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.
- 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.
- Staff refers to the number and type of people employed by the organisation.
- Skills refers to the learned capabilities of staff within the organisation.
- Style refers to the way things are done within the organisation, that is, the work culture.
- Strategy refers to the plans an organisation has for the allocation of its resources to achieve specific goals.
- 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.
- 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.
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.
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):
- Existing competition: How strong is the rivalry posed by the present competition?
- Barriers to entry: What is the threat posed by new players entering the market?
- Substitutes: What is the threat posed by substitute products and services?
- Supplier bargaining power: How much bargaining power do suppliers have?
- 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:
- The number of firms in the industry, the more firms the stronger the competition because there are more firms competing for the same customers;
- 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;
- 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;
- Where customers have low switching costs, this intensifies competition as firms compete to retain their current customers and steal customers from other firms;
- 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;
- 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;
- 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
- 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:
- high capital costs of setting up a business in a particular industry;
- 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;
- lack of the proprietary technology or patents that are needed to become a player in the industry;
- extensive scale and branding of existing competitors may prevent potential entrants from gaining market share and hence deter entry into the market;
- 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
- 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:
- 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;
- buyer propensity to substitute;
- relative price-performance of substitutes; and
- 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:
- The number of possible suppliers and the strength of competition between suppliers;
- Whether suppliers produce homogenous or differentiated products;
- The importance of sales volume to the supplier;
- The cost to the firm of changing suppliers (switching cost);
- The presence of substitute inputs; and
- 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:
- 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;
- 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;
- Brand name strength. A product that has a stronger brand name will be able to be sold for a higher price in the market;
- 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
- The availability of substitutes.
This post, part 4, considers the principles developed by Sun Tzu on strategies for effective leadership. It is the 4th and final part in a series looking at how Sun Tzu’s military precepts provide a timeless guide to modern business leadership. Part one looked at the qualities of successful leaders. Part two considered principles for organising your business affairs. Finally, part three considered the principles for dealing with business rivals.
I have summarised Sun Tzu’s principles into four simple categories:
- Qualities of a successful leader;
- Organising your business affairs;
- Dealing with rivals; and
- Strategies for effective leadership.
4. Strategies for effective leadership
4.1 Create a common philosophy
Marc Benioff, CEO of salesforce.com says that “to be truly successful, companies need to have a corporate mission that is bigger than making a profit…By integrating philanthropy into [the] business model … employees feel that they do much more than just work at [the] company.
He will win whose army is animated by the same spirit throughout all its ranks.
4.2 Foster co-operation
In order to be successful in business it is important to have many experienced employees working together in co-operation.
Adam Smith was the earliest to report the merits of specialization and cooperation some 230 years ago. He compared the output of a Scottish farmer working alone to make pins for his wife with a French pin factory’s daily production. The factory employed experienced specialists, equipped them with the latest tools and organized them to work cooperatively to produce pins. The factory turned out hundreds of times more pins per specialist per day than the farmer working alone. Moreover, the factory-made pins surpassed the farmer’s pins in terms of quality and consistency.
If two armies will help each other in a time of common peril, how much more should two parts of the same army, bound together as they are by every tie of interest and fellow-feeling. Yet it is notorious that many a campaign has been ruined through lack of co-operation…
4.3 Maintain good communication
Being well informed is the only way to make good decisions. Make sure that you have access to the latest information on who is doing what in your organization.
…the commander whose communications are suddenly threatened finds himself in a false position, and he will be fortunate if he has not to change all his plans, to split up his force into more or less isolated detachments, and to fight with inferior numbers on ground which he has not had time to prepare…
4.4 Pick your men carefully
A leader must use the skills of his employees to best advantage by using the right man in the right place.
The skilful employer of men will employ the wise man, the brave man, the covetous man, and the stupid man. For the wise man delights in establishing his merit, the brave man likes to show his courage in action, the covetous man is quick at seizing advantages, and the stupid man has no fear of death.
4.5 Control your men with kindness and discipline
If [subordinates] are punished before they have grown attached to you, they will not prove submissive; and, unless submissive, they will be practically useless. If, when [your subordinates] have become attached to you, punishments are not enforced, they will still be useless. Therefore [subordinates] must be treated in the first instance with humanity, but kept under control by means of iron discipline.
Bestow rewards without regard to rule, issue orders without regard to previous arrangements; and you will be able to handle a whole army as though you had to deal with but a single man.
4.6 Set up a dependable systems of reward and punishment
People respond to incentives, this is one of the first lessons learnt in Microeconomics 101. As such, it is important to encourage good behaviour and discourage poor behaviour with an appropriate system of reward and punishment.
…that there may be advantage from defeating the enemy they must have their rewards.
4.7 Do not micro-manage your subordinates
The art of giving orders is not to try to rectify the minor blunders and not to be swayed by petty doubts. Vacillation and fussiness are the surest means of sapping the confidence of a [company].
4.8 Foster a spirit of enterprise
Encourage your employees to be industrious and hard working.
Unhappy is the fate of one who tries to win his battles and succeed in his attacks without cultivating the spirit of enterprise for the result is waste of time and general stagnation.
Part 3 of 4 considers the principles developed by Sun Tzu for dealing with business rivals and follows on from part one which looked at qualities of successful leaders, and part two considered the principles for organising your business affairs.
I have summarised Sun Tzu’s principles into four simple categories:
- Qualities of a successful leader;
- Organising your business affairs;
- Dealing with rivals; and
- Strategies for effective leadership.
3. Dealing with rivals
3.1 Employ experts and consultants
When operating in a foreign country it is important to seek the advice of local experts so that you can best take advantage of local laws and natural advantages. When operating in an unfamiliar industry, employ consultants to provide specialized knowledge on the industry and the competition.
Know your [competition], know yourself and you can fight a hundred battles without disaster…
3.2 Use spying, deception and bluff
Donald Krause, consultant and author of The Art of War for Executives
, believes that people whose scruples do not include spying and appropriate levels of deception will not be very successful in business or politics.
Spies are a most important element in [business], because on them depends a [company]’s ability to [act].
Do not publicly release definite business plans.
The spot where we intend to fight must not be made known for then the enemy will have to prepare against a possible attack at several different points.
Release confusing, incorrect or contradictory reports to the media. Your competitors will not know what you are planning to do, and they will not be able to prepare accordingly.
All [business] is based on deception…when able to [release a new product], we must seem unable; when using [much energy], we must seem inactive…If your [competitor] is of choleric temper, seek to irritate him. Pretend to be weak, that he may grow arrogant.
3.3 Understand the motivation of your allies
We cannot enter into alliance with [other companies] until we are acquainted with their designs.
3.4 Attack your competitor’s reputation
Donald Krause, author of The Art of War for Executives, says “…personal attacks are frequently used in business situations when more logical methods might fail. The person using the personal attack tactic is usually the one operating from the weaker position. Personal attacks are particularly effective in environments where performance is subordinated to personality. … I have found that Sun Tzu’s description of the ideal circumstances for a personal attack, as I interpreted the fire attack section, work excellently in real life.”
3.5 Poach customers and employees
Poaching a highly trained senior employee from one of your competitors is equivalent to training twenty of your own. Some of your juniors will leave you, some will prove useless, and some will be unsuccessful for other reasons. You will need to train ten juniors in order to create one senior employee; your competitor must do the same.
…a wise general makes a point of foraging on the enemy. One cartload of the enemy’s provisions is equivalent to twenty of one’s own, and likewise a single picul of his provender is equivalent to twenty from one’s own store…Because twenty cartloads will be consumed in the process of transporting one cartload to the front.
