INTRODUCTION
A great deal must be learned about an organization so that strategy
formulation decisions can be based upon appropriate information. It almost
goes without saying that strategists must understand all there is to know
about the internal operations of an organization before strategy can be
effectively formulated and implemented. The external influences acting
on the firm also must be analyzed, documented, and understood to manage
the strategy process effectively. This chapter focuses on conducting both
external and internal analyses for the purpose of generating information
for strategy formulation.
The chapter has two major sections--environmental analysis and internal analysis. An organization's environment consists of two parts: The industry within which it operates (for multibusiness firms, the industry is usually considered the activity in which the firm generates the majority of its revenue), and other environmental dimensions--economic, political/legal, social, and technological. The section of this chapter devoted to internal analysis first addresses financial analysis--the process of learning about the financial performance of the firm or organization. Very often financial analysis will bring to light several financial strengths and weaknesses that are indicative of strategic or operating capabilities and problems within the various strategy levels and within functional areas.
Financial analysis is typically followed by internal diagnosis of functional areas. This process identifies strengths and weaknesses within such areas as marketing, personnel, research and development, and others.
Together these four analytical activities--environmental, industry, and financial analysis and internal diagnosis of functional areas--are undertaken to generate a data set consisting of strengths, weaknesses, threats, and opportunities that comprehensively describes the internal and external characteristics of the organization. This information is then used as input to the strategy formulation process. It is factored with data about past strategies, mission, corporate culture, managers' values, and so on to evaluate the success or failure of present strategies. As a result present strategies either can be modified, left as they are, or replaced as necessary in a particular situation.
STRUCTURE OF DATA
By its nature strategic management necessitates contextual thinking--the
recognition that all organization activities, whether planned or not, occur
under sets of very specific and real circumstances. These circumstances
or contexts often change dramatically over time, and differ substantially
from firm to firm, industry to industry, and market to market.
The withdrawal of the United States from the 1980 Olympic Games left many firms in the lurch. A small specialty T-shirt manufacturer was stuck with unsalable inventory. The NBC television network found itself out hundreds of millions of dollars in lost broadcasting and advertising revenues. Under different circumstances these ventures might have proved successful, but conditions largely outside their control changed to doom their prospects to failure.
The key to effective strategic management is to make major managerial decisions that shape actions by the firm that will correspond positively with the context within which those actions ultimately take place. As shown in Exhibit 2-1, to some degree the action context will be dictated by internal conditions--strengths and weaknesses within the firm. The financial resources of NBC allowed it to weather the Olympic storm; for the T-shirt enterprise, the lack of adequate financial strength did not.
On the other hand, the action context is dictated to a great degree by conditions external to the firm. These conditions constitute the firm's operating "environment." To some extent the firm can shape the overall environment to its advantage. Henry Ford's introduction of mass production of automobiles stimulated the U.S. economy in a manner that invigorated consumer markets for his products. Genentech, the recombinant DNA research firm, made biotechnical advances that had profound impacts, not just on Genentech's operating circumstances, but on the future of humankind as well. Nonetheless, few firms enjoy a scale of impact that allows major shaping of the overall climate in which they operate, particularly over the long run. Instead well-managed business enterprises adapt to environmental change so that they can take advantage of opportunities that arise and minimize the otherwise adverse impacts of environmental threats. This involves assessment of present environmental circumstances (for reaction) and the forecasting of future conditions (for proaction).
These key positive and negative factors of both the firm's external environment and its internal operations are outlined in Exhibit 2-2, which represents the data set developed for strategic management. A data set has both present and future time frames as internal and external, positive and negative factors are forecast into future periods. Environmental and industry analysis involves filling the right-hand sectors of the data set with information pertinent to a particular firm.
Analysis of the internal operations of the organization results in a collection of strengths and weaknesses that would fill the left-hand cells of the data set model.
Environmental conditions affect the entire strategic management process. Management's perceptions of present and future operating environments and internal strengths and weaknesses provide inputs to goal and action plan choices. They can also affect the manner in which implementation and internal circumstances will dictate the effectiveness of strategies as they are implemented (including alterations in the environment itself).
The implementation stage of strategic management provides the real, as opposed to the expected, interface between the firm and its environment.
The effects of the environment on the organization, as well as the success of its present strategies, are ultimately reflected in its financial statements. A large part of the task of internal diagnosis is accomplished by financial analysis. Of course, there is more to analyzing the internal operations of a business than financial analysis. By understanding the theory and practice of management, marketing, accounting, personnel, production, and other functional aspects of organizational performance, internal strengths and weaknesses beyond those found by financial analysis can be found. But financial analysis uncovers clues to functional strengths and weaknesses.
Both environmental and industry analysis procedures consist of four interrelated processes:
Finally, a procedure for carrying out an internal analysis is discussed that consists of two phases. The first is financial analysis. The four processes above apply to financial analysis, but with some modifications. An assessment taxonomy and a set of environmental boundaries are well established for financial analysis and are explained in that section. Key variables are the various financial entities measured during such an analysis and assessment of their potential impacts on the firm is its purpose.
In the second phase of an internal analysis, the other functions of the firm are analyzed. The financial analysis reveals many questions about the operations of functional departments, which can be answered through analysis of those departments. However, the four processes do not apply so neatly to the other functional areas, but they do apply generally. For each area an assessment taxonomy must first be developed, although it and the boundaries of each function will be different. Consequently we present a taxonomy and a set of key variables for each major function.
The appendix to this chapter more specifically contains sources for conducting research on environmental and industry information, which should help guide students through library research during environmental and industry analyses for case studies.
FORMAL VERSUS INFORMAL SCANNING
Sensing the pulse of environmental threats and opportunities is a natural
and continuous process in business planning. In many organizations it is
done on an informal basis. The construction firm executive who learns from
a golfing colleague of a request for bids on a major construction project
is gaining information that could affect the performance of his firm--information
that would be no more valuable had it been acquired through more systematic
means. Discovering changes in tax statutes by perusing the Wall Street
Journal is no less important than learning about them through a well-established
monitoring system within the firm's tax accounting office. Indeed, the
talent for acquiring valuable information through informal means often
marks the successful entrepreneur and manager.
To rely totally on informal means, however, increasingly exposes the firm to missed opportunities and unforeseen threats. A rained-out golf game or an overlooked column in the Wall Street Journal can have profound implications, even if the implications themselves go unnoticed. Therefore, a systematic approach to environmental assessment is important for the management of uncertainty and risk.
One formal approach to generating data about environmental conditions is survey research. The use of both original and contracted survey research for purposes of evaluating the present corporate environment offers a lot of promise for strategists.1 For analysis of external concerns in the present, survey research is a way to accurately identify the attitudes of selected population groups toward the company. In fact, virtually any external constituency's attitudes toward the organization can be assessed through survey research methods.
ENVIRONMENTAL ANALYSIS
ASSESSMENT TAXONOMY
The dimensions of environment can be generally classified by a set
of key factors that describe the economic, political/legal, technological,
and social surroundings. These, in turn, can be overlaid by the various
constituents of the firm, including shareholders, customers, competitors,
suppliers, employees, and the general public (Exhibit 2-3). To assess environmental
conditions, concern is focused on opportunities and threats that exist,
or may arise, through impacts on and by the firm's constituents.
Key Economic Variables
Changes in economic circumstances can be as global as the new worldwide
economic order initiated by petropolitics, or as localized as a small town
plagued by a plant closing. Firms that anticipate economic change and identify
the constituents through which that change will be applied, can better
adapt goals and action plans. By the late-1990s, major oil producing firms
has shifted their source of supply from middle-eastern countries to Venezuela
because of uncertainties about the political and economic environment of
the middle east.
Shareholder expectations of financial return are dictated in part by alternative investments and their associated returns and risks. Interest rates, tax policies, shareholder incomes, availability of funds for margin-purchased equity investments, and expectations of future economic circumstances will shape changes in equity investor profiles and/or the financial performance expectations of the firm's owners. In the early 1980s, high returns on money market instruments (representing corporate and government debt) led to massive shifts from equity holdings by private investors to those shorter-term debt instruments. In many cases this disturbed long-standing shareholder composites (making more room for institutional investors, for example) and pressured management to focus more closely on generating higher short-term returns.
Personal income, savings, employment, and price-level trends can have dramatic effects on the attractiveness of a firm's products or services in output markets--not only final markets, but intermediate markets as well. In efforts to reduce costs during inflationary periods, automotive manufacturers during the 1980s reduced their reliance on outside suppliers for automobile components. This, in turn, led many component manufacturers to retrench or redirect their marketing efforts elsewhere (e.g., replacement parts).
Similarly, total sectoral outputs, movements in private-sector capital replacement and expansion, government spending, and the allocation of the consumer dollar can have dramatic impacts between and within industrial sectors. Each can be set off as macroeconomic changes well outside the control of the firm, yet may be buffered by appropriate strategic action. Twenty years of inflation, for example, increased consumer use of $50 and $100 bills in retail trade. Among other implications, this meant that many retailers had to replace cash drawers, or entire cash registers, to accommodate these denominations. More significantly, the collapse of the Soviet Union has led to decreased government spending in the U.S. on defense items. Many thousands of prime defense contractors and their subcontractors spent the early-1990s trying to develop new strategies based on non-military products.
Economic conditions faced by competitors can play a large part in shaping a firm's strategies and policies. The movement of manufacturers out of the "snow belt" to areas of the country with lower energy costs could provide decisive competitive advantages vis-a-vis those who remain. Transportation costs, on the other hand, could reduce those savings. Competitors selling to diverse markets might realize less volatility in their capital bases and abilities to compete across economic cycles than might a firm with a narrow product/market scope. In any case it is important to recognize that the economic conditions faced by the competition may be different in form and substance from those faced by the target firm.
The capacity, reliability, and, in some case, the survivability of suppliers are largely a function of their economic climate. Both debt and equity capital markets often realize significant swings as a result of overall economic conditions. The firm accessing these markets experiences the repercussions. Federal discount rates and changes in reserve requirements have both short-term and long-term implications in primary capital markets, and often affect the private sector borrower through secondary markets. The available supply of goods and services can be affected by the overall economic health of suppliers, including their productivity, alternative markets, and cost structures. To the extent that the target firm represents a major market for a supplier, that firm becomes a significant factor in the economic climate the supplier experiences. The choice of multiple versus singular sources of supply might be dictated by assessments of suppliers' economic bases as well as by the degree of control the buying firm can maintain over them. Though adverse economic circumstances could threaten sources of supply, They could also provide buying leverage for the firm or represent new opportunities for backward integration.
The economic climate of the firm is also manifested through employees. Wage and benefit escalations are often as much a function of the overall economic circumstances employees face as they are unilateral policy set forth by employers. Rising consumer prices are usually translated into expectations and/or demands for increased compensation. Shifts in employment status, including societal and regional unemployment levels, can increase or decrease these pressures. Economic conditions usually affect employees unevenly, thus requiring creative policy adaptation. Depression of housing markets in the early 1980s, for example, led a number of large employers to buy homes from transferred executives, who were unable to sell them at reasonable prices, if at all. This inadvertently put a number of these firms into the real estate "business" (albeit on a relatively small scale), tying up capital and effort.
Clearly, economic conditions have wide-reaching effects on the general public. These can be as abstract as alterations in high birth rate trends or as direct as changes in personal income. Conversely, public expectations and behavior substantially determine the health or inadequacy of the economy, through earning, spending, and saving patterns. In any case the general public is so intertwined in the mechanics and psychology of a firm's economic climate that movement by one can have dramatic implications for the other. Kinder-Care Learning Centers, Inc., a chain of child-care centers, both profited by the economic (and social) trend toward working mothers and contributed to the trend by providing necessary child care at reasonable cost. The overall impact was synergistic.
Finally, in assessing the economic dimension of a firm's environment, it is important to recognize the interrelated nature of the participants. The multiplier effect in macroeconomics has its micro counterpart. Raw data on prices, wages, savings, government spending, manufacturers' shipments, and the like are valuable in themselves, but represent only the front line of a truly comprehensive analysis.
Key Political/Legal Variables
Business firms, like people, are touched directly and indirectly by
political/legal influences at all levels of government (federal, state,
and local). These influences run the alphabetic gamut from antitrust to
zoning. The scale of federal intervention in business is matched only by
its turbulence. The Center for the Study of American Business concluded
that federal regulation of business "cost the American economy more than
$100 billion in 1980. Approximately $5 billion represented the administrative
costs of the major regulatory agencies, and the balance, compliance costs."2
In addition to serving as regulatory bodies, governments also represent a major factor in the private sector through fiscal policy. Taxation and government spending can represent both opportunities and threats, depending upon the nature, timing, and position of the impacted enterprise. And, of course, fiscal policy can have dramatic impacts on the overall economic climate of the firm.
Shareholders are affected by governments in a variety of ways. Changes in tax structures can affect tax exposure on corporate payouts when treatments of capital recovery versus earnings distributions are considered. To the extent that corporations themselves are shareholders, intercorporate shareholding can be constrained by antitrust laws. Security and Exchange Commission regulations can affect the "tradability" of shares as well as dictate corporate disclosures. Laws dealing with pension funds and other forms of institutional investing can exhilarate or impair changes in investor profiles. Incorporation laws often constrain flexibility in capital restructuring. All of these impositions, in turn, create the need for corporate adaptation to shareholder expectations and requirements. Government-mandated sales prohibitions (e.g., on certain firearms) can limit markets. Similarly, export restrictions (national and interstate) can impose market constraints. Conversely, public policies targeting industries for rejuvenation or expansion can open up a host of market opportunities (such as trade-adjustment programs in energy and steel). Social legislation (e.g., environmental protection, health, consumer protection) can create markets for new classes of products and services as well as limit those where noncompliance exists.
Politics and law are influenced by, and have an impact on, competitors. Antitrust can sustain or impair industry structures and thereby affect the nature of present and future competition. Import restrictions can limit foreign competition. Patent laws provide competitive protection for patent holders. Governments themselves can be suppliers (e.g., mineral rights). And, of course, the viability of suppliers as a whole can be affected by all forms of political/legal influences. During mid-1993, hospital administrators in the state of Maine estimated that they were experiencing about a 20 percent vacancy rate in their facilities. Retrenchment became necessary to survival for a large number of facilities. The Maine legislature then passed a law freeing their state's hospitals from antitrust provisions that prohibited asset-sharing among institutions. This minor legal change alone may save countless millions of dollars in Maine's health care industry by eliminating unnecessary duplication of equipment purchases and operations. Cooperation among hospitals is no longer an antitrust violation. Similarly, state legislatures adopting mandatory automobile insurance laws have had dramatic affects on their states' insurance industries.
Protection of employees is clearly a major matter in any firm. Wage laws, labor statutes, equal employment opportunity, occupational safety and health, employee privacy, and pension fund controls all represent areas of strategy concern. Further, the public sector competes with the private sector for employees. Through support of education and training programs, the public sector also represents a source of labor.
Finally, the political/legal climate is both a function and a determinant of public sentiments. Federal regulatory reform (including deregulation) is a prime example. Public expectations of business behavior can cause, and be caused by, shifts in partisan politics, which in turn can affect the overall socioeconomic climate in which private sector enterprises operate. Expansionary and technologically aggressive moods on the part of the general public have their counterparts in business and industry, though they need not always be similarly timed (Wall Street, the public, and Washington are occasionally out of phase in this regard).
Assessing and forecasting the political/legal environment require creativity and a sensitivity to industry-specific matters. Unlike the economic environment, the political/legal environment requires a largely "soft" calculus where numerical relationships and extrapolations are often unavailable or inappropriate.
Key Technological Variables
Electronics, bioengineering, chemicals, energy, medicine, and space
are but a few of the fields in which major technological change have opened
new areas to private enterprise. In some cases entire industries have emerged
seemingly overnight (such as genetic engineering), bringing with them new
opportunities, and new threats, in the marketplace. In other cases technological
changes within industries have brought new forms of product competition
(e.g., micro technologies in electronics) that require an openness to new
applications. In still others technological process changes (as in the
use of robots in automobile manufacturing) have led to different competitive
advantages in production costs and product quality. In all instances the
firm subject to technological obsolescence or intent on maintaining some
form of technological leadership must stay abreast of technological innovation,
and to the extent possible, forecast future technological change and its
potential for acceptance. That Timex vastly underestimated market acceptance
of the digital watch early in its life cycle is but one of many instances
of technological displacement having adverse effects on those caught unaware.
Technological change has had implications for shareholders, primarily through communications and information processing. High-speed, computer-based market reports are reaching increasingly larger proportions of stock market participants. On-line office and in-the-home displays mean quicker reaction time in market "plays," and the proliferation of FAX machines and worldwide e-mail systems make round-the-clock real-time communications commonplace.
New products and processes resulting from technological innovation can result in redefinition of customer bases or customer demands. The design of new, relatively lightweight diesel engines opened up a host of opportunities in the passenger-car industry. Computer-aided design and computer-aided manufacturing (CAD/CAM) have led to the expectation of shorter lead times and much closer tolerances in many industrial and consumer products industries (e.g., aerospace and automobiles). The home information revolution not only may expand markets for consumer product retailers, but may well lead to better informed, more discerning retail customers.
So too the nature of competition can be redefined as technological advances unfold. In the oil-well wire-line (or "logging") industry, new techniques allow in-the-well sensing of critical geophysical characteristics (temperatures, pressures, etc.) while drilling gear is in place. Older technologies require expensive and time-consuming removal of the gear before these measurements can be made. Thus those firms with access to the new technology have a marked, competitive advantage. Price is no longer a significant factor when the competition for business is between those with and those without the technology.
In acquiring the advantages of new technology, a firm might rely heavily on its suppliers. Manufacturers may turn to equipment suppliers for the latest in robotics, or food processors to pharmaceutical or chemical firms for the latest in preservatives. In each case technological advantage is passed through the production chain, with competitive differentials possible at each stage.
Sources of supply can also be redefined with technological innovation. Fiber optics, for example, may well displace metal wire as a primary medium in telecommunications. Telecommunications firms thus would turn to the glass industry instead of the wire industry for this critical material.
Employees continually experience the impact of technology by virtue of changes in requisite skills and job assignments. Automation has led to the conversion of hand labor to higher skills needed in machine design, operation, and maintenance. Even work routines are affected. As telecommunicating attracts ever-greater interest, more and more types of work may be accomplished more effectively and efficiently away from the traditional workplace (at home or at local offices).
Finally, technological change looms large in the overall picture of public experiences and expectations. Dissatisfaction with technological lags in the steel industry led to government investigations. Fear about runaway advances in bioengineering have resulted in self-imposed restraint among firms involved. Expectations of technological solutions to serious socioeconomic problems (e.g., energy) may have implications for public policy and for strategic adaptations within affected industries. And of course everyday life is changed permanently by technology. The spread of Automatic Teller Machines in banking has dramatically changed our banking habits. Not many people under-thirty remember the pre-ATM days when consumers had difficulty accessing their cash on weekends because the banks were closed. The time we save preparing food by microwave oven we now lose by watching video-taped movies at home!
Few firms are left untouched by technological change, although some may be more severely or rapidly affected than others. To the extent that technological innovation is a key factor of success in a given industry, it must be monitored and forecast aggressively. In all cases at least a general sensitivity to the technological environment is a primary component of successful strategic planning.
Key Social Variables
The overall social climate in which business operates has broad systemic
implications for U.S. firms rooted in the free enterprise system. Under
the doctrine of "enlightened self-interest," business enterprise exists
to satisfy the needs and wants of society, which can sustain or impair
the enterprise's existence through public pressure. On a more micro level,
it is clear that public wants and needs can significantly determine the
effectiveness of a given firm's strategy. The marketing concept is designed
to deal with one facet of the business-society relationship on a firm-by-firm
and product-by-product basis.
As with the other dimensions of a firm's environment, social conditions can pose both opportunities and threats. Computer crime, for example, has become a major concern in industry, and is expensive to control. At the same time, a new field within the computer industry has emerged to provide computer crime control services and systems. Thus one profits from the social circumstances from which the others suffer economically.
Since present and future shareholders are drawn from segments of the general public, demographic shifts hold the potential for redefining shareholder profiles. To the extent that age or marital status distribution may be related to preferences for income-yielding as opposed to capital-appreciation equity investments, overall growth strategies and dividend payout policies may be affected. Increased education and greater awareness of stock and debt investments provide the potential for expanding capital markets. Clearly pension programs are affected by age distributions of the participants, which in turn affect the availability of debt and equity funds.
Institutional investors have also placed immediate demands (albeit with limited success in some instances) on individual firm's operating strategy. A number of religious groups, in their capacity as institutional investors, took issue with the involvement by U.S. firms in the Union of South Africa. As shareholders the groups called for complete withdrawal from that country or the reformation of personnel strategy in branches there so that they would not conform to the host government's apartheid mandates.
Demographic research within marketing circles is precisely designed to assess population characteristics as they relate to market potential and threats. An aging population, for example, represents a distinct opportunity for a firm selling geriatric products. Increases in the number of "live alones," and therefore households, represent many opportunities for firms selling household products. Similarly, data on consumer buying habits might allow a firm to reposition its marketing channels or alter its advertising mix. Changing consumer awareness and concomitant market responses might call for changes in product quality or positioning. Consumer perceptions of the quality of Japanese-made products, for example, have changed so dramatically over the past fifteen years as to give the Japanese an a priori differential competitive advantage, as opposed to an earlier disadvantage, in this regard. Perceived quality differentials have reversed in many industries so that domestic manufacturers must now compete on the basis of price.
Special trends and fads also have marked implications for product/market choices. Increased interest in personal health has led to major market opportunities in products and services from health foods to jogging clothes to in-the-home medical equipment. Athletic clubs became a booming new industry in some parts of the U.S. Greater concern over crime has allowed industrial security firms to expand to consumer markets with home security devices. And certainly success in the apparel industry is closely linked to fads and styles in the marketplace.
Competitors may be positively or negatively affected by social change, depending upon how they have adapted to it. Regional shifts in population have given some firms in the housing industry a distinct locational advantage (e.g., those in the sun belt), which also is true for firms that rely on population increases for market expansion. United States firms hold a distinct advantage over overseas competitors among buyers whose nationalistic spirit inspires a preference for U.S.-made products.
Suppliers face similar social constraints and promises. The existence of cooperatives, particularly in agriculture, reflects a collectivist approach toward the marketplace, the binds of which the buying firm may have to tolerate.
Aside from strictly labor pool concerns, modern enterprise must also consider the changing needs of employees in developing effective strategies. Flexible hours, the four-day work week, job sharing, the cafeteria approach to employee benefits, and other personnel strategy matters are largely responses to changing employee requirements. Increased demands for leisure time, individual privacy, freedom from harassment, equal opportunity, personal safety, and job protection all represent fundamental social expectations that have become manifest in the management of the workplace.
Finally, the general aura of social change, including shifts in basic ideologies, can have profound implications for the propriety of strategic choice. Social consciences can bring with them challenges that call the most successful business enterprises to task. Dow Chemical's napalm production during the Vietnam era resulted in unwanted visibility that led to a deemphasis of the Dow name on its consumer products. Concern over the ability of both the public and private sectors to control nuclear power safely has set the entire industry back on its heels. In both cases the strategic implications have been real and monumental.
Summary of Possible Assessment Variables
Exhibit 2-4 lists common variables to be considered in an environmental
assessment. It is ordered according to the four dimensions discussed above.
Identifying Environmental Boundaries
Defining environmental boundaries involves the choice of criteria or
constraints that will bound the breadth, depth, and forecasting horizon
of the analysis. Breadth refers to the topical coverage of the scan. A
narrow assessment for a metal products firm might entail heavy concentration
on domestic raw material sources, whereas a broader assessment for an international
conglomerate could involve identification of geopolitical instabilities
worldwide. In an extreme case, the breadth could be largely unbounded--an
open-ended search for commercial opportunities, for example.
The depth of environmental assessment determines the degree of detail in the data sought and analyzed. Assessing Mideast geopolitics could be undertaken rather generally by identifying competing power bases and gaining a general understanding of regional political history. On the other hand, such an assessment may be most useful for a textile machinery firm only when brought to the level of examining specific trade restrictions on soft-goods production equipment.
Environmental boundaries can be at least generally established by examining the firm's strategic postures regarding:
FORECASTING
Implicit in all of our discussions thus far is the need to translate
environmental observations into forecasts of the environment within which
future goal and action plan formulation and implementation will take place.
This is not to suggest that business planning calls for determination of
the future. That is largely impossible. Instead we attempt to forecast
or predict environmental conditions (in the context of opportunities and
threats) for the purpose of establishing a strategic data set. This data
(often called "planning premises") becomes the basis for goal and action
plan selection decisions.
In many cases the environmental forecaster needs to make multiple forecasts so that contingency goals and action plans can be developed. For example, a single-point forecast of interest rates one year hence may be a dangerous premise upon which to base an expansion strategy. Instead well-reasoned multiple forecasts of interest rates can lead to contingency expansion strategies, one of which could be implemented as certain economic conditions unfold.
Forecasts can be made in the context of reasonable ranges. Here the analyst is less concerned with anticipation of precisely what the future will bring than with the likely future nature of environmental conditions. This is especially useful when the forecasting horizon is more distant. For example, one might predict a decrease in federal defense spending in the range of 5-10 percent per year over the next five years or continued Japanese investment in U.S. industry, but at a level not to exceed that of, say, 1989. The general direction of change is addressed within the confines of anticipated limits.
Forecasting Techniques
Though a multitude of forecasting techniques might be catalogued, only
a few have received recognition in strategic management circles. These
techniques can often be used in conjunction with each other to identify
opportunities and threats.
Trend extrapolation is probably the most widely used. Most simply put, this involves picking a tracking factor or environmental variable, noting its trend (statistically or otherwise), and extending that trend into the future. Lead and lag correlates often are used in the process. Linear and nonlinear statistical models and techniques can be used when hard numerical data exist. This normally involves line fitting to historical data, and extending the line into future periods. Most spreadsheet programs and some operating systems have easy-to-use trend line extrapolation routines built into them. Of course, more sophisticated packages like SPSS (Statistical Package for the Social Sciences) and SAS (Statistical Analysis Software), installed on most computer mainframe systems and also available in microcomputer versions, allow detailed trend line analyses.
As with other forecasting techniques, the validity and reliability of trend extrapolation must be carefully evaluated in each application. Parameters must be appropriately selected, and intrinsic or environmental constraints identified. If this is not done, incorrect forecasts can result - extrapolating the growth of a young blade of grass could easily yield a tree.
Forecasting by analogy is another widely used technique, although it is not a formal forecasting method. It involves identification of precursor or concurrent events and simple recognition of the relationship. For example, one might have been able to forecast a decline in public interest in the Space Shuttle program after the first launch since there was a similar decline reaction to Columbus' unspectacular second voyage to the New World.3 In this case the forecaster is really examining a series of analogous (though not identical) events. Because forecasting by analogy is used where historical data are inadequate for the more formal trend extrapolation, its validity and reliability are open to challenge.
Delphi represents yet another forecasting procedure. Developed by the Rand Corporation, it basically involves the use of expert opinion through anonymous, iterative, controlled feedback among a group of participants (the expert panel). Normally the panel is polled by questionnaires in a search for opinions on reasonably well-defined issues. Each member responds with a forecast and reasons for it. These responses are then statistically compiled and fed back anonymously to all members of the panel. This routine continues through subsequent iterations as the information is reprocessed by the experts and new forecasts are generated. Ideally the composite results will move toward a consensus. Though this technique is employed fairly widely in public and private sector planning, it would be of limited use to the student case analyst.
Simulations and econometric models are designed as numerical interpretations of real-world systems (e.g., national economies, ecologies, production systems). They involve the estimation of theoretical and empirically based relationships, which, when taken together, interact quantitatively to produce forecast outcomes. Computers are normally used to make the calculations.
A particular advantage of these techniques is the ability to perform sensitivity analyses. Here the analyst changes assumptions or estimations within the model to generate varying outcomes. For example, in a dynamic population forecasting model, one might wish to assess the impact of changes in personal income on population mobility. By varying the income variables in the model, the analyst examines this impact on whatever mobility variables the model contains, thus assessing their sensitivity to income changes. In doing so the analyst is able to evaluate the model itself, as well as gain some understanding of contingency outcomes.
Cross-impact analysis is a forecasting technique designed to assess the interactions among future environmental conditions. The analyst begins by assuming that a set of future environmental circumstances will come true (e.g., four new industry entrants, each holding a 5 percent market share within six years). Through the use of matrix analysis, the analyst then attempts to assess the impact of these circumstances on the possibility and timing of others (such as price competition). If nothing else, the analyst is able to expose forecasting inconsistencies and to clarify underlying assumptions in the forecasts themselves.
Finally, scanning and monitoring are forecasting methods insofar as they involve future thinking. The scan is the equivalent of a 360-degree radar sweep, but monitoring is the choice for specific environmental variables or factors that are tracked over time. The latter merely helps refine and make the gathering and processing of environmental information more efficient. For example, an environmental scan may identify a somewhat subtle shift in the packaging industry toward paper containers for liquid consumer products. A firm interested in this matter might then choose to monitor industry shipments in that product category closely, and ultimately generate a forecast of future volume. The forecast could involve any of the other techniques.
An Important Caveat. Forecasting is not crystal ball gazing. It is conjecture! The analyst must be prepared to revise forecasts as necessary so that appropriate strategy adjustments can be considered. A forecast that is right in its substance but wrong in its timing can destroy attempts to attain goals. Firms that anticipated, indeed relied on, a second postwar baby boom are still waiting. Understanding the present and anticipating the future are key ingredients of strategic management.
INDUSTRY ANALYSIS
Industry analysis complements analyses of the other dimensions of a
firm's environment. It focuses on the industries in which the firm competes.
The breadth and depth of industry analysis and the boundaries for information
gathering are defined by these industries. Thus industry analysis involves
the same processes as those identified earlier for environmental analysis,
except that it logically must be preceded by identification of the appropriate
industries for analysis along with descriptions of the various characteristics
of those industries.
Industry analysis is relevant in any of these situations:
The industry perspective must be used cautiously since an individual firm or business unit can hardly be considered completely protected from direct extra-industry influences. For example, relaxation in occupational safety and health standards for an industry may come at the same time that an individual firm is singled out for stricter compliance enforcement. The analyst, therefore, is cautioned to assess direct environmental influences as well as the portion of the environment that affects overall industry conditions. Michael E. Porter developed an assessment model for analyzing industry structure that focuses on the forces imposed on the process of competing by five influences: The intensity of rivalry among competitors, the threat of new entrants, the threat of substitute products, the bargaining power of suppliers, and the bargaining power of buyers or customers. This "Five Forces Model of Competition" is presented in this section.
Exhibit 2-5 represents the relationships between a firm and its industry, and an industry and its environment. Some environmental influences affect a firm through the industries in which it competes. These influences, the nature of their present and future effects on the appropriate industries, and characteristics of the relationships between the firm's relevant industries and the firm itself are the subjects of industry analysis.
Multiple product/service firms, particularly those that are diversified, will often hold "membership" in more than one industry. This will obviously require multiple analyses and creative cross-cutting of industries in the compilation and analysis of data.
Defining an Industry
In general an industry is nothing more than a cluster of economic units
(firms or business units within firms) that are grouped together for analytical
or cooperative purposes. Trade associations are the purest manifestation
of the latter purpose. Trade associations themselves define criteria for
membership and establish networks for information sharing and cooperation.
Thus the American Boat Builders and Repairers Association defines its own
industry scope and becomes a private sector information depository (among
other functions) within the confines of that scope.
A more universal taxonomy for analytical purposes is that provided by the U.S. Government's Standard Industrial Classification (SIC) scheme.4 It is designed to furnish a common framework for gathering, tabulating, analyzing, and cross-referencing data in a uniform fashion. The SIC clusters "establishments" (as opposed to legal entities or firms) together on the basis of the primary type of activity in which they are engaged (normally defined by product or service category). These clusters are named and coded to provide the needed uniformity and comparability. The more digits in the code, the more narrowly defined is the cluster. The coding scheme results in a nesting arrangement of "divisions," "major groups," "groups," and "industries" (Exhibit 2-6). Industries are assigned a four-digit code. Additional digits are used for subdivisions within industries.
As a practical matter, the definition of an industry is left to the analyst and need not be confined to institutional classifications. Geographic boundaries, customers, suppliers, technologies, or other peculiar dimensions of a business may better serve the purposes of clustering enterprises for competitive analysis. Indeed the creative strategist in search of new product/market opportunities and threats will define and redefine industries at will.
Levels of Analysis
Industry analysis focuses interest on two primary levels:
At the second level of analysis, the actions of individual competitors are of interest so that the analyst can identify (1) competitive differentials and (2) key success factors. In essence a search is made to uncover basic prerequisites for success in the industry (e.g., access to well-established distribution channels) and to examine the competitive weaponry wielded by the industry's players (e.g., product modifications). Here the focus is on the manner in which industry members position themselves vis-a-vis one another in the broader context of overall industry change.
An Industry Study Guide
Exhibit 2-8 is a guide for conducting an industry study. At best it
represents a departure point for gathering and analyzing industry-specific
data. In using it the analyst should maintain the dual-level perspective
outlined so that both an industry's molecular composition and the body
of the whole are given ample consideration.
As with the more broadly based environmental analysis, the output of the industry study should be in the form of prognoses. That is, assessment of industry conditions should be forward looking, representing opportunities and threats to which the firm might adapt its goals and action plans. This can be expedited in part by focusing on changes in industry structures and practices.
Finally, the analyst is cautioned that there are no single "cookbook" sources of data for a truly comprehensive industry analysis. Gathering and analyzing industry data is a long and arduous process that requires creativity and patience. Gaining familiarity with basic sources of business information obviously is the first step. The appendix to this chapter offers a brief composite of some of the more common published information sources available for this purpose. And don't forget the many computer data search services that are available. Probably the most useful of these for student projects are CD Disclosure and ABI/INFORM.
Porter has identified five basic forces that collectively describe the state of competition in an industry:6
The actors within an industry on whom these forces exert pressure are, respectively, the industry's competing firms themselves, potential new entrants to the industry's markets, suppliers (vendors), customers, and makers of substitute products.
Obviously, the starting point for conducting an analysis of the five forces of competition is to identify all the competitors, potential new entrants, major suppliers, the demographics of customers, and makers of and nature of substitute products. Competitors would not only have to be identified, but various distinguishing data about the industry would also have to be specified. For each competitor this data would include market share, product line differences/similarities, market segments served, price/quality relationships represented by products, growth/decline trends, financial strength differences, and any other information that will help describe the industry.
Arranging the five forces and the major actors within an industry produces the "five forces model" as follows:
The key task of the analyst is to understand the underlying causes of each of the competitive forces at work. With this knowledge, a company's strengths or weaknesses can be clarified, and the most fertile areas for drafting competitive thrusts can be defined. Also, knowing the magnitude of competitive forces allows the strategist to identify the most important trends that are emerging as opportunities and threats.
Next, we'll identify typical characteristics of each competitive force, and the kinds of factors that can create strength for the five sets of competitors.
Intensity of Rivalry among Competitors
Some industries appear "sleepy" because of a low level of rivalry among
competitors. An example might be industrial fasteners, the manufacturers
of nuts and bolts and other devices used to connect the components of products.
A large number of quite small manufacturers accept low levels of profitability
as a cost of staying in business. Competition is low key with little effort
and expense devoted to differentiating brands or single products. Such
firms often produce a catalog and send representatives to trade shows to
demonstrate products, or use sales forces or independent sales representatives
for selling. They usually compete on the basis of price, delivery times,
or the convenience of either large or small lot sizes. There are virtually
no screw machine companies advertising on television!
On the other hand, some industries are characterized by a high level of competitive activity. For example, the brewing industry has many competitors who battle fiercely with each other over market share. There is little natural differentiability in beer, so brewing firms develop complex promotional and advertising programs to try to gain the upper hand in consumer awareness. We have seen ads, appeals, posters, jingles, demonstrations, sales, and many other types of promotional and advertising program by beer brewers and distributors to differentiate their product on the basis of taste, brewing process, alcohol content, social acceptance, ingredients, price, "naturalness," similarity to foreign beer brands, dissimilarity to foreign beer brands, strength of flavor, weakness of flavor, and so on. Lately, small retail location-based breweries have been popping up all over the country who make their own beer.
For breweries of a given revenue size, capital investment is large so exit barriers are high. There are few alternative uses of a defunct brewery. So participants fight it out intensely for a share of the huge beer market.
Generally, the factors that tend to precipitate intense rivalry in an industry are the following:
Industrial buyers are companies that purchase the firm's product or service to be used as a component in its product. Continuing with the Firestone example, automobile manufacturers who put Firestone tires on new cars, would be one group of its set of industrial buyers. By contrast, commercial buyers would be other companies that sell Firestone's products to consumers. An example would be any of the large discount store chains that handle Firestone tires, like Wal-Mart, K-Mart, Sears, etc.
Buyers, whether consumer, industrial, or commercial, can enjoy positions of strength over the firm from which they purchase products by superior bargaining power. For example, a large retailer ("commercial buyer" to its supplier) with a loyal customer base and high volume of sales of the product in question, may be able to virtually dictate price, shipping arrangements, order quantity, quality level, and other factors to its vendors.
Similarly, an automobile manufacturer could have a powerful bargaining position over a tire maker or the entire tire industry if a large volume of tires was sought for installation on a popular auto line. (Of course, the wise tire maker would prevent itself from becoming too dependent on one buyer by strenuously developing similar relationships with other companies.) Toyota uses "multiple sourcing"--buying from several producers of the same components--to prevent dependency on too few suppliers. Thus it has a strong bargaining position on matters of price, quality, delivery times, etc., as its suppliers compete with one another to gain favor with its buyers.
An industry's buyers tend to be powerful relative to the firms they are buying from when the conditions listed below apply (keep in mind that these factors apply as well to a group of consumers and to industrial and commercial buyers):
Suppliers
Providers of goods and services to an industry have power over their
customers through their ability to set price and control quality, delivery
time, and order quantity. If these customers cannot successfully play off
one supplier against another to protect themselves, then the industry's
profits can be drained off by suppliers.
The problem is that the supply of wild PLs fluctuates dramatically from year-to-year with climatic conditions. In some years there are not enough wild PLs to stock all the growth farms. In other years there is an oversupply of wild PLs. During the years of wild PL undersupply, the price of hatchery-grown PLs skyrockets and the PL hatchery operators thrive. Indeed, they have the power during these years to control the profitability of the much larger (in terms of revenue) mature shrimp mariculture industry. But during the wild PL oversupply years, they may receive no revenue at all. For Ecuadorian shrimp hatchery operators, periods of extremely high bargaining power and virtually no bargaining power may be separated by only a few months.
Substitute Products
The shrimp industry example above also demonstrates the plight of an
industry facing a substitute for its product. Although it is an extreme
case, seed shrimp hatchery operators really only have an industry at all
during the years when their product's substitute, wild seed shrimp, are
in short supply. Hatchery operators are spending heavily on research to
increase the survival rate of their product. If they are successful in
this endeavor, then they may be able to displace the wild seed shrimp industry
altogether.
During years when there are not quite enough wild seed shrimp to go around, shrimp growers use some hatchery grown seed stock. Their availability limits the price that the wild PL fishermen can charge for their product. This price ceiling is typical of all industries facing substitutes.
Manufacturers of products and suppliers of services must constantly scan their environments for the potential emergence of substitutes. The most dangerous substitutes are those that show potential for improving price-performance trade-offs and those made by firms or industries earning high profits. In these cases, strategies must be formulated to protect against displacement by the substitute product/service.
Potential Entrants
New entrants to an industry pose several threats to existing competitors.
New competitors can reduce the market share of all participants by dividing
the "pie" into more pieces. They also may bring new technology or greater
resources not available to present competitors and achieve a high market
share position quickly to the detriment of all existing participants.
Corporate parent firms that diversify into an industry by acquisition are especially dangerous to existing competitors both because of their "deep pockets" and potential management expertise. A restaurant in the tourism-driven town of Newport, Rhode Island, rapidly gained market share from other restaurants in town when it was acquired by a large international corporation. The parent made capital available to the restaurant and after a major facilities overhaul, hiring of professional management, and implementation of other profit oriented moves, the restaurant quickly became the "industry leader" in Newport. Although corporate ownership does not guarantee success of a restaurant, this example points out the threat to current participants presented by corporate diversification into their industry.
The threat of new entrants to an industry is high when barriers to entry are low. Low entry barriers would apply in the following situations:
Depending on what similarities exist, industry participants can be organized by them into a set of strategic groups. For mapping strategic groups, the best bases for organizing participants are key dimensions of competition. By arraying competitors according to two key competitive factors on a two-dimensional chart (where each axis represents one of the factors), their relative positions on those factors can be analyzed. Then conclusions about market openings and closed segments can be drawn so that the analyst can plan offensive or defensive moves. The following strategic group map of product price versus geographical coverage shows room for potential growth in the high price-wide coverage part of the market:
In this simplified strategic group map, none of the competitors (Firms A-J) offers a high-priced version of the industry product for wide geographical distribution. Therefore, a competitor might formulate a strategy to enter this segment much like Toyota and Nissan did with the Lexus and Infiniti car models.
The factors used to identify the axes could be any strategic variables that are measurable and important dimensions of competition within the industry. Probably the most often used axis titles are price and perceived quality.
Exhibit 8-1.1 shows a strategic map based on perceived quality and breadth of menu offerings for a collection of restaurant chains. For purposes of preparing this map, 100 college students were asked their opinions of relative quality of the set of restaurants within their geographical area. As such, relative vertical position is a result of respondents' perceptions, not of an absolute measure. One might conclude from the map that the "holes" in the market are for high quality, moderately wide menu restaurants (top center) and wide menu choices of low price/low quality items, possibly cafeteria style places (bottom right).
Comprehensive financial analysis consists of four elements: ratio analysis of the firm's historical financial performance, interpretation of cash flow position, analysis of retained earnings position, and predictions of future financial statements.
All findings of the financial analysis should be reduced to strengths and weaknesses of the firm and located accordingly in the data set for the present time frame. Then expected changes in each item can be forecast.
Financial Ratio Analysis
Financial ratio analysis (FRA) is a process whereby the analyst or
manager determines the degree of financial health represented by the firm's
financial statements. Toward that goal there are a number of ways in which
FRA can be useful.
First, it can aid in interpreting and evaluating income statements and balance sheets by reducing the amount of data contained in them to a workable amount. After computing several key ratios whose numerators and denominators are made up of selected items from the statements, a comprehensive analysis of the firm's financial position can be conducted by evaluating the resulting ratios.
Second, FRA can make financial data more meaningful. Any ratio strikes a relationship between the numbers in its numerator and denominator. By selecting sets of numbers that are logically related, only a few ratios may be necessary to comprehensively analyze a set of financial statements.
Third, ratios help to determine relative magnitudes of financial quantities. For example, the magnitude of a firm's debt has little meaning unless it is compared with the owner's investment in the business. Thus the debt/equity ratio strikes a relationship between these quantities such that their relative magnitudes can be established.
Because of these advantages, FRA can help managers or external analysts make effective decisions about the firm's credit worthiness, potential earnings, and financial strengths and weaknesses. It involves simply selecting the financial entities to be compared from either the income statement or the balance sheet, dividing one by the other, and comparing the product with a base. This comparative base could be a history of ratios for the firm (trend analysis), average ratio values from past periods computed from financial statements of other firms in the same industry (industry average comparison), or a combination of the two.
To use the first of these approaches, a ratio's historical values are computed to determine whether its trend is increasing, decreasing, or constant. The second approach requires availability of industry average financial ratios that were computed in the same way as those of the firm under analysis. There are several published sources of data for such comparisons. The major ones are Dun and Bradstreet's Key Business Ratios,7 The Troy Almanac,8 and Robert Morris Associates' Annual Statement Studies.9 Trade associations also publish financial data computed on their member organizations. This data is very useful but unfortunately ordinarily available only to members.
Financial Dimensions
The financial structure of a business has several dimensions. Each
financial dimension may be measured by several ratios, but the financial
dimensions themselves normally are not directly measurable. To analyze
a firm's financial structure comprehensively, then, one must select a set
of ratios made up of subsets, each of which represents a dimension. In
this section financial dimensions are explained first. Then the ratios
that collectively measure each dimension are discussed. The method of computation
for each one is presented, followed by its interpretation.10
Liquidity. The liquidity of a firm is its ability to pay current liabilities as they come due (current liabilities are debts due within one year). The only funds available for payment of short-term debt are either cash or other current assets readily convertible to cash. Consequently liquidity is measured by ratios that strike a relationship between current liabilities and selected current assets.
Current assets
Current ratio = Current Liabilities
Current assets are those normally expected to flow into cash in the course of a merchandising cycle. Ordinarily they include cash, notes and accounts receivable (due within the next twelve months), inventory, and marketable securities (at current realizable values).
Current liabilities are short-term obligations for the payment of cash due on demand or within a year. Ordinarily they include short-term notes and accounts payable for merchandise, current portion of long-term debt, taxes due, and other accruals.
Interpretation: This ratio is a rough indication of a firm's ability to service its current obligations. Generally the higher the current ratio, the greater is the "cushion" between current obligations and a firm's ability to pay them. The stronger ratio reflects a numerical superiority of current assets over current liabilities. However, the composition and quality of current assets are a critical factor in the analysis of an individual firm's liquidity.
Current assets - inventories
Quick ratio = Current liabilities
Interpretation: Also known as the "acid test" ratio, this is a refinement of the current ratio and is a more conservative measure of liquidity. The ratio expresses the degree to which a company's current liabilities are covered by the most liquid current assets. Generally any value of less than one to one implies a reciprocal "dependency" on inventory to liquidate short-term debt.
Coverage. Coverage refers to a firm's ability to service debt that involves interest or premium payments. Ratios that measure coverage consist of one component to estimate flow of funds into the firm and another for periodic payments on debt.
Earnings before interest and taxes
EBIT to interest = Annual interest expense
Interpretation: This ratio is a measure of a firm's ability to meet interest payments. A high ratio may indicate that a borrower would have little difficulty in meeting the interest obligations of a loan. This ratio also serves as an indicator of a firm's capacity to take on additional debt.
Net profit plus depreciation,
Cash flow to current = depletion, and amortization expenses
maturities of long-term debt Current portion of long-term debt
Interpretation: This ratio expresses the coverage of current maturities by cash flow from operations. Since cash flow is the primary source of debt retirement, this ratio measures the ability of a firm to service debt repayment and is an indicator of additional debt capacity. Although it is misleading to think that all cash flow is available for debt service, the ratio is a valid measure of the ability to service long-term debt.
Profitability. This familiar dimension of a company's financial structure concerns management's ability to control expenses and to earn a return on committed funds. Ratios that measure profitability usually consist of a profit element and one that represents the amount of funds invested in whatever aspect of the firm is of interest to the analyst.
Net profit can be calculated either before or after taxes. Robert Morris Associates and the following explanation use net profit before taxes. The analyst should ensure that the ratio elements used to compute the profitability ratios (and others as well) are the same as those used to compute the industry average against which the ratio's value will be compared. Also note that the following two ratios are converted to and reported as percentages.
Net profit before taxes (percent)
Return (before taxes) Tangible Net worth
Interpretation: This ratio expresses the rate of return on tangible capital employed (called net worth or capital or owners' equity less intangibles). While it can serve as an indicator of management performance, the analyst is cautioned to use it in conjunction with other ratios. A high return, normally associated with effective management, could indicate an undercapitalized firm. A low return, usually an indicator of inefficient management performance, could reflect a highly capitalized, conservatively operated business.
Net profit before taxes (percent)
Return (before taxes) = Total assets
on total assets
Interpretation: This ratio expresses the return on total assets and measures the effectiveness of management in employing the resources available to it. If a specific ratio varies considerably from the ranges found in published sources, the analyst will need to examine the makeup of the assets and take a closer look at the earnings figure. A heavily depreciated plant and a large amount of intangible assets or unusual income or expense items will cause distortions of this ratio.
Leverage. The extent to which the firm relies on debt as opposed to owner's capital (net worth) is its leverage position. A highly leveraged firm is one with a high proportion of debt relative to owner's investment.
Total liabilities
Debt to worth = Tangible net worth
Interpretation: This ratio expresses the relationship between capital contributed creditors and that contributed by owners. It expresses the degree of protection provided by the owners for the creditors. A lower ratio generally indicates greater long-term financial safety. A firm with a low debt/worth ratio usually has greater flexibility to borrow in the future. A more highly leveraged company has more limited debt capacity. Generally the order or preference given to this ratio is arranged on a continuum such that a low negative ratio is characterized as a weak debt/worth position and a high positive ratio value is perceived as a strong debt/worth position.
Interpretation: This ratio measures the extent to which owner's equity (net worth) has been invested in plant and equipment (fixed assets). A lower ratio indicates a proportionately smaller investment in fixed assets in relation to net worth, and a better "cushion" for creditors in case of liquidation. Similarly, a higher ratio would indicate the opposite situation. The presence of substantial leased fixed assets (not shown on the balance sheet) may lower this ratio deceptively. The order of preference normally given this ratio is the same as debt/worth.
Activity. Activity ratios, also called "efficiency" or "turnover" ratios, measure how effectively a firm's assets are managed. Examining the relationship between a measure of sales and an asset account is their purpose.
Cost of sales
Inventory turnover = Inventory
Interpretation: This ratio measures the number of times inventory is turned over during the year. High inventory turnover can indicate better liquidity or superior marketing. Conversely it can indicate a shortage of needed inventory for sales. Low inventory turnover can indicate poor liquidity, possible overstocking, obsolescence, or, in contrast to these negative interpretations, a planned inventory buildup in preparation for future material shortages. A problem with this ratio is that it compares one day's inventory (at the end of the accounting period) with cost of goods sold and does not take seasonal fluctuations into account. One way to resolve this problem when sufficient data are available is to calculate cost of sales and average inventory by month to develop turnover ratios for each month. Further, it may prove extremely useful to break up cost of sales and inventory by different classes of products.
365
Day's inventory = Inventory turnover ratio
Interpretation: Division of the inventory turnover ratio into 365 days yields the average length of time units are in inventory.
Net sales
Receivables turnover = Accounts and notes receivable (trade)
Interpretation: This ratio measures the number of times accounts and notes receivable (trade) turn over during the year. The higher the turnover of receivables, the shorter is the time between sales and cash collection. For example, a company with net sales (total sales less returns and/or allowances) of $720,000 and receivables of $120,000 would have a sales/receivable ratio of 6.0, which means receivables turn over six times a year. If a company's receivables appear to be turning over more slowly than the rest of the industry, further research is needed and the quality of the receivables should be examined closely.
A problem with this ratio is that it compares one day's receivables, shown at statement date, with total annual net sales and does not take seasonal fluctuations into consideration. An additional problem in interpretation may arise when there is a large proportion of cash sales to total sales. The latter problem may be resolved by including only those sales made on credit in the numerator. This would tend to give a closer approximation of true receivables turnover. Note, however, that the turnover averages hereafter reported include all net sales in their calculations, regardless of cash or credit terms.
As with inventory turnover, it may prove useful to make these calculations by month so that seasonal fluctuations can be accounted for.
Average collection period = 365
or "day's receivables" Receivables turnover ratio
Interpretation: This figure expresses the average time in days that receivables are outstanding. Generally the greater the number of days outstanding, the greater is the probability of delinquencies in accounts receivable. A comparison of a company's daily receivables may indicate the extent of a company's control over credit and collections. The terms offered by a company to its customers, however, may differ from terms within the industry, and should be taken into consideration. In the example above, 365 - 6 = 6; that is, the average receivable is collected in sixty-one days. Again the distinction between cash sales and credit sales may prove useful in calculating this ratio.
Net sales
Sales to working capital = Net working capital
where net working capital equals current assets less current liabilities.
Interpretation: Working capital is a measure of the margin of protection for current creditors. It reflects the ability to finance current operations. Relating the level of sales arising from operations to underlying working capital measures how efficiently working capital is employed. A low ratio may indicate an inefficient use of working capital, whereas a very high ratio often signifies overtrading, a vulnerable position for creditors. Generally the order of preference given to this ratio (from strongest to weakest) is as follows: low positive, high positive, high negative, low negative.
Sales to net = Net sales
fixed assets Net fixed assets (net of accumulated depreciation)
Interpretation: This ratio is a measure of the productive use of a firm's fixed assets. Largely depreciated fixed assets of a labor-intensive operation may cause a distortion of this ratio.
Net sales
Sales to total assets = Total assets
Interpretation: This ratio is a general measure of a firm's ability to generate sales in relation to total assets. It should be used only to compare firms within specific industry groups and in conjunction with other operating ratios to determine the effective employment of assets.
100 PERCENT STATEMENTS AND REVENUE
AND EXPENSE DISTRIBUTIONS
The 100 percent statements and revenue and expense distributions contained in Robert Morris Associates' Annual Statement Studies (RMA) present a series of accounts as percentages of a respective total. Total Assets, Total Liabilities and Net Worth, Net Sales, Total Revenues, and Total Expenses are used as bases. Component accounts are presented as percentages of each of these totals.
These "spreads" of major accounts can be used to determine the comparability of the magnitude of the same accounts in a specific firm. They are useful for spotlighting excessively large or small account totals in income statements, balance sheets, and cost accounting records. Unusual totals may indicate areas deserving close management attention.
How to Read RMA Tables
Industry average data in most of the available sources, but in RMA specifically, are computed by first calculating the respective ratio for each firm in the appropriate SIC category. These ratios are then ordered from "strongest" to "weakest" (on the basis of criteria used by RMA and general banking guidelines). The ratio that represents the midpoint in this list is the median. Note that this figure is not the typical average or "mean," but is the figure that falls halfway between the strongest and weakest in the data set. Simple interpolation is carried out when no ratio in the ordered list exactly represents the midpoint. Similarly the figure that falls halfway between the median and the strongest ratio is the upper quartile; the figure halfway between the median and the weakest ratio is the lower quartile.
In the RMA data tables, the figures in each ratio cell are ordered as follows:
Strongest
|
25% down the list | -------- Upper quartile
|
50% down the list | -------- Median
|
75% down the list | -------- Lower quartile
|
Weakest
Note that the highest ratio numerical value is not always the strongest, nor is the lowest always the weakest. For example, for the debt-to-equity ratio, the higher the value goes, the weaker is the firm's financial position. While interpreting the ratio values, keep in mind the description of each ratio presented. Remember that ratios often must be evaluated in conjunction with one another if proper conclusions are to be drawn. Notation used by RMA is explained in Exhibit 2-9.
Other Ways to Evaluate Ratios
Often the analyst can find no comparative ratios for the SIC Code being evaluated. In these cases, there are three other evaluation techniques that may be helpful. They are (1) create your own comparative data, (2) trend analysis, and (3) internal analysis.
Create Your Own Data. To create one's own comparative data, other firms like the one analyzed must be found. Then averages are computed of the ratios of the other firms which are most relevant to the nature of the analysis. These averages are then used for evaluation of the ratios computed on the firm in question. Obtaining the financial information on a sufficient number of other firms to do such an analysis used to require hours of digging through hard-copy financial reports on those firms. Today, with the availability of on-line Internet and library-based data services and such resources as Bloomberg terminals, constructing a set of industry average financial data is quite easy. Customized data sets may even be more applicable to the firm being analyzed because the analyst can select members of the comparative base data set.
The following table of ratios was developed on firms similar to Imasco, Corp., a Canadian holding company that owns Hardee's Food Systems, Imperial Tobacco, Shoppers Drug Marts, Genstar Development, UCS Group, and Canada Trust Financial Services, all unrelated subsidiaries (its largest source of revenue [49 percent] was the tobacco business):
______________________________________________________________
______________________________________________________________
Financial Ratios for Firms Similar to Imasco Corp.
(only two of the original eleven ratios are presented)
______________________________________________________________
American Brooke Liggett Philip
Imasco Brands Group Hanson Group Loew's Morris RJR
Ltd. Inc. Ltd. Ltd. Inc. Corp. Corp. Nabisco
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Current Ratio
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1992 1.53 .46 .89 1.75 1.26 .51 1.05 1.21
1991 1.47 .51 .64 2.10 1.09 .45 1.07 1.06
1990 1.68 .54 1.18 2.13 1.13 .50 1.09 .75
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Times Interest Earned
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1992 4.10 6.18 .60 2.66 2.95 -2.48 6.93 2.10
1991 3.43 5.69 -.58 2.78 51.77 8.53 5.22 1.32
1990 3.20 4.74 8.25 2.82 236.14 6.43 4.86 0.95
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These displays for the Current and Times Interest Earned Ratios and the calculations that produced them are from an assignment completed March 7, 1994 by Steven O'Loughlin and Robert Landsfield, for the Strategic Management course in the MBA Program, University of Rhode Island College of Business Administration. In all, eleven ratios were computed for 1990, 91, and 92 on the eight firms above for an analysis of the financial condition of Imasco, Ltd.
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______________________________________________________________
Holding companies normally show up in the industry average data sources under the SIC Code of their largest source of revenue. For example, Textron would be considered an aerospace firm although they have many other subsidiaries that have nothing to do with aerospace. For the above analysis of Imasco, no suitable industry average source could be found so eleven ratios were computed on the firms listed. Then Imasco's ratios were compared to them.
This approach is obviously a lot of work, but it may be the only alternative for analyses where no suitable comparative data is already prepared, or where the analyst feels available data sets are inappropriate for one reason or another.
Trend Analysis. In the absence of comparative financial information, the analyst could also construct trend lines of the ratios of the firm being analyzed. This may only tell whether ratios are increasing or decreasing, but that is useful information even if there is nothing else. In the case of a firm with a 1.5 current ratio, for example, knowing whether this value is on an increasing or decreasing trend tells a lot about the financial health of the firm. Most analysts would have a positive reaction to this value on an increasing trend line, and a negative one on a decreasing line.
Internal Analysis. This approach calls for playing one ratio value off against others, so to speak, to see if there is balance among the financial dimensions represented by ratios. For example, suppose the firm had a current ratio of less than one (indicating that current liabilities amounted to more than current assets.) Suppose further that the quick ratio was similarly low. One would then hope that such a firm did not carry large amounts of debt because of its weak liquidity. So next the analyst might compute the debt-to-equity and debt-to-total assets ratios to see if they were relatively high or low. One would have to know beforehand that a value of 2.0 for the debt-to-equity ratio is generally considered to be the upper limit. If this ratio had a value of, say, 2.4, then one might conclude that the company had a heavy debt load given that it was rather illiquid.
Then, the analyst would likely look at a few profitability ratios hoping to see high values in order to support the high debt and weak liquidity. Discovering low profitability would likely precipitate a very negative evaluation given the high leverage and weak liquidity.
The internal analysis would continue in this fashion until potential weaknesses and strengths had been identified. Then additional information about the firm would be sought to either confirm or deny the financial evaluation.
Funds Flow Statements
The funds flow statement presents summaries of transactions of the firm that showed up as changes in balance sheet items from one accounting period (usually one year) to the next. Funds flow statements, in one of several forms, became required parts of firms' financial statements by mandate of the Accounting Principles Board's Opinion No. 19. The reason for this requirement is that neither the balance sheet nor the income statement presents the nature of transactions undertaken by the firm (they show the net effects of transactions).
Funds flow statements may appear in financial reports under one of several possible names the most common of which are "sources and uses of funds statement," "statement of changes in financial position, and "cash flow statement." We will refer to them collectively as funds flow statements.
Two basic viewpoints can be used to construct a funds flow statement: changes in working capital and changes in cash.11
Working Capital Viewpoint. When working capital changes are the basis for the funds flow statement, changes affecting exclusively short-term assets and liabilities are not presented.
The reason is that a transaction involving two or more short-term accounts would have no effect on working capital and would not be included. Consequently a funds flow statement on the working capital basis explains how working capital was affected by noncurrent changes in sources and applications of working capital as follows:
Sources of working capital
Cash Flow Viewpoint. A funds flow statement prepared from the cash flow viewpoint explains all the working capital changes that the working capital statement contains plus changes in short-term accounts other than cash. Thus, in an overall sense, it analyzes changes in the cash account between one period's balance sheet and another period's balance sheet. Examples of sources and uses of cash according to the cash flow viewpoint follow:
Sources of cash
Retained Earnings
The statement of retained earnings simply shows adjustments in retained
earnings for the year. It includes the retained earnings at the beginning
of the year, the addition or subtraction caused by net income, the deduction
of dividends (if any were paid), and the year-end balance of retained earnings.
This statement is important because it highlights the distribution of net income between dividends and reinvestment. The difference between annual dividends and annual net income is the amount invested in operations. The retained earnings year-end balance is the accumulation to date of the annual portions of net income that have been reinvested in the firm. Incidentally, past periods' retained earnings typically are not held in cash, but are invested in other assets.12
PREDICTING FINANCIAL PERFORMANCE
The financial impact on the firm of a strategic change is presented
in pro forma (predicted) financial statements. These statements include
a cash budget, an income statement, and a balance sheet prepared over the
appropriate planning periods. Typically the income statement and balance
sheet are projected first to show expected sales and expenses (income statement),
the level of assets necessary to generate those sales (left side of the
projected balance sheet), and the way in which assets will be financed
(the right side of the projected balance sheet).13 Then a funds
flow statement is prepared to give more detail on cash or working capital
transactions expected to be necessary for operations to proceed as planned
(although one approach calls for constructing the cash budget first).
There are four approaches to projecting financial statements: The percent-of-sales method, the statistical-relationship method, the budgets-and-ratios method, and the breakeven sales method. All require a sales forecast as a foundation for predicting other components.*(See "Suggested Sales Forecasting References" at end of chapter). Many techniques are available for predicting sales, of which the details are inappropriate for this book. The most popular of these for the external analyst are probably the percentage-change, regression, and trend-line-extrapolation methods. For an analyst forecasting sales from inside a firm, the most popular techniques are probably the sales-force-composite, survey-of-executive-opinion, and regression approaches. We will assume that the analyst already has a sales forecast.
Percentage-of-Sales Projections
Of the methods available for constructing pro forma statements, the
most popular for purposes of strategic analysis is the percentage-of-sales
method. It is discussed in more detail here than the other techniques.
(Detailed explanation of these is beyond the scope of this book). Thus
what follows is an outline of the appropriate financial estimation procedures.
Readers are referred to the references for more detailed development of
techniques.
The percentage-of-sales approach involves the following steps:14
| Assets | Liabilities |
| Cash | Accounts payable |
| Receivables | Accruals |
| Inventory | |
| Plant | |
| Equipment |
An expected dollar increase in total sales (signified by ^TS--that's "delta TS") has to be financed by some combination of accounts payable and accruals, long-term debt, sale of stock, and retained earnings. Of these four accounts payable and accruals (current liabilities) tend to follow sales most closely. Thus we simply assume that the total percent of accrued liabilities and payables to sales (B/TS*100)--current liabilities that vary directly with sales expressed as a percentage of total sales, will be equal to the portion of total assets that they will be used to finance in the short term. The percent of total assets to sales (A/TS*100) less the percent of payables plus accruals (B/TS*100) equals the percentage of total assets that will have to be financed with either long-term internal (retained earnings) or external (selling stock or borrowing) sources, or both.
To estimate the retained earnings portion of total asset investment, multiply the expected percentage of after-tax earnings (m--net after-tax profit margin on sales) by expected sales (TSa--total expected annual sales) to get the dollar net income figure that is predicted. Then determine the forecast retained earnings retention ratio (d--percentage of annual retained earnings not paid out in dividends) and multiply it by expected net income. This results in the estimate for future dollar retained earnings, and also for future dividend payments.
This process may be expressed in the following simple formula:16
External funds needs (EFN) =[A/TS(^TS)-B/TS(^TS)]-dm(TSa)
in which
| A/TS | = | net total assets that vary directly with sales expressed as a percentage of sales | |
| ^TS | = | change in total sales expected (in dollars) | |
| B/TS | = | liabilities that vary directly with sales expressed as a percentage of total sales | |
| d | = | percentage of retained earnings not paid out in dividends | |
| m | = | after-tax profit expressed as a percentage of sales | |
| TSa | = | total sales predicted for the year |
An example may clarify this approach to estimating external funds needs.
Assume that a change in marketing strategy for Jones Company is expected
to generate a 20 percent increase in sales from $5 million to $6 million,
or $1 million. Further, suppose that on last year's balance sheet, Jones
Company's total assets amounted to 69 percent of sales and all of its current
liabilities were 15 percent of sales. Also, its income statement for last
year reported after-tax earnings of 4 percent of sales ($200,000), 50 percent
of which was paid out in dividends. Assuming no other financial structure
changes, what amount of additional external funding would be needed to
accommodate the $1 million projected sales revenue increase? To derive
an estimate following the percentage of sales procedure, the following
variable values apply:
| A/TS | = | .69 | |
| ^TS | = | $1,000,000 | |
| B/TS | = | .15 | |
| d | = | .5 | |
| m | = | .04 | |
| TSa | = | $6,000,000. |
| External Funds Needed (EFN) | =.69($1,000,000)-
=.15($1,000,000) =.5(.04)($6,000,000) =.54($1,000,000)-=.02($6,000,000) = $540,000-$120,000 = $420,000 |
Weston and Brigham also present a modification of the EFN computation that permits the analyst to consider the effects of an increased rate of inflation on the percentage of an increase in sales that would have to be financed externally:15
Percentage of external funds (PEFN) = I - m (1+g)d
g
in which
d and m are the same as in the previous example
I = (A/TS - B/TS)
g = Firm's expected growth rate--inflation rate plus or minus the firm's relative growth rate
As the growth rate rises, the percentage of financing supplied by external sources increases in this formula. Thus, in high inflation times, the role of the cost of external financing becomes more critical in the evaluation of strategic actions requiring asset investment.
To illustrate suppose that Smith Company was growing with the rate of inflation, about 6 percent. This would mean that it would experience little real growth. Assume the following values apply:
I = .5
m = .05
d = .6.
(1+.06)(.6)
= .5-.53 = -3%.
Thus the percentage of the expected increase in sales that would have to be financed externally is negative three percent. This means that the company would not only not have to acquire additional funds, but would have excess funds in the amount of three percent of the expected sales increase, that it could distribute as dividends or invest in one way or another.
This value would rise considerably should Smith Company decide to attempt sales growth of ten percent. The value for growth would increase by ten percent to .16, assuming the rate of inflation remained at .06. Completing the computation reveals that 28 percent of the firm's sales growth would be financed with external funds. Then, were the rate of inflation to rise by 4 percent, the percentage of external financing to sales growth would rise to 32 percent. During inflationary times, it is more difficult to finance growth simply because more funds have to be raised to account for the influence of inflation. The PEFN computation makes it relatively easy to estimate the effect of inflation on the financing requirements that so often accompany strategy changes.
With pro forma income statement and balance sheet constructed, the analyst can then develop a pro forma funds flow statement. This is a matter of isolating the changes between the last historical statements and the pro forma statements according to the following categories:
Budgets and Ratios Methods
One technique applies to strategic management systems with comprehensive
budget programs. Essentially it involves breaking out budget categories
by financial statement account and then adding (subtracting) budget quantities
to (from) statement quantities.18
Two other variations are appropriate to strategic planning.19 One calls for constructing a cash budget first, and then factoring cash budget quantities into a pro forma income statement and balance sheet.
The other relies on past ratios. With a sales forecast and a set of historical ratios, the balance sheet and income statement can be constructed. Ratios with sales in either the numerator or denominator can be converted into dollar values by appropriate mathematical manipulations. For example, accounts receivable for the pro forma balance sheet is obtained by multiplying the receivables-to-sales ratio by expected sales.
Breakeven Pro Formas
Although not actually a way of predicting financial structure in the
sense of forecasting what is expected to occur, breakeven pro formas can
be useful for strategic analysis. According to this approach, the analyst
first determines the level of sales that would be necessary for the firm
to break even, that is, to generate a precisely zero profit. Then, by using
accounts as percentages of sales, statistical relationships, or ratios,
the pro forma statements are developed around the breakeven sales level.
This approach is especially useful for showing what the critical financial condition would be for a firm with declining sales or deteriorating financial health were it to hit breakeven point. The analyst may even compute the rate of decrease of sales and determine how much time is available for a turnaround when sales are declining. A rough estimate is obtained by basing the breakeven computation on income statement data. This estimation procedure simply involves dividing the firm's gross margin percentage into total dollar operating expenses (which roughly approximate fixed costs).20
To illustrate, for Ajax Company, Exhibit 2-10, gross margin is 20 percent on sales of $100 million with total operating expenses of $15 million. Applying the following relationship,
Estimated Breakeven Sales (BE) = Total Operating Expenses /
Gross Margin Percent,
approximate breakeven sales is as follows:
Estimated BE = $15,000,000 / .2 = $75,000,000.
------------------------------------------------------------------ Exhibit 2-10: Ajax Company
Income Statement, 19__
------------------------------------------------------------------
Suppose Ajax Company's sales were declining at about $10,000,000 each year. About how many years, assuming the trend continues, do Ajax Company's managers have to affect a turnaround before profits start to swing negative? The difference between present sales and estimated breakeven sales is $25,000,000 ($100,000,000 - $75,000,000). With a sales decline of $10,000,000 per year, the company has roughly two and one-half years ($25,000,000 / $10,000,000) within which to turn the trend around before reported income becomes negative.
In this case, a turnaround recommendation which would not be expected to begin to take affect for, say, five years, might not be welcomed if the company had insufficient resources to last that long. Rough as it is, this estimate gives the analyst an idea of the time frame within which he/she can work.
This procedure is also useful for new ventures. In this case the important decision is whether it is reasonable to expect that the approximate breakeven sales level can be reached and exceeded within a certain time period.
The detailed techniques of breakeven analysis are presented in most accounting and finance textbooks as well as in other functional textbooks. We do not discuss it here but advise students to employ this tool where possible.
INTERNAL DIAGNOSIS: OTHER FUNCTIONAL AREAS
Most strategic operating characteristics are manifested either directly
or indirectly as symptoms in a firm's financial statements. These symptoms
must be "dug out" of the statements and then interpreted in operational
terms for strategic analysis to begin. Through the interpretation of operational
causes of financial symptoms, the strategist can identify many of the firm's
strengths and weaknesses. But, as Berg has noted, "There is a temptation
to spend too much time on the analysis of financial performance and position
... and not enough time on the more difficult analysis of the underlying
factors ... "21 These underlying factors are usually the strengths
and weaknesses uncovered during analysis of other functional areas. In
other words financial analysis can reveal symptoms of problems or evidence
of strengths in the other functional areas. (It can also indicate that
certain environmental factors are affecting performance).
Therefore, financial analysis can be viewed as a way to uncover questions about performance, to which the answers are likely to be found by analysis of other functional areas. For example, if financial analysis showed relatively high gross profits for a firm experiencing declining sales, the analyst would probably turn to either its marketing function (to determine if prices charged by the firm were too high) or its production systems (to see if raw materials inventory costs were leading to excessive cost of goods sold). Similarly, where gross margin is about average but net (operating) margin is low, the analyst would likely find some operating expense accounts that were unusually large. These excessive accounts should then be traced back to the functional areas generating them to find evidence of inefficiencies.
In the sections that follow, we first explain the processes of internal analysis generally. Then an approach to the analysis of each of the major functional areas and present strategy is described. Our decision to present internal analysis after financial analysis is not intended to imply that financial analysis should necessarily preclude functional area analysis. Indeed, we agree wholeheartedly with Professor Berg that real insight into the operating strengths and problems of organizations will come only after analysis of the operating characteristics of functional areas.
Process of Internal Analysis
There are two fundamental ways to conduct an internal analysis: vertical
and horizontal.22 For the vertical approach, strengths and weaknesses
are identified at each organizational level. The horizontal analysis corresponds
to the functional areas of the SBUs. Strengths and weaknesses are identified
for each function. We prefer the horizontal approach because it seems to
be more universally applicable. Analysis can be focused on functional departments,
or whatever basis of departmentalization has been used in a particular
organization.
The major dimensions of each area are outlined and discussed in the subsections that follow. They are intended as beginning points for analysts to formulate their own evaluation systems for each case study or organization analyzed.
Stevenson found that managers seem to use three types of criteria in identifying strengths and weaknesses: historical, competitive, and normative.23 Analyzing functional areas by historical criteria means comparing present values with their historical counterparts and identifying strengths and weaknesses on the basis of those comparisons.
Competitive comparisons involve assessing similarities and dissimilarities with successful competitors and finding strengths and weaknesses accordingly. Similarly normative comparisons are those where present characteristics are compared with ideal values as perceived by the analyst or an expert opinion.
In practice the process of identifying strengths and weaknesses can be one of the most educational experiences top managers can have. Especially enlightening are the enumeration and discussion of weaknesses. Since responsibility for the performance of SBUs and functional departments often rests with single managers, identification of weaknesses at these levels can be painful and embarrassing for those people. These discussions must be handled carefully to prevent alienation and to bring about constructive solutions to whatever problems are revealed. However, the analyst must make sure that all weaknesses are identified, even though some feelings may be hurt.
The process of internal analysis involves the following steps:
Operational Factors of Each Functional Area
After identifying the appropriate functional areas to study in the
internal analysis, the next step is to decide what aspects of each one
to analyze. By the time most students take a course in strategic management,
they have completed courses in each functional area and topics related
to them. Those courses and the texts used in them are the best sources
of evaluative criteria for the functions of organizations.
Marketing. Consistent with marketing convention, this function is analyzed by examining the operating characteristics of the organizations' products/services, price, promotion, distribution, and new product development systems. Interest is focused on all aspects of each of these systems that have not already been identified as part of the financial analysis. Examples of checkpoints for each factor are as follows:
Personnel and Union Relations. The overall purpose of the personnel function is to manage the relationship between employees and the organization. Therefore, internal analysis of the personnel function is an assessment of the strengths and weaknesses of that relationship. This function can be analyzed by examining the following factors and questions or others tailored to the organization:
Wheelwright suggests evaluating production strategy by analyzing its consistency and emphasis.24 First, the analyst should evaluate the consistency of production strategy with business strategy, other functional strategies, and with the overall business environment. The categories within production strategy itself should exhibit a high level of consistency as well. Then, the extent to which production strategy is focused on factors of success should be evaluated. This involves making sure that priorities among production activities are appropriate to business strategy, that business level opportunities have been addressed, and that production strategy is communicated, understood, and integrated with other functional strategy managers.
Research and Development. Research and development (R&D) provides technical analysis and support to other departments, and designs products or processes to meet market needs and thereby generate a profit. Operation of R&D must strike a balance between practicality and creativity in order to contribute successfully to profit goals. Overemphasis on practical matters can impair future profitability because few innovations will be generated. Overemphasis on creativity could result in generation of few marketable product ideas while researchers explore the frontiers of their scientific disciplines. The correct balance between creativity and practicality for a particular firm is a strategic issue that cannot be decided absolutely. That is, this balance is a function of the extent to which the organization requires either innovation or market emphasis, and that issue is a function of business-level goals and action plans.
Conducting an internal analysis of the R&D function involves identifying strengths and weaknesses in R&D activities such as the following:
Changing structure is risky. Therefore, it should not be tampered with unless there is either a problem present that must be corrected or one that can reasonably be expected to develop if a change is not made. In either case, though, organization structure should be changed only because of specific problems. That is, there is no absolutely best structure, but only the structure that minimizes organization-related problems.
Some of the criteria that can be used to analyze organization structure are as follows:
Whether present strategies are stated explicitly or must be inferred from behavior of the organization, the goals and action plans currently applicable must be identified and analyzed. The idea is to determine which strategies are working (that is, which action plans are being implemented in such a way that their associated goals are being met) and which ones are not. Information about the relative success of current strategy can then be fed into the process of formulating and implementing new strategies. In this way problems associated with existing strategies can be corrected by formulating modifications or replacements for them and effective strategies can be improved upon, retained as is, or extended so that strategic success is facilitated.
The following steps can be followed to evaluate current strategy at any of the four levels of strategy:
SUMMARY
This chapter discusses the processes of environmental and internal
organizational analysis. Although each of these analyses consist of identifying
the strengths, weaknesses, threats, or opportunities confronting the organization
in the past, present, and future, the context of each is different.
Environmental analysis involves identifying the major present and future threats and opportunities to or from the organization's principal constituents (shareholders, customers, competitors, suppliers, employees, and general public) along the dimensions of the organization's economic, political/legal, technological, and social environments. Then the same process is applied to the industry in which the firm operates.
Internal analysis consists of conducting a financial analysis followed by a study of the performance characteristics of the organization's other functional areas to identify the strengths and weaknesses of its operations.
Recognizing that a firm should make a strategic change, structuring the essential goal and action-plan sets, and implementing them are risky endeavors without first analyzing the probable impact on the firm's financial condition. It was widely understood that Chrysler had to start producing more smaller automobiles to survive. Yet the financial requirements of this new direction were especially difficult to meet and had to be planned meticulously.
In the last section of the chapter, an approach to the analysis of other functional areas is presented along with a set of suggested evaluative criteria for each of them. This typology is offered as a beginning point for students to develop their own analytical procedures. In fact one's approach is likely to differ substantially from organization to organization.
REFERENCES