Strategy Survival Guide

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The Five Forces Framework can be used to gain insights into the forces at work in the industry or environment, which need particular attention in the development of strategy. It is important to use the framework for more than simply listing the forces. The following questions help focus on the implications of these forces: • What are the key forces at work in the environment? These will differ by type of industry. • What are the underlying forces in the macro-environment that are driving these forces? For example, lower labour costs for software and service operators in India are both an opportunity and a threat to European and US companies. • Is it likely that the forces will change, and if so, how? • How do particular industries/departments stand in relation to these competitive forces? What are their strengths and weaknesses in relation to the key forces at work? • What can we do to influence forces? Cost Structure Analysis Cost structure analysis can help provide answers to questions such as: • Is the good/service inherently expensive to supply, or might market conditions (excess demand and/or lack of competition) be pushing cost higher? • How do costs behave as a supplier scales upwards? For example, are (dis)economies of scale experienced, are there stepped costs (e.g. in the case of telecoms networks as significant additional investment is needed to push capacity past certain thresholds)? • Is the supply of the good/service dominated by fixed or variable costs? • What sunk costs are incurred in setting up supply? Will these sunk costs limit new entrants and/or form the basis for games by incumbents? Crucially, an understanding of such issues will provide insight as to how suppliers behave in the market, and how they might react to changes in government involvement – e.g. via subsidies and regulation. As such, cost analysis can suggest policy responses and help to predict the outcome of different policies. Cost structure analysis forms one half of business modelling and profitability analysis. Such an approach enables a full break-out of cost and revenue drivers and allows an analysis of profitability by customer, type of good/service or division. In policy making terms, for example, this might mean the ability to estimate profitability by different types of Post Office customer, or the likely sustainability of childcare provision in different areas. Steps to take: Define cost buckets Gather evidence Construct spreadsheet model Investigate sensitivities Sense check • Break costs into mutually exclusive buckets • Define a useful split • Refer to the issue tree for guidance • Gather management account, business plans, annual reports • Interview managers of supply or other experts • Use survey data if appropriate • Create a spreadsheet model that will allow the user to vary all inputs • Refer to the modelling section for more guidance • Vary inputs by +/- 10% and see results • Vary inputs to model discrete scenarios • Construct output tables, charts or other communication tools as appropriate • Check results and insights versus other evidence e.g. business plans, research results, interviews with experts • This IS crucial: you have constructed a bottom up model: does it reflect reality? Potential insights • Mix of sunk, fixed, variable costs • Dominant cost categories • Key cost drivers • Cost / profitability reaction to changes in conditions • Is the model reflecting reality? Strategy Survival Guide – Strategy Skills Page 138
Defining cost buckets Costs can be broken out according to a number of different splits. For example, a childcare provider’s costs might be broken out according to age of child, or function, such as staff, child costs (food and consumables), property costs, administrative overheads etc. It is important to find a mutually exclusive split – where each cost can be placed in only one of the categories. A logic tree may help in this process. Gathering evidence In some cases, detailed management accounts from existing suppliers might be available. In other cases, estimates might need to be pulled together from a range of different sources. Be aware that you are attempting to analyse costs for one example supplier – it cannot and will not reflect everyone in the market. Thus the need to run sensitivities and sense checks later in the process. Constructing a spreadsheet model Theoretically, you could stop after the previous step and still gain insights into the likely operation of the market. However, by pulling the estimates of costs in different categories together into a spreadsheet, further analysis can be conducted on the sensitivity of costs and supply on particular elements. This, in turn, allows one to predict likely reactions to policy options or new regulations. The spreadsheet itself should be as adjustable as possible to allow sensitivities and scenarios to be run easily. Refer to the modelling section for advice on the construction of spreadsheet models. Investigating sensitivities The spreadsheet model will allow adjustment of the cost variables to investigate the overall effect on the cost of supply or the profitability of a supplier (if the revenue side has been added). In many cases, there will be numerous variables that can be changed. It is important to alter one at a time, in a methodological fashion, in order to derive the results from changes in one variable at a time. A second approach is to run specific scenarios on the model – changing all the variables at once according to one view of the world. Sense checking The cost structure analysis conducted will have been based on a series of assumptions. However well these assumptions have been grounded in hard evidence, it is crucial to check that the results of the assumptions acting altogether make sense. Results can be checked with experts in the field, existing suppliers and other business plans that are available. This triangulation of results in important to ensure confidence in the messages being drawn from the analysis. This also brings up a limitation to the analysis conducted: however sophisticated the modelling, it can only be based on a series of assumptions. It does not reflect an actual outcome. It can therefore give insights into key drivers and likely reactions, but is not "the answer". Strengths • The structure, conduct, performance model provides an overarching framework for assessing the industries being studied. It provides a useful insight into the context within which a department or industry has been operating. • The forces at work model provides a comprehensive checklist for analysing the structure of industries and sectors. It can be used to identify what further analysis is required. • Cost structure analysis is potential very powerful since it can feed into a better understanding of market functioning and likely reactions to changes in policy. • In areas where evidence has tended to be based on anecdote, cost structure analysis and modelling can bring significant new insight to the debate. Weaknesses • A model of costs or profitability can only give a simplified indication of the way the world works. It must not be viewed by the team (or stakeholders) as "the answer". Key messages can be drawn from running sensitivities or scenarios on the model, but should be carefully sense checked. • Attempts to allocate overhead (shared) costs – such as administration – between different products, people or plants are fraught with difficulty and should be approached with caution. Each stakeholder will have an opinion on how such costs ought to be allocated. • Cost structure analysis and profitability analysis will involve many variables and the team may wish to run sensitivities on most if not all inputs. This makes it crucial that key messages are drawn out for communication to stakeholders, without getting bogged down in technical details. The right insights need to be communicated in an effective way. This may mean significant lengths of time spent interpreting results within the team prior to communication to stakeholders. Strategy Survival Guide – Strategy Skills Page 139
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Building an Evidence Base 113 Data
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A Framework for Strategic Direction
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