In September 2008, the McKinsey Quarterly published an interactive audio presentation on the GE-McKinsey 9-Box Matrix.

An outline of this framework is provided below, but I highly recommend watching the original presentation.

1. Background

The 9-Box Matrix follows in the footsteps of Boston Consulting Group’s growth share matrix which was introduced in 1968.

The 9-Box Matrix was developed as part of work that McKinsey did for GE in the early 1970s. At that time, GE had around 150 business units and was faced with the challenge of how to manage such a large number of business units profitably.

The 9-Box Matrix was developed as a result of the realisation that it is important to separate the ability of a business to generate cash from the decision about whether to put more cash into the business.

2. Purpose

The 9-Box Matrix offers any decentralised corporation with multiple business units a systematic approach to help it decide where to invest its cash.

The 9-Box Matrix solves the problem of trying to compare potentially very different business units: one might be capital intensive; another might require high advertising expenditure; a third might have economies of scale.

Instead of relying on the projections provided by the manager of each individual business unit, the company can determine whether a business unit is going to do well in the future by considering two factors:

1. attractiveness of the industry; and
2. the business unit’s competitive strength within that industry.

3. Using the matrix

(Source: McKinsey Quarterly)

Placing each business unit within the 9-Box Matrix offers a framework for comparison between them.

In order to keep things simple, the framework offers only three investment strategies:

1. Invest/Grow;
2. Selectivity/Earnings; and
3. Harvest/Divest.

Allocating one of these investment strategies to each business unit is a necessary first step. However, it is important to note that two business units that have been given the same strategy will not necessarily be treated in the same way. For example, a strong unit in a weak industry is in a very different situation than a weak unit in a highly attractive industry.

After placing a business unit into one of the nine boxes, there are at least two questions that are worth asking:

1. If a business unit is in one category, say “selectivity/earnings”, is there anything that can be done to change its position? That is, would it be possible to move a business unit from the “selectivity/earnings” category and into the “invest/grow” category by making any kind of strategic investments?
2. If a business unit is to receive money, what should it do with that money? It is important that money is given with a purpose in mind because the best use of money will vary depending on the industry and on the business unit. For example, advertising to enhance the brand might work for one business unit, whereas investing to increase research and development might work for another.

4. Axes of the matrix

The 9-Box Matrix places “industry attractiveness” along the vertical or y-axis, and “competitive advantage” (otherwise known as competitive position, or competitive strength of the business) along the horizontal or x-axis.

4.1 Industry attractiveness

Industry attractiveness refers to whether the industry is going to do well in the future. Are most players in the industry likely to do well? How easy will it be for the average company in the industry to make profits over the long run?

There are a number of different factors that affect industry attractiveness and those factors will vary in importance from industry to industry, for example: long run growth rate of the industry, current profitability, etc.

The Structure Conduct Performance model or, its more popular simplified version, the Porters Five Forces model both provide a formal approach to look at industry attractiveness.

4.2 Competitive advantage

According to Coyle, the first formal definition of “sustainable competitive advantage” was not determined until the mid-eighties.

In the early days of the 9-Box Matrix, analysts used proxies for sustainable competitive advantage:

• Is the business unit’s market share growing? Maybe we can infer from this something about its competitive advantage.
• How strong is the business unit’s brand equity? That is, how much of a price premium can it charge?
• Is the company more profitable than its competitors?

A business has a competitive advantage when it is able to achieve profits that exceed the industry average. Competitive advantage may be established by offering consumers greater value by way of:

• lower prices;
• differentiated goods or services that justify higher prices; or
• establishing a market niche and achieving a narrow, rather than an industry wide, competitive advantage.

5. Available strategies

5.1 Invest / Grow

A business unit will be in the “invest/grow” category if the prospects for the industry as a whole are attractive and the business unit’s position in the industry means that it is likely to do better than most of the other firms in the industry.

A business unit in this category should be given as much money as it needs regardless of whether it can generate those funds itself.

5.2 Selectivity / Earnings

Business units in this category are given second priority to those in the “invest/grow” category. So, the amount of money spent on business units in the “invest/grow” category will determine how much money is left over for business units in this category.

When allocating money to a business unit in this category, it is important to be selective about where the money is spent and monitor earnings closely. With the right combination of strategies, it may be possible to move the business unit into the “invest/grow” category.

In this part of the matrix it is a good idea to be careful. If the business unit doesn’t improve then it may be best to invest money elsewhere.

5.3 Harvest / Divest

A business unit will be in the “harvest/divest” category if it is in an unattractive industry and its competitive position is weak.

There are two suggested strategies:

1. sell the business unit (divest); or
2. increase short-term cash flows as far as possible, even at the expense of the business unit’s long term future (harvest).

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1. Background

The idea of the Product Life Cycle was first developed in 1965 by Theodore Levitt in an article entitled “Exploit the Product Life Cycle” published in the Harvard Business Review on 1 November 1965.

2. Benefit of the Product Life Cycle model

For a business, having a growing and sustainable revenue stream from product sales is important for the stability and success of its operations. The Product Life Cycle model can be used by consultants and managers to analyse the maturity stage of products and industries. Understanding which stage a product is in provides information about expected future sales growth, and the kinds of strategies that should be implemented.

3. Product Life Cycle model

The “Product Life Cycle” is the name given to the stages through which a product passes over time. The classic Product Life Cycle has four stages:

1. Introduction,
2. Growth,
3. Maturity, and
4. Decline.

3.1 Introduction

At the market introduction stage the size of the market, sales volumes and sales growth are small. A product will also normally be subject to little or no competition. The primary goal in the introduction stage is to establish a market and build consumer demand for the product.

There may be substantial costs incurred in getting a product to the market introduction stage. Substantial research and development costs may have been incurred, for example, thinking of the product idea, developing the technology, determining the product features and quality level, establishing sufficient manufacturing capacity, preparing the product branding, ensuring trade mark protection, etc. Marketing costs may be high in order to test the market, launch and promote the product, develop a market for the product, and set up distribution channels.

The market introduction stage is likely to be a period of low or negative profits. As such, it is important that products are carefully monitored to ensure that sales volumes start to grow. If a product fails to become profitable it may need to be abandoned.

Some of the considerations in the introduction stage include:

• Product development: research and development of the basic technology and product concept, determining the product features and quality level.
• Pricing: should penetration pricing or a skimming price strategy be used? A skimming price strategy might be appropriate where there are very few competitors.
• Distribution: distribution might be quite selective until consumer acceptance of the product can be achieved.
• Promotion: marketing efforts are aimed at early adopters, and seek to build product awareness and to educate potential consumers about the product.

3.2 Growth

If the public gains awareness of a product and consumers come to understand the benefits of the product and accept it then a company can expect a period of rapid sales growth, enter the “Growth Stage”. In the Growth Stage, a company will try to build brand loyalty and increase market share.

Profits are driven by increased sales volume (due to growth in market share as well as an increase in the size of the overall market). Profits might also be driven by cost reductions gained from economies of scale, and perhaps more favourable market prices. Competition in the Growth Stage remains low, although new competitors are expected to enter the market. When competitors enter the market a company might be subject to price competition and increase its marketing expenditure.

Some of the considerations in the Growth Stage include:

• Product improvement: product quality might be improved, additional features and support services added, and packaging updated.
• Pricing: if consumer demand is high the price might be maintained at a high level.
• Distribution: distribution channels might be added as consumer demand increases.
• Promotion: promotion is aimed at a broader audience. A company might spend a lot of resources on promotion during the Growth Stage to build brand loyalty.

3.3 Maturity

When a product reaches maturity, sales growth slows and sales volume eventually peaks and stabilises. This is the stage during which the market as a whole makes the most profit. A company’s primary objective at this point is to defend market share while maximising profit.

In this stage, prices tend to drop due to increased competition. A company’s fixed costs are low because it is has well established production and distribution. Since brand awareness is strong, marketing expenditure might be reduced, although increased marketing expenditure might be needed to retain market share and fight increasing competition. Expenditure on research and development is likely to be restricted to product modification and improvement, and perhaps research into improved production efficiency and product quality.

Some considerations for the mature product market include:

• Product differentiation: increased competition in the mature product market means that a company must find ways to differentiate its product from that of competitors. Strong branding is one way to do this.
• Pricing: prices may be reduced because of increased competition. Firms in the market should be careful not to start a price war.
• Distribution: distribution intensifies and incentives may be offered to encourage preference to be given over competing products.
• Promotion: promotion will focus on emphasising product differences and creating/maintaining a strong brand.

3.4 Decline

A product enters into decline when sales and profits start to fall. The market for that product shrinks which reduces the amount of profit available to the firms in the industry. A decline might occur because the market has become saturated, the product has become obsolete, or customer tastes have changed.

A company might try to stimulate growth by changing their pricing strategy, but ultimately the product will have to be re-designed, or replaced. High-cost and low market share firms will be forced to exit the industry.

As sales decline, a company has three strategy options:

• Hold: maintain production and add new features and find new uses for the product. Reduce the cost of manufacturing (e.g. move manufacturing to a low cost jurisdiction). Consider whether there are new markets in which the product might be sold.
• Harvest: continue to offer the product, reduce marketing expenditure, and sell possibly to a loyal niche segment of the market.
• Divest: Discontinue production, and liquidate the remaining inventory or sell the product to another firm.

Some considerations for a declining market include:

• Product consolidation: the number of products may be reduced, and surviving products rejuvenated.
• Price: prices may be lowered to liquidate inventory, or maintained for continued products.
• Distribution: distribution becomes more selective. Channels that are no longer profitable are phased out.
• Promotion: Expenditure on promotion is reduced for products subject to the Harvest and Divest strategies.

4. Criticisms

The Product Life Cycle is useful for monitoring sales results over time and comparing them to products with a similar life cycle. However, the Product Life Cycle model is by no means a perfect tool. Products often do not follow a defined life cycle, not all products go through each stage, and it is not always easy to tell which stage a product is in at any one time. Consequently, the life cycle concept is not well-suited for the forecasting of product sales.

The length of each stage will vary depending on the product and the marketing strategies employed. A Product Life Cycle may be as short as a few months for a fad or as long as a century or more for a product like petrol cars. In many markets the product life cycle is longer than the planning cycle of the organisations involved. Major products often hold their position for several decades or more, indeed, Coca-Cola was introduced in 1886 and is still the leading brand of cola.

The Product Life Cycle is only one of many considerations that a company must bear in mind. The product life cycle of many modern products is shrinking, while the operating life for many of these products is lengthening. For example, the operating life of durable goods like household appliances has increased substantially. As a result, a company that produces these products must take their market life and service life into account when planning.

Some critics have argued that the Product Life Cycle may become self-fulfilling. For example, if sales peak and then decline a manager may conclude that a product is on the decline and cut back on marketing, thus precipitating a further decline.

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What are lenders looking for?

It is important to understand what lenders look for when they lend money because companies often need to borrow money for various reasons: increase cash reserves, refinance existing debt, pay regular operating expenditures, research and development, capital expenditure, product development, expansion into new markets, strategic acquisitions, etc.

There are five criteria that most lenders use to assess a borrower’s creditworthiness:

1. capacity to generate sufficient cash flows to service the loan;
2. collateral to secure the loan in case the borrower defaults;
3. capital that shareholders have invested in the business;
4. conditions prevailing in the borrower’s industry and broader economy; and
5. character and track record of the borrower and the borrower’s management.

It is important to keep in mind that lenders don’t give equal weight to each criterion and will use all five criteria to create an overall impression of a company’s creditworthiness. Lenders are typically cautious and weakness in one of the five criteria may offset strength in all of the others. For example, if a company is in a cyclical industry (e.g. construction, auto, or aviation) the company may find it difficult to borrow money during an economic downturn even if the company shows strength in all of the other criteria. Similarly, if a company’s management has a bad reputation and poor track record then the company may find it difficult to borrow money even if it has strong financial statements.

Taken together, these five criteria indicate a borrower’s ability and willingness to repay its debts. As such, if you are advising a company in relation to raising finance, you must ensure that each of the five criteria is fully addressed in your loan request.

Let’s consider each of the five criteria in a little more detail:

1. Capacity

Capacity to repay a loan is the most important criterion used to assess a borrower’s creditworthiness. The borrower must be able to satisfy the lender that it has the ability to repay the loan. To satisfy itself of the borrower’s capacity, the lender will consider various factors including:

1. Profitability: What are the revenues and expenses of the borrower?
2. Cash flows: How much cash flow does the business generate? The lender is interested not only in cash flows from operations, but also cash flows from investing and financing activities. What are the timing of cash flows with regard to repayment?
3. Payment history: What is borrower’s payment history and track record of loan repayment?
4. Debt levels: How much debt does the borrower have? How much debt can the borrower afford to repay?
5. Industry evaluation: What is the normal debt/liquidity level for companies in the borrower’s industry?
6. Financial ratios: There are a number of financial ratios, such as debt and liquidity ratios, that lenders will evaluate before lending money: e.g. debt to equity ratio, debt to asset ratio, current ratio, quick (acid test) ratio, operating cash flow ratio, working capital ratio, etc.

2. Collateral

While cash flows are the primary source for the repayment of a loan, collateral provides lenders with a secondary source of repayment. Collateral represents the assets that are provided to the lender to secure a loan. In the event that the borrower fails to repay the loan, the collateral may be seized by the lender to repay the loan.

The borrower must usually provide the lender with suitable collateral. To do this, the borrower normally pledges hard assets like real estate, office equipment or manufacturing equipment. However, accounts receivable and inventory might also be pledged as collateral.

Service businesses and small companies may find it difficult to provide lenders with the collateral they require because they have fewer hard assets to pledge. If the borrower doesn’t have the necessary collateral, the lender may require personal guarantees from the borrower’s directors or from a third party such as the borrower’s parent company.

3. Capital

Capital is the money that shareholders have personally invested in the business. Capital represents the money that shareholders have at risk should the business fail.

Lenders are more likely to lend money to a borrower if shareholders have invested a large amount of their own money in the business. If the business runs into financial difficulty, then the capital of the business provides a cushion for repayment of the loan. If shareholders have a large amount of capital invested in the business, this indicates they have confidence in the business venture and that they will do all that they can to ensure the borrower does not default on the loan.

4. Conditions

Conditions refer to two factors that the lender will take into account. Firstly, conditions refer to the overall economic climate, both within the borrower’s industry and in the economy generally, that could affect the borrower’s ability to repay the loan. For example, during recessions and periods of tight credit it becomes more difficult for small businesses to repay loans and more difficult for lenders to find money to lend. Thus, during these periods a small business will find it difficult to borrow money and must present lenders with a flawless loan application.

In considering the overall economic climate a lender may consider various questions including:

1. What is the current business climate?
2. What are the trends for the borrower’s industry? How does the borrower fit within them?
3. What is the short and long-term growth potential in the industry?
4. How is the market characterised? Is it an emerging or mature market?
5. Are there any economic or political hot potatoes that could negatively impact the borrower’s growth?

Secondly, conditions refer to the intended purpose of the loan. The borrower’s reasons for seeking the loan should be spelt out in detail in the loan application. Will the money be used to buy new equipment for expansion? Will the money be used to replenish working capital to prepare for a seasonal inventory build-up?

5. Character

Character refers to the general impression that the borrower makes on the prospective lender. The lender will form a subjective judgement as to whether the borrower is sufficiently trustworthy to repay the loan.

Lenders want to put their money with companies that have impeccable credentials. Relevant factors that a lender may consider in deciding whether the borrower is sufficiently trustworthy include:

1. What is the character of each member of the management team?
2. What reputation do management have in the industry and the community?
3. What educational background and level of experience does management have?
4. What is management’s track record?
5. What is the overall consumer perception of the borrower?
6. Is the borrower progressive about its waste disposal, quality of life for its employees, and charitable contributions?
7. Does the borrower have a track record of fulfilling its obligations in a timely manner?
8. What is the borrower’s payment history and track record of loan repayment?
9. Are there any legal actions pending against the borrower? If so, what is the reason for these legal actions?

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1. Background

Value Chain Analysis is a concept that was first described and popularised by Michael Porter in his 1985 book, Competitive Advantage.

2. Relevance of Value Chain Analysis

In order to understand the activities that provide a business with a competitive advantage, it is useful to separate the business operation into a series of value-generating activities referred to as the value chain.

Value Chain Analysis involves identifying all of the important activities in which a business engages and then determining which ones give the company a defensible competitive advantage. By doing this, we can identify which activities are best undertaken by the company itself and which ones are able to be outsourced.

3. Value Chain Analysis explained

Michael Porter introduced a generic value chain model that comprises a sequence of activities common to a wide range of firms. Porter suggested that the activities of a business could be grouped under two headings:

1. Primary activities: those that are directly concerned with creating and delivering a product; and
2. Support activities: those that are not directly involved in production, but may increase effectiveness or efficiency.

The firm’s margin or profit depends on its ability to perform these activities efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of the activities in the value chain.

3.1. Primary activities

The primary activities in Porter’s model include:

1. Inbound Logistics: Receiving and storing externally sourced materials.
2. Operations: Manufacturing products and services – the way in which inputs are converted into final products.
3. Outbound Logistics: Getting finished goods and services to consumers.
4. Marketing & Sales: Identification of customer needs and the generation of sales.
5. Service: Supporting customers after the product or service has been sold to them.

3.2. Support activities

The support activities in Porter’s model include:

1. Human resource management: Recruitment, training, development, motivation and compensation of employees.
2. Infrastructure: Includes a broad range of support systems including organisational structure, planning, management, quality control, culture, and finance.
3. Procurement: Sourcing resources and negotiating with suppliers.
4. Technology development: Managing information, developing and protecting new products and services, developing more efficient processes, and improving quality.

4. Application of the Value Chain Analysis

4.1. Steps to take

Value Chain Analysis can be broken down into a three sequential steps:

1. Break down a company into its key activities under each of the headings in the model;
2. Identify activities that contribute to the firm’s competitive advantage either by giving it a cost advantage or creating product differentiation. Also identify activities where the business appears to be at a competitive disadvantage; and
3. Develop strategies around the activities that provide a sustainable competitive advantage.

4.2. Cost advantage

A business can achieve a cost advantage over its competitors by firstly understanding the costs that are associated with each activity and then organising each activity to be as efficient as possible.

Porter identified 10 cost drivers related to each activity in the value chain:

1. Economies of scale
2. Learning
3. Capacity utilisation
4. Linkages among activities
5. Interrelationships among business units
6. Degree of vertical integration
7. Timing of market entry
8. Firm’s policy on targeting cost or product differentiation
9. Geographic location
10. Institutional factors (regulation, union activity, taxes, etc.)

A firm can develop a cost advantage by controlling these 10 cost drivers better than its competitors.

A cost advantage can also be pursued by reconfiguring the value chain. Reconfiguration means introducing structural changes such as a new production process, new distribution channels, or a different sales approach. For example, Qantas structurally redefined its maintenance of aircraft, which was traditionally conducted by inhouse engineers, by outsourcing this function to private overseas contractors.

4.3. Product differentiation

Product differentiation can be achieved by a business by focusing on its core competencies in order to perform them better than its competitors.

Product differentiation can be achieved through any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors, providing high levels of product support services, or designing innovative and aesthetically attractive products are all ways of creating product differentiation.

5. Issues arising from the Value Chain Analysis

5.1. Linkages between Value Chain activities

Value Chain activities are not isolated from one another. Rather, one value chain activity often affects the cost or performance of other ones. Linkages may exist between primary activities and also between primary and support activities.

Consider the case in which the design of a product is changed in order to reduce manufacturing costs. Suppose that the new product design inadvertantly results in increased service costs; the cost reduction could be less than anticipated and even worse, there could be a net cost increase.

5.2. Business unit interrelationships

Business unit interrelationships can be identified using the Value Chain Analysis.

Business unit interrelationships offer opportunities to create synergies among business units. For example, if multiple business units require the same raw material and the procurement process can be coordinated then bulk purchasing may result in cost reductions. Such interrelationships may exist simultaneously in multiple value chain activities.

5.3. Outsourcing

Value Chain Analysis assists management decide which activities should be outsourced. It is rare for a business to undertake all primary and support activities internally. In order to decide which activities to outsource managers must understand the firm’s strengths and weaknesses, both in terms of cost and ability to differentiate.

6. Case example

For example, Coca-cola might have the following value chain elements:

1. Research and development (Will cherry taste good with cola?)
2. Manufacturing (How much does the bottling plant cost to build and run? How often do factories need to be re-engineered?)
3. Cost of goods sold (How much does it cost to manufacture cola? Is there a frost in Florida that will drive up the cost of cherries?)
4. Packaging and shipping (How much does that new design of packaging cost? Are many cans of cola lost in transit? What are the fixed costs of shipping?)

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This is a useful framework for evaluating the marketing strategy for a product.

The Four P’s consist of:

1. price ;
2. product ;
3. position/place; and
4. promotion .

1. Price

The pricing strategy employed by a firm for a particular good or service will have a significant effect on profit.

There are many different pricing strategies that can be employed in different combinations, including:

1. Price differentiation – setting a different price for the same product in different segments of the market. First degree price discrimination involves charging each customer a different price. To do this, the seller must be able to observe each customers willingness to pay, this is very difficult to do in practice. Second degree price discrimination involves varying the price according to quantity sold. Third degree price discrimination involves varying the price by location or market segment. For example, charging discounted prices for students.
2. Dynamic pricing – a form of first degree price discrimination, dynamic pricing is a flexible pricing mechanism that allows online companies to adjust the price of identical goods to correspond to a customer’s willingness to pay. This is made possible by using data gathered from a customer including where they live, what they buy, and how much they have spent on past purchases.
3. Predatory pricing – aggressive pricing intended to undercut competitors and drive them out of the market.
4. Limit pricing – a low price charged by a monopolist in order to discourage entry into the market by other firms.
5. Using a loss leader – a loss leader is a product sold at a low price to stimulate other profitable sales. For example, the 30 cent soft serve cone at McDonalds.
6. Penetration pricing - the price is set low in order to gain market share.
7. Marginal cost pricing - the practice of setting the price of a product equal to the cost of producing one extra unit of output.
8. Market-orientated pricing – setting a price based upon analysis of the targeted market.
9. Psychological pricing – pricing designed to have a positive psychological impact. For example, selling a product at $3.95 instead of $4.
10. Skimming – charging a high price to gain a high profit, at the expense of achieving high sales volume. This strategy is usually employed to recoup the initial investment cost in research and development, commonly used in electronic markets when a new product range is released.
11. Premium pricing – involves keeping the price of a good or service artificially high in order to encourage a favorable perception among buyers.
12. Target pricing – a method of pricing whereby the selling price of a product is calculated to produce a particular rate of return on investment.
13. Seasonal pricing – adjusting the price depending on seasonal demand.
14. Cost-plus pricing – a very basic pricing strategy where a firm sets price equal to unit cost of production plus a margin for profit.

2. Product

Product differentiation is a source of competitive advantage. Product differentiation is the process of describing the differences between a good or service in order to demonstrate the unique aspects of the good or service and create an impression of value in the mind of the consumer.

The major sources of product differentiation include:

1. Vertical differentiation –where products differ in their quality. For example, BMW and Hyundai.
2. Horizontal differentiation – where products differ in features that cannot be ordered. For example, different flavours of ice-cream.
3. Availability – where products are available at different times (e.g. seasonal fruits) and locations (e.g. location of an ice-cream store near the beach). See section 3, “Position/Place”.
4. Perception – branding, sales, and promotion can be used to distinguish a product in the market. See section 4, “Promotion”.

Successful product differentiation leads to monopolistic competition. In a monopolistically competitive market consumers perceive that there are non-price differences between products. As a result, even though there are a large number of producers, each producer has a degree of control over price.

3. Position/Place

The physical location of a good or service can be a source of competitive advantage. For example, imagine we have two ice-cream stores. One ice-cream store (Store A) opens next to a popular tourist beach, and one ice-cream store opens in the backstreets of a quiet suburb (Store B). We expect that Store A will be able to charge a higher price and sell more ice-cream than Store B, other things being equal.

4. Promotion

Promotion is used to enhance the perception of a good or service in the minds of consumers. A promotion will draw peoples attention to any features of a product that people might find attractive including its quality, specialised features, availability, brand name, or image.

Promotion can be carried out in various ways including:

1. advertising (developing brand awareness);
2. publicity (sponsoring a sports team);
3. public relations (donating to charity);
4. celebrity appearances;
5. door to door sales;
6. price discounting (see section 1, “Price”); and
7. quantity discounting (two for one offers, bundling).

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1. Background

Developed around 1978, the 7-S framework first appeared in a book called The Art of Japanese Management by Richard Pascale and Anthony Athos, and also featured in In Search of Excellence by Thomas Peters and Robert Waterman.

McKinsey has adopted the 7-S model as one of its basic analysis tools.

2. Benefits of the 7-S framework

The 7-S framework is a useful diagnostic tool for understanding the inner workings of an organisation. It can be used to identify an organisations strengths and sources of competitive advantage, or to identify the reasons why an organisation is not operating effectively. As such, the 7-S framework is an important analysis framework for mangers, consultants, business analysts and potential investors to understand.

The 7-S framework provides a guide for organisational change. The framework maps a group of interrelated factors, all of which influence an organisation’s ability to change. The interconnectedness among each of the seven factors suggest that significant progress in one area will be difficult without working on the others. The implication of this is that, if management wants to successfully establish change within an organisation, they must work on all of the factors, and not just one or two.

3. McKinsey’s 7-S framwork explained

The 7-S framework describes seven factors which together determine the way in which an organisation operates. The seven factors are interrelated and, as such, form a system that might be thought to preserve an organisation’s competitive advantage. The logic is that competitors may be able to copy any one of the factors, but will find it very difficult to copy the complex web of interrelationships between them.

1. Shared values (also called Superordinate Goals) refer to what an organisation stands for and believes in. This includes things like the long term vision of the organisations, its charitable ideals, or its core guiding principles. For example, the core guiding principle at McKinsey is professionalism.
2. Staff refers to the number and type of people employed by the organisation.
3. Skills refers to the learned capabilities of staff within the organisation.
4. Style refers to the way things are done within the organisation, that is, the work culture.
5. Strategy refers to the plans an organisation has for the allocation of its resources to achieve specific goals.
6. Structure refers to the way in which an organisation’s business units relate to each other. For example, a company may use a centralised system where all key decisions are made at the head office.
7. Systems are the practices and procedures that an organisation uses to get things done, e.g. financial systems, information systems, recruitment and performance review systems, etc.

As a consultant, you will need to ask targeted questions to identify the organisation’s strengths and weaknesses on each of the above factors.

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1. Net Present Value (NPV) explained

The net present value (NPV) of an investment is the present value of the series of cash flows generated by the investment minus the cost of the initial investment. Each cash inflow/outflow is discounted back to its present value and then summed together:

Where t is the time of the cash flow; r is the discount rate (see below for further explanation); Ct is the net cash flow (cash inflow minus cash outflow) at time t; and Co is the cost of the initial investment made at time zero.

NPV is used to analyse the profitability of an investment. As a general rule, assuming you have selected an appropriate discount rate, only those investments that yield a positive NPV should be considered for investment.

2. The discount rate

The rate used to discount future cash flows to their present value is an important variable in the net present value calculation. To some extent, the selection of the discount rate depends on the use to which the NPV calculation will be put.

2.1 Option 1 – cost of capital:

One option that is often used is to use a firm’s weighted average cost of capital.

There are two problems with using the cost of capital for the discount rate. Firstly, it may not be possible to know what the cost of capital will be in the future. One solution to this problem is to use a variable discount rate that increases over time to reflect the yield curve premium for long-term debt. A yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity and is usually upward sloping asymptotically. There are two common explanations for why the yield curve is upward sloping. Firstly, it might be that rising interest rates are expected in the future and investors who are willing to lock their money in now therefore need to receive a higher rate of interest. Secondly, even if interest rates are not expected to rise, longer maturities involve greater risks to an investor and so, to compensate for these inherent uncertainties about the future, a risk premium should be paid.

The second problem with using the cost of capital for the discount rate is that it does not take into account opportunity costs. A positive NPV calculation would tell us that the investment is profitable, but would not tell us whether the investment should be undertaken because there may be more profitable investment opportunities.

2.2 Option 2 – opportunity cost:

A second option is to use a discount rate that reflects the opportunity cost of capital. The opportunity cost of capital is the rate which the capital needed for the project could return if invested in an alternative venture. Obviously, where there is more than one alternative investment opportunity, the opportunity cost of capital is the expected rate of return of the most profitable alternative.

For example, assume that a firm has two investment options, investing in Project A (its existing line of business) or Project B (a new line of business). Based on past experience, the firm knows that it can obtain a 15% return from investing in Project A. This means that the opportunity cost of capital for investing in Project B is 15%. Thus, an NPV calculation for Project B will use a discount rate of 15%.

3. Common pitfalls

3.1 Negative future cash flows:

One potential problem with NPV is that if, for example, the future cash flows are negative (for example, a mining project might have large clean-up costs towards the end of a project) then a high discount rate is not cautious but too optimistic. A way to avoid this problem is to explicitly calculate the cost of financing any losses after the initial investment.

3.2 Adjusting for risk:

Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not necessarily mean that this is a valid way to adjust a net present value calculation. One reason for this is that where a risky investment results in losses, a higher discount rate in the NPV calculation will reduce the impact of such losses below their true financial cost.

3.3 Dealing with negative NPV:

The general rule is that only those investments that yield a positive NPV should be considered for investment. However, this will only be true if we have selected an appropriate discount rate. For example, in the example in section 2.2, if we used a discount rate higher than 15% in the NPV calculation for Project B then obtaining a negative NPV calculation does not necessarily mean that we should reject Project B. Unless we have intellionally chosen a higher discount rate to adjust for the risk of the project, the negative NPV result does give us any useful information.

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Harvard Business School professor Michael Porter, in his 1979 book Competitive Strategy, developed the Porter’s Five Forces.

The Porter’s Five Forces framework is used to determine the competitive intensity and attractiveness of an industry. Attractiveness in this context refers to the overall industry profitability. You can use this framework when introducing a new product, expanding into a new market, divesting a product line, acquiring a new business, or assessing the cause of declining sales or profitability.

In determining the competitive intensity of an industry, Porter’s Five Forces include three forces from ‘horizontal’ competition (1, 2 and 3), and two forces from ‘vertical’ competition (4 and 5):

1. Existing competition: How strong is the rivalry posed by the present competition?
2. Barriers to entry: What is the threat posed by new players entering the market?
3. Substitutes: What is the threat posed by substitute products and services?
4. Supplier bargaining power: How much bargaining power do suppliers have?
5. Customer bargaining power: How much bargaining power do customers have?

1. Competition: How strong is the rivalry posed by the present competition?

The intensity of competition in an industry is affected by various factors, including:

1. The number of firms in the industry, the more firms the stronger the competition because there are more firms competing for the same customers;
2. Slow market growth leads to increased competition because there is only a small number of new customers entering the market each year, firms must compete to win existing customers;
3. Where firms have economies of scale, that is they have relatively high fixed costs and low variable costs, the more they produce the lower their per unit costs become. This results in more intense rivalry between firms as they compete to gain market share;
4. Where customers have low switching costs, this intensifies competition as firms compete to retain their current customers and steal customers from other firms;
5. Low levels of product differentiation between firms leads to increased competition. Where a firm has a strong brand name or a highly differentiated product, this reduces the intensity of competition;
6. Diversity of competition (for example, firms from different countries and cultures) reduces the predictability and stability in the market.  Uncertainty in the market leads firms to compete more agressively, thereby driving down firm profits in the industry;
7. High exit barriers increase competition because firms that might otherwise exit the industry are forced to stay and compete. A common exit barrier is where a firm has highly specialised equipment that it cannot sell or use for any other purpose; and
8. An industry shakeout will result in a short period of intense competition. Where a growing market induces a large number of new firms to enter the market, a point is reached where the industry becomes crowded with competitors. When the market growth rate slows and the market becomes overcrowded, a period of intense competition, price wars and company failures ensues.

2. Barriers to entry: What is the threat posed by new players entering the market?

In theory, any firm should be able to enter a market, however, in reality industries often possess characteristics that prevent new players from entering the market (barriers to entry).  Barriers to entry reduce the rate of entry of new firms, thus maintaining the level of profits for those firms already in the industry.

Barriers to entry may exist for various reasons, including:

1. high capital costs of setting up a business in a particular industry;
2. where an industry requires highly specialised equipment, potential entrants may be reluctant to commit to acquiring specialised assets that cannot be sold or converted into other uses if the venture fails;
3. lack of the proprietary technology or patents that are needed to become a player in the industry;
4. extensive scale and branding of existing competitors may prevent potential entrants from gaining market share and hence deter entry into the market;
5. government regulations: Government may regulate to prevent new firms from entering an industry. It might do this because of the existence of a natural monopoly. A natural monopoly is an industry where one firm is able to produce the desired output at a lower social cost than could be achieved by two or more firms (social costs being the sum of private and external costs). Natural monopolies exist because of the existence of economies of scale, and examples include railways, water services, and electricity; and
6. Individual firms may have economies of scale. The existence of such economies of scale creates a barrier to entry because an existing firm can produce at a much lower cost per unit than a new firm.

3. Substitutes: What is the threat posed by substitute products and services?

Economics defines substitute goods as goods for which an increase in demand for one leads to a fall in demand for the other. In the Porter’s Five Forces framework, a reference to a substitute good refers to a good in another industry. For example, natural gas is a substitute for petroleum.

Good A and good B are substitutes if they can be used in place of one another (at least in some circumstances). The existence of close substitutes constrains the ability of a firm to raise prices and, as the number of substitutes increase, the quantity demanded will become more and more sensitive to changes in the price level (i.e. price elasticity of demand for the product increases).

The threat posed by substitute goods is affected by various factors, including:

1. the cost to customers of switching to a substitute product or service (switching costs). For example, the cost of switching between the Windows operating system and Apple operating system might be prohibitive because computer programs and accessories are built to work with one operating system or the other;
2. buyer propensity to substitute;
3. relative price-performance of substitutes; and
4. perceived level of product differentiation.

4. Supplier bargaining power: How much bargaining power do suppliers have?

Suppliers are providers of the inputs to the industry, for example, labour and raw materials. Factors that will effect the bargaining power of a supplier include:

1. The number of possible suppliers and the strength of competition between suppliers;
2. Whether suppliers produce homogenous or differentiated products;
3. The importance of sales volume to the supplier;
4. The cost to the firm of changing suppliers (switching cost);
5. The presence of substitute inputs; and
6. Vertical integration of the supplier or threat to become vertically integrated. Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers. For example, a car manufacturer may also own a tyre manufacturer.

5. Customer bargaining power: How much bargaining power do customers have?

Customers are the purchasers of the goods or services produced by the company.  Factors that will effect the bargaining power of a customer include:

1. The volume of goods or services purchased. If the customer purchases a significant proportion of output, then they will have a significant amount of bargaining power;
2. The number of customers. The fewer customers there are, the more bargaining power they will have to negotiate price. For example, in America the market for defence equipment is a monopsony, a market in which there are many suppliers and only one buyer. As such, the Department of Defence has strong bargaining power to negotiate the terms of supply contracts;
3. Brand name strength. A product that has a stronger brand name will be able to be sold for a higher price in the market;
4. Products differentiation. A firm that produces a product or service that is unique in some way will have more bargaining power and will be able to charge a higher price in the market; and
5. The availability of substitutes.

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1. Background to the BCG matrix

In 1968, BCG developed the growth share matrix, which is a simple conceptual framework for resource allocation within a firm. The BCG matrix is a 2×2 matrix that considers relative market share and market growth.

2. Purpose of the BCG matrix

The BCG matrix is a management tool that serves several purposes, including to:

1. classify products in a company’s product portfolio into four business types (Stars, Cash Cows, Question Marks, and Dogs);
2. help index a company’s product portfolio according to the cash usage and generation of its products;
3. determine the priority that should be given to different products in a company’s product portfolio; and
4. assist management in developing strategies to tackle various product lines.

3. BCG matrix explained

The idea behind the growth share matrix is that the amount of cash that a product uses is proportional to the rate of growth of that product in the market, and the generation of cash is a function of market share for that product. Money generated from high-market-share/low-growth products is used to develop high-market-share/high-growth products, and low-market-share/high-growth products.

Under the BCG matrix, products are classified into four business types:

1. Stars are leaders in high growth markets. Stars grow rapidly and therefore use large amounts of cash. Stars also have a high market share and therefore generate large amounts of cash. Over time, the growth of a product will slow. So, if a Star maintains a high market share, it eventually becomes a Cash Cow. If not, it becomes a Dog.
2. Cash Cows are highly profitable, and require low investment because they are market leaders in a low-growth market. Growth is slow and therefore cash use is low, and market share is high and therefore cash generation is high. Money generated from cash cows is used to pay dividends, interest, and overheads, and to develop Stars and Question Marks.
3. Question Marks are the real cash traps and gambles. Question Marks grow rapidly and therefore use large amounts of cash. However, they do not have a dominant market position and hence do not generate much cash.
4. Dogs generate very little cash because of their low market share in a low growth market. BCG refers to these products as cash traps. Although they may be sold profitably in the market, Dogs are net cash users and BCG indicates that, in terms contributing to growth, they are essentially worthless.

4. Available strategies

1. Develop: The product’s market share needs to be increased to strengthen its position. Short-term earnings and profits are forfeited because it is hoped that the long-term gains will outweigh these short term costs. This strategy is suited to Question Marks if they are to become Stars.
2. Hold: The objective is to maintain the current market share of a product. This strategy is often used for Cash Cows so that they continue to generate large amounts of cash.
3. Harvest: Under this strategy, management attempts to increase short-term cash flows as far as possible (e.g. by increasing prices, and cutting costs) even at the expense of the products long-term future. It is a strategy suited to weak Cash Cows or Cash Cows that are in a market with a limited future. Harvesting is also used for Dogs, and for Question Marks that have no possibility of becoming Stars.
4. Divest: The objective of this strategy is to get rid of unprofitable products, or products with a low market share in a low growth market. Money from divestment can then be used to develop and promote more profitable products. This strategy is typically used for Question Marks that will not become Stars and for Dogs.

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1. SWOT analysis explained

Albert Humphrey is credited with inventing the SWOT analysis technique.

SWOT analysis is a strategic planning tool used to evaluate the strengths (S), weaknesses (W), opportunities (O), and threats (T) involved a business venture. It involves specifying the objective of the business venture and identifying the internal and external environmental factors that are expected to help or hinder the achievement of that objective.

After a business clearly identifies an objective that it wants to achieve, SWOT analysis involves:

1. examining the strengths and weaknesses of the business (internal factors); and
2. considering the opportunities presented and threats posed by business conditions, for example, the strength of the competition (external factors).

By identifying its strengths, a company will be better able to think of strategies to take advantage of new opportunities. By identifying current weaknesses and threats, a company will be able to identify changes that need to be made to improve and protect the value of its current operations.

2. Criticisms

SWOT analysis has two clear weaknesses. Firstly, using SWOT may tend to persuade companies to write lists of Pros and Cons, rather than think about what needs to be done to achieve objectives. Secondly, there is the risk that the resulting lists will be used uncritically and without clear prioritisation. For example, weak opportunities may appear to balance strong threats.

3. Case example: drinks manufacturer

Let’s use SWOT analysis to consider the strategy of a hypothetical prominent soft drinks manufacturer called Coca-Cola. Coke is currently the market leader in the manufacture and sale of sugary carbonated drinks and has a strong brand image. Sugary carbonated drinks are currently an extremely profitable line of business. The company’s goal is to develop strategies to achieve sustained profit growth into the future.

3.1 Strengths

A firm’s strengths are its resources and capabilities that provide the firm with a competitive advantage in the market place, and help the firm achieve its strategic objective. Coke’s strengths might include:

• strong product brand names,
• large number of successful drink brands,
• good reputation among customers,
• low cost manufacturing, and
• a large and efficient distribution network.

3.2 Weaknesses

Weaknesses include the attributes of a business that may prevent the business from achieving its strategic objective. Coke’s weaknesses might include:

• lack of a large number of healthy beverage options, and
• large manufacturing capacity makes it difficult to change production lines in order to respond to changes in the market.

3.3 Opportunities

Changing business conditions may reveal certain new opportunities for profit and growth. Coke’s opportunities might include:

• new countries and markets that Coke might expand into, and
• a lack of any strong global fruit juice or other healthy beverage manufacturer leaves a gap in the market.

3.4 Threats

Changing business conditions may present certain threats. Coke’s threats might include:

• shifting consumer preferences away from Coke’s core products, and
• new government competition regulations that prevent the acquisition of large competing soft drink companies.

3.5 Proposed strategy

The main opportunity for Coca-Cola is the rising popularity of healthy beverage alternatives, such as water and fruit juice. The dominance of Coca-Cola and the increasing number of competition regulations that prevent Coke’s acquisition of competing drink manufacturers presents a threat to Coke’s objective to obtain profit and growth. A proposed strategy may therefore be to find small healthy beverage manufacturers with quality products. Purchasing these small companies will not raise competition concerns. Coke might use its strong brand name, manufacturing capacity and distribution networks to obtain strong market penetration for its newly acquired healthy beverages.

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Note: Thank you to Mimi Zou for bringing this analysis framework to my attention.

1. Background

MECE is one of the hallmarks of problem solving at McKinsey (The McKinsey Way by Ethan M. Rasiel). McKinsey consultants use the MECE framework when trying to think clearly about a business problem. Victor Cheng, former McKinsey consultant and creator of CaseInterview.com, indicates that:

The definitive book on this subject is the Pyramid Principle by Barbara Minto. It’s a book that describes an approach to communicating complex ideas in easy to understand ways. It is based on the MECE Principles and was a book often referred to and used while I was at McKinsey. (Note it’s a pricey book at $150/copy)

2. Benefit of the MECE framework

The MECE framework is a useful model for analysing a business problem because it aids clear thinking by ensuring that categories of information do not overlap, and by reducing the possibility of overlooking information by requiring that all of the categories of information taken together should deal with all possible options.

3. MECE explained

MECE is a principle which is used to organise information which is mutually exclusive and collectively exhaustive. Information should be grouped into categories so that each category is separate and distinct without any overlap (mutually exclusive), and all of the categories taken together should deal with all possible options (collectively exhaustive).

McKinsey’s MECE framework can be applied to a lot of different business problems, for example, “what is the source of Coca-Cola’s declining global profitability?”.

Coca-Cola could use a MECE tree diagram to help them locate the source of declining profitability.  The diagram as a whole represents the problem at hand; each branch stemming from the starting node of the tree represents a major issue that needs to be considered; each branch stemming from one of these major issues represents a sub-issue that needs to be considered; and so on.

According to Ethan Rasiel, a major issues list should not contain more than five issues, with three being the ideal number. If you are not able to categorise a problem in 5 major issues there is always the option of creating a category of “other issues”.

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In your consulting case interview you will most likely be required to make a recommendation on a hypothetical business problem. Understanding how to use the cost benefit analysis could come in handy.

Incidentally, I think I should explain my choice of photo for this article. I strongly oppose the use of drugs, especially cocaine. However, if you live in a big  city (or not-so-big city, as the case may be) you probably have friends or at least know a few people who take drugs. But for me it goes further than that. On more than a few occasions I have engaged in impassioned arguments with certain of my lovely but misguided friends and been forced to defend my position against the use of illegal drugs. To avoid getting all philosophical about it, which is where my arguments against hedonistic behaviour usually go, suffice to say that from a long term perspective the temporal, fleeting and transitory pleasures of drug taking, which certain of my friends like to refer to as “benefits”, are significantly outweighed by the resulting costs and implications.  But I digress …

The cost benefit analysis

One of the most basic analysis frameworks you can use to solve a business problem is the “cost-benefit analysis”. This method is fairly self-explanatory. It involves weighing up the total expected costs and benefits of one course of action against another. Having done this, you will be able to formulate a more well-thought-out solution to the business problem.

For example, consider the following business problem (Project Gold Mine). Your client says to you, “Currently we run a single gold mine (Mine A) and are trying to decide whether we should expand Mine A or build a second mine (Mine B). Which project should we undertake?” In this problem there are three possible recommendations: (1) expand Mine A, (2) build Mine B, or (3) do nothing (i.e. maintain the status quo). To make a recommendation, you will need to consider the benefits and costs of each course of action.

Evaluating the benefits

In considering the benefits, you will mainly want to think about revenue (Revenue=quantity x price); more on this in a later post.

Counting the cost

As far as I’m aware, there are four types of costs that you need to pay attention to: sunk costs, fixed costs, variable costs, and opportunity costs. I will consider them in turn.

1. Sunk costs

Sunk costs are expenditures that have already been made and cannot be recovered. As such, sunk costs should not be factored into your decision-making process. For example, in Project Gold Mine the original cost of building Mine A is a sunk cost. This money has already been spent and cannot be recovered, it is therefore a sunk cost, and should not be factored into the decision-making process.

2. Fixed costs

Fixed costs are costs that do not vary with the quantity of output produced. In the Project Gold Mine example, fixed costs might include things like rent, land taxes, utilities and other overheads.

It is important to understand that fixed costs are fixed only in the short term. In the short term, the cost of labour may be a fixed cost if the mining company cannot vary the number of employees due to contract obligations. In the long run, these contracts can be renegotiated. In the long run, nearly all costs are variable, even things like rent, because the mining company could move its operations overseas to a country where operating costs are lower.

3. Variable costs

Variable costs are costs that vary with the quantity of output produced. In the Project Gold Mine example, the main variable costs would be the cost of extracting the ore from the ground, and the cost of transportation.

When making decisions in the short run, variable costs are the only costs that should be considered because, in the short term, a company cannot change its fixed costs.

4. Opportunity costs

The opportunity cost of an item is what must be given up to obtain that item.

In the Project Gold Mine example, failing to consider opportunity costs could lead to the wrong decision being made. Consider the following hypothetical:

If the mining company expands Mine A the profit is $1 million, and if it builds Mine B the profit is $2 million. Which project should it undertake? Building Mine B is the more profitable of the two projects; however, the company also needs to consider the opportunity cost of building Mine B. In this hypothetical example, the profit obtained from not undertaking either project is $3 million. So, although building Mine B is the most profitable project, doing nothing is even more profitable.

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