. They dug up thousands of acres of coastal land, spent heavily on various equipment, feed, and housing. But when the white-spot disease (signalled by white spots on the shrimp) wiped out crops between 1994 and 1996, lending agencies pulled the plug, and funds dried up. Today, there are about 100 aquaculture companies along the coast. About half a dozen export goods worth Rs. 100 - Rs. 200 crore. Many of the others are small and medium players with exports in the region of Rs. 20 to Rs. 25 crore. Most of these companies have learned to spread their risks, by splintering the value chain into separate divisions or entire companies: one for farming, one for processing, one for exports, one for consultancy. A good example is Nekkanti Sea Foods of Visakhapatnam, which sources shrimps from farmers along the coast. Instead of shrimp farming, Nekkanti has focused its energies on processing, packaging and building its brands, Akasaka Star and Akasaka Special, sold in seven countries. According to an industry expert, “each aspect gets the dedication and focus it requires with people having the required skill sets.” Nekkanti has correctly understood that small passionate farmers can manage operations more efficiently than corporate executives with a 9-5 mindset. The experiences of shrimp farmers are an indication of the risks involved in making very heavy early commitments in an emerging industry. The reverses seen by the aquaculture industry also stress the importance of concentrating on a small segment of the value chain.
Floriculture The floriculture boom was sparked off by rising rose prices in the 1990s. As prices peaked worldwide, many entrepreneurs rushed to grow roses. But so did counterparts in other countries, as the great rush began to the great flower auctions in Holland. By the middle of the decade, supply increased significantly while there was a worldwide floriculture downturn. Meanwhile, many Indian floriculturists had spent heavily on imported greenhouses, equipment and consultants. Some had even set up greenhouses in the scorching heat of the north. Many of these companies crumbled under soaring costs. The early players in fact imported green houses at double the price, plant material at three times the present day value, and paid huge technical collaboration fees –Rs. 40 lakh for projects of Rs. 7 to Rs. 10 crore.
Managers need to develop antennae that can sense a shakeout before their competitors do so. They can detect early warning signals by systematically monitoring the rate of entry of new players, the amount of excess capacity in the industry and a fall in price. Scenario planning, discussed earlier, can focus attention on change drivers and force the management team to imagine operating in markets which may bear little resemblance to the present ones. Studying other markets which have already seen a shakeout, which are similar in terms of structure and are susceptible to the same triggers can also be of great help. Examining how the same industry is evolving in other countries and regions can also provide useful insights. Day refers to survivors from a boom and bust shakeout as adaptive survivors and those from a seismic shift syndrome as aggressive amalgamators. Adaptive survivors successfully impose discipline in operations and respond efficiently to customer needs and competitor threats. Dell is a good example of an adaptive survivor. During the initial shakeout in the PC industry in the 1980s, Dell survived due to its lean build-to-order direct selling model. In the early 1990s, Dell stumbled when it entered the retail segment and its notebook computers failed to get customer acceptance. CEO Michael Dell did not hesitate to make sweeping changes in the organisation. He put in place a team of senior industry executives to complement his intuitive and entrepreneurial style of management. Today, Dell is the largest manufacturer of PCs in the world. Quite clearly, it has been an adaptive survivor in an industry, which has seen the exit of several players. Aggressive amalgamators show an uncanny ability to develop the right business model for an evolving industry. They usually make one or more of the following moves: rapidly acquire and absorb smaller rivals, cut operating costs and invest in technologies that increase the minimum scale required for efficient operations. Arrow Electronics, one of the largest electronic components distributors in the US is a good example of an aggressive amalgamator. Between 1980 and 1995, Arrow made more than 25 acquisitions, expanded internationally and cut costs by rationalising its MIS, warehousing, human resources, finance and accounting functions. In the Indian cement industry, Gujarat Ambuja seems to be emerging an aggressive amalgamator. Not only has this company cut energy and freight costs aggressively, but it also has become active in the Mergers & Acquisitions (M&A) arena. For companies which find it difficult to become adaptive survivors or aggressive amalgamators, there are alternative survival strategies. These include operating in a niche market segment, joining hands with other small players through strategic alliances and finally to sell out and get the best price possible. The timing of the sale is crucial. Selling at the right time will maximise revenues. Neither a desperate sale nor excessive procrastination is desirable.
A framework for making strategic moves:
The strategic moves of a company can be broadly classified into three: capacity expansion, vertical integration and diversification. All these moves involve some risk, as they are based on assumptions that may or may not ultimately turn out to be true. A careful understanding of these risks and of how they can be minimized if not eliminated is important. Let us examine each of these strategic decisions.
Managing capacity expansion:
When firms add capacity, they may not be able to utilise their capacity fully. Not adding capacity is also risky as a competitor may do so and gain a large market share. The risk associated with capacity expansion is largely due to uncertainty regarding the following factors:
i) Future demand – quantity and price realisation
ii) Future prices of inputs
iii) Technological advances
iv) Reactions of competitors
v) Impact on industry capacity
Capacity expansion is often narrowly applied to manufacturing. In many businesses, manufacturing is a trivial or non-existing activity. So, capacity needs to be understood in terms of the investments made in the most critical area of the value chain. Thus, in the pharmaceuticals industry, capacity has to be defined in terms of scientific manpower and sales force. In a software development company, capacity has to be understood in terms of the number of programmers employed. Many Indian software industries, which recruited software engineers aggressively during 1999 and 2000, now seem to be in big trouble. Many of these engineers are now on the bench.
Industry over capacity is one of the important risks which companies have to consider while expanding their individual capacity. The risk of excess capacity is particularly high in commodity type businesses. In such industries, since products are not differentiated, firms tend to add capacity to generate economies of scale. Risk is also high when capacity cannot be increased in incremental amounts, but only in big lumps. Over capacity may also happen in industries characterized by significant learning curve advantages and long lead times in adding capacity. When there is a large number of players, when there is no credible market leader, and when firms expand indiscriminately, excess capacity usually results. A pre-emptive capacity expansion strategy, which aims to lock up the market before competitors can do so, is quite risky. This strategy requires heavy investments. The firm should have the capacity to withstand adverse financial results in the short run. If competitors do not back down or demand does not rise as expected, the firm can land in big trouble. A firm adopting this strategy should have a certain degree of credibility. Preemptive expansion of capacity is generally not advisable when competitors have non economic goals, consider the business to be strategic in nature and have substantial staying power. Take the example of the Indian Internet Service Provider (ISP) industry which saw the entry of many players during the dot com boom. According to the Internet Service Providers Association of India, 437 players had applied for licenses but only 120 of them were in business in mid 2001. In April 2001, Delhi had 22 ISPs providing services to 2.5 lakh subscribers. The five leading ISPs - VSNL, Mantra, Satyam, NOW and Dishnet, had most of the market share. The remaining catered to just 2352 subscribers on an average. This is clearly an untenable situation in an industry where the initial investment ranges from Rs. 70 lakhs to Rs. 2.5 crores (to offer about 10,000 connections). At least 30,000 connections are needed to make operations viable. To make the business viable, a national level player needs 500,000 subscribers spread over a few cities. The only realistic way of removing the excess capacity seems to be through a wave of mergers. Only five ISPs are expected to survive in the next 12 – 18 months at the national level. Players like Satyam who have a large customer base spread over many cities are still making losses. Texas Instruments (TI) has a unique way of adding capacity without taking undue risk. As demand is cyclical, excess capacity built during the good times becomes a liability during a recession. At Dallas, TI manufactures a wide range of products – low cost DRAM memory chips, customised and expensive microprocessors and sophisticated integrated circuits. Much of the production process, which involves placing transistors in silicon chips, is common across products. Only in the final stages, do the customised chips undergo refinement. TI runs the plant at full capacity but cuts back on production of cheaper DRAM chips and increases that of more sophisticated items when required. Solectron, a company based in Milpitas, USA, specialises in the manufacture of circuit boards for various customers whose demand can fall or rise from time to time. Solectron uses computer software to manage capacity in a flexible way. By reprogramming robots and other machinery, the Milpitas factory can make different types of circuit boards for different customers on the same production line. The Japanese are masters in the use of flexible manufacturing systems. In 1992, Toyota15 built a new plant in which the entire assembly process could switch to a different model in just a few hours. The plant cost much more than a traditional plant where a switchover would have taken weeks. But Toyota was able to add value and minimize risk by generating more options in the same plant.
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