140. Marketing Finance

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MarketingFinance

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MarketingFinance Turningmarketingstrategies intoshareholdervalue KeithWard AMSTERDAM BOSTON HEIDELBERG LONDON NEWYORK OXFORD PARIS SANDIEGO SANFRANCISCO SINGAPORE SYDNEY TOKYO

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ElsevierButterworth-Heinemann LinacreHouseJordanHillOxfordOX28DP 200WheelerRoadBurlingtonMA01803 Firstpublished2004 Copyright©2004KeithWard.Allrightsreserved TherightofKeithWardtobeidentifiedastheauthorofthiswork hasbeenassertedinaccordancewiththeCopyrightDesignsand PatentsAct1988 Nopartofthispublicationmaybereproducedinanymaterialformincluding photocopyingorstoringinanymediumbyelectronicmeansandwhether ornottransientlyorincidentallytosomeotheruseofthispublicationwithout thewrittenpermissionofthecopyrightholderexceptinaccordancewiththe provisionsoftheCopyrightDesignsandPatentsAct1988orunderthetermsof alicenceissuedbytheCopyrightLicensingAgencyLtd90TottenhamCourtRoad LondonEnglandW1T4LP.Applicationsforthecopyrightholder’swritten permissiontoreproduceanypartofthispublicationshouldbeaddressed tothepublisher PermissionsmaybesoughtdirectlyfromElsevier’sScienceand TechnologyRightsDepartmentinOxfordUK:Phone:+4401865843830 fax:+4401865853333:e-mail:permissionselsevier.co.uk. Youmayalsocompleteyourrequeston-lineviatheElsevierhomepage http://www.elsevier.combyselecting‘CustomerSupport’andthen ‘ObtainingPermissions’ BritishLibraryCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheBritishLibrary LibraryofCongressCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheLibraryofCongress ISBN0750657707 TypesetbyIntegraSoftwareServicesPvt.LtdPondicherryIndia www.integra-india.com PrintedandboundinGreatBritain ForinformationonallElsevierButterworth-Heinemannpublications visitourwebsiteatwww.bh.com

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Contents Preface xi PartOne:Overview 1 1 CreatingRealShareholderValue 3 Overview 3 Introduction 4 Afocusonshareholdervalue 8 Riskandreturn 9 Makingaprofitisnotgoodenough 11 Creatingmarketingassets 17 Definingshareholdervalue 22 Creatingsustainableandrealshareholdervalue 25 Consideringbothbusinessandfinancialrisk 26 Note 29 2 TheVirtuousCircleofAnalysisPlanningandControl 30 Overview 30 Introduction 32 Astrategicmarketingfinanceapproach 33 Thefinancialplanningandcontrolprocess 39 Brand-ledstrategies 47 Customer-ledstrategies 48 Product-basedstrategies 50 Casestudy–RudolphandtheElves 52 Discussionofproblem 53 PartTwo:AnalysisandDesign 59 3 TheStrategicManagementProcess:SettingGoals andObjectives 61 Overview 61 Introduction 62

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vi Contents Missiongoalsandobjectives 65 Multilayeredstrategicmanagementprocess 69 Corporatecentres 74 Casestudy–therisefallandriseofIBM 77 TheriseofIBM 77 Thefallstage 78 Thesecondrising 79 Strategicanalysis 81 Verticalintegration 84 Multinationalsandrisk-takingappetites 87 Casestudy–multinationalstrategies 88 Overseasinvestments 88 Cross-bordersourcingdecisions 90 Strategicopportunity 94 4 FutureCompetitiveEnvironmentReview–Competitor Analysis 97 Overview 97 Introduction 98 Definingthecompetition 100 Competitoranalysisasadecision-makingaid 103 Competitoranalysisasatwo-stageprocess 104 Agametheoryviewoftheindustryvaluechain 110 Detailedbuttailoredanalysis 115 Sourcesofcompetitorinformation 117 Casestudy–MarlboroFriday 118 Marketbackground 119 UnderstandingPhilipMorris 121 Thepricereaction 122 Competitorreactions 124 Theresultingimpact 125 5 ExistingPositionAppraisal 128 Overview 128 Introduction 129 SWOTanalysis 130 Casestudy–exampleofaSWOTanalysis 132 Othertechniques 135 Casestudy–petrolretailing–isitpartoftheretailing oroilindustries 137 Background 137 Strategicanalysis 139 Productlifecycles 142

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Contents vii Casestudy–EbenezerScroogemeetsMiserShylock 145 Caseanalysis 146 PartThree:Planning 151 6 ThePlanningProcess 153 Overview 153 Introduction 154 Corporatevalues 157 Gapanalysisandcontingencyplanning 161 Anintegratedprocess 165 Strategicplanninglevels 167 Top-downversusbottom-up 170 Morethanabudget 172 Casestudy–KnightFoods 174 Background 174 Cannedmeatproducts 174 Thesustainablecompetitiveadvantage 175 Post-launchdevelopment 176 7 StrategicInvestmentEvaluationandControl 179 Overview 179 Introduction 180 Paybackperiod 182 Discountedpayback 184 Discountedcashflows 185 Accountingreturnoninvestment 189 Apersonalapproachtostrategicinvestmentevaluation 190 Practicalimplementationissues 191 Probabilityestimates 194 Realoptions 199 Realoptionexample 203 Casestudy–PeterPiperispuzzled 207 ProjectA 207 ProjectAanalysis 208 ProjectB 209 ProjectBanalysis 210 ProjectC 211 ProjectCanalysis 213 8 Brand-BasedStrategies 215 Overview 215 Introduction 216

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viii Contents Brandsasintangibleassets 219 Realisingtheassetvalue 220 Branddevelopment 222 Developmentversusmaintenanceexpenditures 227 Brandattributes 230 Brandevaluationprocess 236 Anoverallperspective 239 Casestudy–PhilipMorrisversusBATplc 239 9 Customer-LedStrategies 241 Overview 241 Introduction 242 Marketingsegmentation 243 Customeraccountprofitabilityanalysis 247 Relationshipmarketing 250 Customervalue 253 Customerlifecycleprofitabilityanalyses 254 Casestudy–DMConfectioneryLtd 259 Background–Theoriginalbusiness 259 Thenewbusinessopportunity 259 10 Product-BasedStrategies 262 Overview 262 Introduction 263 Directproductprofitability 265 Productattributes 268 Productlifecycleprofitabilityanalysis 270 Penetrationversusskimmingpricingstrategies 275 Crosssubsidisation 276 Reinvestingtoreplaceanexistingcompetitiveadvantage 277 Strategicuseofstandardcosting 279 Casestudy–Sub-assemblersInc. 282 Transferpricing 285 Casestudy–TissuesUnlimited 285 PartFour:Control 291 11 ExercisingControlovertheFuture 293 Overview 293 Introduction 294 Integratingcontrolintotheplanningprocess 300 Impactoforganisationalstructure 303 Criticalsuccessfactorsofamarketingfinanceprocess 304

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Contents ix Arapidlychangingcompetitiveenvironment 308 Casestudy–McDonald’s 316 Background 316 Strategicanalysis 317 12 EstablishingPerformanceMeasures 320 Overview 320 Introduction 321 Newperformancemeasures 322 Accountabilityandcontrollability 325 Keyperformanceindicators 330 Tailoredfinancialcontrolmeasures 334 Casestudy–Coca-ColaInc. 340 Background 340 Strategicanalysis 342 Index 344

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Preface The objective of this book is to place marketing finance clearly within the context of the marketing strategy of a business. Strategic management for the vast majority of commercially focused companies is aimed at creating shareholder value. Nowadays the creation of shareholder value for most of thesecompaniesiscentredaroundtheirmarketingstrategies.Thisshouldmean that great emphasis is placed upon ensuring that these critically important marketingstrategiesdoinrealitycreateshareholdervalue. Unfortunately for many companies developments in both information technologyandmanagementaccountinghaveledtoanincreasinggapbetween the marketing strategies and the management accounting systems used within thesecompanies.RelativelyrecentlyIhavebeenencouragedbytheintroduc- tionintoseveralleadingcompaniesof‘marketingfinancemanagers’typically these were financially trained managers who were physically moved to work alongside their marketing colleagues. In some cases this role has been inter- preted as ‘accounting for marketing’ which means deciding how to code up themarketingdirector’sexpenseclaimsoitcanbepostedtothegeneralledger Thisisnotmarketingfinanceasitisdealtwithinthisbook. The book does not attempt to deal comprehensively with all the detailed aspectsofmarketingstrategiesmarketingplanningetc.thesehaveeachbeen thesubjectofmanybooksalready.Neitheristhisabookondetailedaccounting rules financial accounting standards etc.. It deliberately tries to sit in the middle exactly where the true marketing finance manager should sit however asyouwillrealiseasyoureadthebooksittinginthemiddleisnotthesameas ‘sittingonthefence’.Ihavestrongviewsonmostissuesrelatingtomarketing finance and these are clearly expressed in the body of the book. These views have developed over the 30 years that I have spent being deeply involved in theinterfacebetweenmarketingstrategyandfinance. Theessentialroleforfinancialevaluationandcontrolaspartofthemarketing planning process is now accepted by leading companies and in some cases the marketing finance manager works closely with the marketing research team to help develop a much more ‘fact’ based marketing strategy. For many companies particularly in the fast moving consumer goods industries this processstartedbymeasuringandmanagingbrandvaluesbutthelatestareaof

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xii Preface focusisoncustomerrelationships.Howeverformanycompaniesthemarketing strategy is still product based therefore each of these strategic thrusts is con- sideredindetail. The book is structured around the analysis planning and control concept that underpins strategic management marketing planning and management accounting. However when properly applied in practice these separate phases becomesomewhatblurredandoverlappingthereforeitisnorealsurprisethat the same has happened to the structure of the book. It seemed silly to talk about a brand evaluation process or valuing customer relationships without at thesametimeconsideringhowtocontrolsuchamarketingstrategy. Hopefully the book will stimulate some new thinking by both marketing andfinancepractitionersabouthowmarketingfinanceshouldbeimplemented. Myaimwasneithertoturnaccountantsintomarketingmanagersnorviceversa. Afterallnastydefinitionscanbeappliedtobothbytheotherside:anaccountant issomeone‘whoknowsthecostofeverythingandthevalueofnothing’while amarketingmanagerissomeone‘whoovervalueseverythinganddoesn’tcare aboutthecost’.Ifamarketingfinancemanagercansitinthemiddlebyunder- standing both shareholder value and customer value as well as the right costs totakeintoconsiderationforeachstrategicmarketingdecisionthenitwillbe atrulyvalue-addingroleinanybusiness. I sincerely hope that the effort involved in writing this book proves worth- while by providing you the reader with benefits that also outweigh the cost incurred in buying it. I would like to thank my wife Angela for doing all the figuresandmylong-timesecretarySheilaHartforcomingoutofretirement totypethetextshecanatleastreadmyhandwriting. KeithWard

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PartOne Overview

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1 CreatingRealShareholder Value Overview The overriding aim of a company is to create value for its shareholders on a sustainablebasisoverthelongterm.Inordertocreatethisvaluethecompany hastodevelopandthenexploitoneormoresustainablecompetitiveadvantages whichwillallowittoearnsuperprofitsonacontinuingbasis. Most modern sustainable competitive advantages are the result of the suc- cessful implementation of marketing strategies e.g. brand building customer loyaltydevelopmentmarketsegmentation.Thesemarketingstrategiesnorm- allyrequiresignificantlong-termupfrontinvestmentswhichmustberegarded as high-risk expenditures by the business because if they do not work the expenditureisoftenirrecoverable. It is therefore vitally important that these strategic marketing investments are rigorously financially evaluated prior to their commitment and properly financiallycontrolledduringtheireconomiclives.Thiscanonlybeeffectively achievedbyanintegratedmarketingfinanceapproach.Ifhoweverthesemar- keting strategies are very successful they can create the most valuable assets ownedbymostmodernbusinesseswhicharerepresentedbyintangiblessuch as brands marketing knowledge regarding customers and channels technical know-how patents and licenses. These intangible assets can produce very high ratesofreturn formanyyearsiftheyaremanagedproperly.Thereforea strategicallyorientedmarketingfinancesystemisneededtoevaluateandcon- troltheseassetsifthebusinessistooptimisetheshareholdervaluegenerated. Real shareholder value is created by earning on a sustainable basis a rate of return exceeding the risk-adjusted required rate of return for any particular business. This can be measured in several interrelated ways: as the net present value of the future expected cash flows from the business using the required rate of return as the discount rate as the economic profit or residual income earned in a particular year this is the excess return over the required rate of returnforthebusinessinthatyearasthetotalshareholderreturnachievedby the investors in the company on an annual basis this is the total of any divi- dendyieldreceivedfromthecompanyplusorminusthemovementintheshare priceduringtheyear.

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4 MarketingFinance The total shareholder return is the only truly externally based measure of value creation but if it is not backed up by the internally focused value mea- surestheshareholdervaluecreationmaynotprovetobesustainable.Thishas beenclearlydemonstratedbythespectacularbutpainfullyshort-livedboomin telecom media and technology share prices at the end of the 1990s. Massive but very speculative increases in these share prices with correspondingly massive capital gains to their shareholders were very rapidly followed by even more spectacular falls in many of these share prices as it became clear that most of these companies were simply not capable of delivering even in the long term the levels of return on which their high share prices had been based. If real shareholder value creation is to be sustained over the long term the criticalmarketingassetsmustbefullydevelopedandthenproperlymaintained over their economic lives. A sensible approach in marketing finance is there- fore to distinguish between development and maintenance marketing expend- ituresastheirobjectivesaresignificantlydifferent.Theobjectiveofdevelopment marketing expenditure is to create a valuable long-term asset and hence the returnsfromthistypeofinvestmentwillbereceivedovertheeconomiclifeof theasset.Converselymaintenancemarketingexpenditureisdesignedtokeep theexistingmarketingassetsintheirpresentvaluablecondition.Consequently the returns are much more short term and it can be argued that the failure to spend adequately on maintenance is often reflected very rapidly in declining salesrevenuesandprofitstreams. Introduction At present many businesses feel themselves under attack from several sides. On one hand investors often complain that their ‘financial returns’ generated from investmentsinthese businesses are woefully inadequate while financial markets and their regulators are becoming paranoid about the validity of the financialresultsbeingdisclosedbylargecompanies.Ontheotherhandenvir- onmental groups and even consumer associations are vociferously complain- ingthatcommercialcorporationsareachievingexcessiveprofitsattheexpense of the environment and/or by cynically exploiting their consumers. These businesses may also feel oppressed by excessive government interference many small businesses feel severely constrained by an increasing burden of government-imposedregulationswhilemultinationalcorporationsfaceincreas- ingly zealous tax authorities seeking to set aside their internal groupwide transferpricingarrangements. Insidethesebusinessesthereisalsogreatpressureforchangeandacorres- pondingly high level of stress and potential for conflict within the organisa- tion. Marketing departments are increasingly being challenged to justify their expenditurelevelsintermsof‘economicaddedvalue’growthinsalesvolumes

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CreatingRealShareholder Value 5 sales value or even market share is no longer a sufficient justification for an increaseinthisyear’smarketingbudget.Indeedsomecompaniesdonotseem able to identify specific links between most of their marketing activities and their long-term strategic objectives in such circumstances it is not surprising thatthemarketingbudgetisbeingevermorerigorouslychallenged. Similarly many finance and accounting departments are also struggling to define their future role within the new business paradigm. The staggering increases in the potential both for automating routine transaction processing and also for outsourcing to specialist suppliers the remaining workload has transformed the role of internal finance personnel. They are being challenged to change not only their focus but also their organisational structures. The strategic challenge for finance is to move from a transaction processing and managementreportingfocuslocatedontheperipheryofaverticallystructured functionallybasedorganisationtoastrategicdecisionsupportfocusintegrated within the key horizontal business processes of the new twenty-first century organisation. Nowhere is this challenge more important than in the interface between marketing and finance. In many businesses the marketing and finance func- tions can often find themselves in apparent direct conflict often due to a lack of the close working relationship which finance has developed with other areas of the business notably operations and production. Indeed it can be the case in some companies that marketing managers feel that the main interest of their financial colleagues is to stop them spending money. Conversely it can appear to these finance managers that the principal objective of their marketing colleagues is to spend as much money as possible on increasingly esotericadvertisementsveryexpensivetradeandconsumerpromotionshigher customerdiscountsetc. This conflict can be disastrous for the business as increasingly the long- term sources of value creation result from the successful implementation of marketing strategies. For many industries simply controlling the production side of the supply chain is no longer a sufficient condition to achieve long- term value creation. Indeed many businesses are deliberately exiting from the actual production of the products that they sell as they see this business process as distracting their focus from the real sources of added value. These marketingledsourcesofvaluecreationincludemarketsegmentationbranding customer loyalty and strategic partnering with selected channels of distribu- tion. Clearly if the business is to achieve its long-term objectives in this type of competitive environment it is essential that its marketing expenditures are welldirectedandeffectivelycontrolled. Such effective control can only be exercised if the marketing and finance areas work together in one integrated partnership. A significant challenge facing the finance function in many businesses therefore involves changing their perceived involvement in marketing activities from that of a cost-adding

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6 MarketingFinance constrainttothatofavalue-addingenablingpartner.Inanincreasingnumber ofbusinessesthisisbeingachievedbycreatingtherolesofmarketingfinance managers who are physically located in the marketing area and are seen as part of the marketing management team. As such they should automatically beinvolvedin thedevelopmentofthemarketingstrategyitsimplementation subsequent modification and ongoing control. Ideally they will share several management performance measures with their marketing colleagues yet they haveaclearfinancialresponsibilitytoremainobjectiveintheirfinancialevalu- ationsofproposedmarketingexpenditures. Whetherornotaparticularbusinessadoptsthismarketingfinancemanager rolethisbookarguesforaverycloselyintegratedlinkbetweenmarketingand finance. In far too many businesses the marketing strategy and the financial plan are like a bad jointly composed musical. The music is composed by one party and the words are written completely separately by another person then and only then the two are put together The words of the marketing strategy can often seem to bear no relevance to the financial numbers in the business plan. Even more scarily for investors there sometimes seems to be no marketing-based explanation for the actual financial performance of the company that is revealed to the world’s capital markets in the company’s publishedfinancialstatements. A marketing finance approach requires a financial involvement in at least two closely related but distinct aspects of marketing activities. Prior to the actual commitment by the organisation to spend money a rigorous financial evaluation should be carried out. This is because true financial control can only be exercised in advance of any legally binding financial commitment oncecommittedthebusinesswillincurcancellationchargesorevenhaveto pay the full cost if it changes its mind. This financial evaluation compares the proposed expenditure against the potential benefits taking into account the risks involved in the particular activity. This evaluation should include any other potential ways of achieving these particular objectives of the business. Thefinancialevaluationprocessshouldalsoindicatehowthesuccess/failure of the expenditure can be assessed and how quickly this assessment can be made. It may be possible to improve the overall probability of success before having to commit the majority of the expenditure this may be achieved by undertakingmarketingresearchactivity.Thisrisk-reducingtype ofmarketing expenditureshoulditselfbeevaluatedfinanciallyandanyearlywarningindi- cators of success/failure should be identified. Any marketing activities where such early warning indicators can be identified are significantly lower risk than those where ‘success’ can only be assessed after all the expenditure has been incurred. If the initial expenditure has clearly failed the business can avoid incurring the rest of the already doomed expenditure as long as early andeffectivefinancialcontrolshavebeenidentified.

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CreatingRealShareholder Value 7 Marketing finance can therefore be regarded as two interrelated processes offinancialevaluationandcontrolandtheseprocessesaredevelopedthrough- outthebook.Muchofthechallengerelatestoputtingfinancialvaluestowell- established marketing activities and objectives. Within the marketing area many specific control measures have been developed to evaluate and control awiderangeofmarketingactivities.Indeeddifferentmarketingobjectivesare achieved by very specifically aimed marketing techniques. Unfortunately far toooftentheseverydifferentmarketingapproachesarefinanciallycontrolled using a single financial measure which is consequently often inappropriate. A keyobjectiveofthisbookistohighlighthowappropriatelytailoredfinancial measurescanbeusedwhenamarketingfinanceapproachisimplemented. This is exacerbated because the most common financial performance measures consider the efficiency with which the activity has been carried out rather than the effectiveness with which it has achieved its pre-determined objectives. An example using advertising expenditure may make this clearer. The‘efficiency’ofpurchasingmediaadvertisingwhetherTVairtimenewspaper space etc. can be measured in terms of the ‘cost per thousand’ potential customersreachedbythecampaign. EFFICIENCYISDOINGTHINGSRIGHT EFFECTIVENESSISDOINGTHERIGHTTHINGS However such an efficiency-focused measure says very little about how ‘effective’ the advertising expenditure was in terms of achieving its pre- determined objectives. The specific marketing objectives for this advertising campaign could range from creating brand awareness through changing the attitudesofpotentialcustomersorstimulatingtrialbynewcustomerstoincreas- ing the rate of usage by existing customers – each of which would probably useadifferentstyleofadvertisingcommunication. In marketing terms the achievement of any of these different objectives should be measurable e.g. any increase in brand awareness can be measured by testing the level of brand awareness before the advertising activity and re-testing afterwards. Thus marketing can normally ‘prove’ whether it has achieveditsmarketingobjectivee.g.raisingbrandawarenessfrom30percent to40percentwithinthetargetgroupofconsumers.Thekeymarketingfinance questioniswhetherachievingthisobjectivebyspending£5milliononadvert- isingwasfinanciallyworthwhile. The brand awareness both before and after the campaign could be tested in order to see if the marketing objective was achieved and the efficiency with which the £5 million of advertising was purchased could be assessed. How- ever the money has not necessarily been effectively spent unless the benefit ofincreasingconsumerawarenessby10percenthasbeenfinanciallyevaluated as being worth well in excess of the £5 million cost that is to be incurred.

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8 MarketingFinance Clearlytobeofanyvalueasafinancialcontrolthisfinancialevaluationmust be carried out before the expenditure is committed i.e. the advertising is bookednotactuallyrun. Even more clearly such an evaluation which relies on estimates of the future sales revenues that are expected to result ultimately from increased brand awareness cannot be conducted by the finance function in isolation. It requires an integrated approach from both marketing and finance as does the ongoing control process as the expenditure is committed. This is necessary as itmaybepossibletoreducetherelatedriskbyphasingtheadvertisingexpend- iture in order to check that it is generating the increased awareness required e.g.bydoingaregionalorsegmentedtestfirst. Thisintegratedapproachtothefinancialevaluationandcontrolofmarketing activitiesis atthe verycentre ofmarketingfinancebutforthis tobepractical the strategic marketing objectives must themselves be integrated and aligned with the overall objectives of the business. This is considered in depth in the restofthischapter. Afocusonshareholdervalue The most common financial objective of modern commercial corporations is ‘tocreateshareholdervalue’.Consequentlythedifferentiatingelementswithin mission statements and long-term corporate objectives relate to the ways i.e. the ‘hows’ in which this shareholder value is to be created on a sustainable basis. Creating shareholder value will be broken down into several stages in this chapter but the overall concept is quite straightforward. Shareholder value is only created when shareholders achieve a total return that is greater than the returnthattheyrequirefromthatinvestment. Shareholders can only achieve returns from their investments in companies in one of two ways: they can receive a dividend from the company and the value of their shares can go up or it can go down. This total shareholder return TSR is shown in Table 1.1 with the capital growth element having aplusorminusimpactonthedividendincomeelement. These two elements are inextricably linked as dividends represent profits and cash paid out of the company to its shareholders. Hence the higher the Table1.1 Totalshareholderreturn AnnualtotalshareholderreturnTSR dividendyield ±capitalgrowth Dividendyield Capitalgrowth Dividendpershare Pricepershare -------------------------------------------- - 100 × Sharepricechange Openingshareprice ------------------------------------------------ - 100 ×

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CreatingRealShareholder Value 9 dividendpay-outratiotheproportionofpost-taxprofitspaidoutasdividends in any particular year the lower the relative level of profits and cash which can be reinvested in the business. It is these reinvested profits that are the majorsourceofthefuturegrowthofthebusinessandthisfuturegrowthleads to increases in the share price. Not surprisingly therefore some very high growth companies pay no dividends at all as they want to reinvest all their internallygeneratedcashflowsinordertogrowasfastaspossibleinthefuture. Thismeansthattheonlycurrentsourceofshareholderreturniscapitalgrowth generatedfrom anincreasingshareprice.Ifthe highgrowthstrategyfailsthe sharepricemaycollapsespectacularlyandsuddenlywhichhighlightsthekey financialrelationshipbetweenriskandreturn.Thiscriticalrelationshipwillbe emphasisedthroughoutthebook. Riskandreturn It is a fundamental principle of finance that investors will demand a return commensurate with the risk characteristics that they perceive in any invest- ment.ThisisillustratedinFigure1.1whichisknowncolloquiallyastherisk/ return line as it shows the required return for any given level of risk. This deceptively simple relationship is critical to understanding the creation of shareholder value. The two axes are deliberately labelled ‘perceived risk’ and ‘required return’: the return required by investors is driven by the risks they perceive in the investment. If I do not fully understand the risk that I am takingImaysettleforalowerrequiredreturnthanabetterinformedinvestor. Alternatively sophisticated investors may accept a very low probability of a particularly disastrous outcome as they have a well-diversified portfolio of other investments and thus settle for a much lower required return than more Required rate of return Risk-adjusted required rate of return line Zero risk rate of return Level of return required by investors in investment Y Specific risk of investment Y Perceived risk profile of investment Figure1.1 Risk-adjustedrequiredrateofreturn

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10 MarketingFinance naiveinvestorswhoareterrifiedofpotentiallylosingmostoralloftheirinitial investment even though this outcome is very unlikely. What is important is the risk perception of the investors and this risk perception drives their requiredratesofreturn. If risk perceptions are so important we clearly need a definition of risk from the perspective of any investor. Risk is created by volatility in future expected returns. In Figure 1.1 a minimum positive required rate of return is shownwheretherisk/returnlinecutstheverticalaxis.Thisminimumrequired rate of return carries a zero risk perception which means guaranteed certain future returns. For investors in stable economies this normally means govern- ment guaranteed borrowings e.g. US Treasury Bills UK Government Gilts European Central Bank debt. At the time of writing the returns from these investmentsarelowi.e.interestratesintheUSAandContinentalEuropeare beinghelddownbythecentralbanksinordertotrytostimulatetheireconomies but these returns are at least not volatile. If the USA government promises to pay you a seemingly paltry 1.25 per cent p.a. interest you can at least be confident of exactly how much interest you will receive and when you will receiveit. Accordinglyanormallyrationalriskaverseinvestorrequiresanincreasein the expected future return from any more risky investment in order to com- pensateforanypotentialvolatility.Thusthecauseandeffectrelationshipisas showndiagrammaticallyinFigure1.2anyexpectedvolatilityinfuturereturns creates an increased perceived risk profile in investors that increases their requiredrateofreturn. Of course investors know in advance of making their investment in most governmentbackeddebtinvestmentsGiltsTreasuryBondsNationalSavings Certificatesetc.exactlywhattheirreturnwillbei.e.theinterestratepayable is stated on the debt offering. This is clearly not the case with most equity i.e. stocks and shares in companies investments and this lack of certainty increases risk perceptions and hence required rates of return. Further if the historical track record of a company’s shares shows significant volatility in share prices and even dividend payments most investors will require much higher returns from the company as they will extrapolate this past perform- ance as their best guide to the future performance of the company’s shares. Therefore expected volatility in future returns Perceived risk Required returns Figure1.2 Riskandreturn

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Creating RealShareholderValue 11 Financial markets use various models to estimate the relative volatility of different industrial sectorsandofthecompanieswithineachsector.The main formulaisderivedfromoursimplerisk-returnlineandisknownasthecapital assetpricingmodelCAPMwhichisshowninFigure1.3. The CAPM calculates the beta factor for each company by comparing the correlationofthecompany’shistoricvolatilitywiththatofthestockmarketas a whole. If the stock market rises or falls by 5 per cent and share A moves by 7.5 per cent but share B only moves by 4 per cent then share A is relatively much more volatile than share B arithmetically share A has a beta factor of 1.5 while share B has a beta factor of only 0.8. This means that the required return K E for share A will be significantly higher than for share B a numer- icalillustrationofthisisgiveninTable1.2. Makingaprofitisnotgoodenough Table 1.2 indicates how much more challenging life is for a highly volatile company caused by shareholders’ natural dislike for risk. However what is The Capital Asset Pricing Model CAPM The return demanded by shareholders often referred to as the cost of equity capital K E increases with the perceived risk of the investment. Risk is measured in terms of the volatility in the level of return over time. Mathematically this can be represented as: K E K F +βK M – K F where K F Return on a risk-free investment K M Return on the stock market in total β Volatility of a particular share By definition the stock market has a β of 1 K M – K F The premium return required for accepting the risk associated with the stock market 0 Risk Market portfolio K E K M – K F K F K M Return β Figure1.3 Riskandreturn–thefinancialmarketsformula

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12 MarketingFinance oftenforgottenevenbyfinanceprofessionalsisthattheupwardsloping‘risk- adjusted required rate of return line’ of Figures 1.1 and 1.3 is in reality the shareholders’ indifference line. In other words moving from any point on the linetoanyotherpointonthelinemerelycompensatestheinvestorforachange in their risk perception it does not of itself create shareholder value. Thus using our numerical example of Table 1.2 investors who require a 4 per cent p.a. return for a risk-free investment will require a 9 per cent p.a. return for taking on the overall stock market risk. Similarly as is shown in Figure 1.4 they regard an 11.5 per cent p.a. return from share A as equivalent to i.e. neither better than nor worse than an 8 per cent p.a. return from share B due totheirdifferingriskprofiles. In financial terms if shareholders receive or expect to receive exactly the level of return which they require from any investment they have simply swapped a present capital sum the purchase price of the investment for a future set of cash flows the future dividend streams from the company plus anyexpectedultimatesaleproceedsfromtheinvestmentwhichhaveanequal presentvalue. 1 Hencenoshareholdervaluehasbeencreated.Shareholdervalue Table1.2 Relativecostsofcapitali.e.requiredratesofreturn Baseassumption:K F Returnonarisk-freeinvestment 4p.a. K M −K F Equitymarketpremium 5p.a. ShareA β 1.5 ShareA β 0.8 UsingCAPMi.e.K E K F +βK M −K F ForshareAits’sK E 4 +1.55 11.5 WhileforshareBit’sK E 4 +0.85 8 0 0.8 1 1.5 4 8 9 11.5 Required return Perceived risk β Shareholders’ indifference line Figure1.4 Risk-adjustedrequiredrateofreturnasshareholders’indifferenceline

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Creating RealShareholderValue 13 is only created when total returns are greater than the risk-adjusted required rate of return. Thus a company can achieve positive accounting profits on a consistent basis without creating any real shareholder value at all. Hence throughout the book the term super profits will be used to describe share- holder value enhancing levels of profit a super profit represents the excess rate of return over the required rate of return. This is defined more rigorously slightlylaterinthechapter. In a perfectly competitive market market forces would dictate that all investments would receive only their risk-adjusted required rates of return. If anybusinesswasgeneratingsuperprofitsnewcompetitorswouldimmediately be attracted into the industry and their entry would drive down the overall achievable rates of return so that the super profits were eliminated. Such is the theoretical world of perfect competition Consequently no shareholder value would be created. Accordingly shareholder value can only be created byexploitingimperfectionsinthemarketplace. The greatest imperfections arise in product markets i.e. the actual market- placesinwhichspecificproductsaresoldtoidentifiedcustomers.Forexample barrierstoentryintoanindustrycanbecreatedbytheexistingcompetitorsor monopolist to keep out any new entrantsthus preventing the rules ofperfect competitionfromapplyinginthatindustry.Thisisdiagrammaticallyillustrated inFigure1.5.Asaresultnewcompaniescannoteconomicallyaffordtoenter this industry even though the financial returns available are above normal levels.Thisrestrictiononpotentialnewcompetitionenablestheexistingplay- ers in the industry to sustain an apparently excessive financial return on their investments. However in reality the creation of an effective barrier to entry normallyrequiressubstantialadditionalinvestmente.g.inveryheavymarket- Barriers to entry Co. A Co. C Co. D Existing competitive environment very attractive Co. B Potential competitor Potential competitor Potential competitor Potential competitor Keeping out new competitors−maintaining existing high levels of return Figure1.5 Asustainablecompetitiveadvantage–developinganentrybarrier

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14 MarketingFinance ing expenditure to develop a strong brand. Thus this apparent rate of super profitsshouldfirstberegardedasprovidingthenormalrequiredrateofreturn on this additional investment. Only the remaining excess return if any repre- sents ‘real shareholder value creation’. This issue is considered in more depth inChapter2. If companies are seeking to develop marketing strategies that will create shareholdervaluethensomesimpleevaluationguidelinesshouldproveextremely helpful. We have already established that real shareholder value is only created from investment decisions where the expected return is greater than the share- holders’ required rate of return. However any change in the shareholders’ risk perception will create a corresponding change in their required rate of return. Thus shareholder value-adding strategies can be diagrammatically representedasshowninFigure1.6. Any strategic move that takes the company to a position below the share- holders’ risk/return line destroys shareholder value i.e. the shaded area in Figure 1.6. As already discussed moves along the risk/return line are neutral intermsofshareholdervaluethehigherorlowerreturnbeingcounterbalanced SUPER PROFITS require that EXPECTED/ACTUAL RETURNS REQUIRED RETURNS Risk Return β o Increase return more than risk K o Reduce risk more than return Start point Shareholders’ risk/return line Any strategy which moves the company to a point below the shareholders’ risk / return line reduces shareholder value The optimal value-adding strategic direction D B A C Figure1.6 Shareholdervalue-addingstrategies

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Creating RealShareholderValue 15 by the change in the associated risk perception. Thus any shareholder value enhancing marketing strategy results in a move to a position above the risk/ returnline.Itisnotsimplyaquestionofincreasingreturnorreducingriskbut of the level of increased return compared to the increased perception of risk andviceversa. From Figure 1.6 it is clear that strategy A is shareholder value enhancing whilestrategyBisvaluedestroying.Bothmarketingstrategiesseektoincrease both returns and risk but for strategy B the increased risk perception more thanoutweighstheincreasedexpectationofreturn.Itispossiblethatfinancial markets may be fooled for a while by the increased level of returns but once the increased risks associated with the new strategy are realised share prices will fall often quite dramatically further than they had earlier risen. Strategy A is a very common marketing-led strategy to try to create shareholder value and many examples will be given throughout the book the common theme acrossmanyofthesestrategiesistheword‘growth’. Almost any growth strategy whether growing shares in existing mature marketsenteringnewmarketswithexistingproductslaunchingnewproducts toexistingcustomersetc.increasestheriskofthebusinessandhenceshare- holdersrequireanincreasingreturn.Thecriticalquestionthereforeiswhether the expected or predicted increased returns more than offset the required increase in returns due to the heightened risk perception. As discussed at length later in the book the gap in the planning and control process of many businesses is the absence of this linkage between risk and return. Most finan- cial evaluation processes focus exclusively on the changes in future returns which assumes that the risk level is unaffected by the planned marketing initiatives. In fact there is a very interesting shareholder value-creating strategy that actually sets out to reduce the level of returns in the future but to make these lower future returns much less volatile and much more predictable i.e. less risky this is direction C in Figure 1.6. The simplest example of this type of strategyisthepurchaseofinsurancebyacompanythereturnsarereducedby the amountofthe insurance premiumpaid.Butthe insuredcompany hopesto avoid any future volatility in its financial performance that would have been caused by the adverse impact of the insured event. An extreme example is giveninPracticalInsight1.1. PracticalInsight1.1 Addingvaluethroughinsurance Many companies particularly in the USA have been forced into bankruptcy by ever increasing personal injury claims from contact with asbestos. TN a UK- basedinternationalcompanyfacedhugeclaimsestimatedatover£350million

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16 MarketingFinance Thereareanumberofspecificmarketingstrategiesthatseektocreateshare- holdervaluebyreducingperceivedriskproportionatelymorethantheyreduce future returns. A simple exampleis the negotiation of long-term discounts for loyal customers e.g. ‘overriders’ or long-term agreements the granting of a discount obviously reduces returns but the objective is to make these lower returns significantly less volatile by ‘guaranteeing’ future sales from these more loyal customers. As discussed in Chapter 9 a shareholder value focus requires an understanding ofhowmuch volatility canbe reducedfordifferent levelsofcustomerdiscount. In Figure 1.6 it is clear that the optimal value-adding strategic direction shownbystrategyDistoincreasefuturereturnswhilereducingtheperceived risk of the marketing strategy. This reducing risk perception can result in a reduction in the required rate of return so that the shareholder value-creating gap between expected and required rates of return can be substantial. Not surprisingly because it is the most attractive strategic direction to take it is themostdifficulttoachieve.Inordertogenerateincreasedfuturereturnswith reducedlevelsofriskthebusiness musthavedevelopedastrong‘sustainable competitive advantage’ also often referred to as a ‘differential advantage’ a ‘core competence’ or as above an ‘entry barrier’. Developing such a differential advantage is the main objective of modern marketing strategies. Astrongsustainablecompetitiveadvantageshouldenableacompanytoincrease its future rates of return to levels well above both its required rate of return andtheratesofreturnachievedbyitscompetitors. However its sustainable competitive advantage could also mean that even in the event of a downturn in the market its rates of return are less volatile in the future than those of its competitors. This lower volatility will result in a reduced level of perceived risk and a consequently lower required rate of return. This means we can now expand our concept of super profits a super profit is the excess return achieved by a business due to the development and main- tenance of a sustainable competitive advantage. As stated above the excess return represents the surplus expected or actual return over the rate of return requiredbyinvestors. AddingvaluethroughinsuranceContinued related to its historic association with the asbestos industry. The company’s advisersestimatedthatthisunquantifiedliabilitywasreducingthegroup’smarket capitalisationbyaround£1000million.Bypurchasinganinsurance-basedcapon its asbestos liabilities the company was able to remove the excess discount even though it had to pay a significant premium to get this insurance cover. The premium reduced profits but the reduced risk perception resulted in increased shareholdervalue.

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Creating RealShareholderValue 17 Creatingmarketingassets Akeyaspectofacompetitiveadvantageintermsofitsabilitytocreateshare- holder value is its sustainability. If competitors can match the competitive advantageimmediatelyorevenrelativelyquicklythecompanywillbeunable to exploit it to achieve a super profit. As already stated any sustainable competitive advantage should act as an effective entry barrier which stops competitors from coming into the financially attractive market created by the business.ThesortsofentrybarriersthatcanbeerectedareshowninFigure1.7 the possible entry barriers shown are not meant to be totally comprehensive buttheyillustrateanumberofimportantissuesrelatingtosustainablecompet- itiveadvantagesandtheirfinancialcontrol. Itisclearthatsomepotentialentrybarriersarethedirectresultofmarketing activities e.g. branding and control of channels of distribution but several more can only be fully exploited through the implementation of the appropri- ate marketing strategy such as low unit costs technology barriers licence protectionetc..Howeveralltheseentrybarriersarenormallyonlydeveloped bysubstantialinvestmenti.e.upfrontexpendituresandthisinvestmentmust be regarded as high risk. If the entry barrier does not work i.e. if competitors canfindawayrounditorthroughitthecompanywillbeunabletogeneratea returnonthesubstantialexpenditurewhichwasdesignedtodevelopthecom- petitiveadvantage. It should also be clear from the illustrations of entry barriers shown in Figure 1.7 that they have a finite economic life. The clearest example of this is a patent that expires at the end of its 20 year life. The company Co. A Co. D Co. C Co. B Existing competitive structure Learning curve Scale of investment Patent protection Prospective new competitors Prospective new competitors Prospective new competitors Technology barriers Economies of scale License protection Branding barriers Low unit costs Channel of distribution Legal constraints Figure1.7 Useofentrybarriers

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18 MarketingFinance may be able to extend the economic life of some entry barriers by carefully managing the sustainable competitive advantage e.g. as has been done by certain very strong brands such as Coca-Cola but as is discussed in more detail later in this chapter this will normally require additional marketing expenditure in order to maintain the entry barrier. Alternatively the busi- ness may decide to reinvest part of its current level of super profit in devel- oping a replacement sustainable competitive advantage for when the initial advantage ceases to be effective. Good examples of this are ethical pharma- ceuticalcompaniessuchasGSKthatofteninvestheavilyinbrandingtheir patented drugs such as Zantac. This actually reduces the level of super profits achieved during the patent period as they are then effectively a monopoly supplier. However it can create strong existing customer loyalty and very good overall product awareness which can work as a very effect- ive competitive advantage once the patent has expired particularly if new channels of distribution such as the ‘over the counter’ market are also exploited at this time. The economic lives of these entry barriers can also be shortened dramat- ically due to changes in the external environment as is illustrated in Practical Insight1.2. PracticalInsight1.2 These entry barriers are the really important sources of shareholder value creation and should therefore be managed as the key assets of the business. Unfortunately possibly because many of them are intangible and somewhat nebulous to most finance managers many companies still regard their tangi- ble fixed assets factories offices plant and machinery etc. as the only real assets of the business. Without any intangible marketing assets to exploit TheCigaretteIndustryintheEU The cigarette industry in most developed markets is very heavily branded and severaloftheseleadingbrandshavebeenverysuccessfulformanyyears–partic- ularly Marlboro owned by Philip Morris PM. PM has managed the Marlboro brand very carefully and has changed the product attributes so as to appeal to successive generations of smokers. Thus originally Marlboro Full Flavour i.e. the ubiquitous red chevron box was dominant but this is now smoked almost exclusively by older smokers. Younger adults are attracted to Marlboro Lights whichhasaverystrongshareofyoungersmokersinmostEuropeanmarkets. HoweverthenewEUdirectiveoncigarettelabellingwillbanallproductrefer- ences to ‘light mild fresh etc.’ so that many of the leading brand names e.g. Marlboro Lights Mild Seven etc. face significant marketing communication challenges in maintaining their brand imagery which has been developed over manyyears.

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Creating RealShareholderValue 19 thesetangibleassetswouldprobablygenerateatmosttheshareholders’required rateofreturn. This means that many marketing activities i.e. those aimed at developing a strategic marketing asset should be financially evaluated and controlled as strategic investment decisions irrespective of how they are treated for finan- cial accounting purposes. Any financial investment involves spending money now in the expectation that in the future returns will be generated to more thanrecoverthisinitialexpenditure.Wheretheperiodoverwhichtheseexpected returns should be received is likely to be much longer than the current finan- cialyearitisimportantthataproperlong-termfinancialevaluationiscarried out.Thisisparticularlyvitalwheretheseinvestmentexpendituresareregarded ashighriskduetothevolatilityassociatedwiththepotentialoutcomes.Ifthe success of these investments is also critical to the achievement of the organ- isation’slong-termobjectivesandoverallmissiontheneedforasoundfinan- cialevaluationandcontrolprocessbecomesparamount. In very many businesses these factors are most obviously present in the keymarketinginvestmentsthatarebeingmadeindevelopingbrandsentering new markets launching new products and developing new channels of distri- bution such as the Internet. Thus it is vital that these high risk long-term investments are financially evaluated using the most sophisticated techniques available. Many companies would automatically calculate a full discounted cash flow for even the simplest relatively small investment on labour saving machinery in their factory or operations areas. Yet these same companies often do not carry out such a long-term evaluation of much larger expend- itures in the marketing area. Indeed it is still not uncommon to find almost no financial justification supporting many significant marketing initiatives. Per- hapsthisattitudeispreservedduetothefinancialaccountingrulesof ‘writing off’i.e.expensingallmarketingexpenditureintheyearinwhichitisincurred thismaydeterfinancemanagersfromconsideringany‘marketingexpenditure’ ascreatinganasset. However the proper definition of an asset is ‘anything which will generate future net cash inflows into the business’ this clearly includes brands trade- marks customers channels of distribution products etc. Thus some market- ing expenditure should be financially evaluated and controlled in exactly the same way as for other more tangible assets but the way marketing itself classifies its expenditure is also very unhelpful. Many businesses still persist with the classification of marketing expenditures between ‘above the line’ meaningmainlymediaadvertisingand‘belowtheline’meaningpromotions for both trade and end customers etc.. This distinction literally refers to where the expenditures tend to be shown in the profit and loss account but in today’s marketing environment they have almost no relevance at all. The increasingpowerofmanychannelsofdistributionsuchassupermarketretail- ers and even consumers let alone industrial customers together with an

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20 MarketingFinance increasingfragmentationinmassmarketingmediae.g.TVchannelshasled toasignificantincreaseintheproportionofmanymarketingbudgetswhichis spent ‘below the line’ i.e. directly to channels and end customers. If this is a moreeffectivemeansofachievingthemarketingobjectivesofthebusinessit is extremely sensible to do this. The change from ATL to BTL is irrelevant theonlyrelevantchangewouldbeintheobjectivesoftheactivity. Amuchmoreimportantwayofanalysingmarketingexpenditurehasunfor- tunatelybeenignoredbymostcompanies.Ashasalreadybeenstatedcreating anyvaluablelong-termassetrequirestheinvestmentofsubstantialfunds.This is also true for marketing assets which require significant financial support during their developing periods. This development expenditure creates the attributes of the asset such as brand awareness distribution access customer loyaltywhichwillgeneratethesuperprofitsofthefuture. Once the marketing asset has been developed to its full potential as with any asset it must be properly maintained or it will decline in value very rapidly. A feature of many marketing assets such as brands is that some of their attributes such as brand awareness can decline very quickly if they are not properly maintained. Thus another component of the marketing budget is maintenance expenditure. Development expenditure is designed to increase the long-term value of the marketing asset by improving specific attributes of theassetwhilemaintenanceexpenditureaimstokeeptheseattributesattheir existing level. It has already been stated that all sustainable competitive advantages have finite economic lives and this is equally true for marketing assets. Thus the mixofdevelopmentandmaintenancemarketingexpenditurewillchangeover the life cycle. During the initial launch period all the marketing expenditure will be development activity as it is aimed at building the value of the asset also there are not yet any attributes to be maintained. Once the asset starts to beestablishedtheexistingattributesneedsomelevelofmaintenanceexpend- iture but the majority of the marketing expenditure still goes to developing the asset to its optimum level. Once this optimal level is reached there is no longer a financial justification for more development expenditure any excess marketing support will result in very small positive financial returns or quite possibly have a negative impact on the future earnings potential of the asset thisisdiscussedinChapter8.Consequentlyforthisfullydevelopedmature marketingassetallthecurrentmarketingactivitywhichmaybeconsiderably lessthanwasspentduringthedevelopmentphaseshouldbetargetedatmain- tainingtheasset’scurrentpositionandstrengths. Eventually the marketing asset will approach the end of its economic life and at this time the business may quite consciously reduce the marketing supportbelowthefulllevelrequiredtomaintainproperlytheasset’sattributes. Inotherwordsthedeclinestageofthemarketingasset’slifeismanagedsoas tomaximisethecashflowsreceivedbythebusiness.Indeedthisisthecritical

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Creating RealShareholderValue 21 financial performance measure for any marketing asset the objective is to maximise the super profits earned over the economic life of the asset. Due to thelonglifecycleofmanyoftheseassetsthishastobeexpressedintermsof thenetpresentvaluesofthecashflowsthatareexpectedtobegeneratedover thiseconomiclife. Also because the economic life can in certain cases be extended some marketingexpendituremaybespecificallytargetedatextendingtheeconomic lifeoftheasset.Analternativemarketingstrategymaybetotransfertheexist- ingstrongassetattributessuchasfromabrandfromadecliningproducttoa new growing product. Even though doing so will accelerate the decline of the currentproductitmayextendtheeconomiclifeofthe‘brand’assetbyassoci- atingitwithanother‘appropriate’product. Thisdistinctionbetweendevelopmentandmaintenancemarketingexpend- iture is very important because the timing of the returns from each type of expenditure is very different. Development expenditure represents a long- terminvestmentandthereturnsmaynotbereceiveduntilseveralyearslater. Thus the marketing expenditure is incurred now but the financial benefit is probably not felt in the current accounting year. The impact of reducing maintenance marketing expenditure is likely to be much quicker because as many attributes can decline quite rapidly there is likely to be a correspond- ing fall-off in sales revenues and profits. However for very strong brands such as Coca-Cola as is discussed in Practical Insight 1.3 the accumulated strength of the brand attributes may keep sales levels up in the short term evenifmarketingsupportwassignificantlyreducedthisdoesnotofcourse mean that the long-term health of the brand has not been severely damaged. In many companies the marketing budget represents a very significant proportion of total expenditure. When the company comes under short-term profitpressureitisthereforeverycommonforthefinancialdirectortolookto marketing to make a significant contribution towards any required reduction in total expenditures. Under the traditional classification system it is easy to predictwheremostofthesecutsinmarketingexpenditurearelikelytofall:on the long-termdevelopmentactivities. This is becausereducingthesedevelop- ment expenditures this year will have only limited impact on sales revenues and profits this year so that the benefits of reducing marketing expenditure willdroptothebottomline. Unfortunately the impact of this reduction in development marketing expenditure will be felt in future years because the marketing asset will not becomeasfullydevelopedaswasintended.Atleastbysegmentingmarketing expenditures into development and maintenance activities the long-term consequences of such short-term action will be more clearly highlighted and thefutureexpectationsforthebusinesscanbeappropriatelymodified.Thebest way of really focusing on these issues is through a well-designed marketing

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22 MarketingFinance financeplanningandcontrolprocesswhichisinitiallydiscussedinChapter2 anddevelopedmorefullyinChapter6. PracticalInsight1.3 Definingshareholdervalue We have now established that marketing assets are for many businesses the major source of super profits and that super profits are key to creating share- holder value. Now we need to define this concept of shareholder value more rigorously. Therearethreeslightlydifferentbutlinkedwaysofmeasuringshareholder value:shareholdervalueanalysiseconomicprofitandtotalshareholderreturn. The shareholder value-added approach popularised by Alfred Rappaport usesdiscountedcashflowtechniquestoestimatethevalueofanypotentialinvest- ment discounting forecast cash flows by the shareholders’ required rate of returni.e.thecompany’scostofequitycapital.Rappaportstatedthatthevalue ofacompanyisdependentonsevendriversofvalueasshowninFigure1.8. The management of the business can use their expert insider knowledge to develop sales profit and cash flow forecasts for the first five value drivers. The required time period for these forecasts is dictated by the time period of competitiveadvantagei.e.valuedriversixandthisisdeterminedbytherel- ativestrengthofthecompetitiveadvantage.Thusastrongbrandmaygenerate high super profits for a much longer period than a small technical product innovation. Discounting these cash flow projections at the company’s cost of capital leads to a value being placed on the business by the management. This tech- nique can quite easily be applied to individual divisions within a large group Coca-Colare-emphasisesthelongterm InDecember2002Coca-Colaannouncedthatitwouldstopissuingquarterlyand yearly forecasts. It argued that this process placed too much emphasis on the short-term financial performance of the company rather than the more important long-termprospects.Itsaidthatitwouldinsteadofferdetailsofits‘valuedrivers strategic initiatives and operating environment’. Douglas Daft chairman and chiefexecutivesaid‘Establishingshort-termguidancepreventsamoremeaning- ful focus on the strategic initiatives that a company is taking to build its business andsucceedoverthelongrun.Wearemanagingthisbusinessforthelongterm.’ ForacompanylikeCoca-Colawithverystrongbrandingandaveryhighlevel ofmarketingsupportthepotentialtomanipulateprofitsinanyoneyearisrelatively easy by reducing its marketing expenditure. However in such a marketing-led businessthisshort-termfocuscould beseverelydamaging to the mostimportant assetpossessedbythecompanyi.e.thebrand.

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Creating RealShareholderValue 23 wheretheindividualvaluescanbeaggregatedtovaluethegroup.Alternatively the shareholder value impact of possible marketing strategies can be assessed usingthistechnique. Theproblemwithshareholdervalueanalysisisapplyingitfromoutsidethe company which is exactly what current and prospective shareholders are trying to do. In order to arrive at an estimated company value these outsiders require a great deal ofinformation aboutthe companyits futurestrategyand the competitive environment in which it will be operating. Many serious investors such as the renowned Warren Buffett of Berkshire Hathaway and leading stock market analysts therefore use their own tailored versions of this shareholdervalueanalysistechnique. Shareholder value analysis quite deliberately de-emphasises the short-term performance of the business i.e. this year’s financial results in favour of focusing on the long-term potential of the company. Hence it is quite compli- cated to use shareholder value analysis as a periodic measure of performance how to do this is discussed later in the book. Many companies therefore use economic profit also known as residual income as a periodic indicator of shareholder value creation. Economic profit is the surplus earned by a busi- ness in a period after deducting all expenses including the required rate of return on the capital employed in the business i.e. it is what we have previ- ouslyreferredtoassuperprofit.ThecalculationisillustratedinTable1.3. Economic profit has the major advantage that it teaches managers a great respect for capital – it is no longer seen as ‘free’ – and can encourage them to runtheirbusinessessoastominimisecapitalemployed.Inmanycasesthisis beneficial to shareholder value creation because lots of high risk growth strategies do not generate sufficient extra return to service the extra capital Sales growth Operating profit margin Cash tax rate Incremental investment in capital expenditure Investment in working capital Time period of competitive advantage Value-adding movement Cost of capital Figure1.8 Rappaport’ssevendriversofvalue

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24 MarketingFinance requiredtofinancethegrowth.Howeveraseconomicprofitisasingleperiod measureitcaniftakentoextremesleadtoanundercapitalisedbusinesswhich cannotgrowtoitsfullpotential. As stated above there is a relationship between economic profit and full shareholder value analysis shareholder value analysis shows the value of a business over its lifetime while economic profit shows whether the company is creating value in any single period. More rigorously the discounted value of all the projected economic profits of a business will equal the shareholder valueanalysisfigure. BothSVAandeconomicprofitare‘internal’measuresofshareholdervalue in that they show how well the company is using its competitive strategy to create value from the product-market mix it selects. The total shareholder return TSR measure introduced earlier in the chapter is externally focused it looks at the value created for shareholders whether through dividend incomeorcapitalgrowth.TheTSRcalculationisillustratedinTable1.4. Table1.3 Calculatingeconomicprofit/residualincome/superprofit Operatingprofitaftertax £240000 Capitalemployed £2million Costofcapital 10 Calculation1 Operatingprofitaftertax 240000 Less:costofcapitalcharge£2m ×10 200000 Economicprofit £40000 Calculation2 Economicprofit capitalemployed ×spreadofreturn wherespreadofreturn returnoninvestment − requiredreturn £2m ×12 −10 £40000 Table1.4 Calculatingtotalshareholderreturn Sharepriceon1January 100p Sharepriceon31December 110p Capitalgainintheyear 10p Dividendpaidon31December 5p Totalreturn 15p TotalshareholderreturnTSR×100 15 15p 100p - ---------- -

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Creating RealShareholderValue 25 From the perspective of shareholders TSR is probably the most accurate measure of value – it shows what they have actually received from the company in the period.Howeveritcanonlyaccurately measure the pastand even this past financial ‘performance’ may not properly reflect the actual performance of the business and particularly of the managers running the business. Share prices and especially movements in share prices reflect the market’s expectations rather than actual corporate performance. Thus only adequate performance from a company expected to do poorly might increase the share price far more than superb performance from a company that was already a market favourite and which had a correspondingly highly rated existingshareprice. Creatingsustainableandrealshareholdervalue Also a company could itself be doing well but itcould be in an out-of-favour sector and find that its own good financial performance is not reflected in the returns to its shareholders. Alternatively a poor company could see its price rise for reasons unconnected with its underlying performance. When used as a measure of senior managers’ performance TSR is normally benchmarked againstsimilarcompaniese.g.thoseinthesameindustryorsector.Thishelps toeliminatesomebutbynomeansallofthesedifficulties. This was very clearly illustrated in the dramatic split within stock markets during1999and2000between‘oldeconomy’sharesand‘neweconomy’shares. During the late 1990s investors became increasingly excited about the prospects for the new high growth industries being created from the know- ledgerevolution.Thussharepricesofmanynewcompaniesinthetechnology media and telecoms TMT sectors rose dramatically even though these companies were not yet trading profitably. All of the current share price was apparently based on the future super profits which would be generated by these companies. Indeed some long establishedcompanies particularly in the telecoms sector were re-invented as new high growth businesses due to the potential of combining mobile telephony Internet access text and visual messagingetc.. As these share prices boomed investors were desperate to raise funds to rideonthebandwagonthustheysoldtheirsharesintheboringoldcompanies whichwereproducingthesamegoodsprofitsanddividendsthattheyhadfor manyyears.Consequentlywhileoverallstockmarketssoaredtorecordlevels many sound well-established shareholder value-creating companies saw their share prices fall and they dramatically under-performed the stock market in terms of the TSR generated during this period. Indeed as explained in Practical Insight 1.4 the capital markets developed new valuation criteria for some of these businesses as their valuations could not be justified using traditional financial methods such as discounting expected future cash flows. Not surprisingly this ‘irrational exuberance’ to quote Alan Greenspan

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26 MarketingFinance has ended in tears and now we are in general back to more soundly based valuationmodels. PracticalInsight1.4 Consideringbothbusinessandfinancialrisk There is yet another dimension to shareholder value that we need to consider attheoutsetasitwillreappearthroughoutthebook.Sofarwehaveconsidered therelationshipbetweenriskandreturnwiththeshareholders’perceivedrisk as being the determinant of their required rate of return. Now we need to dividethisconceptofriskintotwoparts:businessriskandfinancialrisk. As with all the other functional strategies marketing operations human resourcesetc.thatarenowdevelopedbymostcompaniesasessentialaspects of their strategic management process a company’s ‘financial strategy’ must be tailored to the needs of the overall corporate and competitive strategies that arebeingimplementedbythebusiness.Ifthefinancialstrategyisappropriately designedandproperlyimplementeditcanenhanceshareholdervaluebuteven moredramaticallyasisillustratedinPracticalInsight1.5whenaninappropri- atefinancialstrategyisappliedtheentirebusinesscanbeplacedinjeopardy. Business risk describes the inherent risk i.e. volatility in expected returns associated with both the underlying nature of the industry that the business is Creatinga‘bubble’effect The rapid growth potential of some ‘new’ industries led to some innovative methodsofshare valuation beingused by many investors during the TMT boom. Unfortunately but not surprisingly this led certain companies to try to perform wellintermsofthenewvaluationdriversbeingappliedtothem.Asthesedrivers in some cases became more and more removed from the underlying shareholder value drivers an inevitable valuation ‘bubble’ was blown up which subsequently burst with disastrous consequences for all involved shareholders employees regulators and even the executives directly involved in ‘manipulating’ their own performance. A simple example relates to both WorldCom and Enron where sales revenue growth was seen as a key value driver by the financial markets. If sales grew rapidly then profits would eventually follow seemed to be the logic. However if salesgrowthforitsownsakebecomestheobjectivethenthereisnocertaintythat thesegrowingsaleswillactuallybeprofitable atall.Thusbothcompaniesentered into extremely complex and technically convoluted ways of stimulating their apparent sales levels. Thus reported sales revenues grew exponentially from year to year but net cash inflows did not grow at the same rates as most of this sales growthwasanaccountingcharade. Ifthesepublishedfinancialresultshadbeenanalysedintermsofthelong-term strategy being employed the sustainable competitive advantage being exploited andtheexpectedcompetitivereactionperhapsamorerationalvaluationforthese companiesmayhavebeenmaintainedandtheireventualtotalcollapseavoided.

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Creating RealShareholderValue 27 inandthespecificcompetitivestrategythatitisimplementing.Thusaverynew focused single product high technology company such as a business devel- oping a specific aspect of biogenetic engineering would have a very high intrinsicbusinessrisk.Itmustberememberedthatofitselfneitherahighnor a low business risk is better as long as the relative level of financial return matchesthelevelofassociatedriskeitherisacceptable. However businesses with such dramatically differing levels of risk require fundamentally different financial strategies. Financial risk is the risk inherent in the company’s choice of financing structure and this involves both the sources of finance used and the ways in which investors receive their returns e.g.primarilydividendyieldorcapitalgrowth. Funding for a company can at its simplest be raised by selling shares to investors who become part owners of the business or by borrowing money from a bank or other lender. The lender does not become a part owner but remains a creditor of the company and requires both payment of interest on the debt and eventually the repayment of the amount lent. As such the lender has much more control over their expected future returns and they may increase this control i.e. reduce their risk by taking security over the assets owned by the business. The shareholders stand behind any lenders in terms of receiving any returns but they can if the business is successful receive very high returns while the return to the lender is normally fixed. Our normal rule of a positive correlation between risk and return still applies to financial risk so that the required return on debt financing borrowed funds is signifi- cantly lower than on equity funding money raised by selling shares in the company. Thiswouldappeartomakeitattractiveforcompaniestoraisemostoftheir required financing by borrowing if it is a much cheaper source of money. This is why we must consider the combination of business and financial risk. Lenders such as banks regard their loans to companies as relatively low risk because they effectively transfer much of the risk to the company. Failure to makeinterestorprincipalpaymentstoyourbanknormallyleadstotheliquid- ation of your company. Thus any company with a high business risk which will often show up as volatile financial results should not rely on debt finan- cing. The business and financial risk profiles combine together to give the overallriskprofileforthebusiness inthe same mannerasallsequentialprob- abilities i.e. mathematically the individual factors are multiplied together to get the combined result. To do this properly we have to be sure that we are assessing financial risk from the right perspective. In this case that is the perspectiveofthecompanyraisingthefinancingi.e.theborrowerorissuerof thenewshares. Debt financing is a high risk form of funding to the borrower because the lenderhastransferredtothemasmuchofthetotalriskaspossible.Conversely because shareholders keep most of the total risk themselves i.e. they cannot demand a dividend payment and the company does not have to repay the

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28 MarketingFinance money invested as long as it continues trading equity financing is a low risk source of funding. The shareholder value enhancing combined strategies are illustratedinFigure1.9. Combining a high business risk strategy with a high financial risk strategy such as would be achieved by funding our start-up bio-tech company with almost all debt financing gives a very very high total risk profile. Such a company might succeed spectacularly but it is much more likely to fail completely and disappear. It is now well established that very high business risk enterprises should be funded with equity and that this equity should be providedbyinvestorswhounderstandthattheirinvestmentmaybetotallylost ifthebusiness fails i.e.byspecialistventurecapitalists.This provides alog- icalcombinationofhighbusinessriskandlowfinancialrisk. Anotherlogicalshareholdervalueenhancingcombinationistoputtogether alowbusinessriskstrategyandahigherriskfinancialstrategy.Alowbusiness risk company will produce predictable profits and cash flows due to its low volatility and these will enable it to pay both the interest and principal pay- ments on its borrowings. If this low business risk enterprise uses primarily equityfundingitismissingoutonasignificantopportunitytoaddshareholder valuethroughitsfinancialstrategy. PracticalInsight1.5 Outofonewrongboxintoanother For its final years under Lord Weinstock GEC plc was criticised by financial analystsforcombining a lowrisk businessstrategy with avery lowriskfinancial strategy.Inthe1960sand1970sWeinstockrestructuredtheUK’selectronicsand Business risk Financial risk HI HI LO LO Figure1.9 Combiningbusinessandfinancialrisktocreateshareholdervalue

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Creating RealShareholderValue 29 Thiscombinationofbusinessriskandfinancialriskcaneasilybeappliedin marketing finance as will be illustrated throughout the book. Clearly high-risk marketing strategies such as brand launches new product launches and new marketentriesshouldberegardedasbeingfinancedwithventurecapitaltype ofequityfundingwithitscommensuratelyhighrequiredrateofreturn.Lower risk marketing activities where the prospect of total loss is negligible and where the expected return is predictable within much tighter parameters can utilisethemuchlowercostdebttypefundingappropriatefortheselowerrisk businessstrategies. Note 1 The concepts of discounted cash flows and present values are considered below and in more depth in Chapter 7 when strategic investment evalu- ationtechniquesarediscussed. defence contracting industries through take-overs and mergers. During the 1980s and early 1990s the group was highly profitable and cash generative but main- tainedastrongnetcashpositionwithalowdividendpay-outratio.Consequently its total shareholder return was relatively poor as its share price under-performed theboomingstockmarket. In the late 1990s a new management team was brought in Lord Simpson as Chief Executive and John Mayo as Group Finance Director. They very rapidly transformedthegroupthroughverylargescaledisposalsandacquisitions from a well-diversifiedgroupinvolvedinmaturerelativelystablebutlowgrowthindus- tries into a highly focused telecoms business mainly based around the USA marketswhereGEChadneverhadanystrongpresence.Theiracquisitionswere financed by cash payments using the existing GEC cash mountain then the proceeds from selling GEC’s original core businesses and finally from raising largescaleborrowings. The renamed group now called Marconi subsequently suffered a dramatic crisis in the ensuing downturn in the telecoms sector. This resulted in a financial restructuringbythelendingbanksthatlefttheoriginalshareholderswithlessthan 1 per cent ownership of the company as much of the outstanding debt was converted into equity. There are people in the City of London who regard Lord Weinstock as dying shortly after the collapse of the group he built up of a brokenheart.

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2 TheVirtuousCircleofAnalysis PlanningandControl Overview Strategic management is normally regarded as an integrated management approach drawing togetherall the individual elementsincluding the critically importantmarketingstrategyinvolvedinplanningimplementingandcontrolling abusinessstrategy. Thusitclearlyrequiresanunderstandingofthemissionand/orvisionofthe organisation the ‘why’ it exists statement and of its long-term goals and objectives‘where’itwantstogo.Theremustalsobeacomprehensiveanalysis of the environment in which the business both is currently and will in the future be operating ‘where it is’. This analysis process must include all the internaloperationsandresourcesbothexistingandpotentialoftheorganisation but equally importantly must cover the external aspects of its environment. This includes competitors suppliers customers the economy governmental impactsaswellaslegalandotherregulatorychanges. The combination of ‘where the organisation is’ and ‘where it wants to go’ will normally identify the need for a series of co-ordinated actions to bridge thegapsbetweenthetwoorevenmerelytomaintainitscurrentpositionifthe external environment is changing adversely. These business ‘strategies’ must be developed in the context of the internal and external environments so as to ensurethattheyarepracticalifnotthegoalsandobjectiveswillremainadistant theoretical‘wishlist’ratherthananachievableplanforthebusiness. A key elementin achieving this is that the planning process mustexplicitly consider the responses of those stakeholders significantly impacted by the proposedstrategiesparticularlythosecompetitorscustomersand/orsuppliers thatareadverselyaffected. Formanylargeorganisationsitisalsoimportantthatbusinessstrategiesare developed at the appropriate levels within the organisation thus an overall corporate strategy is needed for the organisation in total with separate but linked competitive strategies for each subdivision of the business which is directly competing for identified customer groups with a specified product rangeagainstknowncompetitors.Howeversofarthesebusinessstrategiesare

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TheVirtuousCircleofAnalysisPlanningandControl 31 only plans and the full process of strategic management includes the imple- mentationoftheselectedstrategies. Some of the goals and objectives are long term and the relevant strategies willbeimplementedinadynamicandcontinuallychangingexternalenvironment. Thereforeitismostunlikelythatall thepredictedoutcomesfromthese action plans will be achieved. There is a need for a feedback process of evaluation control and where necessary modification. Many such modifications will result in changes to those selected strategies that are not working effectively but in some circumstances the organisation may be forced to accept that its originalgoalsandobjectivesarenotattainableintheactualexternalenvironment orwithitsavailablesetofresources. Thus strategic management is a continual iterative process of analysis planning and control. Marketing finance must therefore follow a similar process if it is to contribute positively towards the sustainable creation of shareholdervalue. Howevermarketingstrategiesarealsospecificallytailoredtothecompetitive environment in which each particular business is operating. The marketing financeprocessshouldbeequallytailoredtofittheenvironmentandtheensuing marketing strategy. There are widely differing strategies that can be imple- mentedeveninthesameindustryatthesametimeandthesedifferingstrategies requiresuitablytailoredcontrolprocessesandperformancemeasures.Thereis a need for a hierarchy of both economic and managerial performance measures for all businesses but it is critical that some of these performance measures incorporateindicationsofhowwellthebusinessisdoingintermsofitslong-term objectives. It is particularly important that the performance measures are tailored to the key strategic thrusts of the business if these change the marketing finance process may need to be changed as well. One common strategic marketing thrust is to develop strong brands as a sustainable source of differential advantage. A branded strategy requires a good brand evaluation process if the resulting high brand expenditures are to be properly finan- cially evaluated and controlled. Brands can be based on either customers or productsbutothertypesofmarketingstrategycanbeeithercustomerledor product based. In a customer-led strategy the long-term customer relationship should be regarded as a critical asset of the business thus development expenditure is investedtowinthecustomerandmaintenanceexpenditureisneededtoretain the relationship for its full potential economic life. Life cycle customer account profitability analysis is therefore important in such a relationship marketing-orientedbusiness. Similar issues occur with product-based strategies and a suitably tailored response is required. Product life cycle costing is now quite a well-developed technique in some industries using the dynamic cost reducing relationship of

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32 MarketingFinance theexperiencecurvetojustifysettingpricesbelowthecurrentlevelofcostsin ordertodevelopasustainablecostadvantage. Introduction A traditional approach to management accounting follows the same analysis planning and control framework that is relevant to strategic management and is shown in Figure 2.1. One criticism of the truly traditional approach is that theseindividualstagesareeachcarriedoutinisolationbyseparatepartsofthe organisation and are regarded as an end in themselves. As will be argued throughout this chapter and indeed through the whole of the book much greater value is created from operating ‘analysis planning and control’ as an integratediterative process so thatthe dividing lines between any twostages becomeveryblurred. Financialanalysisisrequiredtoestablishwherethebusinessistodayandto ensure that the strategic goals and objectives are realistic and meaningful. Howevertraditionallymanagementaccountinghastendedtofocusoninternal analyses such as performance compared to this year’s budget or last year’s performance etc.Also this financial analysis is often done for the business as a whole whereas the business strategy may deliberately seek to create a numberofdifferentiablemarketsegmentswhichcanbeattackedwithspecifically tailoredmarketingstrategies.Thebusinessstrategyisveryconcernedwiththe externalenvironmentandthereforethefinancialanalysisprocessshoulditself befocusedonexternalissuesandparticularlycompetitorsandcustomers. Financial planning is supposed to set out how the business intends to move from ‘where it is today’ to ‘where it wants to be in the future’ i.e. how it will achieve its ‘realistic’ goals and objectives. Unfortunately many traditional Planning Inward focus of process Control Analysis Figure2.1 Traditionalmanagementaccountingprocess:analysisplanningandcontrol asaniterativeprocess

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TheVirtuousCircleofAnalysisPlanningandControl 33 management accounting planning systems are really simply extrapolations of the past e.g. last year’s sales plus a percentage and last year’s costs minus a percentage and take no account of the external environment in which the companyisoperating.Recenteventse.g.September112001haveshownthe irrelevanceofover-simplifiedplansbasedonextrapolationsofthepast.There are relatively few major industries in the world that have easily achieved any plansestablishedpriortothedestructionoftheTwinTowers.Suchamomentous event forces businesses to sit down and rebase their future plans for some e.g. USA airlines and other travel related businesses their objectives will have changed e.g. survival rather than growth for others the strategies required to achieve their previously agreed objectives may need amending in thelightofaslowdowninglobaleconomicgrowthanddramaticfallsinmajor capitalmarkets. Financialcontrolseekstomonitorhowwelltheagreedobjectivesarebeing achieved by providing feedback to the relevant decision-makers. However ‘control’ is much more than explaining how far away actual performance is fromtheplannedlevel.Thefeedbackshouldbeusedtomakecorrectingdecisions to put the business back on course or to change the aim of the business towards modified objectives. Financial monitoring and reporting i.e. control should therefore be regarded as a positive tool of management acting as a muchneededlearningprocessforthedifficulttaskofmarketingplanning.Far toooftenthefinancialcontrolprocessisseenasawayofapportioningblame forwhatwentwrongorasameansofclaimingthecreditforwhatwentright. It is also vitally important that the financial controls used by the business are appropriate to the particular marketing strategy being employed and the stage of implementation that the strategy has reached. Unfortunately most large organisations still use only one method of monitoring financial performance the most common being some form of accounting return on investment i.e. profit divided by the investment tied up in the business across all the disparate subdivisionsmakingupthegroup. Astrategicmarketingfinanceapproach The main problem with the traditional approach to management accounting is not therefore to do with the analysis planning and control concept. It is the excessive focus internally within the business what I have for years described asthe‘budgetactualvariancesyndrome’.Havingestablishedwithgreateffort andoftenmuchpainthebudgetfortheforthcomingyearmanagementaccount- antswillspendallyearreportingingreatdetailhowwellorbadlythebusiness is performing against this budget. This detailed reporting will continue even though the budget may have been rendered completely irrelevant by some uncontrollableexternaleventearlyinthefinancialyearorevenbeforethenew yearactuallystartedbutafterthebudgetfortheyearhadbeenfinalised.

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34 MarketingFinance The only statement any of us can make with certainty about any business plan that we have ever been involved in is that ‘it will be wrong’ Even if the financial objective was to make £10 million profit and the actual profit was exactly £10 million it will in reality be a different £10 million in other wordsthesourcesoftheactualprofitwillnotbeexactlythoseexpectedinthe originalplan.Thisisaninevitabilityofplanningforthefutureinanuncertain relativelyvolatilebusinessenvironment. Therefore as indicated in Figure 2.2 it is critically important that the impactoftheexternalenvironmentisconsideredateachstageoftheanalysis planning and control process. However the main objective of Figure 2.2 is to highlight the relative importance and emphasis within each of these stages. This is done by the different black arrows emanating from each box in the diagram while the external environment exerts a consistent pressure on the business throughout. The key objective of the analysis phase is to find out aboutandunderstandasfaraspossiblethecurrentandfutureexternalbusiness environmenthencetwoexternallyfacingarrowswithonlyonelookinginside thebusiness.Mostbusinesseshavealotofinternalanalysisincludingallthis year’smanagementaccountssalesanalysescostingdataetc.Whattheyneed as a basis for planning for their future is information about the specific envir- onment in which they will be operating in this future. This means that the greatest emphasis in the analysis phase must go on predicting the future business environment. Unfortunately this is not the case for most businesses in many planning processes the major external environmental analysis consists of a précis of the latest EIU Economist Intelligence Unit report for thecountryinwhichthebusinessisoperating.Thisisnotmeantasacriticism Internal business focus Control Planning External environment External environment External environment External environment External environment Analysis Figure2.2 Takingtheexternalenvironmentintoaccount

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TheVirtuousCircleofAnalysisPlanningandControl 35 of EIU country reports as such but these are fairly obviously generalstatements of a best guess for the overall macroeconomics for particular countries. The report may give the view that inflation will be 2.5 per cent the rate of exchange will be€1 to 1 unemployment will remain high at 8 per cent the balance of trade will continue to be negative at 2.5 per cent of GDP GDP growth will slow to 1 per cent and the government will run a fiscal deficit of 3percentofGDP. The key very powerful analysis question is ‘so what’ What would this macroeconomic environment mean for our business in terms of market size pricing opportunities cost pressures from suppliers and employees competitor initiativesbothfromexistingcompetitorsandanynewcompetitorswhomight be attracted into our market place etc. Also this set of EIU forecasts is a consensus or most likely outcome from an infinite range of possibilities. Manyreaderswillhaveseenthereviewsthataredoneattheendofeachyear whentheforecastsofvariousexpertsarecomparedtotheactualoutcomesfor that year. Not surprisingly the maximumrangesbetweentheextremeforecasts and the actual out-turns can be very great indeed. Thus the analysis process should try to identify what sort of ‘range’ there could be during the plan period this must be done for those most critical external factors having the greatesteffect on thebusiness. For example in an export-led business a forecast of€1 to US1 may lead to an assumption of a relatively stable market place but if thepossiblerangeforthe currency is from€1 to US 0.75 cents or€1 toUS1.20thefuturecouldbefarlessstableifeitheroftheseextremeswere to happen. A failure to identify the need for contingency planning which is considered in detail in Chapter 6 can have dramatic consequences for any businessasisillustratedinPracticalInsight2.1. PracticalInsight2.1 Contingencyplanningforadevaluation During the 1990s Argentina staged one of the most amazing economic turn- arounds ever. From hyperinflation at the end of the 1980s measured in ‘000s of percentage points it peaked during 1989 at 20233 per cent p.a. by the mid- 1990s Argentina had a lower inflation rate than the USA. During this period the economyshowedverystronggrowthinGDPsothatArgentineconsumersbegan to feel much better off. This transformation was achieved by a new economic plan instituted by the Carlos Menem government elected in 1989 and re-elected following a change in the constitution in 1993. A key element of this economic planwastofixtheexchangerateoftheArgentinepesototheUSAdollaratparity i.e.1peso US1. This rate held from 1991 until the end of the 1990s despite Argentina having massive foreign debts very low foreign currency reserves and running a foreign trade deficit throughout this period. In December 1999 a new President was electedandhe‘promised’tomaintainthefixedexchangerate.This‘promise’was

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36 MarketingFinance In Figure 2.2 both the planning and the control phases have five arrows comingoutoftheirboxesandthisistoindicatethattheyaremoreimportant and should therefore receive more emphasis than the analysis phase which has only three arrows. However the balance between internally facing and externally directed arrows differs. The strategic planning exercise is carried out to devise action plans strategies which should achieve the corporate objectives the analysis phase should have ensured that the objectives were realisticgiventheexpectedexternalcompetitiveenvironment. Howeveranystrategicinitiativestartedbythebusinesssuchaslaunchinga new product or entering a new market is likely to trigger a competitive responseparticularlyifitstartstobesuccessful.Alternativestrategiestocreate shareholder value may have adverse impacts on other stakeholders who may also react e.g. raising prices ahead of inflation or seeking to hold down input prices from third party suppliers. Thus the planning process needs to consider the impact of the proposed action plans on all those affected and to identify whatpossiblecounterinitiativestheymaylaunch. The implementation of this game theory approach to marketing planning is consideredinmoredepthinChapter 4butitshouldbetakenonestagefurther. Theoutputfromtheanalysisphaseshouldbeusedtoidentifywhatnewinitiatives wouldbeinthebestinterestsofcompetitorsaswellascustomersandsuppliers. In other words does the expected external environment enhance or diminish the relative competitive strength of our business This can be particularly important where a range of potential future external environments has been identified if in some of these one business gains a significant competitive advantagewhileinothersparticularcompetitorsdo.Clearlythemostappropriate ContingencyplanningforadevaluationContinued reflectedintheEIUcountryreportandhencetheforecastexchangeratefor2000 and2001was1peso:US1. Companies in Argentina based their planning on this critical assumption despitethecountryalreadybeingincrisistalkswiththeIMFregardingnewfund- ing to finance the gap between foreign currency reserves and the foreign debt repaymentstobemadein2000and2001. The ensuing economic crisis caused by the very substantial devaluation of the ArgentinePesowasmademuchworseformanycompaniesbytheabsenceofany contingencyplanforsuchadevaluation.Theauthorhasheardanumberofsenior company executives from this country state that the government ‘said it would notdevalueandtheEIUdidnotpredictitsohowwerewetoknow’.Nogovern- ment has ever said in advance that it would devalue and the EIU report very clearly stated that it was ‘the government’s stated plan to maintain the current exchangerate’. Externallyfocusedanalysisaimstoidentifythosechangesinthebusiness envir- onmentthatcanhaveamaterialimpactonthebusiness.Predictingsuchapossib- ility does not mean that the business can stop it happening but it does mean that thebusinesscantakestepstominimisetheimpactshouldithappen.

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TheVirtuousCircleofAnalysisPlanningandControl 37 marketing strategy will depend upon which of these alternative competitive environmentscenariosprovestobecorrect.Thismeansthatabusinesscannot prepare one plan but must prepare a range of plans if it is to cope with an uncertainfutureexternalworld. Even more variants need to be developed if the response by competitors orcustomersorsuppliersetc.toanyproposedstrategyisbynomeanscertain. Obviously no business has the time or the resources to produce an infinite number of alternative plans and so there needs to be a process for selecting the most important elements that need to be considered this is discussed in Chapter6. Howeverthe key issue is to focus back on the overriding objective to create shareholder value and the consequent need to develop some form of sustainablecompetitiveadvantageifsustainablesuperprofitsaretobeachieved. All of these sustainable competitive advantages are by definition really relative statements in that they refer to things which one business does better cheaper faster etc. than all others. They also need to be considered in the context of the customers who are willing to continue to pay a price for the goods or service that enables the supplier to generate a super profit. In other words the customers must still perceive themselves as getting good value for money even in the absence of direct effective viable competition. This means that the marketing finance planning and evaluation process must have thisexternalfocusinthatitmustincludeacomprehensiveanalysisofcompetitors and customers. This competitor analysis must not be limited only to obvious existing competitors as new potential competitors may be attracted to any industry or sector that is generating super profits. Indeed existing customers and even suppliers may be tempted to become competitors through vertical integration if the potential returns are high enough. It is essential that the company’scurrentpositionisprotectedasfaraspossiblebyinvestingincreating strongentrybarrierstodeteralltheidentifiedpotentialcompetitors. Financemanagersaremostunlikelytoidentifyontheirownallthepotential novel marketing strategies that competitors may initiate to try to break through an existing entry barrier. Competitor analysis as discussed in Chapter 4 thereforeneedstobedoneasaco-ordinatedeffortutilisingalltheknowledge and skills available within the business. Failure to identify these threats can transform the power base within an entire industry in only a few years as is illustratedinPracticalInsight2.2. PracticalInsight2.2 Fromcommoditysupplierstodominantbrands In the very early 1980s the PC industry was starting and the dominant computer companiesneedednewsuppliersforthisveryhighgrowthpotentialproduct.This was particularly true for IBM which although by far the largest and most profit- ablecomputercompanyintheworldwasalateentrantintothePCmarket.Inan

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38 MarketingFinance Thisexampleofcompetitoranalysisalsoillustratestheintegratedoverlapping nature of a good analysis planning and control process. Some companies regard competitor analysis as part of their pre-planning analysis effort and indeed once a year they analyse their competitors and issue a formal glossy reportcoveringtheirfindings.Ofcourseifthesecompetitorsstartnewstrategic initiatives just after this annual exercise is completed the basis of the company’s strategic plans is completely undermined. It is not important how or where you classify particular activities as part of analysis planning or control. These critical areas such as competitor analysis must be a continuous part of the equally integrated and continuous strategic marketing finance approachtoplanningandcontrol. ThecontrolelementofthisoverallprocesshasaswasshowninFigure2.2 agreateremphasisinternallywithinthebusinessthanontheexternalenvironment i.e. three internal arrows compared to only two externally facing arrows. Thisisclearlybecausethefocusofmanagementcontrolisonone’sownbusiness we have already established that a lot of the external environment is beyond thecontrolofanysinglebusiness.Whatreallyneedsjustifyingthereforeisthe continuingsignificantexternallyfocusedelementwithinthiscontrolactivity. It is clearly necessary for all businesses to monitor the success with which theirchosenstrategiesarebeingimplemented.Asalreadydiscussedanybusi- ness strategy is based on a large set of assumptions many of which will turn out to be wrong. Contingency plans should have been prepared for the major foreseeable alternative scenarios but for many businesses their actual external competitive environment will contain a number of unpredicted elements. As already stated monitoring performance against an already irrelevant plan FromcommoditysupplierstodominantbrandsContinued efforttogetintothisrapidlygrowingmarketasquicklyaspossibleIBMunusu- ally at the time outsourced the operating system to Microsoft and the main processor chip to Intel. It saw these items as necessary commodity inputs to a productthatitwoulditselfbrandthusIBMwouldtakethedominantshareofthe total value chain. It could also switch its business to another supplier if it didn’t getthepriceitdemanded OverthesucceedingyearsbothMicrosoftandIntelfollowedanaggressivebrand- ing strategy in a very successful attempt to turn themselves from subservient commodity suppliers to dominant branded goods companies. Indeed the key issuesformostPCandlaptoppurchasersnowadaysarethatthemachinesupports Microsoft’s latest version of Windows and contains an Intel Pentium processor the name on the outside of the PC or laptop is largely irrelevant. Thus the once dominant branded computer companies have been turned into the commodity suppliers which now need the branded components. Their relative profitabilities confirmthenewbalanceofpower. ThefurtherchangesinIBM’sstrategyareconsideredinacasestudyinChapter3.

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TheVirtuousCircleofAnalysisPlanningandControl 39 is not a real control process. The control process itself therefore needs to provideamethodofupdatingoftenreferredtobyfinancemanagersas‘flexing’ the existing plan in order to incorporate the latest information on the real worldinwhichthebusinessisoperating. Onceagainsomebusinessesmightarguethatthisisconfusingcontrolwith analysis but the key objective is to improve the decision-making within the business not compartmentalise activities and responsibilities. This external element of control should certainly help to update the analysis element for next year’s planning as it keeps the external review up-to-date. Indeed for a few companies where this continuous process is now well entrenched it is almost impossible to state where analysis stops and planning and control start. This is indeed how it ought to be but it is not necessarily the case as is illustratedinPracticalInsight2.3. PracticalInsight2.3 Thefinancialplanningandcontrolprocess Themainobjectivesofanyfinancialplanningandcontrolprocesswhetheror not it follows the continuous integrated strategic marketing finance approach Planningmanagersprepareplans Many years ago or at least it seems like it soon after I had qualified as an accountant I moved into industry and was given the job of planning manager for a division of Mars Ltd. Basically the job involved working with sales and market- ing managers and operational managers to prepare regular revised plans for the business. These proposed plans were presented to the top management team and onceapprovedtheywerepassedtolinemanagerstobeimplemented. As the business started to fall short of these plans my job was to produce a revisiontotheplaninfactweproducedarevisedforecasteverymonthalthough some of the changes were quite small. Quite soon the top managers decided that theplanningprocesswasquitegoodafteralltheyeventuallyapprovedeachplan before it could be implemented. However the control process must be deficient asthebusinesswasnotachievingtheseexcellentplans. Their solution was to promote me to Financial Controller so that I then had responsibility for both the preparation of the plans and their subsequent imple- mentation. Suddenly the fun went out of life I could no longer produce a superb plan to takeover the universe and then throw it over the wall of the organisational structure for my colleagues to try to achieve. Scarily I still today come across quite a lot of companies that have planning managers whose entire role in life is to prepare plans. Even worse as discussed in Chapter 6 there are planning managers in large organisations whose main role in life is to make sure other peopleplan

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40 MarketingFinance advocated above and throughout this book are to enable the organisation to develop implement and control a strategy that seeks to achieve its long-term objectives and overall mission. A good control process would indicate when modificationswereneededintheoverallstrategythroughshort-termfeedback loopsandappropriateperformancemeasures.ThusasindicatedinFigure2.3 thelong-termobjectivesmustbeconsistentwiththeshort-termbudgetsactually usedbythecompanyonaregularbasis. Itisanobviousbutimportantstatementthatthecurrentyear’sbudgetmust be the first year of the long-term plan but in many companies this does not stay the reality as the year unfolds. No plan is ever implemented without significant modifications not least because as already discussed there are always unforeseen changes in the external environment. Hence during the yearthetacticsandeventhestrategymayneedtobechanged.Itisimportant that these required changes are as far as possible still consistent with the long-term objectives of the business. At least these long-term objectives should be taken into account as the possible modifications to the strategy are being considered. If necessary the objectives themselves may need to be modified but the required supporting information for such an important decision must be readily available as is shown by the feedback arrows in Figure 2.4. This feedback and modification process is developed in more depth in Chapter 6. Unfortunately in many cases changes are made during the year that enable the short-term budget to be achieved at the expense of theselong-termobjectives. This can happen because the performance measures in use within most businesses focus almost exclusively on the short-term budget period i.e. the current financial year. This would not necessarily matter as long as these performance measures included clear indicators of how the business Goals Objectives Strategy/Long-term plans Tactics/Budgets Mission Figure2.3 Theverysimplebusinessmodel

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TheVirtuousCircleofAnalysisPlanningandControl 41 was doing in terms of its long-term objectives e.g. market shares brand health indicators penetration of new customers. In most cases these longer-term performance indicators are missing. It is as already mentioned quite common for the main performance measures to focus on sales reve- nues and profits this year even though the marketing strategy may be based on the business developing new sustainable competitive advantages. This concentration on short-term performance increases the pressure on managers to compromise on longer-term investments in order to deliver the required financial performance now. Marketing activities often bear the brunt of this because as mentioned in Chapter 1 marketing expendi- ture is regarded as an expense in the current year. Few managers would seriously consider stopping halfway through building a new factory yet many companies curtail development marketing expenditures in order to hit this year’s profit target. It is therefore very important that businesses develop an appropriate set of performancemeasurementswhicharebothcloselyintegratedwiththeirlong-term objectives and provide early indications when things are not going to plan. This is the focus of Part Four of the book where all of these issues are discussed in more depth. A business needs performance measures at three different levels if it is really to stay in control of its long-term performance theseareshowninFigure2.5. The highest level of performance measure relates to the overall economic performance of the company as this is of fundamental interest to its shareholders. In other words is the business operating in attractive Establish the mission goals and objectives Formulate and select the appropriate strategies and tactics Design feedback loops to assess performance and to allow for changes during implementation Implement monitor and revise Figure2.4 Thestrategicmanagementprocess

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42 MarketingFinance markets and industries where shareholder value can be created If not the long-term strategy should be either to improve the competitive environ- ment e.g. rationalise the industry or develop some new differential advantage or to exit from this industry in order to invest in more attractive areas. This top level of performance measure says very little about the relative performance of the business and its managers. In certain very financially attractiveindustriestherelativelyfewcompaniesinvolvedmayallearnsuper profitsandthuscreateshareholdervalue.Equallyinanover-suppliedextremely unattractive industry the best management team in the world should lose less money than the rest but they will find it impossible to create shareholder value.Thusthesecondtierofperformancemeasureisneededtoputtheabsolute levelofeconomicperformanceintoanappropriaterelativecontexta30percent p.a. return on investment looks decidedly less impressive if all the competition is achievingover50percent. This introduces a key issue for performance measures. Some performance measuresaredesignedtoreflecttheeconomicperformanceofthetotalbusiness or of a particular part while others focus on the managerial performance of the people running the total business or specific parts of it. Few performance measuresworkwellinbothareasbecausewhileeconomicperformancemeasures must take into account all the factors affecting the business managerial performance measures should only include elements where the manager Performance measures are needed at three levels to indicate: The economic attractiveness of the industry/sector Can shareholder value be created in this industry Are entry/expansion strategies or exit/rationalisation strategies more appropriate The relative competitive performance of the business Absolute performance is meaningless unless placed in its appropriate context. Internal measures of the key areas for this business The relative competitive positioning within the specific external environment will highlight the key areas for attention within the business if the strategic objectives are to be achieved. 1 2 3 Figure2.5 Strategicallyrelevantbusinessmeasures

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TheVirtuousCircleofAnalysisPlanningandControl 43 whose performance is being assessed can exert some degree of control. It is unfair and extremely demotivating to hold managers accountable for something overwhichtheyhavenocontrol. At the very top of the organisation there may be very little need to distin- guish between economic and managerial performance measures. As far as shareholders are concerned it is the board of directors’ responsibility to ensurethattheircompanyisinvolvedinattractivemarketsthusentryandexit decisionscanre-positionthecompanyasnecessary.Atlowerlevelswithinthe business managers have increasingly less freedom of action or managerial discretion i.e. a southern region sales manager cannot normally decide they would rather base their business in the north or sell a completely different range of products manufactured possibly by a competitor. Hence different managerial performance measures must be used for different levels. The challenge which is discussed in Chapter 12 is to ensure that each level of performancemeasureisconsistentwiththeoverallobjectivesofthetotalbusi- ness. This concept which is generally known as ‘goal congruence’ is based ontheverysimplebutverytruemaximof‘whatyoumeasureiswhatyouget’ i.e. people tend to try to achieve the objectives they are set. If by achieving these objectives they move the business away from its long-term objectives and strategy it is the fault of the people setting the objectives not the people doingtheachievingthisisillustratedbyPracticalInsight2.4. PracticalInsight2.4 Achievethemeasureearnthebonus Having been promoted to the role of financial controller as discussed in Practical Insight2.3Inowhadmuchgreaterresponsibilityforachievingthekeyperform- ance measures set by the group for the business division. Mars Group is well known for setting its businesses quite aggressive financial targets but these are always expressed in terms of ‘Return on Total Assets’ orROTA.ROTAiscalcu- lated as profit before interest tax and depreciation divided by the total assets invested in the business and expressed asa percentage.Totalassetsisusedtostop managers playing games with payment terms to suppliers which can be done if returnonnetassetsisusedasisthecasewiththemajorityofcompanies. This immediately means that there are two sometimes conflicting ways of increasingROTAprofitcanbeincreasedbysellingmoregoodsraisingpricesor reducingcostsorassetscanbereduced.Sizeablebonusesarepaidtothemanage- mentteamifROTAtargetsareexceededsothereisastrongincentivetodothis. In many businesses particularly where the target returns are high e.g. over 40percentbeforebonusesareearneditmaybeeasiertoachievethisbyrestricting investmentin newassetsor even massaging theaccounting treatments of certain itemswherepossiblethisisdevelopedinthemaincasestudyinChapter6.This may be done even though the long-term strategy of the business is to go for growth while the markets it is involved in are themselves still growing as is discussedlaterinthischapter.

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44 MarketingFinance The third level of performance measure should be very specific to the particular business and its long-term objectives. These measures must be appropriatelytailoredtotheparticularbusinessandthelevelwithinthebusiness at which they are being applied. It has already been established that there is a vastrangeofpotentiallysuccessfulcompetitivestrategieswhicharebasedon aspecificsetofsustainablecompetitiveadvantages.Severalofthesedifferent strategies may be successfully implemented in various segments of the same industry at the same time. The performance measures used should be appro- priatetothespecificrequirementsofeachdifferentcompetitivestrategy.This clearlymeansthatdifferentcompaniesinthesameindustrymaybeusingvery different performance measures. Indeed the focus of their marketing finance planningandcontrolsystemshouldprobablyhavefarmoreincommonwitha companyinacompletelydifferentindustrybutwhichisimplementingavery similarstrategythanwithacompanyinitsownindustrythatisimplementing a completely different strategy. This is illustrated in the case study described at the end of this chapter. A key issue therefore for a really good marketing finance process is that it is tailored to the needs of the business. This means thatiftheneedsofthebusinesschangebecausethestrategyhas changedthe tailored performance measures used in the business should also change. Unfortunatelymanycompaniesarestrugglingtocontroltheirmarketingactivities because they are still using control systems and performance measures designedforpreviouscompetitivestrategies. Onewayofillustratingthisproblemusesadevelopmentofthewell-known Ansoff matrix to highlight the different strategic thrusts that a business can have. The Ansoff matrix has been widely used for many years as a marketing planning tool as it very simply illustrates the possible ways in which a busi- ness can try to fill the gap between its current level of performance and that required to achieve its long-term objectives. The beauty of the matrix is the claritywithwhichitdescribesthesestrategicoptionsi.e.increasetheshareof existingmarketswithexistingproductssellnewproductstoexistingcustomers sellexistingproductstonewcustomersorsellnewproductstonewcustomers. TheAnsoffmatrix illustrated inFigure 2.6hasonlybeenmodifiedfrom its original format in terms of the descriptions applied to the boxes for selling new products to existing customers and selling existing products to new customers.Beforeconsideringthesetheothertwopossibilitieswillbebriefly examinedfromamarketingfinanceperspective. Theimplicationsofgrowingabusinessbysellingmoreexistingproductsto existingcustomersthetoplefthandboxofFigure2.6havebeenextensively researched over many years with some amazingly obvious results. One of thewonderfulaspectsofbeinganacademicisthatyoucanspendalotoftime researching something that is blindingly obvious to most practitioners. Strat- egies to increase market share have been shown to create most shareholder value when the relevant market is itself growing strongly. This is because if

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TheVirtuousCircleofAnalysisPlanningandControl 45 the market is static or declining any increase in volume by one company has to come at the direct expense of competitors. They are likely to respond aggressively most probably through some kind of price cutting activity which could reduce the total profitability of the industry. Thus the strategy may be successful in gaining market share but it will not necessarily generate ahigherlevelofsuperprofits.Ifthetotalindustryisgrowingstronglythereis much less chance of such aggressive competitive reaction. Their own sales may still be increasing even though they are in fact losing market share the sales growth and consequent market share increase being achieved out of the newsalesfortheindustry. As discussed in more depth in Chapter 4 companies are increasingly using game theory-based strategic analyses in order to predict both competitive responses to their marketing initiatives and likely marketing initiatives of competition. From the marketing finance perspective shareholder value can beseparatedintotwophases:creatingvalueandcapturingvalue. Creating value refers to marketing strategies that seek to increase the total value generated by the industry e.g. increasing the total size of the market addingvaluetoexistingproducts.Thusitispossibleforallcompetitorsinthe industry to benefit from these ‘creating value’ strategies although they will not all benefit equally. Strategies aimed at creating value should result in less aggressive competitive responses they can even be described as ‘co-operative’ waysofcompeting. Products Existing Existing New New Customers Market penetration strategy Existing customer-led strategy Existing product-led strategy Diversification Figure2.6 PotentialstrategicthrustsofbusinessesbasedonAnsoffmatrix

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46 MarketingFinance Capturingvalueisallaboutgainingagreatershareofthetotalvalueavailable within the industry. As a result it tends to be a ‘win–lose’ game and this can result in much more aggressive competitive reactions. In some disastrous examples these reactions resulted in dramatic price wars which left everyone much worse off financially. The marketing finance process should therefore identify the type of shareholder value creation that should result from the proposed marketing strategy. This will help to predict the likely competitor response. Selling new products to new customers the bottom right hand box of Figure 2.6 has also been quite well researched and the resulting shareholder value creation is also disappointing. A very common rationale for adopting this strategy is that it ‘reduces the risk profile of the group’. However a ‘new new’ strategic thrust is really an increasing risk strategy because it is not normallybuiltonanyexistingcompetitiveadvantageasisshowninFigure2.7. Theremaining two boxes are themodifiedheadings fortheoriginalAnsoff matrix because the key strategic thrust relates to the existing source of competitive advantage on which the growth strategy is based. In the case of selling new products to existing customers this should be the loyal base of existing customers for which new products are to be developed or acquired. Correspondingly the marketing strategy of finding new customers segments or markets in which to sell existing products should be built on an existing successfulproductwhichiscapableofgeneratingasuperprofitinitsexisting market. These strategic thrusts are considered briefly in the remainder of this chapter but in Part Three each has a separate chapter that deals with the key issuesinmuchmoredepth. Products Existing Existing New New Customers Diversification reducing or increasing risk Figure2.7 DiversificationusingtheAnsoffmatrix

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TheVirtuousCircleofAnalysisPlanningandControl 47 Brand-ledstrategies Brands can be based either around products e.g. Coca-Cola Marlboro MicrosoftInteloraroundcustomerse.g.TescoMarksSpencerWal-Mart Citigroup HSBC Virgin. They are therefore considered before either customer-led strategies or product-led strategies as a number of common issuescanbemoresimplyexplained. Ifamarketingstrategybasedonbrandsistobeshareholdervalueenhancing the brand must enable the business to earn a super profit on its more tangible assets i.e. the brand becomes an intangible asset of the business. However brand assets can achieve such a super profit in different ways and these differentwaysrequireappropriatelytailoredmarketingfinanceprocesses. A strong brand may enable the ‘branded product’ to be sold at a higher price than its unbranded equivalent. Alternatively an equally strong brand could be sold at exactly the same price as other products but command a significantlygreatershareofthemarketonaconsistentbasis.Athirdbranding positioningwouldbetocombineaslightlyhigherpricetogetherwithahigher market share. It is important that the control process understands and focuses onthespecificbrandstrategy. Thereareanumberofstagesinvolvedindevelopingandthenmaintaining a brand as a shareholder value enhancing asset. Some success although not necessarily uniform success must be achieved at each stage if the brand is to have a sustainable super profit generating capability. For a repeat purchase consumer brand these stages include awareness creation propensity to purchase ability to purchase i.e. distribution trial rates repurchase rates adoption rates usage rates and ultimately loyalty and advocacy rates. In many businesses marketing research has developed specific effectiveness measures for each of these stages. The marketing finance challenge is to develop a comprehensive brand evaluation model that can incorporate these non-financial effectiveness measures. Several companies such as BAT Diageo Cadbury Schweppes are now using such overall brand evaluation models as key elements in evaluating and controlling their brand marketing expenditures. These models are based on the discounted cash flows that are predicted for the brand and on an assessment of the brand strength which is used to determine the discount rate applied to these predicted cash flows the strongerthebrandthelowerthediscountrateapplied. Clearly many assumptions have to be made to arrive at the eventual discounted cash flow result i.e. the brand value but this is not the point. Unfortunately many companies focus far too much on the resulting brand valuewhereastheprocessshouldberegardedasabrand evaluationexercise. Itisnottheabsolutevalueatanypointintimethatisimportantbutthemovements in the value and the directional trend in the key brand attributes as discussed in Chapter 8. Such a model can be used in the marketing resource allocation

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48 MarketingFinance exercise that has to be done in any planning process. It can financially evaluate proposed incremental development expenditure and ascertain the required levelofmaintenancemarketingsupport.Theseevaluationsarebynomeanssimple and straightforward because the relative effectiveness of one company’s expenditureisaffectedbythemarketingspendofcompetitors. Customer-ledstrategies A customer-led strategy is designed to encourage existing loyal customers to try new products that are launched under the same brand. Retailing particularly supermarkets and financial services are two industries in which many companies have implemented customer-led strategies. To a large extent they were forced to do this as it became increasingly difficult to build sustainable differential advantages around the products involved in either industry. Thus as shown diagrammatically in Figure 2.8 any customer-led strategy is built around the existing customers of the business. A critical question for evaluating such a growth strategy is therefore ‘which customers should form the basis for future growth’ The shareholder value-focused answer is clearly to base the strategy around those customer groups from which the company cangeneratesustainablesuperprofits. This requires strategically oriented long-term customer account profitability CAP analysis to be carried out. This CAP analysis should indicate the relativeprofitabilityofdifferentgroupsofcustomersbutitshouldnotbeused as an attempt to apportion the net profit of the business among the different customers. Indeed apportioning or ‘spreading’ costs among customers can Main strategic thrust Products Existing New Existing New Customers Figure2.8 Customer-ledstrategies

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TheVirtuousCircleofAnalysisPlanningandControl 49 destroythemainbenefitsfromtheCAPanalysisasisillustratedinChapter9. Theanalysisshouldsupporttheimportantstrategicdecisionsregardingwhich customer segments should be invested in etc. Thus the resulting information mustberelevanttothesedecisionsandthisisnotachievedifalargeproportion ofindirectcostsareapportionedtothesecustomers. Thekeyphraseis directattributablecostingwheretherealcostdriversfor each major customer related cost are identified. These cost drivers are what causes the cost to be incurred by the business and what makes the level of the costchange.Iftheyareaccuratelyidentifiedthiswillindicatehowcustomers should be grouped together. The idea is to group together customers who are treatedverysimilarlyandtoseparategroupswheretherearesignificantdifferences in the cost levels incurred and hence potentially in the rates of return achieved. Many companies now operate quite sophisticated CAP systems of this sort but if the strategy is to be based around customers the analysis needs to be done on a long-term basis. Such long-term CAP analyses are less common. Theideaistoevaluatewhichtypesofcustomersarefinanciallyworthinvesting in because over their economic life cycle as a customer the business expects to be able to generate a positive net present value from such an investment. This type of marketing strategy is commonly referred to as relationship marketing because the business tries to develop i.e. invests in a long-term relationship with the customer. If a relationship marketing strategy is being implementedthemarketingfinancesystemneedstobeappropriatelytailored so that these key customer relationships are managed as a long-term business asset.Thusdevelopmentandmaintenancemarketingexpendituresoncustomers areveryrelevantconcepts. Indeed in a relationship marketing-based strategy attention moves away from customer acquisition towards customer retention and development. The keypriorityisretaininganddevelopingthemostvaluablelong-termcustomers. However in order to attract and then retain these very valuable long-term customers the supplier must create more value for these customers than the competitionanysustainablelong-termrelationshipmustbemutuallybeneficial. Customer value can be defined as the perceived benefit obtained by the customer less the price paid and any other ‘costs’ e.g. time inconvenience effort incurred in order to own the good or service. Customers who do not perceive that they are getting value from a relationship are likely to defect probably without generating sufficient value to justify the original marketing investment. Companies are now trying to assess customer lifetime value and are using increasingly sophisticated tools to do so. Data warehouses and data mining tools assist organisations in measuring the economic value of customers. Predictive modelling techniques can be used to predict the remaining lifetime of the relationship with the customer and the likely resultant future stream of

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50 MarketingFinance profitsandcashflows.Theeconomiclifetimevalueofthecustomeristhepresent valueofthenetcashflowsexpectedtobegenerated fromthecustomer. If the main strategic thrust of the business is based on customers it is also important that these customers form an important element in the performance measures used within the business. If this is not done many of the business support areas will focus on achieving their own performance measures often tothedetrimentofthelong-termdevelopmentofthesecriticalcustomer-based assets. Product-basedstrategies An alternative but possibly equally attractive marketing strategy is to base future growth around existing products as is shown diagrammatically in Figure 2.9. These products may also be strongly branded but the critical element in this strategy is that the growth opportunities are based on finding new markets new segments or simply new customers to which to sell these existingproducts. Not surprisingly this marketing strategy should be built on those products that can achieve a sustainable level of super profit in their existing markets. Hencea focusforthetailoredmarketingfinance systemshouldbeadecision- oriented long-term direct product profitability DPP analysis. As with the customer profitability analysis theobjective of DPP is to indicatetherelative profitability of different product groups. Therefore apportioning indirect costs in an attempt to arrive at a ‘net profit’ for each product can destroy the validity of the analysis and lead to disastrous resource allocation decisions beingmadetheseareillustratedinChapter10. Main strategic thrust Products Existing New Existing New Customers Figure2.9 Product-basedstrategies

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TheVirtuousCircleofAnalysisPlanningandControl 51 For most businesses and indeedfor all of the large number of DPP analyses that I have personally been involved in the allocation of directly attributable product-specificcoststoappropriatelygroupedproductscanhighlightsignificant differences in the relative profit contributions from these differing product groups. Once again if the DPP analysis is to be used to support long-term strategic decisions such as to identify those products which should be launchedinternationallytheanalysismustconsiderthelong-termsustainable profitabilityoftheproducts. In some industries this requires the use of some product life cycle costing techniques because the product costs will change in a predicable way over time. It is now well established that the costs of producing many products both goods and services decline in real terms over time due to a number of factors. These include learning by employees that makes them more efficient the introduction of new technologies and the economies of both scale and scope. These are combined together in the ‘experience curve’ concept which enables businesses to predict the rate of decline of their real production costs perunitascumulativeproductionvolumesincrease. This predictive knowledge can be used in the marketing strategy because the business could set its prices today based on its long-term costs rather than its current costs this is diagrammatically illustrated in Figure 2.10. Such a pricing strategy would probably result in the business making a loss on its current sales but these sales should increase rapidly as the low selling price stimulated demand. These increasing sales volumes should propel the busi- ness rapidly down its experience curve – towards its long-term cost level at which point it should be generating a super profit. If it can gain a sustainable long-termcostadvantageoveritscompetitorsbythisstrategyitshouldregard The ‘short-term loss per unit’ if successful is really an investment in developing a long-term sustainable cost advantage Log cumulative volume Log price and cost per unit in real £’s Profit margin to achieve long term required rate of return Long-term achievement of super profit Today’s selling price Long-term cost per unit Long-term expected volume based on today’s selling price Prices set now based on long-term costs Short-term losses Current costs per unit Figure2.10 Lifecyclecostingtechniques.Strategicuseofexperiencecurvesin settingprices

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52 MarketingFinance the initial ‘losses’ as an investment in creating a sustainable competitive advantage. The idea of having a sustainable cost advantage also indicates another important aspect of product-based strategies. The strategic marketing finance needs of a low cost-based strategy are fundamentally different to those of product-based strategies built on differentiated or value-added products. Thus the required competitor analysis focuses on the source of relative competitive advantage or disadvantage. Where the main basis of competition is on price becausethereisnocustomerperceiveddifferenceamongcompetingproducts the relevant competitor analysis should concentrate on cost benchmarking. In suchacommoditystylepriceconsciousenvironmentthelowestcostsupplier willnormallywinandrelativelysmallcostdifferencescanbecritical. However if the basis of competition is differentiation rather than price an excessiveemphasisonexternalcostcomparisonsoreveninternalcostreductions canbeverycounterproductive.Acostdifferencenolongernecessarilyindicates a competitive advantage or disadvantage because it may be the source of the customerperceiveddifferentiationthatinrealitycreatesthesuperprofit.For these businesses the focus needs to be on the value-adding elements rather than on the costs. Marketing finance therefore must become involved in the assessment of ‘perceived use values’ where the perception is by the custom- ers of the differences between competing products. The perceived added value is then compared to the relevant incremental cost incurred in achieving the difference with any resulting positive value gap being evaluated for sustainability. Casestudy–RudolphandtheElves In an attempt to illustrate much of the above discussion this chapter closes withadeliberatelystylisedandwhimsicalcasestudy.Howeverthecasestudy is accurately based on the toy industry and has very many applications to any seasonallyaffected business.Itaimstoshowhow amarketingfinance system mustbetailoredtothespecificneedsofeachbusiness. Rudolph was beginning to regret his rapid rise up the managerial ladder this time last year he had been head chauffeur but a continuing severe head cold had made him ask SC as he was known in the business for an indoor job. He had started as assistant stores controller but his skills and self-motivation had led to his promotion to Head of Production Scheduling and Controller Of The Corporate Headcount HOPSCOTCH for short. One of his main roles was clearly to plan the production of the year’s toy requirements and to recruit and train the labour necessary to achieve this level of output. He had instantly identified one key problem: seasonality in sales He had therefore approached the marketing department regarding ways in which this peak couldbereduced.Howevertheyfeltthatcustomerswouldbeveryaversetoa

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TheVirtuousCircleofAnalysisPlanningandControl 53 change in delivery patterns even if it were geographically organised. They had been trying for many years to generate additional purchase opportunities so that some spreading would take place but this had not really reduced the peakvolumeatChristmas. They did accept that Rudolph’s problems were increasing because their market research was becoming less reliable and was also being received later very few letters now seemed to come down the chimney until October at the earliest. The lack of reliability and hence very late surges in demand for certain products were apparently due not only to the increasing sophistication of customers but also to the greater product range availability which created shorterproductlifecyclesthantheyhadbeenusedtointhepast. Thusinrecentyearstheyhadbeenleftwithlargeunusablestocksofcertain items. One potential reaction to this problem was to produce only low volumes of‘fashion’itemsearlyintheyearandconcentrateonmakingthemainly‘low risk’productsinthisperiod–thiswascomplicatedasfewerandfewerproducts could be classified as low risk. Such a seasonally based system did enable production to be matched more closely with demand as the demand could be moreaccuratelyassessedbutitalsoincreasedproductioncostssignificantly. Not only was overtime working required but temporary labour was also hired. This meant increased training for short-term assistants. In spite of this training Rudolph knew that wastage and rework costs would be significantly higher due to the temporary labour and tiredness on the part of the permanent employees.OffsettingthisofcourseRudolphhadsomesavingsarisingfrom not having to rent vast outside warehouses and also in interest costs because hedidnothavetofinancethehigherinventorythatwouldresultfromaneven levelofproductionthroughouttheyear. Thereseemedtobesignificantdisadvantagestoeitherseasonalmatchingor evenproductionbutRudolphhadthoughtofonefurtheroption.Ifheinvested inautomatedproductionfacilitiesinparticularflexiblemanufacturingsystems then he could cope with the increased seasonal demand by running the machinesforlongerhoursandheshouldn’tneedtohireanytemporarylabour with all of its associated problems. If he didn’t need the output he could turn the machines off and since the labour element involved would not be very greatitwouldn’twastemuchmoney.Wasthistheanswertohisproblem Discussionofproblem Rudolph in his employment for Santa Claus has a number of very unusual competitive advantages which include an incredibly powerful brand name a uniquedistributionsystemwhichenablesdeliveriestobemadetoallthechildren in the world on the same night of the year plus the not unimportant fact that allthesedeliveredproductsaregivenawayfree

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54 MarketingFinance Therefore to analyse the main marketing finance issues it is sensible to place the problem in the more realistic setting of the toy industry. There are two existing strategies in use and a third employing flexible manufacturing systems has been proposed. Figure 2.11 summarises the advantages and disadvantages strengths and weaknesses of the existing options and it is clearbutnotsurprisingthattheadvantagesofonesystemarethemaindisad- vantagesofthealternative. In order to select the best alternative each toy company should review its businessstrategyandthenidentifythecriticalsuccessfactorsforthatstrategy. Clearly the chosen strategy should build on and emphasise the advantages of one system and minimise theimpact of its disadvantages. Only then therefore can a decision be made as to whether even production seasonally variable productionortheflexiblemanufacturingsystemsshouldbeselected. Ifthetoycompany’smarketingstrategywastoconcentrateonthemorestable segmentofthetoymarkete.g.plastictoysforthe0–5yearagecategorythen it could logically implement an even production strategy. The risk of stock obsolescence is much lower than in the volatile high fashion segment of the marketwhereastrategyofseasonallyvariableproductionisthusmoresensible. Also in the more stable product groups it may be more difficult to command any price premium against competition. Thus cost efficiency in production maybeasignificantcompetitiveadvantagewhiletheenhancedproductquality islikelytobemorerelevanttothesetypesoftoys. Should the marketing strategy emphasise the high fashion segment of the toy industry where product life cycles are much shorter it is much more important to have production matched to orders. This is much easier to achieve with seasonally variable production levels but even in this manufac- turing environment there will be a need for very great production scheduling flexibility.Akeyfocusofthemarketingfinancecontrolsystemwillbeongetting very up-to-date sales information and translating this into revised production Higher unit costs Poor quality Increased wastage rework Poor machine utilisation High inventory levels − Storage costs − Financing costs − Risk of stock obsolescence Disadvantages of system Production matched to sales − Low inventory − Low stock obsolescence − Low financing and storage costs Flexibility in manufacturing scheduling Lower unit costs Better product quality Efficient well-planned production − Stable well-trained workforce − Low wastage/rework Good machine utilisation Advantages of system Seasonably variable production Even production Figure2.11 Rudolph’sinitialoptions

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TheVirtuousCircleofAnalysisPlanningandControl 55 schedules. This requires information not on what is being shipped by the toy company to its wholesalers or retailers but on what is being bought by consumersfromthesechannelsofdistribution.Oneoftheoriginalkeystothe successofbusinessessuchasBenettonandBodyShopwasexcellentimmediate feedback of information on what products were selling well this has now become a critical part of most retailing strategies e.g. using bar scanning at thecheck-out. Themorestableproductstrategycanuselonger-termtrendanalysistopredict the demand for its products e.g. demographics. One of the delights of this segment is that it is actually very easy to predict how many 4 or 5 years old children there will be next year or even in 3 or 4 year’s time However this type of analysis is irrelevant to a very short life cycle product. Many high fashion toys are now linked to the latest blockbuster film e.g. Harry Potter Star Wars and Lord of the Rings or a TV programme and it is consequently almostimpossibletopredictthesaleslevelsuntilthefilmhasactuallyopened. Thismeansthatveryveryfastmarketingresearchisneededandtheoperations of the business have to be tailored to this critical need for responsiveness and speed. Thus one good performance measure is to look at the ‘cycle time’ of thebusinessi.e.howlongdoesittaketoturnanorderintoadeliveryobviously reducingthiscycletimebyevenafewdayscanenablemorehighlyprofitable salestobeachievedand/oravoidsubstantialinventorywrite-offs. Thisemphasisonflexibilityismuchlessimportantinthemorestablestrategy where as already mentioned cost efficiency is often critical. As the company isregularlyproducingthesameproducttheuseofstandardcostingandvariance analysiscangivegoodinformationonhowefficientlythecompanyisproducing thetoysandsomeexternalcostbenchmarkingwouldprovideusefuladditional information.Thiscouldbeproducedaspartoftheregularmonthlymanagement accounting pack and trend information on costs could also be built up and comparisons made from year to year. In the volatile high fashion business some information would be needed much more rapidly than monthly and long-term trends are not relevant by the time the first sets of variance analyses hadbeenpreparedthebusinessmaywellhavestoppedproducingtheparticular product.Thusthishighfashionstrategyrequiresfastbutapproximatefinancial information. It can accept the necessary approximations because cost is not normally the critical success factor product availability in time to satisfy this very short-lived demand is much more important. Many branded fashion productscanachievesubstantialpricepremiumssothatcostinefficienciescan berecoveredinthehighersellingprices. Figure 2.12 tries to summarise the main differences between the most appropriatemarketingfinancesystemsforthesetwoverydifferentbusinesses. As has been argued throughout this chapter because the marketing strategies areverydifferenttheirmarketingfinancesystemswhichshouldbetailoredto theneedsofthemarketingstrategyshouldalsobeverydifferent.

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56 MarketingFinance Atfirstsightflexiblemanufacturingsystemswouldappeartohavemostof theadvantagesofbothcurrentstrategiesandhenceavoidtheirdisadvantages. Various products could be produced without a drop in quality or requiring additional labour. Thus the fashion products could be produced at the end of the year so that the marketing information was more reliable. However if the required output level can be produced in a very short period of the year i.e. the run-up to the pre-Christmas sales periods it is obvious that the machines willbedramaticallyunder-utilisedduringtherestoftheyear.Amajorflawin Rudolph’s argument is that ‘turning off these flexible machines when they weren’t needed wouldn’t waste much money’. Also the cost of acquiring really flexible manufacturing systems is normally much greater than trad- itionalsinglefunctionequipment.Thelastthingthatacompanywantstodois to leave very expensive plant and machinery idle: the return on investment will rapidly decline. Consequently any company will want to run its flexible machinery for 24 hours a day 7 days a week. This may mean that the com- panyhastoexpanditsrangeofproductsinordertofullyutilisetheexpensive investment in sophisticated plant and machinery. There are two possibilities andbothhaveimportantstrategicimplications. One commonly adopted choice is to expand the range of toys manufac- tured and sold by the company. The high fashion toys whatever they may turnouttobethisseasonareproducedlateintheyearbutmuchmorestable demand toys are produced on the flexible machinery during the first 9 months of the year. This sounds very efficient but it is critically important that the company implements a strategically oriented costing system. The flexible Dynamic flexible chaotic – willing to change very rapidly and often Stable strong planning systems good procedures and processes Style and nature of organisation Summarised approximate some issued daily weekly lots of reforecasts no fixed budgets Monthly detailed accurate full-pack incorporating comparisons to last year etc. Frequency and nature of management accounts Cycle time Order fulfilment measures e.g. On time in full Standard product costing and in depth variance analysis Key operational performance measures Immediate feedback on final consumer demand and attitudes Trend analysis on demand e.g. Demographics Key marketing information Seasonally variable production Even production Figure2.12 FocusofRudolph’smarketingfinancesystems

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TheVirtuousCircleofAnalysisPlanningandControl 57 machineryisveryexpensiveanditshighcostisrecoveredthroughadepreci- ation charge to the products it is used to manufacture. However the stable demand products that are produced for most of the year could have been manufactured using much cheaper dedicated machinery in the even produc- tion strategy. If these products are charged a depreciation cost representing the extra investment required for ‘flexibility’ they will look very expensive and may be unprofitable – remember it is unlikely that any price premium can be obtained for this type of product. The cost driver i.e. the cause of the cost being incurred of the extra investment in flexibility is the desire to producehighfashiontoysandthereforeallthisextracostshouldbecharged to these specific products. Apportioning the total costs across all products destroys the decision support nature of the marketing finance analysis that is beingprepared.Unfortunatelyveryfewcompaniesseemtohaveproductcost- ingsystemswhichdirectlyallocateandattributecoststoproductsinthisway. The second way of expanding the product range is to produce products otherthantoys.Iftheflexiblemanufacturingsystemenabledalmostanyform of plastic injection moulded product to be produced the company could produce high fashion toys in the run-up to Christmas but manufacture a wide range of other plastic goods during the rest of the year. This more clearly results in a very fundamental change in the business strategy as marketing toysisnowonlypartofthebusinessandmarketingwouldneedtounderstand the requirements of many other customers. Indeed it is quite easy to see how the whole emphasis of the company’s strategy could change from being a marketing-focused toy company to a technology-oriented plastic goods manufacturing company. In fact it was observing just such a change in one company’s strategy that led me to write Rudolph and the Elves as a case study An alternative strategic response would be to identify the key shareholder valueprocess withinthebusiness andto concentrateonthis.In theseasonally variable production strategy the company needs to be very good at under- standing its market and very very fast both at getting information from this market and the products back to the market. What it doesn’t have to be brilliantatismanufacturingtheproductseitherintermsoftheircostorinter- estingly their quality in many cases. Therefore what many such marketing- focused businesses now do in the toy industry and in other rapidly changing industriesistooutsourcetheactualproductionoftheproducts.Insomecases this may be the total product while other companies retain some elements suchasfinalassembly.Thisenablesthecompanytofocusitskeyresourceson the rapidly changing demands of its many customers while its suppliers only need to focus on satisfying the requirements of one customer our marketing- focusedcompany. This approach is followed throughout the rest of the book where financial techniques and concepts are discussed in the context of the overall business

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58 MarketingFinance strategybutparticularlythecriticalmarketingstrategy.Hopefullybytheend ofthebookthereaderwillbeabletocarryoutamuchmoreexhaustiveanalysis ofRudolph’sproblemsandsuggesttheoptimumsolution. TosendanysuggestedsolutiontoRudolph–writeitoutandthenburniton anopenfiresothatthesmokegoesupthechimney

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PartTwo AnalysisandDesign

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3 TheStrategicManagement Process:SettingGoalsand Objectives Overview Most modern businesses are quite complex and consequently need to develop andcontrolstrategiesatseverallevelswithintheirorganisationsrangingfrom theoverallcorporatestrategyatthetopdowntotheverydetailedcompetitive strategies needed for each different product/market interface. The challenge forsuchgroupsistoensurethateachlevelinthesestructuresmakesapositive contribution towards creating shareholder value achieving this may require changestotheorganisationalstructure. The strategic management process should start with a vision statement ‘what the business is’ and/or a mission statement ‘what the business wants tobe’.Theseunquantifiedstatementsaremadeincreasinglymorespecificby thedevelopmentofgoalsandobjectivesfortheorganisation.Howeverdifferent groupsofstakeholdersmayneedspecificgoalsandobjectiveswhicharedirectly relevantforthemitisclearlyimportantthatthesegoalsandobjectivesareall mutuallycompatibleandallinlinewiththeoverallmissionstatement. Forevensimpletightlyfocusedbusinessestranslatingthemissionstatement into practically usable objectives and strategies can become quite complicated. Normally specific functional objectives and strategies need to be established. Forlargermorediversegroupsthechallengesarecorrespondinglygreater.Each groupneedstoconsiderhowitsorganisationalstructureimpactsontheachieve- mentofitsoverallmissionandcorporategoalsandobjectives.Themostrelevant structure is often to break the group into strategic business units where each suchdivisionhas responsibilityforexternalcustomers and/oraspecificrange of products. However many large groups have now adopted mixed structures wheremarketfocuseddivisionsaresupportedbyfunctionallybasedcentresand someinternallydrivenbusinessessuchasITmarketingresearch.Thesemixed structures often create as many problems as they solve but the key objective is to obtain economies of scale in the more general groupwide activities and processes while achieving clear market focus where specifically required at thedivisionallevel.

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62 MarketingFinance Inlargegroupsthecostsincurredbythecorporatecentrecanbesignificant and many such centres are consequently seen as destroying part of the share- holdervaluethathasbeencreatedbythemarket-focuseddivisions.Itispossible forcorporatecentresthemselvestobeshareholdervalueenhancingbutinorder toachievethistheyneedtohaveaveryclearunderstandingoftherolethatthey arefulfilling. Anotherstrategicissueformanybusinessesistheirlevelofverticalintegration. Industriesalmostinevitablystartoutbeingveryhighlyverticallyintegratedbut astheymaturemanygothrougha‘verticaldisintegration’process.Thestrategic management process should enable sound strategic decisions to be made on whetherthecurrentorproposedlevelofverticalintegrationisappropriateforthe stageofdevelopmentoftheindustry.Unfortunatelymanycompaniesfailedto spotthepotentialtransitionfromspecialistsupplierhelpingtomaketheindustry less vertically integrated to potential competitor taking over much of the shareholdervaluecreatedbytheindustryuntilitwastoolate.Thetransferpricing systemusedwithinverticallyintegratedindustriesiscriticalinidentifyingthose elements in the industry value chain that actually generate super profits. The value-creatingelementsmust be protectedagainst potential new entrantswhich mayappearasspecialistsuppliers. Organisations should focus on business processes so that they understand which processes truly add value. There are three different classifications of businessprocessfromthisperspective.Afewprocessesgeneratethesuperprofits of the business and the strategic management process must identify these so thattheycanbeprotected.Therearesomeactivitiesthatdonotaddvalueandare notessentialtotheachievementofthecompany’sobjectivesandtheseshouldbe discontinuedassoonaspossible.Howevermostbusinessprocessesdonotcreate shareholdervaluebuttheyareessentialinotherwordstheyneedtobedonebut attheminimumcostpossible. Multinationals and aspiring global businesses face a number of additional risks and thus need to understand and effectively communicate across the organisation their risk-taking appetite neither high nor low risk taking is necessarilyverygoodorverybaditissimplyverydifferent. Introduction Most financial investments should today be viewed as two-stage processes. Investorsi.e.primarilyshareholdersbutincludingotherprovidersoffunding such as banks put money into a business in the expectation of receiving a morethanacceptablefuturereturnrelativetotheirperceivedriskprofile.As shown in Figure 3.1 the business invests these available funds in a range of businessprojectsproductsandmarketsbusinessdivisionsetc..Theseprojects may involve a number of unrelated products being sold in a range of diverse markets. Indeed the complexity and scale of most modern corporations have

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TheStrategicManagementProcess:SettingGoalsandObjectives 63 effectively removed the investors from any possible direct involvement in or even evaluation of the detailed competitive strategies which are selected and implemented for each of these product-market-related investment projects. As a result investors have to base their investment decisions on a broader evaluation of the probable success of the corporate strategy for the whole group in which they invest. However the development of such a two-stage process can significantly increase the costs of the investment process. Con- sequently there is a need for modern companies to demonstrate how their corporatestrategiesasopposedtotheirdetailedcompetitivestrategiescreate shareholder value rather than merely adding cost. This means that for the majority of today’s complex organisations strategic management should be a multilayered process that looks at the value-adding role of each level in the organisation. StrategicmanagementhasalreadybeendefinedinChapter2asanintegrated management approach which draws together all the individual elements including the critically important marketing strategy involved in planning implementingandcontrollingabusinessstrategybusinessstrategyhowever now encompasses overall corporate strategies detailed competitive strategies andalllevelsinbetween.Inthispartofthebookweareconcentratingonthe analysisanddesignphaseofouriterativeanalysisplanningandcontrolprocess. Thus the focus is on understanding the business environment in which the businesscurrentlyisandwillbeinthefutureoperatingalthoughtheoverlapping and integrated nature of the process should be remembered. In Chapters 4 and 5 theareasofcompetitoranalysisandexistingpositionappraisalareconsidered while this chapter looks at some of the key issues involved in designing a strategicmanagementprocessforamoderncompany. The two-stage investment process Shareholders and others invest in company Company invests in portfolio of projects In a perfectly competitive market the portfolio of projects will always achieve exactly the return demanded by shareholders and other sources of finance i.e. no value is created. 1 2 Figure3.1 Addingvalue

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64 MarketingFinance Manybusinesses startoutas tightlyfocusedowner-managedorganisations withaveryrestrictedrangeofproductsservinganincrediblywell-definedmarket. At this stage there should be little if any conflict between the corporate objectives which have been defined from the overall mission statement and thedetailedcompetitivestrategywhichisactuallybeingimplemented.Except of course that at this stage very few businesses have clearly defined mission statementscorporateobjectivesorcompetitivestrategies.Evensothecombin- ation of controlling investors and senior managers as the same people means thatthereisnotyetanygapbetweentheaimsofownersandthekeyinternally based strategic decision-makers. Also the restricted product/market interface oftheorganisationnormallymeansthatthecompetitivepositioningoftheinitial operation is quite easily decided. It is during the ensuing growth phase and beyondforsuccessfulstart-upsthatthecomplexityoflargergrouporganisation structuresappearandfrequentlythreatenthecontinuedsuccessandshareholder valuecreationofthebusinessunlessthestrategicmanagementprocessdevelops and adapts to its new environment. Hopefully it already comes as no surprise thatthestrategicmanagementprocessshouldthereforebetailoredtothespecific needsoftheorganisationandthestakeholderswhoareinvolvedinthebusiness. These stakeholders are diagrammatically represented in Figure 3.2 and some oftheirconflictingneedsareillustratedinPracticalInsight3.1andthroughout thischapter. Strategic decisions are influenced by a wide range of internal and external stakeholders Business and financial strategy Shareholders Investment institutions Family members Prospective investors Debtholders Banks Investment Institutions Individuals Managers Board of directors Senior managers Other managers Customers Direct customers End consumers Consumer groups Suppliers Long-term suppliers Sub-contractors Raw material suppliers Government Tax authorities Trade department Employment department Competitors Existing potential Employees Individuals Unions/staff associations Pensioners Community Local community Environmental bodies Public at large Figure3.2 Stakeholdersversusshareholders

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TheStrategicManagementProcess:SettingGoalsandObjectives 65 PracticalInsight3.1 Missiongoalsandobjectives Thesetermshavealreadybeenusedanditisthereforesensibletoclarifytheir meanings.Unfortunatelytheredoesnotseemtobeuniversalagreementonthe differences between these terms but at least in this book they will be applied inaccordancewiththeirmostliteralinterpretationandintheheirarchyshown inFigure3.3. Frompublictoprivate–anincreasingtrend An increasing number of high-profile and very successful business people are coming to the conclusion that running a publicly quoted company adds far more cost and aggravation than it adds value. One of the earliest and most vociferous complainantswasSirRichardBranson.HefloatedhisVirgingrouponthestock market but very soon raised private funding to buy back all the shares that had been sold to external shareholders. He argued that the communication problems involved in talking to ‘the city’ and what he perceived as the ‘short-term focus’ of the stock market were having a significant adverse impact on his long-term strategy. Amuchmorerecentexamplehasbeen thespectacularsuccessofPhilipGreen in his privately funded takeover and rapid turnaround of the previously publicly quoted BhS and Arcadia retail groups. He has attributed at least part of his success to his ability to communicate his key strategic focus directly to the key stakeholdersinthiscaseemployeesandsuppliersinthebusiness.Havingproved his abilities he is at the time of writing in a position to mount a potential £3 billion plus bid for Safeway the supermarket retailer without needing to consider theuseofthepubliccapitalmarkets. Both of these entrepreneurs plus an increasing number of others are finding it easier to implement their long-term strategies without the involvement of a large bodyofexternalshareholders. Vision statement Mission statement Goals Objectives Figure3.3 Hierarchyofbusinessaims

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66 MarketingFinance The most general and vague is ‘the vision statement’ which encompasses the way in which the organisation would like to impact its environment. This can become so lofty and altruistic as to be of no value expressing how ‘the world will become a better place due to the existence of this company’. More usefully a vision statement sets out the long-term general aims of the business. By keeping the statement general and the timescale imprecise the stated vision may be unachievable in practical terms but can still provide a target for the organisationtokeepheadingtowards. Many organisations regard vision statements as unhelpful and select ‘the mission statement’ as their most general expression of purpose. A mission statement should reflect the specific role that the business plans to fulfil over the long term. It therefore implicitly excludes areas of activity as well as expressly including others. The mission does not have to be prescriptive in termsofthegoodsandservicessuppliedbythebusinessastheseproductswill probably change over time. However the mission statement should indicate the sectoral focus of the organisation e.g. fast moving consumer goods added-value convenience food products business services etc.. Despite this it need not define specific direct customer groupings that will be targeted as thesemayalsochangeovertimeasnewchannelsofdistributionaredeveloped. For example increasingly consumer goods companies can target their end consumers directly by using the Internet and other direct channels rather than sellingthroughwholesalersandretailersthishasnotchangedtheir‘missions’ whicharestilltobe‘consumer’goodscompanies. Themajorbenefitofhavingamissionstatementand/oravisionstatement is to communicate the ‘organisational purpose’ to all the stakeholders who interactwiththebusiness.Thesestakeholdersincludeemployeesshareholders customers suppliers etc. as was shown in Figure 3.2 and the mission state- mentshouldhelpthemtounderstandwhatthisparticularbusinessisallabout. This means that the mission statement should be clear as to the critical long- termpositioningofthebusinesswithregardtoqualityservicepriceetc.Also as discussed in Chapter 6many companies now include statements regarding ‘corporate values’ and ‘guiding business principles’ which cover attitudes to employees and their working environments customers and suppliers as well asshareholders. The mission statement should not contain specific financial objectives or targetratesofreturnforshareholdersbecausethesewillchangeovertimeand withmarketconditions.Howevermanycompaniesdoincluderelativeadjectives suchas‘leading’‘best’‘largest’etc.ifsotheseadjectivesmustbeplacedina proper context so that the meaning is not contentious. Does being ‘the largest company in the washing powder industry’ refer to sales revenue profits assets employedorthesizeoftheactualpacketsofwashingpowdersoldAlsoisthe ‘industry’ being considered global regional national or local More seriously given our focus throughout the book on turning marketing strategies into

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TheStrategicManagementProcess:SettingGoalsandObjectives 67 shareholdervalueanyreferenceto‘largest’‘best’etc.shouldbefollowedby indicating how this positioning would assist in increasing shareholder value. In some industries economies of scale are so dominant that there is an obvious and direct linkage between size i.e. having the largest sales revenue and financial value created. However in many industries the greatest shareholder value is generated by businesses occupying very well-protected niche positions rather than supplying the greatest volume across all market segments. This necessary marketing focus in mission statements is now more common and manycompanieshaveevenadoptedthemaximthatprofitfollowsratherthan leadsthesuccessfulsatisfactionofmarketrequirements.Forthesecompanies long-term super profit generation and consequent shareholder value creation remains an integral part of their corporate mission but they accept that profits comefromthebusinessbeingsuccessful.Thiscanonlybeachievedbyselling productsthatcreatesatisfiedcustomers. Thus in general we can say that the vision statement describes ‘what the business is’ while the mission statement states ‘what the business wants to be’ inoverallterms.These generalstatements thatapply toallstakeholdersin the business need to be translated into more understandable statements for the differentgroupsofstakeholdersthisistheroleoftheorganisation’sgoals.Thus separate ‘goals’ may be established for customers employees and suppliers aswellasforshareholders. It is at this level of establishing more specifically relevant aims and targets thattheorganisationmaycomeupagainstconflictingdesires.Allthedifferent groups of stakeholders may be quite happy with the organisation’s overall mission statement but they may have very different emphases which only become highlighted when separate goals are developed for each group. For example if the mission statement referred to the ‘development and marketing of high-quality products’ in a specified sector shareholders would probably assume that ‘high quality’ would result in high relative selling prices and consequently high profit margins. Customers may have interpreted this as ‘good value for money’ and resent any attempt to charge above average sell- ing prices. Employees might be expecting the ‘high-quality products’ to lead to a dominant market share with consequent positive impacts on employment prospectsandpaylevels.Thebusinesshastodevelopmutuallycompatiblegoals for each of these separate groups of stakeholders which are in line with the overall mission statement so that these potential conflicts are minimised but without creating confusion or communication problems in the future. Goals are established for shorter time frames than the mission statement but they shouldnotneedtobechangeddramaticallyintheshortterm. This means that the strategic management process needs yet another more measurablesetofaimsandtheseareprovidedbytheobjectivesoftheorgan- isation.Theseobjectiveswillnormallyprovideamorequantifiedstatementof the goals of the business and detailed strategies are then designed to achieve

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68 MarketingFinance theseobjectives.Thismakesitcriticallyimportantthattherightobjectivesare establishedbothintermsofthebusinessdirectionwhichtheysetandthelevel at which the desired performance is established. Objectives have to be realistic and achievable if they are to form a meaningful basis for monitoring actual performanceagainstthisisdevelopedinChapter6intermsofdifferentbusiness attitudes towards objective setting. This is much less important when setting a visionormissionstatementasan‘idealistic’ultimatetargetcanstillbeworth having but as the aims of the organisation are made more definitive they shouldalsobecomemorepractical.Inordertoachievethislevelofpracticality theobjectivesshouldbesetinthespecificcontextoftheexternalenvironment in which the business is and will be operating. This requires that both internal and external constraints are taken into account these issues are discussed in Chapters4and5. It is also important that these quantified objectives focus on the correct strategic areas of the business. Far too many businesses still get this totally wrongtheyestablishagoodmissionstatementaimingtobe‘thebestcompany in their chosen sector’ they develop a well-focused integrated set of goals which set out what being ‘the best company’ would mean for each key group of stakeholders and they reduce all this to a single measurable objective whichistogrowprofitsat20percentperyearWhileitistruethatitismuch easier to assess whether profits have grown by 20 per cent year on year than to decide if the company is getting ‘better’ or is actually ‘the best’ it is obvi- ously an inadequate single performance target on which to base the design of the company’s competitive strategies. It is this excessive focus on purely financial objectives that leads to management behaviour that frequently results in the achievement of the objectives of the business at the expense of movingclosertothegoalsandmissionoftheoverallorganisation.Theobject- ives must be more quantified measurable and hence possibly shorter term derivatives of the organisation’s goals thus each important group of stake- holdersforwhomaseparategoalisestablishedshouldberepresentedinthese business objectives. The supremacy of financial objectives means that share- holders appear to dominate but as previously stated super profits result from the development of a sustainable competitive advantage and the creation of satisfied customers. An exclusive use of any financial measure can create major problems for even the most successful business as is illustrated in PracticalInsight3.2. PracticalInsight3.2 Hoistwithitsownpetard Sir Clive Thompson Chief Executive of Rentokil Initial plc became known in the city of London as Mr 20 because his group delivered this level of earnings persharegrowthforyearafteryear.

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TheStrategicManagementProcess:SettingGoalsandObjectives 69 Multilayeredstrategicmanagementprocess As discussed above all organisations should have an overall vision and/or mission statement. For simple tightly focused businesses this statement can then be developed into a series of appropriate goals. These goals can them- selves be translated into quantified corporate objectives so that the most suit- able strategies can be selected and implemented. However even for such a well-defined business these overall objectives will almost certainly prove to be inadequate because organisations simply do not function as total entities. In order to achieve the overall corporate objectives strategic decision-makers will have to choose among alternative marketing strategies different oper- ational methods various human resource policies and a range of potentially innovative ways of financing the business. In other words appropriate func- tional strategies have to be selected but many of these alternative functional strategiesmaybeincompatiblewitheachother.Anearlystageinthestrategic management process even in this simple business must be to ensure that an internally consistent set of functional objectives is established thus hopefully automatically ruling out mutually incompatible functional strategies. This requires feedback loops to allow for any required modifications to individual functionalobjectivesoreventotheoverallcorporateobjectives. There is therefore a hierarchical set of interdependent strategic objectives ineven asimpleorganisation.Notsurprisinglyin thecaseofalargediversi- fied group the problem of turning an overall mission statement into a set of specific measurable objectives can be much greater. While it may be possible to set out for the organisation as a whole goals and objectives that are Rentokil as its name implies started life as an ‘infestation control consultant’ or ‘rat catcher’ to most of us but grew into a widely spread business services group.Thecompany’srapidgrowthcoincidedwithanequallyrapidexpansionin the business services sector as more and more companies looked to outsource non-core support activities. Much of this growth was by acquisition and these deals were financially engineered to assist in delivering the targeted e.p.s. growth. Mathematically as any business grows and grows it needs to find bigger and bigger acquisitions to create the same proportionate positive impact on its e.p.s. growth. Eventually in other words the business becomes dependent on more internallygeneratedorganicgrowth.Thesector’srapidexpansionwasitselfstart- ing to slow by this time and continuing to generate this rapid annual increase in earningspersharewasbecomingevermoredifficult. UnfortunatelybutnotsurprisinglyforSirCliveandRentokilInitialitsshare- holders had got used to 20 per cent p.a. growth. Consequently when the group eventuallyfailedtodeliver20percentdeliveringapathetic17percentinstead the share price fell significantly. It fell much further when Sir Clive re-based future growth expectations to the ‘low double digits’ level even though this still represented significantly better performance than the business service sector in total.

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70 MarketingFinance appropriateforthecorporatemissionthiscanbeameaninglessirrelevantexer- ciseiftheactualbusinessiscarriedoutbyagroupofsmallerbusinessunits. Historically large businesses were normally organised on either a functional or a divisional structure. A functional structure obviously groups together all thefunctionalskillsandactivitiesintooneareaultimatelyunderthesupervision of one line manager e.g. the marketing director who has direct control over all the product and brand managers this type of organisation is illustrated in Figure3.4.Thejustificationforthistypeoforganisationstructureisprimarily that by concentrating all the similar resources together the greatest possible economiesofscalecanberealisedalsobetterqualityspecialistmanagersmay beattractedtoandretainedwithintheselargerfunctionalareas.Howeversuch large functions may lack a close market focus and may see ‘developing their expertise’ as more importantthan serving the needs of the group’s customers. This is a common criticism of centralised marketing functions and product developmentactivities. The best way of focusing managerial attention on specific markets is to subdivide the business into separate divisions that are given control over all thefunctionstheyneedtomakethemalmostautonomousbusinesses.Normally the central management of the organisation retains control over some key elements such as funding which stops the divisions being truly independent butcanstillallowagooddegreeofstrategicdiscretion.Itisalsoquitecommon to create divisions which only provide internal support services e.g. marketing Group managing director Research and development technical director Distribution director director Personnel director Marketing manager Financial director Information technology director Sales and marketing director Operations Field sales manager Sales manager Market research manager National accounts manager Sales training manager Product brand manager Product group manager Product group manager Product group manager Product brand manager Product brand manager Area managers Key account managers Information needs:- Sales managers need financial information on profitability of customers and areas/channels of distribution Brand managers need financial information on the profitability of brands including by channels of distribution etc. Figure3.4 Functionallybasedorganisationstructure

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TheStrategicManagementProcess:SettingGoalsandObjectives 71 research information technology or where one particular process/function e.g. manufacturing is grouped together to gain economies of scale e.g. production efficiencies but where all the output is sold within the group. There are a number of control issues raised by the different methods used to chargefortheseservicesandtheseareconsideredinPartFour. The most relevant divisions of a group for strategic management purposes arenotsurprisinglycalledstrategicbusinessunitsSBUs.SBUsaredefined as being divisions of an organisation where its managers have control over their own resources and discretion over the deployment of these resources within specified boundaries. In other words the SBU has its own mission statement and set of goals indeed some groups have even re-named these as ‘divisional charters’. Normally SBUs will have external customers and each SBUwillfocusonaparticularmarket/sectorandproductgroupconsequently it will face specific competitors that may not be shared with any other div- isionswithinthegroup.Thisdivisionallybasedorganisationstructureisshown inFigure3.5. One very common way of implementing a divisional structure is to split geographic regions into separate divisions e.g. Europe Asia Africa etc.. Thissimpleapproachcancreateawiderangeofproblemsateachstageofthe strategicmanagementprocessandcanalsoleadtosomeverystrangegeographic linkages. Many large groups will have a range of products at different stages of development and with varying levels of success and most or all of these products will be present in most or all of the regions. Thus each region faces the same range of strategic issues but the organisation structures do not ensure that they all choose the same solution nor does it mean necessarily that the divisionsshare thebestsolutionacross thegroup.Alsomostlarge geographic Group managing director Divisional managing director Divisional managing director Divisional managing director Divisional managing director Divisional managing director Divisional managing director Divisional research and development director Divisional sales and marketing director Divisional operations director Divisional financial director Divisional personnel director Divisional systems director Separate functional organisations within each operating division replicated across all divisions Group staff Figure3.5 Divisionallybasedorganisationstructure

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72 MarketingFinance regions include some markets which have greater similarities with other markets located outside their region e.g. Australia and New Zealand for manyproductssharemoresimilaritieswithNorthAmericaandWesternEurope thanwithmostoftherestofAsia. Obviously a divisional structure cannot achieve the economies of scale of a functional organisation but the functional basis will not be as market focused. Not surprisingly therefore mixed organisational structures have been developed which try to obtain the benefits of both the traditional formats. A common form of such a mixed structure is illustrated inFigure 3.6 where the separate operating divisions concentrate on their existing products and markets. However the centralised group organisation provides those overallsupportfunctionsthatcangreatlybenefitfromtheeconomiesofscale that can only be achieved by carrying out these activities for the group as awhole. Unfortunately this combined type of organisation creates almost as many problems as it solves. Although the groupwide functionally organised areas can achieve good economies of scale there is now a high risk that they will lose the market focus that is achieved by locating smaller less efficient units within the operating divisions. Thus the group may gain efficiency but lose effectiveness if the functional support areas do not concentrate on areas of mostinteresttothedivisionswhichtheyaresupposedtobesupportingthisis illustratedinPracticalInsight3.3. PracticalInsight3.3 Theworstofbothworlds One very large multinational consumer goods company has a mixed organisation structure. It has six regional directors and eight global functional directors that withonemanagingdirectorgivesitanexecutiveboardoffifteenverysuccessful opinionatedpeople.Moreimportantlyitcreatessomestrategicownershipissues. Group managing director Divisional managing director Divisional managing director Divisional managing director Divisional managing director Group human resources director Group systems director Group finance director Group research director Divisional distribution director Divisional operations director Divisional sales and marketing director Figure3.6 Mixedorganisationalstructure

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TheStrategicManagementProcess:SettingGoalsandObjectives 73 Anotherincreasingly popularway oftryingto solvetheeconomies ofscale issue is by creating a matrix type of organisation structure. In its simplest form this consists of most areas of the business reporting to two different managers who have different types of responsibilities for the area. Typically an area will have a functional boss and a divisional line manager as well. Clearly this type of structure creates a number of complications in manage- ment reporting which require that the differing managerial roles are clearly definedandunderstoodbyallthoseinvolvedandaffectedbythematrix. The major roles for the overall functionally based managers are to ensure the efficient utilisation of existing resources and the development of adequate futureskillstoservethestrategicneedsofthegroup.Converselythedivision- ally based managers should concentrate on the effective use of the resources undertheircontroloravailabletotheirdivisionssothattheselectedcompeti- tivestrategiescanbeimplemented. Matrix structures have been further refined by some types of companies in ordertoallowatleastpartsofthegrouptobemanagedasaseriesofprojects which are resourced and staffed as required. This project-based structure is frequently used by people-based businesses such as large firms of account- ants advertising agencies investment banks and IT consultants which regu- larly need to put together multidisciplinary teams for special projects. The various types of skill may be permanently organised on a functional basis with managers who are responsible for people development and overall resourcinglevels.Whenaparticularprojectteamisrequiredtheprojectman- ager specifies the people skills and career background needed for the project together with all the other resources and these are supplied by the resource controlling functional managers. Once the need within the project is satisfied the individuals are reallocated to their next assignments by the appropri- ate resource managers. Thus the projects are really a series of temporary sub- divisionsofthegroup. The group sales and marketing director strongly believes that the group’s future successdependsonthedevelopmentofafocusedportfolioofinternationalbrands theareaofitsbusinesswherethegroupiscurrentlyaverypoorsecondtoitsmain competitor.Theregionaldirectorsareresponsiblefordeliveringthecurrentprofit stream of the business and for achieving the group’s short-term e.p.s. growth targets.Thiscanbeachievedfromtheexistingmaturelocalbrandsbutthesehave relatively limited long-term growth potential. However the international brands require significant marketing investments for several years if they are to deliver their long-term potential. This high marketing support would depress current profits: each regional director isunwilling to accept this negative impact on their own regions although they all accept that the group needs to develop these brands.

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74 MarketingFinance Corporatecentres Therangeandcomplexityoforganisationalstructuresthatarecurrentlyinuse makeitclearthatthestrategicmanagementprocessmustitselfbeflexibleenough to cope with the implications of all these possibilities. However one aspect of organisational structure is facing almost universal challenge. Corporate centres are under attack In the major developed markets of the world not only is the trulydiversifiedconglomerateseenasadinosaurfromabygonecorporateera but also the corporate centres of very many other large corporations are seen as an endangered species facing ever increasing demands and challenges to justifytheircontinuedexistence. Corporatecentresareseenasaddingcostsnotcreatingvalue.Thenextlogical conclusionisthatthesecorporatecentresactuallydestroypartoftheshareholder value created by the underlying business divisions hence the trends towards demergers management buy-outs re-focusing initiatives etc. Also many corporate centres have engaged in severe cost cutting exercises and dramatic head-countreductions. However there is some new research that indicates that corporate centres canactuallycreateshareholdervaluebutonlyiftheyfocusonthemostrelevant activitiesfortheirgroup.Inthespaceavailableitisonlypossibletogiveavery briefprécisofthisnewcorporateconfigurationsmodelbutitshouldbeuseful as it will be applied in the case studies discussed later in the chapter. Corporate centres can either interact with their business units directly or indirectly. Direct interventionmeansthatthecorporatecentredoesthingsonbehalfofthebusi- ness units while indirect involvement means that the corporate centre leads tells guides inspires or motivates etc. the business units to do things them- selves. Corporate centres similarly can create shareholder value in only two ways they can reduce the total costs incurred by the group or they can increase the value generated by the group. In this model we have described these sources of corporate advantage as economies of scale i.e. reducing costsandcreatingknowledgei.e.increasingvalue.InFigure3.7thestyleof involvement direct or indirect and the source of corporate advantage are combined to generate a classic 2 ×2 matrix the final version of the model usesamuchmoreattractive‘rainbow’formatwhichisintroducedinChapter6. The second matrix shown as Figure 3.8 shows how a corporate centre can createvaluebyoperatingineachofthefourpossiblecombinations. This demonstrates that there is no unique way in which a corporate centre cancreatevaluebutthecorporatecentremustselectthecorporateconfiguration as set out in Figure 3.9 which is appropriate for its group of businesses and theirkeystrategicthrusts. TheControlsconfigurationwherethecentrefocusesonimposingfinancial targetsandcontrolsbutleavesthebusinessdivisionstodecideonthedetailed competitive strategies needed to achieve these targets is suitable for large

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TheStrategicManagementProcess:SettingGoalsandObjectives 75 diversified groups where the centre acts primarily as a shareholder only such as Hanson was and Rentokil Initial may have become. The Scale configuration involves a much greater degree of direct intervention in the business units becausecertainactivitiesandprocessesarecentralisedinordertoreducetotal coststhisnormallyrequiressomestandardisationacrossthegroupifthemax- imum economies ofscalearetobe realised.Themostcommon areas forsuch cost saving centralisation are support functions such as accounting IT etc. but increasingly core processes such as manufacturing RD and even sales and distribution are directly controlled by corporate centres. The key aspect ofthisconfigurationisthattheshareholdervaluejustificationiscostreduction. Total cost reduction by direct intervention of corporate centre Total value-added increased by direct intervention of corporate centre Total cost reduction through indirect corporate centre involvement Total value-added increased through indirect corporate centre involvement Cost reduction Increased value What i.e. Source of corporate advantage How i.e. nature of involvement by centre Direct Indirect Figure3.7 Corporatecentres:causalrelationshipofthemodel–thewhatandhow Activities performed centrally at lower cost Knowledge leveraged across the group through centre’s involvement Financial targets and controls imposed Creation of new corporate know-how facilitated by centre Economies of scale Knowledge Corporate involvement/intervention Direct intervention Indirect involvement Source of corporate advantage Figure3.8 The‘value-added’bythecorporatecentre

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76 MarketingFinance The remaining two configurations are based on increasing value by either creating new knowledge or leveraging existing knowledge more extensively acrossthegroup.IntheScopeconfigurationexistingknowledgewhichcurrently represents a competitive advantage for one division but which could have applications in other divisions is more fully leveraged across the group. This normally means that the corporate centre needs skills in process and systems management because its role is in sharing the expertise that has been developed by the business unit. This is critically important particularly where as is increasingly thecase this leveragableknowledgeis in themarketing function of the business. The corporate centre does not ‘manage the key brands centrally’or‘directlycontrolkeycustomers’itmakessurethatalltherelevant divisions know what has proved successful elsewhere in the group and insists thatthisbestpracticeisappliedifappropriate. Centralisation of brand management or customer account management actuallyfitsintothe Scale configurationas itisnormallydone toreduce costs by standardising advertising or sales processes etc. For truly marketing-led groupstheScopeconfigurationisnormallymuchmoreappropriate. TheCreativeconfigurationiswherethecorporatecentreactsprimarilyasa visionary leader setting out the vision for the business and the way in terms of beliefs behaviour and style in which this vision should be realised. The key roles are to motivate and facilitate it has an indirect involvement in its business units the business units to work together to create new competitive advantages for the group. Creative configuration groups are often highly innovative and there is a high degree of trust between the corporate centre and the business units this ‘trust’ is often notably lacking in the Control configurationgroups. Scale configuration Scope configuration Economies of scale Knowledge Corporate involvement/intervention Direct Indirect Source of corporate advantage Controls configuration Creative configuration Figure3.9 Thecorporateconfigurationsmodel

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TheStrategicManagementProcess:SettingGoalsandObjectives 77 Ourresearchdemonstratesthatlotsofcorporatecentresdonotreallyunder- stand how they are trying to add value while many others think that they are in one particular configuration but their business divisions believe that their behaviour puts them in a completely different position. In some groups the viewofthecorporatecentredependsonwhichpartofthebusinessyouarein as is illustrated by both Practical Insight 3.4 and the IBM case study which follows. PracticalInsight3.4 Casestudy–therisefallandriseofIBM TheriseofIBM In 1914 the Computing Tabulating Recording Company was in some trouble and consequently recruited an outsider to sort out its problems the next time this was to happen was in 1993. Tom Watson Sr took over a business making mechanicaldevicesforprocessingdataonpunchedcardsandfromitformed the modern IBM. In 1924 the company’s name was changed to International Business Machines and much of the famous IBM culture was established duringTomWatsonSr’speriodofcontrol. HoweverthereallydramaticgrowthcameaftertheSecondWorldWar.IBM entered a period of consistently strong sales growth with high profit margins Confusedsignals Returning to the very large multinational referred to in Practical Insight 3.3 its corporate centre manages to be in all four configurations at once. Not surpris- ingly many of its divisional managers are confused about their relationship with theircorporatecentre. The executive chairman and managing director consistently articulate their vision for the company as ‘being the leader’ in their industry globally and this includes a number of clear but general strategic statements. The central sales and marketing function is focused on leveraging existing knowledge by codify- ing several of the excellent processes techniques and skills that have been developed around the group. The operations area is centralising several major core processes such as manufacturing sourcing and distribution in order to achievemuch greatereconomies ofscale. The group financial director is setting aggressive targets for cost reduction acrossthegroupbothatthecorporatecentreandwithintheregionalstructurein ordertoachievetheprofitsgrowthrequiredbythefinancialmarkets. Each of these initiatives and emphases has been carefully thought through and is perfectly logical. The challenge is to communicate how all of these corporate centre roles come together at the product/market interface where the company ultimatelyhastocompetesuccessfully.

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78 MarketingFinance and strongly positive operating cash flows. At first this growth was based on typewritersandinthe1950sIBMhad72000staffandsalesrevenuesofover 500million. IBMdidnotactuallypioneerthecomputerrevolutionbutitembraceditso emphaticallythatitrapidlycametodominatethenewindustry.Usingitsexisting sizesalesforcemuscleandmarketingskillsithadtakenan80percentshare of the USA computer market by the end of the 1960s. This growth continued even faster than its rapidly growing industry sales revenues of 7 billion in 1970grewto40billionby1980.In1980IBMhada38percentshareofthe global computer industry’s salesrevenuesbut a 60 per cent shareof its profits. This financial power enabled it to invest vast sums in RD at the end of the 1980sIBMwasspending9billionperyearonRD. WhenJohnAkerstookoverasChairmanandChiefExecutiveOfficerin1985 he was a lifetime IBMer he publicly predicted sales revenues would grow from 46 billion in 1984 to 180 billion in 1994 this would actually have beenaslowerrateofgrowththanhadbeenachievedintheprevious10years. IBM expanded its organisation to cope with this expected growth by 1986 total headcount was over 400000. IBM’s profitability continued to boom during the 1980s with profits after tax going from under 3 billion in 1980 to well over 6 billion in 1984 and 1985. Profits fell slightly in 1986 and 1987 but the share price continued to outperform the Dow Jones Index significantly. IBM’s share price was obviously affected by the crash in 1987 but it still outperformedthroughthemiddleof1989thesharepricehadbeenbelow50 at the beginning of the 1980s reached over 130 by 1985 peaked at 168 in 1987butwaswellabove100inearly1989. IBM’s success was built on its dominance of the mainframe computing market at the end of the 1980s IBM had a 44 per cent global market share and an 85 per cent share in the USA of the compatible mainframe market. Mainframes contributed the vast majority of IBM’s profits 60 per cent due notonlytotheirshareoftotalsalesbutalsototheirveryhighprofitmargins even in 1990 gross profit margins of 55 per cent were being generated on these hardware sales. IBM’s total sales revenues in 1990 were 69 billion including10billionofsoftware11billionsupportservicesand4billion of rentals and financing and profits after tax were back up over 6 billion. When these results were announced early in 1991 the share price climbed backto130. Thefallstage UnfortunatelyforIBMthesectorthatitdominatedi.e.mainframecomputing was the one that was no longer growing in the still rapidly expanding computer industry. Since the mid-1980s the trend had been towards client–server networks and in the early 1990s this growth exploded by 1994 client servers

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TheStrategicManagementProcess:SettingGoalsandObjectives 79 accountedfor50percentofUSAtotalapplicationsfromwellunder10percent atthestartofthedecade. IBMwasalsolateintothePCmarketandrusheditsdevelopmentprogramme by buying in the operating system from Microsoft and the microprocessor from Intel. Subsequently IBM failed to retain exclusive rights to either of these products and the rest as they say is history Once it entered the PC market IBM leveraged its market muscle and soon became the No.1 supplier of PCs. However even with 10 billion sales revenues its PC business was only ever marginallyprofitable. The mainframe market was not about to completely disappear overnight not least because of the 1 trillion invested by customers in mainframe-based software systems. IBM developed parallel processor-based computers which would run these existing software systems but act as servers on networks however these new products were not available until 1994. Also the USA economywentintorecessionattheendofthe1980sitwasneitheradeepnor a long recession as the economy started to grow again in 1991. However if companies are facing recession they normally look to make savings and deferring a major expenditure item such as replacing or upgrading the main- framecomputermaylookattractive. The combined impact on IBM was substantial its mainframe sales rev- enues fell 20 per cent in 2 years but the gross margins on these reduced sales wereslashedfrom55percentto38percent.Actualgrossprofitsonhardware salesfellfrom25billionin1990to14.1billionin1992.GivenIBM’svery high fixed cost base it still had almost 400000 employees in 1990 this resulted in the company reporting after tax losses in both 1991 and 1992 it made significant provisions in both these years for cost cutting measures includingaround100000jobcuts.Notsurprisinglythesharepricefellsharply andbyearly1993itwaswellunder50thiswasnothelpedbyamassivecut in the company’s dividend payment and a credit downgrading by Standard PoorstheydowngradedIBMfromAAAthebestthereistoAA-. Thesecondrising On1April1993LouGerstnerjoinedIBMasChairmanandChiefExecutive. His impressive career had started at Harvard followed by McKinsey where he made principal at 28 and American Express where he rose to President No. 2 in the company. In 1989 he had been hired by KKR to run RJR Nabisco following its leveraged buyout and it was from RJR that he came to IBMthusnohightechnologybusinessesinhisbackground. The first quarter results for 1993 continued the gloom mainframe sales were down again service sales revenues were again up sharply but they were still not significantly profitable. The share price fell to 40 which gave the company a market capitalisation of 25 billion while its outstanding debt

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80 MarketingFinance totalled30billion.AsanasideIntelandMicrosoftbothalsohad25billion market capitalisations at this time but nearly 10 years before they had been worth very little while IBM had been worth 100 billion. Within 18 months Gerstner had changed the entire executive board and only one of the new memberscamefromwithinIBM.Heinitiallyfocusedonreducingcostsandat the end of 1994 headcount had been reduced to a total of 225000 with more stilltogo. The business mix continued to change mainframe sales had fallen dramat- ically to 10 billion with storage products also down to 5 billion while the non-profit generating businesses of PCs 10 billion and services 10 billion continued to grow. However the company made a profit 3 billion again in 1994 on sales revenues of 64.1 billion. The big news was the 3.5 billion acquisition of Lotus Development but other than that cost cutting and con- solidation continued in 1995. In 1995 and 1996 demand for ‘mainframe’ computers including IBM’s new generation re-bounded strongly and this further helped IBM’s profit recovery. The major growth emphasis within the companywasintheservicesareasystemsintegrationconsultancyoutsourcing maintenancewithacombinationofacquisitionsandorganicgrowth.In1997 thisnewfocuswasformallyrecognisedwiththecreationofaGlobalServices Division this new services business exposed IBM to a completely new set of competitors systems consultancies including Accenture Cap Gemini Sogeti SemaEDSwhichappliedaverydifferentbusinessmodel.The1995acquisition of Lotus had more explicitly opened up competition against software houses including Microsoft and IBM had also started to sell its technology to other technologycompaniesincludingcompetitorsandtobuyintechnologywhen strategicallyrelevantorfinanciallyattractive. During the first half of 1997 the stock market decided that the ‘new’ IBM wasaveryattractiveinvestmentandtheshareswhichuntilthenhadseensome good but volatile growth since Gerstner’s arrival nearly doubled in value. This took IBM’s market capitalisation back over 100 billion as the shares reached record levels there had been a 2 for 1 stock split in January 1997 so a 1997 share price of 90 was equivalent to 180 in the 1980s. As a further asideitshouldbenotedthatIntelandMicrosoftwerebothbynowcapitalised at well over 100 billion. By 1997 two-thirds of IBM’s 76 billion of sales revenuecamefromfastgrowingareassuchasPCsandservices. The dramatic growth in IBM’s share values continued as the stock market gotintoitstechnologymediatelecomsTMTfrenzyofthelate1990s.During 1999 the shares got very close to 200 which meant that Lou Gerstner’s substantial package of stock options granted when he joined in 1993 with a share price equivalent of around 20 had become very valuable indeed. Most IBM shareholders did not resent this because they had seen their own investmentsinthecompanytransformedinoneofthemostamazingcorporate turnarounds.

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TheStrategicManagementProcess:SettingGoalsandObjectives 81 Strategicanalysis IBM’sinitialsuccessinthecomputerindustrywasfoundedonatotalfocuson the needs of their major customers together with good products. Its sales force had unrivalled access to the key strategic decision-makers in the major USA corporations and they acted almost as strategic consultants rather than computer sales people. Given IBM’s emphasis on mainframes it was very logicalforittoconcentrateontheselargestcustomersthatneededthisscaleof processingpoweri.e.thebigbanksairlinescarcompaniesetc..Thismeant that IBM could develop an excellent understanding of the future systems needs of these customers and so build a strong long-term relationship IBM was an expert in relationship marketing long before the term had been invented IBMalsobecamerecognisedasaverystrongbrandwiththebyline‘Nobody ever got fired for buying IBM’. In other words it was a risk-reducing brand in a period when decision-makers such as financial directors saw the new fangled information technology as a significant risk i.e. what happens to my business if my new automated order processing system doesn’t work This enabled IBM to achieve premium prices for its products particularly to its smallernon-core customerswhenitscostbasedue toits massive scalewas potentially lower than its competitors. During its first rising IBM was helped bythesecompetitorswhichallseemedtotake‘BigBlue’asarolemodeland triedtocopyitsstrategy.ForexampleICLtheUK-basedcomputercompany tried to maintain a full equivalent product range despite having total annual salesrevenuesof1billioninaperiodwhenIBMwasspendingseveraltimes thatamountonRD. ThissuccesshadfollowedaclassicalpatternIBMgainedadominantshare of its domestic USA market when this market was itself growing rapidly and it subsequently launched the now successful products internationally. In this second phase it was helped by many of its major USA-based customers who during this period were themselves undertaking significant international expansion. Its organisation structure therefore reflected the importance of its major customers each really major customer had a main board member identified as the ‘head’ of its relationship management team and its product development emphasis was on serving the future needs of these customers. The apparent profitability of mainframes was increased due to IBM’s internal management system and structure. The most powerful salespeople sold the largest most valuable systems i.e. mainframes and they would do almost anything to safeguard the relationship with key long-term customers. This meant that many add-on products and support services would be provided at lowpricesoratcostorevenfreeifitincreasedtheprobabilityofmakingthe next big sale of a system upgrade. As long as mainframe sales continued to growandtheirmarginswereverystrongthisdidnotseemtomatter.

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82 MarketingFinance Thedeclinestagewastriggeredbyseveralofthesefactorsgoingintoreverse at roughly the same time. The mainframe sector was not growing as fast as the rest of the industry because customers were buying replacement machines or upgrades rather than being completely new purchasers. These replacement purchases will always be more volatile in demand as customers can defer the decision the same is seen in many consumer markets. As the leader in the industry with the closest customer relationships IBM should have been the most capable player of predicting and hence planning for this volatility. This highlights the biggest criticism of IBM’s strategy during its period of market dominance as Lou Gerstner put it it started to believe that it knew what was best for customers rather than finding out what customers really wanted and then giving it to them. In other words as discussed in Chapter 5 arroganceandcomplacencyweresignificantcontributorstoitsdecline. Also these customers changed during this period. The mystique surrounding computersstartedtodisappearasanewgenerationthathadgrownupwiththem moved into business. Customers were much less willing to pay a premium to buythebrandsecurityofferedbyIBM.Theywantedtopayforthebestequipment todoeachspecifictaskandwerenowhappytohavearangeofITsuppliersfewer and fewer companies are now exclusively supplied by one systems company. For IBM this created a large problem if its brand no longer represented re-assurancethenitspremiumpricingleftitsimplylookingexpensiveinmany industrysegments.ThiswastotallyborneoutbyFinancialWorldmagazinewhich annuallyvaluestheleadingbrandsintheworldinthemid-andlate1980sIBM hadbeenplacedthirdbehindonlyCoca-ColaandMarlborobutby1994IBMhad fallento290ththeyonlylisted290withanegativevaluationof7billion. Competitors had also improved their strategies and were now attacking IBMonawholehostofdifferentfrontse.g.verycheapIBMclonedproducts veryexpensive butincrediblyspecialisedmachinesintegratedsystemsaimed at specific market segments. IBM was dying the death of a thousand cuts ratherthanbeingbeatenbyasinglefullfrontalassault. The corporate culture and organisation structure did not help IBM during this period it re-inforced the previously successful behaviour that was no longerrelevantforitsnewcompetitiveenvironment.OriginallyIBM’sorgan- isationallowedandeffectivelyencouragedcompetitionwithinthegroupthus manufacturing businesses could produce any products within the range and quote prices to any of the sales and marketing divisions. The logic was that if weareforcedto competeinternallyweshouldbeabletocompeteexternally giventhatmanyofIBM’sdivisionswere biggerthanitsexternalcompetitors this worked while the businesses were growing. However IBM’s increasing dominance became a problem in such a rapidly changing industry. Each new generation of computers was both more powerful and cheaper than the previous one this meant computer companies needed to sell more and more machinestogetafinancialreturnonthecapitalinvestmentrequiredforeachnew

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TheStrategicManagementProcess:SettingGoalsandObjectives 83 generation. Yet the rate of technological development was increasing which resulted in shorter and shorter product life cycles. If IBM introduced a new generationcomputeriteffectivelykilledoffsalesoftheexistinggenerationthat italreadydominated it was shooting itself in the foot. Therefore it wanted on one hand to extend each product life cycle until it had generated a healthy financial return but on the other hand it needed to innovate to maintain its dominationitbecameharderandharderfinanciallytojustifyintroducingnew products within the business. This explains why much of the output of IBM’s massiveRDexpenditureendedupbeingexploitedbyothercompaniesIBM couldnotseethefinancialreturnfromintroducingititself. Towardstheendofthe1980sJohnAkerssoughttochangetheorganisation structure into four geographical marketing and sales units and nine manufac- turing units the thirteen units being known as ‘Baby Blues’. The nine manu- facturingunitswere‘product’or‘technology’basede.g.storagedevicesbutonly onei.e.thePCdivisionwasnotheavilydependentuponmainframesalesfor its profitability as of course were all four marketing and sales units. Hence thisre-organisationdidnotdiminishtheimportanceofmainframesgiventhis importanceandthenewpowerofthesedivisionalmanagerstheproportionof RDexpendituredevotedtomainframedevelopmentactuallyincreasedprior toLouGerstner’sarrival.Alsothebalanceofpowerwas stillheavilytowards thetechnologistsinthecompanywiththeroleofsalestogetthecustomer‘to buywhatwehavecomeupwith’.Itisself-evidentthattowardstheendofits first success phase the corporate centre had no clear picture of what role it wastryingtofulfilorofhowthecompanyneededtochange. Thus when Lou Gerstner arrived with the significant advantage of no previously developed ‘sacred cow’ views of how high technology companies should be managed he attacked the corporate culture and the management at thecentre.HedidnotagreethatIBMhad‘poorproducts’hefeltithad‘lousy management’. He made some seemingly minor but symbolically important changesheintroducedcasualdresstogetawayfromthedarksuitwhiteshirt andbluetieuniformthathadpreviouslymadeIBMemployeessoeasytospot. He encouraged IBM business groups to collaborate rather than compete he openedupthecompanytobuyingtechnologyiftheyhadn’tgotitandtoselling their technology to other companies including competitors. He also changed theorganisationstructureandthemanagersheadinguptheorganisationsoas to highlight the importance of the new growing areas of the industry and the needs of their key target customers. However most importantly he gave great clarity to the role of the corporate centre. For someone who quite famously repeatedly stated that ‘the last thing IBM needs now is a new vision mission statement or strategy’ he effectively gave the business a new vision mission statementandstrategyandamassivelyincreasedfocusonshareholdervaluehe tookIBMfromamainframecomputermanufacturerbacktothe‘globalsolutions’ companywhichithadreallybeenduringitsfirstperiodofsuccess.

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84 MarketingFinance Interestingly the new IBM is still heavily dependent upon mainframe computers foritssuperprofitsdespitethegrowthofitsotherbusinesses.Itwill befascinatingtoseehowwellitsurvivesthenextsignificantdownturninUSA corporate confidence and the probable resulting deferral of replacement mainframe purchaseswhichlooksincreasinglyimminentatthetimeofwriting. ItwillalsohavetodothiswithoutMrGerstneratthehelm. Verticalintegration It can be argued that IBM’s turnaround strategy was substantially based on vertical integration with it moving further down its industry value chain towardstheendcustomer.Suchadeliberatestrategicmovetowardsbecoming moreverticallyintegratedraisesinterestingissuesasisdiscussedbelow. Initiallythe companies starting a new industryalmostinevitably have to be highlyverticallyintegratedasexternalsuppliersofrequiredcomponentsetc. simply do not exist. This was certainly true to some extent for the computer industrybutevenmoresoatthebeginningoftheoilindustryandcarindustryas isdiagrammaticallyshowninFigure3.10.Indeedaveryfamousexamplewas HenryFord’sdevelopmentoftheModelTwherepigironenteredoneendofthe manufacturing process and finished cars left at the other the only part not produced on site were the tyres but if rubber trees could have been grown in Detroitnodoubtthismighthavehappenedaswell. However as industries develop more and more specialist suppliers become available and provide the opportunity for the original players to become less vertically integrated. These specialist suppliers can often develop sustainable competitive advantages due to their greater focus on one single segment of the Raw materials End user The initial vertically integrated phase – the company has no choice Car industry Pig-iron input Smelting/bending Manufacture of components Assembly Distribution After-sales service End consumer Oil industry Exploration Production Refining Distribution Wholesaling Retailing End consumer Figure3.10 Theinevitabilityofverticaldisintegration

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TheStrategicManagementProcess:SettingGoalsandObjectives 85 industry value chain. By supplying other companies in the same industry or in other industries requiring a similar input these specialists can often generate significanteconomiesofscalethatcanreducethetotalcostsincurredintheindus- try supply chain. As always how this value enhancement is shared amongst the potential beneficiaries is determined by their relative competitive strength and thiscanpresentaseriousthreattotheoriginallyverticallyintegratedcompanies. Ultimately the industry can become dominated by focused specialist companies and this is often at the expense of these creators of the industry if they do not identify until it is too late whether these specialist suppliers can turn into potential competitors as shown in Figure 3.11. When an industry is completely vertically integrated it is very difficult to establish which activities/ processesinthetotalvaluechainreallycreatetheshareholdervaluegenerated bytheindustry. Does finding oil create all or most of the value If it is left under the desert or sea it is much less valuable than when properly extracted refined and distributed to a final end user. It is relatively easy to establish the total value createdbythetotalindustrybutmuchmorecomplicatedtobreakitdowninto its component stages. Many vertically integrated companies try to do this by introducingsystemsoftransferpricingfromeachstagetothenext.Unfortunately far too often such transfer pricing systems are merely attempts at ‘fairly’ apportioningthetotalprofitabilityoftheindustryacrossthesestages.Amajor contributor to this abuse of transfer pricing is the international tax system becausemosttaxauthoritiesaroundtheworldwillaccepttransferpricesbased onamark-uponthecostoftheoperationforexamplecostplus10percentis quitecommonforthetaxauthoritiesinanycountrythisatleastensuresthat In a developed industry the company has ‘too many choices’ Specialist suppliers or competitors Specialist suppliers or competitors Oil industry Exploration Production Refining Distribution Wholesaling Retailing End consumer Raw materials End user Car industry Pig-iron input Smelting/bending Manufacture of components Assembly Distribution After-sales service End consumer Figure3.11 Theinevitabilityofverticaldisintegration

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86 MarketingFinance they receive some taxation from vertically integrated activities carried out in theirjurisdiction. Transfer pricing systems should seek to indicate which segments of the industryvaluechaingeneratetherealsuperprofitsasthesemustbedefended against potential competitors including specialist suppliers. As has already beendiscussedentrybarriersonlyactasadeterrentagainstpotentialcompetitors and therefore it is important that they are erected before the specialist suppliers become established in the industry. A classic example from the computer industryrelatestothedevelopmentofthePCsectoralreadyreferredtointhe IBMcasestudyandinChapter2. PCsweredevelopedandlaunchedbytheexistingcomputercompaniesplus afewnewentrantsintothesectorsuchasAppleComputers.Thesecompanies saw the major value creation activities as being the box manufacture and the associatedbrandingbuttheyclearlyneededotherthingstomakethePCwork successfully. They considered the operating system and even the core micro- processorascommoditycomponentswithintheoverallvaluechainitwaseasier to get someone else to produce them so these computer companies could focus on the really important areas of the industry. Of course it was too late to react onceMicrosoftandIntelhaddevelopedtheirownincrediblystrongbrandingand grabbedmostoftheindustryvaluesharereducingthecomputermanufacturers tolargelycommoditysuppliersthemselves. Transfer pricing should therefore focus on the strategic choices facing the vertically integrated business and is another key element to be considered in designing the organisation’s structure. As well as indicating which value- creating activities must be protected a good transfer pricing system should highlight non-value-adding activities where an exit strategy such as actively encouragingspecialistsupplierstoenterwouldincreaseshareholdervalue. This really argues that organisations should focus on business processes so thattheyunderstandwhichprocessestrulyaddvaluei.e.positivelycontribute to shareholder value. In practical terms this means that all business processes shouldbeclassifiedintooneofonlythreecategories: 1 Criticalvalue-addedprocesses 2 Non-value-addedbutessentialprocesses 3 Non-value-addedandnon-essentialprocesses. The critical value-added processes generate the super profits of the business andthefocusofthestrategicmanagementprocessmustbetoprotectthemand todevelopthemtotheirfullpotential.Thismeansthattheseprocessesmustbe keptin-houseandbemanagedasthekeyassetsofthebusiness.Anyoutsourcing oftheseprocesseswillovertimegiveawaythecompany’ssourceofcompeti- tive advantage it is therefore essential that the corporate centre knows what thesecriticalvalue-addedprocessesare.

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TheStrategicManagementProcess:SettingGoalsandObjectives 87 Fortunately these critical value-added processes are normally very few in number in my experience 90 per cent of the super profits are contributed by 10 per cent of the processes and for most businesses most of these processes are in the sales and marketing area. This means that most business processes fall into the non-value-added but essential classification they need to be carried out but they add cost rather than value. The key objective for these processes should therefore be to achieve the required outputs at the minimum cost possible. This minimum cost may be achieved by outsourcing this activity from a thirdpartysupplierandforthesenon-criticalnon-value-addingprocessesthis is not a significant strategic risk. However there is a lot of research evidence to suggest that a major source of cost savings from outsourcing comes from re-defining i.e. reducing the expected level of the activity or process this is particularly true for internal support activities. Interestingly many otherwise sophisticated organisations do not have service level agreements SLAs for internal support activities but would automatically insist on them if an outside supplier were providing the service. SLAs provide a key benefit of forcing the customers the recipients of the service to specify exactly what it is that they require and are prepared to pay for. SLAs also provide a major benefit of enabling responsibility and accountability to be properly assigned asisdiscussedinPartFour. The non-critical non-value-adding and non-essential processes should be discontinued wherever possible and minimised everywhere else. A key problem of many re-structuring initiatives such as business process re-engineering is that these processes are made more efficient when they should be stopped altogether.Manyfinancialcontrolmeasuresemphasisetheefficiencywithwhich a company’s strategy is being implemented rather than focusing on the effectivenessthisareaisalsodevelopedinPartFour. Multinationalsandrisk-takingappetites There are an increasing number of companies that have expanded their mission statementsandcorporateobjectivestoincludethewordglobalthusgivingthe impression that they intend to extend their presence and influence to all parts oftheworld.TodateIstillpreferthedescription ‘multinational’foreventhe most international of these companies. To be truly global a company should not really have a home base that is significantly more important to it than any otherarea.Thusitsbusinessesshouldbespreadaroundtheworldinproportionto the relative shares of relevant purchasing capability but more importantly its ownership and management team should also be drawn from and be repre- sentative of this global base. Most companies even very international ones likeIBMCoca-ColaCitigroupetc.stillhaveadominanthomeinvestorbase andarestrictedsourcefortheirseniormanagers.

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88 MarketingFinance Thereforealthoughtherearealreadyseveraltrulyglobalmarketsparticularly financial markets such as currencies which do not worry about international bordersandtimezonesandseveralglobalbrandssuchasCoca-ColaMarlboro MicrosoftandInteltheseglobalmarketsandproductsareservicedbymulti- national companies. These multinationals do worry about the currency in which they earn their profits because if your shareholders are predominantly basedintheUSAtheywillwanttoseetheirfinancialreturnsexpressedinUS dollars. This specific risk aversion can have important consequences for the designofthemultinational’sstrategyasisillustratedinthenextfewcasestudies basedaroundthecarindustryandFordMotorCompanyinparticular. Casestudy–multinationalstrategies Overseasinvestments Ford Motor Company was started in the USA and its main shareholders are still based there hence its profits are reported externally expressed in US dollars. However it manufactures and sells cars and trucks all over the world and this can raise significant long-term medium-term and short-term issues forthegroup’scentralmanagement. The first fundamental strategic management issue is how it should regard its long-term investments in these different countries in terms of the exchange risk involved. One of Ford’s earliest overseas investments was in the UK and thiscanbeusedtoillustratetheissueforsimplicityandobviousconfidentiality issues all the numbers in this case study have been modified but the rationale andconclusionsarestillcompletelyvalid.Assumingthatitsinitialinvestment in the UK cost £250 million when the exchange rate was 4:£1 yes it really was at this level once this represented a cost to its USA shareholders of 1 billion on which they required a return of say 20 per cent in US dollars. However with the subsequent depreciation of sterling against the US dollar thisoriginalinvestmentwouldnowhaveaconvertedvalueofonly400million £250millionataspotrateofexchangeof1.60:£1.Thislooksdisastrousat first sight but does not necessarily represent a real economic loss to the USA multinational it expected to generate the return on its investment through the profits and dividends produced by selling cars not by selling the factory at sometimeinthefuture.ThisisillustratedinFigure3.12whichshowsthatas long as profit margins on UK sales can be maintained in real terms and the salesvolumesareinlinewiththoseplannedatthetimeoftheinitialinvestment the required US dollar denominated financial return can still be generated from theUKbusiness. Sterling has fallen in value relative to the US dollar because of the higher level of inflation in the UK than in the USA over this long-time period relative differences in inflation are the primary causes of long-term movements in

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TheStrategicManagementProcess:SettingGoalsandObjectives 89 currency values.HigherinflationmeansthatUKincomesroseintermsoftheir sterlingvaluesrelativetoincomesintheUSA.Iftherateofexchangebetween the two currencies stayed the same people with £ sterling incomes could travel to the USA and bring back import the cheaper goods. When the gap became large enough arbitrageurs would export goods from the USA to the UK and effectively guarantee themselves a profit as is shown in Figure 3.13. As more people did this there would be an increasing demand for US dollars intheforeignexchangemarketandanincreasedsupplyofsterlingasimport- ersintotheUKsoldsterlingtobuydollarstopayfortheirimports.Inanyfree market such a shift in relative supply and demand leads to a compensating changeinpricei.e.sterlingdepreciatesagainsttheUSdollaruntilsupplyand demandarebackinequilibrium. USA company Investment 1bn Expected return on investment 200 m p.a. i.e. possible dividend stream. Invest in UK plant Exchange rate 4:£1 UK plant £250 m Potential repatriation of profits 4:£1 higher inflation in UK than in USA over investment period Actual return on investment still 200 m p.a. Potential repatriation of profits actual rate 1.60:£1 Produces sells product in local currency planned profits of £ 50 m p.a. Actual position on UK production and sales UK local profits £ 125 m p.a. Figure3.12 Long-termcross-borderinvestments 1 Initial situation The equivalent price of the product in the two markets is the same: thus no gain can be achieved by transfer. 2 Inflation in UK 20 per cent higher than in USA – no change in exchange rate Arbitrageur can now buy the car in the USA for equivalent of £5000 take it to the UK and sell it at the new UK price of £6000. 3 Inflation higher in UK– exchange rate adjusts Buying the car in the USA for 10 000 now costs the equivalent of £6000 which is its UK selling price. Price of goods Price of goods Price of goods Rate of exchange Rate of exchange Rate of exchange USA US US US UK USA UK USA UK 10 000 10 000 10 000 Car Car Car £5000 £6000 £6000 2 2 1 1 1 1.6667 : : : : : : £ £ £ Figure3.13 Purchasingpowerparity

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90 MarketingFinance Clearlythispositioncanremainoutofbalanceintheshortandevenmedium term due to government interference through monetary or fiscal policy or even regulatory impact on capital or trade flows. Eventually however market pressures will force governments to move into line with the underlying economic reality. Consequently it is valid to argue that in the long term all relativepurchasingpowersinlocalcurrenciesareequalthisconceptisknown as the theory of purchasing power parity. Higher inflation in one country will ultimately result in a decline in the value of that country’s currency. The critical issues for the economic return on an investment in such a country e.g. the UK are whether the specific local currency selling prices will rise proportionately to the inflation differential and whether the company can maintain its profit margin during such an inflationary period. If it can its sterling profits would besufficientlyincreasedsothattheywouldconvertbackintotherequiredUS dollarreturnontheoriginalinvestmentaswasshowninFigure3.12. For the car industry and many others this analysis was also valid for many otherlong-terminvestments.ManymultinationalsincludingForddecidedto build manufacturing plants in Spain in the early 1970s based on its entry into theEUinthepost-Francoeraofindustrialisation.AtthetimeSpainhadmuch lower labour costs than most of Europe particularly Germany and the UK even after allowing for relative labour productivity. During the following decades Spain experienced much higher relative inflation levels and conse- quently local labour costs in pesetas increased dramatically. However this local currency increase was almost exactly offset by the depreciation in the relative value of the peseta so that the relative labour cost advantage for the Spanishproductionfacilitieswasactuallyachievedaspredictedintheoriginal financialevaluations. In the long term purchasing power parity works but the short-term fluctu- ationscancreatesignificantvolatilityinprofitsforamultinationalgroupsuch as Ford as was discussed in Chapter 1 volatility in profits increases risk perception which in turn causes increased required rates of return. A truly ‘global’ company might not worry about this but most multinationals certainly do.TheintroductionoftheEuroacrossmostEuropeancountrieshasofcourse changedthisbutithas also forced eachof the Euro denominated countries to keep its inflation rate the same as all the rest they cannot now devalue or depreciatetheirwayoutoftrouble. Cross-bordersourcingdecisions Ford faced another cross-border problem for many years that also illustrates thecomplexityofstrategicmanagementinmultinationals.Itsproductioncapacity inGermanyexceededitssaleslevelsinGermanybutitpossessedanefficient cost-effectiveplantthatitwishedtofullyutilise.ExportingcarsfromGermanyto othercountriesisoneobvioussolutionbutwhatifFordalsohasaplantinthat

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TheStrategicManagementProcess:SettingGoalsandObjectives 91 countrylike the UK.Forseveralyears Fordwas exportingcarsfromGermany totheUKeventhoughitsUKplantswerenotworkingatmaximumcapacity. Thestrategicevaluationofsuchasourcingdecisionwill obviouslyneedtobe done well in advance and consequently will normally be done at planned or budgetedexchangerates.Thisisagoodillustrationoftheneedforthecorporate centre to ensure that all divisions use a common planned exchange rate if each business could choose its own rates no decision would probably be reached. If the actual rates of exchange differ from these the group must be able to change the decision if necessary while trying to reduce the risk that such exchange rate volatility could invalidate the original decision. The logic oftheinitialdecisionissetoutinFigure3.14usingtheillustrationofthesame car produced and sold in the UK and Germany with the equivalent impacts beingshowninUSdollarswhichaspreviouslydiscussedishowthecorporate centre will view the outcome the financial analysis uses deutschemarks because the analysis of this situation related to a period prior to the launch of theEuro. The important thing about the logic of this decision is that there are two prerequisitesbeforeitmakeseconomicsensetomanufacturecarsinGermany and ship them to the UK while leaving capacity idle in the UK. The first obvious point is that the German production costs must be relatively lower than the British equivalent this is satisfied in Figure 3.14 with German costs of 10000 and British costs of 12000. This cost differential must be large enough to cover both the physical costs involved in shipping the car from Germany to the UK and any increased manufacturing costs in Germany e.g. ofproducingaBritishspecificationrighthanddrivecar. Howeverthesecondprerequisiteisthatsellingpricesfortheequivalentcar inGermanymustbelowerthaninBritainasthegroupwouldavoidtheon-costs by selling all its German production in Germany and UK demand could still be satisfied profitably from UK production facilities. From Figure 3.14 this is also true as the German selling price is 12000 while the UK selling price is 15000. Indeed this lower German selling price means that despite its superior manufacturing efficiency the group makes a lower profit in producing and Budgeted rates of exchange UK selling price UK production cost Profit UK selling price German production German production cost New profit UK US dollar equivalents Germany 4DM £7500 £7500 £6000 £5000 £1500 £1 15 000 10 000 12 000 12 000 3000 2000 £2500 DM 24 000 DM 20 000 DM 20 000 DM 4000 German selling price Profit Export production Improved group profits 2: £1 2:£1 4DM:£1 5000 :: 2 Figure3.14 Sourcingdecision–exchangerateimpact

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92 MarketingFinance selling a car in Germany 2000 than by producing and selling the same car in the UK 3000. However by combining the lower production cost base with the higher selling price the group profit is substantially increased 5000 this is clearly potentially a source of super profit as long as it is sustainable. The rationale for this situation is that the UK selling price is dictated by domestically based manufacturers that all face the higher UK production costs whiletheGermansellingpriceisdrivendownbythemoreefficientdomestically based and even more market dominant producers. The relative selling prices in each market were also affected by the market shares of the group in each countryhighintheUKandmuchlowerinGermany. Thusatthebudgetedratesofexchange£1:2:4DMthedecisiontoproduce cars in Germany and export them to the UK makes sound economic sense. However it introduces an additional foreign currency exposure for the group. Iftheratesofexchangefluctuateastheyalmostcertainlywillthedecisionmay no longer be valid and the group could end up financially worse off. If the actual rates of exchange are as shown in Figure 3.15 £1: 1.667: 3.25DM the decision outcome can be re-calculated. These actual rates of exchange could be caused by different rates of inflation as discussed above i.e. in the USA 0 per cent inflation while the UK had an extreme level of 20 per cent. Thestrengtheningofthedeutschemarkcanbeexplainedbyproductivitygains inexcessofpricerisesi.e.realcostdeflationinthemanufacturingsector. IftheGermanbusinesscouldmaintainitslocalsellingpriceitwouldshow a smallgaininitsUSdollarprofitsbutifithadtopassonitsproductioncost reduction to its customers it would merely maintain its equivalent profitability. As long as the UK company is able to increase its selling prices in line with inflationthusmaintainingitsrealmarginsitwillgeneratethesameUSdollar profit.Thisistrueforbothlocallyproducedcarsandimportedsalestherefore thereisthesameeconomiclogicforimportingcarsastherewasoriginally. Howeveras argued abovepurchasing powerparity only works inthe very long term and in the short term exchange rates do not move directly in line Actual rates of exchange Increased UK selling price Increased UK selling price Increased UK production cost Profit Profit Profit Imported product Imported cost UK US dollar equivalents Germany Unchanged German selling price Reduced German production cost Reduced German production cost Increased profit on German production and sale Converted £1: 1.667 Same US profit 3000 1.667 2307 5000 £9000 £7200 £1800 £9000 £6000 £3000 Same US profit £1:DM 3.25 DM 3.25 DM 24 000 DM 19 500 DM 4500 £1 DM 19 500 :: Figure3.15 Sourcingdecision–contdactualratesofexchange

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TheStrategicManagementProcess:SettingGoalsandObjectives 93 withrelativeratesofinflation.Consequentlythereisariskthattheactualrates ofexchangegiveninFigure3.15arenotcausedbydifferentialinflationrates. Afurtherreviewofthesourcingdecisionisneededtohighlightthekeyimpli- cationsandrisksinvolved. If the group decides to export cars from Germany to the UK it will leave UK capacity idle while additional resources may be committed in Germany to meet this increased demand. There is a physical planning period during whichitmaybeimpossibleandcertainlywouldbeveryexpensivetoreverse thisdecisiononcetakenandimplemented.Itcouldthereforebeverycostlyif during this physically committed timescale exchange rates suddenly changed so as to destroy the economic logic of the sourcing decision. For example if theexchangesuddenlymovedto£1:3DMthegroupcouldfinditselfcommitted toimportingcarsfromGermanywhichwerenowmoreexpensivethanthoseit could produce locally i.e. 20000DM 3DM: £1 gives an imported cost of £6666.5 against a local cost of £6000. It would be sensible for the group to consider hedging against the possibility that a previously sensible decision becomes economically disastrous due to a change in external circumstances as long as the hedging cost itself does not affect the logic of the original decision. In this example this could be done by fixing the rate of exchange for the imported cars through a forward purchase agreement for the deutschemarks required. If the rate on the forward contract was better than 3.33DM: £1 the company has effectively guaranteed that the imported cars will be cheaper than the locally sourced alternative. However the group has also given up the possibility that these cars could be substantially cheaper if the rate stayed still or even went the other way An alternative hedging strategy therefore tries to safeguard the downside risk associated with an adverse exchange rate move- mentbuttoretainthepotentialbenefitiftheexchangeratemovesfavourably. Thusiftheexchangeratemovedto4.25DM:£1thecostoftheimportedcars is reduced still further but not if the company is committed to a forward rate agreement. This upside potential can be retained if an option an option is arightbutnotanobligationasisexplainedinChapter7tobuytherequired deutschemarks is purchased a premium is paid to buy such an option. If the actual rate declines the option is exercised and the downside can be avoided but if the rate improves the optionis allowed to lapse and the requiredcurrency is bought directly in the spot foreign exchange market. Therefore the insurance typeofoptioncontractwouldnotbeusedbutthepremiumpaidhasstillreduced thepotentialvolatilityinfuturefinancialresults. Thisexampleshowshowalargegroupcanmanageitsinternationalsourcing issues but the challenge remains how does such a group implement this type ofstrategy.Itisclearlyinthegroup’sinterestsbutnotnecessarilyineitherof the individual division’s i.e. Germany and the UK interest to undertake the hedging strategy. Some groups would enforce this from the centre often by

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94 MarketingFinance centralising these activities but this direct intervention leads both to a large corporate centre and the strong possibility of demotivated business divisions astheylosemanagerialdiscretion.Othergroupsseektomotivatealldivisions toactin thebestinterestsofthegroupso thatthecorporatecentreshouldnot needtogetinvolvedinrefereeingorlegislatingforthistypeofissue.Another way is to set target profits for all divisions expressed in US dollars so as to ‘encourage’ divisional managers to look for ways of ensuring not only their localcurrencybutalsotheirUSdollarequivalentearningsstreams.Forsome multinationalcompaniesadownsideofthiscanbeatendencyfordivisionsto speculateinforeigncurrencymarketswithverydisastrousconsequences.The lastalternativeisforthecentretoshowhowbestpracticewithinthegrouphas created value and to leverage that best practice e.g. by using options more widelyacrossthegroup. Thereforethewayinwhichamultinationalapproachesthistypeofproblem should be dictated by the strategic role of the corporate centre i.e. which corporate configuration they are in. The specific managerial performance measures thatshouldbeusedforeachofthese corporatecentrestrategicroles areconsideredinChapter6andPartFour. Strategicopportunity This exchange rate problem for Ford actually helped in an acquisition oppor- tunity within the automotive industry. For all of its life as an independent car company Jaguar had a reverse position on currency exposures to Ford Motor Company. Jaguar produced cars in the UK but sold many of these cars in the USAgeneratinglargeUSdollarrevenuesagainstitspredominantly£sterling cost base. Its management could and did hedge this foreign currency risk by entering into forward rate agreements for its expected US dollar income. This strategyreduceditsvolatilitybutalsotookawaythepotentialupsideoncurrency movements. HoweverJaguarfacedamorefundamentalstrategicproblembecauseitsmain competitorsintheUSAcarmarketwereactuallyalsoimportersbutprimarily from Germany i.e. Mercedes Benz BMWPorscheand Audi.Consequently their foreign currency exposures were between the deutschemark now Euro andtheUSdollarnot£sterlingandUSdollars.Fromacompetitiveperspect- ive Jaguar could find itself significantly worse off if exchange rates moved the wrong way. If sterling was to strengthen against the US dollar Jaguar wouldifnothedgedneedtoincreaseitsUSAsellingpricesinordertomaintain itsUK-basedmarginsits£sterlingdenominatedsellingpricesfortheseexported carswouldotherwisefall.Howeverifatthesametimethedeutschemarkwas to weaken against the US dollar its German-based competitors could if also unhedged actually reducetheirUSdollardenominated selling prices and still make as much local currency profit as before. This means that if it wanted to

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TheStrategicManagementProcess:SettingGoalsandObjectives 95 be sure of being competitively priced in the USA market Jaguar had to look at its competitors’ cost base and their hedging strategies as well as its own position. IfwenowaddtogetherFord’snetpositionandJaguar’sasisdoneinFigure3.16 the offsetting exposures give a ‘combined group’ a natural hedge. Jaguar generates US dollar revenues that are attractive to Ford’s USA-based share- holderswhileJaguar’sUK-basedcostswouldpartiallybalanceFord’sexcess UK sales revenues. This still leaves Ford with excess German production costs but this now puts Jaguar in the same position as its direct competitors. Obviously there would be many other strategic reasons for such an acquisition butthevalueofsuchanaturalhedgecouldenableonebiddertojustifypaying more than other potential bidders. Once acquired the corporate centre would need to consider how it set the managerial performance targets for Jaguar’s top management team it would no longer be sensible for them to continue theirprevioushedgingstrategytosafeguardsterlingprofits. Onesuchotherstrategicreasonfortheacquisitionistherelativebrandpos- itioningoftheproductswithinthegroups’portfolios.Fordwouldstronglyargue thatitcouldneverrecoverthefull‘value’ofitstopoftherangeproductse.g.the FordScorpio.Consumertestingindicatedthatiftheproductcouldbebranded as a BMW or a Mercedes customers would be willing to pay a significantly higherprice.Inotherwordsthecurrentbrandimagewasinappropriateforthe actualengineeringqualityofthecar.ConverselyJaguarhadforseveralyears retained a very good brand image particularly in the USA despite a poor reputation for manufacturing quality.Iffollowing the acquisitionFordcould mergeitsengineeringandproductionskillsintoJaguar’simagerythecombined productofferingcouldpotentiallygeneratesignificantsuperprofitsandhence US dollar UK pound German Deutsche Mark Jaguar Ford Generates excess through export sales Needs to pay main cost base Competitor cost base – so important to pricing strategy Needs to pay dividends etc. to shareholders Generates excess through export sales Has excess due to high manufacturing cost base same as Jaguar competitors Figure3.16 Naturalhedgingstrategyopportunities

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96 MarketingFinance createshareholdervalue.ThuswhatFordactuallypurchasedwasabrandasit hadtoinvestheavilyinupgradingJaguar’sexistingmanufacturingfacilities. Thishadtobeseenasasignificantriskbecauseifconsumersperceivedthe new Jaguar models as really Fords they would be unlikely to be willing to continue to pay the same premium pricing as before. If however Ford could improvetheproductqualitywhilemaintainingthedistinctandseparatebranding of Jaguar the acquisition should have proved very successful. This type of financial impact could be evenmore dramatic ifFerrari and Maserati customers perceived themselves as actually buying a very expensive Fiat. This is why it is essential that corporate centres really understand what their role should be and how their organisations should be structured if the chances of achieving their overall goals and objectives are to be increased rather than reduced through its indirect involvement or direct interventions. The importance of understanding your competitors has also been highlighted and the key issues involvedincompetitoranalysisareconsideredinthenextchapter.

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4 FutureCompetitiveEnvironment Review–CompetitorAnalysis Overview Amarketingfinanceapproachrequiresagreatlyincreasedemphasisonexter- nallyorientedanalysisandakeyelementinthisisasoundlybasedcompetitor analysis. Thefirststageinanycompetitoranalysisistoestablishexactlywhoarethe company’s competitors. Competitors can only be realistically defined by customers – your competitors are your customers’ alternative suppliers. This definition of competitors should include both existing competitors and new potentialcompetitors. However thefocusof thecompetitor analysisisdifferent foreachtypeofcompetitor.Potentialcompetitorsmaybedeterredfromentering the market i.e. actually becoming competitors if sufficiently strong entry barriersareerectedintimeexistingcompetitorscannotbydefinitionbedeterred. Aggressive competitive activity may drive existing competitors out of the industrybutthismaynotbepracticaliftheseexistingcompetitorsfacehighexit barriers. This identification of either entry barriers or exit barriers highlights that competitoranalysisshouldbeusedasadecision-makingaid.Thusitisnotenough to produce an annual analysis of a competitor’s published financial results competitor analysis needs to be forward looking and focus on relative differ- encesbetweenthebusinesses.Thisrelativeanalysismeansthatthecompetitor analysis process must betailored to the particular needs of each company and its competitors thus the focus of the competitor analysis process will be very different depending on whether the basis of competition is selling price or value-addeddifferentiation. Agoodcompetitoranalysissystemreallyinvolvesatwo-stageprocess.The first stage consists of placing each competitor’s business into its correct context and this can be facilitated by classifying the competitors into a series of non- mutuallyexclusivecategories.Thesehighlightthekeyroleofthecompetitors andthetypesofstrategicthruststhattheyarelikelytoemploy.Amajorobjective of competitor analysis is to predict strategic initiatives by the competitor and theirresponsestomovesmadebythecompany.

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98 MarketingFinance Notsurprisingly thereforeanincreasingnumberofcompanies areutilising gametheoryasabasisfortheircompetitoranalysisandstrategydevelopment. Themostsustainableshareholdervalue-enhancingscenarioiswheretheindustry is a positive-sum game that can allow all the players in the industry to create shareholder value. This means that the analysis should distinguish between ‘creating-value’and‘capturing-value’strategies.Creating-valuestrategiesincrease thetotalvaluegeneratedbytheindustrywhilecapturing-valuestrategiessimply takeagreatershareoftheexistingtotalvalueavailable.Theworstresultiswhere competition becomes value destroying i.e. the industry becomes a negative- sumgamesothatthereislessvaluetobesharedamongallthecompetitors. The second stage of competitor analysis involves a detailed but tailored comparisonofthedifferencesbetweenthecompanyandeachofitscompetitors. Such an analysis must produce readily usable information rather than masses ofirrelevantdata.Ifthemainbasisofcompetitionissellingpriceakeyelement of competitor analysis will be relative cost benchmarking. In order to obtain therequiredinformationthecompanymayneedtousesomequitesophisticated andcreativeanalysesbutnormallyasufficientlyaccuratecostcomparisoncan beobtained.Howeveranoveremphasisoncostbenchmarkingcanbeunhelpful if competition is based not on selling price but on product quality or service levels etc. In such cases the competitor analysis must try to place values on thesedifferentiatingattributesandcomparethesevalueswiththecostsincurred inachievingthedifferentiation. There is a wide range of sources of information that can be used to provide competitor information but most of the required data is normally already available within the company. The challenge is to turn this data into usable management information and to incorporate it into the company’s strategic decision-makingprocess. Introduction One of the major distinguishing features of a marketing finance approach is the concentration on providing comparative financial information on other businesses. The main area of interest is obviously to gather analyse and disseminateinformationoncompetitorsbutthischapteralsoconsidersbriefly the other elements of the value chain namely suppliers and direct customers. Clearlyabetterunderstandingoftheirpossiblealternativecompetitivestrategies canbeofgreatassistancetoabusinessinselectingitsownstrategy. As discussed in Chapter 2 traditional management accounting has concen- trated on analysing the internal cost structure of the organisation and then planning how this structure will change in the future so that a long-term plan andashort-termbudgetcanbedeveloped.Theactualcostbaseisthencompared against this budget as the year unfolds. In more sophisticated businesses the original budget can be flexed to take account of significant changes in the

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FutureCompetitiveEnvironmentReview–Competitor Analysis 99 external environment so that the comparisons with actual results are more meaningful. This traditional type of management accounting system provides two main typesofbenefitstotheorganisation: First the analysis and planning process sets out the forecast financial out- comeoftheproposedbusinessstrategiesfortheplanningperiod.Thisenables the managers to decide whether this planned outcome is satisfactory or not. If theoutcomeisnotacceptabletheplancanbemodifieduntilthebestpotential resultisobtained.Alsoifthecriticalsuccessfactorshavebeenproperlyhigh- lighted in the analysis process as discussed in Chapter 5 the sensitivity analysisonthesecriticalsuccessfactorscanbeappliedtothefinancialplanso that managers can identify the key risks and opportunities that may occur. This can again enable the plan to be modified prior to implementation or the businessmaytrytoreduceitsexposuretoaparticularkeyriskbyadoptingsome appropriatehedgingstrategy. Second once the plan has been implemented the control process provides a methodofcomparingactualperformanceagainstplannedperformance.This comparisoncanenablechangestobemadetotheplanasnecessaryinthelight oftheactualoutcomesoftheinitialstrategicdecisions.Thesesubsequentdecisions shouldasalwaysbebasedonthelatestinformationavailableandthisrequires that the plan should be updated to take account of material changes since it was formulated hence many businesses now use a rolling forecast system as the basis against which actual performance is compared as discussed in Chapter6. Thebenefitsofthistypeofmanagementaccountingareunquestionablebut such a system does not explicitly address some of the major issues facing businesses when they are trying to develop a competitive strategy. Competi- tive strategies have already been defined as specific courses of action that are designed to create sustainable competitive advantages which should enable thebusinesstogeneratesuperprofitsfromwhichshareholdervalueiscreated. A competitive advantage can only by definition be created by comparison tocompetitorsandthiscomparisonshouldbeaspreciseandclearlydefinedas is practicable. Thus in most good traditional management accounting systems suchcompetitivecomparisonsareimplicitlyincludedintheessentialforecasts of market share gained and pricing levels that are assumed for the planning period. However unless these competitive assumptions are made clear and explicit it can be very difficult during the monitoring and control process to identifytherealreasonsforanydiversionfromtheplannedresults.Forexample if forecast price increases cannot be implemented or made to stick because competitors do not increase their prices the planned profitability of the business canbeseriouslyaffected.Insuchcircumstancesitisvitallyimportantthatthe managers of the organisation can determine if competitors are holding down their prices as a short-term marketing tactic in order to try to gain market

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100 Marketing Finance shareeventhoughtheythemselvesmaybesufferingsignificantcostincreases withaconsequentadverseimpactontheirownprofitability.Shouldthisbethe casethesecompetitorswillneedtoincreasetheirsellingpricesintheshortterm to restore their required profit levels whether the market share growth tactic has worked or not. Alternatively and much more seriously the competitors could have a relative cost advantage that could enable them to maintain these lowerpricelevelsoverthemuchlongerterm. Clearly the appropriate competitive response to these alternative causes of the same market situation should be dramatically different but the ability to identify the appropriate response depends on the quality of the competitor analysisthathasbeencarriedout. Definingthecompetition YOURCOMPETITIONISDEFINEDFORYOUBYYOURCUSTOMERS. COMPETITORSAREYOURCUSTOMERS’ALTERNATIVESUPPLIERS. Thefirststageindefiningwhoareacompany’scompetitorsshouldhavebeen doneaspartofestablishingthemissionstatementofthebusinesscarryingout the competitor analysis. Competitive strategies have to be developed at the levelwherethebusinesssellsproductsindistinctmarketsandagainstidentifi- able competitors. If this identification is not relatively simple and straightfor- ward the business is either inappropriately structured or has not yet defined a sufficientlyclearcompetitivestrategy. However many businesses adopt an internal perspective to identifying competitorsbasedontheindustrysectorwithinwhichtheyoperate.Thisoften brings in too wide a spectrum of ‘competitors’. As discussed in Practical Insight 4.1 a car manufacturer need not consider all other car manufacturers as competitors but should focus its analysis on those companies providing a similarproductofferingasitsowntothesametypesofcustomer.Indeedas illustrated later in the chapter the competitive product analysis carried out by leadingcarcompanieshasbeentakentoaverysophisticatedlevel. PracticalInsight4.1 Averysegmentedindustry Ford Motor Company is one of the leading volume car manufacturers in the worldandhasformanyyearsplacedmuchemphasisonhavinggoodcompetitor analysis.Historicallythisanalysissometimessufferedfromaninternal‘wish-list’ ofcompetitorsratherthananexternallyfocusedrealworld-basedcustomer-driven definitionofcompetitors.Thustoanyoneworkinginthecarindustrytheleading companies to which one would like to be compared would be Mercedes Benz BMWandPorsche.Unfortunatelyifone’sproductrangeactuallyaimsatalower pricedmarketsegmentsuchacompetitoranalysisisnotasrelevantasitshouldbe.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 101 Customer-leddefinitionsofcompetitioncanalsohighlightsomelessobvious but very important competitors. Once the business focuses on alternative suppliers to its prospective customers i.e. its chosen market as its competitors it is forced to define what the customer is actually buying. In some cases the actualgoodorservicemaynotadequatelydefinecompetitorsbecausethecustomer is actually purchasing a group of attributes or benefits rather than the specific product.Hencecompetitorswillbeotherbusinessesprovidingwhatthecustomer perceives as a comparable group of benefits even though the product may appearphysicallyverydifferent. COMPANIESSELLFEATURES. CUSTOMERSBUYBENEFITS. For example cinemas show films to the public and thus compete directly againstothercinemas.Videorentalshopssatelliteandcabletelevisionchannels and increasingly the Internet are competitors which use a different channel of distributionforthesamegenreofproduct.Howevercinemasarereallyalsoin competitionwithotherleisureservicebusinessesastheircustomersmaychoose tospendtheirleisuretimeandmoneyinalternativewayscompetitoranalysis maythereforeneedtoincorporate‘live’theatrespectator-basedsportingevents andotherformsofpassiveentertainment. Identifying competitors consists of finding other businesses that supply alternative competing products to the same end customer even though they may use different strategies including very different channels of distribution. Analysisshouldattempttoidentifynotonlytheexistingcompetitors butalso However following theacquisition of Jaguar that was discussed inChapter 3 part ofFordbecameapotentiallyviablecompetitoragainsttheseluxurycarmanufac- turersi.e.withitsotherluxurycarmarquesAstonMartinandVolvo.Thebasis of the relevant competitor analysis in this segment of the car market should be significantly different to that used in the volume-oriented middle-price catego- ries where the bulk of Ford’s business has been traditionally i.e. cost efficiency isstillimportantbutbrandingandqualityperceptionaremuchmoreimportant. TheVWgroupfaceadifferentcompetitoranalysisproblemduetotheirmulti- branding strategy i.e. ownership of Audi VWSkoda and Seat brands. Originally thesebrandswereinhighlydifferentiatedmarketsegmentsbutSkodaforinstance has undergone a transformation in production and design quality. Also the desire formanufacturingefficiencieshasledtothesharingofmajorelementsacrossthe group’s product range. For example the Skoda Octavia’s top of the range model sharesitschassiswiththeAudiA3andhasaslightlydetunedversionoftheengine intheAudiTT.Thereisclearlythepotentialforcustomerstoassociatetheseprod- ucts as competitive as the author has done by switching from an Audi to a Skoda. In response the group is trying to make the channels of distribution i.e. the dealers appear very differentiated by focusing each one on only part of the group’sofferings.

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102 Marketing Finance and often even more importantly the potential new competitors that may be attractedintothecompany’sareaofoperations.Ifpotentialcompetitorsarenot identified in advance it may be very difficult to compete successfully against themoncetheyareestablished. In many cases new competitors can only enter a market because of some significant change in the external competitive environment. New sources of competitiveadvantagemayemergewhichthenewplayersarebetterplacedto exploit. Alternatively the change could destroy or substantially reduce the strength of the existing competitive advantages held by the original players. TheseissuesareillustratedinPracticalInsights4.2and4.3. PracticalInsight4.2 PracticalInsight4.3 Themilkmandoesn’tknockanymore In the UK retail dairies had established fierce competitive strategies against each other the obvious visible direct competition. This competition was based on service levels with some dairies emphasising the time of delivery while others extended the range of products delivered by the milkman. However a new form of competitor has taken an increasingly large proportion of the market for milk whichisconsumedinthehome. Largesupermarketsenteredtheretailmilkmarketusingtheirbulkbuyingpower asthesupplysideofthemilkindustrychangedconsiderablynewtechnological developments which increased the shelf life of the product and new packaging developmentswhichmadebulkpackagingacceptableandpractical.Theirmove to out-of-town superstore locations and the consequent increase in car usage for shopping made home delivery of bulky products such as milk bread and soft drinks etc. less of an issue for consumers. The competitive environment was changed from one focused largely on service to one dominated by the issue of price many consumers are not now willing to pay thepricepremiumrequiredfor thedeliveryserviceofferedbytheretaildairies. Fromkeyassetstoexpensiveliability In the retail financial services industry a key competitive advantage was for manyyearsthenationalnetworkofbranchesthatthelargeplayersintheindustry all had. This served as a significant entry barrier to new entrants. However technology has now transformed the industry and almost removed the need for branches. Customers can transact their business over the Internet the telephone and through automated teller machines ATMs. A number of completely new businesses have entered the industry and the big players have been forced to launchtheirown‘branchless’equivalents.Thecostadvantagesofnothavinglarge branch networks are substantial and consequently the original large banks are desperately searching for new added-value ways of re-utilising their branches or exitingfromthemascheaplyaspossible.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 103 Focusing on customer-defined competitors and including both existing and potential competitors is very useful in identifying the main purpose of any competitor analysis namely to assist the development and implementation of the company’s competitive strategy. In other words competitor analysis is astrategicdecision-supportprocess. Competitoranalysisasadecision-makingaid THEKEYISSUEISTOUNDERSTANDWHERECOMPETITORSARE NOWBETTERORWORSETHANYOUAREANDHOWTHISIS LIKELYTOCHANGEINTHEFUTURE. It is only after the appropriate set of existing and potential competitors has been identified that the required analytical information can be determined. Thuslikemostotheraspectsofmarketingfinancecompetitoranalysishasto betailoredtothespecificneedsofeachcompany.Alsoalthoughstrategically important good competitor analysis is relatively expensive and should itself besubjectedtosomeformofcost-benefitanalysis. The initial objective is to understand exactly what significant differences exist between the company and each of its main competitors. This means establishing where competitors are better or worse than the company it must always be remembered that a sustainable competitive advantage is a relative concept. A sustainable competitive advantage enables an organisation to do somethingthatcannotbematchedbyanyoneelseintheeyesofitscustomers. Thus a strongly branded product can create very strong customer loyalty because its users do not believe that any competitive offering is as good. Hence a company that employs a strategy of always having the lowest selling priceinitsmarketdoesnothaveasustainablecompetitiveadvantageunlessit is also the lowest cost supplier. If not its competitors can immediately match its low selling prices without being at a relative commercial disadvantage. Indeedatleastonecompetitormaybeabletoundercutthecompany Sustainablecompetitiveadvantagesmustthereforebedescribedintermsof ‘better’ ‘cheaper’ ‘faster’ ‘more reliable’ etc. This requirement for a relative comparison with competitors removes the need for absolute precision in assessingeverycostincurredbyallcompetitors. HAVINGAGOODPRODUCTWILLNOTENABLEYOUTOCREATE SHAREHOLDERVALUEIFYOURCOMPETITORSHAVEABETTER PRODUCT. The ultimate objective for competitor analysis however is not to establish the current position but to indicate the relative competitive positions in the future. The challenge is to project where competitors are heading in terms of

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104 Marketing Finance costs value offerings quality gains and product innovations etc. Again such analysis can be complex time-consuming and correspondingly expensive. It shouldnotthereforebedoneforallaspectsofallcompetitors. Competitoranalysisshouldconcentrateonthestrategicallyimportantaspects of each targeted existing and potential competitor. For example an in-depth cost comparison with a competitor may be of no value if the basis of the competitor’s strategy is either perceived quality of product responsiveness of service levels to customer needs or a highly attractive image-oriented brand. Thefocusoftheanalysismustbeonwhetheranycostpremiumincurredbythe competitor increases its total economic added-value by allowing a substan- tiallygreaterpricepremiumorbycreatingahighdegreeofcustomerloyalty. Where the basis ofcompetition isprimarilyon pricean in-depth costcom- parisonisclearlyimportantnocompanycanjustifyitsclaimtobe‘thelowest cost supplier’ in its industry if it has not done an external cost benchmarking exerciseagainstitscompetitors.Similarlyacompanywhichclaimstohave‘better products’ than any of its competitors should have done customer research to validatetheperceivedextravalueoftheproductandanalysedthisextravalue againstanyextracostincurredindeliveringittothecustomer. Accordingly competitor analysis processes differ significantly in different industries and even within an industry if different competitive strategies are beingemployed.Thismeansthatformanycompaniesthecompetitoranalyses within the organisation may need to be tailored if it is competing in different ways against different competitors in different market segments. Each analysis should provide the appropriate information to support the different strategic decisionsthatthecompanyanditscompetitorswillbefacing. Competitoranalysiscannotthereforebecarriedoutbyanyformofhistorical reconciliationofcompetitors’financialresultswiththecompany’sown.Itmust befocusedonthefutureandmusttrylogicallytopredictcompetitors’desired positionsandtohighlighttheirweaknessessothatthesecanbeattacked. Competitoranalysisasatwo-stageprocess DETAILEDCOMPETITORACTIONSANDREACTIONSCANONLY BEPREDICTEDWHENTHECOMPETITOR’SBUSINESSISPLACED INITSCORRECTCONTEXT. For large complex competitors it is important to understand the competitor’s overall corporate and financial strategy and where this particular part of their businessfitswithinthisstrategy.Manylargecompaniescomprisealargenumber of business units competing directly against a quite diverse range of external businesseswhichareoftenthemselvespartofsimilarlycomplexgroups.Com- petitoractions/reactionsfromanyparticularpartofsuchabusiness will be sig- nificantlyaffectedbythepositionofthisbusinessunitwithinthegroup’soverall portfolioandhowtheotherbusinesseswithinthegroupareperforming.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 105 Withthisinmindcompetitoranalysismustplacetheparticularcompetitive business unit into its appropriate context. This should assist in identifying the most likely goals and objectives that will be established for the competitor by thegroupcentre.Notonlywill these goalsandobjectivesdrive thecompetitor’s own strategy butthey will also have atremendous impacton the competitor’s responsestoanystrategicinitiativesappearinginthemarketplace. The strategic positioning of competitors is facilitated by classifying com- petitors into a number of non-mutually exclusive categories the idea being to buildupapictureofeachcompetitorwhichcanbeeasilyandclearlycommu- nicatedwithinthecompany.Oneobvioussuchclassificationisbetweenexisting andpotentialcompetitorsandithasalreadybeenstatedthatcompetitoranalysis mustconsiderbothclassifications.Howevertheissuesthatneedtobeaddressed aresignificantlydifferent. Potential competitors are by definition not yet present in the particular marketplace e.g. market segment and they may be deterred from entering if sufficientlystrong‘entrybarriers’asdescribedinChapter1areerectedintime. Existing competitors cannot also by definition be kept out of the industry by such entry barriers but they may face ‘exit barriers’ which may prevent them fromleavingtheindustry. It is economically irrational for any company under perfect conditions remember our brief discussion on perfect competition in Chapter 1 when entry barriers were introduced to stay in an industry if it is unable to achieve its required rate of return. If it does so itcontinues to destroy shareholder value year after year. Competitors could therefore be forced to exit from an industry by a company with a strong sustainable competitive advantage if this was used to force down the rate of return achieved by these less well-positioned busi- nesses. However in the real world companies do not automatically leave an industry even though their rate of return is less than that required by their shareholders.Indeedsomecompetitorswillstayinanindustrywheretheyare makinglosses.ExitbarrierswhicharediagrammaticallyshowninFigure4.1 canmeanthattherearesignificantcostsassociatedwithleavinganindustry. Ifthebarriers toexitaresubstantialitmay notbeeconomically rationaltotry todriveoutexistingcompetitors.Inthiscasethecompany’scompetitivestrategy musttakeintoaccountthestrategicintentionsofallexistingcompetitors.Inother circumstancestheoptimumcompetitivestrategymaybetotrytoimprovethe economicattractivenessoftheindustrybydrivingouttheweakestcompetitor here the key role of competitor analysis is to identify which is the weakest competitorandwhatisthebestwayofforcingthemtoexitfromtheindustry. As can be seen from Figure 4.2 there is a wide range of possible exit bar- riers and they must be fully understood before any aggressive competitive action is initiated. It is quite common to see a large business start a price war inanindustrywithsignificantexcesscapacity.Thiswillonlyworktoincreasethe profitability of all the players in the industry if the price reduction stimulates total demand very significantly so as to outweigh the immediate reduction in

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106 Marketing Finance the contribution per unit. More commonly this strategy is used to try to force out the weaker players and therefore reduce the total outputs of the industry thusenhancingthelonger-termfinancialreturnofthoseremaining.Thisstrategy ismuchlesslikelytosucceediftheweakerplayersfacesignificantexitbarriers suchashavingaveryhighfixedcoststructurewithlonglifespecialisedfixed assets and high costs of physically closing down their operations this is Co. A Co. C Co. D Existing competitive environment very unattractive Co. B Stopping existing competitors leaving – despite current low returns or losses Exit barriers Figure4.1 Maintainingtheunattractivestatusquo–exitbarriers High fixed costs Co. A Co. C Co. D Existing competitive environment Co. B Integrated processes – Shared assets Common costs Low avoidable level Piece-meal replacement of assets Long-term supply contract Dedicated assets No alternative uses High costs to close down and leave Long life assets – Figure4.2 Exitbarriers

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 107 illustratedinPracticalInsight4.4.Theirresponseismuchmorelikelytobeto match the price decreaseor eventotake itone stage loweragain.Should this happen the effect of the competitive strategy will be to reduce the overall profits of the industry without necessarily improving the overall long-term com- petitiveenvironment. Even if the competitor could be forced out their likely method of exit also needs to be predicted. Some companies may leave an industry gradually over manyyearsperhapsbynotreinvestingintheirlonglifefixedassets.Theprice- cuttinginitiatorwouldthereforehavetobepreparedtocontinueitsaggressive marketing strategy until the competitor finally left. If financial returns started to increase while the competitor was still in the industry the decision to exit could be reversed. A further alternative strategy is therefore to accelerate the requiredrationalisationoftheindustrybyacquiringormergingwithoneormore competitorseventhoughquiterapidlyafterthecompaniescometogetherthe totalcapacityoftheweakerbusinessiscloseddown. The competitor analysis required in this type of competitive environment shouldindicatetheidealtimetoinitiatethistypeof‘exitforcing’strategyand theprobabilityofitssuccess.Clearlyanysuchinitiativeshouldbeimplemented when the exit barriers are at their lowest. For example in an asset-intensive industry acting just before the competitorcommitstoa significant reinvestment is likely to have a much more positive impact in terms of increasing their likelihood of exiting than waiting until after the competitor has made its reinvestmentwhenthecompetitivereactionwillnormallybetheexactopposite ofthatdesired. The competitor analysis information required includes a life-cycle analysis of the competitor’s existing asset base its required rate of return on this type ofreinvestmentanditscapitalinvestmentdecision-makingprocesssothatthe strategy can be implemented in time to influence the reinvestment decision. Suchstrategicallyfocused information differs considerably from that generated by many operationally orientated competitor accounting systems where the mainsourcesofanalysisarethepublishedfinancialstatementsofdirectexisting competitors. It should also be clear that this information differs significantly from that required in an environment where the company is currently earning superprofitsandthekeyissueishowtodevelopveryquicklystrongentrybarriers inordertokeepoutpotentialcompetitors. PracticalInsight4.4 Theultimateexitbarriers Miningcompaniesandtheextractiveindustriesingeneralhaveasetofbusiness parametersthatcanleavethemlockedintotheirbusinesseseventhoughthepros- pectsofearningareasonablerateofreturnletalonegeneratingsuperprofitsare bleakintheextreme.

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108 Marketing Finance Wenowturntoconsidertheothernon-mutuallyexclusivewaysofclassify- ingcompetitorswhicharesetoutinFigure4.3.Thedegreeofresistancefrom a competitor will often be dictated by whether the particular business that is beingattackedisregardedasacorepartofthegroup’sactivitiesratherthana peripheral activity. Not surprisingly most competitors will defend their core areas of business as vigorously as they can but they may not put the same resourcesorcommitmentintodefendingnon-corepartsoftheirgroup. Similarly the ability and willingness to defend a peripheral business will dependupontheperformanceofthecorebusiness.Ifthecorebusinessitselfis alreadyundersevereattackitmaybeagoodtimetoattackoneofthegroup’s TheultimateexitbarriersContinued Most mines operate with high fixed costs even if they can keep some of their labour costs variable they normally have high overheads. They also have very dedicatedfixedassetswithlongeconomiclivesandvirtuallynoalternativeuses. However in many such industries the value of their output e.g. gold nickel coal is controlled by the external environment and can be extremely volatile. This would make it very attractive to be able to close down temporarily when prices are depressed or at least to reduce the level of output. Their high fixed costs would make this difficult enough but in reality the major problem is the veryhighfinancialcostofclosingdown.Inmostcountriesminingcompaniesare notallowed simply to close down a mine.They must not only make the site safe and pay off the workforce but also repair any damage done to the physical envir- onment this can make it cheaper to continue operating the mine at a loss than to incurthecostsincurredinclosingdown Competitors can be grouped into a number of non-mutually exclusive categories: Core business or peripheral. Position of this business unit within their group’s portfolio e.g. development unit versus main profit generator. Degree of concentration/focus on this business unit e.g. vertically integrated versus dedicated to one area. Key performance measures used e.g. profits/cash flow versus growth/market share. Principal decision-makers e.g. professional managers versus family shareholders. Risk-taking appetite e.g. risk averse versus high risk-taking. Figure4.3 Classifyingcompetitors

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 109 peripheralbusinessesinanattempttoforceaquickexitdecision.Conversely ifthecorebusinessesareallhighlyprofitablecashgeneratingbutmatureoper- ationsitmay notbesucha successfulstrategyaggressively toattack theonly highgrowthbutcashconsumingbusinessinthecompetitor’sportfolio.Thus itisalsoimportanttounderstandthemainrolewithinthecompetitor’soverall strategythatisplayedbytheparticularbusinessbeinganalysed. Anotherwayofclassifyingcompetitorsisbyreferencetotheirrelativelevels ofverticalintegration.Inmanyindustriesitisquitecommontofindcompeting businessesthathaveverydifferentlevelsofverticalintegrationasisthesituation inthecasestudyonthecigaretteindustryattheendofthischapter.BATplcis much more vertically integrated than Philip Morris BAT has tobacco leaf growing interests around the world while Philip Morris buys its tobacco from dealers. This will significantly affect their business strategies and potential responses to changes inthecompetitive environment. Consequently it is import- antthat companies carefully analyse their competitors from this perspective – particularlywhenonecompetitororsmallgroupofcompetitorshasastructure thatdiffersfromtherestoftheindustry. Amajorpotentialproblemfacesanyverticallyintegratedorganisationwhich hascompetitorsdedicatedtoonlyonesectionoftheindustryvaluechainsuch a dedicated competitor can easily identify the contribution generated by its focused business whereas such fundamental analytical information may not besoreadilyavailabletotheverticallyintegratedcompany.Indeedmanyinternal management accounting systems make it very difficult to establish the ‘true’ profitabilityofthedifferentparts ofthe business.Asdiscussedwith reference to the computer car and oil industries in Chapter 3 it is critical that the com- pany’s internal transfer pricing system highlights which areas of the business reallygeneratesuperprofits.Theseareasmustbesafeguardedagainstcompetit- ive threat however far too often transfer pricing systems are merely cost or profitapportionmentprocesses. The oil industry is also a good example of another element of competitor analysis.Themajoroilcompaniesareallhighlyverticallyintegratedwithbusi- nesses ranging from exploration to retail outlets. Many of these companies wouldregardthemselvesasquitegoodatcompetitoranalysisbutmostoftheir analysis was traditionally directed towards other similarly vertically integrated oil companies. Relatively recently large supermarket chains entered the retail fuelmarketinseveralcountries.Theoilindustryfacedanewgroupofcompetitors with very different business strategies developed from a completely different attitude to the industry and its need to be vertically integrated. These super- markets particularly in France and the UK have successfully gained share in theretailendoftheoilindustrybutshownosignsofmovingintooilexploration orrefining.ThisexampleisdevelopedinmoredetailinChapter5. It is also important to understand what performance measures are used by competitors as this will also affect their behaviour under our already stated

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110 Marketing Finance maxim of ‘what you measure is what you get’. If a business wants to grow it should normally have growth as one of its key performance measures rather than focusing on measures of profits or cash flow. Where competing businesses havefundamentallydifferentfocusestheirbehavioursandresponsestospecific opportunitiesandthreatsmaybeequallydifferent.Indeedtheymaybothregard themselvesaswinninginaparticularcompetitiveenvironment.Forexample if one company emphasises growth while its competitor focuses on profits both could be happy if one is gaining market share but the other is increasing itsprofitsbecauseithasarelativelyreducedrateofmarketingsupport–oneis certainlymoreshort-termorientedthantheotherandmaywellneedthemaxim of a short life but a happy one It is therefore critical that the competitor analysis does not stem from any potentially false assumptions regarding the strategic objectives of competitors. Many businesses have fallen into the trap ofassumingthatalltheircompetitorshavethesameobjectivesastheydoand hence that these competitors will use similar performance measures the competitoranalysismustestablishtherealcompetitivesituation. The remaining two classifications i.e. the types of principal decision-maker andtherelativerisk-takingappetitesarereasonablyself-explanatoryandcanbest beillustratedbyalinkedextremeexample.Therearetwocompetitorsinanindus- try both of which have very recently appointed new chief executives. In one companythenewchiefexecutiveis62yearsoldandhasworkedforthecompany for 41 years joining straight from University. He is also the third generation of his family to hold this job not too surprising as his family are the largest share- holdersinthepubliclyquotedgroupwhichalsobearsthefamilyname.Theother companyhashiredinitschiefexecutivefromoutside.Sheis35yearsoldand hasaverysuccessfulcareerrecordtodatebutthisisherfirstappointmentatthis very top level in a group. In her previous sales and marketing roles she had achievedsignificantgrowthinmarketsharessometimesthroughveryaggressive competitivestrategiesincludingstartingseverepricewarsonoccasions. Clearlytheattitudesandrisk-takingprofileofthesetwoexecutivesarelikely tobepolesapartanditisveryimportantthatthisinformationformspartofthe competitor analysis process. Leading companies in this area such as Philip Morris that is the subject of the case study at the end of the chapter maintain a database on the key executives in its competitors so that they know what to expectwhentheymoveintoanewmanagerialrole. Agametheoryviewoftheindustryvaluechain ANYSTRATEGYWHICHAIMSTOCREATEINCREASEDSHARE- HOLDERVALUESHOULDALSOIDENTIFYWHERETHAT INCREASEDVALUEISGOINGTOCOMEFROM.IFITCANNOT ITISNOTASTRATEGY–ITISAWISHLIST.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 111 The continual emphasis throughout the book on shareholder value should leadtoaconsequentfocusonthesourcesofthesuperprofitsthatgeneratethis shareholder value. In fast-growing industries the total value-added produced by the industry can be increasing rapidly. More end users may be buying the good or service existing users are buying more and may be willing to pay increased real prices for enhanced levels of benefits. It can be possible for all the companies in such an industry to generate shareholder value. This can be truebutitisnotnormallythecaseeveninhighgrowthmarkets. Themostlogicallong-termcompetitivestrategyinagrowingmarketistotry to increase market share during this growth phase. As discussed in Chapter 2 muchempiricalevidence existsto suggestthat the greatestshareholder value is produced by the companies with dominant market shares in their industries andthatthesedominantmarketsharesaremosteconomicallydevelopedwhile the market is itself growing. Hence part of the successful company’s growth even in a rapidly growing market comes at the expense of competitors. The competitor may still be growing but at a slower rate than the industry i.e. they arelosingmarketshare. In a slow-growth or static-mature industry almost any growth in sales volumeorrevenuebyonecompanyhastocomeattheexpenseofacompetitor. It is of course likelythat the competitorwill try to defend theirexistinglevels of sales and profits. Hence if such a gain is to be sustainable the aggressive growth company should be utilising a strong competitive advantage against whichthecompetitorhasnodefence. Howeverincreasedlevelsoffinancialreturncanbegeneratednotatthedirect expenseofcompetitorsbutfromsqueezingtheotherelementsoftheindustry supply chain as is shown in Figure 4.4. This means reducing the value-added by eithersuppliers to thecompany orthedirectcustomers of thecompanyso that the company takes an increased share of the total value added by the industry. Again this type of strategic thrust should be based on a sustainable competitive advantage and may depend on a fundamental re-structuring or re-engineering of the current business processes applied within the industry. Really good examples of business process re-engineering result in the total value added by the industry being increased so that all the parties involved couldbenefitonceagaintherearemanyfewerexampleswhere allpartiesdo actuallyshareinthesebenefits. TheseideasareshowndiagrammaticallyinFigure4.4acompetitivestrategy shouldbeclearastothesourceofanyexpectedincreaseinsuperprofits.Further the competitive strategy process should explain why such an increase is sustainable – in other words why the affected competitors suppliers or cus- tomers cannot do anything about it. Unless this process is carried out the company has developed more of a ‘wish list’ rather than a properly evaluated andfinanciallyjustifiedcompetitivestrategy.

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112 Marketing Finance It is quite normal for the sum of the strategic plans of all the players in an industry to be much greater than the total value generated by the industry i.e. they cannot all be achieved. Hence many companies have introduced game theory concepts to build in the dynamic interactions among themselves com- petitorscustomersandsuppliers. The basics of game theory are very easy to state but its practical application can become very complicated. As in any competitive game such as bridge or chessdevelopinga successfulstrategyis considerably assisted by predicting the future actions and reactions of the various players. In other words you have to look forward to potential outcomes and then reason backwards to develop the most successful strategies. However in business there are a range of different types of game as is shown in Figure 4.5. Most other normal ‘games’haveasimplewin–loseoutcomeifIwinthenyouloseandviceversa theycanbedescribedaszero-sumgames. Industries can degenerate into negative-sum games where all the players lose out this can be the result of many destructive price wars as discussed earlier.Itisthereforeimportantthatthecompanyassessestheriskofthistype ofresultensuingfromitsproposedcompetitivestrategy.Converselyitisalso quitepossibleforanindustrytoproducea positive-sum gamewhereallplayers in the industry win also as discussed earlier in a very financially attractive industryallcompaniesinvolvedmaycreateshareholdervalue.Suchaposition is potentially much more sustainable than a win–lose game as no competitor Total value-added controlled by consumers Competitor value- added Competitor value- added The business value- added Customer value-added Supplier value-added Total value-added controlled by consumers Total value- added controlled by consumers Total value- added controlled by consumers Figure4.4 Gametheoryviewofindustryvaluechain

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 113 should want to risk destroying the shareholder value which they are creating. This should still be true even if the win–win is 90:10 in one party’s favour. Thus the strategic intent should be as shown in Figure 4.6 as this is the most sustainable way to create shareholder value. If the industry remains as a zero- sum game particularly one that the company is continually winning there is a risk that competitors become more willing to take greater and greater risks i.e.implementincreasinglyaggressivestrategiesbecauseoftheircontinuing poorfinancialperformance.Thiscouldpushtheindustrybackintoanegative-sum gamewhereallpartiesloseyetthisriskdoesnotseemtobeacknowledgedin manymacho‘winnertakesall’strategiesItisstillbetterobviouslyasshown 1 Zero-or constant sum games Win–lose or lose–win outcomes 2 Positive-sum games - Win–win strategies possible 3 Negative-sum games - Lose–lose strategies quite likely Figure4.5 Differenttypesofgames to win–win We win more than they win Through win–lose We win because they lose From Lose–lose They lose more than we lose Risk of Regressive loop Figure4.6 Differenttypesofgames–strategicintent

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114 Marketing Finance in Figure 4.7 to bethe winner in a zero-sum gamebutthe long-term sustain- abilityofsuchapositionmustbeconsidered. We need therefore to distinguish between destructive competition and con- structive competition. Destructive competition reduces the total value created by all the players in the industry whereas constructive competition seeks to increase the total value created. As discussed in Chapter 2 the link between shareholder value and competitive strategy is also a two-stage process stage one seeks to create value within the total value chain while stage two tries to capture as much of this total value as possible. This is shown diagrammatically inFigure4.8. Thevaluecreationtypeofcompetitioncanoftenbeviewedasaco-operative formofcompetitionverticallywithinthetotalindustryvaluechain.Indeedthe term‘co-opetition’wascoinedbyRayNoordatodescribethisandtheconcept has been developed by USA academics Brandenburger and Nalebuff. However thelogicalresponsibilityformanagingthisvaluecreationcompetitivespiritrests with the dominant player in the industry. If a competitor with a 10 per cent market share increases the total value created by the industry it is likely that 90 per cent of the value they have created will go to other industry players. Unfortunately in many industries the dominant player adopts a strategy that focuses exclusively on capturing more of the existing industry value chain. Win Lose Lose Win Zero-sum games –ve sum game +ve sum game US Competition Figure4.7 Differenttypesofgames Competition particularly among players at same level in value chain Capture value Stage 2 Cooperation particularly vertically within total value chain Create value Stage 1 Figure4.8 Linktoshareholdervalueandcompetitivestrategy

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 115 Thiscanstillbetrueevenwhenthisstrategyresultsinverydestructivecompetitive responsesthistypeofdominantcompanysimplybecomesevenmoreaggressive Other industries suffer interestingly from the lack of a dominant player that is able to manage the total value created by the industry. There are many examples of industries with four or five relatively evenly balanced competitors that quite regularly degenerate into value destroying price wars. Such price warsaremostunlikelytoforceanyofthecompetitorsoutoftheindustryand thus total profitability in the industry is dramatically reduced. This position is often triggered because the total aspirations of all the competitors cannot be met by the total industry e.g. where five competitors all have objectives to achieve25percentmarketshares. Detailedbuttailoredanalysis MOSTCOMPETITORANALYSISEXERCISESPRODUCEAMASS OFIRRELEVANTANDCONFUSINGDATABUTVERYLITTLE APPROPRIATELYTAILOREDUSABLEINFORMATION. Having defined who thecompetitors areand placed each ofthesecompetitors in their appropriate context the second stage of our competitor analysis process involves analysing all the specific competitive advantages and dis- advantages relative to each competitor. This should enable an appropriately tailoredcompetitivestrategytobedeveloped. Thatcompetitoranalysisshouldbetightlyfocusedandhaveclearlydefined objectives should by now be clear. The best objectives are built around com- petitive strategy decisions so that competitor analysis is forced to act in a decision-support manner. However all competitor analysis should be tailored tosuittheparticularenvironmentinwhichthecompanyisoperating.Thiscan mean that even within one company the competitor analysis process may be differentlystructuredforseparatecategoriesofcompetitors. Theanalysismustproducereadilyusableinformationratherthanlotsofstand- ard regular reports on all competitors. The key phrase for all management information which is ‘the right information at the right time to the right people’ can be applied very readily to competitor analysis. The timing of competitor analysisshouldnotonlybegearedtothecompany’sstrategicdecisionprocessbut asalreadymentionedshouldrespondtochangesinthecompetitiveenvironment. For example in the car industry most players conduct extremely in-depth analyses of directly competitive products. When a new competitive product becomes available it is quite literally taken apart and examined in detail to try to establish not only what each modified or new component costs the competitor but also what it would cost the company to incorporate into their equivalentoffering.Additionallythisanalysiswilltrytoestablishthevalueof theinnovationstothecompetitor’scustomers.Thiswell-developedvalue-in-use

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116 Marketing Finance pricinganalysiscanbeseenfromthefocusputbydirectmarketingcomparisons used in their product advertising on differences in levels of equipment per- formance e.g. acceleration top speed etc. fuel efficiency boot and interior space they even value knee room shoulder height etc. for passengers. The practical application of this technique is considered in more depth slightly laterandagaininChapter11. As already established cost benchmarking is essential if the primary basis of competition is selling price but it may give false signals if competitors are selling differentiated products. The cost benchmark that is required is where competitors are likely to be in the future rather than merely where they are now. Thus concentrating on internal costs and planned improvements may giveacompletelywrongimpressionofthecompany’scompetitivepositionif competitors are improving at a faster pace from a better starting position the companyisfallingfurtherandfurtherbehind. Thebestcostbenchmarkisthereforeagainstthelowestcostdirectcompetitor bothintermsofcomparingcurrentcostlevelsandfutureexpectedimprovements. Such direct comparisons may be difficult to make although a very good approximation of relative cost levels can normally be assessed. Hence many companies now do cost comparisons with carefully selected non-competing businesses.Asensibleapproachistoselectnon-competitorsthatareconsidered excellent in a key strategic area e.g. operational efficiency or customer service andtocarryoutcomparisonsagainsttheminthisarea.Thiscanbeusedtoset aninitialinternalstandardortargetbutalsobecausesuchcomparisonscanbe beneficial to all the participating businesses they can be updated regularly and canevenincorporateplannedimprovements. For many large companies a start point for any relative cost comparison exercise can be to use its internal business units as benchmarks. This can establish existing and planned best practice within the group less well- performing business units can be asked to develop plans to bring themselves higher up the league table. Such internal comparisons are only productive if the group can properly make allowances for all the unavoidable differences across its operations as is illustrated in Practical Insight 4.5. If this can be doneitshouldbepossibletobuildupaverygoodpictureofcompetitors’relative positions using similar techniques if not such certain knowledge. A simple initial competitor positioning can be achieved by deciding where they would beinthegroup’sowninternalleaguetableofcostefficiency. PracticalInsight4.5 Flexibilityversushighvolume One very large ‘global’ FMCG company has carried out a comprehensive cost benchmarkingexerciseonallitsfactoriesworldwide.Thishighlightedthevery wide range of cost levels for producing the same product. Many of these cost

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 117 Ifthebasisofcompetitionisnotlargelysellingpricethendetailedcostbench- marking will not provide the whole answer. What is required is an analysis of thespecificsourcesofvalue-addedineachcompetitiveofferingi.e.identifying the differentiators across the products. For each significant difference the competitoranalysisshouldseektoestablishthreethings: 1 Whatvalueisplacedonthiselementbythecustomer 2 Whatdoes/woulditcostthecompetitortoincorporate 3 Whatwould/doesitcostyourcompanytoinclude Numerical examples of this analysis are given in Chapter 11 to show when a sustainable competitive advantage/disadvantage is achieved. This analysis highlights the true value-adding elements of the product as opposed to those thataddcostaswellasindicatingthesustainabilityofthecompetitiveposition. Sourcesofcompetitorinformation INMOSTCASES80PERCENTOFTHEREQUIREDBASEDATA ISALREADYAVAILABLEWITHINTHECOMPANY.THE CHALLENGEISTOPULLITALLTOGETHERANDIDENTIFY THEREMAINING20PERCENT. Thecarindustryillustrationshowsthatinmanyindustriesagreatdealofthe information required for competitor analysis can be obtained from direct examinationofcompetitiveproductsandobservationinthemarketplace.Many companies find that when they implement a comprehensive competitor analysisprocesstheyalreadyhaveavailablemostoftheinputsthattheyrequire. Drawing together from and sharing the information across different parts of the business is the key. Sales divisions come up against competitors every day and will also have a mass of information about how customers rank their differentsuppliers.Equallythesourcingsideofthebusinessshouldhavealotof differences had obvious causes: much lower labour rates in one country much highervolumesgeneratingeconomiesofscaleinanother. However within Europe there was also one plant that had much higher per- unit costs. Eventually it was decided to close down this ‘inefficient’ plant and transfertheproductionvolumestootherlowercostfactorieswhichhadadequate sparecapacity.Unfortunatelytheunitcostsintheseplantssubsequentlyincreased significantlyratherthanreducingashadbeenexpected. The more detailed analysis revealed that the closed factory had been the Euro- pean source for all the small production runs required. Thus it had emphasised flexibility and responsiveness in order to cope with its customers’ demands. The ‘lowercost’plantshadfocusedonlongrunsandstableoperationalplanningthey were now struggling to cope with the complexity of a much increased product rangeandmuchshorterproductionruns.

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118 Marketing Finance informationfromsuppliersregardingcompetitors’supplystrategieswhileopera- tionsandRDdepartmentsshouldregularlybeanalysingcompetitiveproducts. In addition to these ‘internal’ sources of competitor information a large number of other available sources exist as is illustrated in Figure 4.9. Conse- quentlyfindingtherequiredbaseinformationisnotnormallythemainproblem. This is particularly true if it is remembered that relative rather than absolute figuresareneeded. Competitor analysis should have the objective of enabling the company to predict the major actions and reactions of its competitors. This is illustrated belowbyanexaminationofamajorstrategicchangeinoneoftheworld’smost profitableindustries. Casestudy–MarlboroFriday On2 April1993Philip Morrisstaggered thebusinessworldby announcing a significant price discounting promotion across the USA of what was then the world’s most valuable brand Marlboro cigarettes. On 20 July 1993 this pro- motion was turned into a permanent price reduction which was extended acrossallPhilipMorris’premiumpricetobaccobrandsintheUSA.Thismove now generally referred to as Marlboro Friday is likely to go down in history asoneofthemostdramaticstrategicbrandmanagementdecisionsevertaken. TheUSAcigarettemarkethadforalongtimebeentheworld’smostprofit- ablemarkettotalprofitpoolofover10billioninwhichPhilipMorrisPM heldadominantvolumeshare42.3percentin1992andanevengreatervalue Physical observations Government statistics Mutual suppliers Industrial experts and consultants Trade associations Comparative industry analysis e.g. ICC Published financial statements Competitor press releases Trade financial media coverage Physical analysis of competitive products Mutual customers Banks and financial markets Ex-employees of competitors Competitor data base Own employees Figure4.9 Sourcesofcompetitorinformation

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 119 share.Howevertheindustryfacedsomemajorproblems.Althoughverylarge 507 billion cigarettes in 1992 consumption was declining in volume terms at3percentayearastheindustryfacedanincreasinglyhostilebusinessenvir- onment. USA-based manufacturers had maintained production efficiencies through taking advantage of increasing export markets as previously closed markets opened up Japan South Korea Eastern Europe the former Soviet Union and even China but some of these faced medium-term challenges as pressuremountedforlocalisedproduction. Perhaps most significantly domestically there was a marked change to the previouspricesegmentationofthemarketduringthelate1980sandearly1990s. InordertounderstandthisweneedtogobacktothedevelopmentofMarlboro. Marketbackground UnlikeCoca-ColaMarlborohasnotalwaysdominateditsmarketintheUSA. Philip Morris only entered the USA cigarette market in 1934 when volumes were already over 100 billion per year. Marlboro was launched in 1937 and peaked at 2.3 billion cigarettes in 1945. In 1953 Marlboro had a negligible shareofthemarketandwastargetedatfemalesmokers.Itwasre-launchedin 1955 as a filter-tipped cigarette aimed primarily at male smokers then in the late1950s anadvertisingcampaignfeaturingacowboyandwide-openspaces was introduced At this time the leading USA brands Lucky Strike Camel and Chesterfield were all plain cigarettes i.e. non-filtered and these brands did not launch filtered versions until the 1960s by which time Marlboro was wellestablished. Marlboro’s growth was steady rather than spectacular and was fuelled by very high marketing support i.e. brand development investment so that in 1975 Marlboro became the largest cigarette brand in the USA market and in 1983 PM became the largest USA-based cigarette company selling 205 billion cigarettes out of 597.5 billion of which 120 billion were Marlboro. This was interesting because the market volume peaked in 1981 at 638 billion cigarettes and then went into a slow but continual decline. Thus PM had followed our shareholder value-enhancing strategy of gaining market share while the market wasitselfgrowing. Once it had the leading position in the now mature market its strategy changedanditlookedtoincreasetheprofitabilityofthemarket.Accordingly as the price leader with the dominant brand PM took retail selling prices up significantly faster than inflation through the 1980s price rises averaged 7percentp.a.inrealterms.Consequentlyalthoughtotalindustryvolumeswere decliningat3percentp.a.thetotalprofitpoolwasstillincreasingwhatshould beawin–wingameforalltheplayers.Evenwiththesehighrealpriceincreases cigaretteswerestillhighlyaffordableintheUSAduetotherelativelylowby internationalstandardsexcisetaxation.

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120 Marketing Finance As both prices and profit margins grew substantially there were increasing opportunitiesforindustryplayerstolaunchlowerpricedcigaretteswhichstill generatedperfectlyacceptablemargins.ToPMthisdidnotmakeanysenseas it risked turning the industry into a commodity where competition was based on price alone. There was no evidence that lower prices would reverse the downwardtrendincigaretteconsumptionthusindustryprofitabilitywouldbe decreased. They wanted consumer choice to be dominated by brand equity and image not surprising since they were winning hands down under these rules of the game with Marlboro having 25 per cent market share while no other brand had over 5 per cent share. Therefore although low-priced cig- aretteswerelaunchedbackin1981PMstayedoutofthesectoruntil1992. The first competitor to try to change the game by launching very cheap cigarettes was the smallest industry player Liggett. Back in the 1950s and even earlier Liggett had been a major player but it had fallen to around 2 per cent market share with no really viable brands. Unfortunately for the other players the sheer profitability of their industry meant that Liggett was only dyingveryslowly2percentof10 billion isstillmorethan mostcompanies make in annual profits. It felt it had nothing to lose from a high risk aggressive strategy as it was not able to compete against the big boys on brands also it hadjustbeentakenoverbyacorporateraiderwithnobackgroundinthecigarette industry.ItsinitiallaunchofacheapcommoditycigarettecalledBlackWhite was immediately successful and in 18 months it had doubled its total sales volumes. However by the end of the 1980s its sales were back to where they hadbeenbeforethelaunchofBlackWhite. In a declining market Liggett’s volume growth had to come at the expense of its competitors. The biggest losers were R J Reynolds RJR American TobaccoATandBrownWilliamsonBWtheBATsubsidiaryasthey all had sizeable positions in the less strongly branded mid-price segment. During the 1980s PM and the other player Lorillard were largely unaffected as their most important brands were in the high-price segment Marlboro for PM and Newport for Lorillard. RJR with Doral and BW with GPC entered the low-price segment aggressively to try to stop Liggett’s growth. Not only did they stop Liggett but they were in fact too successful and also grewthissegmentquitesignificantly. Not surprisingly the profit margins on these much cheaper cigarettes were substantiallylowerthanthoseachievedonthehigh-pricesegmentdespitethe much lower level of marketing support. Also during this period a number of retailer brands were launched supplied by the major manufacturers who had plenty of spare capacity. This strategy of filling spare capacity while effect- ively shooting yourself in the foot is discussed in more detail in Chapter 11. The result was that by 1989 the total mid- and low-price segments repre- sentednearly30percentofthetotalmarketnottoosurprisingwhentheprice gap between high and low segments represented over one-third of the retail sellingpriceofthehighsegment.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 121 However throughthe 1980s PM continued todeliverhigh profits growth to its shareholders and still stayed out of the low-price segment. To understand this we need to put its USA tobacco business into the context of the group’s overallcorporatestrategy. UnderstandingPhilipMorris Philip Morris Inc. the publicly quoted group has a stated mission of being ‘themostsuccessfulconsumerpackagedgoodscompanyintheworld’andits main strategy to achieve this is through ‘building and protecting’ very strong consumer-based brands. This goal had been translated into a financial objec- tive of delivering 20 per cent p.a. growth in earnings per share an objective which PM achieved in each of the 15 years from 1977 to 1992. However in the latter years of this period analysts had noted that earnings per share had grownfasterthansalesrevenuesandnotablyfasterthansalesvolumesthisis theimpactoftherealpriceincreasesintheUStobaccomarket. The success of Marlboro in the USA and its consequent very strong cash generation enabled PM to launch its cigarette brands internationally and to acquire other branded product companies Miller brewing General Foods Maxwell House coffee Kraft Foods and Jacobs Suchard. However as shown in Table 4.1 although those other businesses were growing strongly and were highly profitable compared to their direct competitors they could not match the profitability and cash generation of the USA domestic tobacco business.Indeedthegrouphadbecomemoreratherthanlessdependentupon Table4.1 PhilipMorris–extractsfrompublishedprofitandlossaccounts billions 1992 1991 1990 Salesrevenues Domestictobacco 12.0 11.6 10.4 Internationaltobacco 13.7 12.2 10.7 Food 29.0 28.2 26.1 Beer 4.0 4.0 3.5 Financialservices 0.4 0.4 0.4 59.1 56.4 51.1 Operatingincome Domestictobacco 5.2 4.8 4.2 Internationaltobacco 2.0 1.7 1.4 Food 3.3 2.9 2.6 Beer 0.2 0.3 0.3 Financialservices 0.2 0.1 0.2 10.9 9.9 8.7

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122 Marketing Finance USA tobacco for its profits growth during the late 1980s by 1992 PM’s domestictobaccobusinessgenerated5.2billionofoperatingincomeonsales revenuesof12billion. Clearlyalogicallong-termstrategyforPMwouldbetoreducethisdepend- ence by growing the profits of its other businesses but the relative profit margins involved highlight the scale of the challenge. To generate the same total profits from its combined food businesses it would need sales revenues ofaround80billionmakingittheworld’slargestfoodcompanybyalongway. Theneedtocontinuetogrowprofitsinadecliningmarketwascreatingmajor competitive pressures for the group so could PM change the expectations of its shareholders particularly as BAT plc the second largest international cigarettecompanyhadanearningspershareannualgrowthtargetofhighsingle digitsi.e.8percentp.a.Unfortunatelyatthepubliclylistedcompanylevel PM does not compete primarily with BAT which has its main listing on the London Stock Exchange. USA-based investors who are considering whether to hold PM shares would see their main alternatives as being other USA- based fast-moving consumer goods FMCG companies such as Procter Gamble Kellogg Coca-Cola Anheuser-Busch brewers of Budweiser. It may come as no great surprise to learn that during this period these ‘competitors’ weredelivering20percentp.a.earningspersharegrowthtotheirshareholders thus PM was virtually pressured into setting an aggressive and challenging financial target. For these other FMCG businesses the target was less challeng- ingastheirmainmarketswerestillgrowing AnotherpieceinthispuzzleisthatPMhadrecentlyappointedanewChairman and Chief Executive Michael Miles. For the first time he did not come from the cigarette side of the business. In fact Miles had been acquired with Kraft FoodswherehehadbeenChiefExecutiveOfficer.InterestinglyKrafthadfaced severepricecompetitionintheUSAcheesemarketfromretailerbrandsandit hadrespondedtoalossinmarketsharebyreducingthepriceofKraft’sbrand leader by 20 per cent. This price reduction had worked in that the share had been regained The group maintained that it would act whenever necessary to protect its brands as is evidenced by the following statement in its 1992 published financial statements: ‘After our people our brands are our most important assets. To ensure that every one of our brands is a leader in its category we invested approximately 11 billion in world-wide marketing activities. Many of our products faced intensified price competition in 1992. When necessary we maintained our market position by adjusting our prices andexpandingourdiscountalternatives.’ Thepricereaction The continued growth of the very low-price segment eventually forced PM to respond. In 1992 they launched Basic into this segment and it sold 11 billion

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 123 cigarettesin1992and24billionin1993i.e.ittookasizeableshareimmediately. However this really increased the level of competition at the bottom of the market and competitors became more aggressive in their price discounting. PM was already producing cigarettes for retailers as theirown private labels in1992theysold12billionofthese. The real crisis point was reached towards the end of 1992 when previously loyal Marlboro smokers started switching to these very low-priced alternatives. Some competitors actually celebrated gaining Marlboro switchers into their ‘brands’ but the competitive reaction from PM was rapid and predictable. This switching indicated that the price premium for Marlboro was now above itsbrandequityvalueandlogicallythisgaphadtobeclosedbeforeanincreasing exodusfromthebrandbegan. In order to validate this price elasticity issue PM undertook a market test in Portland Oregon during December 1992. The price of Marlboro was discounted for 4 weeks by 40 cents a pack of 20 or 4 for a carton of 200 which was approximately a 20 per cent price reduction to around 1.75. The very cheap cigarettes were selling for between 1.10 and 1.30 and so this reduced the price gap significantly. During the test market Marlboro regained market share while elsewhere it continued to decline and at the end of the testmarketitsshareinPortlandfellbackoncethepricediscountingstopped. Itisfascinatingthatcompetitorseitherdidnotseethisactivityordidnotreal- iseitssignificancehadtheybeenproperlyfocusedoncompetitoranalysis they should have predicted some aggressive response as soon as Marlboro started to lose share and thus would have been watching for exactly this kind of markettest. Followingthisrisk-reducingmarketingresearchPMwasabletogonation- wide with the same 40 cent price reduction on Marlboro on 2 April 1993. By March 1993 Marlboro’s market share had fallen to 22.1 per cent from a peak of 26.3 per cent in 1989 and 24.4 per cent in 1992. The price reduction was introducedinitiallyasapricepromotionratherthanareductioninfutureselling prices for a number of reasons. During the previous 3 years the cigarette industry in the USA had been shipping more cigarettes into the trade than consumers were actually buying what is often referred to as ‘stuffing the pipeline’. This meant that sales and profits looked slightly better at the finan- cialyear-endmuchofthisextrashippingtookplaceattheendofthefinancial yearandinvolvedofferingwholesalersandretailersdiscountsfortakingextra deliveries but it also meant that the trade was holding excessive stocks of cigarettes.IfPMmerelyreduceditssellingpriceofMarlboroitwouldbequite awhilebeforeconsumerssawthenewlowerpricebecausetheexistinghigher pricestockwouldhavetoworkitswaythroughthesystem. PM cut straight through this problem and actually reduced the price of all theinventoryinthechannelofdistributionbyphysicallystickingthediscounted priceonthepacksorcartonsalreadyinthetrade.Thismadetheimpactofthe

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124 Marketing Finance promotion immediate and gained a lot of media coverage but it cost a lot of money PM had to pay the trade the whole value of the discount and took a lot of sales and marketing resources. PM had an advantage because it had a largefieldsalesforceforitsUSAfoodbusinessaswellasitscigarettebusi- ness. Marlboro’s share rose quite rapidly and by July it was back to 25 per cent while the very low-priced competition lost share. On 20 July 1993 the promotionwasconfirmedasapermanentpricereductionandwasextendedto allofPM’shigh-pricebrands.AtthesametimePMalsoadjustedthepricesof its mid-price brands and its own very low-price product Basic it raised the selling price of Basic by around 6 cents per pack and dropped its mid-price cigarettestoexactlythesamesellingprice.Thiswastryingtoforcethewhole market back to only two selling price points high and mid and was a clear signal of PM re-establishing control over the market and reducing price as akeydecision-makinginputforconsumers. Competitorreactions The much lower profitability of the cheaper cigarettes made it impossible for competitors to reduce their selling prices sufficiently to maintain the original pricedifferential.Alsothesmallincreaseinpricesatthebottomofthemarket gave some profit gain to offset what they would all lose from their high- and mid-priceofferings. It might have been possible for some competitors to keep their high-priced brands at their original selling prices e.g. Lorillard with Newport which is a menthol cigarette and thus in a distinct niche in the market so that they would have been at a premium to Marlboro. This could have implied to con- sumers that the only brand that was in trouble was Marlboro as it had had to discount its price. However unless most of the other premium brands also did thistherewasamajorriskofbeingout-of-stepwiththerestoftheindustry. AlsoitappearsthatPMhadthoughtofthisaswellbecauseatthesametime as they reduced the price of Marlboro they also significantly increased their marketing expenditure on the brand. This was a marketing masterstroke although itfurtherreduced the profits generated in 1993.PM had a very good understanding of the strategic thrusts of their main competitors in the USA tobaccoindustry.Mostweretotallyfocusedongeneratingprofitsandcashflow fromtheUSAcigarettemarket.RJReynoldshadbeenthesubjectofamassive leveragedbuy-outin1989andwaslookingforprofitsandcashflowtoservice and repay their substantial debt mountain. BAT plc BW’s parent company hadfoughtoffasimilarleveragedbuy-outattemptandhadpromiseditsshare- holders increased earnings per share and dividends its major single source of profits and cash flow was BW. American Brands which owned American Tobacco had a publicly stated policy of increasing its dividends at a rate of 10 percentperyearanditreliedonitstobaccodivisionformuchofthis.

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 125 As a consequence it was predictable that these competitors would seek to restore as quickly as possible as much of their profit streams as they could. Hence they immediately lookedfor cost savings and slashedtheir discretionary spending in the second half of 1993. By far the largest item of discretionary expenditureinthisindustryismarketingsupportandtherewereseverecutbacks byallthesecompetitorsinthesecondhalfof1993.Thismeantthattheimpact and effectiveness when measured in terms of share of voice as discussed in Chapter 8 of Marlboro’s increased brand expenditure was increased signifi- cantly. PM was therefore able to achieve two objectives during the second half of1993andin1994firstitwasabletore-inforcethebrandimageofMarlboro in the minds of its existing smokers and second it was able to increase its shareofnewsmokersduringthisperiod. PM needed to re-inforce Marlboro’s brand image as there was a real risk associatedwiththepricereduction.Thelowerpricewasaimedatwinningback those smokers who had already switched out of Marlboro to a lower priced alternative and to stop further price-motivated switching. However up to this point Marlboro had lost around 4 per cent market share but still had over 22 percentthus22percentofthemarkethadjustseenthepriceoftheirregular brand reduced significantly. This may sound great but for a number of premium positioned brands it could be disastrous as it implies that the brand is no longer worth its premium price i.e. its image is somehow tarnished and lessattractive.InordertoavoidthisPMspentsubstantialmoneyonMarlboro’s imagery through the Marlboro Adventure Team white water rafting and sky divingetc.–allthethingsyoudowhilesmokingacigarette. Theresultingimpact MarlboroFridayresultedinMarlbororegainingmarketshareduring1993and 1994andtheincreasedmarketingsupportgaineditasignificantlyhighershare ofnewsmokers.Howevertheshort-termfinancialconsequencesweredramatic PM’soperatingincomein1993fromdomestictobaccofellby3billionandit only got back to its 1992 levels in 2000. Thus the immediate financial gain fromregainingmarketsharewasswampedbythenegativeimpactonthetotal valueofthemarketand itsincreasedmarketingsupport.The competitionwas all badly affected financially despite their attempts to reduce marketing costs andinthelongertermseveralhavelostsignificantmarketshareaswell. TheimmediatestockmarketresponsetoMarlboroFridaywasoneofshock withsharepricesdownsignificantly.Thestockmarkethadalreadyanticipated somebadnewswiththesharepricefallingsinceOctober1992.Despite1992’s results showing the normal 20 per cent growth in earnings per share analysts knew that Marlboro was losing share and that the company was ‘stuffing the pipeline’. Thus share prices had fallen from a peak of over 80 to well below 70bythebeginningofApril.

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126 Marketing Finance On2 April1993the share price fellover 13 to close atjustover50this dragged the whole Dow Jones index down by 50 points. During the next week the fall slowed and the price levelled out at 46 the decline in PM’s market capitalisation from its peak in 1992 was an amazing 36 billion. Therefore in terms of shareholder value it looks like a disastrous move Yet most observers and analysts myself included now believe it to be a great marketingmovebyPM The dramatic decline in the share price was created by a classic ‘double whammy’atexactlythesametimethecompany reducestheexpectedfuture returnsandincreasestheperceivedriskoftheinvestors.Riskisaboutvolatility and suddenly nice regular 20 per cent p.a. growth disappears and much lower profitsarenowpredictedforfutureyears.Howeverifyoucomparethelikely outcomes for PM in the USA cigarette industry with Marlboro Friday and without i.e. with a do-nothing alternative Marlboro Friday generates signifi- cantlygreatershareholdervaluethepresentvalueofthefutureexpectedcash flows than the ‘do-nothing’ alternative over the longer term. This is because ‘doingnothing’wouldresultincontinuedlossofmarketsharebyMarlboroas more and more of the market traded down to the very low-priced cigarettes. Reducing the price of Marlboro now reduces profits dramatically in the short term but these may grow in the future as Marlboro regains share and PM can returntomanagingthetotalprofitabilityofthemarket. Thus with the benefit of hindsight the stock market had not reduced PM’s share price sufficiently prior to Marlboro Friday but they panicked and completely over-reacted. As Marlboro regained share PM’s share price did appreciate considerably through the rest of 1993 and early 1994. One impact of the panic was particularly interesting as well as reducing the share prices of PM and its cigarette competitors the stock market also marked down the share prices of the other FMCG branded companies i.e. Coca-Cola etc. The argumentwasthatifMarlboroasaleadingconsumerbrandwasunderthreat thenalltheotherleadingbrandsmustbeaswell.Therewere‘learned’academic journal papers and newspaper articles talking about ‘the death of the brand’ etc. because some people thought that Marlboro as a brand must be dying if PMhadtodiscountitsprice. This reaction is particularly worrying because if Marlboro really was dying PM’s strategy should have been the opposite. Instead of reducing the price theyshouldhaveheldthepriceorevenincreaseditsoastoobtainthemaximum cash flows before the brand finally died. Obviously this is a critical question ifitmakessomuchdifferencetothestrategicresponse.Accordinglyitshould form the focus ofmarketing research prior to the implementation of any price changes.Thekeyquestionsarewhichtypeofsmokersarebeinglostandwhy theseareofcourseclassicalmarketing-researchquestions IfMarlboroislosingpreviouslyloyalsmokersi.e.olderageprofilesmokers who are leaving because the brand is perceived as relatively too expensive

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FutureCompetitiveEnvironmentReview– CompetitorAnalysis 127 thenreducingthesellingpricecouldregainsomeoralloftheselostconsumers. HoweverifMarlboroisnolongerwinningitsshareofnewsmokerswhofeel that the brand attributes are no longer relevant or appropriate to them then dropping the price is simply likely to re-inforce the impression that the brand is dying. PM’s market research confirmed that the problem was selling price elasticity because its market share of new smokers was still greater than its overall market share this shows that the brand still has long-term growth potential. Its exit interviews and switching data also highlighted that it was losingoldersmokerstotheverylowpricedcommoditystyleproducts. It should by now be clear that PM understood most if not all of this at the timebutonekeyproblemwastheirinabilitytocommunicateinadvancewith their shareholders without giving away critical information to their competitors. However their management team did build up significant credibility with the stock market through their handling of Marlboro Friday. As a result when in 1996 PM did a similar price reduction on its branded products to regain market share once again lost to retailer brands and much cheaper commodity style products the stock market believed in their strategy from the start. This was despite the fact that in this market the USA breakfast cereal market PM was onlytheNo.3intermsofmarketsharenottheleader.

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5 ExistingPositionAppraisal Overview The existing position appraisal should provide the basis for developing the futurestrategiesandplanswithwhichtheorganisationaimstoachieveitsgoals and objectives. A major objective of this appraisal is therefore to highlight relevant constraintsandopportunitiesthatmayimpactoneithertheseobjectives ortheappropriatestrategies. Anumberoftechniqueshavebeendevelopedandsubsequentlyrefinedtohelp thisprocess.TheSWOTanalysisstrengthsweaknessesopportunitiesandthreats isagoodexampleofthesetechniques.Itrequiresverycarefulimplementation butifproperlyusedcanprovideveryhelpfulinsightsintothecurrentrelative positioning of the company its strengths and weaknesses and how this may be affected by potential future developments in the external environment the opportunities and threats. Ideally the selected strategies should build on and developtheorganisation’sexistingstrengthssothattheyreducetheimpactof the threats while enabling the opportunities to be exploited and the significance oftheweaknessesminimisedorremoved.Inotherwordstheexistingposition appraisalshouldhighlightthoseareasofthebusinessanditsenvironmentthat arecriticaltotheachievementofitsgoalsandobjectives. Porter’s ‘5 forces model’ is a good diagrammatic way of representing the relativestrengthsofthevariouscompetitiveforceswithinanyindustryinternal existing rivalry buyer power supplier power threat of new entrants and threatofsubstituteproducts.Thekeytoapplyingthistechniqueistofocuson which force is the most important rather than producing a balanced view on all five whereas it is important to produce a more balanced SWOT analysis. Another very popular Michael Porter model outlines generic strategies that couldcreateshareholdervalueifsuccessfullyimplemented.Acompanyhasto be either the lowest cost supplier in its chosen market or have a sustainable differentiation advantage that enables it to command a higher selling price. Thesealternativestrategiesmaybeimplementedindustry-wideorbyfocusing ona smallernicheormarketsegment.Increasinglymanybusinessesnow talk about needing to achieve both lowest cost status and a differentiated position whattheynormallyreallymeanisthatoneparticularadvantagecannolonger sustainablyoffsetanysignificantdisadvantageintheother

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Existing Position Appraisal 129 Anotherverypopularanalyticaltechniqueistheproductlifecycleparticu- larlywhenappliedwithsomeformoftheBostonMatrix.TheBostonConsulting Group’s Matrix considers the key drivers of success for a product as it moves through its life cycle. This makes it very useful provided that an organisation can determine both where its products currently are in their respective life cycles and when they are likely to move to the next stage. Unfortunately in practiceitisonlyrelativelyeasytostatewiththebenefitofhindsight where aproductwasseveralyearsagoandtoestablishwhenitchangedfromgrowth to maturity etc. It is much more difficult to use the product life cycle in an ‘ex-ante’predictivewaywhichisclearlywhatisneededasabasisfordeveloping strategiesandplans. The consideration of the practical application of this technique is deferred until Chapter 12 where the appropriate tailored control and performance measuresarealsoconsideredalthoughitsusewithinbrandedandcustomer-led strategiesisdiscussedinChapters8and9respectively. Introduction Thelogicalstartpointforthestrategicplanningprocessistoreviewthecurrent situation of the organisation in terms of its internal resources and the external environment. This existing position appraisal utilises and builds on the strategic management process and competitor analysis discussed in Chapters 3 and 4 and therefore provides the link into the planning process which is considered in Part Three. Strategic management has already been developed as a multi- tieredprocessandthismeansthatthesituationreviewwillnormallyalsoneed tobedoneatseverallevelsformostmodernbusinesses. However even for today’s complex groups there is often a large degree of commonality in the external environment faced by all its operating units. If this is so it is more efficient to undertake this external part of the analysis on a group-wide basis thus establishing a common view on forecast rates of inflation etc. Carrying out this situation review at the highest common level not only avoids duplication of effort but also ensures that all levels of the organisationarebasingtheirstrategicdecisionsonthesameviewoftheoutside world. Eventhoughthiscommonviewmaybeprovedtohavebeenwrongitshould reducethechancesofcompletelyoppositestrategiesbeingadoptedbydifferent parts of the business. For example in the multinational groups used as case studies and examples in Chapters 3 and 4 it would normally be sensible for one forecast of future exchange rates to be used by all the business divisions. If each division was allowed to make its own forecast it is quite possible that their individual teams of economists would come to completely opposite conclusions after all the collective term for economists should be ‘a dis- agreement’.Thiscouldhaveludicrousconsequencesforsuchagroupwhereby

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130 Marketing Finance if the USA-based division expected the dollar to strengthen against the Euro they would plan on increased imports from Europe. If the continental European divisionforecastthedollartoweakenrelativetotheEurotheywouldprobably beforecastinglowerexportstotheUSA.Thereareobviouspotentialimplica- tionsforresourceallocationdecisionsacrossthegroupe.g.capacityplanning andmarketingexpenditures.Inmanycasestheseconflictingviewswillensure thatthegroupisputatacompetitivedisadvantagewhatevertheactualoutcome oftheparticularenvironmentalfactor. The internal part of the position appraisal will have to be conducted at the level in the group that has control over the resources concerned and which canreallymakedecisionsregardingtheireffectivedeployment.Normallythis will be at different levels in the group’s structure for different areas and as with competitor analysis the strategic planning process must allow for this complexityofanalysisanddesign. SWOTanalysis A major objective of the existing position appraisal process is to highlight constraintsandopportunitiesthatneedtobetakenintoaccountwhenplanning for the future. Consequently an out-of-date analysis is of no value. Informa- tion is needed on the present and on likely changes over the planning time horizon. However the historical perspective can often provide the best basis for assessing these likely future developments and the appraisal must be made in the relative context of competition. This relative competitive grading is most easily carried out in the form of a SWOT analysis. SWOT stands for strengthsweaknessesopportunitiesandthreatsandisnormallyshownasthe 2 ×2matrixformatofFigure5.1. The strengths and weaknesses refer to the internal aspects of the organisa- tion compared both to the competition and to the expectations of the market placei.e.whatthebusinessisrelativelygoodandbadatdoing.Thisinternal analysis therefore utilises the output of the competitor analysis process that Strengths Weaknesses Opportunities Threats Internal External Positive Negative Figure5.1 2×2matrixformatforaSWOTanalysis

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Existing Position Appraisal 131 was discussed and illustrated in Chapter 4. It is essential that this review is done realistically and honestly fooling yourself is a stupid and sometimes fatal mistake as is illustrated in Practical Insight 5.1. It must also be done against the aims of the organisation as set out in the mission statement and corporate goals which were discussed in Chapter 3 as these will indicate which areas of strength or weakness are likely to prove important in the future. This highlights the differences between the very long term unchanging mission statement and the more definitive practically achievable objectives objectives may need to be modified in the light of the organisation’s current strengths and weaknesses whereas the organisation may need to change these existing strengths and weaknesses in order to move towards its long-term missionstatement PracticalInsight5.1 The modification of objectives may be particularly necessary as a conse- quence of the analysis of the external environment. This seeks to highlight external threats i.e. potential constraints and opportunities for the business. Previously established objectives may be clearly seen as unachievable in the light of this analysis or the identification of new future opportunities may reveal that the existing objectives are set at far too low a level. As shown in Figure5.2thereisa broadrange ofexternalfactorsthatneedtobe takeninto account. There is a resulting danger that the SWOT analysis becomes an unmanageably long list of apparently equally important items. If the situation reviewistobeofassistancetostrategicplanningthesefactorsmustberanked in order of importance so that only the main priorities are included in the AnhonestSWOTanalysis Some years ago I was conducting a strategy workshop for the UK’s leading elec- trical retailer and started by getting the group to develop a SWOT analysis for their business. Quite rapidly a large number of strengths were identified but no weaknesses were forthcoming. Despite considerable encouragement they were unable to identify any relative weaknesses and therefore I unilaterally added ‘com- placency’ to their SWOT chart. This prompted one manager to leap up and declarethathe’didentifieda‘weakness’.Hethensaid‘ourmainweaknessisthat we don’t know how good we really are’. I quite rapidly added ‘arrogance’ to the weaknessessideoftheSWOTchart More recently I was working with a building services business that was preparingtofloatontheUKstockmarket.Theirtopmanagementteamidentified a wide range of weaknesses and threats partially offset by some opportunities whatweremissingweretherelativestrengthsoftheirhighlysuccessfulorganisation. I suggested ‘modesty’ and ‘humility’ could be ‘strengths’ at least this ‘stimulus’ resultedinamorebalancedfinalmatrix.

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132 Marketing Finance matrix. This can bestbedemonstrated by usinga realcase studyexamplefor confidentiality reasons the name of the company has been omitted from the casestudy. Casestudy–exampleofaSWOTanalysis The company is a well-established leading branded biscuit manufacturer which had key strengths in its strong brand franchises developed over many yearsandaverygooddistributionnetwork.Thishadbeenbuiltupbyitslarge national sales force that sold directly to the major retailers and gained access to smaller outlets through a network of wholesalers. Both of these strengths created barriers to entry for potential new competitors and consequently in thepastthecompanyhadgeneratedsuper profits. Howevermorerecentlythecompanyhadexperiencedincreasedcompetitive activity in its marketplace as the industry matured and total sales growth slowed significantly. Another weakness was its dependence on retailers for access to consumers if total sales are static retailers will want to reallocate their shelf space to products where sales are growing. The largest retailers were also using their increasing buying power to take an increasing share of the total industry supply chain i.e. by raising their margins and were looking to develop their own retailer brand versions of some of the company’s leading brands. Thus there was heavy competition among existing manufacturers as companies fought to retain their access to the consumer and their share of the static total market. Increasingly this competition was being based around pricethusputtingincreasedpressureonprofitmarginswithconsequentpressure on marketing expenditure and product innovation. If insufficient marketing supportwasprovidedtotheirbrandsaprincipalstrengthofthecompanywould beerodedquiterapidly. Organisational objectives and strategies Supply chain analysis Suppliers Competitors Customers Pest Political environment Economic environment Social issues Technological developments analysis Figure5.2 Externalenvironmentalfactors:affectingorganisationalobjectivesand strategies

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Existing Position Appraisal 133 Although the total market was static there were as always some segments which were showing quite strong growth unfortunately the company was not wellrepresentedinmanyofthehighestgrowthareas.It hadregardedtheseas peripheral products e.g. snack bars being sold initially at least through alternative channels of distribution e.g. health food shops petrol stations confectioners that were not the traditional strengths of its sales force. Indeed several of these innovations were not even launched by biscuit companies Consequentlywhenthesenewproductsgaineddistributionthroughsupermar- kets the company found it difficult to gain shelf space for its own ‘late to the market’ versions. It had tried umbrella branding to link some of the new products to its well-established mainstream biscuits but the brand association hadseemedillogical to consumers it had actually had an adverse effect on its mainstreambrand. The company had large scale production facilities but so did most of its competitors. Indeed the industry in total had excess capacity and this had led someplayerstogointocontractmanufacturingforthelargeretailersandeven forsomewholesalersandvoluntaryassociationgroupsi.e.producingbiscuits branded by the retailer. So far the company had refused to go down this strategic option but it accepted that the potential use of this fact in its adver- tising ‘if it doesn’t say “X” on the packet it didn’t come from our factory’ had been weakened by recent strategic moves by some very large food com- panies such as Kelloggs Heinz and Nestle. This is discussed in more depth in Chapter 11. The company had maintained its total focus on the biscuit industrywhileseveralofitscompetitorswerenowpartsofmuchlargermore widelyspreadfoodbusinesses.This‘diversification’intootherrelatedproducts had enabled these competitors to gain some economies of scale and scope fromsomesignificantcostswithintheindustrysupplychainsuchassalesforce distributionandpackagingcosts.Sincebiscuitslikewashingpowderarearela- tively low-value item compared to their physical bulk compared to razor blades and cigarettes and also need protective packaging during shipment these costs can be quite significant and had been rising faster than the price increaseswhichcouldbeobtainedgiventheexternalcompetitiveenvironment. A consequence of all this was that the historic profit and cash generation achievements of the company were unlikely to be maintained in the future. However there was the potential opportunity for the company to acquire related productsorbrandswhichcouldbenefitfromitsstrongsalesandmarketingskills the historic lack of successful product innovation made organic developments significantly more risky for this company unless it made changes internally. Converselythecompanycoulditselfhavebecomethetargetforanacquirerthat believeditcouldreduceassociatedcostsorrationalisetheproductioncapacityof theindustry.ThisanalysisissummarisedinFigure5.3. The rationale for a SWOT analysis is easy to say but much more difficult to do in practice. The selected strategies should build on and develop the

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134 Marketing Finance organisation’s strengths so that they eliminate or minimise the impact of the potential external threats and the externally identified opportunities should be exploited if possible to reduce the significance of the weaknesses while the organisation improves its performance in these areas.Iflooked atin this way theexistingpositionappraisalshouldhighlightthoseareasofthebusinessand itsenvironmentthatarecriticaltotheachievementofitsgoalsandobjectives. Theavailableanalysisandplanningresourcesshouldbeconcentratedonthese critical success factors and the business strategies should be selected accord- ingly. Many organisations seem to forget that their relative competitive positions can change considerably over time and that the external environment can be extremely volatile. Consequently the critical success factors may also change and this may require a corresponding adjustment to the main strategic thrusts of the organisation and to its strategic positioning. What makes this particularly complicated in practice is that the same piece of information may result in inputs to at least two apparently conflicting sides in the position appraisalasisillustratedinPracticalInsight5.2. PracticalInsight5.2 Thegoodnewsandthebadnews Paul Adams Managing Director of BAT plc made a very balanced comment in 2002 when he said ‘The good news in Germany is that Philip Morris is losing market share and the bad news in Germany is that Philip Morris is losing market share’. Internal Strengths Strong brands Focused company Good distribution National sales force Barriers to entry Weaknesses Static market Heavy competitive pressure Dependent on more mature products Stronger customers External Opportunities Strong position in market Good financial record Strong sales and marketing skills Funding for new investment Possible acquirer of other products/brands Threats Retailer brands Commoditisation of market New growth segments New focused entrants Possible acquisition target Positive Negative Figure5.3 SWOTanalysisforabrandedbiscuitcompany

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Existing Position Appraisal 135 Othertechniques There are many other techniques that can be used to provide a comprehen- sive analysis of the current position and only some are introduced in this chapter. One very neat diagrammatic way of representing the relative strengths of the competitive forces in an industry was developed by Michael Porter during the 1980s and is shown in Figure 5.4. Porter’s ‘5 forces model’ has Clearly for a company with a mission statement ‘to regain leadership of the internationalcigarettebusiness’increasingmarketshareinsuchalargeandprofit- able market as Germany should be good news. This is particularly true when it reflects increasing success for brands that have significant potential in other major markets. Also if the market is not growing this growth has to come at the direct expense of competitors. It is therefore not unexpected that a large loser in suchasituationisthecurrentmarketleaderwhoalsohappenstobetheNo.1global competitor. Howeverwhenthiscompetitorisalsolosingmarketsharetoothercompetitors throughpurepricecompetitionthismaybeverybadnews.Aswasillustratedby the Marlboro Friday case study discussed in Chapter 4 Philip Morris has shown itself to be quite prepared to reduce the selling priceofMarlborowhenitbelieves that this is necessary to restore ‘branding as the principal basis of consumer choice’. The loss of Marlboro market share to very low price commodity style products thus increases the possibility of a very expensive price war in the market. Even without a severe pricing response any increasing emphasis on price as the mainbasisofcompetitionin a previously brand-based marketshould be seen asa significantthreat. The most important part of the analysis is the cause of the change rather than simply noting the change thus a movement in market share may well be both goodnewsandbadnews. Supplier power Existing level of competition rivalry Threat of new entrants Substitute products Buying power Figure5.4 Industryanalysis:competitiveforcesmodel–Porter’s‘5forcesmodel’

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136 Marketing Finance been widely used across many industries and it can be usefully applied with his later technique a development of the added-value concept which he called the value chain. The value chain as was illustrated by the zero-sum gamediagram shownasFigure4.4in thepreviouschapterlooksatthetotal value added by the industry and by the particular organisation within the industry. Further it tries to identify both the source of any increases in this added value and its corresponding level of sustainability. Porter’s development of the value chain breaks down the contribution of each primary and support activity carried out by the organisation. The objective of this analysis is to highlight the activities which contribute most significantly to the total value added to this extent the technique mirrors the business process classification referredtoinChapter3andisillustratedinPracticalInsight5.3.Thestrategic planningprocessseekstoimproveonordefendthecurrentshareofthisvalue added that is gained by the organisation these strategy models therefore tend to focus on capturing value while Porter’s model of generic strategies can highlightopportunitiestocreatemorevalue. PracticalInsight5.3 MichaelPorterinhis1980book‘CompetitiveStrategy’outlinedthegeneric strategies that could create shareholder value if successfully implemented over 20 years later these generic strategies are still widely used by companies intheirstrategicplanningprocessesbuthavenotsurprisinglybeendeveloped somewhat during this period. As is shown in Figure 5.5 to be successful across its chosen industry an organisation must either be able to supply the product from the lowest cost base within the industry or be able to command a higher price in the market by differentiating its product in the minds of its customers. The business may not be able to sustain either of these strategies acrossthewholeindustry.Itshouldthenadoptthethirdstrategiccategorythat istofocusonaparticularsegmentoftheindustryoftenreferredtoasa‘niche’ Sustainablestrengthorthreat Averysuccessfulmarketingconsultancycompanywouldcertainlyhaveincluded itsteamofconsumerpromotionsconsultantsasamajorcompetitivestrength.They had developed an excellent reputation in the market for innovative tailored and highly productive promotions which gave them continual repeat business from a rangeofmajorclients. What they failed to recognise and thus to remove through granting sizeable equityparticipationwasthethreattotheircontinuedsuccessthatsuddenlymateri- alised when the whole of this management team left to start their own company. Withinaveryshortperiodthe‘loyal’majorclientshadfollowedtheteamtotheir newbusiness.

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Existing Position Appraisal 137 strategywhereitcancommandasustainablecompetitiveadvantage.Logically thissustainablecompetitiveadvantagecanbeachievedineachnichebyeither being the low-cost supplier or differentiating the product so as to achieve a highersellingprice. Portermademuchoftheproblemscausedbybeing‘stuckinthemiddle’of an industry i.e. being neither ‘lowest cost’ nor ‘properly’ differentiated but he always refers to these strategies as alternatives. Many companies now believethatintheirverycompetitiveindustriestheyshouldbeboththelowest cost suppliers and differentiated to be successful however there are no good examples of companies that have achieved both in one industry. What is now true is that even companies selling differentiated products must ensure that they are as cost-competitive as possible in other words any relative cost disadvantagemustbecausedbytheirdifferentiationandhencevalue-adding attributes. Also even companies selling ‘commodity’ style products where sellingpriceandconsequentlyrelativecostlevelsarecriticalmustensurethat their commodities continue to provide their potential customers with an equivalentsetofbenefits.ThusPorter’sgenericstrategiesarenotnowseenas extreme alternatives but as integral parts of the need to develop competitive advantages in order to achieve sustainable levels of super profits. This can most clearly be illustrated by another case study highlighting how the changing externalenvironmentdramaticallyimpactsonthebasisofcompetition. Casestudy–petrolretailing–isitpartofthe retailingoroilindustries Background As discussed in Chapter 3 the oil industry like many others was started by a few very highly vertically integrated companies. Indeed the ‘oil’ industry is still dominated by the major multinational or global players they used to be Overall cost leadership strategy Industry-wide differentiation strategy Segment cost leadership strategy Focused differentiation strategy Lowest cost supplier Perceived uniqueness Strategic advantage Strategic target Segment focus Industry-wide Figure5.5 Portermodelofgenericstrategies

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138 Marketing Finance referredtoasthe‘sevensisters’butrecentindustryconsolidationhas sharply reducedthesizeofthefamily.Theyhavefacedincreasinglevelsofcompetition intheir‘up-stream’operationsi.e.explorationandproductionfromthe‘national’ oil companies often state owned or state backed like PDVSA of Venezuela PEMEXofMexicoPETROBRASofBrazil.These‘national’oilcompanies notsurprisinglyhavetendednottobesogeographicallydiversifiedalthough several of them are becoming more vertically integrated by moving into downstream operations such as oil-derived chemicals plastics aviation fuel and petrol retailing. Some of the original oil majors have taken a strategic decision to curtail their direct involvement in some of these ‘downstream’ activities e.g. by exiting from ‘chemicals’. However these oil majors now face increasingly severe competition in the petrol retailing element of their down- streambusinesses. This newer competition from supermarket retailers has been most successful inFranceandtheUKwhereretailershavegainedcombinedmarketsharesof over50percentand30percentrespectively.Thiscasestudywillfocusonthe developmentintheUKmarketbutthismirrorswhathappenedinFrance. Supermarkets first sold petrol in the UK in 1974 and this move coincided with the opening of out-of-town superstores. Their marketing of petrol was consistent with their normal retailing strategy the petrol was retailer branded and sold at a discounted price relative to the normal pricing of the oil majors. The initial share gains were quite modest but as their new store openings acceleratedinthe1980ssodidtheinroadsintothesharesheldbytheestablished petrolretailers. The oil majors had different forms of involvement in petrol retailing some sites were directly owned and operated others were owned but managed by a third party still more were franchised i.e. owned and managed externally butexclusivelysuppliedbytheoilcompany. Bytheearly1990sthesupermarketsintotalhadtakena20percentmarket shareandhadaround600petrolstationsbetweenthem.Thiswasaverysmall proportion of the total number in the UK just under 20000 at the end of the 1980s but this total was reducing quite rapidly. Despite the supermarkets opening new petrol sites this was more than offset by the closures by the oil majors and particularly the independents thus 600 sites closed in 1993 and 1000in1994. In the mid-1990s the supermarkets took their petrol retailing strategy into itsnextmoreaggressivestage.Thefirststagehadbeentoopenpetrolstations onlyonthesiteoftheirmajornewstoresbutthesecondstageinvolvedopen- ing petrolstations withsmallsupermarketsattached.Tesco Expressofwhich there were fourteen at the end of 1996 is the best example a Tesco Express outlet consists of a 200 square metre supermarket selling a range of chilled andfreshgoodslocatednextdoortoapetrolstation.Intheirpublishedfinancial statements to the end of 1996 Tesco highlighted the growing importance of

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Existing Position Appraisal 139 petrol as a source of profitability it had contributed over 10 per cent of the retailer’sprofits.Thetrendhascontinuedwithmoresupermarketchainsopening smallerstoresmanyofwhicharebasedaroundpetrolstations.Themostrecent movehasbeenforjointventuresbetweenanoilcompanysupplyingthefuel andasupermarketsupplyingallthenon-oilgoods. Not surprisingly there have been significant changes in the competitive strategiesoftheoilmajors.EssothelargestUKpetrolretailerwith2100petrol stationsatthetimetestmarketeda‘PriceWatch’campaigninSeptember1995. This went national in 1996 and aims to make each Esso service station price competitiveagainstitslocalcompetitionincludinganysupermarkets. Shellthesecondlargestwitharound2000sitesintotalfocusedonits‘Select’ stores of which there are around 800 and developed them as convenience retail outlets for example ‘Select’ is in the top five sandwich retailers in the UK.Thistotalconvenienceretailingmarketiscertainlylargeandtheshareof petrol stations is growing. Petrol station forecourt shops have around a 10 per centshareofthemorethan£30billionUKconvenienceretailingmarketalso insomeservicestationshopsmorethanhalftheturnovercomesfrom‘non-petrol buying’ customers. Shell has also gone quite heavily into customer loyalty technology with its SMART card concept this has been given broader appeal bybringinginothercompanies.Howevercompetitioninthisareaisalsogrowing as BP is now involved in ‘nectar’ collectibles with Barclaycard Sainsbury’s andDebenhams. BPthethirdlargestpetrolretailerintheUKhadalreadyredevelopedsome ofitssiteswith‘ExpressShopping’providinghotfoodsandbakeryproducts thisconcepthasbecomemuchmorewidelyspreadacrosstheirsites.Thusallthe oil majors are trying in different ways to become much more retail oriented intheirservicestationoperationsinanattempttocompeteeffectivelyagainst thesupermarkets.Partofthisresponseisalsotolearnwhatworksbestsothatit canbeappliedtobuildentrybarriersinthosemarketsaroundtheworldwhere the supermarkets or other new entrants have not yet become the serious threat theyareintheUK. Strategicanalysis So how did it come to pass that long established very sophisticated global oilcompaniesfindthemselveslosingouttoabunchof‘pile’emhighsell’em cheap’ex-markettradersTheeasiestwaytodescribethisistopersonalisethe analysis by looking at Shell and Tesco as examples of the developments in petrolretailing. Shellhaveforover100yearsbeenveryproudofhowtheyhavedeveloped their corporate brand their logo has been seen on all their petrol stations around the world and has come to stand for quality applied technology but moreimportantlyoil-basedproducts.InotherwordstheShellbrandisbased

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140 Marketing Finance around the product and this brand awareness has helped Shell in building retail market share in developing markets such as Asia and Latin America. The key attributes of the Shell brand when applied to petrol were originally risk reduction through consistent product quality and national/international availability. Consumers became loyal to Shell petrol because they believed it reduced the possibility of damaging a very expensive asset their car which theyperceivedcouldresultiftheyboughtacheaperpetrolfromtheveryearly discounters in this market. They were therefore prepared to pay a premium pricefortheknownbrandedproduct.Alsothehighlyvisiblenationalnetwork of Shell petrol stations continually reinforced the brand awareness and reas- suredmotoriststhatwherevertheyweretheywouldalwaysbeabletobuytheir preferred brand. The oil majors all looked for appropriately highly visible sitesonmajorroadintersectionsonroutesusedeverydaybymotoristsgoing toandfromworkwhichwerecorrespondinglyexpensive.Alsobecausethey were now ‘in retailing’ the oil majors had to set up organisational structures bothtomanageallthesesites2000spreadalloverthecountryandtosource and distribute all the other products sold through their forecourt shops. As a result they had relatively high overheads and their shops were relatively expensivethisdidnotmatteraslongastheywerenotprimarilycompetingon price. In the past forecourt shops were widely regarded as being expensive but theywere convenient particularlywhentheyweretheonlyshopsopenlate atnightandatweekends. Tesco opened its first out-of-town superstore in 1974 and this represented a majorstrategicriskforthecompany.Itsprevioussuccessfulstoreshadbeen in town centres but now customers would need to travel out to get to the new store the clear risk was that nobody came. A key difference was that many morecustomerswouldusetheircarstogettothesenewstoreshencevastcar parking had to be provided but also an opportunity was created. If cheap petrol was made available on site there would be an added incentive for customerstobringtheircarstothenewsuperstorethesupermarketswereperhaps particularly fortunate that 1974 was the year of the first major increase in oil pricesasthismademotoristsfarmoreconsciousofrelativepetrolprices.The supermarkets utilised this low-price petrol idea even more cleverly because initially they gave motorists a voucher for each litre of fuel purchased which entitled them to money off in the superstore in most cases the value of the voucher represented all of the gross margin made by the retailer on the petrol sales.Thusthesupermarket’sstrategywithpetrolwasatfirstsimplytouseit to reduce the business risk associated with their move to out-of-town locations. As a product in its own right it certainly would not generate a super profit because it was being sold at a discount and the supermarkets initially had no buyingpower. However a longer-term strategy was already being developed and this involved using the very high customer visibility of petrol stations to develop

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Existing Position Appraisal 141 the retailerbrandsthat supermarketswerebuildingduringthe 1970s.IfTesco had no interest in the branding potential for petrol the easiest solution would have been to get Shell or another oil major to provide a petrol station on the siteofeachnewsuperstore.Tescohadnorelevantproductknowledgepriorto 1974andtherearequiteimportantrisksinvolvedinstoringinbulkandselling a product like petrol these risks could easily have been passed back to the existing experts. The key difference is that the branding strategy of Tesco is built around the customer rather than the product thus a Tesco retailer branded product should be perceived as being good value for money while providing perfectly acceptable quality. By the 1970s petrol had become a commodity for most consumers the grades of petrol were standardised and the car manufacturers specified what octane-rating petrol should be used e.g. 95 RON for most standard cars. Consequently consumer loyalty was being eroded and the oil majors were finding it increasingly difficult to maintain consumer-perceivedproductdifferentiationintheirbrandedpetrolthismeant that petrol had now become an ideal product to be used within the retailer- brandingstrategies. The sustainability of the discounted selling price now becomes a key element in this strategy the oil majors are much bigger and should therefore be able to match or even undercut the selling prices of the supermarkets. At this time the supermarkets are buying their petrol in the international spot markets where the price is highly volatile. However their other costs are significantlylowerthanforthe oilmajors.The attributable landandbuilding costs are quite low if the petrol station is located on an out-of-town superstore site particularly as in most cases the land would otherwise have been used for additional free car parking. The supermarket chains already have all the required infrastructure to supply and manage their store networks all they require in addition is one or two people to actually buy the petrol. On the actual site their costs are also much lower because each superstore site already has over 100 employees and needs an additional two or three till operators per shift in the petrol station while the oil company has to staff up each location from scratch. Thus their fixed costs are lower and their investmentislowerbuttheirkeyinputpurchasingpriceisvolatileandshould potentiallybehigher. Thisraisesthecriticalquestionofhowtheverticallyintegratedoilcompanies setthetransferpricetotheirdownstreampetrolstations.Inorder‘toassessthe economic viability of each business’ most oil companies used an externally set value for their internal transfer price they used the spot price in the inter- nationally traded oil market As just stated this price is very volatile and as these input prices are translatedinto output prices by the oil industry’s retailing businessesthisinevitablyresultsinequallyhighvolatilityinretailpetrolprices. For the oil companies this still causes great volatility in their overall profits because to a very large extent their upstream internal costs for exploration

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142 Marketing Finance production refining and distribution are unaffected by this spot price for oil and petrol. However for the supermarkets this meant that a volatile input price was compensated for by an equally and exactly matching volatility in the selling price. This left the supermarkets with a relatively low but stable gross margin on each litre of petrol sold the low margin meant that sales volumes became critical but the superstore locations and discounted retail prices could almost guarantee high-volume sales remember supermarkets have achieved over 30 per cent market share with less than 10 per cent of the total sites through each outlet. This consistent total margin after deducting the much lower attributable fixed costs and allowing for the required rate of return on the lower attributable investments could still produce a super profit once the supermarketsgainedsufficientmarketshare.Hencepetrolrapidlybecameakey strategicproductforsupermarkets. Theoilcompaniesfacedafurthercompetitiveproblemduringthisperiodas supermarketsextendedtheiropeninghourstheyhadalwaysopenedtheirpetrol stationsfor24hoursaday7daysaweekwhereitmadeeconomicsense.This highly visible retail competition made it virtually impossible for other retailers including forecourt shops to justify having much higher prices due to their convenienceof‘beingopenwheneveryoneelseisclosed’.Thishasforcedthem to become much more efficient retailers how effective they have become is aninterestingquestion. The changes in the external environment changing opening hours chan- gingoutletlocationsandthesignificantchangesinthecustomers’perception oftheproductareducinginterestinproduct‘quality’meantthattheentryof a new set of competitors has transformed the competitive arena for the original players.AswasmentionedinChapter4thefact thatthecompetitiveanalysis of the oil majors previously focused on the other oil majors meant that they lacked any useful information with which to counter the new arrivals before it turned into a battle for survival. Conversely because the petrol retailing arms of the oil companies sold other consumer goods Coca-Cola Marlboro Cadbury’s etc.thesupermarketshadalwaysincludedthemintheircompetitor analysisevenbeforetheymovedintopetrolretailing. Productlifecycles It has been a well-established idea for many years that products follow a ‘life cycle’ which affects both the current rate of sale and more importantly the appropriate strategic options for the future. The petrol retailing case study as wellastheearlierMarlboroFridayandIBMcasestudiesisanexamplewhere anindustryissignificantlyaffectedbythematuringofthemainproductwithin the industry. It is very common to find that the basis of competition changes as a productmovesthroughthestagesofthelifecycle.Thismeansthatthereare differentcriticalsuccessfactorsineachstageandtheseshouldresultindiffering

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Existing Position Appraisal 143 strategic thrusts and focuses from companies involved in the industry. These varyingstrategiesrequiredifferentsuitablytailoredcontrolmeasurestheseare developedinChapter12. The product life cycle has therefore been developed by many organisations into a general strategic planning concept for this to work effectively it is essential that the existing position appraisal identifies both where the product currently is in its life cycle andwhen it will move to the next stage. It is often very difficult to obtain sound answers to either of these questions but the use of the Boston Matrix developed by the Boston Consulting Group and illus- trated in Figure 5.6 can make the analysis both easier and more meaningful. Thetechniqueattemptstorelatecriticalstrategicissuestothedifferentphases oftheproductlifecycleandtoshowhowsuccessfulstrategiesmustbeappro- priately tailored to the changing needs of the business. Many organisations havedevelopedtheirownmoresophisticatedversionsofthebasicmatrixbut forsimplicitythisdiscussionwillusetheoriginalformatdevelopedbyBCG. Figure 5.6 shows the matrix with rate of market growth on the vertical axis and relative market share on the horizontal axis with the circular arrow depictingthedirectionoftheproductlifecycle.Rateofmarketgrowthistakenas a key indicator of the attractiveness of the industry because most businesses wouldprefertobeinvolvedinarapidlygrowingmarketthanastaticordeclining one. Relative market share is used to show the competitive strength of the companyintheindustrybecauseagreatdealofempiricalresearchhasshown that companies with dominant market shares tend to produce higher financial HI HI LO LO Rate of market growth Relative market share Star Cash cow Dog Re-investment funding Product life cycle Figure5.6 ThegrowthsharematrixproductportfolioBostonConsultingGroup

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144 Marketing Finance returns. Much of this evidence has been produced from analysis of a large database over 3000 mainly USA-based businesses known as PIMS which stands for profit impact of market strategies this is run by the Strategic Planning Institute and allows businesses to compare their performance with similarorganisations. The analysis of the database seems to indicate that three sets of factors are predominantlyinfluentialindeterminingtherelativefinancialperformanceof an organisation. One major element is as mentioned above the relative com- petitive position of the business as represented by relative market share in Figure 5.6. However increasingly other representative factors such as relative product quality and customer service levels are seen as more important in some industries. Another set of factors takes into account the relative attrac- tiveness of the market and this is included in Figure 5.6 as rate of market growth. However the relative attractiveness is also affected by the degree of com- petition within the market and this is impacted by the level of entry and exit barriers etc. The third set of factors describes the investment intensity need for capital in the industry and the operational productivity level of profit marginscoststructureandsparecapacityintheindustryoftheindustry.One of the key elements of Porter’s ‘niche’ strategy is that a focus on a smaller market enables the business to develop a much larger and hence more profit- able relative market share. The Boston Matrix also highlights once again the need to do this analysis at the appropriate level within the business i.e. the detailed competitive strategies must be developed at the SBU level because products can be at various stages of their life cycles in different markets at exactly the same time. This means that each such market could require a differently tailoredcompetitive strategyparticularlywhenasisquitecommon the overall group has widely varying relative market shares in most of these markets. The popularity of the Boston Matrix has undoubtedly been aided by the adoption of short emotive titles wildcat/problem child/question mark star cash cow and dog for each of the four boxes in the matrix. It is unfortunate thatthesetitlescarrysuchobviousqualitativeconnotationsasisevidencedby the use of three such titles for the launch phase of the life cycle ‘problem child’ sounds much more negative than ‘wildcat’ which itself is clearly very risky but more exciting than a neutral ‘question mark’ At first sight to an ambitious marketing management team it may seem much more challenging and interesting to run a business/brand portfolio that is in the ‘star’ phase rather than a ‘cash cow’ yet risk averse shareholders may prefer the boringly pre- dictable stream of super profits which flows from a successful ‘cash cow’ business. As already mentioned the implications for designing performance andcontrolmeasuresarediscussedinChapter12whereeachphaseofthelife cycleisanalysed.

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Existing Position Appraisal 145 Casestudy–EbenezerScroogemeetsMiserShylock In an attempt to draw together the material included in this chapter and the othertwochaptersinPartTwoanotherreformattedcasestudyisnowanalysed. The case study has again deliberately been set in a fictitious environment as withRudolphbutonceagainthestatementsincludedareallrealquotes these particular quotes come from senior managers in the car industry the electrical white and brown goods industry and supermarket retailing which areallindustrieswheresuchstrategieshavebeenemployed. Ebenezer Scrooge had at last found employment that gave him true job satisfaction. As Accounts Payable Manager of Cratchett Critchett and Crutch hewasableonadailybasistorefusetopaysupplierseventhoughtheywere genuinelyowedmoneyforgoodsdeliveredtoandservicesperformedforthe company. Of course he only refused outright in extreme cases but the use of broken promises ‘the cheque’s in the post’ being devious e.g. requesting very small credit notes but holding up the entire payment as a result and evenoutrightliesthecomputer’sbrokendownsowecan’tprintanypayments etc.meantthateachdayatworkwasacompletedelight. Whataddedtohispleasurewasthatthemorecunninghebecameinavoiding paying money out the more money he got paid by his employer. The company ran an overall management incentive scheme based on return on investment whereby outstanding creditors reduced the net investment element. However they also set targets for individual managers and Ebenezer’s was geared to creditor days outstanding the longer he took to pay the more bonus he got paid.Obviouslyheaddedallthesebonusestohisexistinghoardofmoneythat washiddenunderhisbed. InpreviouscompaniesScroogehadalwaysfacedpressurefromcolleaguesin the sourcing and supply departments and the operations areas. They complained thatsupplierswouldrefusetodeliverbecausetheyhadn’tbeenpaidorthatqual- ityandservicewasdeteriorating.Heconsideredthisasapoorbuyingstrategyas theyshouldhaveidentifiedalternativesupplierstowhomtheycouldturn.Atlast hehadfoundapurchasingmanagerwhosharedhisaiminlife. Miser Shylock had learnt his negotiating skills in Continental Europe and claimed to have been responsible for closing down at least thirty companies by refusing price increases or cancelling orders and even contracts at short notice. He found recessions and downturns as a particularly productive envir- onment for his style of negotiations. At the beginning of the current year he had written to all their major suppliers informing them that due to the severe competitivepressuresCCCwasfacingherequireda5percentpricedecrease fortheforthcomingyear.Miserbelievedinalwayshavingatleasttwocurrent suppliers plus one more submitting quotations for all new contracts. He felt that by doing this he could obtain the lowest possible input prices and nor- mally keep them below the full costing of suppliers i.e. ‘There will always be

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146 Marketing Finance one supplier willing to price on a marginal basis in order to get our business. The mistake they make is to believe that once they are established they can increase prices in order to restore their profit margins. I always go for competi- tivetenderingtokeeptheirpricesdown.’ Scrooge and Shylock worked closely and happily together though their colleagues never seemed to see them smile helped by CCC’s dominant position in its industry. ‘It is very difficult for most of our suppliers to stop deliveries because we are late in paying them. Miser has always got alterna- tiveswaitingandsoweremainrelativelyunaffectedevenifwehavetoswitch suppliers. My staff are now very good at paying just before we get taken to court although obviously we do occasionally wait too long and incur court costsetc.Howeverwecanoffsetthesecollectioncostsagainsttheinterestwe have earned by keeping the suppliers’ money. I have in fact argued that my department should be run as a profit centre by properly crediting us with the interestearnedonthecreditors’moneythatweplaceondeposit.Afterallitis freemoneysoweshouldgetasmuchofitaspossible.’ Bob Cratchett CEO of the company felt distinctly uncomfortable about these views expressed to him by Shylock and Scrooge. He was not sure that they were in the long-term interests of the business but he could not dispute theshort-termprofitimprovementsincetheyhadbothjoinedthecompany. Caseanalysis A sensible start point for analysing this case is to consider the competitive environment in which such a supply strategy could be implemented. The key element is of course that there is a dramatic imbalance between the relative powers of supplier and customer the analysis also considers some examples wherethepowerresideswiththesupplier.Thisdiscussionwillthereforehigh- lightwhereitwillnotworkandthesignificantproblemsthatcanbecausedby suchsignificantimbalancesinpowerwhentheyareabused. The suppliers that most commonly face this hostile competitive environ- ment are those in industries made up of many relatively small businesses selling to few much larger customers. The buying pressure from these limited powerful customers is increased when the products involved are effectively undifferentiated commodities this enables customers to switch supplierseasilyandmakes‘sellingprice’thekeybuyingcriteria.Howeverthe absolutely critical factor for this situation to exist is that there must be excess capacityatthesupplier’slevelintheindustryvaluechain.Suchexcesscapacity can mean even very large suppliers have almost no negotiating power with much smaller customers. The key elements in this analysis are summarised in Table5.1. If these commodity producing suppliers are competing on price they may wellsettheirsellingpricesbelowfullcostsimplyinordertogainvolumebut

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Existing Position Appraisal 147 they only need to do this if there is not enough demand to go around This positionisexacerbatedwhenthesuppliersalsofacehighexitbarriersbecause although none of them is doing well financially the excess capacity is likely toexistforalongtime.Themostcommonexitbarriersinvolvedarededicated longlifefixedassetsthatarereplacedonaprogressivepiecemealbasisallied to a very high fixed cost structure e.g. coal mining power stations steel basicchemicalsflourmillingpaperandboardmillsetc.Thesituationiseven more likely to persist when there are no substantial additional economies of scale to be gained once the normal operating scale has been achieved this makes it very difficult for any single supplier to gain a sustainable cost advan- tagethatwouldenableittodriveoutitscompetitors.Italsomakesiteconom- ically difficult to justify rationalising the industry’s capacity through merger oracquisition. At the other end of the scale the excess capacity in the industry may be preserved due to very low entry barriers and a poor flow of information across the fragmented industry. This occurs in many service industries such as office services businesses and many types of specialist retailers where despiteahighlevelofbusinessfailurestherealwaysseemtobeenoughnew entrants to maintain an overall excess capacity position the power is norm- allyexercisedbythedominantsuppliernotbythecustomere.g.consumer. In both these extremes these companies must also find it very difficult to create any meaningful differentiation in their output or to add significant value in other ways thus the power remains with the other party in the negotiation. Turning to the dominant customer position of CCC this strength is most easily maintained when they are transforming these commodity inputs into a much more added-value product e.g. one that is itself highly differentiated in itsmarket.Thismeansthatthecustomercanerectstrongentrybarriersinorder Table5.1 Competitiveenvironment Supplier Customer Manysmaller Fewlarger Commoditystyleproducts Addedvalueproducts Excesscapacity Strongstabledemand Noeconomiesofscale Lowswitchingcosts Highexitbarriers Highentrybarriers Lowentrybarriers Differentialadvantages Cannotaddvalue Cancontrolquality Can’tdifferentiate Don’tvaluerelationships

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148 Marketing Finance to maintain its high levelof super profits particularly to preventthe suppliers from trying to move further down the value chain. The car companies and electrical goods manufacturers have been extremely good at achieving this it is a massive strategic move to go from making small components for a car to producing the whole car Another way of achieving this is by branding the ‘commodity’productbeforesellingitonakeypartofsomeretailerbranding such as is done by Marks Spencer is that the ‘product’ supplied to them gains value simply because it carries their brand name– theconsumer neither knows nor cares which supplier actually made the product. Again car companies have increased their power by effectively de-branding most car components. Years ago many consumers did know and care what brand of lights starter motor battery fuel injection system etc. was in their car but notanymore. It is clearly helpful for these customers if they incur low switching costs when they change suppliers as they frequently will. This regular switching may require them to hold additional buffer stocks to allow for any delay in obtaining new deliveries or they may take supplies from several sources at the same time. Clearly this either means that product quality is not important or that it can be economically controlled by the customer this is much easier with commodity style products. What is particularly important is that thecus- tomer is not interested in developing long-term relationships with its suppli- ersi.e.itdoesnotplaceanyvalueoncontinuitypossibleinnovationandnew productdevelopmentetc. This highlights one increasingly common strategy where Scrooge and Shylock could do dramatic damage if customers want to build increasingly closemutuallybeneficialrelationshipswithalimitednumberofkeysuppliers theycannotcontinueto‘screwthemdownonprice’and‘takeexcessivelylong payment periods’. A classic example is the ‘just-in-time’ delivery strategy whichrelieson‘asrequired’responsesfromsuppliers.Veryfewsupplierswould continue to deliver ‘within 4 hours’ of receiving an order if they have not yet been paid for the goods that they delivered within 4 hours over 90 days ago particularlyiftheywerealsoforcedtousemarginalpricingtogettheordersin thefirstplace. Even if customers do not want such responsive relationships they must be aware that their suppliers will be desperately keen to change the nature of the current trading relationship. Thus if the demand for their product is growing thekeyexcesscapacityconditionmayberemovedandtheirnegotiatingpower will be considerably reduced. Normally they will not surprisingly find that they are the last customer to be supplied if and when there is a shortage suppliers often have long memories and do bear grudges Hence this type of supplier strategy is most commonly found in relatively mature industries where customers see input prices as very important to maintaining their own existingdominantshareoftheirmarket.Itisveryinterestingtofindthatthere

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Existing Position Appraisal 149 are many companies that state that they now do ‘value relationships’ with their suppliers but where Scrooge and Shylock look-alikes are still running theiraccountspayableandsourcingactivities.Themarketingfinanceapproach tocreatingvaluereallydoesrequireafullyintegratedapproachacrossthewhole organisation.

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PartThree Planning

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6 ThePlanningProcess Overview Theplanningprocessrequiresamultitieredstructurethatmatchesthestrategic management process discussed in Part Two. Most large organisations have a corporate philosophy and culture that has a significant impact on how they plan.Somebusinessesdevelopveryconservativeplansthattheyintendtoexceed while others set extremely stretching targets that they will do well to get near to.Neitherplanningstyleisrightorwrongbuttheyeachhaveimportantimpli- cationsforthetailoringoftheirassociatedplanningprocesses. Gap analysis and contingency planning are useful planning techniques but they need to be very carefully put into practice. The business should decide whichofthefourpotentialwaysoffillingthegapbetweenextrapolatedcurrent performanceandthedesiredobjectivesbuildsonitsexistingcorecompetences. Contingencyplansshouldbedevelopedforthoseunlikelyexternaleventsthat could have dramatic implications for the organisation. The focus of strategic planning should be on the most important most likely external business environment. Theplanningprocessshouldbefullylinkedwiththecontrolprocessandthe performance measurement system with all of them being consistent with the businessobjectivesandstrategies.Organisationalstructuresshouldbedesigned to be consistent with competitive strategies and if strategies are changed significantlythestructuresshouldbereviewedtomakesurethattheyarestill appropriate. Corporateplanningoftheportfolioofbusinessescomprisingthegroupshould only be done at the very top of the organisation while detailed competitive strategyplanningcanonlybeeffectivelydoneattheverybottomoftheorgan- isation. Therefore all other levels of the organisation should help to make the drawing together of the myriad of small business unit plans easier this suggests that a structure based around commonality of strategic thrust and competitiveenvironmentmaybevalueadding. The planning process will inevitably be partly top-down i.e. targets driven outfromthecentreandpartlybottom-upi.e.issuesandopportunitiesproposed from the business units. The dominant element has implications for the size of and the information needed by the corporate centre. The planning process

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154 Marketing Finance shouldbeanintegratedpartoftheongoingstrategicmanagementoftheorgan- isationandnotseenasa‘one-off’annualeventthatdistractsmanagerialatten- tionawayfromrunningthebusiness. Oneincreasinglypopularwayofachievingthisistheuseofrollingforecasts thatforcethebusinessregularlytoupdateitsviewofthefuture.Bymakingthe planning process more continuous and integrated within the normal manage- ment role the emphasis on the annual plan is reduced and planning becomes seenaswhatitmustbeacriticallinemanagementresponsibility. Introduction Part Two considered the various elements involved in conducting a thorough analysis of the current situation of an organisation. If this is properly carried outmanyofthekeyissuesregardingplanningforthefuturewillalreadyhave beenconsidered.Indeedthesituationreviewaims toshownotonly wherethe businesscurrentlyisbutalsowhereitislikelytogoifnochangesaremadeto the current strategies. Similarly a good SWOT analysis should highlight the critical success factors for the business and hence where changes to the exist- ingstrategyarelikelytohavethemostbeneficialeffect.Furtherthecompetitor analysisshouldpredictthemostlikelymarketinginitiativesbycompetitorsso thatappropriateresponsesandcounterinitiativescanbedeveloped. The planning process which is the focus of this chapter should therefore concentrateonchoosingamongthealternativecoursesofactioni.e.strategies and tactics that could improve the likelihood of achieving the organisation’s goals and objectives. This direct linkage has already been discussed in Chapter 2 and is re-shown diagrammatically as Figure 6.1 for completeness. Obviously a key part of the planning process is to provide information on the rangeofpossibleoutcomesforthesealternativecoursesofaction.Howeveran equally important element is to assess the risks associated with each of these Goals Objectives Strategy/long-term plans Tactics/budgets Mission Figure6.1 Theverysimplebusinessmodel

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ThePlanningProcess 155 alternatives as already stated most businesses still fail to incorporate an ade- quaterisk assessment process within their planning and controlmodels. Their principalfocusisonassessingtheexpectedreturnsfromnewstrategieswhich carries an implicit but unreasonable and unrealistic assumption that all these alternativeshavesimilarriskprofiles. Anotherverycommonproblemofplanningprocessesisthatourverysimple planningmodelofFigure6.1becomestransformedintothemonstershownin Figure6.2.Evenworseisthatthiscomplexprocessisthenreducedtoa‘plan- ning timetable’ with specified dates by which each separate activity must be completed.Thisisnormallyachievedbyworkingbackwardsfromtherequire- ments for the ultimate approval of the final plan e.g. if as was the case for one company the relevant main board meeting is scheduled for 6 December then the divisional plans must be finished and approved by 10 November to allow for group review and consolidation into an overall corporate plan that can be circulated to the board members at least one week before the actual meeting. In this large very sophisticated group the annual planning process had started in early July with the issue from the corporate centre of the basic macroeconomic assumptions to be used for the next planning period. This enabled all the underlying business units whose individual plans would then initially be consolidated into divisional plans to work out their own planning timetables. First they had to agree their own objectives with their divisional managers as well as translating the overall global group assumptions into Mission Goals Long-term strategy Objectives Strategic plan Short-term Strategy/tactics Budget /short-term plan Implementation Monitor outcome Assumptions on critical factors Modify assumptions Modify strategies Modify plans / objectives Feedback loops Feedback loops Update analysis External environment review Internal appraisal Reforecasting / flexing Figure6.2 Theplanningprocessincontext

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156 Marketing Finance a specifically relevant detailed set for their external environment. Then they had to agree the review process that their plans would go through so that an agreed deadline for submissions was established. In practice this meant that theircriticallyimportant‘strategicplan’neededtobeagreedduringoneweek in late September. Many of the divisions attempted to focus on this ‘planning exercise’bytakingthetopmanagementteamawayfromtheofficefortwodays oftenaweekendinordertoconsidertheirstrategyfor thenextfew years This incredibly bureaucratic approach to planning which is very common inlargegroupsexplainsthecynicismexpressedinChapter3regardingtherole of most planning managers. Most planning managers do not ‘do planning’ they ‘manage’ the ‘planning process’ by establishing and monitoring the plan- ning timetable. In many companies it is considered much more important to have met the planning timetable’s deadlines than to have developed a mean- ingfulbusinessplan.Thegoodnewsisthatweshouldnotwantplanningman- agerstodotheplanningplanningisacriticallinemanagementresponsibility The bad news is that planning and control must be completely integrated into the organisation’s overall strategic management process rather than being seenasanadministrativeimpositionfromthegroup’scentre. The objective of this chapter which is then developed through the rest of Part Three is to set out a more logical planning process which builds on the in-depth analysis and design advocated in Part Two. At the beginning of the book the overall strategic management process was broken into four stages as was shown in Figure 2.4. These four stages can now be linked into the key marketing finance activities as is done in Figure 6.3. The existing position Establish the goals and objectives Formulate and select the appropriate strategies and tactics Design feedback loops to assess performance and to allow for changes during implementation Implement feedback loops monitor and revise In other words planning and control should be completely integrated into the strategic management process. Future competitive environment review Establishing performance measures and benchmarks Existing position appraisal and analysis Internal planning and target setting Update analyses reviews strategies and objectives Figure6.3 Theplanningprocessanditsmarketingfinanceinterfaces

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ThePlanningProcess 157 appraisal and future competitive environment review that were discussed in Part Two clearly affect the goals and objectives that are established for the business.Theyalsohaveasignificantimpactontheappropriatestrategiesand tactics that should be adopted in the future. The planning process also affects thesestrategiesandtacticsbutmustdrivethedesignofthefeedbackloopsthat are needed to facilitate control once the plan is implemented. These feedback loops should incorporate appropriate update analyses and reviews of both the strategiesandwherenecessarytheobjectives.Theestablishmentofappropri- ately tailored performance measures and benchmarks is considered in part in thischapterbutisdealtwithindepthinPartFour. Corporatevalues As discussed in Part Two strategic management in most complex modern organisationsmustbemultitieredandtheplanningandcontrolprocessesneed to be similarly structured. The detailed planning process at the individual business unit level should be tailored to the specific needs of each such unit and its particular competitive environment. However most large groups have an overriding corporate philosophy and corporate culture that has a strong influence on both the corporate goals and objectives and also the strategic thruststhatseektoachievethemasshowninFigure6.4. Corporatephilosophyreferstothekeyfundamentalattitudesandbeliefsthat pervadethewholeorganisationandcanconstrainsometypesofbehaviouras well as empowering other actions by even quite junior employees. This overall philosophymayhaveoriginallybeencreatedorstimulatedbytheorganisation’s foundersorearlyleaderse.g.afoundingfamilysuchasintheMarsfamily-owned group that is used as the basis of the case study at the end of this chapter. The vision of the company Corporate philosophy Corporate culture Strengths weaknesses – specific corporate competencies Assumptions critical risk analysis Opportunities threats Corporate strategic thrusts Corporate goals performance objectives Figure6.4 Corporatevisioning

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158 Marketing Finance Similarlycorporateculturecanbeviewedasthesumofthesharedvaluesand beliefsthesharedassumptionsandphilosophiesi.e.thenormstowhichpeople withintheorganisationcanallrelate.Increasinglylargepubliclyquotedcorpor- ations and many other organisations are seeking to make their corporate philosophiesmoreexplicitbycommunicatingthembothinternallyandexternally. The external communication aspect has received a significant boost through the relatively new emphasis oncorporate social responsibilitywhich requires businesses to explain how they relate to and impact on their total set of stake- holders as was shown in Figure 3.2 rather than just their shareholders. Intern- ally corporate philosophies are often described as ‘guiding business principles’ or something similar and are used to set out what the senior managers in the company both believe and/or want their organisation to be. As shown in Figure 6.4 therefore it is logical for the corporate philosophy to be derived from and to be consistent with the organisation’s vision statement. However what is even more important for the future success of the business is that the corporate philosophy is consistent with the corporate culture. Culture shows the beliefs and values that are actually ‘shared’ across the organisation rather than those that top managers would like to be held All the research in this areahighlightshowdifficultitistochangecultureandthatitisstronglybased oninformalsystemsandroutineswithstoriessymbolsandritualsbeingvery importantfactorse.g.whatsortofbehaviourgets‘rewarded’inthisorganisation. However it is also clear that the corporate philosophy must be consistently reinforced by the performance measures used within the company and by the styleofitsplanningprocess. CorporatestylewasintroducedinChapter3asitrelatestothewayinwhich the corporate centre interacts with its underlying businesses and the overall nature of the group as is shown in Figure 6.5. Thus at one extreme a large groupcouldconsistofawiderangeofunrelatedbusinesseswheretheprimary role of the corporate centre is to manage the portfolio of disparate businesses so that decision-making is highly decentralised. At the opposite extreme the group could be highly centralised with the corporate centre taking a highly involvedroleindecision-makingacrossitstightlyfocusedgroupofbusinesses. Clearly there is a continuum of types of groups in between these extremes. Another element that has a significant impact on the overall planning process istheorganisationalstructurewithinalargegroup.AsdiscussedinChapter3 themostcommonstructurerevolvesaroundgeographicgroupingsofthebusiness unitscomprisingagroup.Alternativestructuresemphasisetheindustriesinwhich business units are based or the technologies they utilise or the competitive environmentstheyface.Withingroupscomprisingcloselyrelatedbusinessesthe structurecanbebasedonthestageofdevelopmentofthemarketortheparticular competitive strategy that is being employed. Encouragingly more large groups are now moving away from geography to a strategically more relevantwayof groupingtheircomponentbusinessestwointerestingrelativelyrecentdevelop-

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ThePlanningProcess 159 ments are to classify business units according to ‘the rules of the game’ that theyareplayingbyandby‘theparticularroleoftheirmarket’withinthegroup. Clearly the combination of the organisational structure that is implemented and the corporate style of the group will have a significant impact on the corporate planning process that should be used and on the challenges faced by and guidelines required for this process. However corporate style also refers to the way in which the group is managed from the centre and this was also introduced in Chapter 3. The Corporate configurations model shown in Figures 3.6 3.8 and 3.9 can be developed into the more sophisticated Rainbow Diagram shown in Figure 6.6. The vertical axis still represents the style of corporate involvement i.e. direct or indirect and the horizontal axis shows the source of corporate advantage i.e. cost reduction through economies of scale or value-adding through knowledge. This rainbow format of the model highlights the different requirements for the planning and control processes withinthefourpreviouslydiscussedconfigurations. The Controls configuration normally has a tight formal planning process withtargetssetforthebusinessunitsbythecentre.Acommoncontrolsystem for such groups is to compare actual business unit performance against the budgeted level of performance with the consequence that the focus of the business units’ management teams is exclusively on their own financial performance.Themostcommonperformancemeasuresusedinthesetypesof groupsarethereforeprofitssomeformofreturnoninvestmente.g.returnon capitalemployedandcashflowatthebusinessunitlevel.Akeypotentialrisk in this environment is the use of ‘budgeting game playing’ by the business units to try to negotiate lower financial targets for the forthcoming planning Corporate strategic thrusts Corporate goals performance objectives Organisational structure Business units/divisions split by: –Industries/markets –Technologies/comp. environments –Strategies/stages of development Corporate style Centralised/decentralised Portfolio management/direct involvement Related/unrelated businesses Corporate planning processes challenges guidelines Business unit strategic planning process Figure6.5 Corporatevisioningcontd

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160 Marketing Finance period. This type of planning process is consistent with the lack of detailed business unit knowledge at the corporate centre in the highly diversified and decentralised groups that typify the ‘shareholder’ corporate style of the Controls configuration.Italsoreinforcesthecommonlackoftrustbetweenthecorporate centre and the business units and the absence of collaboration among the businessescomprisingthegroup. Thiscanbecontrastedwiththeotherindirectcorporatestyleofinvolvement namelytheCreativeconfigurationwithits‘leadership’corporatestyle.Inthis configurationthefocusofcorporateplanningistoidentifypotentialnewgroup- widecompetencesorsourcesofcorporateadvantageandtheactualcorporate planning process should be tailored to the particular group vision and values suchas‘innovativeleadershipoftheindustry’.Thisshouldmakebusinessunit managers concentrate on how well their individual business objectives and strategiesfitwiththegroup’sspecificvaluesratherthanfocusingexclusively on their own financial performance. This requires the control system to incorporatesomemeasureofthecontributionmadebythebusinessunittothe overalldevelopmentandgrowthofthegroupakeyelementisthereforesharing of new innovative ideas across the group. This ‘sharing’ should be facilitated by the corporate culture of openness and trust that is vitally important to this Creative configuration. Common performance measures used correspondingly reflect a group approach plus the key aspects of the corporate vision/values e.g.cross-divisionalinitiativesnewideasdevelopedandnewproductslaunched. Agoodpracticalexampleofthisis3Mwhichinordertomaintainitsinnovative Controls S cale Scope Creative Fit to group vision/values No exploitation of know-how within group Identify new potential group competences Tailored to vision/values Group contn. plus sharing of ideas Cross-divisional initiatives/product launches/new ideas developed G row th p lus utn of / contn to groupw ide com petences O w n business performance plus contn to group M ore debate between centre businesses Leveraging existing group com petences Inappropriate central com petences U tilising group process advantages P rofit perform ance /asset utilisation R elative cost performance responsibilities Top dow n b ut shared ROCE profits cash Flow Individual performance versus budget Tight formal process Targets issued from centre Game playing by business units Financial performance Coordinated planning of centralised resou rces D em otivation of business units C ost reductions / competitiveness Corporate involvement Direct Indirect Source of corporate advantage Economies of scale Knowledge Nature of planning process Common performance measures Key risks Corporate configuration Focus of business unit management Focus of planning process Control systems © Ward Bowman Kakabadse Figure6.6 Therainbowdiagram:theplanningandcontrolprocess

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ThePlanningProcess 161 culture sets a standard that at least 50 per cent of sales revenues should be generatedfromproductslaunchedinthelast5years. The direct involvement configurations i.e. scale and scope should have similarly tailored planning and control processes as is detailed in Figure 6.6. TheresearchonwhichtheRainbowmodelisbasedindicatesthatitispossible to change from one configuration to another but that this is most commonly achieved alongside if not caused by a change in the top management team. This isillustrated by several ofthepractical insights inthis chapterincluding PracticalInsight6.1. PracticalInsight6.1 Gapanalysisandcontingencyplanning One very well-known planning technique that can be used at either the cor- porate or the individual business unit level is gap analysis. This takes the gap betweenthe projectedperformanceofthe businessifitcontinuesasitise.g. asisshownbythesituationreviewanditsobjectivesandtriestoindicatehow thisgapcanbefilled.DiagrammaticallythepossibilitiesareshowninFigure6.7 andthesearenotbycoincidenceverysimilartothoseincludedintheAnsoff Matrix in Figure 2.6 as the Ansoff Matrix shows all the possible ways of generatingsalesgrowthsellmoreexistingproductstoexistingornewcustomers orsellnewproductstoexistingornewcustomers. Theproblemswithgapanalysisareonceagainwiththewaysinwhichitis normally practically applied. The corporate or business unit objectives are oftendefinedinsomeidealformwiththeresultthattheapparent‘gap’ishuge requiring very aggressive and correspondingly very risky strategic initiatives if such a gap is to be filled. As already discussed all objectives should be Whychangeawinningformula GE the USA-based conglomerate was widely regarded as having a very com- prehensive planning and control process before the now world famous Jack Welch was made Chairman and Chief Executive at the beginning of the 1980s. Howevertherigidandsomewhatbureaucraticplanningprocessobviouslydidnot suit the style in which Jack Welch intended to manage the group. Accordingly a completely new process was instituted across this vast multinational whose businessesrangedfrompowerplantsandjetenginesthroughaeroplaneleasingto investmentbankingandconsumercredit. The continuedgrowthin salesrevenuesprofitsandshareholdervaluecreation through most of Jack Welch’s long period of leadership showed the long-term valueofsuchacompletechange.Followingthedepartureofsuchauniqueleader it will be interesting to see if GE’s planning process is transformed again to suit thestyleofitsnewtopmanagement.

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162 Marketing Finance established in the context of the particular relevant external environment that should already have been comprehensively analysed. However even if this is done businesses still have very different planning styles in the way in which they set such objectives. Some businesses quite deliberately take a prudent approachtoestablishingtheirtargetsandobjectivesastheircorporateculture isthat ‘targets should bemetoreven slightlyexceeded’.Attheother extreme targets can be set that are severely stretching and may only be achieved if everything goes really well however by aiming at such BHAG’s big hairy audacious goals as these have now become known the business may greatly exceednormalexpectationsevenifitfallsalittleshortofthestatedobjective. Neither behaviour is right or wrong but they are very clearly different and correspondingly require different planning processes and particularly tailored feedbackloops. Inthe very cautious planning environmentitis tobe expected that the vast majority of objectives will be achieved and the emphasis of the planning process is on ensuring that these achievable objectives contain acceptable levels of both economic return and management stretch. The variances from theconservativeplanarelikelytoberelativelysmallandwillprobablybeon balance slightly positive as the culture is one of over-achievement even if this iscreatedbyconsciouslyunder-promisingduringtheplanningprocess.Themuch more aggressive ‘let’s go for it’ style of planning will result in much more significant deviations from the highly stretched targets included in the plan and most of these variances will represent shortfalls against the ‘planned’ performance. The feedback loops and the performance criteria used in these differing styles of business must be tailored to their separate requirements otherwise managers may feel very badly treated when their performance is Performance measures e.g. Sales revenue/ contribution/ profit/ R.O.I. Corporate objectives Extrapolation of history Time Diversification Product development Market development Market penetration Total gap between objectives extrapolation of history Figure6.7 Gapanalysis

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ThePlanningProcess 163 appraised. It can be a very salutary experience to move from one style of company to the other which means that managers can go down a very steep andoftenpainfullearningcurveasisillustratedbyPracticalInsight6.2. PracticalInsight6.2 The main benefits to be gained from using gap analysis as with any of this typeofplanningtechniquearetodowithresourceallocationdecisions.Asstated earlier the key focus of planning is to make decisions i.e. exercise choices about how and how much of the identified ‘gap’ i.e. the required improve- ment in performance should be filled. It is now generally accepted that more focusedbusinessescreategreatershareholdervaluethanverywidelyspreadand highly diversified ones. Yet in most marketing textbooks managers are still recommendedtouseallthepossiblewaysingapanalysisandtheAnsoffMatrix togrowtheirbusinesses.Itisclearlyimpossibletobehighlyfocusedonseveral thingsatthesametime.Itisalsomostunlikelythatanybusinesshasstrongcore competences in each of the areas i.e. growing share in existing markets devel- oping new customers and new markets developing and building new products and diversifying into unrelated products sold in new markets. If the strategic choices are not building on established strengths the risks associated with these strategiesaresignificantlyincreasedwhichofcoursemeansthattherequired ratesofreturnarealsohigher.Yetthesustainablelevelsof expectedreturnsare unlikelytomatchtheseincreasedrequirementsunlessstrongentrybarriershave been erected based on sustainable competitive advantages developed by the business. The planning process should therefore highlight the most appropriate Game-playinginplanning The new sales and marketing director of a large FMCG company set the tone for the forthcoming planning round in his initial address to his new company’s sales conference. He said ‘Let me make it clear that in my career to date in several other companies I have never failed to achieve any sales target or marketing objective that I have been set. I expect this standard of performance to be applied throughout this organisation.’ Somewhat amazingly he was very surprised at the low sales plans that were initially submitted to him shortly thereafter particularly as this company had had a reputation for aggressive forecasting. In a similar FMCG group I once worked with a sales and marketing director who was an expert at game playing when it came to agreeing objectives. As an ex-rugbyplayingprematurelybaldverylargemanDaveregularlyfooledsenior executives by being able to cry to order during planning meetings. Once he felt the targets being talked about were getting even slightly difficult he would let a few tears roll gently down his cheeks to show ‘how seriously he viewed the task hewasbeingset’

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164 Marketing Finance sources of future growth so that the available resources can be focused in thisarea. Another increasingly popular planning technique is contingency planning which is also sometimes known as scenario analysis. The whole basis of planning isthat the future is ‘unknowable’and thatmanyofthe required base assumptionswillprovetobewrong.Consequentlyorganisationsideallyneedto develop a range of plans that will enable them to succeed in whatever future environment they find themselves. Clearly no business can or should have the capability to develop the infinite range of plans that are needed to cope with the possiblecombinationof futureevents.Thusaprioritisingprocessisrequired and this is diagrammatically shown in Figure 6.8. The axes represent the probability of an event or potential outcome occurring and the potential impact on thebusinessifthatdoeshappen.Logicallythemainfocusofstrategic planningisbasedonthemostlikelyfutureenvironmentandthemostimportant eventsi.e.thetoprighthandcornerofFigure6.8.Howeverinthetoplefthand cornertherearesomefuturecircumstancesthatalthoughnotverylikelytocome to pass would have very significant impacts on the business if they actually happened. These require contingency plans to be prepared so that the organ- isation knows what it should do as soon as the ‘unlikely’ but material event happenssuchasapossiblecurrencydevaluationthelaunchofaneworimproved product by a competitor the entry of a new competitor the loss of a major customer the start of a significant price war. Of course the assessment of the ‘probability of occurrence’ is much easier if a comprehensive assessment of thefuturebusinessenvironmenthasbeencarriedout. Scenario analysis became much more popular after it became widely known that Shell by using the technique had identified the possibility of a massive rise in oil prices prior to the first OPEC led oil crisis in the early 1970s. Focus of strategic planning Prepare contingency plans Operational planning Not worth planning for HI LO LO HI Potential impact Probability of occurrence Figure6.8 Contingencyplanning/scenarioanalysistechniques

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ThePlanningProcess 165 Anintegratedprocess Thereforetheoutcomeofasoundstrategicallyorientedplanningprocessis a base plan based on the most likely future business environment supported by a number of contingency plans which indicate how the business should respond to significant differences from its expected situation. These contin- gency plans should cover both positive and negative changes because if the organisation has not considered the upside potential it may not be able to respond quickly enough to take full advantage of the ‘surprise good news’. ThisisillustratedinPracticalInsight6.3. PracticalInsight6.3 Thisoverallplanningprocessneedstobeintegratedintoafullplanningand controlsystemasshowninFigure6.9inwhichtheplanningprocesslinksfully withthecontrolprocessandtheperformancemeasurementsystemwithallof them using the same management information system. It is quite astonishing to me that at the beginning of the twenty-first century there are still many organisations that prepare plans outside their normal accounting systems. Some of these businesses then spend a lot of time trying to reconcile e.g. inputting into the ‘general’ ledger the inputs to their planning processes with those used by their monthly ‘control’-focused reporting systems so that the per- formance measures which are normally based on their plans can meaning- fully assess the relative actual performance against these plans. Other businesses in this position have actually given up trying to reconcile their plans with their actual results which means that the performance measures Unexpectedandunplanned Around 30 years ago I was working as a management accountant for Mars Confectionery when value-added tax was about to be introduced on consumer goods in the UK. The company ran lots of planning models trying to assess the impactofvariouspossibleratesoftaxthatmightbeappliedtotheirproducts. At this time confectionery products faced some adverse pressures based on health concerns and particularly dental concerns among children. Therefore most oftheplanningalternativesconsideredrelativelyhigherratesoftaxonsugar-and chocolate-based products than on other foods which were widely expected to be zerorated.ItcameasagreatsurprisewhentheUK’sfinanceministerannounced as part of his budget speech that all foods including confectionery were to be zeroratedforVAT. The sales and marketing and finance teams did an excellent job of responding veryquicklytothiscompletelyunplannedforbutnonethelessverygoodbusiness opportunity. However in their industry Shell would have had a much better potentialforexploitingtheirsuddenexternalchangewhichhappenedaroundthe sametime.

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166 Marketing Finance they use are based on one or the other or in some cases something else altogether Alloftheseelementsshouldbedrivenbyandbeconsistentwiththeorganisa- tional objectives strategies and structures. Readers may already have gathered that I am a firm believer that organisational structure must follow the strategies selected by the business if you change your strategy you should review your structure to check that it is still relevant. This is also true if the organisation changes its objectives significantly and this may be caused by the externalenvir- onmentorbyinternallydrivenchangessuchasisthecaseinPracticalInsight6.4. PracticalInsight6.4 Oldmutual–nolongeroldoramutual Old Mutual had been a leader in the life assurance industry in South Africa for many years but like several locally dominant such companies it looked to take advantage of externally imposed restrictions being lifted. Thus at the end of the 1990s it changed dramatically it demutualised and became a publicly quoted companywithalistingontheLondonStockExchangeaswellasinSouthAfrica. Its top management team was strengthened and moved to London from where it made several large acquisitions particularly in the USA primarily of asset man- agementratherthanlifeassurancebusinesses.Theacquisitionoflargeinstitutional shareholders rather than the policyholder members it had had as a mutual required amuch clearer focus on shareholder value and a rigorous financial evaluation of resourceallocationdecisions. Not surprisingly the group rapidly developed a new more integrated planning and control process to meet these dramatically changed requirements. Obviously developingandimplementingsuchasignificantchangeonlyaddedtothealready high pressures on management that were caused by the other sizeable changes in apreviouslyrelativelystableorganisation. Organisational objectives strategies and structure Planning process Management information system Performance measurement system Control process Figure6.9 Anintegratedprocess

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ThePlanningProcess 167 Strategicplanninglevels Having stated that organisational structure should follow strategy we now need to return to the issue of the multitiered nature of strategic management and hence of the planning process. As shown in Figure 6.10 there are two absolutely imperative levels of planning in any large complex organisation. Corporate planning which primarily consists of deciding upon the compos- ition of the portfolio of businesses that comprise the group must be done at theverytopoftheorganisationforthewholeorganisation.Ifseparatepartsof the group are allowed to make their own independent decisions on dynamic acquisitions/divestments or organic moves into new areas of activity the group is really running a ‘portfolio of portfolios’ in that the overall group is built up from several ‘independent’ sub-groups beneath the ultimate parent. There is a mass of research and academic theory to show that this is always sub-optimal from a shareholder value point of view and hence should be avoided. As it can be avoided quite easily by the design of the planning pro- cess implemented within any group it is surprising how often it is still found tobeaproblem. Thesecondplanningimperativeisthatdetailedcompetitivestrategyplanning canonlybemeaningfullycarriedoutatthelevelwherespecifiedproductsare soldtoidentifiablecustomerswithknowncompetitorsi.e.atthelowestpractical sub-division of the organisation. As stated in Part Twomany different competi- tivestrategiesmaybeinuseatthesametimewithinanyonelargebusinessand thedetailedplanningprocessneedstobefocusedonthespecificrequirements Group/central organisation Centrally provided shared services Corporate planning level Total organisation Divisional organisation Product/ market interfaces Detailed competitive strategy planning level Figure6.10 Strategicplanninglevels

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168 Marketing Finance of each such individual competitive arena. For many large groups this would create an administrative nightmare and their planning managers could find it unacceptablycomplextogodirectlyfromlotsofrelativelysmallplanningunits tothetotalgrouphencetheuseofintermediatedivisionalstructuresinwhichto bringtogetherthesedetailedcompetitivestrategyplans. As soon as the intermediate ‘grouping together’ role of divisions is clearly statedIbelieveitbecomesfairlyobviousastothebestwaytodothisadmin- istrativelyrequired‘grouping’.Theseparatebusinessunitsshouldbegrouped bycommonalityofcompetitivestrategyandkeystrategicthrustsasthisshould highlight the relative strengths of their planned strategies more easily. It should also enable divisional managers to develop specialist skills and in-depth know- ledge in a particular type of strategy e.g. growing market share in rapidly growing markets and would make discussions and interchange among the business units within any division much more productive and value enhancing. The common divisional groupings by geography industry etc. are simply administratively convenient and may make for more efficient consolidations ofbusinessplansbuttheydonotmaketheplanningprocessmoreeffectiveas statedveryearlyinthebookweshouldbemuchmoreinterestedinimproving effectivenessi.e.doingtherightthingsratherthandoingthewrongthingsmore efficiently. Figure 6.10 also contains two different sorts of activities coming out of the top ‘total organisation’ box. This relates to activities carried out by the group’s centreandraisesanimportantquestionastowhethertheyshouldbechargedout to the divisions and hence ultimately to the underlying business units. These centrally provided activities can be split into two distinct categories the first represents centrally provided shared services where the group’s centre carries out activities that would otherwise have to be done by the divisions for them- selves.Thesecondcoversthoseactivitiesthatthecorporatecentreneedstodo simplybecauseitisagroupordecidestodobecauseitthinksthatitisagood idea. There is a very common economic justification for any group carrying out activities centrally economies of scale as is the justification for the centre’s directlyinterveningroleintheScaleconfiguration.Inotherwordsitcostslessto do something once for the group as a whole or at least for a large part of the group than for each division to do it for themselves e.g. setting up a global accountspayablecentreratherthanhavingoneineachcountryorevenseveral in many countries. If the centralisation of activity is justified on the economies ofscalebasistheappropriateshareofthetotalcostshouldbechargedtoeach benefitingbusinessunitwithinthegroup.Thetransferpricesforthiscentrally provided service should be by definition less than it would cost the business units to do it for themselves and so they should not argue about the amount theyarecharged.Yetassoonasanydiscussiononcentrallyprovidedservicesin alargegroupstartsthebusinessunitsalwayscomplainthat‘thecentre’scharges

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ThePlanningProcess 169 areexcessive’andthat‘theycoulddoitforlessthemselves’Eithertheeconomies of scale are not being realised in which case the shared services should be reviewedorthecentreisincludinginitschargescoststhatrelatetootherirrele- vantactivitiesthatthe businessunitsdonot seeasnecessaryordirectlyworth- whilei.e.theywouldnotdoitthemselvesifitwasn’tdoneforthembythecentre. Thesegroupactivitiesthatarecarriedoutbythecentreforthecentreshould befinanciallyjustifiedatthecentreandpaidfordirectlybythecentre.Including these costs in the transfer charges made to operating divisions as is done by mostlargegroupscreatesdistrustandantagonismwithinthebusinessunitsand destroysakeylinkagebetweenaccountabilityandcontrollabilitythisisdeveloped in Part Four. I accept that many groups want to recharge to their divisions all the costs incurred at the group centre for tax or fiscal reporting purposes this caneasilybedoneinthefinancialaccountingsystembutsuchnon-controllable charges from the centre must not form any part of the financial measures that are used to judge managerial performance at the divisional or business unit level. However financial transfers must be made for any services provided by the centre for the benefit of and on behalf of the divisions because without theinclusionofthesecoststheeconomicperformanceofthedivisionscannot be properly assessed. Hence critically important resource allocation decisions may be wrongly made as the supporting information could be fundamentally flawed. The complexity of this process in many large groups is illustrated by PracticalInsight6.5. PracticalInsight6.5 Separateinternalservicecentres Alargefirmofinsurancebrokershadsomeyearsagomadeaconsciousdecision to centralise the majority of its administrative services and had in fact set this up as a separate division of the group. Thus the group contained some operating divisions that were organised according to particular product areas e.g. aviation insurancemarineinsuranceetc.whileotheroperatingdivisionswereorganised according to customer groupings e.g. UK retail broking which was itself geographically segmented. All of these divisions were provided centrally with their administrative support which included accounting human resources man- agementinformationsystemsandfacilitiesmanagement. Thecostsincurredwereallocatedtotheusersviaatransferpricingmechanism. As with most businesses the charging system led to frequent and violent com- plaints from the operating divisions particularly as the services division’s costs represented around 20 per cent of group revenues. The issue came to a head as a result of one strategic planning exercise where profit improvement across the groupwasidentifiedascritical. Theseniormanagementofthecentralisedmanagementservicesdivisioncould quite easily cut their costs significantly but this would have a detrimental effect on the level of service provided to the operating divisions. Two possible areas

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170 Marketing Finance Top-downversusbottom-up Another very common issue in developing a practical planning process is the directional flow of objectives situation review and outline plans. A top-down planning process establishes goals and objectives for the business units at the corporatecentreandthetaskoftheplanningprocessistoshowhowthesetargets can be achieved. Fairly obviously in most such groups the business units all initiallycomplainthattheirtargetsareunrealisticallyhighandtheplanninground can be subjected to a great deal of ‘game playing’. There may be some ‘back pocket’ hiding of accruals and reserves that can ‘very reluctantly’ be released when‘thecentredemandsanadditional10percentprofitgrowth’.Thistop-down process is most commonly found in the Controls configuration style of group where the lack of detailed knowledge at the centre about the individual busi- nesses means that such groups tend to be managed by using a few financial performancemeasures. A bottom-up planning process initially builds the overall plan up from the lowest levels within the business units i.e. individual product sales to specified customergroups.Thisresultingplanisreviewedforacceptabilityagainstthe group’s overall objectives and required modifications are then discussed with Separateinternalservicecentres Continued identified for substantial savings were systems development but competitors werealreadyaheadinthisareaandknowntobeinvestingheavilyandamoveto cheaperofficesawayfromthemainbusinesscentres. It was clear that this support division could not make sensible strategic deci- sions in isolation of the operating divisions even though it had been set up as a separate ‘business’. Consequently its strategic planning exercise necessitated very close involvement from its ‘customers’ with respect to both the level of service that they required to achieve their own divisional objectives and the level that they could afford. This question of affordable cost meant that centralised servicesweresplitintotwotypes: 1 agroupstandarde.g.conditionsofemploymentthatwasconsideredessen- tialforalldivisionstoadheretoifthegroupimagewastobemaintained 2 discretionary levels of service that were negotiable between each division and theadmindivision. Withinthediscretionaryareastheoperatingdivisionshadtherighttooptoutif theyfelttheservicewastooexpensiveornotnecessaryfortheirtypeofbusiness. This obviously made the admin division much more customer focused with a greater emphasis on adding value to the group rather than just reducing its cost base.Indeedasaresultofthisiterativeplanningprocessthecentralisedsystems development budget was not only significantly increased but also re-focused on the areas of potential competitive advantage that the operating divisions high- lighted.

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ThePlanningProcess 171 the individual business units. If these individual discussions are to be value- adding they need to be tailored to take into account the specific situation of each business unit as opposed to a more top-down approach that would demand a uniform ‘10 per cent’ increase from everyone. This means that the corporate centre requires much more detailed information from its businesses ifitistobeabletohavemeaningfulstrategicdiscussionswitheachoneonce again this is a good justification for making the intermediate groupings i.e.divisions based around commonality of strategies and external environ- ments. Any good planning process not surprisingly contains elements of both ‘top-down’ and ‘bottom-up’ approaches a key way of assessing the group’s planningstyleisunderstandingwhichapproachisthemoredominant.However a challenge facing many large groups is that on one hand they want their cor- porate centres to become more value-adding in their interactions with the business units i.e. less of ‘do this because the centre says so’. However this requires more information at the centre and either more resources at the centre or more effort by the business units to provide the required information to the centreinareadilyusableformat.Ontheother hand mostof theselargegroups arealsodesperatelytryingtoreducethesizeoftheircorporatecentresYetagain thereisaneedtoidentifywhatactivitiesactuallyaddvalueandwhatmerelyadd cost.In manygroupstheirmultitiered organisations e.g. businessunits to areas to regions to the centre create what I refer to as a ‘civil service approach to PrimeMinister’sQuestionTime’.Thismeansthatmanagersateachlevel spend agreatdealoftimeandeffortworkingoutanswerstoquestionsthat‘mightbe asked’bythelevelabovequiteoftenregularreportsarepreparedbecauseonce on a whim the sales and marketing director asked for some type of analysis thathadn’tthenbeenprepared It is very important that all levels in the group are using consistent but not necessarily the same ways of assessing the opportunities and risks facing the businesses during the planning process. Ideally there should be a sufficient degreeoftrustandself-confidencewithinagroupthatbusinessunitmanagersare able to respond to a question from the centre that they do not know the answer becausetheydonotbelievetheyneedtoknowthattobeinfullcontroloftheir businessunfortunatelyinsomegroupsthiswouldbeapotentiallyveryhighrisk and very low return strategy However it must be emphasised that detailed competitiveplanningisprimarilydoneforthebenefitofthebusinessunitsand notforthecorporatecentrehenceitmustnotberegardedassomethingimposed onthemfromabove. Also the planning process should not be regarded as an annually occurring eventwhere foralimited period each yearavastamountof business resources aretiedupin‘completingtheplanningprocess’.Onceovertheseresourcescan thenbere-directed‘torunningthebusinessagain’withtheobviousimplication thattheplanningprocesshasnothingtodowithactuallyrunningthebusiness.

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172 Marketing Finance Toavoidthistheplanningprocessmustnotbeallowedtobecomeamechanistic centrallyprescribedbureaucraticallydrivenprocesswhereoncefinishedthe plan is filed away and not referred to again until the start of the following year’splanningprocess. Theoverlappingphasesofouranalysisplanningandcontroliterativeprocess shouldmeanthatplanningisregardedasacontinuousandessentialelementin runningthebusiness.Howtoachievethisinpracticeisdiscussedbelowafter anotherpracticalinsightillustrationofplanninginalargegroup. PracticalInsight6.6 Morethanabudget Abudgetcanbedefinedasanagreedquantifiedplandesignedtotrytoachieve an agreed set of objectives in a given short-term period which is normally one year.Logicallythebudgetshouldbe the first yearofthelonger-termstrategic plan that is the focus of this chapter. Hence the budget objectives should be completelycompatiblewiththeobjectivesofthelong-termplan. Howeverfartoooftentheshort-termbudgetobjectivessuchasthisyear’s profit target are achieved at the expense of the long-term plan objectives such as brand building or increasing customerpenetration.This is normally caused because the budget objectives do not contain any early indicators of movement towards the longer-term objectives e.g. the first steps towards brand building Atop-downapproachinpractice Although he has been heavily criticised by some commentators Lord Weinstock implemented a very focused planning process across GEC during his years in charge. Financial objectives were centrally set and tended to incorporate strong elements of management stretch the focus was on improving profit returns on investment and cash generation from year to year with a consequent risk that businesses within the group shied away from making long-term investments. All thebusinessunitssubmittedsummarisedmonthlyaccountsdirecttothecorporate centre and each general manager knew that they could expect a direct telephone call from Lord Weinstock to question any significant deviation from their plan. The corporate head office of GEC could be kept very small because the chief executive knew all the around 150 businesses well enough to have a relatively detaileddiscussiononeachone’sperformance.Thisispossiblewhenoneindividual has been largely responsible for building up the group and has been involved in thedevelopmentoracquisitionofmostbusinesseswithinthegroup. Itisofcoursemuchmorechallengingforanewtopmanagementteamcoming in from outside who will normally require much more support at the centre and more information from the business units. The business units will probably find such a dramatic change in the group’s planning processes very challenging indeed asprovedthecasewiththetransitiontoMarconi.

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ThePlanningProcess 173 maybeincreasedbrandawarenessimprovementsinpotentialcustomers’attitudes towards the brand and initial trials of the brand by new customers. If these linkages are not included it is too easy for managers when they come under short-term profit pressure to cut back on their development marketing expend- itureinordertoachievethisyear’skeyperformancemeasure. This short- and long-term conflict can still arise even if there is no initial incompatibilitybetweentherelativesetsofobjectives.Allplansandhenceall budgets are based upon a set of assumptions some of which will inevitably turnouttobewrong.Theactualcompetitiveenvironmentmayrequireamodified strategy and even a change in the long-term objectives of the business. Many sophisticated companies accept this but still regard the short-term budget once it is agreed as ‘a fixed-in-stone contract between the business unit and the centre’. If this is the case there may develop a significant conflict between achievingthesenowout-of-datefalsebudgetobjectivesandthemodifiedlong- termobjectives. This is frequently referred to as a ‘no surprises’ culture but no surprises does not mean ‘no changes’ it means no surprising changes What large groups find completely unacceptable is when a business unit continues to predict thatitwillachieve its budgeted profit and cash flow for the year until suddenly in the final 1 or 2 months it flags up a significant shortfall in performance. At this stage it is impossible for the centre to do anything about thisunder-performancebutifithadbeenforewarnedmuchearlierintheyear it may have been able to institute changes either in this business unit or else- where in the group to compensate for the performance gap. At least it would havebeenablelogicallytoconsiderthetradeoffbetweenshort-termandlong- term performanceandtomanage the expectation ofits externalshareholders. Thusno surprises means warning aboutchanges to plans as farin advanceas possible. Of course if a range of contingency plans has been developed the impact of the changed competitive environment should already have been assessed and reviewed to some extent. This makes the incorporation of such changes mucheasierbutanywaytheyareoftentakenintoaccountby‘flexingthebudget’. Mostcompaniesthatuseflexedbudgetsonlytakeaccountofchangesinsales volumes but flexing should be applied to all the uncontrollable elements of the competitive environment so that the plan reflects what would have been included if these elements had been correctly predicted. Although the elements themselves e.g. rate of inflation exchange rates etc. may be uncontrollable thebusinessshouldbeabletopredictboththeirpossiblelevelsandtheimpact ofsuchlevelsontheirstrategyandpossiblyontheirobjectives. Theproblemscausedbythefixedstaticnatureofbudgetshaveledanincreas- ing number of businesses to prepare rolling forecasts throughout the year. Thus at the end of the first quarter of the year the business re-forecasts to the end of the current year and adds in the first quarter of the following year.

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174 Marketing Finance Consequently the business is always looking a full year ahead there should alwaysbeaninitialbasisforthisrollingforecastintheexistingstrategicplan so the additional workload involved is not massive. Also if a rolling forecast process is in place the extra effort needed to produce the more formal ‘plan’ each year is much less as the business is regularly updating its look into the future and always basing it on the latest available information on the external environment. Hence a rolling forecast system is a major way of making the planning process fully integrated into the strategic management of the business asittakestheemphasisoffthe‘annualplan’. Casestudy–KnightFoods Background ‘Knight Foods’ is the European convenience foods division of a very large family-ownedfast-movingconsumergoodsgroup.Ithasbeenoneofthefastest growing divisions within the group in recent years as the two main world-wide divisionsconfectioneryandpetfoodsoperateinrelativelymatureindustries. The group uses return on total assets ROTA as the principal financial performance measure for its divisions and ROTA is measured against the target setintheplanandthatachievedinthepreviousyear.Seniormanagement within the divisions have a significant bonus linked to the relative financial performanceoftheirbusiness. Much of the future growth of Knight Foods was dependent upon the success ofexistingandpotentialresearchanddevelopmentinitiatives.Thiscasestudy tracksthedevelopmentofonesuchinitiativeovertimeandconsidershowthe successfullaunch ofthis rangeofnewproductsledtochangesinthebusiness strategyandthusitsstructure. Cannedmeatproducts Originally the division had no involvement in meat products being focused primarily on rice- and potato-based technologies. However by applying variations to existing proven group processing technologies the division had developeda new meat-processingtechnologythatshouldenablelessexpensive cutsofmeattobepresentedinanattractiveform.Themostimmediatelyobvious form of presentation to the consumer was as convenience/cooked meats e.g. canned meat pie fillings etc. A particularly attractive market opportunity was in the catering market where the existing products did not contain a guaranteed number of ‘chunks’ of meat which led to significant problems of portion control. Thus the marketing specification for the new product included a very consistently sized chunk which would enable each can to contain a specified numberofpiecesofmeat.

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ThePlanningProcess 175 Consumer research had identified reluctance to buy existing canned meat productsthatwereseentocontainlumpsoffatorgristleandchewymeat.Thus the marketing brief was to enable an advertising message of ‘no lumps of fat or gristle’ to be used for the new brand. The technology underlying the new product consisted basically of bowl chopping mixing and blending into an emulsion before extrusion into strips for cooking. The cooked strips were then chopped into chunks and canned. The emulsifying and extrusion process ensured ‘no lumps’ of fat or gristle in the product while the extrusion and slicing process ensured a consistent chunk size and provided precise control overthenumberofchunkspercan. Thesustainablecompetitiveadvantage The market opportunity was assessed as significant enough to generate super profits provided that the company could generate a high volume of sales. The financial evaluation was based on gaining share of the existing market even though it was felt likely that the improved product would also attract new consumers or regain lapsed users. It was also decided to base the financial projections on selling the new product at the same price as existing products thusplanningtopassalltheproductbenefitsontotheconsumer. A key part of the risk evaluation was that the process technology involved was not a realistic competitive advantage as once the product was launched competitors would be able to analyse the product and reverse engineer their own version quite quickly. Therefore the potential sustainable competitive advantage was in being first to market and building the brand identity that owned the ‘no lumps of fat or gristle’ positioning thus if competitors launched their ‘me too’ versions their marketing action would not only increase the sector but also reinforce Knight Foods’ existing position so that its early dominant share of this growing sector would mean their sales would continue togrow. The product development challenge was therefore quite easy to define. It was already possible to meet both aspects of the marketing brief without any sophisticated technology you simply started with prime cuts of meat trimmed off all the fat and gristle and then chopped it into regular chunks. The problem wasthereforeoneofcost i.e. producingagoodqualityproduct ata rawmater- ial cost that enabled the finished product to be sold at the same retail price as the existing product in the marketplace. A further problem was that market prices of the various cuts of meat required for the process varied significantly over time. Thus there was a need for substantial flexibility in the formulation of each product in the range to ensure that the total raw material cost objec- tives were to be achieved consistently. The product development team were set the challenge of producing product formulations that would have coped with the range of raw material input costs that had been experienced in recent

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176 Marketing Finance years while matching both the quality and cost standards set for the new proposedrange. Anothersignificantplanningriskrelatedtothecommitmentofthesignificant capital investment required for a national scale meat plant as stated earlier the division had no existing meat-based production facilities. In order to reduce this risk an evaluation was carried out to see if the major investment couldbedeferreduntilthesuccessoftheproductlaunchwasestablished.This couldmosteasilyhavebeenachievedbyinitiallylaunchinginarelativelysmall test market getting consumer feedback and if successful launching nationally once the new national plant had been constructed. Unfortunately this would have provided competitors with a wonderful opportunity to develop and launch their own improved products at almost the same time potentially destroying thekeybrandingadvantage. Therefore the initial launch had to be on a national basis but it could be done with a limited product set from within the full planned range. A very labour- intensive scaled up pilot plant was used to manufacture the initial volumes requiredforthelaunch.Thisresultedinveryhighvariableproductcostsinitially which meant that early sales volumes generated virtually no contribution. Howeverforgoingthiscontributionmeansthatthecapitalinvestmentcouldbe deferreduntilthesuccessoftheinitiallaunchhadbeenevaluated.Thelonger- termfinancialevaluationwasobviouslydoneusingthevariablecoststructure predictedoncethenewnationalmeatplanthadbeencompleted. Post-launchdevelopment The new products were successfully launched and the national plant was constructed on the same site as the existing businessbut it was established as aseparatebusinessdivision.Thiswasdonetocreatefocuswithinitsmanage- ment team on the existing new meat products and some other potentially excitingrelatedtechnologiesthatwereunderdevelopment. However the new business was not totally self-sufficient as it relied upon certainsharedservicessuchassteamgenerationeffluenttreatmentsitesecurity and general administration including payroll etc.. It also utilised the existing Knight Foods’ national sales force and distribution network although it had its own brand marketing team. There was obviously a need to establish a transferpricingsystembetweenthetwoinvestmentcentresfortheseservices. The first principle is that it should make economic sense for both parties to continue to work together in these areas i.e. if the new meat division could have provided its own services for less than it was being charged then it should have gone off and done so. However the meat division’s sales were expected to grow very rapidly as it gained market share and launched new variantsunderthenewlyestablishedbrandumbrella.Thismadeforecastingits demand levels particularly for highly volume-sensitive items like steam and

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ThePlanningProcess 177 effluent treatment very difficult a key question was who should pay for the meat division’s forecasting inaccuracies The logical answer was clearly the meatdivisionbutthescaleoftheproblemcouldbeminimisedoncethenature ofthecostsincurredwasanalysed. Thecostsforraisingsteamorprocessingeffluentcanbeclearlybrokeninto a fixed element and a variable per unit element. The fixed cost levels are determined by the way in which such facilities are set up to run e.g. running them 24 hours per day 7 days a week or 16 hours per day 5 days a week. Once this decision is taken and the size of the facility has been established these costs should not change significantly during the year. Thus the meat division could establish its planned requirements and should receive an appropriate annual fixed cost recharge. The expected volatility would be caused by the actual volumes of product produced by the meat division and the corresponding volumes of steam used and effluent produced. However suchaserviceprovidershouldbeabletocalculatea‘planned’variablecharge per unit given that their fixed costs had already been taken into account. The meatdivisionwouldthenpaythisvariablechargeperunitforalltheunitsthat it actually used. Any inefficiencies in the provision of the service by the providingbusinessunitwerebornebyitastheywereclearlyoutsidethecontrol of the new meat division. This transfer pricing system needed to be covered by a service level agreement SLA between the two divisions so that both divisions were absolutely clear about their responsibilities in this area. As stated before nosensible organisation wouldenter intosuch a deal with a third partywithoutsuchanSLAbutmanybusinessesstilldosowhendealingwith otherbusinesseswithintheirowngroupsitnearlyalwaysendsintears Resolving the sales force charge used slightly different logic the distribu- tioncostingproblemsareconsideredinChapters9and10.Themeatdivision generalmanagerwantedtoensurethatthesalesforcewereproperlymotivated to get distribution for his new and expanding range of products. If they only received a small contribution per unit sold he was concerned that they might prefertospendtheirtimesellingKnightFoods’othermoreestablishedproducts. AstheywerepartoftheKnightFoods’organisationtheyeffectively‘received credit’ for all of the contribution generated from these sales. However if the salesforceweregiventoohighacontributionrateonmeatsalestheperform- ance of the meat division would itself look very poor. The General Manager had initially assumed not surprisingly that the two divisions had to share the availabletotalcontributionbetweenthem. However in the case of motivating and assessing managerial rather than economicperformancethisdoesnothavetobethecase.Asfarasthegroupis concernedtheproductionandsaleofmeatproductshavearbitrarilybeensplit betweentwodivisionsifthissplitadverselyaffectsthebehaviourofeitheror both parties the group will suffer. Therefore the group’s interests are served by having the sales force focus its resources on those products that will

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178 Marketing Finance generatethegreatestlong-termbenefitforthegroup.Thisismosteasilydeter- minedifthecomparativeprofitcontributionsonalltheproductstobesoldby the sales force are calculated on the same basis. Hence the Knight Foods’ sales force was creditedwiththe full contributionfromthemeatsales theyachieved whilethemeatdivisionwasalsocreditedwiththesamefullcontribution.The importantthingaboutmanagementinformationisthatitshouldberelevantand useful not that it necessarily adds up The meat division was also charged with the equivalent cost of the sales resources that were occupied developing itsbusinesssothatitseconomicperformanceassessmentandfuturedecision- makingwerenotdistorted. Theseresourceallocationdecisionsaresoimportanttotheplanningprocess that they form the focus of the next chapter before in the remaining chapters ofPartThreeweconsiderindepththethreemaintypesofmarketingstrategy namelybrand-basedcustomer-ledandproduct-basedstrategies.

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7 StrategicInvestmentEvaluation andControl Overview Strategicinvestmentdecisionsoftenareone-offopportunitiesthathaveavery wide range of alternative potential outcomes and may depend on a sequence ofsuccessfuloutcomestoearlierstagesinthetotalinvestmentprogramme. The payback method of evaluation is a good indicator of the risk involved in an investment opportunity particularly if expressed as a proportion of the expectedeconomiclifeoftheproject.Thediscountedpaybackcalculationallows forthetimevalueofmoneybyapplyinganegativeinterestratetofuturecash flowstobringthemtotheirequivalentpresentvalues. Thisisalsodoneinthefulldiscountedcashflowtechniquebutthediscount factorsareappliedtoallthefuturecashflows.Inthenetpresentvaluemethod a criterion rate of discount is selected and applied to all the cash flows so that a net present value is computed the higher a positive net present value is the morefinanciallyattractiveistheproject.Ifthecriterionrateisveryclosetothe shareholders’requiredrateofreturnthenetpresentvalueisaverygoodindi- catoroftheshareholdervaluecreationpotentialoftheinvestmentopportunity. TheinternalrateofreturnIRRmethodappliesalternativeratesofdiscount to all the expected cash flows until one is found that generates a net present value of zero this discount rate is the project’s IRR. Although it is very populartheIRRdoeshaveseveralflawsandproblemswiththeresultthatthe net present value method is to be preferred. The net present value can be turned into a percentage or ratio by dividing it by the value of the original investmentthisiscalledtheprofitabilityindex.Theprofitabilityindexcanbe used to rank possible alternative investments if companies wish to maximise thenetpresentvaluegeneratedfromanyfinitecapitalinvestmentbudgetapro- cessknownascapitalrationing. Thewiderangeofpotentialoutcomesandsequencedstagesofmanystrategic investment decisions mean that the use of probability estimates can be very useful.Theprobabilitiesofsuccessofeachstageareassessedandthesecanbe used to compute the cumulative probability of the ultimate cash inflows. This process takes account of the specific project risks so that these probability adjusted cash flows can be discounted using the company’s cost of capital.

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180 Marketing Finance If the ‘success’-based cash flows are used a much higher discount rate must be applied to take into account the risks involved in the project. Applying a veryhighdiscountratecreatessomeproblemsbecauseitcanheavilydiscount some relatively certain cash outflows in the early years of the investment project. Manystrategicinvestmentprojectscanalsobeviewedascontainingoptions which can themselves be significantly valuable. These real options have the same value drivers as the more familiar financial options but the practical application of the sophisticated option valuation models requires sound common sense if the value of any flexibility is to be accurately reflected. The use of real option valuations is particularly relevant in phased high-risk strategic investments that have very low or even negative net present values under normaldiscountedcashflowtechniques.Thevalueoftheoptioncanfre- quently more than outweigh the negative net present value of the underlying cashflows. Introduction In the previous chapter the main focus of the planning process was high- lightedas‘makingchoicesamongtheavailablestrategicalternatives’i.e.making strategic investment decisions. Not surprisingly therefore this chapter exam- ineshowsuchimportantdecisionsshouldbemade. A strategic investment decision is any long-term expenditure that is specif- ically aimed at achievingthe key strategic objectives of the organisation.Thus they are not restricted to the traditional view of capital expenditure appraisal processes which normally focus exclusively on expenditure relating to the acquisition or development of tangible fixed assets. Indeed in most organisa- tions the really important strategic investment decisions try to develop a sus- tainable competitive advantage from which the company can generate super profitsandconsequentlycreateshareholdervalue. This means that strategic investment decisions can involve expenditure on anyofthefollowing: • Branddevelopment • Newmarketentriesnewsegmentsandnewcustomergroups • Customerrelationshipdevelopment • Productinnovationanddevelopment • Researchanddevelopment • Salesanddistributiondevelopment • Newchanneldevelopment • Acquisitionsjointventuresandstrategicalliances • Businessprocessre-engineeringprogrammes • Informationsystemsandtechnology

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StrategicInvestmentEvaluationandControl 181 Aspreviouslystateditisthepurposeoftheexpenditurethatisimportantand nothowitistreatedforfinancialaccountingpurposes. As with any long-term expenditure strategic investment decisions should be subjected to a very rigorous financial evaluation prior to approval and an appropriatefinancialreviewandcontrolprocessduringthecommitmentperiod. Thus as discussed slightly later in this chapter all the normal capital project evaluationtechniquescanbeappliedbutcertainmodificationsmaybeappro- priateduetothespecificcharacteristicsofstrategicinvestmentdecisions. Thereareseveralcharacteristicsofmanystrategicinvestmentdecisionsthat distinguish them from the more common operational investment decisions thatmanagersfaceonaregularbasis.Thusstrategicinvestmentdecisionsoften are one-off opportunitiesthat consequently require specifically tailored finan- cial evaluations. These financial evaluations require forecasts of future sales revenues and costs as for all long-term decisions but these forecasts should be based on the specifically appropriate set of assumptions that are relevant forthisparticularstrategicdecision.Furtherthepotentialalternativeoutcomes of such strategicinvestmentdecisions frequentlyhave a very wide rangee.g. fromstrongsuccesstocompleteandtotalfailureandlong-termultimatesuccess maydependonasequenceofsuccessfuloutcomestoearlierstagesinthetotal investmentprogramme. Theuniqueness ofmost strategic investment decisions makes itmost desir- able that they can be predicted sufficiently far in advance so that the required evaluationcanbecollectedordeveloped.Theidentificationofthemostlikely future strategic investment decisions that the organisation will face is made much easier if the key value-added processes within the business have been identified as discussed in Chapter 3. For many companies the failure to do thismeansthattheirmostcriticalstrategicdecisionshavetobemadewiththe leastsupportinganalysisofanydecisiontakenbythecompany.Unfortunately it is still the case that most ongoing decision-support processes are based aroundthemuchmorepredictablebutmuchlessvaluecreatingroutineoper- ationaldecisionsthatbusinessesregularlyface. All long-term investment evaluation techniques are trying to compare the future expected returns from current expenditures where the decisions differ as to the size and timing of both the investment and the expected returns the relative certainty i.e. the risk profile of the investment of these expected returns and the overall economic life of the project. It should be remembered that all financially based decisions must be evaluated using only the future cash flows that are directly associated with that decision i.e. sunk costs that have already been incurred must be ignored in the financial evaluation. The principal methods of financially evaluating capital projects are based on this fundamentalpremiseandtheseareeachbrieflyexplainedandthenputintothe context of strategic investment decisions where the potential source of share- holder value creation is some form of intangible asset. However for reasons

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182 Marketing Finance of pressure of space in this chapter the initial illustrations have deliberately beenkeptverybriefandthemajorin-depthexamplesaregivenasusualinthe extendedcasestudyattheendofthechapter. Paybackperiod Thepaybackmethodoffinancialevaluationcalculateshowlongitisexpected totaketorecovertheoriginalinvestmentmadeintheprojecti.e.incashflow terms when the cumulative cash inflows equal the cash outflows required for the investment. The calculation is shown in Figure 7.1. The shorter the time neededtopaybacktheinvestmentthebettertheinvestmentlooksatfirstsight to the businessso thatin both Figures 7.1 and 7.2 projectA payback period of2yearslooksbetterthanprojectBpaybackperiodof2.5and3years. The advantages of the payback calculation are that it is very simple to cal- culate and it does to some degree take the timing of cash flows into account. Thus a large cash inflow in Year 1 will probably result in a shorter payback than if this cash inflow was deferred until Year 3. However the main advan- tage and thus focus of the calculation is that it highlights the risk associated with an investment i.e. the longer the time taken to recover the initial invest- ment the greater the risk associated with the investment. Unfortunately in its simplest form the payback technique does not allow projects to be ranked by theirtruerelativeriskprofiles.ThisisillustratedbylookingatFigures7.1and 7.2inslightlymoredepth. In Figure 7.1 project B has a slightly longer payback than project A but it has a much morestable expectedannualcashinflowwhichactuallyindicates a lower level of risk unless somehow A’s very volatile remember that vola- tility is our key indicator of risk expected cash inflows can really be very accurately predicted Figure 7.2 illustrates an even more common issue in Year Comparing two projects: both require an initial investment of £1 million but cash inflows differ Project A B 0 investment £1m £1m 1 inflows £1 00 000 £4 00 000 2 ” £9 00 000 £4 00 000 3 ” £ 50 000 £4 00 000 4 ” £7 00 000 £4 00 000 5 ” £2 00 000 £4 00 000 Payback period 2.0 years 2.5 years i.e. time to break even Figure7.1 Paybackperiod

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StrategicInvestmentEvaluationandControl 183 strategic investment decisions because although project B has a longer pay- back period it is expected to continue to generate financial returns for 10 yearswhileprojectAispredictedtoendafteronly4years. Thepredictionoftheeconomiclivesoflong-terminvestmentsisclearlynot onlyvitallyimportanttotheirvalidfinancialevaluationbutalsoverydifficult in many cases. One simple way of making the payback technique much more relevant to assessing the true risk profile of strategic investment decisions is thereforetoexpressthepaybackperiodintermsoftheexpectedeconomiclife of the investment. As shown in Figure 7.2 if only 30 per cent of the project’s expected life is used up to recover the initial investment the risk profile is lower than when 50 per cent of a relatively short expected economic life is needed to do this. For short economic life projects this revision to the simple payback calculation is particularly valuable encouragingly some companies arenowusingthismethodasakeyriskindicatorfortheirstrategicinvestment decisions. Howeverthepaybackmethodcanneverbethesoledecisioncriteriabecause itdoesnottakefullaccountofanycashinflowsthatareexpectedtobereceived after the initial investment has been recovered. It is also very difficult to set a maximum payback period or even a maximum proportion of economic life beforepaybackmustbeachievedformostrealstrategicinvestmentdecisions that involve developing a sustainable competitive advantage. This is possible formanyotherinvestmentprojectssuchascost-reducinglabour-savingactiv- ities but becomes more problematic when the investment requires ongoing expendituresoverseveralyearsbeforeanysizeablecashinflowsaregenerated such as is often the case with developing new brands entering major new marketsorlaunchingcompletelynewproducts. Another problem of the simple payback calculation is that it does not adequately reflect the importance of the expected timing of the cash flows becauseinFigure7.1theexpected£400000cashinflowsinYears2and3for Project A B Payback period 2 years 3 years Prefer project A on payback period alone However: expected economic 4 years 10 years life of project Proportion of expected life required to payback original investment 50 30 Figure7.2 Payback

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184 Marketing Finance project B are both seen as worth the same as that expected in Year 1. This problemcanbereadilysolvedbyusingthediscountedpaybacktechnique. Discountedpayback It is very clear that the passage of time affects the value of money and any long-term decisions that include spending funds now in the anticipation of receiving benefits in future years cannot be properly evaluated without taking into consideration this impact of the decreasing value of money with time. Thus the £400000 cash inflows expected in Years 2 and 3 for project B in Figure 7.1 are not worth the same as that expected in Year 1 because of the time delayinreceiving.It is quite possible to calculate how much each year’s delay ‘costs’ by applying a compound interest rate to the earliest sum to be received. If the £400000 received in Year 1 was invested at a 5 per cent p.a. interest rate it would have grown to £420000 in Year 2 and to £441000 in Year3thereducingpurchasingpowerofmoneyduetoinflationclearlyshows that money received sooner is more valuable than later. This simple value of money impact can still have quite dramatic impacts on investment evalu- ations even in a period of relatively low inflation and correspondingly low interestrates. However the time gap between making an investment and receiving the returns from it can also affect the risk perception of the investor as a longer timedelaymeansthatmorethingsmaychangeandpotentiallygowrong.This is reflected in financial markets by what is described as an ‘upward sloping yield curve’ over time this simply means that normally investors require a higher rate of interest for holding a long-term investment than they do for holdingashort-termone.Thismeansthatinvestorsrequiretobecompensated formorethantheinflation-basedlossofpurchasingpowerovertime. The discounted payback version of the technique acknowledges the true valueofthetimingofcashflowsbyapplyingadiscountfactori.e.anegative compound interest rate to all the future expected cash flows. Thus all future cash flows are translated into their equivalent present values so that they become directly comparable. This means that the adjusted present values can be meaningfully added together. The simplest analogy is probably to think about trying to add up financial values expressed in several different curren- ciessuchasUSdollarseurosyenand£’ssterling.Theoriginalanswertothe calculation would be meaningless but if all the separate currencies are converted to a single base they can then be added together. It doesn’t really matter which common currency base is used but being British I would auto- matically convert currencies into £’s sterling as this would make the resulting value more meaningful to me. Similarly the cash flows from different time periods could be converted into any common period but it is most logical to convert the future expected inflows back to today’s present equivalent value

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StrategicInvestmentEvaluationandControl 185 as this is both most readily understood by managers and also directly com- parable to the proposed investment outflows. The actual mechanics of the discounting process are illustrated in Figure 7.3 where the cash flows for the projects A and B of Figure 7.1 are discounted to their present values using a discount rate of 10 per cent per year. The basis for selecting the rate of dis- countisdiscussedinthenextsectionofthechapter. Not surprisingly the discounted paybacks for both projects A and B in Figures 7.1 and 7.3 are increased to over 3 years as the present values of the later cash inflows are reduced. However the decision ranking from using the discountedpaybacktechniqueisstillthesametheshorterthepaybackperiod thebetter.Whiletheintroductionofdiscountingremovesonemajorobjection to the simple payback calculation the technique still suffers from the other disadvantageasittakesnoaccountofanycashflowsthatoccursubsequentto breaking even in cash terms. This disadvantage can be removed by using the fulldiscountedcashflowtechnique. Discountedcashflows This concept adjusts all the cash flows expected to result from a strategic investmentdecisiontotheirpresentvaluesbyapplyinganappropriatediscount factortoallfutureitems.ThiscalculationisalsoshowninFigure7.3andshows netpresentvaluesof£474100forprojectAand£516000forprojectBwhen a discount rate of 10 per cent is applied. Under this method a criterion rate of discount is selected and applied to all cash flows appropriately so as to give a presentvalueforallitems.Thenetresultofthesecashoutflowsandinflows is called the net present value of the investment the higher the positive net presentvaluethebetter. The criterion rate of discount that is used should reflect the risk associated withtheproposedinvestmentsothatmanycompaniesusetheirshareholders’ Year Discount Gross Present cash flow 0 1 1 90.9 2 743.4 350 37.5 4 5 Project B Project A Break even period Net present value 3.27 years 3.02 years 1000 248.4 273.2 300.4 330.4 361.6 1000 1000 1000 Gross Present +516.0 value 400 400 400 400 400 124.2 478.1 value 100 900 700 200 0.621 0.683 0.751 0.826 0.909 factor cash flow +474.1 £000’s Figure7.3 Usingsameprojectsbutintroducingtimevalueofmoney10

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186 Marketing Finance required rate of return i.e. their cost of equity capital discussed in Chapter 1 as their normal discount rate. One major advantage of using the shareholders’ requiredrateofreturnasthediscountrateisthedirectlinkagethatisachieved toshareholdervalue.Anypositivenetpresentvalueforaproposedinvestment indicates that the expected cash inflows if achieved would be shareholder valueenhancing.Asthisisthemainfinancialobjectiveofcommerciallymotiv- ated organisations the net present value version of the discounted cash flow techniqueisverywidelyused. There are some differences in the way companies implement the technique relating to the cash flows that are used and the resulting discount rate that is applied.Withoutgettingtooboggeddowninthetechnicalitiescompaniescan discountthenetcashflowsresultingfromtheprojectafterdeductingtheimpact of any debt-based financing used by the company’s equity cost of capital. Alternativelytheoverallcashflowsbeforetakingaccountofthesedebt-based fundingimpactscanbediscountedatthecompany’sweightedaveragecostof capital. The weighted average cost of capital takes account of the required returnsonbothequitycapitalanddebtfundingandtheproportionofeachthat isusedbytheorganisation. It is often argued that the criterion rate of discount should take account of the specific risk of the particular activity being undertaken. This means that while the company’s cost of capital can be used as a starting point the actual discount rate applied may be increased or decreased to adjust for specific risk issues.Therearestrongargumentsfornotusingdiscountratesthataremateri- ally different to the cost of capital and it can be preferable to allow for the investment’s specific risks by adjusting the project’s expected cash flows as isexplainedlaterinthechapter.Theseargumentsarebasedontheactualcom- putational basis used in the discounting calculation and also apply to the alternativefulldiscountedcashflowtechniquetheinternalrateofreturn. Theinternalrateofreturnmethodappliesalternativeratesofdiscounttoallthe expectedcashflowsinflowsandoutflowsuntiladiscountrateisusedthatcauses theinvestment’sdiscountedcashflowstobreakeveni.e.thenetpresentvalueis zero. This break even discount rate is called the internal rate of return of the projectthehighertheinternalrateofreturnthebetter.Thebasisofthetechnique isillustratedinFigure7.4wherea20percentdiscountratestillgivesapositive net present value for the cash flows of project B from Figure 7.3. However a 30percentdiscountrategivesasmallnegativenetpresentvaluethebreakeven ratemustconsequentlybebetweenthetworatesandlinearinterpolationormore computer-basedcalculationstellsusthattheinternalrateofreturnIRRisat 28.8 per cent. This IRR is then normally compared to the company’s required rateofreturnagainshareholdervalueshouldbecreatediftheIRRexpectedfrom theinvestmentisgreaterthanthecompany’scostofcapitalforthislevelofrisk. IRR is becoming increasingly popular as the basis of evaluating strategic investment decisions and research questionnaires and anecdotal evidence

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StrategicInvestmentEvaluationandControl 187 indicate that this is primarily because it generates its answer as a percentage while the net present value is an absolute number. This can be easily under- stood as we all tend to think of financial returns in terms of percentages e.g. the cost of capital the rate of interest the return on investment. However it is somewhat worrying as the IRR technique does have conceptual flaws to do with its actual computation. One flaw is relatively minor in that each time the annual cash flows expected from the investment change signs the computa- tion can produce an additional answer i.e. two IRRs are calculated this can happen quite frequently such as if another burst of development expenditure is needed in Year 2 or 3 or if the capacity of the investment is planned to be increased significantly following a successful launch. It is actually normally quite easy in practice to identify which of these multisolutions is the relevant oneandwhichcanbeignored. Thesecondflawismorefundamentalasitcanmake thesolutiongenerated aninaccuratereflectionofthetrueexpectedshareholdervalue-creationpoten- tialoftheinvestment.Thecomputationappliesthesameoftenhighdiscount ratetoallthecashflowsinvolvedinthestrategicinvestmentopportunity.This can mean that expenditures that will take place in Years 1 2 and 3 say may be discounted by a high-rate IRR so thatthey are included in the computation at significantly lower present values yet these expenditures will definitely takeplaceastheyarethebasisoftheexpectedmuchlesscertainfuturereturns. Equally in most strategic investment decisions the ultimate generation of highsustainablecashinflowsisdependentonaseriesofearlierstepsthathave tobesuccessfullycompletedfirst.Itisnotlogicaltoapplyveryhighdiscount ratestotheseearlieractivitiessimplybecausetheoverallriskoftheinvestment is high this is the reason for not wanting to increase the criterion discount Discount rate 30 Year Cash flows Factor P.V. Factor 0 1000 1 1000 1 1000 1 400 0.833 333.2 0.769 307.6 2 400 0.694 277.6 0.592 236.8 3 400 0.579 231.6 0.455 182.0 4 400 0.482 192.8 0.350 140.0 5 400 0.402 160.8 0.269 107.6 +196.0 –26.0 Discount rate 20 Break even point 222 The overall break even for the project is given by the discount rate which results in an NPV of 0 For project B £000’s 28.8 i.e. IRR for project B 20 + 196.0 × 30–20 using linear interpolation Net present value P.V. Figure7.4 Numericalexampleofinternalrateofreturncalculation

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188 Marketing Finance rate when using NPVs dramatically away from the company’s cost of cap- ital.Thisisillustratedinthecalculationsusedslightlylaterinthechapter. AfurtherproblemoftheIRRcalculationisparticularlyimportantformany long-term marketing-led strategic investments where the cash inflows if the investment is successful may continue for many years but will take several yearstobecomesignificantlypositive.TheIRRcalculationgivesmuchhigher relative results for shorter-term investments that became cash positive in the earlyyearsoftheprojectthisisagainduetotheapplicationofthe‘high’break- even rate of discount that is applied to all the cash flows. This excessively decreases the impact of long-term cash inflows from successful brands new marketentriesandnewproductlaunches. Another significant problem of the IRR technique is that it does not lead to the optimal allocation of resources when businesses are capital rationed. The theoryoffinancesaysthatcompaniesshouldundertakeallinvestmentswhere the expected return is greater than the required return as this will maximise shareholdervalue.Howevermostorganisationshavelimitedresourcesinterms ofcapitalandmanagementetc.sothatanimportantelementoftheirplanning and investment processes is to ensure that they undertake the most attractive availableopportunities.Infinancialtermsthismeansmaximisingthenetpresent valuethatcanbeachievedfromtheavailableinvestmentfundsunfortunately this is not necessarily achieved by investing in the projects that generate the highestIRRs. Howeverifthenetpresentvalueofeachstrategicinvestmentisdividedby the investment required to undertake the project this does provide a ranking criterion that will maximise the shareholder value generated from available investment resources. The resulting profitability index which is shown in Figure 7.5 highlights the proportionate super profits potential of each avail- able investment in other words how much shareholder value should be gen- erated for each £ million invested. In Figure 7.5 project A would be preferred Note: Profitability index is simply the net present value divided by the original investment and expressed as a percentage or a number. A few companies use the average investment rather than the original investment Project A B Net present value + £10 m +£1 m Original investment £100 m £1 m Profitability index 10 100 Figure7.5 Profitabilityindex

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StrategicInvestmentEvaluationandControl 189 to B on the basis of net present value alone £10 million compared to £1 million but project A ties up £100 million of investment funds in order to generate its £10 million NPV. In a world of unlimited access to capital the company should do both A and B but B should be higher up the invest- mentpriorityrankingduetoitsmuchbetterprofitabilityindex.Thereforethe preferablenetpresentvalueversionofdiscountedcashflowcanbeturnedinto a percentage measure of shareholder value creation without introducing the conceptualflawsofIRR. Accountingreturnoninvestment Anothercommoninvestmentevaluationtechniqueistheaccountingreturnon investment ROI calculation. The calculation compares the average annual profitexpectedtobemadebytheprojectwiththeaveragevalueoftheinvest- ment normally the net book value of the assets employed over its economic life. The major focus of the ROI technique is to compare this average ROI achieved by the investment over its economic life with either the current ROI achieved by the company or its target rate of return. The logic is that if the company only invests in projects that beat the target ROI then the company mustintimealsobeatitstargetunfortunatelysuchlogicwhenbasedonaver- ageratesofreturnisveryoversimplistic. Thetechniqueisagainapparentlyverypopularbecauseitproducesafinan- cialresultthatis expressed in a percentage format and this percentage can be easily compared to the most common financial measure of performance used bybusinessesi.e.actualROI.Howeversuchanannualisedprojectedperform- ancemeasuredoesnotenablemanagerstochooseamongalternativeinvestment opportunities would you prefer an investment that is expected to generate an average30percentROIfor5yearsoronethatshoulddeliver25percentROI for8years A relatively simple adjustment to the calculation makes the comparison of relative ROIs more meaningful and helps to rank competing projects more appropriately. The accounting ROI in a specified year of the project say Year5iscomparedtothecompany’srequiredROI.Thismodificationremoves alltheproblemsassociatedwithcalculatingaveragesandsetsa‘comparable’ standardforwhenallnewprojectsshouldbegeneratingvalue-addingreturns i.e. it tries to introduce some assessment of risk. However it still penalises long-life investments if the same specified year of evaluation is used for all projects. A better modification is therefore similar to the change proposed to the payback technique where a maximum proportion e.g. half of the invest- ment’s economic life is allowed before the project is required to achieve the company’srequiredaccountingrateofreturn. Even after this adjustment there are still problems associated with using accounting ROI as a basis for evaluating strategic investment decisions. The

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190 Marketing Finance main one is that the whole technique is obviously based around accounting measures rather than the more objective cash flows required for net present values and discounted paybacks. This means that the results of the evaluation are affected by the accounting treatment applied to the expenditures incurred and inflowsgeneratedbytheinvestmentopportunity.Forexampleifmarket- ing development expenditure is capitalised as an asset on the organisation’s balance sheet rather than being expensed as it is incurred the resulting accounting ROI would be significantly altered. This is self apparently nonsensical as the same amount of money has been spent to try to achieve exactlythesameobjectiveshencethefinancialevaluationshouldgeneratethe sameresult Apersonalapproachtostrategicinvestmentevaluation Normally an organisation will be attempting to rank or grade a diverse range of investment opportunities so as to decide how it will invest its available funds. Due to the diversity in timescale size scope and nature of these possibleinvestmentsitisnormallysensibletouseacombinationofmeasures ifthemostappropriatechoicesaretobeselected.Overmanyyearsofinvolve- ment in such processes I have developed a personal set of criteria that I use forthispurpose. Themostimportantcriterianotsurprisinglyfromwhathaspreviouslybeen written in this chapter are the profitability index of the investments and the netpresentvaluemethodofdiscountedcashflows.Anotherusefulandimport- ant measure of risk is the discounted payback calculation but in addition I include the maximum cumulative cash outflow required by the investment thismeasuresthemaximumdownsidethattheorganisationisbecomingexposed to if the project goes wrong at the worst possible time. It indicates whether theinvestmentis‘affordable’intermsofnotrunningtheriskofeitherdragging the whole company down or at least forcing the deferral or cancellation of othervalue-addingopportunities. In addition I prefer to prepare the cash flow projections using the most appropriatefinancingpackageforthespecificinvestmentopportunityandthen use a discount rate based on the company’s cost of equity capital. This means that if the investment involves the acquisition of major re-saleable tangible assets such as freehold land and buildings a significant proportion of debt financing may be utilised. However if the investment is primarily on brand marketing expenditure this should be financed exclusively with equity. Thus Ido not like to use the weighted average cost of capital averaging concept as Ihaveyettocomeacrossan‘average’strategicinvestmentopportunity. Anotherimportantelementintherankingprocessistounderstandtheexist- ing portfolio of investments within the organisation. If the business currently consists primarily of very mature products that have no significant growth prospectslong-term investmentsthatdoprovide strong growthpotentialmay

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StrategicInvestmentEvaluationandControl 191 be more highly attractive than another short-term investment with similar financialreturns. Practicalimplementationissues There are a number of practical issues that have to be addressed in applying these capital project evaluation techniques to strategic investment decisions. Themostimportantoftheseisensuringthattheinvestmentwillifsuccessful increaseshareholdervalueandthisbringsusbacktotheissueofselectingthe appropriatediscountrateandtechnique. One issue that regularly causes problems for many organisations is how to take account of inflation in these long-term financial evaluations. The basic solution is very simple as is shown in Figure 7.6. There are two ways of preparing future cash flows and two ways of setting a discount rate and it is essential that a consistent approach is adopted in both areas. Future cash flows can either be forecasted including a prediction of future inflation or they can be done in real terms i.e. excluding inflation. This does not mean that all future cash forecasts are based on today’s levels because the fore- castsshouldshowanyexpectedrelativechangesintheserealvalues.Inother words if labour or other significant costs are expected to increase in future inrealtermsthischangeshouldbeincludedandanassessmentthenhastobe made as to whether selling prices are expected to be increased in line with future inflation or faster than inflation so as to maintain contribution margins in real terms. Similarly discount rates can be calculated to include expected inflation or at the real required return rate that excludes predicted inflation. Real Nominal Real Nominal Discount rates Future cash flows i.e. inc inflation Figure7.6 Implementationissues:impactofinflationonDCFanalysis

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192 Marketing Finance What is clearly unacceptable is to build inflation into future cash flows and thendiscountthoseinflatedcashflowsatarealnon-inflationrelateddiscount rate. Future investments will all tend to look ridiculously attractive while converselyifinflationisexcludedfromthecashflowforecastsbutincludedin the discount rate applied the business will find it impossible to financially justify any new investments. If inflation is allowed for in the cash flow fore- casts a compatible rate of inflation should be included in the discount rate anditisthisneedforcompatibilitythatiscurrentlycausingproblemsinmany organisations. Most businesses in the developed countries have now got used to the rela- tivelylowinflationratesthathavepersistedforseveralyearsintermsofonly incorporatingverylowinflationintotheirnewcashflowforecasts.Forexample the normal rate of inflation used for strategic investment decision forecasting in the UK is at the time of writing 2.0 per cent to 2.5 per cent p.a. which is exactly in line with the inflation target set for the British Central Bank by the UK’sgovernment.Howeveralargenumberofthesesamecompaniesarethen discountingthesecashflowprojectionsbydoubledigitdiscountratese.g.10 per cent to 12 per cent p.a. this automatically implies that they are looking for an 8 per cent or even 10 per cent real rate of return on their new strategic investments This is far higher than these organisations have ever achieved in thepast Other companies use a real discount rate rather than the nominal one that includes inflation and inflation-exclusive cash projections on the logic that this makes it unnecessary to forecast future inflation. Unfortunately it is still necessarytoforecasttherelativenetimpactofinflationonthecashprojections as otherwise the totally unrealistic assumption is implicitly included that all future cash flows are index linked i.e. are unaffected by future inflation. I personally find it much easier to do all discounted cash flow calculations usingnominalprojectionsandanominaldiscountrateensuringthatthesame rateofinflationthatisincludedinthecashflowprojectionsisalsoincludedin thediscountrate. Thisdiscountrateisasalreadydiscussedbasedontheshareholders’required rate ofreturnbutas shownin Figure 7.7this cost ofcapital is determinedby the company’s existing risk profile. All strategic investment projects have their own risk profiles and therefore have their own required rates of return. This means that a low-risk project like project A in Figure 7.7 would create shareholder value because it is above the project risk/return line even though it generates a rate of return that is less than the company’s existing cost of capital.Thetheoreticalargumentisthatifthecompanyundertooksuchalow- risk project it’s more predictable cash flow returns would over time reduce theoverallriskprofileofthetotalcompany.HoweverIknowmanychiefexecu- tives and chief financial officers who are not prepared to wait for this reduc- tion in their risk profile which would be seen in a lower beta factor being

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StrategicInvestmentEvaluationandControl 193 appliedtotheircompanybecausetheybelievethatinvestorswouldbeimme- diately upset at the lower rate of return being generated by the new invest- ment. Therefore these companies often set the minimum required rate of return often referred to as ‘the hurdle rate’ at or even slightly above their currentcostofcapitalasshowninFigure7.8. Unless these companies implement the kinked return line shown in Figure 7.8 they will find project B from Figure 7.7 financially attractive. Although project B generates a projected return that is greater than the company’s current cost of capital it also has a higher project risk than the company’s current risk profile. From Figure 7.7 it can be seen that it would indeed be shareholdervaluedestroying.Iforganisationswanttoensurethatprojectslike ‘B’ are rejected they can insist on increasing rates of return for all projects Project risk Project risk/return line B A Company cost of capital Project expected return Company risk profile Figure7.7 Implementationissues:projectriskandreturn Project risk Minimum return Increasing return Company risk profile Company cost of capital Project expected return Figure7.8 Minimumreinvestmentreturnrequirements

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194 Marketing Finance withhigherriskprofilesi.e.byassessingtheprojectbetafactorsthanthatof the overall company hence the common ‘kinked’ hurdle rate requirement for strategicinvestmentdecisions. Unfortunately this process tends to introduce a skewed distribution into the portfolio of strategic investment decisions that gain financial approval. The shaded segment area in Figure 7.8 shows low-risk investment opportunities thatwillberejectedbecauseofthecompanycostofcapitalminimumrequired rate of return. Unless this company identifies some high-return but low-risk investmentsmostofitsnewinvestmentswillhaveriskprofilesthataregreater thanthecompany’scurrentriskleveli.e.theywillbeabovetheupwardslop- ing portion of the line as it is very unlikely that many projects can be found thatfitabovethehorizontalportionofthiskinkedrisk/returnline.Thisresults inevitably in the company’s risk profile increasing over time which is not necessarilyabadthingbutIhaveneverseenanyorganisationstatethisasone of its strategic objectives. If the business wants to maintain its current overall risk profile it should accept that its portfolio of new strategic investment projects should contain both higher and lower risk profiles. The lower risk investments should be financially evaluated against a correspondingly lower required rate of return i.e. the straight line project risk/return line of Figure 7.7istobepreferredtothekinkedlineofFigure7.8. Probabilityestimates Asmentionedatthestartofthischapteracommonfeatureofstrategicinvest- mentdecisionsisthattheyconsistofseveralquitehigh-riskstagesthatneedto be successfully completed before the potential high financial returns can be realised.Thisintroducesanotherchallengeintothestrategicinvestmentevalu- ation process that can partially be handled by incorporating the probability estimatesofsuccessforeachofthesestages. Figure7.9showstwoprojectswiththesameexpectedvaluebutverydifferent risk profiles due to their dramatically different ranges of possible outcomes. Project A is expected to have a value of 1000 or nothing while B is only Value of Probability Expected outcome of outcome value 1000 – 10 90 100 100 – 100 Project A Value of Probability outcome of outcome value 80 100 120 25 50 25 100 20 50 30 100 Project B Expected Figure7.9 Implementationissues:useofprobabilityestimates

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StrategicInvestmentEvaluationandControl 195 expected to vary between 80 and 120 at the extreme i.e. very close to its expected value of 100. Indeed 50 per cent of the time B should actually generateitsexpectedvaluewhileAcannotachieveitsexpectedvalueof100 alwayshavingahighvariance10percentofthetimeitwilloverperformby 900but90percentofthetimeitwillunderperformby100.Itisclearlythis volatility in possible outcomes that drives the assessment of the risk profile butitshouldalsoindicatewherethefocusoffinancialcontrolshouldbeplaced. Many businesses would spend most of their effort in trying to refine their assessment of the value of the successful outcome of project A is it really 1000 or 900 or 1100 This is a waste of time for such an unlikely outcome this high-risk project has a small likelihood of delivering a very high return. The focus should be on making it more likely that this high return will be achieved. As shown in Figure 7.10 if the probability of success could be increased from 10 per cent to 20 per cent the expected value of the project is doubledtheremaining80percentprobabilityoftotallossstillmeansthatthe project has a high-risk profile. However in the already low-risk project B increasingtheprobabilityofactuallyreceiving100from50percentto60per centdoesnothingatallfortheoverallexpectedvalueinlow-riskprojectsthe focus of the financial evaluation should be on the assessment of the value of theoutcomesratherthanonrefiningstillfurthertheirprobabilitydistributions. This simple illustration highlights how the use of probability estimates can help but it becomes much more powerful when there are a series of high-risk stages as is shown in Figure 7.11. In this highly simplified version of a real strategicinvestmentcasethecompanyidentifiedaphasedinvestmentprogramme for the development and launch of a high-risk new product. In Year 1 some marketing research costing £2 million was to be undertaken. This would be Value of Probability Expected outcome of outcome value 1000 – 20 80 100 200 – 200 Value of Probability Expected outcome of outcome value 80 100 120 20 60 20 100 16 60 24 100 In project A a 10 increase in the probability of success to 20 results in the doubling of the expected value of the element although the remaining 80 probability of total loss means that this element still has a high risk profile. In project B a 10 increase in the probability of the most likely outcome has no effect on the expected value of the project. Project A Project B Figure7.10 Implementationissues:revisinginitialprobabilityestimates

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196 Marketing Finance reviewedattheendoftheyearandwasassessedashavinganinitialprobabil- ityofsuccessof50percentifitwasunsuccessfultherestoftheprojectwould becancelled.ThenextstageinYear2involvedproductfeasibilitytestingand more marketing research costing £4 million and a probability of success rating of 60 per cent. If this worked Year 3 involved pilot scale production and test marketing requiring a net cash outflow of another £4 million with a success expectation of 70 per cent. Year 4 was the full national launch with consequentnegativecashflowsof£6millionbutahigherprobabilityofsuccess of 80 per cent due to the successful outcomes of all the previous stages. Following a successful national launch the company expected to generate £11millioncashinflowsperyearrepresenting£10millionannualprofitplus adepreciationadd-backof£1millionfor11yearsfromYear5toYear15. The cash flow items shown in column 1 of Figure 7.11 represent the cash flows that will occur if each stage is successful hence they are often referred to as the success cash flows. However given the probabilities associated with each stage it is ‘relatively unlikely’ that the company will actually receive its £11million in Years 5–15. Mathematically the cumulative probability of successofeachsubsequentstagecanbecalculatedbymultiplyingtogetherthe probabilities associated with all the prior stages this is done in column 3 of Figure 7.11. This shows that it is only 16.8 per cent likely that the ultimate nationallaunch willbesuccessful.Putanotherway as isdonein column4 of Figure7.11theprobabilityadjustedexpectedinfloweachyearfromYear5to Year 15 is not £11 million but only £1.85 million i.e. £11 million ×0.168. Eachofthecashoutflowshassimilarlybeenreducedbyitsappropriatecumu- lativeprobabilityofsuccessorindividualriskfactor. Thus for our project we now have two very different looking cash flow projectionsandweneedtodecidewhichonewearegoingtodiscountinorder to evaluate the project. Different companies would choose either of these but 1 2 3 4 Expected annual cash flow Probability of success of previous stage Cumulative probability factor Probability adjusted expected annual cash flow £ ms 2 × previous Year’s 3 Years 1 x 3 £ ms 1 2 3 4 5–15 2 4 4 6 11 100 50 60 70 80 100 50 30 21 16.8 2 2 1.2 1.26 1.85 Figure7.11 Useofexpectedvaluesinhigh-riskstrategicinvestmentdecisions

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StrategicInvestmentEvaluationandControl 197 the key issue is that the discount rate used must be very different. The whole purpose of using the probability estimates is to identify and focus on the specific risks associated with each stage of the strategic investment project. Therefore the probability adjusted expected cash flows should be discounted at a lower rate and normally the company’s cost of capital is reasonably appropriate. Some companies use the risk-free rate of return to discount these cash flows but the risk-free rate is only appropriate for ‘certainty equivalent’ cash flows i.e. where all the risk has been removed. Our exercise does not make it certain that the company will receive £1.85 million per year for 11 years it has merely taken account of the sequential risk process involved in thislong-termstrategicinvestment. Ifthesuccesscashflowsareusedinthefinancialevaluationamuchhigher discountratemustbeusedtotakeaccountofthehigherriskprofilethatisstill included in these cash flows. As shown in Figure 7.12 a discount rate of 35 per cent per year has a similar impact as applying the cumulative probability factors and then using a discountrate setatthe levelof the company’s cost of capital. The problem with this method is that it means that a very high dis- count rate 35 per cent is applied to all the projected cash flows even though they obviously have very different risk profiles ranging from the certainty of spending £2 million this year to the much less likely receipt of £11 million in Years5–15assessedas16.8percentprobable. Another advantage of using the probability method of assessment is that it enables almost automatic updates as the project moves from stage to stage. Thus if as is shown in Figure 7.13 the first year has been successfully com- pleted on budget and no other estimates or probability factors have changed each of the annual cash flows has become 1 year nearer and twice as likely to Comparison of net present value calculations Probability factor adjusted cash flows Unadjusted cash flows Expected annual cash flows £m Discount factor 15 Present value Original annual cash flows £m Discount factor 35 Present value i.e. Company cost of capital Year 1 2 3 4 5–15 2 2 1.2 1.26 1.85 0.870 0.756 0.658 0.572 2.992 1.74 1.51 0.79 0.72 5.53 2 4 4 6 11 0.741 0.549 0.406 0.301 0.828 1.48 2.20 1.62 1.81 9.11 Net present value Net present value +0.77 +2.00 Figure7.12 Useofexpectedvaluesinhigh-riskstrategicinvestmentdecisions

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198 Marketing Finance occurthe50percentprobabilityofsuccessoftheoriginalYear1isnolonger applicable. These new cash flow forecasts can now be re-discounted at the same discount rate i.e. the company’s cost of capital as was originally used. If the success-based cash flows are being used the subsequent years’ values have not changed but the risk profile of the project has reduced thus the dis- count rate should be reduced somewhat. In this project a rate of 30 per cent rather than the original 35 per cent gives an equivalent assessment of the projectasisshowninFigure7.14. Ifinditverystrangethatmanycompanieshavetroublewiththeideaofassess- ing probabilities of success for each stage of a major strategic investment Increasing present values as project success becomes more likely Update on project The first investment stage Year 1 has now been successfully completed on budget. No other estimates have been changed and the same probability factors have been applied to the expected remaining future cash flows. Year Annual cash flow £m Probability of success of previous stage Cumulative probability factor Probability adjusted expected annual cash flow 1 2 3 4–14 4 4 6 11 100 60 70 80 100 60 42 33.6 4 2.4 2.52 3.70 Figure7.13 Useofexpectedvaluesinhigh-riskstrategicinvestmentdecisions Probability factor adjusted cash flows Unadjusted cash flows Expected annual cash flows £ m Discount factor 15 Present value Original annual cash flows £ m Discount factor 35 Present value 1 2 3 4–14 4 2.4 2.52 3.70 0.870 0.756 0.658 3.441 3.48 1.81 1.66 12.73 4 4 6 11 0.741 0.549 0.406 1.118 2.96 2.20 2.44 12.30 Net present value Net present value +5.78 +4.70 Recomputing net present values As the total risk associated with the project has now reduced the discount factor used on the gross unadjusted expected cash flows should be reduced approximately 30 would generate a similar NPV as produced by the probability adjusted cash flows. Year Figure7.14 Useofexpectedvaluesinhigh-riskstrategicinvestmentdecisions

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StrategicInvestmentEvaluationandControl 199 because they see the process as ‘subjective’. Yet these same companies see nothing subjective in projecting cash flows for the next 20 or 30 years and thenchoosinga‘high’discountratetoreflecttheriskassociatedwiththepar- ticular project. The use of probability assessments means that the appropriate line managers can be totally involved in the process and innovative ways of assessing or even improving the chances of success may be identified. In most companies the choice of the risk-adjusted discount rate is solely under thecontrolofthefinancefunction. Realoptions Even using cumulative probabilities in these sequential strategic investment decisions does not fully reflect the potential value of some high-risk opportu- nities as it does not apply a financial value to any flexibility that may exist regarding subsequent investment decisions. Each decision point in the invest- mentprogrammemaycreateanoptionforthecompanytocontinueornotand these options can have significant value. This is particularly true where add- itional information can be gained during the intervening period for which therestoftheexpenditurecanbedeferred. An option is a right but not an obligation to buy or sell an asset within a specified period of timeatagivenprice the exercise or striking price of the option. A call option is the right to buy an asset a put option is the right to sellanasset.Overthelast30yearsfinancetheoryhasdevelopedverysophis- ticated models for valuing financial options e.g. those relating to stocks and shares foreign currencies etc.. More recently there has been a growing awareness that this methodology can be applied to valuing the real options created as part of major strategic investment decisions. Space in this book doesnotallowacomprehensivediscussionofoptionvaluationtechniquesbut all the normal valuation models are based around the five basic value drivers ofoptions.ThesearesetoutinFigure7.15andareamazinglylogical.Options are valuable only where the value of the asset involved is volatile thus an Five parameters 1 Current price of the underlying asset P 2 Exercise price of the option E 3 The instantaneous variance of the asset returns σ 2 4 The time to expiry of the option t 5 The risk-free interest rate r f Figure7.15 Optionvaluedrivers

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200 Marketing Finance optiontodeferforayearthedecisiontobuyahouseorashareetc.isvaluable if you think house prices etc. may change significantly during this year. This makesvolatilityakeydriverofoptionvaluesbutthevolatilitymustmakethe optionexercisableifitistogeneratevalue.Thereforetherelationshipbetween the current asset price and the exercise price is another key driver of option valuethe closerthe exerciseprice istothe currentassetpricethe morevalu- ableistheoptionasitismorelikelythatitwillultimatelybeexercised.Ifthe exercise price of a call option is already below the current asset price the option is said to be ‘in the money’ for a put option this happens when the exercisepriceisabovethecurrentassetprice.Logicallyanoptionwith2years to run is more valuable than an option with an unexpired life of 2 weeks and therefore the time to expiry of the option is also important as an option value driver. The last factor the risk-free interest rate relates to the fact that the exercise price does not have to be paid until the option is exercised which is normally at the end of its life. If the asset was actually bought or sold the value would be paid immediately therefore the comparison should be made betweentheassetpriceandthepresentvalueoftheexerciseprice.Thismeans thattheexercisepriceoftheoptionisdiscountedbacktoits‘certainty’present valuebyusingtherisk-freediscountrate. Eachoftheseoptionvaluedrivershasanequivalentforstrategicinvestment decisions so that the methodology can be applied to real options as is shown in Figure 7.16. In strategic investment decisions the option does not relate to buying or selling an asset but rather to carrying on with the investment programme. Hence the current asset price is normally the present value of the investment’sexpectedcashflowswhiletheexercisepriceoftheoptionisthe subsequentexpenditurerequiredtofinishtheprojectandconsequentlygenerate theseexpectedcashflows.Thelifeoftheoptionisclearlythepotentiallength ofdefermentforthesesubsequentexpendituresandthetimevalueofmoneyis Option value driversapplied to real options Five parameters 1 Current price of the underlying asset P – present value of investment’s cash flow 2 Exercise price of the option E – subsequent expenditure required to acquire the total investment 3 The instantaneous variance of the asset returns σ 2 – volatility of the investment’s returns 4 The time to expiry of the option t – length of deferment period 5 The risk-free interest rate r f – time value of money Figure7.16 Valuingtherealoptions

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StrategicInvestmentEvaluationandControl 201 the same as for financial options although several companies seem to prefer touse their own costof capitalratherthan the more appropriate risk-free rate. The most difficult issue in most cases is the volatility of the investment’s returns but this can be quite simply assessed by considering the range of the potential outcomes. It is not necessary to try to get over-sophisticated to gen- eratecontinuousrangesandstatisticaldistributionslikemanypractitionersin this area I prefer to exercise common-sense judgements rather than spurious complex calculations. A logical frame ofreference forvolatilities in high-risk strategicinvestmentscanbegainedbyconsideringtheannualvolatilityofthe relevant stock market sector the overall USA stock market index has had an annualstandarddeviationwhichisthesquarerootofthevarianceof ±26per cent over the past 5 years. Most individual strategic investment projects will thereforehaveannualvolatilitiessignificantlyinexcessofthis The main advantage of incorporating the real option value drivers is that it canhighlighthowflexibleandphasedbuthigh-riskinvestmentscanbefinan- cially worthwhile even if the current net present value of the investment is negative using the probability-adjusted expected cash flows. The cumulative volatility value impact from the real options built into the investment may more than offset the current negative net present value. This type of invest- ment would not be accepted under traditional discounted cash flow analysis even using cumulative probability factors. A very simple initial example may makethisclearerandthisisgiveninFigure7.17. Under traditional discounted cash flow analysis this investment would not be started since it shows a negative NPV of £4 million. At first sight it looks evenmoreabsurdtospend£1milliontoacquirea1-yearoptiononanegative NPVproject.HoweverFigure7.17alsoshowsthattheexpectedreturnshave quiteahighvolatilityassessedtobe30percentperyearandcouldtherefore A simple example Present value of expected but volatile returns P £100 m Present value of required investment E £104 m Volatility of returns per year σ 30 Risk-free interest rate r f 6 It is possible to defer the investment for 1 year t at a cost of £1 m. Should the £1 m option fee be incurred The company’s cost of capital is 10 Traditional DCF analysis NPV today £100 m–£104 m –£4 m Figure7.17 Valuingtherealoptions

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202 Marketing Finance be significantly higher than the current ‘expected’ present value of £100 million. This means that the investment could have a substantial positive net present value e.g. £130 million minus the less volatile investment costs of £104 million. Equally the cash inflows could turn out to be much less valu- ablethantheexpected£100millionbutitcouldbeworthspending£1million tofindout. The1yeardeferraloptionisvaluedinFigure7.18byapplyingthewell-known Black and Scholes option pricing model to these particular values. As stated before the details of the valuation are beyond the scope of this book but it should be clear that it is well worth spending £1 million to acquire an option that is valued at £9 million. It must be clearly understood that paying the £1 million option fee does not mean that the £104 million investment will automaticallybeundertakenin1year’stime.Thisinvestmentwillbereassessed priorto the expiry of the optionwhena betterassessment ofthe likely returns maybepossible. The use of real options is therefore particularly relevant where the total investment will be made on a phased basis and the subsequent investments depend on the situation at the particular time when they are to be made. The companyiseffectivelycreatingitsownrealoptionsandtheseneedtobevalued appropriately.Thereareseveralcommontypesofstrategicinvestmentdecision- created options and these are summarised in Figure 7.19. One of the most common examples is a new market entry where the initial entry can be done onaphasedbasiswhilemuchgreaterinformationisgainedabouttheparticular market thus the benefits of phasing and learning by waiting are obtained. Aslightlymoredetailedexampleofsuchadecisionisgivenbeforeendingthe chapterwithanin-depthcasestudy. A simple example contd However the investment of £1m purchases an option to go ahead or not at the end of 1 year. This option can be valued by using option tables: σ √t and P/Ee -r f t 0.3√1 and 0.3 and 0.93 9 × 104 06 1 1.1 100 . This represents the option value as a percentage of the underlying asset value. Thus the option value is £100 m × 0.09 £9 m Figure7.18 Valuingtherealoptions

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StrategicInvestmentEvaluationandControl 203 Realoptionexample An initial market entry requires an up-front investment of £10 million and losses are expected for the first 2 years. If the sales growth targets and other success indicators are being met a significant second phase investment of £150millionwillthenbemadeinYear3.Subsequentlysignificantlyenhanced profitsandcashflowsareanticipated.TheseareshowninFigure7.20. There is a currently assessed 50 per cent probability that the second phase investmentwillbemadeprobabilitiesonallsubsequentcashinflowsareignored to keep the analysis relatively simple. The volatility of the second phase investment’scashflowprojectionsisestimatedtobe40percentperyear. Flexibility options values dependent on volatility of fuel costs/supplier prices/ exchange rates labour costs etc. Varying outputs/methods e.g. dual fuels/ sourcing/location American call option but with dividend flows i.e. early exercise may be worthwhile Learning by waiting timing/deferment Put option on value of abandoned assets Abandonment Call option on subsequent stages Phased investments Real option created Type of decision Figure7.19 Examplesofrealoptions Project cash flows – expected results if second phase goes ahead 15 20 14 8 10 – – – – from second phase 1 2 2 2 – 2 4 – Cash inflows – from first phase – – – 150 – – 10 Investments Perpetuity p.a. 6–15 p.a. 5 4 3 2 1 0 Year N.B. Company cost of capital 10 £m Figure7.20 Asimplifiedphasedinvestmentexample

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204 Marketing Finance ThediscountedcashflowsforthecombinedprojectareshowninFigure7.21 using a10 per cent discount ratethe company’s cost of capital and applying the50percentprobabilityfactortoallthesecondphasecashflows.Thisshows that the overall project generates a nil net present value i.e. it has an IRR of 10 per cent but there is a potential realoption as to whether to undertake the secondphaseoftheinvestment. A better way therefore of evaluating this investment is to consider it as a first phase investment of £10 million that acquires for the company an option to make a subsequent £150 million investment. The financial evaluation is consequently the sum of the net present value of phase 1 plus the net present valueoftheoptiontodophase2. Phase1canbeevaluatedusingconventionaldiscountedcashflowandthisis shown in Figure 7.22 the resulting negative net present value £2.66 million means that phase 1 is not worth doing just for itself. To this we need to add the value of the option and this uses our five option value drivers as shown in Figure7.23. Theexpectedpresentvalueofthecashflowsresultingfromthesecondphase investmentcanbecalculatedfromadiscountedcashflowasisdoneinFigure 7.24. Care is needed to ensure that the present value of these cash inflows is then compared to the present value of the required second phase investment the £150 million is the amount to be spent in Year 3 discounted at the risk- free rate of 6 per cent. This discounted present value of the investment £125.94 million is higher than the expected present value of the inflows but this is not critical because these expected inflows are highly volatile and we aregoingtovaluethatvolatilityasisdoneinFigure7.25. Overall DCF evaluation applying 50 probability factor to second phase 20.32 45.84 5.59 4.10 60.08 1.65 3.64 10 Present value 2.39 3.82 .621 .683 .751 .826 .909 1 Discount factors 10 8.5 12 9 6 80 2 4 10 Net cash flows 8.5 12 9 6 5 2 4 – Cash inflows 75 10 Investments Perpetuity p.a. 6–15 5 4 3 2 1 0 Year NPV £0.48 m i.e. the overall project generates a nil NPV £ m Figure7.21 Asimplifiedphasedinvestmentexamplecontd

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StrategicInvestmentEvaluationandControl 205 Introducing option values Phase 1 can be evaluated using conventional DCF 2.39 10.24 – 1.65 3.64 10 Present values 2.39 5.12 .751 .826 .909 1 Discount factors 1 2 – 2 4 10 Cash flows Perpetuity p.a. 4–15 p.a. 3 2 1 0 Year NPV £2.66 m i.e. Phase 1 is not worth doing as a stand-alone project Figure7.22 Asimplifiedphasedinvestmentexamplecontd Introducing option values To evaluate phase 2 as an option we need the five option value drivers: P the present value of the cash inflows from the extra investment E the required new investment £150 m σ the volatility of this investment’s returns assessed to be 40 t the deferment period 3 years r f the risk-free interest rate 6 Figure7.23 Asimplifiedphasedinvestmentexamplecontd Cash inflows for phase 2 35.85 76.4 8.69 5.46 7.51 – – – Present values 2.39 3.82 .621 .683 .751 .826 .909 1 Discount factors 10 15 20 14 8 10 – – – Cash inflows Perpetuity p.a. 6–15 p.a. 5 4 3 2 1 0 Year Present value £118.89 m N.B. This is still less than the true present value of the required new investment £150 m if this is discounted at the risk-free interest rate 6 it has a present value of £125.94 m. If discounted at 10 this is reduced to £112.7 m which is how the overall project evaluation was done to generate the combined NPV of £0.48 m. Figure7.24 Asimplifiedphasedinvestmentexamplecontd

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206 Marketing Finance Thehighvolatility40percentp.a.andthelongdefermentperiod3years when combined with the relative closeness of the current asset value and the option exercise price make fora very valuable option.The £30millionoption value easily outweighs the small negative NPV £2.6 million generated by phase1oftheinvestment.Thusthe£10millioninvestmentshouldbeundertaken asisshowninFigure7.26. Figure 7.26 also shows how the profitability index can still be applied to these types of investment decisions however using the original investment overstates the attractiveness of projects that also have negative cash flows in their early years. It is much better to use the present value of the maximum cumulative investment that is required by the project this is shown as the adjustedprofitabilityindexandthisishowitisalsodescribedinthefollowing case study. Even after this adjustment the profitability index at 1.79 is still incredibly good but this still does not mean that the second phase investment Valuing the option Applying the option value drivers and option tables σ √t and P/Ee –r f t Option value 0.69 and 0.94 approx 25 Therefore the option has a value of 25 of £119 m around £30 m This significantly outweighs the small negative NPV on phase 1 Figure7.25 Asimplifiedphasedinvestmentexamplecontd Re-assessing the investment The revised evaluation of the current investment shows a positive NPV of £27.4 m £30 m option value – £2.6 m phase 1 NPV When this is placed in the context of an initial investment of £10 m by calculating the profitability index the attractiveness of this flexible investment is highlighted. P.I. NPV £27.4 m £27.4 m 2.74 Original invt £10 m Adjusted P.I. NPV 1.79 PV of cum. invt £15.3 m Figure7.26 Asimplifiedphasedinvestmentexamplecontd

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StrategicInvestmentEvaluationandControl 207 willbeundertaken.Thiswilldependuponareassessmentofthefinancialevalu- ationusing theimprovedunderstandingoftheexpected returns thatshould be gainedduringthefirst3yearsofmarketentry. Casestudy–PeterPiperispuzzled Peter Piper was puzzled and perplexed so he picked a particular portfolio of proposed projects to present to his colleague Suzy Seller whose support he sought as he searched for the single supreme solution to the evaluation and controlofstrategicinvestmentdecisions. Peter Piper’s large diversified group used ROI as the principal financial measureofperformancebutuseddiscountedcashflowcalculatingbothIRRs and NPVs as the main method of approving capital expenditure proposals. The divisional ROI targets were based on the previous year’s achievements andthecurrentexternalenvironment.TheIRRcriteriawerebasedonthegroup’s currentcostofcapitalassessedtobe15percentandthelevelofriskassociated witheachproject. Peter Piper’s European division was achieving 35 per cent ROI against a group average of 30 per cent but it was well aware that a number of its prod- uctswereverymature.Thesethreepotentialprojectshadrecentlybeenputup to the divisional board for possible approval. The impact on the future prof- itabilityofthedivisiondiffereddramaticallyandthedecisionregardingwhich ifanyshouldbeputuptothegroupaspartofthedivision’sstrategicplandid notseemtohimobvious. ProjectA An existing retail business unit within the European division one of the few relatively new and growing businesses had identified new branches that would enhance profitability significantly but required investment in freehold property plus additional stock levels. The net cash flow after tax from these new branches was forecast at £3 million per year and the economic life of the project was taken under group guidelines to be 10 years. The property investment should have a high but unknown residual value and in the absenceofbetterinformationthishadbeenassumedtobethesameasoriginal cost i.e. £10 million. The stock investment of £4 million was assumed to be recovered at the end of the 10 years. If the properties were leased rather than being bought an after tax annual rent of 5 per cent for a 10-year lease would bepayable. ThebasicfinancialevaluationisshowninTable7.1.

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208 Marketing Finance ProjectAanalysis Project A is relatively low risk because the group is already in this retail market and should be able accurately to assess both the investments required and the expected returns. The key risks involved are that the new shops are in poor locations and consequently do not generate the expected rate of return. However if this was the case the company could rapidly close these failing shops down sell the properties and transfer the inventories to their remaining shops thus recovering most of their original investment. This exit strategy option highlights how low the risk associated with the project is. The project is also shareholder value enhancing as it generates a positive NPV when discountedat15percentthecompany’scostofcapital. Unfortunatelythedivisionalmanagementteamisunlikelytoputtheproject forward as in each of the next 10 years it shows an accounting return of 21.4 per cent p.a. compared to the current divisional level of 35 per cent and a group average of 30 per cent. This shows the potential conflict between shareholder value measures based on long-term cash flows and costs of cap- ital and accounting-based measures based on historic costs of assets. Clearly it is in the group’s interest for this project to be invested in and it probably shouldbedoneeveniftheIRRwasslightlybelowthecompany’scurrentcost ofcapitalduetothelowriskinvolved. Table7.1 ProjectA–DCFcalculation IRR 21.4 Timing Cashflowitem Amount Discountfactor 15 Present value Yr0 Investment £14m 1 £14m Yr1–10 Profitstream £3m 5.019 £15.06m Yr10 Returnoninvestment £14m 0.247 £3.46m Netpresentvalue £4.52m Profitabilityindex 0.32 Accountingreturn Year 110 Netbookvalueofinvestment 10m 10m Workingcapital 4m 4m 14m 14m Profitaftertax 3m 3m Returnoninvestment 21.4 21.4

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StrategicInvestmentEvaluationandControl 209 However if the project is properly evaluated both the divisional manage- mentandthegroupshouldwanttoinvestinthenewretailoutlets.Theinvest- mentcanreallybedividedintotwoprojectsonebasedinretailingandonein investing in freehold property. The reason for the low accounting ROI is the £10 million cost of the new shops where the financial return is the saving of the£500000rentalcostiftheywereleasedi.e.a5percentannualisedreturn. The only financial justification for buying freehold property is that it is expected to increase in value but in this evaluation it has been assumed to be worth what it cost at the end of the 10 years. Interestingly one strength of the discounted cash flow technique using the time value of money is that chan- ging the residual value even by±100 per cent makes very little difference to the net present value of the project it is still worth doing the project even if theshopshavenoresidualvalueattheendof10years Oncethefreeholdpropertyinvestmentisremovedtheremaining£4million investmentininventoriesgeneratesanannualexpectedreturnof£2.5million an annual accounting return on investment of 62.5 per cent which is well above the division’s targets. Also the amended projecthas an IRR of 62.5 per cent and NPV at 15 per cent discount rate of £9.54 million giving a profit- ability index of 2.38 making it a very attractive project indeed The potential landlordofthefreeholdpropertywillbequitecontenttogeneratea5percent after tax yield on its investment as this should cover its financing costs and give it all the potential long-term increase in the value of the property. Ultimately this would be reflected in the rental values charged to the tenant so that Peter Piper might want to spend part of the increased financial return on buying an option to limit the rent increases at the end of the initial 10 year lease. ProjectB A manufacturing business unit within the division had proposed a spin-off fromoneoftheirmainproductlinesi.e.arangeextension.Thenewproducts would be linked to the existing product range through umbrella branding and should therefore become profitable straight away. However the expected economic life of these high cash flows from the investment project was only 5 years due to the maturity of the main product range. The investment requiredwas£10millionforplantandequipmentwithafurther£2millionfor bothstocksanddebtors.Theresidualvalueoftheplantwasnegligibleandthe fashion nature of the product indicated a risk of not recovering the inventory value at the end of the project. The annual profit stream was projected to be £3 millionforeachofthe5yearswhichtranslatesintoanannualcashinflows of£5milliongiventheannualdepreciationchargeof£2million. ThebasicfinancialevaluationisshowninTable7.2.

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210 Marketing Finance ProjectBanalysis At first sight project B looks financially attractive. It generates a good net present value and a high IRR thanks to its high cash inflows from Year 1. Alsoitsaccountingreturnoninvestmentisgoodduetotherapiddepreciation of the investment in plant and machinery by Year 3 it is beating the current ROIperformanceofthedivision. Howeverthekeyriskassociatedwiththisprojectisactuallythelengthofits economic life and this is not under its own direct control due to the umbrella branding strategy. As discussed earlier a good risk assessment technique in this situation is to calculate the discounted payback as a proportion of the expectedeconomiclifeoftheproject.Forthisprojectthiscanbeshowntobe almost 80 per cent of the 5-year life as the discounted payback period is almost4yearsatadiscountrateof15percent.Thismeansthatiftheestimate of economic life was wrong by 1 year the project would generate almost no shareholder value if the project actually lasted 2 or 3 years longer the value createdwouldbesubstantial. Insuchcasesitisimportanttodoasmuchresearchaspossibletorefinethe estimateofthiscriticalfactor.Ifnosatisfactoryreassurancecanbegainedthat Table7.2 ProjectB–DCFcalculation IRR 25.1 Timing Cashflow item Amount Discountfactor 15 Present value Yr0 Investment £14m 1 £14m Yr1–5 Profitadd backdeprecia- tion £3 +2m 3.352 £16.76m Yr5 Debtors recovered £2m 0.497 £0.99m Netpresentvalue £3.75m Profitabilityindex 0.27 Accountingreturn Year 12 3 4 5 Netbookvalueof investment 8m 6m 4m 2m 0m Workingcapital 4m 4m 4m 4m 4m 12m 10m 8m 6m 4m Profitaftertax 3m 3m 3m 3m 3m Returnoninvestment 25 30 37.5 50 75

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StrategicInvestmentEvaluationandControl 211 the existing umbrella branding would remain strong for at least 4 yearsthis projectshouldberejectedonthegroundsofrisk. ProjectC Another business unit within the division had already spent £5 million on developing an exciting new product concept that could eventually take the business into new market segments although the product could be tested and launched in existing markets and to existing customers of the group. This phased development plan meant that high initial expenditures would need to be followed by additional years of negative cash flows before if the project wasultimatelysuccessfulhighprofitsandcashflowswouldbegenerated. An investment of £10 million in plant and machinery was required nil residual value and £4 million was estimated as needed for working capital all treated as spent in Year 0 and reclaimed in Year 10. Additional expendi- turesonfurtherRDandthenlaunchmarketingwouldresultincashoutflows in Year 1 of £2 million then £1 million in Year 2 and a small £1m inflow in Year 3. From Years 4 to 10 a successful launch in Year 3 would generate annualcashinflowsof£11million. Theprobabilityoffuturesuccessforeachyearwasasfollows: SuccessofYear1netexpenditure 78 SuccessofYear2netexpenditure 85 SuccessoflaunchinYear3andYears4to10projections 90 The financial evaluation of the probability adjusted cash flows is shown in Table7.3. Table7.3 ProjectC–Applyingprobabilityforecaststooriginalcash flows IRR 18.1 Profitabilityindex 0.22 Adjustedprofitabilityindex 0.19 Year Gross cash flow Probability foryear Cumulative probability Expected value Discount factor 15 Present value 0 £14m 1 1 £14m 1 £14m 1 £2m 1 1 £2m 0.870 £1.74m 2 £1m 0.78 0.78 £0.78m 0.756 £0.59m 3 £1m 0.85 0.66 £0.66 0.658 £0.43m 4–10 £11m 0.90 0.60 £6.60m 2.736 £18.06m 10 £4m 1 1 £4m 0.247 £0.99m Netpresentvalue £3.15m

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212 Marketing Finance An alternative proposal was to do some additional market research and productconcepttestingbeforecommittingthe£14milliononplantandwork- ing capital. If the results were positive the cumulative probability of overall successwouldbeimprovedto80percentfromthecurrentlevelof60percent 0.78 ×0.85 ×0.90 ×100 per cent by spending an additional £500000 now. ThefinancialevaluationofthisadditionalexpenditureisshowninTable7.4. The project could be financially evaluated using the ‘success’ cash flows asdiscussedearlierin thechapterandthediscountedcashflowcalculation is showninTable7.5soastoindicatesomeofthepotentialproblems.Ifthecost ofcapitalisusedasthediscountratethenetpresentvalueisincreasedsignifi- cantly but this figure is clearly misleading because of the risk factor that is stillincludedinthese‘success’assumingcashflowforecasts.ThehigherIRR 28.0 per cent versus the 18.1 per cent shown in Table 7.3 needs to be comparedtoahigherrisk-adjustedrequiredrateofreturnasdiscussedearlier the key question is by how much should the required rate be increased to reflecttheassociatedrisk The accounting ROI calculation is shown in Table 7.6 and this highlights the problem of using this method on this type of project. Where the annual accounting return has a range from highly negative through zero to a maximum of 250 per cent any calculation of an ‘average’ has to be seen as completely meaningless. Indeed as soon as this project moves into significant success it starts to generate an incredibly high 100 per cent rate of return on investment. Table7.4 ProjectC–Usingadditionalmarketresearchspendof£500000 Inotherwordsitisworthspendingupto£5mnowtoincreasetheultimateprobabilityof successfrom60to80. Theoverallproject’snetpresentvaluewouldincreaseto£8.67mandtheprofitabilityindex to0.60or0.52onanadjustedbasis. Evaluatingincrementalactivity: Year Gross cashflow Probability change Expected value Discountfactor 15 Present value 0 £500k 1 £500k 1 £500k 4–10 £11m 20 £2.2m 2.736 £6.02m Netpresentvalue £5.52m

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StrategicInvestmentEvaluationandControl 213 ProjectCanalysis The relevant financial evaluations are those included in Tables 7.3 and 7.4. It is obviously sensible to spend the additional £500000 on marketing research before committing the high initial investment of £14 million and then invest- ing a further £3 million in the two subsequent years. This demonstrates that Table7.5 ProjectC–DCFcalculation:‘Success’cashflows IRR 28.0 Profitabilityindex 1.09 Adjustedprofitabilityindex 0.92 Timing CashflowItem Amount Discount factor15 Present value Yr0 Investment £14m 1 £14m Yr1 Lossaddback depreciation £2m 0.870 £1.74m Yr2 Lossaddback depreciation £1m 0.756 £0.76m Yr3 Breakevenadd backdepreciation £1m 0.658 £0.66m Yr 4–10 Profitaddback depreciation £11m 2.736 £30.10m Yr10 Recoveryworking capital £4m 0.247 £0.99m Netpresentvalue £15.25m Table7.6 Accountingreturncalculation Year 1 2 3 4 5 ----- 9 10 Netbookvalueof investment 9m 8m 7m 6m 5m 1m 0m Workingcapital 4m 4m 4m 4m 4m 4m 4m 13m 12m 11m 10m 9m 5m 4m Profitaftertax 3m 2m – 10m 10m 10m 10m Returnon investment 0 100 111 200 250

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214 Marketing Finance the funds ‘at risk’ peak at £17 million in Year 3 and the present value of this £17 million is used in calculating the adjusted profitability indices shown in thetables. The critical impact on the net present value from this project is once again different from the previous two projects discussed in this case study. There is verylittleimpactifthecashinflowslast1yearmoreorlessthanthepredicted 10-year life assumed in the evaluation because of the impact of discounting onthecashflowsinYears10and11e.g.thepresentvalueofthe£11million expected in Year 10 is only £2.72 million. Also a relatively small change in the value of the annual cash inflow is much less than a similar proportionate change in project A this is because of the delay in receiving the cash inflows untilYear4.Themostimportantimpactismadebytheyearinwhichthecash inflows start if they are delayed even until Year 5 the net present value becomes negative. However if the high cash inflows can be started 1 year earlierthenetpresentvalueismorethandoubled. The focus of the financial evaluation should therefore be on the develop- ment of the sales levels following launch and the time control over the activ- ities that need to precede the launch. In this type of project it is often possible to accelerate the launch date by carrying out several activities simultaneously rather than sequentially. Obviously this may have implications for the risk profile associated with each item of expenditure that is affected but another potential way of improving the financial evaluation would be to defer the majorinvestmentitemsifthisispossible.Thiswasamajorwayofimproving theprojectintheKnightFoods’casestudydiscussedinChapter6.

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8 Brand-BasedStrategies Overview Brands can be based on either products or customers. A product-based brand strategy such as Coca-Cola and Marlboro enables the business to grow and create shareholder value by finding new customers for the existing product. On the other hand a customer-based brand enables shareholder value to be created by new products being sold to existing customers. All strong brand strategies are self-limiting in that if the brand is stretched too far its strength canbeirreparablyweakened. If a competitive strategy that is based on brands is to be shareholder value enhancing the brand must enable the business to earn a super profit on its more tangible assets. In other words the brand is itself an intangible asset of thebusiness. There are only limited ways in which a brand can generate a super profit. Astrong brand can enablethe underlying ‘product’ whether good orservice tobesoldatahigherpricethanwouldbeobtainablewithoutthebrand.Alter- nativelymoreoftheunderlying‘product’canbesoldatthesamepriceeither by increasing the market share gained or by increasing the size of the total market.Itisclearlypossibleforabrandtogenerateasuperprofitbyacombina- tionofslightlyhigherpriceandhighermarketshare. In all these cases the ‘brand’ increases the financial return that can be generated from the ‘product’ but a strong brand can also reduce the volatility of the cash flows produced by the underlying product. This reduced volatility reduces the perceived risk of investors and can result in a lower required rate ofreturn. There are a number of stages involved in developing a brand into a long- term asset. This development process requires considerable financial invest- ment by the brand owner. Marketing has now developed quite sophisticated research techniques and methodologies that can evaluate the effectiveness of activities at each stage in the brand development process. The challenge for marketing finance is to turn these purely marketing measures into financially relevant measures that can ensure these successful brands are shareholder valueenhancing.

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216 Marketing Finance In order to develop a brand to its ‘full potential’ value significant market- inginvestmentsarerequired.Inordertofinanciallyevaluateandcontrolthese investments marketing budgets should be split between development and maintenance activities. Development marketing expenditure aims to increase thelong-termvalueofthebrandassetitsfinancialreturnmayonlyberealised some years into the future. Maintenance marketing expenditureis designed to keep the brand attributes at their current level. Some marketing expenditure mayalsobeaimedatextendingtheeconomiclifeofthebrand. Brands can be positioned to reflect how well the underlying product works functionalattributesortoemphasiserepresentationalattributese.g.imageof thetargetcustomer.Corporateorumbrellabrandingcanreducethemarketing investment required to develop a portfolio of independent brands. However it can also reduce the flexibility of response of the single branded company and canincreaseitsriskprofileunlessallthebrandsshelteringundertheumbrella fitcompletelywiththekeybrandattributes. Brand loyalty is a critical but complex subject it is very important that marketingresearchestablishesthereallevelofandreasonsforbrandloyalty as this has important consequences for the specific focus of the marketing strategythatshouldbeimplemented. Akeyelementinthemarketingfinancesystemforabrand-basedstrategyis abrandevaluationprocess.Thissensiblyappliesthestrategicinvestmentdecision criteria to evaluating alternative brand development expenditure levels so as to allocate marketing investment resources as effectively as possible. It is not designed to produce an accurate brand valuation at a point in time this can only be established by actually selling the brand to a willing buyer the price achievedequalsitsmarketvalue. Introduction Brand-based strategies can be built around brands that emphasise either cus- tomers or products. Therefore it is logical to consider the implications for marketingfinanceofsuchbrand-basedstrategiesbeforeinthefollowingchap- ters examining the specifically relevant issues arising from a customer-led strategyandaproduct-basedstrategy. Aproduct-basedbrandedstrategylookstobuildonthecurrentstrengthsof aparticularbrandwithitsexistingcustomersbyfindingnewcustomersforthe existingproductssoldasthebrandasisshowninFigure8.1.Thisisthebasis of the many famous global ‘product brands’ such as Coca-Cola Marlboro IntelandMicrosoft.Theiroriginalsuccesswasnormallyachievedintheirdomestic market and from this very strong base the product branding was developed internationally.Thekeyfactoristhatthebrandisintegrallyassociatedwithone particular product or relatively tightly focused range of products e.g. Shell- andoil-basedproducts.

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Brand-BasedStrategies 217 Arelativelynewerbrandingstrategyistobasethebrandaroundaparticular group of customers and to generate future growth by identifying other things thatcanbesoldunderthesamebrandingtothissamegroupofcustomers.Thus the future brand development is based on increasing the range of relevant products sold rather than necessarily expanding the markets or segments in which the existing products are sold. Not surprisingly these customer-based brands have been extensively utilised by companies in industries that have greatdifficultyindevelopingsustainableproduct-basedbrands. Thus many retailers have focused on investing to create very strong brands inordertobuildstrongloyaltyfromtheirexistingcustomers.Thisloyaltyhas enabledtheseretailerstoexpandsignificantlytherangeofproductssoldunder the retailer’s own brand to these customers. In the UK the ultimate example of this was Marks Spencer because all the goods sold in its stores were for manyverysuccessfulyearsexclusivelylabelledStMichaelitsownin-house retail brand. This retailer developed such immense loyalty and trust from a whole generation of customers that it was able to move into a wide range of goodsandevenservices.Thusinadditiontosellingfoodothergroceryproducts and clothes the group launched home furnishings furniture and even financial services.IndeedatthetimeofitsinitiallaunchMarksSpencer’sfirstretail investmentproductsreceivedahigherlevelofconsumeruptakethananyprevious similar launches. This may have been helped by a few high-profile collapses of‘investmentschemes’ataroundthesametimewiththeresultthatinvestors were very keen to place their money with someone they knew and could trust to deliver ‘good value for money’. However it is interesting to note that this was achieved even though Marks Spencer could not extend their famous ‘noquibblemoneyback’guaranteetothesenewfinancialservicesproducts Ofcoursetherelevanceofaparticularbrandmaychangeovertimeitwill bearguedthroughthischapterthatbrandsdohavelifecyclesitissimplythat Existing Products Existing New New Consumers Customer- based brand strategy Product- based brand strategy Figure8.1 Brand-basedstrategies

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218 Marketing Finance someverystrongbrandshaveverylonglifecycles.Ifandwhenthishappens thecompanycangetintofinancialdifficultiesveryquicklyparticularlyifthe brand name is also the company name. This happened quite spectacularly to Marks Spencer at the end of the 1990s when their products particularly theirclotheswerenolongerseenasappropriatetotheircoreloyalcustomers. As one generation of loyal customers gets older and their children turn into adultsthesenewyoungadultsdonotnecessarilywanttowearthesamebrand astheirparentsstilldothisisillustratedinPracticalInsight8.1. PracticalInsight8.1 MarksSpencerhashadbothtoreinvestinitscorebrandandtomodifya key element in its original marketing strategy now premium products that do not bear the St Michael branding are available in its stores. The strength of a goodbrandcanthereforesometimesultimatelybecomeaweaknessifallloyal customers associate the brand with a certain price and quality position it can be impossible to incorporate within the brand products that fall well outside thisveryclearlydefinedpositioning. Another industry that has based many of its marketing strategies on customer-ledbrandingisfinancialservices.Thishasprovedcriticalinachieving a sustainable competitive advantage in a very competitive marketplace where the economic life of any new product-based advantage can be measured in daysorweeks.Assoonasanynewfinancialproductismarketedcompetitors can reverse engineer how it works and thus normally can launch their own versions incredibly quickly. So quickly that the innovator cannot generate a sufficientfinancialreturnonitsRDcostsandlaunchmarketingexpenditure. Unless that is it can develop a reputation for innovation with a large body of potentially loyal customers. Such a customer-based branding strategy can Levi’s–re-engineeredforanewgeneration LeviStraussdevelopedaverystrongbrandincasualclothingthatbecameanicon fortheyounggenerationinthe1960sand1970sastheyrebelledagainstthestaid formalityoftheclotheswornbytheirparents.Levi’scontinuedtoflourishasthis generation grew slightly older because they modified the product: fuller figure jeansrelaxedcomfortfitjeansetc. Howevereventuallythisstillloyalgroupofcustomershadteenagechildrenof theirownandtheywantedtheirownbrand.Levi’sfacedasignificantlossofsales theirageingoriginalcustomersboughtlessjeansandkepteachpairforlongerif they failed to win the next generation.A combination of re-inventing the product ‘engineered to fit’ modifying the sales process customised fitting with made to measure jeans plus a ‘shrink to fit’ bath in some stores and completely new youth-focused advertising no more 1950s heritage allusions has effectively extendedthebrandlifecyclebutatonepointitwasaveryclosething.

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Brand-BasedStrategies 219 be applied in several different ways product innovation quality of service lowcostsandhencelowpricestailoredservicesforspecificmarketsegments etc.A classicexample ofsuch acustomer-ledbrandisVirginasis illustrated inPracticalInsight8.2. PracticalInsight8.2 Brandsasintangibleassets Whateverspecificformthebrandingstrategytakesthemarketingexpenditure required to develop and then maintain the resulting brand must be rigorously financially evaluated and controlled. Indeed the key financial justification for developing any brand-based strategy is that the resulting brands will create shareholdervalue.Asthenormalaccountingtreatmentforallmarketingexpend- iture is to write it off i.e. expense it in the year in which the expenditure is incurred brands do not normally feature as assets on the balance sheets of brand-basedcompanies. This means that these companies should if their branding strategies have beenfinanciallysuccessfulbeearningasuperprofitonthemoretangibleassets thatthey do includeontheirbalancesheets.Ifinditextremelyinterestingthat manycompaniesthatclaimtoownseveralveryvaluablebrands do notinfact deliver any excess financial return on their exclusively tangible assets e.g. factoriesetc.thatsupportthese‘valuable’brands. Of course it is true that a strong brand really is an intangible asset of the businessandshouldbemanagedassuch.Indeedinmanybusinessesthebrand Virgin–stretchingabrand Richard Branson founded Virgin as a small record label which grew rapidly following the spectacular success of a few previously unknown artists. The busi- ness then moved into music retailing with Virgin stores and then into an airline Virgin Atlantic. The airline competed on the North Atlantic route with the major dedicated airlines such as BA but its branding appealed to a younger traveller. Thus it offered a different seating mix of mainly cheap seats with no frills and ‘Upper Class’ which even had its own bar area on the upper deck of the aero- plane. The brand was further extended into Cola and alcoholic drinks vodka and then financial services and mobile telephones. The brand positioning in these services was to offer an uncomplicated product explained in language the con- sumer could understand. All of these brand extensions were consistent with the image of non-conformity slight irreverence and a desire to get things done in yourownwaythatwasepitomisedbySirRichardBranson’sownlifestyle. Virgin then moved into branding inter-city train services a move that person- ally I cannot relate back to the brand values and consumer segmentation that had provedsosuccessfulinthepast.

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220 Marketing Finance portfolioisundoubtedlythemostvaluableassetownedbythegroup.However before considering how we should financially evaluate control and manage such a potentially valuable asset it is important to understand clearly where thebrandvaluecomesfrom.ManyofthebrandvaluationsthatIhavereviewed and seen over recent years do not value only the ‘brand’ as they include all the future cashflowsexpectedtobe generatedfromfuture salesforecasts i.e. theyalsoincludethereturnrequiredonthetangibleassetsthatenabletheunder- lyingproducttobeproducedandsold.Asisdiscussedinmoredepthbelowa proper brand evaluation exercise should ideally only include those additional financialreturnsthatareattributabletothebrandwhichshouldbedistinguished fromtheunderlyingproduct. In any brand marketing textbook it is immediately made clear that a brand ismorethantheunderlyingproducti.e.goodorservice.Abrandisaproduct withadistinctivepreferablyuniquepropositionthatisconsistentlydelivered through time and place. Brands may also convey something more representa- tional e.g. emotional about its users rather than just reflecting the relative functionality of the product. Indeed a successful brand creates or articulates thesustainabledifferentialadvantageoftheunderlyingproduct.Ifthespecific attributes of this successful brand can be identified an appropriate brand evalu- ationprocedurecanbedevelopedwhichseparatesoutthetruevalueaddedby the branding process. The main features of successful and hence valuable brands are: innovation differentiation service and quality. If this cannot be properly achieved the financial evaluation must ensure that proper allowance ismadefortherequiredrateofreturnontheadditionaltangibleassetsthatare required to produce the ‘brand’. This is considered again later in the chapter whenthedetailsofbrandevaluationarediscussed. Realisingtheassetvalue A true brand asset should enable a level of super profit to be earned and this caninrealityonlybeachievedinafewwaysasisshowninFigure8.2. A strong brand asset should enable: The ‘product’ to be sold at a higher price or More of the ‘product’ to be sold at the same price i.e. its market share is increased or it increases the total market size or A combination of higher price and higher market share to be achieved Figure8.2 Brandassetsrealisingtheassetvalue

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Brand-BasedStrategies 221 Conceptually the simplest way of exploiting a strong brand is through premium pricing of the branded product when compared to its unbranded equivalent. However in the real world this comparison is often far from simple. The premium priced branded product will often have added functional benefitsforcustomersthatarenotavailableonthelowerpricedversions.The additional costs incurred in adding these features/benefits must be taken into consideration as was discussed in Chapter 4 when discussing competitor analysis. The added value gained from any premium pricing is clearly net of theseadditionalcosts. However as mentioned in Part One the strength of the brand probably resultedfromasubstantialinvestmentinmarketingexpenditureoveranumber of years. This increased marketing investment should have been regarded as quite high risk as if it did not succeed in building a successful sustainable brand there would be no financial return at all. Thus the financial evaluation shouldhaverequiredacompensatinghighleveloffinancialreturniftheinvest- ment proved successful. Alternatively the expenditure would have needed to bephasedsothatrelativelysmallamountswerecommitteduntiltheprobability ofasuccessfuloutcomewasincreasedtoanacceptablelevelaswasdiscussed inChapter7. A second way of achieving super profits from a branded strategy is if the brand enables a greater volume of sales to be achieved than would have been the case with an unbranded equivalent product. Thus the brand is sold at the samepriceasitsunbrandedcompetitionbutmoreissoldbecauseofitsbrand- ing. This may be due to it gaining an increased market share or the branding could actually increase the total market size. Of course the challenge for any brandevaluationistoestablishwhatthemarketshareofanunbrandedequiva- lent product would have been in order to assess the value added by the brandedstrategy. As these brands sell at the same price as other products in the market they are often described as ‘value for money’ brands. We all know what is meant bythephrasebutitstillannoysmebecausetotheirpurchasersallbrandsmust bebydefinition‘goodvalueformoney’evenifIampayingapremiumprice forthebrand Obviously these two ways of realising the brand asset value can be used in combinationaslightlyhighersellingpricetogetherwithabettermarketshare. Indeed a great deal of the marketing research effort in brand-led companies should be directed towards trying to identify the optimal pricing and volume mix for each brand. It is important that the financial evaluation and control processunderstandsandfocusesonthespecificbrandstrategy.Inallthesecases thebrandincreasesthefinancialreturnthatcanbegeneratedfromtheproduct andthefinancialevaluationwhichmustobviouslybedonebeforethemarketing investment expenditure is committed compares the expected present value of thatincreasedfinancialreturnagainstthetotalfinancialexpenditurerequired.

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222 Marketing Finance However a strong brand could reduce the volatility ofthe future cash flows produced by the product. This might be through developing strong customer loyaltysothatlessswitchingtakesplacewithalternativeproducts.Thestrong brand image might mean that in times of volatility in total demand in the industry a flight to ‘quality’ or ‘good value for money’ makes the sales rev- enues of the brand less volatile than its competition. These less volatile cash inflowsclearlyreducetheriskassociatedwiththebrandandshouldresultina lowerrequiredrateofreturn. Ideally a very strong brand should generate higher future returns that are lessvolatilethusgeneratingshareholdervaluebymovingintheoptimalvalue- adding strategic direction i.e. increasing returns while reducing risk as was shown by direction D in Figure 1.6. The selected source of shareholder value creation clearly has an important impact on the brand evaluation process that shouldbecarriedoutforallbrands.Howeverbeforeconsideringthisitisneces- sarytosummarisebranddevelopment. Branddevelopment There are a number of stages involved in developing and then maintaining abrand.Spacedoesnotallowatrulycomprehensivecoverageofthisareaand anyway this is already done in most good marketing texts. Thus it is more than adequate for our purposes to consider the specific stages in the develop- ment of a repeat purchase consumer brand. A successful sustainable ‘repeat purchase’ consumer brand normally has achieved some degree of success in allofthestagesshowninFigure8.3howeverthelevelofsuccessmaynotbe uniformacrossallthestages. Thefirstchallengeistocreatesomelevelofawarenessofthebrandamong consumers. This awareness can be created and tested at different levels such asunpromptedspontaneousawarenessoftheinitialadvertisingusedtolaunch the brand. Thus targeted consumers can be asked whether they are aware of theproductcategoryandifsowhatbrandstheyknowabout.Respondentscan alsobepromptedbygivingthembrandnamesorstorylinesfromadvertsetc. This type of marketing research can be done both before a further burst of advertising takes place and then repeated afterwards enabling the impact of thenewadvertisingtobeassessedintermsofchangingawareness. As will be shown in this section each stage in the brand development processcanbe subjectedtothiskindofmarketingresearchthroughwhichthe effectivenessofeachparticularitemofmarketingexpenditurecanbeassessed. The vital gap and hence a crucial role for marketing finance is to link these marketingeffectivenessmeasuresandtechniquesbacktotheoverridingobject- iveofcreatingshareholdervalue.Inotherwordstodemonstratehowcreating additional brand awareness can contribute to generating a super profit this canonlybedonebydevelopingboththemarketingandfinancialeffectiveness

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Brand-BasedStrategies 223 measures into an integrated set. The old ‘I know I waste half my advertising expenditure but I don’t know which half’ must be seen in the twenty-first century as unacceptable given the capabilities of a good marketing finance system. Creating awareness is only a very first stage in developing a sustainable brand and the impact of this awareness needs to be researched. Consumers may all recall your advertisements but this is not helpful if the adverts made themlesslikelytotrythebrand.Thusattitudinalresearchcanbecarriedoutto see whether the awareness created is positively inclined towards the brand. Theawarenessresearchshouldalsocheckthatconsumerscanactuallyassoci- ate your advertisements with your brand therehave been a numberof classic examples of extremely creative award winning advertisements that actually ‘enhanced’ the awareness of a competitor’s brand. On a very silly personal level I have always assumed an inverse correlation between the number of advertising awards won by a marketing team and the effectiveness of their advertising campaigns. This is not too surprising from someone who used to workforcompanieslikeMarswhose‘AMarsadayhelpsyouworkrestand play’ has over the past 50 years won no advertising awards but has helped to sellmanymillionsofMarsbars. Wehavenowcreatedawillingnessonthepartofsomeconsumerstotrythe brand so that our next task is to make it readily available. For a consumer productthiscanbemeasuredthroughthedistributioninretailoutletsorother appropriate channels of distribution. The best measure of distribution is the ‘valueweighted’levelofdistributionasthisadjustsfortherateofsalethrough A successful sustainable ‘repeat purchase’ brand has achieved success in the following stages The level of success may not be uniform across all areas however Awareness Propensity to purchase i.e. interest and desire are created Ability to purchase at least a minimum level of distribution is achieved Level of trial targeted purchasers actually buy the product Repurchase an adequate proportion of triallists repurchase the brand Level of usage these repurchasers adopt a satisfactory level of regular usage of indicating satisfaction in use the brand Figure8.3 Branddevelopment

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224 Marketing Finance the different shops rather than simply showing the proportion of shops that stock the brand. Also we can track the effective distribution which highlights ‘outofstocks’inretailoutletsthataresupposedtostockthebrand. During thelaunch and developmentof abranditmay bevery importantto gain distribution in very specific channels of distribution e.g. where opinion formers and early adopters do their shopping as getting them to try the brand maybecriticaltoitslong-termsuccess.Insuchacasethisspecificelementof distributioncanbetargetedandmonitoredclosely.Againthisisalreadydone in most marketing-led companies but the financial evaluation of the optimal levelofdistributionismuchlesscommon. Many fast moving consumer goods companies track their value-weighted level of distribution for each of their brands on a regular basis normally monthly.Thenormaltargetistoachieveashighalevelaspossibleandlevels of 95–100 per cent are not at all unusual in this sector. However with the increasing level of concentration in retailing a relatively high level of value- weighted distribution can be achieved with a much lower level of numeric- weighted distribution i.e. your brands are available in the larger shops that sellmore.Thiscanmeanthatinordertogainanadditional5percentinvalue distribution you need to deliver to another 10 per cent or 15 per cent of the total retailers. The additional costs involved may not make it financially worthwhile to do this particularly as the rate of sale in these much smaller retailoutletsmaybeverylowindeed.Thiscouldmeanthatconsumersbuying for the first time from such outlets could obtain a less than perfect product whichcouldputthemoffthebrandforever. However as discussed in more detail in Chapter 9 there may be other strategic reasons for wanting to obtain distribution in smaller outlets that do not at first sight make financial sense. It may be a way of creating brand awarenessthroughcommunicatingdirectlyatpointofpurchaseasisdoneby cigarette companies now that most mass media advertising is unavailable to them or of stimulating trial by key consumers who we know happen to shop inthesespecificoutlets.ManyFMCGcompaniesalsoclassifyretailersinterms oftheprofileoftheircustomerssothattheycanfocustheirmarketingexpend- iture on those channels of distribution that have the highest proportion of targetconsumers. Theobjectiveofbothawarenesscreationanddistributionisobviouslytoget targetedconsumerstoactuallybuyandusetheproduct.Thereforetrackingthe rate of trial by new users is a critical piece of marketing research however this really requires very carefully focused marketing research. Most new suc- cessful brands have very specific target groups of consumers for whom the particular brand attributes should be especially relevant see the case study at the end of the chapter. It is therefore potentially much more beneficial if one ofthesetargetedconsumerstriesthebrandastheyshouldbemuchmorelikely to be converted to a regular user. Also consumers have very different profiles

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Brand-BasedStrategies 225 when it comes to trying new products and they bring distinctive personal approaches to purchasing decisions. At one end is a group that will basically tryanyandeverynewbrandthatcomesontothemarkettheyareoftenknown as innovators. Thus gaining trial by this group may not be too difficult but as they will then move on to try the next new brand achieving any degree of brand loyalty from them may be next to impossible. At the other extreme are the very slow adapters who need a long time to be convinced of the benefits of changing from their existing buying routines. However once they have been converted to your brand they will need an equal amount of convincing to move away to a competitor’s offering. In between according to Kearton’s Adaptive Innovative Index there are a group of early adapters who could be convincedtotrythenewbrandquitequicklyandmaybeinfluentialingetting otherstotryitaslongastheylikeit.Ofcourseiftheydon’tlikeittheymay beequallyinfluentialinstoppingthelateradaptersfromevertryingthebrand. These concepts of consumer loyalty are developed later in the chapter but it should already be clear that trial by particular groups of new consumers may be financially worth much more than purchases by another potentially less loyalgroup. For certain consumer product segments it is very important that trial is obtainedfromtheinnovatorseventhoughtheythemselvesmayneverbecome truly loyal to the brand. They may be extremely influential on the subsequent purchases made by their followers who look to see what has been tried by their leading opinion formers. This question of achieving and assessing the rate of trial is a good illustration of how financial evaluation and control should be integrated with marketing strategy and marketing research. The initial brand development strategy should have considered what level of trial by which relevant consumer segments was needed to make the brand launch successful. The marketing plan should then have set out what level of aware- nesswithcorrespondingattitudinalassessmentswasrequiredineachimport- antrelevantconsumersegmentationandwhatlevelofdistributionwasneeded to achieve this level of trial. Only when these have been established can the marketinglaunchbudgetforthebrandbeproperlydeveloped.Unfortunatelyit is still far too common to find brand launch plans that jump suddenly and mysticallyfromveryhighlaunchadvertisingneedstohighmarketshares.This makes it impossible to control the brand development in its early stages as it is only after all the marketing expenditure has been spent that the company canseeifthehigheventualmarketsharewasachieved. Sensible financial control over brand developments requires measurable targets to be set for each phase of the process and ideally for each of these phasedtargetstobeputtogetherinanoverallmarketingplanthatwillifeach phase works result in the ultimate market share desired by the company. As thebranddevelopsproblemscanthenbeidentifiedearlyandtheweakpoints in the implementation process can be rectified. For example it is not enough

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226 Marketing Finance to know that the rate of trial for a new brand is not on target is it caused by lack of awareness low propensity to purchase or lack of product availabil- ity Only by knowing which element of the marketing mix is not working can the resource allocation decision be properly made. There is little point in spending still more money on taking brand awareness up to 65 per cent from its existing 50 per cent if the low level of distribution at 20 per cent means that the willing triallists are finding it very difficult to buy the product. Astonishingly I am aware of several ‘leading’ FMCG branded companies thatareonlynowbeginningtousethissequentialsuccessassessmentprocess toidentifytheweaklinksintheirbranddevelopmentorcustomerrelationship developmentchain. The importance of this phased financial control process at the next stage in brand development is even more clear-cut the next stage is getting an ade- quate proportion of triallists to re-purchase the brand. Clearly re-purchasing the brand indicates a degree of satisfaction in using the product for the first time. Equally too low a level of re-purchase should lead to a fundamental reassessmentofthebrand’sdevelopmentplan.Thereareanumberofpossible explanations but most of them are not good news The worst situation is that trial was by exactly the targeted group of consumers and they simply don’t like it there is then little point in gaining further trial until the product has beenfixed.Infacthavingmoreconsumerstrythebrandbeforeitworksprop- erly could damage it irretrievably as they may never come back to try any subsequent‘newimproved’offering. Another common cause of this conversion rate problem is that the wrong consumershavebeentryingthebrand.Thisindicatesthateitherthemarketing isbeingbadlytargetedorthatthecurrentchannelsofdistributionareinappro- priate again these need to be rapidly reviewed against the original specific targets that were set before significant additional marketing expenditure is committedtotrytocreateadditionaltrial. The final stage in the brand development process for our repeat purchase consumer brand is achieving a satisfactory rate of regular usage among these converted triallists. Our targeted consumers may like the brand when they try it but if they only adopt it as a small part of their total consumption of the productcategorythewholebranddevelopmentmaynothaveprovedfinancially worthwhile. Thus prior to the brand launch and prior to the commitment of any significant launch marketing expenditure an overall model of how the required ultimate market share will be achieved should be developed. This model should highlight both the overall risk associated with the brand launch andthecriticalelementsinthedevelopmentprocessthatneedtobemonitored most closely. If the initial risk assessment is unacceptably high the company mayneedtoundertakesomepre-launchmarketingresearchincludingpossibly carryingoutatestmarket.Rememberthatthemainroleofmarketingresearch istoreducerisknottoincreasereturns

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Brand-BasedStrategies 227 Thus the model should indicate what proportion of the total potential user population is predicted to try the new proposed brand and what level of con- version into regular users is anticipated together with the expected average level of consumption per such regularly using consumer. Clearly the higher the proportion needed at each stage to make the brand launch financially viable the higher is the associated risk I am a great believer in using the reverse break-even method in evaluating this type of project. You calculate the minimum level of market share that is required to ‘just’ financially justify themarketinginvestmentrequiredandsoonbackthroughthemodelforeach stageinthedevelopmentprocessyouthenassesstheprobabilityofachieving eachoftheselevels.Thistechniquewasdevelopedasaresultofsomeperson- ally painful learning experiences one of which is illustrated in Practical Insight8.3. PracticalInsight8.3 Developmentversusmaintenanceexpenditures Thediscussionregardingbranddevelopmentisclearlybasedonthebeliefthat brands can be long-term assets of a business that can produce ongoing size- able future cash inflows if they are properly developed. However this ‘full Marketingsuccessbutfinancialdisaster One of the most successful brand launches that I was ever involved in unfor- tunately also turned out to be probably the greatest financial disaster. We had evaluated a new specialist catering brand of canned-meat products using the new technology discussed in the case study at the end of Chapter 6. As was discussed in that case study the new technology was not itself a sustainable competitive advantage because it could be copied by competition. The sustainable advantage therefore was in being the first to build the ‘technology owning’ brand in this market. Thisincreasedtheriskbecauseitmeantthatitwasnotpossibletocarryoutany really meaningful marketing research such as a test market prior to launching the new brand. However we were confident that the new branding offered significant customer benefits and a sustainable differential advantage should be achievable. Thefinancialevaluationshowedasuperprofitlevelofreturnifamarketshare of above 15 per cent was achieved and this seemed conservative. Following the brandlaunchallcustomerreactionswereverypositiveandweachievedvirtually a 100 per cent repeat purchase rate from those customers that tried the brand unfortunatelyourrateofsaleindicatedamarketshareofjustover5percent. Aftersomeadditionalresearchwecametotheconclusionthatwehadinfact achieved an astonishing 60 per cent market share within 9 months of launch. However the total market was therefore only one tenth the size that we had originallyestimated

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228 Marketing Finance potential’ will as with most long-term assets only be realised if these brands receive significant investments during their development periods. These mar- keting investments normally in the form of advertising and promotional expenditure develop the brand attributes that are the source of the long-term sustainablecashinflowsfromthebrand. Hencethefinancialreturnfromthesemarketinginvestmentsmaybeseveral yearsintothefutureandtheymustbefinanciallyevaluatedusingthediscounted cashflowtechniquescoveredinChapter7.UnfortunatelyasdiscussedinPart One the normal accounting treatment for marketing expenditure does not classifyevensuchlong-termmarketingactivitiesastruefinancialinvestments. This means that it can be possible to improve the short-term financial per- formance of a business by cutting back on development marketing activities even though this probably means that the brands will never come anywhere neartotheirfullpotentialvalues. It is therefore critically important that marketing budgets are split between developmentactivitiesandmaintenanceactivitiesratherthanbeingmeaning- lessly classified between above-the-line and below-the-line. If development marketing budgets are reduced in an attempt to boost short-term profits the long-termindicatorsthatmustbepartoftheoverallperformancemeasurement process should be reassessed.Forbrand developmentthese would bespecifi- cally developed brand health indicators that show the relative future strength ofthekeyelementsofthebrand. However it must also be remembered that brands are developed in a com- petitiveenvironmentandtheeffectivenessofmarketingexpenditureissignifi- cantlyaffectedbycompetitors’levelofspending.Thisisshowndiagrammatically in Figure 8.4 where the curve drawn is an extreme version to make the point clearly. Effectiveness of expenditure Marketing expenditure 1 Less than critical mass expenditure 3 Diminishing returns set in for additional expenditure 2 Very cost- effective expenditure Figure8.4 Relationshipofmarketingexpenditureandeffectiveness

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Brand-BasedStrategies 229 Ifacompanyspendstoolittleonbranddevelopmentinaheavilysupported industrytheeffectivenessofitsspendwillbeminimal.Unlessacriticalmass of marketing support is spent the company will not overcome the level of ‘noise’ that already exists in the market place and the targeted customers will not register the desired messages. The effectiveness may be very low due to therelativelyhigherlevelofcompetitiveexpenditureorothergeneralmarket- ingactivitythatdrownsoutthecompany’sspecificmarketingmessage.Clearly this critical mass level can be reduced if the targeted group of customers can be so highly segmented that they can be very specifically e.g. individually addressed. This is area 1 on the left hand side of Figure 8.4. Once this critical mass point is passed there is normally a very strong positive correlation between increasing marketing expenditure and its effectiveness area 2 in Figure8.4.Howeverthereisapointwherethelawofdiminishingreturnssets in and incremental marketing expenditure has almost no additional impact some observers believe that the curve in area 3 can actually turn down as additional expenditure annoys existing customers so much that they switch away from the brand. The particular shape of the S-curve for any industry is obviously dictated partially by the nature of the product and the degree of involvement of its customers but it is also significantly impacted by the level ofcompetitivemarketingactivityintheindustryatthetime. Not surprisingly this has led to the development of a relative marketing expenditure measure: share of voice. Share of voice SOV refers to the proportionateshareofthetotalmarketingexpenditurespentbythecompany’s brand. One increasingly common relationship compares this SOV to the rela- tiveshareofmarketachievedbythebrand i.e.its valuemarketshareSOM. AsshowninFigure8.5theratioofSOV/SOMcanbegreaterthan1equalto 1orlessthan1. If a brand is proportionately outspending its share of market i.e. SOV/ SOM 1 then the company is investing in developing the attributes of the brand.Thisinvestmentshouldhavebeenrigorouslyfinanciallyevaluatedbefore commitment and should be controlled by monitoring changes in the brand attributes or other leading brand health indicators. Once the brand has been fullydevelopedthelevelofmarketingsupportshouldbedesignedtomaintain SOV SOM SOV SOM SOV SOM 1 A development/investment strategy 1 A maintenance/holding strategy 1 Normally a cash-/profit-extracting strategy Figure8.5 ShareofvoicecomparedtoShareofmarket

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230 Marketing Finance the brand at its current position. The required level of maintenance marketing expenditureshouldstillbeassessedbyreferencetocompetitivelevelsofexpend- iture the objective may well be to achieve an SOV/SOM ratio of 1. However this required expenditure must still be financially justified by evaluating the sustainablelevelofcashinflowsthatcanbegeneratedbymaintainingthebrand. There is potentially one brand in any market that may be able to sustain its currentmarketsharewhilespendingproportionatelylessonmarketingsupport thanitsshareofmarketi.e.havinganSOV/SOMratio1.Thisisthebrand with the dominant market share because such a brand often achieves econo- mies of scale in its marketing expenditure that are not available to its smaller competitors. Thus due to its dominant market share it can still significantly outspend in absolute terms all ofits competitorswhile spending proportion- ately below its market share. If it actually spent at its proportionate rate it wouldfinditselfinarea3ofFigure8.4i.e.intheareaofrapidlydiminishing returns. Notwithstanding this specific powerful sustainable competitive advantage inmostcasesanSOV/SOMratiobelow1indicatesthatthebrandisnotbeing properly maintained and will in the long term decline in strength. This may be the appropriate strategy if the brand and/or the market are coming to the end of their life cycles. However one particular strength of brands is that it is often possible to transfer the brand attributes to another product before the decline of the original product has irretrievably damaged the brand attributes. Ifthebrandissuccessfullytransferredtoanotherproducttheeconomiclifeof the brand has clearly been extended. This transfer of brand attributes should befinanciallycomparedwiththealternativestrategyofdevelopinganewbrand specificallydesignedforthenewproduct.Similarfinancialjustificationsshould be done for all brand umbrella and brand extension strategies which are dis- cussedbelowastheyinvolvesignificantrisksthatmustbetakenintoaccount as wellas the benefit of reducing the brand investmentneeded for developing anewbrand. Ihavecomeacrosssomebrand-ledcompaniesthatmaintaintheyaredevel- opingaparticularbrandeventhoughitisveryclearthattheirSOV/SOMratio is below 1 for this ‘development’ brand. The only possible explanation is that their marketing expenditure is being spent significantly more effectively than the competition is. Unfortunately I have yet to find such a company that can demonstratethisgreatereffectivenessasalreadymentionedthiscanbeachieved by better market segmentation and more specific targeting of customers this areaisdevelopedinthenextchapter. Brandattributes So far in this chapter I have made several references to brand attributes it is now time to discuss this concept in more detail. Some brands deliberately

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Brand-BasedStrategies 231 convey something very positive about how well the product works or the technical characteristics of the product the marketing emphasises the func- tionalattributesofthebrand.Otherbrandsdonottryto‘befunctionallybetter’ than the rest but they create an image that is attractive and relevant to the targeted customer. This image may be emotional trusting or caring etc. prestigiousrebelliousyoungcreativeintelligentetc.theemphasisisonthe representational attributes of the brand. The differences are shown diagram- maticallyinFigure8.6andareillustratedinPracticalInsight8.4. PracticalInsight8.4 Whisky-segmentedbrandattributes The alcoholicdrinksindustryisdominatedbybrand-basedstrategiesandthefew large global players all have a wide range of brands. Some of these brands are very image-focused while others deliberately emphasise the specific functional characteristics of the underlying product. Unsurprisingly in the whisky industry these different brand positions appeal to specific segments of the total whisky- drinkingpopulation. Whisky can be produced as a blend of different malts with the blending process being designed to ensure that the final product quality and taste is com- pletely consistent from year to year. Most branded blended whiskies therefore emphasise their representational attributes e.g. premium brands are associated with a rich and exciting lifestyle image wind surfing across an exotic sun-filled bay. However whisky can also be produced as a single malt brand from a specific verysmalldistillerylocatedononesingleriverinScotlandorIreland.Theproduct HI HI LO LO Brand’s functional attributes Brand’s representational attributes Critical success factor: product attributes Highly attractive and very valuable brand Commodity product Critical success factor: brand Image Figure8.6 Brandattributes:functionalorrepresentational

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232 Marketing Finance The importance of brand attributes is that the marketing communications should emphasise the critical success factors whether they are image-related orproduct-related.Thisofcoursemeansthatthemarketingresearchmustbe similarlyfocused.A successfulimage-orientedbrandmayonlyneedtobe‘as good as’ the competition in terms of its underlying product’s performance as longasitsimageattributescreatesustainedcustomerloyalty. If a brand can outperform the competition in terms of both functional attributes and representational attributes it has the potential to be a very valuable brand indeed. However it may still face potential attack from more specialisedbrandsthatemphasiseonlyonedimensionbutmovefurtheralong their chosen axis in Figure 8.6. This is what happened to IBM during its period of decline from the world’s third most valuable brand to bottom of the league table as was discussed in the case study in Chapter 3. No single company took over IBM’s position as a risk-reducing high-quality computer manufacturer but a range of companies established much more focused pos- itions within the computer industry. IBM’s use of a single brand across the whole industry made it very difficult for it to adapt its position to reflect the increasingly different requirements of its new more sophisticated and more segmentedcustomers. Many companies have used the concept of corporate or umbrella branding inordertoreducethemarketingcostofdevelopingarangeofseparatestand- alone brands. When it works well the linked brandings can reinforce each other but even so it must be remembered that each new brand extension can put at risk the existing overall brand franchise. Very good examples of this comefromthecarindustrywheremanymanufacturerstrytolinktheirvarious models together under the corporate name. Thus the Mercedes brand has a very strong brand image and also very good functional attributes which have enabled it to achieve good market shares in its chosen premium segments alongside a premium price position. Therefore using this brand umbrella to launchsmallercarsintomorevolume-orientedmarketsegmentsthe190range the‘A’ClassandtheSmartcarmustbeviewedashighriskandbefinancially evaluated accordingly. If Maserati and Lamborghini owners perceived them- selvesasdrivingveryexpensiveFiatsthepricepremiumobtainablemightfall dramatically. Whisky-segmentedbrandattributesContinued characteristics differ significantly from area to area and from year to year depending on the peatiness of the soil through which the water passes and the level of rainfall. Many whisky drinkers express very strong preferences for their particular favourite single malt brand and its very strong functional characteristics.

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Brand-BasedStrategies 233 All the brands placed under the umbrella should therefore share the same attributesandbrandpositioning.Insomeindustriescompaniesgotosignific- antlengths toavoidcustomersrealisingthatmanyofthe brandsinthe market areactuallysuppliedbythesamecompanyeachbrandhavingitsowndistinct identity and often its own direct competitor this is illustrated in Practical Insight8.5. PracticalInsight8.5 Branding is normally designed to create some form of customer loyalty as there is a lot of research to demonstrate that loyal customers are much more profitable than new ones this is used in Chapter 9. There is some very inter- estingresearchintocustomerloyaltyforconsumergoodsbyKnoxandWalker that is summarised in Figure 8.7 which resulted in their diamond of loyalty that is shown as Figure 8.8. The right hand side of the diamond shows the levelofbrandsupportshownbydifferentconsumersbrandsupportisdemon- strated by the brand’s relative share of the consumer’s total purchases in this category. The lefthand side of theloyalty diamond shows brand commitment thatreflectstheattitudeoftheconsumertowardsthebrand.Technicallybrand Aplethoraofwashingpowders The washing powder industry is dominated globally by Procter Gamble and LeverBrospartofUnilever.Howeverthesetwodominantcompanieseachhave awiderangeofwashingpowderbrandsmostofwhichcompetedirectlyagainst a specific brand of the other company. It is difficult to justify this plethora of brandsonthepremisethatthissignificantlyincreasesthesizeofthetotalmarket. People presumably wash their clothes when they are dirty. Also the brands are supportedindividuallywithoutstrongdirectlinkagebacktotheowningbusiness sothatnorealgroupidentityisdevelopedwiththeconsumer. Thusthereislittleeconomyofscaleinvolvedinthemarketingmessagesbeing sent to the end consumer. However a wide range of existing brands will mean that retailers don’t want to stock any more brands in this category. This makes it very difficult for any new entrant to gain distribution for their new brands. With- out strong retail distribution any other brand development expenditure will be ineffectiveaspotentialtriallistsareunabletofindthenewbrand. However this competitive marketing strategy can still be effective even if the new competitor gains some retail distribution. In a mature consumer market some consumers are inherently loyal to their existing brand while a proportion will be willing to try something new this new choice may be made almost on a random basis just to buy something different. Hence if the existing market is made up of only two brands any new brand will have a chance of gaining one- thirdofthese‘floating’consumers.Iftherearealreadyoverthirtyexistingbrands therandomtrialfactorfallsdramaticallytoaround3percentthusthenewbrand willfindittoughertoachievetrialandhenceaviablemarketshare.

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234 Marketing Finance commitment is a combination of product involvement and perceived brand risk. Without getting into too much detail product involvement describes the level of interest that the consumer has in the particular product category and the perceived brand risk reflects the relative degree of willingness/reluctance to switch to another brand. These combinations of product involvement and perceived brand risk that result in each consumer category’s overall brand commitmentareshowninFigure8.9. Thesefourclassificationsofdifferenttypesofloyaltyhavequitesignificant implicationsforthemarketingstrategyofanybusinessinvolvedinthissector and therefore for the focus of the marketing finance process within such a business these implications are summarised in Figure 8.10. The switchers classification shows low brand support together with low productinvolvement and low brand risk perception basically they will decide what brand to buy dependinguponwhatisonspecialofferastheywalkroundthesupermarketetc. Variety seekers Switchers Loyals Habituals HI LO LO HI Brand commitment Brand support Knox Walker 1994 Figure8.7 Customerloyaltyclassifications Loyals Variety seekers Habituals Switchers Brand commitment Brand commitment Brand support Brand support Knox Walker Figure8.8 Thediamondofloyalty

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Brand-BasedStrategies 235 The product category holds very little interest for them and each company needs to do something different to grab their attention albeit temporarily. The implication is that the marketing strategy to gain these consumers should emphasise specific promotions to gain immediate short-term sales opportuni- tiesbutthesepromotionswillnotdeveloployaltyfromtheseconsumers.They will switch to the best special offer next time they go out to buy this product categorythereforeeachpromotionmustbefinanciallyworthwhileonitsown accounttherewillbenolong-termbenefit. Thevarietyseekersaremuchmoreinvolvedintheproductcategorybutwill onprinciplealwaysbuyarangeofbrandsovertimetheyhavenoproblemin changing from one brand to another. However it is possible to build some brand support so that one specific brand can become a regular part of the rangethattheybuy.Ifacompanywantstoincreaseitslonger-termshareofthis Loyals Habituals Variety seekers Switchers Product involvement Brand risk perception High Low Moderate Low Moderate Moderate Low Low Figure8.9 Driversofloyalty Loyals Improve branding increase risk of switching Maximise distn avoid out of stocks Variety seekers Provide choice/range of brands Switchers Use specific promotions to gain sales Habituals Figure8.10 Implicationsformarketingstrategy

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236 Marketing Finance consumer segment it needs to develop a range of brands that provide these variety seekers with the choices that they crave maintaining a range of rela- tivelysimilarbrandscanobviouslybeveryexpensive. Thehabitualsgroupofconsumersshowahighlevelofbrandsupportinthat theyregularlybuyonlyonebrandbuttheydemonstratealowlevelofinvolve- mentandinterestintheproductcategory.Inotherwordstheybuythisparticular brand out of habit simply because they always have done. This represents a significantriskbecauseiftheyareforcedtobuyanotherbrandtheymaybecome habitually loyal to their new brand. The implications are that the company mustensurethattheirhabitualconsumersareneverforcedtoexperimentwith a competitive brand. This can be done by avoiding out of stocks and ensuring that effective distribution is achieved to enable these habitual consumers to alwaysfindtheirregularbrandsomeconsumergoodscompaniesevenobtain distributioninpopularholidaydestinationsiftheyhavelargeconsumergroups fromthisclassification. The true loyal segmentation will buy other brands if forced to but they will returntotheirfavouritebrandassoonaspossible.Theydocareaboutthebrand- ing and show this through long-term brand support. It is important that the brandingcompanymaintainsthebrandattributesthathavegeneratedthisstrong loyalty.Insomecasesinappropriatebrandextensionshavesignificantlyweak- enedtheloyaltyofthisveryvaluablegroupofcustomers. It should be clear that the brand marketing strategies need to be tailored to the needs of each of these different loyalty segmentations. This requires marketingresearchtoestablishtherelativeimportanceofeachoftheseclassi- fications to any specific brand if most consumers of the brand are habituals the strategy required is quite different than if they are mainly true loyals or varietyseekers.Ifmostareswitchersmarketingfinanceshouldchallengewhether thecompanyreallyhasabrand-basedstrategy. Brandevaluationprocess In a brand-led business the marketing finance system should include a brand evaluationprocesswhichevaluatestherelevantbrandvaluedriversandbrand attributes and arrives at the brand asset value. The process is deliberately calledbrandevaluationbecauseitisnottheabsolutevalueofthebrandthatis really important. All such valuations that are based on discounting expected futurecashflowsaresubjecttotheexerciseoflargedegreesofjudgementand are somewhat subjective. The important issues are the movements in the brand value and its trend over time and as long as the process is applied consistently these are much less subjective even though any single valuation at a point in time may be debatable. Unfortunately several of the brand-based companies that have implemented a brand evaluation exercise have suffered from it being regarded exclusively as developing the brand valuationsthisis highlightedinPracticalInsight8.6.

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Brand-BasedStrategies 237 PracticalInsight8.6 Thebasicsofabrandevaluationprocessaretogeneratetheexpectedfuture cash flows from the brand but as mentioned earlier in the chapter the cash flows should be directly attributable to the brand itself rather than the under- lyingproduct.Forpremium-pricedbrandsthisisquiteoftenpracticalbutitis moredifficulttoseparatethe cashflowsinabrandthatsellsatthe sameprice as unbranded equivalents but generates increased market share. A practical solution is therefore to include all the expected cash inflows but also to deduct a charge representing the required rate of return on the tangible assets required to produce the brand’s cash inflows. This is being generous to the brand as it assumes that all of any super profit is attributable to the brand ratherthantoothersourcesofsustainablecompetitiveadvantage.Ifothersources of shareholder value have been identified such as economies of scale result- ing in lower cost levels then these values can be built in to the brand evalu- ationprocess. These expected cash flows then need to be discounted to their present values and this requires the selection of an appropriate discount rate. As discussed in Chapter 7 the discount rate should not be too far away from the company’s cost of capital and significant risk differences should be handled by using probability estimates to adjust the expected cash flows. Also the valueofanyflexibilitythatcanbeachievedinthebranddevelopmentstrategy should be built in by using some form of real options etc. e.g. a test market that validates the fundamental branding proposition without giving competi- torstheopportunitytolaunchatthesametimenationally. Howeverthefirstsetofexpectedcashinflowsisnottheansweritismerely the start of the brand evaluation process. The model should be re-run using Abrandevaluationexercise One very large global FMCG group with a very large range of brands decided to carry out a brand evaluation exercise as a key input to their brand marketing resource allocation process. Unfortunately this was not properly communicated to the end markets that were actually implementing the process. They simply receivedaninstructionfromheadofficetocompleteyet‘anothertime-consuming andirrelevantexercise’. Mostofthesecountriesdecidedthathighvaluationswereobviouslybetterthan low valuations because nobody wanted to be in charge of poor quality brands. Thusallthepossiblejudgementswereexercisedtogenerateveryhighvaluesand these were duly forwarded to the corporate centre. When they were added together the total brand valuations came to more than ten times the current marketcapitalisationofthecompany. My whimsicaladvice was to sell off as many brands as possible and return the money to the shareholders immediately. Needless to say this advice was neither appreciatednorfollowed.

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238 Marketing Finance alternativelevelsofbranddevelopmentsupportexpenditureinordertoassess the optimum brand value this represents the full potential value of the brand. It may not be possible to invest to this full extent in all of the brands in the company’sportfoliobutsuchabrandevaluationprocesshighlightsthediffer- ent levels of shareholder value that can be created by equal incremental marketing investments in alternative brands. Therefore it is a key element in the criticalresource allocation decision process.This iswhyitis soimportant that the process is implemented consistently through time and across the organisationandwhytheexercisediscussedinPracticalInsight8.6wassuch awastedopportunity. It also highlights why marketing budgets should be split between develop- ment and maintenance activities. Development expenditures should be justi- fied by the increase in the value of the brand asset i.e. by using discounted cashflowtechniquestoevaluatethenetpresentvalueoftheincrementalinvest- ment. The expected economic life of the super profits from the brand i.e. the competitive advantage period should be assessed and regularly reviewed and specificallyreviewedwheneverthecompetitivesituationchangessignificantly. The analysis phase of our continuous process covered in Part Two should have highlighted likely changes in the competitive environment and early warningindicatorsofsuchcriticalchangesshouldbedeveloped.Agoodexample of this is the petrol retailing case study in Chapter 5 where the commoditis- ation of a product-based brand rendered previous valuable brand attributes suchasqualityavailabilityandreassurancerelativelyworthlessastheybecame takenforgrantedbycustomersandmadethevalueformoneybrandingofthe retailersmuchmorerelevant. Maintenance marketing expenditures are designed to keep the brand at its current level of brand strength e.g. keep the brand attributes at their existing levels. It is now very well established that both most brand value drivers e.g. awareness trial etc. and specific brand attributes e.g. image will decay quite rapidly unless they are properly maintained. Consistency in the market- ing communication process e.g. advertising copy strategy and in the brand positioning can decrease this rate of decay mathematically we can describe thisintermsofincreasingthehalflifeofthegeometricdecayratebutnever- theless development marketing expenditure cannot create an infinite impact. Thus the level of maintenance expenditure that is required should be established as already mentioned this requires an assessment of the level of competitivespendingandthereforemayneedreviewingifactuallevelsdiffer significantly from that anticipated. The consequences of under spending on maintenance activity will probably be quickly felt in short-term market per- formance but if sustained should also be reflected in a reduction in the brand assetvalue. Overthelifecycleofabrandtheproportionatemixofmarketingexpenditure will switch from virtually all development activity during the brand launch

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Brand-BasedStrategies 239 there is nothing to maintain to all maintenance activity once the brand has been fully developed. If a brand is reaching the end of its economic life the level of marketing support may be reduced below the level required for complete maintenance of the brand attributes. This should be done so as to maximise the total cash generation over the remaining economic life. How- ever as already mentioned it is sometimes possible to transfer the brand attributes before the brand is irreversibly damaged to another product. Thus the original ‘product’ may die more quickly but the brand can continue on a newlongereconomiclifecycle. Anoverallperspective Awell-designedbrand-focusedmarketingfinancesystemwillhelptoestablish the full potential economic value of a brand. It will also assist in establishing andmonitoringtheeffectiveness ofadditionalbrandexpenditurebyreference toeachbrandattribute. It should also help to establish the optimum mix of brand value drivers often also known as brand health indicators that should be aimed for given theoverallpotentialforthebrande.g.themixofbrandawarenessandeffect- ivedistribution. Such a marketing finance system should assist in the financial justification ofbranddevelopmentexpenditureandinestablishingtherequiredlevelofbrand maintenanceexpenditure. Casestudy–PhilipMorrisversusBATplc As already discussed in the case study in Chapter 4 Philip Morris has had a very successful product-based branding strategy built around its key brand Marlboro which still accounts for over half the cigarettes it sells worldwide. BATplcwhichisnowatotallyfocusedtobaccogroupfollowingthedemerger of its financial services businesses has a vision statement ‘to achieve leader- shipoftheglobaltobaccoindustryinbothaquantitativeandqualitativesense’. UnfortunatelyforBATithasnosinglebrandthatcancomeclosetochalleng- ing either the total sales volumes of Marlboro or its geographic spread of marketswhereitisthebrandleader. However there are alternative branding strategies that do not have to be based around a ‘one size fits all’ philosophy. Therefore BAT is implementing a brand portfolio approach based around its greater in-depth understanding of thesmokingconsumer.Itisseekingtoensurethatits‘brandsaredifferentiated fromeachotherandfromthecompetitionanddirectedatmeaningfulconsumer segments’. It is also looking to develop ‘competitively superior products that enhance theuniqueconsumerpositioningofthedifferentiatedbrandportfolio’including

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240 Marketing Finance aspiringtobethefirsttolaunchacigarette‘thatwillovertimeberecognised byscientificandregulatoryauthoritiesasposingsubstantiallyreducedrisksto health’. Thus product differentiation is being allied with consumer segment- ation and this is to be made available through ‘world-class customer service’. They state that they aim ‘to provide superior service to their trade customers whileimprovingsupplychainproductivity’. TheabovequotationsareextractedfromBAT’s2001AnnualReportinorder to demonstrate that this very clearly different marketing strategy has been publicly communicated to its shareholders and therefore to its competitors including Philip Morris. It is a very good example of how you cannot expect to takeover from the existing leaders by doing the same things that they are alreadydoingidentifyinganalternativestrategymaywellincreasethechances ofsuccess.Howeveritmayalsobemuchlessriskyalbeitmuchmoreboring to stay as a highly profitable No. 2 in a strongly shareholder value-creating industry.

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9 Customer-LedStrategies Overview A customer-led strategy is built around the existing customers and growth is generatedbyidentifyingnewproductswhichcanbesuccessfullysoldtothese customers. A key task for marketing finance therefore is to identify those customers from which the company can generate shareholder value. In any customer-led strategy the marketing strategy is based on a market segmenta- tion but this can be done in a variety of ways. The objective is to identify financially viable groups of similar customers for whom tailored differential positionings can be developed. Marketing finance needs to be involved in the financial evaluation of the identified segments and in the prioritisation of thosewiththegreatestpotentialtogeneratesuperprofits. The financial analysis of these customer groupings is a critical element in customer-led strategies thus a relevantcustomer-account profitability analysis processisessential.Thisshouldonlyincludeattributablecoststothecustomer groupings which results in the need to do a tiered financial analysis as the groupingsgetbroadermoreofthecostsbecomedirectlyattributable. The fundamental idea behind customer-led strategies is that customers can beregardedaslong-termvaluableassetsthustherelationshipwiththecustomer should be invested in developed to its full potential and then maintained for thedurationofitseconomiclife.Theconceptsofdevelopmentandmaintenance marketingexpenditurearethereforeonceagainimportant. A long-term relationship should be mutually beneficial and the company mustthereforealsocreatevalueforthecustomerthebalancebetweenthevalue created for the customer and the value created from the customer should be carefullymanaged. Companiesthatareseriousaboutrelationshipmarketingshouldbeevaluating the life cycle profitability of their customers as this should assist in focusing investmentresourcesonthemostfinanciallyattractivesegments.Therearetech- niques that link the different key strategic thrusts at each stage to the tailored financial evaluation and control process that should be used. However long- termcustomerscanalsoprovideindirectbenefitsandtheseshouldalsobeval- ued. Referrals and referencability together with innovation and learning can mean that certain relationships are financially worthwhile despite generating

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242 Marketing Finance apparently less than required direct returns. These contingent benefits should be valued using the conditional probability simulation and real options tech- niquesdiscussedinChapter7. Introduction AsstatedinChapter8brandscanbebuiltaroundproductsorcustomersbuta customer-basedbrandisdesignedtoencourageexistingloyalcustomerstotry newproductsthatarelaunchedunderthesamebrande.g.retailerbrandssuch asTescoAldiCarrefouretc.. Indeedanycustomer-led strategyisbydefinitionbuiltaroundthe existing customersofthebusiness.AsisshowninFigure9.1thedevelopmentprocess is to identify new products that can be successfully sold to these existing customers. A critical question in the financial evaluation of such a growth strategyistherefore‘whichcustomersshouldformthebasisforfuturegrowth’. If the company has an overall financial objective of creating shareholder valuetheobviousansweristobasethestrategyaroundthosecustomergroup- ingsfromwhichthecompanycangeneratesustainablesuperprofits. This requires a strategically oriented long-term customer account profit- abilityCAPanalysistobecarriedout.ThisCAPanalysisshouldindicatethe relativeprofitabilityofdifferentgroupsofcustomersbutitshouldnotbeused asanattempttoapportionthenetprofitofthetotalbusinessamongthediffer- ent customers. In fact apportioning or ‘spreading’ costs among customers candestroythemainbenefitsfromtheCAPanalysis.Theanalysisshouldsup- port important strategic decisions regarding which customer segments should be invested in etc. The resulting information produced must be relevant to these decisions and this will not be the case if a large proportion of indirect costsisapportionedtothesecustomers. Main strategic thrust Products Existing New Existing New Customers Figure9.1 Focusonexistingcustomers

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Customer-LedStrategies 243 As is explained in the body of the chapter the key phrase is direct attribut- able costing where the real cost drivers for each customer-related cost are identified. These cost drivers are what cause the cost to be incurred by the business and what make the level of the cost change. Once they are identified it normally becomes clear as to how customers should be grouped together. Many companies now operate quite sophisticated CAP analysis systems but if the strategy is to be based around customers the analysis needs to be done on a long-term basis. Such long-term CAP analyses are less common. The idea is to evaluate which types of customers are worth investing in because over their economic life cycle the business expects to be able to generate a positivenetpresentvaluefromtheinvestment.Thistypeofmarketingstrategy is commonly referred to as relationship marketing because the business tries to develop i.e. invests in a long-term relationship with the customer. If this typeofmarketingstrategyisinusethecompanyneedstotailoritsmarketing financesystemtotreatthesecustomerrelationshipsasalong-termassetofthe business. Thus development and maintenance marketing expenditures are as relevanthereastheywereintheearlierdiscussiononbrands. Indeed in a relationship marketing-based strategy attention shifts towards customer retention and development rather than being exclusively focused on customeracquisition.Thekeypriorityisretainingthemostvaluablelong-term customerswhowillmorethanrepaytherequiredmarketinginvestment.How- ever in order to attract and retain these valuable long-term customers the company must create more value for these customers than the competition anysustainablelong-termrelationshipmustbemutuallybeneficial. Customervaluecanbedefinedastheperceivedbenefitobtainedbythecus- tomer less the price paid and other ‘costs’ e.g. time inconvenience incurred in order to own the good or service. Customers who do not perceive that they are getting value from a relationship are likely to defect. If this happens the original marketing investment in acquiring this customer has failed to create shareholdervalue. Experience has taught me that discussions regarding ‘customer values’ can resultinagreatdealofconfusion.Acompanyseekstoachievevaluefromthe customer for itself but a sustainable long-term relationship requires it to deliver value for the customer. In this chapter customer value will be used to describe value for the customer i.e. from the customer’s or buyer’s per- spective and customer account profitability or customer profitability etc. will be used for value from the customer i.e. from the supplier’s or vendor’s perspective. Marketingsegmentation Inanycustomer-ledstrategythemarketingstrategyprocessstartswithcarrying out a market segmentation exercise. The appropriate differential advantages for each of these market segments are identified and the business defines its

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244 Marketing Finance positioning strategy for those attractive segments that it decides to target. A relationship management process is then developed for the customers in thesesegments. Thus it all starts with market segmentation but this segmentation can be doneinmanydifferentways.AsisshowninFigure9.2thereareseveralstages on the road to true market segmentation starting with ‘one size fits all’. The classic example of mass production was of course the Model T Ford which was reverse engineered so that it could be sold at a price that the target consumers could afford. Thus to bring the cost down it was available only in black with no optional extras. This product made Ford Motor Company into the largest car company in the USA and hence in the world at that time but thisleadershipdidnotlastallthatlong.GeneralMotorsdecidedthatconsum- ers wanted some choice in the car that they bought and so they differentiated theirproductswithsomerelativelysmallchangesbutthesewerealsomarketed underseveraldifferentbrandnamesthatstillpersisttoday.Fordstuckwithits standard product concept for some years and rapidly became and has stayed theNo.2carcompanyintheworld. Productdifferentiationisstillnotreallymarketsegmentationbecauseithas been described as ‘bending demand to the will of supply’ in that it is still production-oriented.Theproductismadetolookdifferentandthesedifferences are then offered to the market. It is what I refer to as a sales approach i.e. we sell what we have got rather than a true marketing approach i.e. we make what you want. Therefore true market segmentation seeks to identify what customersreallywantandthenmatchesthecompany’sproductstothesespecific requirements. This can quite easily result in over segmentation or fragmenta- tion of the market where almost every customer wants something unique. Some industries are trying to satisfy this ‘mass customisation’ concept which resultsinvirtuallyindividualsegmentation.Ofcourseformanyindustriesthis isamatterofcostbutthecarindustryandthecomputerindustryhavemoved alongwayalongthisprocessasisillustratedbyPracticalInsights9.1and9.2. From Model T Ford Through Product differentiation To Market segmentation And possibly Individual segmentation One size fits all Inside out planning Outside in planning Mass customisation Mass production Figure9.2 Trendsinmarketingstrategies

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Customer-LedStrategies 245 PracticalInsight9.1 PracticalInsight9.2 For most industries mass customisation equals over-fragmentation of the marketandwouldbefinanciallydisastrous.Thereforemarketsegmentationis reallyanaggregationprocessofgroupingtogethersimilarcustomers.Amarket AlongwayfromtheModelTFord The car industry has progressed a long way from selling a standard product that was made in millions. It is now perfectly possible to design your own personal- isedcarfromamassiverangeofoptions.Thekeyisthatyourcarisobviouslynot made until after you have confirmed exactly what you want this means that you may only be able to see a computerised simulation of your ‘dream’ car before it arrivesasalivingnightmare The challenge for the car industry is to modify its supply chain processes so that there is an acceptable gap between placing your individualised order and the car being delivered to you. This is still creating major conflicts within many of thelargestcarmanufacturersasoperationsmanagerswantlongefficientproduc- tionrunswhilemarketingmanagerswanttoofferincreasinglytailoredproducts. The solution is as discussed in Rudolph and the Elves in Chapter 2 to put greatflexibilityintothesupplychainwhereitisneededandwilladdvalueflexi- bility is normally very expensive. Standard and efficient processes can still be used elsewhere in the supply chain of this market-segmented business. For car companies they use great flexibility in their assembly plants and paint shops where each successive car may be different. They do not need it in their engine manufacturing plants where all 1.6 litre diesel engines should be the same. The marketing strategy must dictate how operations and supply chain processes are structured. DellComputers:anewbusinessmodel Dell Computers has been the fastest growing and most profitable personal com- puter company almost from its launch. It was started with a new business model ofhowpersonalcomputersshouldbesoldtocustomers.Firstitisbasedondirect marketing rather than distributors dealerships or retailers. Second and even more importantly Dell do not hold any finished goods inventory. They assemble i.e. they buy in the components your computer once you have ordered it. This enables customers to specify exactly within the range of options provided by Dellwhattheircomputerwillcontain. This requires Dell to have a very responsive supply chain because order to delivery cycles must be very short in this industry consumers may be willing to waitseveralmonthsfortheirnewMercedestobemanufactured.buttheywillnot wait 2 weeks for their new desktop or laptop. A measure of their success in this areaisthatinsomemarketstheirdeliveryleadtimesforauniquelytailoredprod- uctarelessthanbuyingacompetitor’sstandardproductfromadistributor.

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246 Marketing Finance is defined as ‘the actual and potential buyers of a product’ and it should be remembered that by segmentation or even product differentiation we are automatically redefining markets. Marketing finance has an important role in ensuringthateachoftheseredefinedmarketsegmentationsisfinanciallyattract- ive and to highlight those that have the greatest potential for generating super profits. Segmentationscanbeobjectiveorsubjective.Objectivemeansthatitisfact- based and hence less debatable but often also much less useful and relevant. For business to business industries classic objective segmentations are geo- graphice.g.regionallysizee.g.totalsalesrevenueorganisationtypee.g. internationalnationalregionallocalthesetendnottohelpindirectingfuture strategic investments. More relevant but still hard data-based segmentation criteriacanbebasedon:thedegreeofcompatibilitywithusonthebuyingcri- teria they use their buying methods e.g. central buying decision versus local negotiation their delivery/distribution requirements e.g. delivery to central warehouse or to multiple individual locations the level of importance of the producttothecustomere.g.keyinputversusstandardnon-essentialcommod- ity. There are also softer more judgmental segmentation criteria that can be strategically very relevant these include: level and importance of innovation and flexibility style of key decision-makers e.g. risk-taking professional or riskaversefamilymemberdegreeofloyaltystageofdevelopmente.g.high growthversusmatureordecliningdegreeofsystemscompatibility. For business to consumer industries the range is even greater. Objective segmentations clearly include age gender socio-demographics the normal a b c 1 c 2 d e classifications but these have now been developed into geo-demographics and biographics. Geo-demographics analyses clusters of similar people and families living in particular localised areas so that consumer-focused companies can tailor their distribution of specific products to the particular needs of the consumers that are likely to use the shops in the area. Biographics has really grown out of the data capture capability of bar scanninginthatitclassifiesconsumersbasedontheirretailtransactionsinthe modern world you are what you buy This has led to some classic examples where retailers have changed their store layouts at certain times of the day in response to this information they not only know who you are and what you buybutwhenyoubuyit. However the more rapidly growing method of segmenting consumer mar- kets is based around psychographics these relate to life styles personality types and self-concepts. Lifestyle segmentations focus on activities interests and opinions while personality groupings emphasise things like inner versus outer directness degree of self-monitoring and level of innovativeness. Self- concept measures focus on ‘how we are’ ‘how we want to be’ and ‘how we perceive ourselves to be’ which can of course differ significantly from how we actually are. The important issue in psychographic segmentation is that

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Customer-LedStrategies 247 there is no right or wrong answer the segmentation is try to group together similar types of consumers the problem is that people can try to give you the answerthatthey‘feel’is‘better’. Therearealsostillotherformsofsegmentationthatareparticularlyrelevant to certain industries these include: occasions for purchase or use known as situational context where some consumers will drink different brands when they are at home than they do when out with friends or work colleagues buying/usageintensitywheresomehighusageconsumerswillusemorethan one brand possibly in distinct situations so that share of usage may be an importantpieceofmarketinginformation. It should be clear from this very summarised review of the vast range of segmentationmethodsthatthebasisofsegmentationthatistobeusedrequires careful thought particularly if it is to be used as the basis for major strategic marketinginvestmentdecisions. Customeraccountprofitabilityanalysis A well thought through market segmentation should provide a vertically structured grouping of customers that enables a comparison of their relative profitabilities to be made. As already stated a soundly based CAP analysis is an essential pre-requisite for a customer-led strategy in that it enables the company to identify those most profitable customers on which the strategy shouldbebased. Such a soundly based CAP system must be designed to take account of all thesignificantdifferencesinthewaycustomersaredealtwith.Thustheanalysis of relative customer contributions should compare all the areas of significant difference the customer groupings i.e. the identified market segments and sub-setsoftheseshouldbemadebyreferencetotheirsignificantsimilarities sothattheconsistentdifferencesfromothergroupsarehighlighted. An illustrative example of a CAP analysis is shown as Figure 9.3 for an FMCGcompanysellingthroughdifferenttypesofretailersthekeyissuesare the same for this type of CAP analysis in any other industry. The objective is not to try to arrive at a net profit for each customer or customer grouping as mentioned in the introduction to this chapter apportioning costs to customers candestroythedecisionsupportrelevanceoftheanalysis.Theaimistohigh- light the financial impact of the different characteristics of these market segmentsandofthedifferentwaysinwhichcustomersareserviced. Hence the attributable costs of all the significant differences must be ascer- tained and charged to the relevant customer groups. In Figure 9.3 it is there- fore not by chance that each heading is titled ‘customer-specific’ ‘direct’ or ‘customer-attributable’. If the cost is not incurred directly because of the customer it should not be included in the analysis. For this to be successfully achieved it is essential that the real cost drivers are identified for each such

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248 Marketing Finance areaofcost.ThereisamassofresearchevidencefromCAPanalysesinmany industries that as is shown in Figure 9.4 there are significant differences in the attributable cost levels in many of these areas among different customer groupings. These differences inevitably result in substantial differences in the relativenetcustomercontributions. The problem for many companies is that they have sophisticated costing systems that are primarily based around allocating costs to products rather than to customers. Thus in many cases the total charges to the CAP analysis arebuiltupfromtheproduct-costingsystemdependingupontheactualmixof productspurchasedbyeachcustomergrouping.Thisisclearlyunsatisfactory Illustrative example for an FMCG products company selling through retailers £ Gross sales by customer x Less sales discounts allowances x Net sales by customer x Less direct cost of sales x Gross customer contribution x Less customer specific marketing expenses x Direct sales support costs x Less customer specific direct transaction costs Order processing x W/Housing distribution x Invoice processing x Inventory financing x A/Cs receivable processing financing x Specific sales support x x x Less customer attributable overheads x Net customer contribution x x Figure9.3 Customeraccountprofitabilityanalyses Attributable customer costs Customer-related discounts Selling and order processing Warehousing and distribution Operational costs Marketing including advertising General administration and fixed costs These costs can differ among different customer groups by more than the business profit Hence there is the likelihood of substantial differences in relative customer profit contributions Figure9.4 Customeraccountprofitabilityanalyses

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Customer-LedStrategies 249 particularly when a number of these costs are actually directly attributable to customersasisdemonstratedbyPracticalInsight9.3. PracticalInsight9.3 Itshouldalsobeclearthatthelevelofdirectlyattributablecostsdiffersdepend- ing upon the size of the customer grouping. Thus in some industries there mayberelativelyfewdirectlyattributablecostsattheindividualcustomerlevel but as these individual customers are grouped together more meaningful levels of directly attributable costs are identified and hence more significant differencesamonggroupsofcustomersarerevealed.Thisisdiagrammatically shown in Figure 9.5 as a smooth continuous curve in practice the curve normally has a number of dysfunctional step points in it which highlight the keylevelsatwhichCAPanalysisshouldbefocused. Freightwarehousing:acustomer-ledcost The case study on Knight Foods in Chapter 6 mentioned a distribution costing problem. Knight Foods sells a range of food products that have very different warehousing and freight characteristics. Thus some canned catering products werepackedinheavycasesandfullpalletscouldbestackedontopofeachother right up to roof level whereas some cases of retail products dehydrated potato etc.wereverylightandthebulkproductneededspecialisedpalletrackinginthe warehouse. The company had developed a very complex apportionment system for spreading both the budgeted and the actual freight and warehousing costs across this range of products. Some of the costs were spread on weight some by palletandstillothersbynumberofcasesortimespentinthewarehouse. The input of these costs into the CAP analysis required applying each of these costing bases to the actual product sales made to each customer so as to build up the total freight and warehousing cost for the segment. In no way could this cost bedescribedas‘attributable’tothecustomerorbeusedasthebasisforstrategic oreventacticaldecision-making. However the company actually sent trucks carrying a mixed load of product direct to these customers so that the directly attributable freight costs per customercouldbeobjectivelycalculated.Inthewarehousemostofthecostswere fixedapartfromintheorderpickingareawherethebulkstoredproducthadtobe broken down and repacked for shipment to the customers. This was necessary because customers did not order in the same quantities that the company pro- duced and stored in. There were potentially significant savings to be generated if this ‘bulk splitting’ activity could be reduced and more full pallets and cages couldbeshippedtocustomers. Againthiscostisdirectlyattributabletothewaycustomersorderanditisper- fectly possible to offer customers a discount for ordering in full pallet multiples rather than as was done at Knight Foods for ordering more than 250 cases in total.Asisdiscussedlaterinthechapterthelevelofthediscountshouldbesetas aproportionofthesavingalong-termrelationshipshouldbemutuallybeneficial.

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250 Marketing Finance Relationshipmarketing A customer-led strategy is based on the belief that the customer is the key intangibleasseti.e.sourceofsustainablecompetitiveadvantageofthebusiness. Hence this key asset should be managed so as to maximise the net present valuethatcanbegeneratedovertheasset’seconomiclife.Suchlong-termasset managementwouldnormallyinvolvethreetypesofexpenditure: • Researchtypeexpenditure:toidentifythecharacteristicsofthemostattract- ivecustomergroupingsormarketsegments. • Investment development expenditure: to win business from these target groupsofcustomersandthentodevelopalong-termrelationshipwiththem. • Maintenanceexpenditure:todefendthislong-termrelationshipagainstcom- petitorswhileensuringthatitsfullpotentialisfulfilled. A strategically oriented marketing finance system would therefore have financial evaluation and control processes that assist in justifying and then managingthesedevelopmentandmaintenancelevelsofmarketingexpenditure. Thisideaofinvestingincustomersinordertodevelopalong-termrelation- shipthatwillthenbedefendedhasnowbecomeknownasrelationshipmarket- ing. In a relationship marketing environment the focus changes from the individualcurrenttransactiontothevalueofthelonger-termrelationshipwith the customer. A transaction-led strategy where no assumption of repeat busi- ness can be made emphasises the profitability of each individual sale to the customer hence any ongoing customer-based analysis is really only a series ofindividualtransactions. HI HI Divisional sales Customer groupings Individual customers LO LO Level of aggregation Level of direct cost association Figure9.5 Customeraccountprofitabilityanalyses:costlevelsdirectlyassociated withdifferentlevelsofcustomeraggregation

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Customer-LedStrategies 251 Thefinancialanalysisunderarelationshipmarketingstrategyisfundamen- tally different the company may quite deliberately not try to recover all of its costsduringthe earlystages ofthe relationshipthesecosts are seenaspart of theinvestmentinthecustomer.Thusthequestionoflong-termcustomerreten- tionanddevelopmentbecomesmuchmoreimportantthesemustbesubjected to a proper financial justification because it is not worth retaining a customer atanycost. In any growth strategy based on customers an obvious constraint on the rateofgrowthisthelevelofcustomerslostinanyperiodasnewsaleshaveto begeneratedtomakeupforthoselost.Howeveritisalsowellestablishedthat new customers are generally much less profitable than existing customers particularly in a number of industries where the costs of customer acquisition are very high. There is also research by Bain Co. a firm of strategic consultantsthatdemonstratesthatlong-termcustomersincreasetheirlevelof purchases over time. Further as is discussed later in the chapter long-term customers can be an attractive source of business referrals both from other partsoftheirownorganisationandothercompanies.Equallynegativepublicity fromdissatisfiedex-customersisavoidedifmorecustomersareretained. However the greatest source of value enhancement from retaining and developing customers is that customer service costs decrease substantially overtimeinmostindustries.Manycompanieshaveveryexpensivenewbusiness teams e.g. advertising agencies insurance brokers accountants and lawyers thattargettheprospectivenewcustomers. Once these targets become actual customers they are passed over to their ongoingaccountmanagementteamandthe‘heavyhitters’moveontothenext target. However this is by no means the only area where costs reduce signifi- cantly in many industries it is an expensive process simply to set up a new customer in the accounting and sales administration systems. Also there is a verysteeplearningcurveforbothorganisationsastheystarttounderstandhow theotherparty’sprocessesreallywork.Thereforeadministrativesupporttime andhencecostsnormallyreducesubstantiallyforaperiodbeforelikealllearn- ingcurvesstartingtoflattenout. It should be clear that if a company is serious about implementing a rela- tionship marketingstrategy itshouldunderstandhow itsinternalcosts change overtimewithdifferentgroupsofcustomers.Unfortunatelyveryfewcompanies have costing systems designed to give them this information even though in practicethedatacollectionproblemsarerelativelytrivial.Evenmoreimportant iswhatshouldbedonewiththeinformationwhenitiscollected.Thecostsav- ingsshouldbesharedwiththecustomerbecauseitistheirloyaltyandcontinued business that has generated them also it reinforces the concept of a mutually beneficial relationship. At the same time and even more importantly it builds an entry barrier against competitors that will be targeting these customers by definitionyourloyallong-termcustomerisyourcompetitor’stargetorprospect.

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252 Marketing Finance In order to highlight the importance of these long-term customer relation- ships it is very useful if the whole organisation is focused on ‘satisfying’ thesecustomers’expectationsandrequirements.Someverycommontermsin this area now are ‘surprise’ or ‘delight’ the customer i.e. exceed their expec- tations by giving them something that they were not expecting. I have a problemwiththeseideasunlessthesurpriseanddelightcanbeachievedatno costtothesupplier.Ifthecustomerwasnotexpectingorrequiringsomething it is probable that they will place a low value on whatever ‘extra’ has been delivered. This means that it is quite possible that the vendor has added more cost into the relationship than the perceived added value to the customer this is definitely not shareholder value enhancing. Therefore I happily accept the term‘anticipate’customers’expectationsbecausethiswilldemonstrateagood understanding of and concern for these long-term customers and should be morefullyvaluedbythecustomers.Allareasofthebusinessoperationsqual- ity control supply chain and distribution customer administration as well as sales and marketing must all understand the target customers’ needs. All of theseareasshouldalsohavekeyperformancemeasuresthatrelatetohowwell theyhavesatisfiedthesecustomerneedsandexpectations.Thisisdiscussedin PartFourbutoneexampleisgiveninPracticalInsight9.4. PracticalInsight9.4 Whenisacomplaintnotacomplaint Customercomplaintsareagoodareatoexaminetogetaperspectiveondifferent companies’ attitudes to relationship marketing. One financial services company setitselfaperformancemeasureofspeedofresponsetoacomplainttheirbench- mark was ‘same day reply in the same medium’. Thus if a customer e-mailed a complaint they would e-mail back the same day and similarly for telephone calls faxes etc. They regularly achieved a 100 per cent score and thought that wasgoodUnfortunatelythismeasuresaidnothingaboutresolvingthecustomer’s complaint so that a lot of their ‘same day’ responses were really just acknow- ledgements e.g. thank you for yourcomplaintreceived today. Of course when the customer rang up to complain that no one had done anything about their complaintstheywouldringbackonthesameday. Another financial services company used the number of complaints as its measure of customer service. This resulted in members of staff going to great lengths to avoid actually recording that a complaint had been made they intro- duced a complicated complaints form that had to be completed with lots of detailedinformationtobefilledinbythe‘complaining’customer. AttheotherextremeanFMCGcompanymeasureditssuccessindealingwith complaints by tracking whether the complaining customer was still a customer 6monthsaftertheircomplainthadbeenresolved.Thiswasapplyingthelogicthat a customer that complains is giving you the chance to rebuild the relationship a customer that is past this stage simply ceases to be a customer and often tells lotsoftheircontactswhattheyhavedoneandwhy.

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Customer-LedStrategies 253 One way of achieving this critical focus on customer retention is therefore to ensure that everyone in the organisation regards these key customer rela- tionships as being worth their full life-cycle potential. My favourite example ofthisisWal-Martwhichnowhasanincredible1.3millionemployeesallof whomgothroughaninductiontrainingprogrammeinstitutedbySamWalton thefounder.Hesaid‘Itellallmystafftoseeallcustomersashaving50000 writtenacrosstheirforehead’asthisshouldmaketheemployeesmileandtry tobehelpfultheyaretalkingto‘seriousmoney’.The50000wasSamWalton’s estimate of the life-cycle purchases by the average Wal-Mart customer and wasestablishednearly50yearsago.Nowwearemoresophisticatedbuteven Iwouldnotsuggestthatanyonetriedtopictureacustomerwithwrittenacross theirforeheadthewords‘presentvalueoftheexpectedsuperprofitsoverthe customer’slifecycle’. Customervalue We have already said a long-term relationship should be mutually beneficial and that therefore in order to attract and retain customers a company must create more value for these customers than its competitors. Customer value is the perceived benefit obtained by the customer less the price paid or other sacrificesoftimeconvenienceetc.thatthecustomermakestoowntheprod- uct. Where the perceived benefit derived by the customer is greater than the sacrifices made customer value is created. It is well established that custom- ers’perceptionofvalueisbasedonmorethanspecificationfeaturesandprice andthatvalueperceptionsareformedovertimeandcanbeaffectedbyoutside influences. At first sight increasing customer value seems to increase the seller’s shareholdervalueaswell.Newcustomersareacquiredifhighcustomervalue is generated and existing customers are retained and developed thus total customer account profitability should grow as sales revenues increase. However beyond a particular critical point further increases in customer value will actually reduce the seller’s shareholder value in other words the customer value package has now been made too good. The company is not now ‘capturing’ enough of the total value that is being ‘created’ by the ongoing relationship. Marketing finance needs to be able to identify where this criticalturning pointisin orderto makedecisions aboutthosemarketing strategies that will create shareholder value as well as generating sufficient customer value for those segments targeted for long-term relationship management. This is why it is so critically important that companies are able to value customer relationships and manage customers appropriately at the differentstagesintheirlifecycle.

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254 Marketing Finance Customerlifecycleprofitabilityanalyses CAP analyses are now quite common and in some companies do highlight the relative profit contributions of differing customer groupings in a way that assists in some resource allocation decisions. However an even more import- ant development in profitability analyses for customer-led strategies is the ideaoflifecycleprofitabilityofcustomers.Thistypeofanalysisshouldassist in concentrating resources on those customer groupings where the greatest long-termsuperprofitscanbegenerated. A good way of structuring such a life cycle CAP analysis is by using a variant of the directional policy matrix as is shown in Figure 9.6. The hori- zontal axis represents the relative customer compatibility rating for different individual customers or customer groups. This should be evaluated from the customer’s perspective by considering the factors that are taken into account bythecustomerwhendecidingwhichsuppliertobuyfrom.Normallyapoints factor scoring system is used where each factor usually a maximum of five factors are used is given a weighting and the company is ranked against its competitorsoneachfactorsothatanoverallscoreresults.Thekeyquestionis whether the relative strengths of the company are relevant to this particular group of customers. Thus if a company has built up a strong branded image with a reputation for quality and a high level of service potential customers that are looking for a low cost adequate product would be considered incom- patible. However as this evaluation is done from the customer’s perspective their perception of the potential supplier may be incorrect and could possibly bechangedbythesupplier. The vertical axis normally shows the business potential of the customer where business potential is the share of the customer’s total business that the Desired direction of customer life cycle Development accounts Existing major customers Not in target market Prospects and targets HI HI LO LO Customer compatibility Business potential Figure9.6 Directionalpolicymatrixcustomervariation

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Customer-LedStrategies 255 companyatpresentdoesnothave.Thusaprospectivecustomerisatthetopof the vertical axis because everything is business potential. The overall size of the customer or grouping is indicated by the size of the circle used with the currentpositioningbeingrepresentedbythecentreofthecircle. Customers logically follow a life cycle as is shown by the curve in Figure 9.6 they start in the top right hand box as prospects and targets. Clearly they havehighbusinesspotentialatthisstageastheyarenotyetcustomersandthe reasonnobusinessisbeingdonewiththemyetmaywellbeduetoaperceived low level of compatibility. The top left hand box contains development accounts that still have a high business potential because the company only hasasmallshareoftheir totalpotentialbusiness.Howevertheseaccounts are considered compatible customers so that they should progress downwards into the bottom left hand box as the company gains an increasing share of the available business. The bottom right hand box is not part of the target market because it contains possible customers that are incompatible and have been assessedashavinglowbusinesspotentialmanyofthesewillbesmallcircles wherethetotalbusinessisnotworththeinvestmentrequired. Thisinitialanalysisenablesthecompanytodevelopspecificstrategicthrusts for each stage of the life cycle and marketing finance should be developing similarly tailored financial evaluation measures and control techniques. The keystrategicthrustsareshowninFigure9.7andthemarketingfinancemeasures in Figure 9.8 the easiest way to explain the model is to follow a particular customerthroughitslifecycle. This customer starts off in the top right hand box high business potential but low customer compatibility this means that the customer thinks that the HI HI LO LO Customer compatibility Business potential Development Increase the share of this customer’s total available business Turnaround Improve the company’s compatibility with this customer Maintenance Retain this customer’s business while optimising the company’s profitability DOG To be avoided Main strategic thrust for this customer Figure9.7 Customerlifecycleprofitabilityanalyses–strategicthrust

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256 Marketing Finance company is an unsuitable supplier. Before a long-term relationship can be developedthiscustomer’scompatibilityratingmustbeimproved.Thisbecomes the key strategic thrust for these turnaround accounts the performance meas- ures used should not include sales targets or profit measures at this stage. However marketing finance should have done an evaluation of the potential value of this customer in order to assess whether it is worth trying to change the perceived incompatibility. In some cases such a DCF evaluation will be difficult but it may be possible to regard the first marketing investment as acquiring an option as discussed in Chapter 7 to get to know the customer better. Certainly at this initial stage any DCF evaluation of the potential customer asset value will be done using the probability assessments and risk managementtechniquesdiscussedinChapter7.Marketingfinanceshouldalso usemodellingtechniquestoassessthepotentialimpactofdifferentmarketing approachestothisprospectivecustomer. In some cases the reasons for the apparent lack of compatibility are in fact perfectlyvalidwhatthecustomerwantsdoesnotmatchwiththemarketingstrat- egy of the supplier. This should move the customer down to the bottom right hand dog box as there really is now very low business potential from this customer. Once the compatibility rating has been improved the key strategic thrust should be to increase the share of this customer’s total available business the maximumpotentialsharethatcanbeobtainedshouldbeassessedcarefullyas Customer compatibility Main strategic thrust for this customer HI HI LO LO Business potential Turnaround Maintenance DOG Development TPM: Increasing share of business FEC: re-evaluation of customer potential evaluation of new marketing initiatives TPM: Specific objectives to demonstrate improved compatability FEC: DCF evaluation of total customer potential to justify investment TPM: Share maintenance/Cost efficiency improvements FEC: Sustainable profitability and cash generation Exit strategies/high-risk repositioning initiatives Figure9.8 Customerlifecycleprofitabilityanalyses–tailoredperformance measuresTPMandfinancialevaluationandcontroltechniquesFEC

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Customer-LedStrategies 257 manycustomerswouldneverconsidergoingtoasinglesupplierposition.This meansthatthetailoredperformancemeasureforthesedevelopmentaccountsis the increase in the share of the customer’s business still not current customer account profitability. The focus for marketing finance at this stage of the cus- tomerlifecycleistoreassesstheDCFevaluationofthelong-termpotentialof thiscustomerbynowamuchmoreaccurateevaluationshouldbepossibleas better knowledge of the customer is gained. Also the proposed marketing investmentsshouldbeassessedpriortoimplementationandcloselymonitored to learn their relative effectiveness as a learning process for the future this willinvolveusingshort-termtechniquessuchaspaybackperiodsinaddition tothelong-termDCFtechnique. Asthecompany’sshareofthiscustomer’sbusinessincreasesthecustomer moves down into the maintenance category where the key strategic thrust is toretainthiscustomer’sbusinesswhileoptimisingthecustomeraccountprof- itability. This is the stage when the financial return on the earlier investment in the customer is realised and so the financial measurement focus moves to sustainable customer account profitability and positive cash generation there should be no further need for significant additional investments in specific fixed assets or working capital for this customer once the level of business is fully developed. The tailored performance measures used for maintenance customersshouldbetomonitortheshareofthiscustomer’sbusinessadecline in share should be taken as an indication of loss of customer loyalty and the customer compatibility rating as well as the achievement of cost efficiency improvementsinthewayinwhichthiscustomerisserviced.Partofthesecost efficiencygainscanberetainedsoastoboostthecustomer’sprofitabilitybut as mentioned earlier part should be shared with the customer so that they receiveabenefitfortheirloyaltyandtomakeitmoredifficultforcompetitors tomakethisvaluablecustomerabetterofferthattheycan’trefuse. There are a number of books and articles on relationship marketing that state that long-term customers will pay a premium price because over time they develop higher switching costs. This really worries me as you are effect- ively ‘ripping off’ your most valuable asset simply because they are slightly morereluctanttoleaveyou.Overtimetheyshouldautomaticallybecomemore profitable due to cost efficiencies and your increasing share of their business you should charge them a lower price not a higher one. Marketing finance should be evaluating the potential risk of a competitor stealing this customer andtryingtoidentifyandevaluateloyaltyreinforcingmarketingactivitiesthe financialjustificationofsuchinitiativesisclearlynotanincreaseinreturnbut areductionintheriskoflosingthiscontinuingincomestream. An increasing number of companies are now trying to evaluate customer lifetime values and are using increasingly sophisticated tools to do so. Data warehouses and data mining tools assist organisations in measuring the

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258 Marketing Finance economic value of customers. Predictive modelling techniques can be used to predicttheremaininglifetimeofthecustomerrelationshipandthelikelyresult- ant future stream of cash flows from this customer. One insurance company discoveredthatcustomerswhohaddefectedexhibitedcharacteristicbehaviour patterns itinserted a function into its data warehouse to identify these behav- iour patterns as they emerged and set up a team to manage those customers thatmightotherwisehavebeenlost. True relationship marketing suggests however that even this lifetime eco- nomic value does not necessarily reflect the total value of the customer to the company.Theremaybeotherindirectrelationshipbenefitswhichseemtobe of four types. Referrals word of mouth and referencability can both reduce thecostofacquiringothercustomersproductinnovationforandlearningfrom these relationship customers may benefit the whole company. These indirect relationship effects can mean that certain customer relationships do create shareholder value even though the direct financial returns do not generate a positivenetpresentvalue. However because these indirect benefits are more contingent upon the continuing strength of the relationship different valuation techniques need to be adopted. Three techniques are particularly usefulfor financiallyevaluating and controlling these indirect customer relationship benefits: conditional prob- abilitysimulationandrealoptions.Realoptionsareparticularlyinterestingas thereissomeevidencefromLynetteRyalsaleadingresearcherinthisareato suggestthatoptionsthinkingexplainssomesignificantmarketingdecisionsin thisfield. CAP analysis is complicated even further when the business sells through an indirect channel of distribution to the ultimate user of the product e.g. as is done by many consumer goods companies that sell directly to whole- salers distributors or retailers which then sell on to the final consumers. Increasingly this type of business wants to have sound financial analysis on both its direct customers and its ultimate but indirect consumers. Thus many FMCG companies particularly in the USA have invested very large sums of money in developing very extensive consumer databases. This enables them to know much more about who eventually uses their product even though they bought it indirectly. Clearly if their strategy is to develop new products that will appeal to these same consumers this knowledge is critical. However it also illustrates a significant competitive advantage for the indirect channel of distribution e.g. the retailer as they can gain even more detailed customer information much more cost effectively. This is being used very proactively by the major retailers through their significant investments in retailer brands and customer loyalty programmes store cards etc. that enable them to develop very appropriately designed and

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Customer-LedStrategies 259 targeted newproducts.As theold saying goesinformation ispowerwhen it comes to customer-led strategies. Casestudy–DMConfectioneryLtd Background–Theoriginalbusiness D M Confectionery Ltd was a regionally based privately owned company thatspecialisedinmarketinganddistributingcakes.Itsinitialsuccesswasbased on focusing on the smaller retailers i.e. individual shops and small chains that tended to be owner-managed where its product expertise added signifi- cant value to the customer. It added further value through developing its own regional brand Country Style was the brand name which helped to createconsumerloyaltyfortheproductrangethatwasactuallysourcedfroma numberoflocallybasedbakeries. TheownerandmanagingdirectorMikeAtohadconsiderableskilliniden- tifying and specifying new products and this expanding product range was a keyelementintheprofitablegrowthofthebusiness.Atthisstagethecompany had cash on deposit at the bank as it collected the cash from its customers before it had to pay its suppliers and its needs for capital investment were relatively low. This meant that the financial risk of the business was low but thebusinessriskwasrelativelyhigh. D M supplied a branded product to a range of retailers who relied heav- ilyontheproductexpertiseofD Manditsvan salespeople.Thiscustomer relationshipmeantthatanyunsoldretailerstockwouldbepickedupbyDM at the sell-by-date in order to safeguard their brand. In effect D M was renting space in the retailer’s shop and paying variable rental based on sales achieved.DMalsocontrolledtheshelfliferemainingwhenthecakeswere physicallydeliveredtotheretailerbutasDMwasbearingtheproductrisk it regarded its field force more as sales people than delivery drivers. Its deliv- ery system was therefore not very efficient but it was customer-oriented and veryflexibleanditsrelativelyhighprofitmarginsmeantitsearlygrowthwas financiallysuccessful. Thenewbusinessopportunity Mikewasambitiousandwantedtogrow.Heidentifiedapotentialdemandfor anewrangeofhigh-qualitycakesthatcouldbesourcedfromDanishbakeries. He modified their existing products to his exact specifications and started importingintotheUK.Thesuccesswasastonishingandthisnewproductrange all branded as Country Style brought D M to the attention of the major

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260 Marketing Finance supermarket chains. Mike saw this as the chance to move into a much bigger leagueandenthusiasticallyenterednegotiationswithseveralchains. It soon became clear that these national supermarkets wanted only the importedproductandtheywantedtobranditthemselves.Theyalsointended to order centrally so that D M’s van sales force would be merely delivery drivers and they wanted an efficient and effective distribution service from D M. This represented a big change in D M’s existing business strategy andcurrentsourcesofvalue-addedaswellasrequiringsignificantinvestments in warehousing more and larger trucks and new computer systems to cope with the dramatically increasing volumes and tighter delivery timing require- ments. There was also a significant increase in the working capital tied up in the business as the supermarkets demanded much longer credit terms than had been granted to D M’s original smaller customers many of whom had paidincashatthetimeofdelivery.AlsotheincreasedvolumesfromtheDanish suppliersledthemtoseekfasterpaymentfortheirgoodsconsequentlyDM becameheavilyreliantonbankdebtfinancing. Also the big supermarkets negotiated substantial volume discounts on their already reduced prices they were not buying D M’s branded goods and their selling out price was much more important to them than to the much smaller retailers that D M was used to dealing with. However D M was no longer bearing the entire product risk because as long as it delivered the cakeswithanagreedperiodofshelfliferemainingthesupermarketnowbore this risk they had decided how much to order and it was packaged as their ownbrand.Clearlythisnewbusinesshaddramaticallydifferentvaluedrivers totheexistingbusinessandafinancialevaluationoftheimpactbeforestarting followedbyup-to-datemonitoringthereafterwasessential. UnfortunatelyDMhadalwaysreliedonoverallfinancialdataandduring the very rapid changes even this became more and more out-of-date no man- agement accounts at all were produced for the months during which the new computer system was implemented. The new system did include a CAP analysisandthiseventuallyhighlightedthatsomeofthesenewmajoraccounts werebeingoperatedataloss. Also during this period of dramatic change D M decided to concentrate allitsDanishsourcingwithonesupplierinordertosimplifytheadministrative processes and operational issues. Clearly the mutual dependence between the two increased as the sales of Danish cakes continued to grow. When D M revealeditslackofprofitabilityi.e.whenthenewcomputersystemcameinto operation to its bank the bank became concerned about its level of exposure andaskedquestionsaboutthetimingoffuturepaymentstothisDanishsupplier. Thesupplieragreedtoextenditscreditperiodwhichithadpreviouslyreduced but wanted to be reassured ‘about the strength of D M’s customer relation- ships’ by meeting these key customers. Within 3 months the Danish supplier hadagreedwiththesesupermarketstodelivertothemdirectbypassingDM completely.

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Customer-LedStrategies 261 Inevitably D M went into liquidation because its original business could not possibly support the dramatically increased fixed cost base taken on for the new market segment. Obviously there are many reasons contributing to thecollapseofthecompanyanditwouldbefartoosimplistictosuggestthata goodCAPsystemwouldhavepreventedthishappeningbutitcertainlywould havehelped.

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10 Product-BasedStrategies Overview Aproduct-basedstrategygeneratesgrowthbyidentifyingnewmarketsinwhich existing financially successful products can be sold. Such a strategy should clearly be built on those existing products that have the potential to produce super profits and this makes a system of direct product profitability DPP analysisacriticalareaformarketingfinance. The objective of such an analysis is to highlight the relative profitability of existingproductsthisnormallyrequiresproductstobegroupedtogetherifthe analysisistobe bothpracticalandrelevanttostrategicdecisions.Astheclas- sificationsofproductbecomemoredetailedlesscostscanbedirectlyattributed toeachseparateproductclassificationandtheDPPanalysisbecomeslessuse- fulinitskeydecision-supportrole. The DPP analysis should be tailored to the attributes of the product. Aproduct with a cost advantage should be subjected to rigorous comparative cost analysis but this is much less relevant where the product attributes are based on differentiation and value-added. Ideally this DPP analysis should be done on a long-term basis over the remaining product life cycle so that the future potential of the product can be included as well as its current financial performance. There are two very different marketing strategies for product-based strat- egieswherethecostsoftheproductreduceoveritslifecycleaquitecommon phenomenon known as the experience curve. In one case selling prices today aresetbasedupontheanticipatedlong-termcostsassociatedwiththeproduct the current loss on sales can be regarded as an investment in attempting to developalong-termcostadvantage.Theotherpricingstrategyseekstogenerate profits more quickly either by setting very high initial selling prices or by reducing selling prices at a significantly slower rate than that at which costs are reducing. These high early profits may attract in new competitors or may delaythedevelopmentofthemarket. Many product-based strategies also have the added complexity associated with trying to sell a range of products to the same customers there can often beanelementofcrosssubsidisationamongtheproducts.Anysuchdiscountor rebate granted to a customershould be attributed tothe real cause i.e.itstrue

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Product-BasedStrategies 263 cost driver rather than being apportioned across all the products sold to this customer. All competitive advantages have finite economic lives and therefore a key strategic investment decision is whether the company should reinvest part of the super profits being generated from an existing advantage in trying to develop a replacement competitive advantage. Such reinvestment decisions clearly require rigorous financial evaluation and the risk assessment will be highlyinfluencedbytherelevancetotheproposednewcompetitiveadvantage oftheexistingcorecompetencesofthecompany. Therearemanyproductcostingtechniquesavailableandmarketingfinance shouldlooktoapplythemmorestrategicallybeforetryingtoinventcompletely newones.Thisargumentappliestostandardcostingwherethetraditionalapplica- tionofvarianceanalysisdoesnotnecessarilyleadtoeconomicallysounddeci- sions. If the method of calculating efficiency/usage variances is modified it becomes possible to base operational decisions on the most up-to-date cost information available rather than using the standard costs that may well be overayearold. Transfer pricing is another common area of problems for product-based strategies because far too often it is seen as a method of cost apportionment or cost recovery rather than a genuine pricing mechanism between different partsofthesamebusiness.Thesystemshouldfollowthesameprincipleswhether the transfer price is for a core process within a vertically integrated group or for the provision of support services. Resource allocation decisions should focus on the use of the critical limiting factor within the business i.e. the factor that is constraining the future growth of the business and measure the relative contributions of different products and processes in terms of ‘per unit ofthelimitingfactor’. Introduction Inthepreviouschaptertheissuesrelatingtomarketingstrategiesbuiltaround existing customers were considered. An alternative but possibly equally attractive strategic thrust is to base future growth around existing products. These products may also be strongly branded as was discussed in Chapter 8 but the critical element in a product-based strategy is that the growth object- ives are delivered by finding new markets new segments or new customer groups to which to sell these existing products as is diagrammatically shown inFigure10.1.Obviouslythespecificexisting‘success’attributesoftheprod- uctshouldbedirectlyrelevanttothesenewcustomers. Not surprisingly this strategic thrust should normally be based on those products that can achieve a sustainable level of super profit in their existing markets. This should give marketing finance a head start in such product- based strategies because most businesses have lots of product costing

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264 Marketing Finance information almost all costing systems are structured around allocating and apportioning costs to products. However what is needed is a soundly based decision-focusedlong-termDPPanalysisandunfortunatelymanysophisticated costing systems do not meet any of these criteria.Theyarenotsoundlybased nordecisionorientedandfocusonmonthtomonthcomparisons. As with the customer profitability analysis developed in Chapter 9 the objectiveofDPPistoindicatetherelativeprofitcontributionsfromthediffer- entproductgroups.Thereforeyetagainapportioningalotofindirectcostsin anattempttoarriveata‘netprofit’foreachproductcandestroythevalidityof the analysis and lead to disastrous decisions being taken. Many costing systems include incredibly complex methods of apportioning costs often to otherindirectareasofthebusinesssothatpartoftheseapportionedcoststhen has to be reapportioned before it finally ends up in a ‘product cost’. Equally many costing systems try ‘to recover’ fixed costs by treating them as if they are variable so that a recovery rate per unit of output or some other variable recovery basis such as per machine hour etc. is applied. This can result in thewonderfulterm‘overrecovery’or‘underrecovery’ofthecostdepending ontheactuallevelofoutput.MypersonalfavouritewhichIstillseeregularly in companies’ management accounts is ‘an over recovery of the overhead costs’ meaning presumably that more overheads have been charged to the productcostingsthanwereactuallyspent.Doesthismeanthatoverheadshave become a source of profit If so perhaps we should spend more on them so that we can increase the absolute amount of the over recovery In most cases the company has actually spent at around the level of the fixed cost that it forecastthatisafterallthenatureoffixedcosts. Another potential problem with a traditional approach to product costing can be with the definition of what constitutes ‘a product’. The objective of DPP in a product-based strategy is to highlight which ‘products’ should form Main strategic thrust Products Existing New Existing New Customers Figure10.1 Focusonexistingproducts

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Product-BasedStrategies 265 the basis for the future e.g. for international expansions for line extensions for repackaging for sale to different segments or through different channels etc. In many companies the same basic product may be packed in different sizes and sold under different brands each of which offers a specific value proposition to its respective customers. A good DPP analysis should enable marketing finance managers to ‘cut and slice’ the financial information in the most appropriate and relevant way and at the right level for the particular strategicdecisionthatisunderconsideration.Thisnormallyresultsinproducts being classified into a hierarchical structure with differing degrees of finan- cial information being required at each level as is illustrated by Practical Insight10.1. PracticalInsight10.1 Directproductprofitability Asalreadystatedaproduct-ledstrategyshouldbebasedontheexistingsuccess- fulproductsthatarealreadyachievingorarecapableofachievingsustainable Oneproductormany One of the main products sold by Knight Foods the subject of the main case study in Chapter 6 was dehydrated instant mashed potato IMP. The company hadtwomainconsumerbrandsbutmanufacturedretailerbrandsforanumberof major supermarkets and also sold the product into the catering and industrial sectors. Thus the finished product was packed into a wide range of pack sizes differentcaseconfigurationsetc. Howevertheinitialpartofthemanufacturingprocesswascommontoallthose productsi.e.rawpotatoeswereprocessedintoadehydratedpowderthatwasthen qualitygraded.Thesecondaryprocessvariedwithdifferentadditivesbeingmixed into some products and the premium brand going through a re-agglomeration process so as to form the powder into small pieces of potato. These different formulations then required separate bulk storage facilities although common bulkstoragebyqualitygradewasusedattheendoftheprimaryprocess. Packagingmachineswerededicatedtospecificpacksizesratherthanformula- tionsandthedistributionchannelagainnottheformulationsdictatedthetertiary supply chain costs i.e. distribution key accounts and trade marketing that were attributabletotheproduct. Clearly most of the marketing costs were directly attributable to the brand or thecustomerforretailerbrandslevelintheproducthierarchy. Thus the product costings were a complex mixture of common and shared resources with specifically direct costs by brand pack size distribution channel manufacturing process and quality grade. Clearly some business decisions could haveimpactsatanyorseveraloftheselevelsanditisthereforeimportantthatthe DPPsystemprovidesaccuratetimelyandrelevantinformationtosupportdecisions atallthesepossiblelevels.

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266 Marketing Finance super profits in their current markets or market segments. A growth strategy based on these products seeks to find new markets or segments in which the keydifferentialattributesofthesesuccessfulproductsshouldbesimilarlyappro- priateandrelevantandhencefinanciallysuccessful. Consequentlyanessentialelementinimplementingaproduct-basedstrategy is a good DPP analysis in order to indicate the relative profitability of the product portfolio. DPP analysis has been in use by leading companies for manyyearshavingbeendevelopedoriginallybyProcterGamblePGas ameansofdefendingtheshelfspaceallocationsgiventosomeoftheirleading products. In the 1960s supermarkets were becoming more contribution- oriented and were looking at the rate of contribution generated from each squaremetreofshelfspacetheynowusecubiccapacitysoastotakeaccount ofstackingheightinthestore.Atfirstsightthisplacedbulkyrelativelylow- priced items at a significant disadvantage the classic contrasts were always betweenwashingpowdersandrazorblades.AsPGwasandstillisalead- ingplayerinwashingpowdersitsetouttodemonstratethatiftherateofsale was included in the financial analysis the overall direct profit contribution fromwashingpowderwas atleastasgoodas thesmallermorehighlypriced butlessfrequentlypurchasedalternativeproducts. Not surprisingly this DPP analysis has been developed since these early days but perhaps more surprisingly the most sophisticated versions of the analysishavebeendevelopedbyretailers.Manyretailersnowallocateindivid- ual product facings as well as the total space for a whole category of goods based on a detailed DPP analysis clearly it has become very important for manufacturerssellingthroughtheseretailchannelsofdistributiontocarryout theirownequallyrigorousDPPanalyses.Thisimmediatelyhighlightsoneof the issues discussed in Chapter 9 on relationship marketing and customer valuethemanufacturerneedstodoaDPPanalysistounderstanditsownrela- tive profitability but it also needs to understand the profitability of its direct customers from the various components of its total product range. This issue whichmayresultincross-subsidisationisdiscussedlaterinthechapter. An illustrative example of a DPP analysis for a manufacturing company is given in Figure 10.2 and immediately comparisons can be made with the customer account profitability CAP analysis shown in Chapter 9. In a CAP analysisallthecoststhatareincludedaredirectlyattributabletothecustomer whereas in a DPP analysis they should be directly attributed to the product. Thus all the headings in Figure 10.2 are ‘product specific’ ‘direct product costs’‘productattributableoverheads’withtheresultbeingtoarriveatvalidly comparable‘directproductprofitability’totals.Theactualheadingshouldof course be direct product contribution but P G originally christened the analysisDPPandthenamehasstuck Asbeforetheobjectiveisnottoapportionthetotalcostsofthecompanyin ordertoarriveatacompletelymeaninglessnetprofitbyproduct.Unfortunately I still come across companies doing this with sometimes quite disastrous

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Product-BasedStrategies 267 results. It is quite common to find after apportioning all costs including the CEO’s salary etc. that one or two products make ‘a loss’. If this information isusedasthebasisfordecision-makingthecompanymaydecidethatitwould be better off financially if it stopped selling these ‘loss-making’ products. Of courseoncetheseproductsarede-listeditthenhastoreapportiontheseshared costs unless the CEO is willing to take a proportionate cut in salary etc. to theremainingproducts.Thiscanresultinnewproductsbecoming‘lossmaking’ and hence candidates for termination. Before long we could using such ‘finan- cial analysis’ have justified closing down what was previously a profitable business. TheDPPanalysisshouldonlyincludedecisionrelevantcostsandtheseare the directly attributable costs at the level of the product segmentation that is beinganalysed.This isoneofthekeychallengesofDPPanalysisifthereare too many product classifications there will be a very low level of directly attributable costs and the analysis will not be very helpful as a decision support tool. However if there are too few product groupings the analysis which will be much more comprehensive will be of even less use in decision- making. Clearly as highlighted in Practical Insight 10.1 different types of strategic decision will require different levels of product grouping. As was true for CAP analysis the challenge is to identify the true costdriverforeach type of cost and to use this cost driver to allocate the cost to the appropriate Gross sales by product x Less product-specific discounts rebates x Net sales by product x Less direct costs of product x Gross product contribution x Less product-based marketing expenses x Product-specific direct sales support costs x x x Less product-specific direct transaction costs Sourcing costs x Operations support x Fixed assets financing x Warehousing distribution x Inventory financing x Order invoice collection processing x x x Less product attributable overheads x Direct product profitability x £ Figure10.2 Directproductprofitabilityanalyses:illustrativeexampleofa manufacturingcompany’sDPPanalyses

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268 Marketing Finance product level in the DPP analysis this cost driver should not then automatic- ally be used to apportion the total cost down to lower levels in the analysis. Identifying the ‘causes’ of costs being incurred is therefore critical as is illustratedbyPracticalInsight10.2. PracticalInsight10.2 This issue makes the grouping of products very important. The grouping shouldproduceamanageablenumberofproductcategoriesateachhorizontal division of the total without destroying the decision relevance of the DPP analysis.A good DPPsystem should take accountofallthe significantdiffer- ences in the ways products are developed sourced produced marketed sold and distributed.Thus theanalysis shouldcomparealltherelevantareas ofthe business.Asaresultproductgroupswilloftenemphasisesharedtechnologies raw material inputs processes fixed assets brand names packaging formats anddeliverymechanisms. Productattributes InadditiontodesigningtheDPPsystemaroundthespecificproductgroupings required by any business the analysis needs to take account of the particular Excesswarehousestock:whobearsthecost Continuing to use Knight Foods as an example it had very high finished goods stocksofoneproductgroupinitsIMPrange.Thecateringrangeofproductswas packed in 5-kg cans which were sealed while being flushed with nitrogen and these were packed in cases of six cans. These cases were stacked on pallets and the pallets could quite safely be stacked in the warehouse four high without damaging the product. Also because it was canned and nitrogen flushed this producthadbyfarthelongestshelflifeintheentireproductrange. However most of the orders for catering products were large full truck loads and had significant delivery lead times. Thus these products could have been manufacturedtoordersothatfinishedgoodsstocksofthisrangewouldhavebeen minimal.YetthewarehousewasfullofcateringIMP. Theexplanationwasnottoounexpected.Productionusedthisproductasaway of balancing their production efficiencies due to its long shelf life and ease of storageinotherwordsitwastheclassicfallbackproductbelovedofproduction schedulerseverywhere. Consequentlytheproductiondepartmentshouldbeallocatedtheexcessstorage costsforthiscateringproductastheyaregettingthebenefitinimprovedproduc- tion utilisations and recoveries etc. They are the real cost driver and not the catering sales and marketing team who didn’t ask for the inventory and would prefer not to have had it as it continually generated questions from top manage- mentwhoassumedthattheywerenotsellingenough.

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Product-BasedStrategies 269 productattributespresentintheorganisation.Thesimplestwayofdistinguish- ing product attributes is as we have done before to separate them between costadvantageattributesanddifferentiationattributesasisdoneinFigure10.3. If a product has neither differentiation nor cost advantage attributes it is reallyacommodityproduct.Ashaspreviouslybeendiscussedcommodityprod- ucts sell exclusively on price but no one creates any sustainable shareholder value from producing a pure commodity product. When a product possesses both cost advantage and differentiation attributes the company has a very attractiveproductandshouldbeabletogeneratesubstantialsustainablesuper profits. However in most cases products possess one or other set of attributes and the different types of product attributes require very different DPP systems. ThisanalysisisverysimilartosomeoftheissuesconsideredinChapter5when the details of competitor analysis were discussed. If the product has a strong costadvantage but littledifferentiationcapabilitythestrategicfocus isonthe relative product cost hence cost benchmarking against competitive products isessential. A costadvantage meansby definitionbeing able to produce anequivalent product at a lower cost than competitors. This requires a precise definition of what customers perceive as an equivalent product remember that your com- petitors are defined for you by your customers in terms of their ‘alternative suppliers’.Oncetheequivalentproducthasbeenestablishedanappropriately detailed cost comparison against this competition needs to be undertaken. Thesecompetitivecostcomparisonsshouldindicateallthesourcesofexisting and predicted cost advantages and disadvantages and their likely sustainabil- ity. The analysis is meant to be decision-oriented and therefore it should be HI HI LO LO Differentiation attributes Cost advantage attributes Emphasis on cost advantage attributes Very attractive product Commodity product Emphasis on differentiation attributes Figure10.3 Productattributematrix

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270 Marketing Finance forward looking to suggest actions that are required to remove or reduce any existing cost disadvantages and to prevent potential cost disadvantages. More positively the analysis may highlight potential actions that could build new sustainablecostadvantagesforthefuture. A differentiation advantage indicates that customers perceive some value added in the product that makes it preferable to competitive offerings as was discussed in the chapter on branding this preference may be due to the func- tional characteristics of the product or to its more representational attributes. Any financial analysis of this differentiation attribute requires a clear under- standing of the cause of these customer perceptions of value-added. In most casestherewillbecostimplicationsofthisvalueaddedandtheDPPanalysis must include any additional costs incurred in generating these value-added attributes and a comparison must be made of these costs against the value perceived by the customers. When products have differentiation attributes therefore the DPP system should focus on analysing value-added rather than carryingoutexcessivelydetailedrelativecostcomparisons.Theobjectiveisto valuethespecificdifferentiationattributesofthecompany’sownproductsand competitive products from the customers’ perspective what is now normally knownas‘valueinuse’pricingsoastodistinguishitfromvisualcomparisons of selling prices. The DPP should try to identify the relative costs that either are actually incurred or would need to be incurred by the company and its competitorsindeliveringeachsuchdifferentiationattribute. Alternativelyitmaybepossibletochangecustomers’perceptionsbycreat- ing a new differentiation attribute or strengthening an existing attribute in which case the financial analysis should estimate the investment required to dothisandhighlighttherisksinvolvedinsuchaninvestmentstrategy. Productlifecycleprofitabilityanalysis AsstatedearlierDPPanalysesarenowquitecommonandinsomecompanies are carried out with a high degree of both sophistication and decision rele- vance. Importantly this means that they do indicate the relative profit contri- butionsofdifferingproductcategories. However if the long-term strategy of the organisation is to be structured around the most attractive products it is critical that the segment profitability analysesaredoneoverthelifecycleoftheproducts.Otherwiseamatureproduct maybedirectlycomparedwithanewlylaunchedproductthathasmuchbetter long-termpotentialbutdramaticallylowercurrentprofitability.Thusaproduct lifecycleprofitabilityanalysisshouldassistinconcentratingresourcesonthose productsfromwhichthegreatestlong-termsuperprofitscanbegenerated. Thisisparticularlytrueforthewiderangeofproductsthataresubjecttothe impact of the experience curve during their life cycles. The experience curve which is illustrated in Figure 10.4 shows how the unit cost expressed in real

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Product-BasedStrategies 271 terms thus excluding inflationary impacts reduces as the cumulative volume produced increases. The normal convention is to describe these experience curvesintermsofthepercentageunitcostreductiongeneratedbythedoubling of cumulative output thus the illustration in Figure 10.4 is a 70 per cent experiencecurvewhich is moresteeplydownward slopingthana80per cent one but less so than a 60 per cent curve. The factors driving these unit cost reductionsareprimarilythelearningcurveelementwherebyefficienciesimprove asaworkforcebecomesmoreusedtodoingsomethingplustheeconomiesof scale and technology benefits through which as volumes increase better and cheaperprocessescanbeutilised. An asymptotic exponential curve is somewhat difficult to use in practice butbychangingthedimensionsofeachaxistoalogarithmicbasisthiscurve becomes a nice straight line as is shown in Figure 10.5. This issue of cost levels changing with the volume produced raises an important strategic ques- tion because usually the volume demanded is determined by the selling price established but the selling price is itself normally established by some refer- encetotheexpectedcostlevelasisdiagrammaticallyshowninFigure10.6. Traditionally selling prices in these industries have tended to be reduced more slowly than costs are reducing during the rapid growth stages of the product’s development normally at the time of launch selling prices are set at or below the initially very high unit costs as is shown in Figure 10.7. This means that profitmargins per unitare increasing whilesales volumes are also increasing rapidly the industry should therefore be highly profitable during this period. Unfortunately this has frequently ended in tears because the com- bination of high profits and rapidly growing demand has either attracted in a large number of new entrants or has resulted in dramatic capacity expansion Y 70 Y X Cumulative volume produced Cost per unit in real £’s 2X Figure10.4 Experiencecurve

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272 Marketing Finance Log cumulative volume Log cost per unit in real £’s Figure10.5 Experiencecurveusinglog:logaxes Selling price per unit Forecast volume of sales Cost per unit produced Resulting profit per unit of product Selling price impacts on sales volumes Sales volumes impact on cost of production Figure10.6 Lifecyclecostingtechniques–pricingstrategyinanexperiencecurve environment Launch Growth Shake -out Maturity Selling price Cost Annual sales volumes Log cumulative volume Log price and cost per unit in real £’s . Figure10.7 Lifecyclecostingtechnique:experiencecostcurvesandsellingprices

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Product-BasedStrategies 273 by the existing businesses within the industry. This surge in productive cap- acityhasoftenresultedintheshortsharpshake-outphaseintheindustrythat is shown in Figure 10.7 as the dip in the selling price line i.e. fierce price competitiontakesplaceuntiltheindustrymovesbacktowardsamorebalanced position between supply and demand. Quite frequently of course the selling pricehastofallwellbelowtheunitcostsduringtheintensepricewarthatmay be needed to resolve the excess capacity problem. Once stability is restored the selling price and cost per unit should move in parallel as is shown in Figure10.7andillustratedinPracticalInsight10.3. PracticalInsight10.3 However there is not surprisingly an alternative way of using such a pre- dictable cost reduction linkage with volume. Instead of setting today’s selling price by reference to today’s costs the price today is established by reference to the long-term cost level that will be achieved once the product achieves its fullpotential.Thisclearlywillgiveamuchlowerinitialsellingpriceandshould stimulate demand much more quickly than if the selling price starts high and isreducedprogressively.DiagrammaticallythisisshowninFigure10.8where it is clear that the selling price is based on the expected long-term cost per unitplusarequiredrateofreturnperunitplushopefullyasuperprofitlevel. The strategy behind such a pricing move is to try to develop a long-term sustainablecompetitivecostadvantagebymovingmuchfasterdowntheexperi- encecurvethancompetitors.Thusifsuccessfultheshort-term ‘loss’perunit can be regarded as an investment in developing this sustainable cost advant- age hence producing the hoped for super profit level of return once costs do come down to their long-term expected level. Clearly there are a number of Technologyproductsandexperiencecurves Many consumer technology products have exhibited exactly the pricing and cost characteristics discussed above. The high initial selling prices established at their launch for most of these products video recorders dvd players wide screen and plasma TVs third generation mobile phones etc. severely limit demand to the very wealthy plus those individuals that must have the latest innovation. As sell- ing prices are reduced the products become more mainstream and the demand increases dramatically thus fuelling the reduction in unit costs that comes with increased cumulative volumes. Indeed the companies themselves often manage this process as is currently the case with the latest video mobile phones where companies are already actively forecasting dramatically reducing prices over the next12–18months. Setting a high initial price can be part of a skimming pricing policy as is dis- cussed later but it can also be part of developing the aura around the product. ‘Lastyearit sold for£1000but today you canbuy it for£250’as long as you do notseriouslyannoyallthepeoplewhopaid£1000thismayworkwell.

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274 Marketing Finance risks associated with such a strategy one of which is that it depends critically on the slope of the experience curve for this product if it is actually an 80 percentcurvebutthestrategyassumeda60percentcurveitwillbeafinan- cialdisasterascostswillneverreachtheanticipatedlevel. Also it assumes that reducing the selling price immediately will stimulate demanddramaticallyforsomeproductsitmaybenecessaryforconsumersto see their key influencers i.e. role models buying the early expensive models before the product becomes accepted. However the greatest risk is probably theassumptionthatthiswillbuildasustainablecostadvantage.Itmaybethat competitorsfindacompletelynewwayofproducingtheproductoncedemand has become so large the cost advantage assumes that competitors will follow the leader down the normal industry experience curve. Another possible risk isthatthetotaldemandissimplynotlargeenoughtogeneratethecostsavings needed to make the initial selling price profitable a variant on this is illus- tratedinPracticalInsight10.4. PracticalInsight10.4 Aeroplanedemand–experiencecurvedriven Oneindustrythathasformanyyearsappliedtheexperiencecurvelogicisaero- space. The whole philosophy of developing new aircraft is the linkage between thepotentialdemandandthecostperunit.Thisexplainswhythemajoraerospace companies are so keen to sell options long-term fleet orders etc. to their major potentialcustomersasearlyin thedevelopmentcycle aspossibleanythingthat The ‘short-term loss per unit’ if successful is really an investment in developing a long-term sustainable cost advantage Log cumulative volume Log price and cost per unit in real £’s Profit margin to achieve long-term required rate of return Long-term achievement of super profit Today’s selling price Long-term cost per unit Long-term expected volume based on today’s selling price Prices set now based on long-term costs Current costs per unit Short-term losses Figure10.8 Lifecyclecostingtechniques:strategicuseofexperiencecurvesin settingprices

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Product-BasedStrategies 275 Penetrationversusskimmingpricingstrategies Thisuseoflong-termcostprojectionsasthebasisofcurrentpricingdecisions is a good example ofa‘penetration pricing’strategy. Prices are initially set at lowlevelse.g.belowcurrentcostsinanattempttostimulategrowthindemand and to gain substantial early market share. Thus early losses are expected but the strong market share if it can be retained and the rapidly growing total market should enhance the long-term profitability of the business. Indeed a penetration pricing strategy can be used as an entry barrier to keep potential competitors from entering a rapidly growing industry. If selling prices are set below current costs any new entrant faces the prospect of making losses on their early sales in addition to all the normal investment costs associated with entering a new industry ormarket. This potential for loss making may at least lead to a deferral of any competitive entry until more knowledge regarding the rate of growth and full potential of the market has been gained. Unfortun- ately for this potential competitor such a delay will normally result in more sustained losses when they do enter as the original company will already be progressing down its experience curve and approaching the long-run cost positionatwhichitwillstarttomakegoodprofits. Howeverinmanycasesthefirstcompanyinthemarketlooksattheshort- termopportunityandsotakesadvantageofitsearlydominantpositionandthe low initial demand to set selling prices at a level that enables it to show good profits initially. This ‘skimming’ type of pricing strategy may seem attractive in the short term but the high selling prices will delay the rate of growth in sales volumes. The lower sales volumes reduce the cost advantage that the business can build up over prospective competitors because its cumulative volume will be less and it is the cumulative total volume that gives rise to the major benefits of the experience curve. Also the early high profit margins mayattractnewcompetitors.Ifthecoststructureoftheindustryisoneofhigh fixedcostsandlowvariablecostsasubsequentchangetomuchlowerselling helps to definethe long-termpotentialdemand for thenewaeroplane reduces the risksignificantly. An extreme and slightly silly example of this is that the only thing wrong with the financial evaluation of Concorde was that they didn’t sell the 000’s of them thatwereneededtomakeitfinanciallyviable.Amuchhighervolumewouldhave reduced the direct manufacturing cost per unit dramatically plus enabling the very sizeable development costs to have been recovered over such increased volumes. Unfortunatelytheworlddemandwasnevergoingtobethatbigandthedramatic increasesinfuelpricesnottoolongafterConcorde’slaunchfurthercurtailedany sizeablepotentialdemand.Itisstillslightlysadtolearnwhilefinishingthebook thatConcordeistobepensionedoffattheendoftheyear.

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276 Marketing Finance pricesoncethecompetitivecapacityhasbeeninstalledwillnotprovesuccess- fulsuchpotentialcompetitorsmustbekeptoutifatallpossible. Crosssubsidisation ManycompaniesnowuseDPPanalysisinconjunctionwiththeirCAPanalysis inanattempttoshowhowadvantageousitisforacustomertobuytheirwhole range of products rather than selecting only the top few brand leaders. This strategycanbeenhancedwherefinanciallyjustifiablebygivingthecustomer anadditionaldiscountifthewholerangeofproductsincludinganynewprod- uct launches is stocked. This is a variation on the logic of giving discounts based on the total sales revenue generated from a customer over a specified periodnormallythe financial yearofthe supplierwhenitisreferredtoasan overriding discount and should also be rigorously evaluated by marketing finance. The problem is that the discount is usually given on all the business donewith this customerratherthan only ontheincrementalbusiness.Conse- quently the product mix bought by the customer may be significant if the net contributionsvaryconsiderablyacrosstherange. The extra discount for full stocking is normally beneficial to innovative companiesthatareregularlylaunchingcompletelynewproductsadditionsto existing products range extensions etc. Such a discount can be used to guarantee a critical mass of distribution immediately upon launch so that the launch advertising is not wasted due to an absence of effective distribution. This can be particularly cost effective if the discounts are only given to leading customers that are likely to influence the buying decisions of the majorityofremainingpotentialcustomers.Gainingimmediatedistributionfor new products in these leading customers may almost guarantee initial orders from the rest. However it is critically important that marketing finance under- stands the true cause of such discounts being given so that the cost can be properly attributed rather than being spread across all products or charged directly to the leading customers with a consequent reduction in their relative profitability. Another quite common marketing strategy that creates complications for any product profitability analysis is to use one product as a ‘loss leader’ in order to sell other more profitable products to the same or related customers. Obviously if the majority of customers only purchased the subsidised loss leaderproducttheoverallprofitabilityofthebusinesswoulddisappearalthough growth in sales revenues might be substantial. It is also quite possible that a change in the external competitive environment such as the development of more focused competitors could make the existing cross subsidisation strat- egyunsustainableinthefuturethecomputerindustryillustratesthispoint. Initially most computer manufacturers regarded themselves as producing andsellinghardwareboxesandthesizeoftheboxwasdeterminedbythedata

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Product-BasedStrategies 277 processing requirements of the customer. Almost coincidentally the customer neededsoftwaretooperatethehardwareandtechnicalsupporttomaintainthe complexkit.Asprocessingvolumesincreasedthecustomerneededmoreand more hardware and add-on memory and extra central processing units were bought to plug into the existing hardware. If one company supplies all of a customer’s computer needs hardware software maintenance the customer is only really interested in the total price charged and the relative pricing of individualelementswithinthepackagedoesnotreallymatter. However as soon as new competitors enter the industry with different more focused strategies this relative pricing becomes critical. If the prices of hardwarearesetrelativelyhighwithsoftwareandmaintenancebeingprovided almostatcostthepotentialfornewhardwaresupplierstoentertheindustryis clear. This is particularly true if they specialise in one particular peripheral device such as printers disk drives etc. so that they can quickly gain the maximum economies of scale and produce very good quality products. These new competitors can severely affect the overall profitability of the main computer companies if they reduce these original companies’ share of the previously highly profitable add-on markets. One potential strategic response by the original computer companies could be to alter the relative pricing strategy of the component elements reducing the selling prices of hardware peripheralsbutincreasingsoftwareandmaintenance.Thisclearlyreducesthe attractivenessoftheindustrytofocusedhardwaremanufacturersbutincreases ittoindependentsoftwarehousesandthirdpartymaintenancecompanies.The cross subsidisation almost inevitably makes it attractive for a more focused competitor to concentrate on the product that is showing the excessively high profit margin and to ignore the product that is being heavily subsidised. It is therefore vitally important that the relative pricing strategies for related prod- uctsareonlyestablishedaftercarefulexaminationofthepotentialcompetitive responses. Reinvestingtoreplaceanexistingcompetitiveadvantage Clearly it is possible for one company to maintain its own relative pricing strategywhenitisamonopolysupplierbutashasbeenarguedthroughoutthe book monopoly positions are unlikely to be sustainable in the long term particularly if super profit rates of return are achieved by the monopolist. Therefore a company with any existing strong competitive advantage must analyse both the remaining economic life of the existing competitive advant- ageandwhatitcaneventuallybereplacedby.Ashasalreadybeenmadeclear mostprotectablecompetitiveadvantagesaretheresultofsignificanthigh-risk investments and these investments need to be rigorously financially evalu- atedthisisjustastruewhentherequiredexpenditureisareinvestmentofpart ofthesuperprofitsbeinggeneratedbyacurrentadvantage.

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278 Marketing Finance Thiscanbeillustratedbyanexamplefromthepharmaceuticalindustryof a patented drug. Pharmaceutical companies spend vast amounts on RD in an attempt to develop new molecular entities from which new drugs can be developed.Thereturnfromsuchsuccessfulnewdrugscanbeprotectedbythe granting of a patent which normally has a finite life of 20 years part of this economic life is used up during the development and testing period of the drugbeforethecompanyislicensedtosellit.Thisisshowndiagrammatically asFigure10.9. Duringthismonopolysupplierperiodthepatentownercangenerateahigh return in order to justify its earlier high-risk research investment. However part of this super profit can be reinvested in an attempt to create a new replacement competitive advantage for the period following the expiry of the patent. Although its competitors are not allowed to produce and sell the patented drug they will all be able to reverse engineer its clinical properties and thus will be ready to launch their own much cheaper versions at the known end of the patent period. They can be quite willing to sell at a cheaper price because they did not spend the money on high risk RD and the risk associatedwiththedrugissignificantlylowerasthetotalmarketpotentialhas by now been precisely defined. It is by no means unusual in this industry to find selling prices falling by 80–90 per cent in the year following a patent expiry. Howeverthepatentownercanseektopre-emptthispositionbyavarietyof new marketing strategies as are shown in Figure 10.10 the decision will be significantlyinfluencedbythecorecompetencesoftheparticulardrugcompany. Onepossibilityistouseaversionofthepenetrationpricingstrategydiscussed earlier so that selling prices are reduced towards the end of the patent life. Patented product keeps potential competitors out – but has finite life Potential competitor Potential competitor Potential competitor Monopoly supplier of patented drug Figure10.9 Reinvestingtoreplaceanexistingcompetitiveadvantage:competitive positionduringthelifeoftheoriginalSCA–e.g.apatenteddrug

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Product-BasedStrategies 279 This increases total demand and could enable the company to retain the pos- ition of the lowest cost manufacturer of the drug even after its patent has expired. Unfortunately there is an almost inevitable conflict between a very ‘lean and mean’ low-costculture and the high RD expenditureswith equally highprofitmarginsofapatent-focusedpharmaceuticalcompany. An alternative strategy therefore is to try to develop a new patent related to thesameproductsothattheentrybarrierispreservedforseveralmoreyears. Classic examples from the industry include new delivery formulations slow release versions of the drug and stronger or weaker versions of the original each of these needs careful evaluation of the probability of success prior to any significant expenditure being incurred. Another increasingly common strategy is to develop the product into a brand during its patented period this does not increase the financial return during this period as it is by definition the only product available. However the branding particularly when com- binedwithaccesstoanewdistributionchannelsuchasthe‘over-the-counter’ drugmarketbeforecompetitorsareabletorespondcangenerateahighlevel of consumer loyalty. This can mean that the originator does not have to drop itssellingpriceeventhoughmuchcheapergenericversionseventuallybecome available. Strategicuseofstandardcosting There are already many productcosting techniques thathave been developed. Therefore a marketing finance approach does not need to develop lots of new Low-cost manufacture Branding/distn channel New patent Competitor Competitor Competitor Original patent expired Figure10.10 Reinvestingtoreplaceanexistingcompetitiveadvantage:competitive positionaftertheexpiryoftheoriginalSCA–competitorsarenowabletolaunchtheir versionofthepreviouslypatentedproduct

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280 Marketing Finance techniques it simply needs to use the existing ones more strategically. An excellentexampleofthisisstandardcostingwhichhasbeenverywidelyused forover50yearsbutinmanycompaniescausesmoreproblemsthanitsolves. In many companies there are a wide range of ‘engineering’ type relation- shipswhereforanygivenlevelofinputtheamountthatwillbeproducedcan be predicted with relative confidence indeed the amount that should be produced can often be predicted with absolute certainty. Any difference from this expected level can be attributed to the efficiency of the production processratherthantheaccuracyofthepredictiverelationship.Converselyfor any required level of output the inputs needed can also be calculated. These relationships are by no means restricted to the production or engineering environment examples are common in sales force planning distribution and logisticsandadvertisingawarenesscreationandmaintenance. However the ‘true’ engineering relationships apply to physical quantities e.g.tonnesofsteelhoursworkedcallsmadedeliveriesmade‘opportunities tosee’advertisementsbutforfinancialdecision-makingthesephysicalitems havetobeturnedintomonetaryvalues.Standardcostingdoesthisbycalculat- ing a ‘standard’ rate per unit e.g. per tonne per hour etc. and this is where theproblemsstart.Clearlyanybusinesswantsitsmanagerstobemotivatedto makethebesteconomicdecisionforthecompanyandalldecisionsshouldbe based on up-to-date forward-looking information yet ‘standard costs’ are normally calculated for the whole of next year before the year has even started and are often based on the current year’s actual costs. Also if costs fluctuate significantly away from the standard cost our perception of man- agers’ actual performance may be distorted and they may be motivated to act against the economic interests of the business. A numerical example may make this clearer once the fundamental logic underpinning standard costing hasbeensummarised. A standard cost consists of two basic elements: a standard usage per unit andastandardpriceperunittogethertheyproducethestandardcost.Thusas showninFigure10.11forlabourastandardcostiscalculatedbymultiplying thestandardtimeallowanceforsomespecifiedprocessoroutputbythestand- ard rate for that grade of labour. Therefore a standard cost is the level of cost that should be incurred for a given level of activity and is normally governed by some measurable input–output relationship. Of course it is most unlikely thatinrealitythestandardcostwillbeachievedandoneofthegreatstrengths of standard costing is that it enables a detailed analysis of the causes of the differences between i.e. variances from actual and standard costs. The trad- itional approach to variance analysis which is set out in Figure 10.12 splits thesedifferencesintoausageorefficiencyvariancethenormalnomenclature isusageformaterialsetc.andefficiencyforlabourandapriceorratevariance with rate being used for labour. The objective is quite logically to allocate accountability with controllability and any price or rate variance is often

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Product-BasedStrategies 281 outside the direct control of operational e.g. production managers. My silly example in this area is from the car industry if the price of steel suddenly increases by 25 per cent the manager responsible for body assembly cannot really offset this increase by sending out four-door cars with only three doors fitted Thus the usage/efficiency variance is traditionally calculated using the standardpriceperunitwithalltheprice/ratevariancebeingseparatelyidentified. This appears fine until the full ramifications are evaluated in a period of volatilepricesparticularlywheretherearealternativewaysofworking.Most business outputs can be achieved in a variety of ways ranging from ‘fast and furious’ to ‘slow and steady’ i.e. a rapid rate of output giving good labour efficiency but higher raw material usage or a slower speed with less wastage. If line managers are to make the best possible economic decisions they must be based on the latest possible costs and not on standards that may now be wildlyout-of-date.Thiscanactuallybeachievedbyaveryminorbutsignifi- cant change in the way variances are computed as is shown in Figure 10.13. Theusage/efficiencyvarianceisstillbasedonthedifferenceinphysicalusage betweentheactualandthestandardallowancesbutthisdifferenceisnowturned Standard cost Standard labour cost e.g. for labour processes Standard usage per unit × Standard price per unit Standard time allowance × Standard rate per hour for this grade of labour Figure10.11 Strategicuseofstandardcostingtechniques:componentsof astandardcost Price/rate variance Usage/efficiency variance Standard price per unit Actual price per unit Actual units used – × Std usage allowance Actual usage Standard price per unit – × Figure10.12 Strategicuseofstandardcostingtechniques:standardcosting–the traditionalapproachtovarianceanalysis

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282 Marketing Finance intoafinancialvaluebymultiplyingbytheactuali.e.latestpriceperunit.In factifitisavailableitisbetterstilltousethereplacementpricei.e.thefore- castoranyoutstandingordervaluepriceperunitasthisisthebestestimate offuturecosts. Casestudy–Sub-assemblersInc. Sub-assemblers Inc. had built up a good reputation for the efficient contract production and assembly of a broad range of relatively labour intensive prod- ucts. It did not develop any new products itself and focused on being a low- costcontractorforothercompanies.Asthecompanywasnormallyproducing a constantly changing range of products production managers needed quite wide discretion in the way they ran the operations area. This required up-to-daterelevantfinancialinformationfromthestandardcostingsystem. However although weekly detailed variances were produced the company waslosingoutontherenewalofsomecontractscustomershadindicatedthat competitorswerequotinglowerpricesonestablishedproductlines.Acommon factorintheselostorderswasahighdegreeofvolatilityinrawmaterialprices and consequently large price variances. Sub-assemblers had increased the proportion of self-employed workers used on these contracts with a resulting changeinthelabourrateawayfromthestandardestablishedbeforethebegin- ningoftheyear. One particular contract illustrated the problem the standard cost per unit wasbasedon4hoursoflabourwithanallowanceoftenunitsofrawmaterial as shown in Figure 10.14. However if more care was taken the raw material usage could be reduced to eight units but this way of working would require 6hoursoflabour.ThestandardcostingsystemshowedasinFigure10.15that thisalternativewouldbemoreexpensive. The weekly variance analysis also seemed to indicate that operations were being run effectively as there were net favourable efficiency variances the favourablelabourefficiencyvariancesof£12500morethancompensatingfor the adverse raw material usage variance of £10000. Unfortunately this £2500 Usage / Efficiency variance Actual usage Actual price per unit – × Std usage allowance Price / rate variance Standard price per unit Actual price per unit Standard usage allowance – × Figure10.13 Strategicuseofstandardcostingtechniques:standardcosting–the strategicapproachtovarianceanalysis

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Product-BasedStrategies 283 positivevariancewasfaroutweighedbytheadverserawmaterialpricevariance of£55000evenafterallowingforafavourablelabourratevarianceof£7500 there was still a net £45000 adverse variance on the week’s activities. These calculationsaresetoutinFigure10.16. However Figure 10.14 showed that the actual costs per unit were a long way from those predicted in the standards the labour rate per hour was only £10 compared to £12.50 while the raw material price per unit was a massive £15 compared to only £10 in the standard. This meant in reality savings in labourtimeswereworthlesswhileusingexcessrawmaterialwasmuchmore expensive. Re-computing the efficiency variances using actual prices as is done in Figure 10.17 shows that the real efficiency impact is an adverse £5000ratherthanthepreviouslycalculatedfavourable£2500. Furthermorethesechanges inrelativeinputpricesmeanthatthealternative way of working should also be reassessed as is done in Figure 10.18. This Figure10.14 BasedataforproductX Required weekly output 1000 units Standard costs per unit: Labour cost Standard time × Standard rate per £50 of 4 hours hour of £12.50 Standard raw material Standard units × Standard price £100 cost material Y allowed of 10 per unit of £10 Total standard cost £150 Actual costs for week were: Labour rate per hour £10 Material Y price per unit £15 Actual labour used 3000 hours Actual units of material Y used 11 000 Actual units of X produced 1000 Total costs for week: Labour 3000 hours £10 £30 000 Material Y 11 000 units £15 £1 65 000 £1 95 000 but standard cost for 1000 units £1 50 000 i.e. total adverse variance of £45 000 per ’000 units of X Existing method Slower more careful method Labour costs 4 × £12.50 × 1000 £50 000 6 × £12.50 × 1000 £75 000 Material costs 10 × £10.00 × 1000 £1 00 000 8 × £10.00 × 1000 £80 000 Total costs £1 50 000 £1 55 000 i.e. The alternative method of production would increase costs per 1000 units of X by £5000. Figure10.15 Productiontrade-offsatstandardprices

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284 Marketing Finance showsthattheincreasedactualrawmaterialcostsmeanthatitwouldbebene- ficial to use less raw material even though this requires more of the now cheaperlabourinput.Clearlyitmakessensethatsuchdecisionsshouldusethe most up-to-date cost inputs rather than the now irrelevant and out-of-date standard prices. The strength of standard costing rests on the engineered input–output relationships but these do not extend to the input price relation- shipshenceactualcostsmakeforamoredecision-basedformofanalysisyet disappointingly few companies have made this small alteration to their stand- ardcostingsystems. Labour variances: Labour rate variance Standard rate − Actual rate × Actual hours i.e. £12.50 − £10.00 × 3000 Hours Favourable £7500 Labour efficiency variance Standard usage − Actual usage × Standard rate i.e. 4 × 1000 − 3000 × £12.50 Favourable £12 500 Total favourable labour variance £20 000 Raw material variances Price variance Standard price − Actual price × Actual units i.e. £10.00 − £15.00 × 11 000 Adverse £55 000 Usage variance Standard usage − Actual usage × Standard price i.e. 10 × 1000 − 11 000 × £10 Adverse £10 000 Total adverse labour variance £65 000 Figure10.16 Company’svarianceanalysis Favourable labour efficiency 4 × 1000 − 3000 × £10.00 per hour £10 000 Adverse material usage 10 × 1000 − 11 000 × £15.00 per unit £15 000 Net adverse variance £5000 Figure10.17 Realefficiencyvariancesusingactualprices per ’000 units of X Existing method Slower more careful method Labour costs 4 × £10.00 × 1000 £40 000 6 × £10.00 × 1000 £60 000 Material costs 10 × £15.00 × 1000 £1 50 000 8 × £15.00 × 1000 £1 20 000 Total costs £1 90 000 £1 80 000 Figure10.18 Astrategicallyorientedvarianceanalysis:re-computingthetradeoff atactualpricesbutstandardusages

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Product-BasedStrategies 285 Clearlyifacompetitorhasamorerationallybasedmanagementaccounting processornostandardcostingsystematallitsmanagersmaybemotivated to adjust their relative usage levels to take account of the actual costs being incurred. This revised method of analysis is not trying to hold operating managersresponsibleforpricechangesthattheydonotcontrolbutitistrying to make them take into account the economic realities that the company is facing. Transferpricing Another area of product costing that can create great problems in many com- panies is transfer pricing. Transfer prices should be primarily used to enable economic decisions to be taken regarding the allocation of resources within a vertically integrated group including whether a particular process should be carried out internally or outsourced. Thus these internal prices must use the appropriate level of relevant costs whether incremental or avoidable rather than reflecting an apportionment of the total costs incurred by the business. This is particularly important where a major use of transfer prices is likely to be in selecting which of a range of products is the most financially attractive. In overall terms any business should want to concentrate its resources on thoseopportunitieswiththegreatestpotentialforgeneratingsuperprofitsthe questionishowtoidentifythoseopportunities. However all businesses suffer from some constraints that restrict their abil- itytoexpandinfinitely.Thekeytothefinancialanalysisofresourceallocation decisionsistoidentifythecriticallimitingfactorthatiscurrentlyconstraining the future growth of the business such as the cubic capacity of shelf space in itsstoresfortheretailersmentionedearlierinthechapter.Ifthecompanythen focuses on those products with the greatest contribution achieved per unit of this limiting factor it will in the short term also maximise its overall profit- ability in the long term the company can invest to remove the current constraintsonitsgrowthAcasestudyshouldmakethismuchclearer. Casestudy–TissuesUnlimited It is very common for companies in the pulp and paper industry to be verti- cally integrated indeed several Scandinavian forestry products companies have moved downstream by acquiring paper packaging and nappy producing companies becauseoftheirhigh usageofwoodpulp.TissuesUnlimitedhas a large tissue mill producing bulk tissue from wood pulp and recycled waste paper. It also has converting plants to which much of the bulk tissue is transferred where it is transformed into toilet rolls facial tissues and kitchen towels which are then sold to retailers. Both the tissues mill and the convert- ing plants are run as separate investment centres so that a system of transfer

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286 Marketing Finance pricingisrequired.Thissystemiscomplicatedbecausethereisaninternation- ally traded market place for bulk tissue thus the tissue mill can sell in bulk andtheconvertingplantscouldbuyinfromoutsidesuppliers.Inordertoavoid unnecessarybuyingandsellingthesetransactionsarehandledatthecentreof thegroupbyusingtheinternaltransferpriceasabenchmark. This internal transfer price starts with the variable cost per tonne of each particular product to which is added acontribution per tonne to recover thefixed costs of the tissue mill and its required rate of return on its investment base thisisshowninFigure10.19forasmallbutrepresentativesampleofproducts. Howeverwiththistransferpricingsystemthetissuemillmanagerscurrently find themselves being asked for an increasing proportion of facial tissue pro- duction with the consequent shortage of kitchen towel and toilet tissue being made up by purchases on the bulk tissue market. This is illustrated by Figures 10.20and10.21. Fixed costs of tissue mill Budgeted division profit for year Budgeted output in tonnes ∴ Required contribution per tonne Thus transfer prices were Type of tissue White facial White kitchen towel Coloured kitchen towel White toilet Coloured toilet Coloured facial £12m £ 4m £16m 80 000 £200 Variable cost/tonne 250 230 225 205 210 195 Required contn/tonne 200 200 200 200 200 Transfer price per tonne 200 450 430 425 405 410 395 Figure10.19 Existingtissuetransferpricingsystem Facial Toilet Kitchen towel Budgeted output tonnes 25 000 35 000 20 000 80 000 age 31.25 43.75 25.00 100.00 50 37.5 12.5 100 Actual proportion Figure10.20 Tissuemillproductiontonnages White facial White kitchen towel Coloured kitchen towel White toilet Coloured toilet Coloured facial Buy-in opportunities Sell-out opportunities Tonnage Price/tonne Tonnage Price/tonne Decision Sell out Buy in Buy in No deal No deal No deal £460 £400 £400 £500 £480 £380 £375 – – – – – – – – – – 750 200 275 100 300 330 550 Figure10.21 Latestmarketprice

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Product-BasedStrategies 287 Comparingtheseavailable marketpricesagainsttheinternaltransferprices highlightsthetrendtowardstheproductionoffacialtissues.Thegrouphasan opportunity to buy in white facial at £500 per tonne and coloured facial at £480 per tonne but its own transfer prices are £450 and £430 respectively thus these deals are unattractive. However there is the chance to sell out 750 tonnes of white facial at £460 per tonne which is attractive as it is £10 higher than the required transfer price. The tissue mill can free up capacity to produce this by buying in the coloured toilet tissue at £400 compared to a transfer price of £405 and the coloured kitchen towel at £380 compared to a transfer price of £395. At first glance this strategy should be increasing thetissuemill’sdivisionalprofits. Howeverthetissuemilliswellbelowbudgeteventhoughthemillisoper- ating 24 hours per day 7 days a week. Preventive maintenance is carried out duringthetwofactoryshutdownsduringtheyearwiththeresultthatthemax- imum available hours per machine are 8000 per year 24 ×7 ×47.62 weeks. Since the mill has five similar machines the total production time is 40000 hours.Unfortunatelyforthecurrenttransferpricingsystemtheoutputs per machine hour are not the same for the range of products due to their significantlydifferentbasisweightsingrammespersquaremetreasisshown by Figure 10.22. Also with the heavier products such as kitchen towel the machinescanberunfasterwithoutholesappearinginthetissue. As the proportion of facial tissue being produced increases the total potentialtonnageoutputofthemilldecreasesindeeditisphysicallyimpossible for the mill to produce 80000 tonnes given the projected actual mix in Figure10.20.Thetonnageoutputsofproducingexclusivelyeachspecifictype oftissueareshowninFigure10.23theseillustratethatthemillisnotactually constrainedbytonnageasthischangeswiththeproductmix. White facial White kitchen towel Coloured kitchen towel White toilet Coloured toilet Coloured facial ∗ Assumes economic runs for each product Basis weight gms per sq. metre 16 16 19 19 24 24 Output in tonnes per machine hour ∗ 1.5 1.5 2.2 2.2 2.75 2.75 Figure10.22 Productweights 100 Facial tissue 100 Toilet tissue 100 Kitchen towel Tonnes per hour 1.5 2.2 2.75 Total hours 40 000 60 000 88 000 110 000 Maximum output tonnes 40 000 40 000 Figure10.23 Tissuemillpotentialtonnageoutputs

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288 Marketing Finance The real current limiting factor for the tissue mill is the available machine production hours as these cannot be increased from the current 40000 hours without acquiring another machine. Thus the transfer pricing system should be basedaroundthecontributionpermachinehourthatisrequiredtoachievethe returnsrequiredforthetissuemillthisnewcalculationisshownasFigure10.24. The impact of this change in transfer pricing is quite significant as can be seenbyreviewingthelatestmarketpricesagainstthesenewtransferpricesas isdoneinFigure10.25.Theincreasedrequiredtransferpricesoffacialtissues reversethetrendtowardsmanufacturingthisproductforexternalsaleinbulk. Given the longer time needed to produce a tonne of facial tissue it is import- ant that facial tissue is ‘charged’ for its relatively high usage of this critical limiting factor. Conversely the higher tonnage outputs per hour of kitchen towel and to a lesser extent toilet tissue mean that the required contributions per tonne are reduced so that opportunities to sell out in bulk become more attractive.Thecapacityrequiredcanbe‘freedup’bybuyinginfacialtissuea reversaloftheprevioustrend. This case study illustrates the key issue in designing a transfer pricing sys- tem use the limiting factor of the business as the driving force of the transfer prices. If this is done any decisions involving allocating this critical limiting Product Output per hour in tonnes Contn per hour∗ Contn per tonne Variable cost/tonne Transfer price/tonne White facial White kitchen Coloured kitchen White toilet Coloured toilet Coloured facial 1.5 1.5 2.2 2.2 2.75 2.75 £400 £400 £400 £400 £400 £400 £400 266.67 266.67 181.82 181.82 145.45 145.45 250 230 225 205 210 195 516.67 496.67 406.82 386.82 355.45 340.45 ∗ Contribution per hour is given by:– Fixed costs £12 m £4 m £16 m £16 m Budgeted profit Maximum available hours 40 000 ∴ Required Contn per hour 40 000 Figure10.24 Transferpricesusingcontributionperhour Product White facial White kitchen Coloured kitchen White toilet Coloured toilet Coloured facial New transfer price 516.67 496.67 406.82 386.82 355.45 340.45 Buy-in price Sell-out price – – – – – 500 400 400 480 460 380 375 Decision Buy in Buy in Sell out No deal No deal No deal Figure10.25 Impactofnewtransferprices

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Product-BasedStrategies 289 resource will be soundly based. Managers will logically concentrate their resources on those products that generate the maximum contribution per unit of the limiting factor. In practice an optimum solution can only be achieved whentheproductcontributionsperunitoflimitingfactorareequalisedother- wiseprofitscanbeimprovedbyreallocatingresourcesfromalowercontribut- ingproducttoahigherone. This logic for establishing transfer prices can be applied just as effectively totheprovisionofinternalserviceswithinabusinessthecriticalfactorsfrom the customer’s perspective must be set out in the service level agreement betweenthecustomerandtheinternalsupplier.

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PartFour Control

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11 ExercisingControloverthe Future Overview No one can control the past it can only be explained. The main value from explaining the past is if any ‘learning’ from the past can be applied to make the future better thus historical analysis should be used as a learning process toindicatehowthingsshouldbedonedifferentlyinthefuture.Theperformance measures used by a business must therefore be tailored to the key strategic thrust of that business and should highlight the potential future impact on the keyassetsofthebusinessofanynewstrategicmove. The control process must be completely integrated in the planning process Itrytoavoidusingtheterm‘planning’withoutattachingthewords‘andcontrol’ to it. Therefore businesses should not regard ‘planning marketing’ and then ‘controlling their marketing plans’ as distinct roles or sequential processes. Marketing finance must be totally involved in both planning and controlling marketingactivities. Analysis of the past can be very useful if it is applied to improve decision- makinginthefutureallfeedbackloopsshouldbetreatedasalearningprocess. Unfortunately many management accounting processes overemphasise the purelyhistoricalreconciliationaspectofreporting. Where internal business units are created and transfer pricing systems are implemented there needs to be a service level agreement SLA between the supplierandtheinternalcustomers.SLAsfacilitatetheallocationofresponsi- bilitywithinthebusinessandthusmakegoodcontrolmucheasier. There are a number of critical success factors that can be identified for sound control to be achieved by a marketing finance system. The marketing finance system must focus on strategic decisions that should have been pre- dicted in advance by the linkages between the system and the objectives and strategy of the business. The relevant decision support information should be communicatedtothestrategicdecision-makersinauserfriendlyi.e.immedi- ately usable format. Marketing finance must measure the intangible assets of the business and this is facilitated by splitting marketing expenditure into development and maintenance categories. As control can only be exercised over the future marketing finance should control the commitment process

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294 Marketing Finance rather than focusing on the actual physical payment for or expensing of the marketingactivity.Controlrequiresadegreeofchoicetobepossibleandthus ‘engineered’costrelationshipsshouldbeidentifiedparticularemphasisshould be placed on the truly discretionary activities that marketing managers can undertakepriortoanycommitmentbeingmade. Introduction It should by now be clear that ‘controlling’ marketing involves far more than recording and analysing the accounting transactions that result from market- ing activities. In other words marketing finance is not simply ‘accounting for marketing’. It should be regarded as a two-stage process involving the pre- commitment financial evaluation of proposed marketing expenditure as well astheongoingcontrolovertheseexpendituresastheytakeplace. The objectives of these varied marketing activities are very diverse but marketing has itself developed a range of tailored evaluation processes and non-financialeffectivenessmeasures.Thechallengeforfinanceistofindequally tailored and value-adding ways of controlling marketing expenditures which linktheseactivitiestotheoverallobjectivesoftheorganisation. As already discussed this requires a high degree of integration between marketing and finance and a substantial level of tailoring in the marketing finance system and the resulting performance measures used by the business. Ideally if the marketing strategy changes significantly this should lead to a corresponding change in the tailored marketing finance system. If such a changeisnotmadeitisquitelikelythatthebusinesswillbeusinginappropri- ate performance measures that may motivate marketing managers to act againstthelong-terminterestsoftheoverallbusiness.Anotherpotentialriskis that the marketing finance system does not provide adequate timely decision support information for the new key strategic decisions that the business faces as a result of the change in marketing strategy. Many organisations are taking critical marketing decisions with very little strategic financial evalu- ation because they do not have suitably tailored marketing finance systems. Insuchbusinessesthereisnoreal‘strategiccontrolovermarketing’. This part of the book tries to indicate how such strategic control over marketing can be achieved. This chapter focuses on how control can only be exercisedoverthefutureandhowfeedbackloopsshouldbeusedasalearning processratherthanasamethodof‘apportioningblame’.Thefollowingchap- ter then considers how strategically relevant performance measures should be developedforthewholebusinessbeforebeingappropriately‘cascaded’down through the organisation so that an inter-linked pyramid of key performance indicatorsisputinplace. There appear to be many reasons for the lack of sound financial controls in themarketingarea.Almostallmarketingexpenditureiswrittenoffi.e.expensed totheprofitandlossaccountintheyearinwhichitisspentirrespectiveofthe

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ExercisingControlover theFuture 295 time frame over which the returns may be generated. This is as previously stated in accordance with the so-called ‘prudent’ view underlying financial accounting tell that to investors in Enron and WorldCom because the returns from these marketing expenditures cannot be ‘guaranteed’. However there is no way that a brand launch new market entry or major new product developmentisfinanciallyjustifiablebyconsideringonlythereturnsgenerated in the first year. All long-term investments must be financially evaluated by comparingtheexpendituresrequiredagainstthefutureexpectedreturns.Where these financial returns are only expected to occur well into the future they should be included at their present value equivalent as was discussed in Chapter 7. The actual accounting treatment should be irrelevant to this decision evaluation process as economic business decisions should be based onthefuturedifferentialcashflowsarisingfromthedecisionthisisillustrated in a numerical example later in the chapter. More businesses now follow this soundlogicintheirdecisionevaluationprocessbutthenreverttousingaccounting measures to ‘control’ the implementation of the originally soundly based decision. Thisreversioncanoftenresultinlong-termdisastereventhoughtheshort- term performance measures have been achieved. The rapid growth of retailer brands that has been mentioned earlier in the book is a good example of this. Manycompaniesthatsellthroughretailerswouldregardthemselvesashaving ‘brand-based’ strategies as was discussed in Chapter 8 thus it would be illogical for these companies to do anything that damaged their brands. How- everinmanycasesthatisexactlywhattheyhavedone One initial problem seems to have been caused by their brands not being includedon theirbalance sheets as valuable assets.Thismeant that the poten- tial change in brand values resulting from any strategic moves was not as readily visible as it might have been. Also many of these companies used the very common accounting return on investment ROI ratio as a principal financial performance measure but once again the brand values were not included in this calculation. Consequently it was quite easy to justify utilising some‘spare’productivecapacitytomanufacture‘modified’productsforexist- ingcustomersi.e.largeretailers.These‘modified’productswereoftenalmost the same as the company’s branded products except for the packaging this ‘avoided’ any extra product development costs. However the pricing was normallydramaticallydifferent.Thiswasjustifiedontheargumentthatitwas marginal business e.g. up to 10 per cent of the company’s total volume and would be ‘turned off once demand for the branded products picked up again’. Pricing was therefore often done on a ‘contribution basis’ i.e. variable costs plusamargintocontributetowardsexistingfixedcostssothatnofixedcosts were directly allocated to these incremental sales. In the short term this extra sales volume even with its low-profit contribution would improve the return onnettangibleassetsbutthecompanywasalsocreatingalowerpricedcom- petitorforitsownbrandedproducts.

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296 Marketing Finance Theretailcustomerswerehappyastheyweregettingagoodqualityproduct at a very good buying-in price. This enabled them to sell out at an advanta- geous price even after taking a higher retail margin than on the equivalent branded products logically the retailer should make a greater margin as it is creating a higher proportion of the total value chain by now‘doing the brand- ing’. The next stage of this saga is depressingly predictable the retailer’s products were selling very well and it wanted to increase its orders. This was ‘goodnews’tothe manufacturerbecause itsbrandsweresellinglesswelland thereforeithadmoresparecapacityavailable. Howeverthissizeofordercouldnolongerberegardedas‘marginal’tothe manufacturer and finance departments often now wanted to allocate some overheads to this growing segment of the total business. This meant that the manufacturer wanted to increase its selling price to the retailer. You are now entering one of the most interesting and frequently shortest discussions you will ever come across in business a major retailer wants to say double its orderlevelsanditssupplierwantstoincreaseitssellingpriceforthisincreased order Not surprisingly the retailer normally expects its buying-in price to comedownasvolumesincrease. Clearlytheretailer’sresponsewastothreatentotakeawayallthevolumeto another manufacturer and also there could be significant risk attached to the volume of branded products still sold through this retailer. It is important to rememberthattheretailer’sbrandingstrategywasbasedarounditscustomers hencetheactualsupplierofthisretailer’sbrandwaslargelyirrelevantaslong asthequalityandpricingcanbemaintained.Hencethemanufacturerwasnow selling much more of a commodity product with the ‘differentiation’ being added by the retailer branding which was of course owned by the retailer. Thusmanyofthebrandedmanufacturer’scorecompetenceswerenotrelevant to this new business and its performance measures and control processes shouldalsohavebeenverydifferentasisillustratedbyPracticalInsight11.1. Formanybrandedmanufacturersthegrowthofretailerbrandshasdramatic- ally changed both their profit margins and their marketing strategies. In many FMCG industries there has been a significant downward trend over many years in theprofitability ofmanufacturers thathas been inversely mirroredby theincreaseinprofitabilityofthemajorretailersthroughwhichtheyselltheir brandedproducts. PracticalInsight11.1 Fastmovingconsumergoods:differentstrategies Having worked at both ends of these FMCG industries marketing strategies it is very clear to me that there are significant differences in culture and philosophy andhencetherequirementsforcontrolsystemsandperformancemeasures.

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ExercisingControlover theFuture 297 Ifthesebrandedmanufacturershadhadabrandevaluationprocessinplace as advocated in Chapter 8 they would have needed to take into account the potential impact on these brand values of starting to produce equivalent retailer branded goods. At the very least the relative strength of the brands asshownbytheirbrandhealthindicatorsandhencetheircapabilitytowith- stand this new form of competition should have been reviewed. In some cases this position was made even more difficult as these new ‘contracts’ for retailer own labels as they used somewhat disparagingly to be called by manufacturerswerenotevenunderthedirectcontrolofthebrandedsalesand marketingteams. The performance measures used for manufacturing and operations areas of many groups also create increasing pressures to fill machines and maximise throughputs even at marginal prices e.g. machine utilisation measures total outputmeasuresoutputsperemployeeetc.normallywithoutanyreferenceto profit margins let alone shareholder value measures. As will be repeated through this part of the book the performance measures used in the business mustbetailoredtothekeystrategicthrustofthebusinessintheaboveexample the original branded products strategy of the manufacturers. Moreover these tailoredperformancemeasuresshouldindicatethepotentialimpactonthekey drivers of this strategy e.g. the brand health indicators of the current brands of any new proposed strategic move e.g. the move into producing retailer brands. It is potentially less dangerous to sell incremental volumes of products that are available from utilising spare capacity into a new export market than to sell it to an existing customer merely packaged in a different format however even this can cause problems as is illustrated in Practical Insight11.2. Mars’ philosophy is to seek to create consumer demand through brand mar- keting so that retailers need to stock the brand this is the normal definition of a ‘power’ brand. This does not mean that retailers are not important but it means that the consumer is even more important. There should therefore be more performance measures that focus on consumers than on the direct retail customers. AsFinancialDirectorofSterlingInternationalthebasisoftheTissuesUnlimited case study I saw that this position was totally reversed. The group focused on producing retailer branded products a broad range of small brands for smaller retailgroupsandbulktissueforthebrandedproductsofothertissuemanufactur- ers otherwiseknownas competitors.The mostimportantelementthereforewas the direct customer the retailer etc. as the interface with the end consumer was very indirect and relatively vague. Thus quality was dictated by the direct customer and deliberately ranged from excellent for other manufacturers’ premium-brandedproductstoadequateforsomeretailerbrandsandmostindus- trialcustomers.

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298 Marketing Finance PracticalInsight11.2 Another marketing activity that can create many control problems is pro- motions. The confusion in many companies seems to be caused by the application of a single financial evaluation and control process to all promo- tionalactivities.Unfortunatelythemarketingjustificationsforandconsequent objectivesofdifferenttypesofpromotionscanbequitediverseandthisshould result in more tailored financial control processes. The normal financial justi- fication itself can often be too simplistic even when applied to those promo- tionswhereitisrelevant.Themostcommonformoffinancialcontrolissimply to analyse whether the additional sales generated by the promotion more than outweighthelossofprofitmargincausedbytheeffectivereductioninthesell- ingprice.Thisevaluationandcontrolprocessassumesthatthekeyobjectivefor thepromotionisashort-termincreaseinsalesvolumesbutevenifthisistrue many such promotions have a steal effect from the periods just before and afterthepromotions. As an example let us take the case of a 1-month price reducing ‘on-pack’ promotionofabrandedFMCGproductsoldthroughretailerswheretheentire cost of the promotion is to be borne by the manufacturer. This manufacturer will clearly need to sell the promotion into the retailers in the period prior to its1monthdurationandtheretailersmayquitedeliberatelyreducetheirstocks of the standard product during this period ideally retailers would want zero stocks of the standard product on the day the price reducing promotion starts. Exportsorre-imports One food company I worked for decided to increase output by launching two existing branded products into Scandinavia. The total market potential was not huge and so launch costs were kept to a minimum. The existing pack designs were retained and simply translated and distributors were appointed for the marketsegmentsidentified. This meant that British consumers would readily identify the packs but would notunderstandthecookingandpreparationinstructions.Thepricingstrategywas to make the products highly competitive in order to encourage trial etc. and this couldbejustifiedbecauseitwas‘marginalbusiness’. Soonafterlaunchoneparticulardistributorwasdoingmuchbetterthanallthe others and its volumes far exceeded our estimates of the market segment. Also this distributor suggested that rather than us delivering the containers of product to its port of entry and including the transportation cost in our selling price the distributor would collect the product from our factory for a discounted selling priceobviously. Furtherinvestigationrevealedthatthischangewouldactuallysavethisdistribu- tor2lotsofcostsforcrossingtheNorthSeaastheproductwasbeingre-imported intotheEastern region of Englandand soldata large discountto our UKselling pricestoretailersinthatregion

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ExercisingControlover theFuture 299 This will reduce standard product sales before the promotional period and of coursethesesaleswouldhavebeenmadeatafullrateofcontribution. Also hopefully consumers will increase their purchases during the promo- tionalperiodandthusretailersshouldincreasetheirpurchasescorrespondingly. However consumers may increase their purchases but not their rate of usage whichwouldmeanthatconsumerswillbuylessintheperiodafterthepromotion astheyuseupthecheaperinventoriestheyhavebuiltup.Thusthepromotional assessment must take account of the impact on sales levels at their relative contributionratesbothbeforeandaftersuchavalue-increasingpromotion. Another classic example of this type of problem is illustrated by the recent promotional activities of banks and building societies in the UK retail mort- gage market. Many financial services companies launched promotional offers ofdiscountedmortgagelendingratesofinteresttonewcustomers.Thisencour- agedlotsof existing homeowners toswitchmortgagesuppliers inorderto get alowerrateofinterestinmanycasesthesepeoplewereatthesametimeable toincreasetheirtotalborrowingsforthesamemonthlyrepaymentasthevalue of their property had increased since their original purchase. This spate of re-mortgagingcreatedamassivelevelof‘churn’inthemarketaseachpartici- pating bank and building society won many new customers and lost lots of existing customers. There was obviously a very high cost associated with this promotional bonanza due to the high administration costs of processing new mortgage documentation and closing existing accounts in addition to the reductionintheinterestratespreadonthesenewaccounts. More importantly the impact of this activity has been to reduce signifi- cantlycustomerloyaltytoanyspecificbankorbuildingsociety.Mostofthese promotionalrateswereonlyavailableto‘new’customersandthusanexisting customer did not qualify for a reduced borrowing rate on their existing mortgage where the administration costs would be negligible. They were ‘forced’tomovetheiraccounttogetthebestdealavailableandthiswasdone in an industry that claims to have ‘customer-led’ strategies where building customerloyaltyisimportant A value-increasing promotion is normally regarded as any promotion that reduces the effective selling price e.g. a directly lower selling price a buy some get some free offer a larger pack size for the normal selling price etc. Value-adding promotions offer something else other than a reduced purchase pricetothecustomerthiscantaketheformofaloyaltyprogrammesomeform of collectible a prize giving competition etc. Different types of promotion canbeusedtoachieveawiderangeofbothtacticalandmorestrategicobject- ives.Anappropriatelytailoredparticularlyintermsofthetimeperiodcovered financial evaluation and control process should therefore be used for each specificpromotionalactivity. Thisisbecomingevenmoreimportantasforanincreasingnumberofindus- triesthefragmentationofmasschannelsofcommunicatione.g.theexplosion

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300 Marketing Finance in the number of television channels and the increasing advertising overload of consumers mean that more and more companies are using promotional activitiesaskeyelementsintheirbrand-buildingstrategiesthephrases‘retail media’ and ‘new world of marketing’ are becoming increasingly common in FMCGcompanies. Integratingcontrolintotheplanningprocess That was quite deliberately a long introduction to this chapter as it attempted to show how the control process must be properly integrated into the total analysis and planning process of the business. Some readers may remember that in Part One I made the statement that planning and control are equally important and both are more important than analysis. Yet a glance at the balance of this book three chapters on analysis five chapters on planning and only two chapters on control does not seem to bear out this initial state- ment. This is because throughout the chapters on analysis and planning I have kept referring to the control issues that need to be considered. Indeed the more important statement from Part One is that analysis planning and control is a continuous iterative process and the boundaries between each stageandthenextshouldbecomeveryblurred. It is therefore illogical to use the term planning without linking it to the appropriately tailored control process that will be applied to monitor how successfully the plans are being implemented. The critical aspect about any controlprocessisthatitmustfocusonthefuturebecauseashasalreadybeen stated the past can only be explained not controlled. Unfortunately this is a classic example of the Pareto 80:20 rule being applied the wrong way round inmostcompaniesatleast80percentof themanagementaccountingreports produced are reconciliations and explanations of what has already happened. Thusendlessanalysesareproducedoflastmonth’sactualperformanceversus budgetlatestforecastthesamemonthlastyearthepreviousmonthandthen similarcomparisonsaredoneonayeartodatebasis. Obviouslytheseanalysesandexplanationscanbeusefulbutonlyiftheyare applied in a positive manner in order to improve decision-making in the future. Thus all feedback loops should be treated as a learning processand explanationsofactualeventsareakeyfeedbackloopaslongasthereispoten- tial future relevance. This means that a totally different focus needs to be applied to the financial analysis of actual results and outcomes. The most important areas for analysis are those that are most likely to recur frequently in the future and these are frequently in the marketing area of the business: price changes competitor initiatives tax and regulatory changes exchange ratemovementseconomicconditionchangesincludingbusinesscycles.Even thoughtheexactsetofcircumstances willneverbereplicatedtherecanoften be key learnings to be gained about the reactions of customers competitors andsupplierstoparticulartypesofchangeinthebusinessenvironment.

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ExercisingControlover theFuture 301 These learnings for the future are of much greater value than an incredibly detailed analysis of the specific events that happened last month unfortu- natelytheemphasisstilltendstobeonproducingaccurateprecise‘facts’that are of little use in driving the business towards its long-term objectives. The role of marketing finance is to help the organisation to achieve its goals and objectives not to provide a detailed explanation of why and how it failed to meetthem.Evenworseiswhentheroleincludes ‘who’screwedupaswellas thewhyandhowofunderperformance.Acultureof‘blameapportionment’in financialreportingleadstotheabsenceofrisk-takingwithintheorganisation. Thirty years ago as a young management accountant one of my roles was to write the notes that accompanied the monthly set of management accounts thatIwasresponsibleforpreparing.Allthemajorvariancesfromtheplanand the latest forecast had to be explained and in order to do that I went and talkedtothemanagersofeachareaofthebusiness.Inotherwordsthesenotes were prepared with in reality by these line managers because they had the detailedinformationonwhat hadactuallyhappenedintheprevious month.In mytermsifanythingIhadproducedinmymonthlyaccountsfortheirareaof responsibility cameas a surprise to themtheywerenot properlyincontrolof theirpartofthebusiness.Thebenefitandvalue-addedofthisprocesswasnot therefore in producing the actual notes to last month’s accounts which told the responsible managers nothing that they did not already know it was in providing a very valuable input to the re-forecast for the rest of the current year and for future medium- and long-term planning. An example of a good linkage between a control process and future decisions is given in Practical Insight11.3. PracticalInsight11.3 Short-runpricingdecisions Using the Tissues Unlimited case study of Chapter 10 the tissue mill faced a regular problem of how to set a selling price for short run urgent orders for bulk tissue.Thetissueproductionprocessgoesfromlightcolourstodarkandthenthe machines are stopped the tanks washed out and machines cleaned down and the cyclestartsagain.Interruptingthisprocessthereforeincreasesmachinedowntime and also the production efficiency is lower on a short run as the machines never gettorunoptimally. Prior to the change in the basis of transfer pricing the responsible manager madeaneducatedguessastohowmuchextratochargepertonneforthesesmall uneconomic quantities. However the new transfer pricing system focused on the limiting factor of output which was identified as available machine hours and a requiredcontributionpermachinehourwasestablished. This made the pricing of any special orders quite straightforward. The start pointwasobviouslythevariablecostpertonneforthespecifiedqualityoftissue. The next required input was an estimate of the total production time required for theorderintermsofmachinehoursi.e.thisincludedanydowntimerequiredto

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302 Marketing Finance Anotherkeyelementforagoodcontrolprocessisthatitshouldindicatethe sustainabilityofthepresentsituationandwhateventswillindicateinadvance that this situation is likely to change. This is particularly true for an existing differentialadvantage heldbya businessthe carindustrycompetitoranalysis example from Chapter 4 can be expanded to illustrate this point. The market- ing finance question is whether an existing differential advantage held by our company or by a competitor is really a sustainable competitive advantage. It is easiest to explain this by using two sets of very simplified numbers for a hypothetical example of one advantage held by us and one held by the main competitorthesevaluesaresetoutinTable11.1. ThevaluesinTable11.1highlightthatourcurrentdifferentialadvantageis a relatively small value enhancer but it is sustainable it would cost the competitormoretoadditintotheirproductthanthecustomerconsidersthatit is worth therefore it would be value destroying for them to do so. At present the competitor holds an apparently much greater value-enhancing advantage perceived use value of 200 with a cost to the competitor of only 140. How- ever the cost to us of matching the competitor’s current offering is even less than the competitor’s current cost level. This shows that this position can immediately be attacked by us adding in the same offering into our product and thus matching the competitor. If we do this our value creation will be greaterthan thatgenerated by the competitorsame perceived use value 200 but a cost of 130 instead of 140. The next marketing decision is whether we wanttobemoreaggressivebyreducingthesellingpricetothecustomerbecause of our cost advantage i.e. we could include this current option as a standard Short-runpricingdecisionsContinued changeover to this colour and furnish the total time to produce the ordered ton- nage and then to switch back to the normal production schedule. This total time multiplied by the required contribution per hour gave the minimum acceptable total contribution that needed to be added to the variable cost for the particular order. Table11.1 Differentialadvantage:sustainabilityevaluation Advantage heldbyus Advantageheld bycompetitor Perceivedusevaluetocustomer 100 200 Costtocurrentprovideri.e.us/competitor 90 140 Costtocompetitor/ustomatchcurrentoffering 110 130

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ExercisingControlover theFuture 303 fitment on our product because it would cost the competitor more to do the same. In this case the narrow cost differential relative to the high perceived valuebythecustomermakesthisunlikelybuttherearesomeextremelygood examplesofthisbeingdoneinthecarindustry. A classic example was the Japanese car industry looking to create an add- itionaladvantageoutoftheirsuperiormanufacturingqualitythisqualitymeant that their cars did not go wrong as often as their competitors’ cars. Unfortu- natelythiswasnotvaluedveryhighlybythecustomeratthetimeofbuyinga newcar.Thefirstphasewastoofferanoptionalextendedwarrantythatcould be purchased at the same time of buying the car the uptake on these was not very high as they were seen by customers as expensive. Indeed they were expensive as they represented a source of super profits to the car companies particularly Japanese car companies that needed to spend less on repairing their cars during this extended warranty period. The next phase was much more significant as the Japanese manufacturers included ‘for nothing’ an extended 3 year unlimited mileage or restricted mileage warranty on many of their cars. This tried to force customers to value this benefit when they compared cars from competing manufacturers. The Japanese companies also knew that it would cost their competitors far more to match this product enhancement.Obviously itforcedtheUSA-andEuropean-basedmanufactur- erstofocusontheirbuildqualitysothattheirwarrantyclaimscostswouldbe reduced significantly. As an aside this had an adverse impact on the profit- ability of the car dealerships for which warranty work had represented an importantsourceofprofits. Impactoforganisationalstructure As has been discussed before many companies are breaking their businesses down into smaller parts with the aim of making each sub-division focused on profitability and in some cases even shareholder value. This does not create many major problems when each business division represents a relatively stand-aloneorganisationwithitsownexternalcustomersproductsandideally assets what was defined in Part Two as a strategic business unit. However many groups want to go much farther than this and seek to create ‘internal’ businessdivisionsthroughtheuseoftransferpricingmechanisms. Thekeyaspectoftransferpricingasagenuinepricingsystembetweenwill- ing buyers and sellers rather than a cost apportionment exercise has already been covered but for truly internally focused divisions an equally important factor is the establishment of SLAs. An SLA sets out exactly what is being suppliedbyonepartoftheorganisationtoanotherandthuswhatisbeingpaid for. In other words it is exactly the same as the contract that would be agreed with an outside supplier if this activity was to be outsourced. The benefits of

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304 Marketing Finance this are self-evident in terms of clarifying exactly what the transfer price representsbutthemainbenefitsareintermsofcontrol. If a good SLA has been drawn up and therefore is agreed between the supplieranditsinternalcustomerstheseparateaccountabilitiesforperform- ance should also be clearly understood. This is where many SLAs fall down becauseeithertheydonotspecifypreciselywhateachpartyisresponsiblefor or the responsibilities stated do not match with the factual controllability of futureevents.TheaccountabilityofthesupplierinanyinternalSLAistoper- formtothetermsoftheSLAandthesuppliershouldthenbepaidaccordingly. ItisthereforetheresponsibilityofthecustomersideoftheSLAtoensurethat thislevelofperformanceiswhatisactuallyrequiredandthatthetransferprice represents good value for money. In many cases there will be some involve- ment from the centre to facilitate or arbitrate but the outcome still needs to be betweenawillingbuyerandawillingsellerifnotthetransferpricingprocess can introduce a significant accountability and controllability gap that is coveredindetailinthenextchapter. Criticalsuccessfactorsofamarketingfinanceprocess For several years I headed up a research centre in Cranfield School of Managementthatconcentratedonmarketingfinanceissuesandwedeveloped somecommon‘criticalsuccessfactors’forcontrolofthisarea.Thesehavebeen more recently refined and I include them here as a way of drawing together thecontrolissuesfacedbymarketingfinancedepartmentsandmanagers. CRITICALSUCCESSFACTOR1 Validatethelinkagesbetweenobjectivesstrategiesandmarketing financesystems. As emphasised throughout the book there must be clearly established links between the goals and objectives of the business and the strategies that are selectedtoachievethem.Furthertheseoverallstrategiesmustbelinkedtothe detailedtailoredcompetitiveandfunctionalstrategiesthatareimplementedby thesub-divisionsofthebusiness.Marketingfinanceshouldvalidatetheselinks for the sales and marketing strategies and develop appropriate leading indica- torsofwhethertheobjectiveswillbeachieved. More importantly the marketing finance system should highlight the key strategic decisions that will have a significant impact on the successful out- comeofthesestrategies.Indeedmarketingfinancemustbefocusedondecision support and particularly on supporting the key strategic marketing decisions. The system has to be able to assist not only in the initial strategic marketing decisions but also in monitoring updating and quite possibly revising those decisionsasthemarketingstrategiesareimplemented.

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ExercisingControlover theFuture 305 CRITICALSUCCESSFACTOR2 Closethecommunicationgapbetweenmarketingandfinancemanagers. Themarketingfinancesystemmustcommunicatethenecessaryinformation tothemarketingmanagersmakingthesekeystrategicdecisions.Thiscommu- nication process must take into account the potentially significant differences in the way that different types of managers assimilate information. If the informationisprovidedinanon-userfriendlywayorevensimplyanunfamiliar wayatworstit will not beusedat allwhileatbestit maydelaythe decision as it will require further processing by the decision-maker. If this additional processing is not done properly it could even result in an incorrect decision beingtaken. Itisstillquitecommontofindthatinternalfinancialinformationisproduced informatsdesignedbyaccountantsforaccountants.Manymarketingmanagers findlargetablesoffinancialnumbersbothincomprehensibleandveryboring giventheflexibilityandprocessingpowerofmoderncomputersitisperfectly practical to provide all strategic decision-makers with individually tailored reporting formats. The important issues in designing each such format are to remove the risk of misunderstanding by the decision-maker and to reduce the timerequiredtoassimilatetheinformationbeforethedecisioncanbetaken. CRITICALSUCCESSFACTOR3 Identifythelikelytypesofstrategicmarketingdecisions. The tailored communication process is based on the simple but immensely useful logic of providing ‘the right information to the right manager at the right time’. Given the common ‘one-off’ nature of strategic decisions it may be very difficult to deliver relevant useful financial information in time for it tobeusedinthedecision-makingprocessunlessmarketingfinancecanpredict sufficiently well in advance what types of marketing decisions are likely to be made. Fortunatelyitisrelativelystraightforwardtocharacterisestrategicmarketing financedecisionsintofourmaintypes.Thepositive2decisionsinvolveenter- inganewareaofbusinessandexpandingonanexistingareaboththesedeci- sions normally involve the allocation of financial resources to implement the decision. The financial evaluation of these types of decision should be based on the incremental costs and benefits that are expected to result from the decision. The more negative 2 decisions are forms of exit evaluations either to exit completely or to stay in but on a reduced scale of activity. The exit decision may involve direct closure or sale to another business but the financial evalu- ation should be carried out by comparing the financial cost or benefit that is expectedtoderivefromstayinginwiththebestalternativemethodofexiting.

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306 Marketing Finance Itshouldberememberedthatbothofthesefinancialoutcomescanbenegative sothattheleastcostalternativewouldbeselected.Thebenefitsofclosureare clearlytherealisablevaluesofanyassetsthatcanbesoldplusthesavingsthatcan beachievedbyceasingtopayforcertainexistingcosts.Thustherelevantcostsare theavoidableorseverablecoststhatwillbesavedasaresultofthedecision. The problem for marketing financeis notonly thatdifferentfinancial inform- ation i.e. incremental or avoidable future cash flows is needed for the different types of strategic decision but also these decisions do not require the normal financialinformationproducedbymostmanagementinformationsystems.These systems concentrate on historic cost analysis and these costs tend to include sophisticatedbasesofapportionmentthatoftendestroytheirdecisionrelevance. CRITICALSUCCESSFACTOR4 Providetherelevantinformationfortheparticulardecision. Strategicdecision-makersdonothavetimetosortthroughmassesofirrele- vant financial information. First information not data must be provided so thatadditionalprocessingorcombiningofpiecesofinformationisunnecessary. Seconditiscriticalthatonlyrelevantfinancialinformationisprovidedtothe decision-maker. This means producing specific tailored reports to support particular decisions. If the traditional accounting logic of including lots of apportionedcostsisfollowedasmentionedabovetheresultingfinancialana- lysis will serve only to confuse the decision-maker. Decision-makers require supporting financial information that shows how the economic returns are expectedtochangeasaresultofthedecision. CRITICALSUCCESSFACTOR5 Focusonandmeasuretheintangiblemarketingassetsofthebusiness. Using the adage ‘what gets measured gets done’ marketing finance must develop an evaluation process for measuring the key marketing assets of the business. Thus brands customers channels of distribution should be treated asthemajorassetsthattheyareformostorganisations.Thisevaluationshould include both those marketing assets that are currently being exploited and thosethatarecurrentlybeingdevelopedforfutureexploitation. Thisrequiresmarketingexpendituretobesplitbetweendevelopmentactiv- itiesdesignedtoimprovethelong-termvalueofamarketingassetandmain- tenanceexpendituredesignedtokeepanexistingmarketingassetatitscurrent level. The financial impacts and the appropriate financial evaluation and controlprocessesaredifferentforthesetypesofmarketingexpenditure. CRITICALSUCCESSFACTOR6 Truefinancialcontrolcanonlybeexercisedinadvanceoffinancial commitment.

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ExercisingControlover theFuture 307 Most management accounting reports reflect the actual activities of a par- ticularperiode.g.themonthlyprofitandlossaccountbutmarketingfinance shouldbefocusedondecisionsupport.Theactualdecisionistakenatthetime of committing to the expenditure not when the activity actually takes place theexampleofbookingadvertisingmonthsinadvancewasusedearlierinthe book. Thus the main emphasis of a marketing finance system should be on commitments not on accounting expense or even expenditures i.e. when the physicalpaymentleavesthecompany. CRITICALSUCCESSFACTOR7 Identifywheremanagementdiscretionisrestrictedthroughengineered costrelationships. In many marketing activities even before formal financial commitment managershaveverylimiteddiscretionduetothephysicalinputtooutputrela- tionships that rule the activities. These ‘engineered’ costs enable the physical relationshipstobeusedasthecontrolmechanismratherthanthelesspredict- ablefinancialrelationship.Thisisapplyingthegenuineformofstandardcost- ing that was discussed in Chapter 10 and an example applying this to sales forcecontrolisgiveninChapter12. CRITICALSUCCESSFACTOR8 Marketingobjectivesandtheengineeredrelationshipsmaybothchange overtime. Although these ‘engineered’ relationships can greatly enhance the control ofmanymarketingactivitiestheytendnottobebasedonanyimmutablelaws of physics. Changes in the external environment changes in technology the entry of a new competitor changes in the attitudes of key customers could make the old physical relationships no longer relevant. Equally the marketing objectivesofthebusinessarenotsetinstoneandmaychangeovertime. Themarketingfinancesystemattheveryleastneedstobeflexibleenough tocopewithsuchchangeswhentheyoccur.Howeveragoodmarketingfinance systemshouldhighlightthepossibilityofsuchchangesandindicatethelikely consequences of these possible changes. Modelling techniques sensitivity analysesetc.canbeofgreatvalueinthisarea. CRITICALSUCCESSFACTOR9 Identifyappropriatefinancialandnon-financialperformancemeasures foralllevelsofthebusiness. It has already been stated that the business needs both economic per- formance measures and managerial performance measures. These measures should distinguish between committed and truly discretionary expenditures

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308 Marketing Finance development and maintenance expenditures and incorporate any physically engineeredrelationships. As this area is the main focus of the following chapter it will not be dis- cussedindepthhere. CRITICALSUCCESSFACTOR10 Developanoverallmarketinginvestmentplanningandcontrolprocess. Ideally the marketing finance system should develop into an overall marketing investment planning and control model that enables competitive initiativesandexternalenvironmentchangestobesimulatedaswellasevaluating internalmarketingstrategies.Suchanoverallmodelwouldlinkwiththeover- ridingcorporateobjectivesandtheresultingeconomicperformancemeasures. However it would also incorporate and validate the appropriateness of the varying levels of managerial performance to ensure that they were all in line withthecorporateobjectivesandtheeconomicreturntargetsforthebusiness. It would be used to evaluate specific key elements of marketing plans and the model would obviously be updated using actual outcomes to improve the predictions of the future. In other words it would genuinely use its feedback loopsasalearningprocessratherthanasanapportionmentofblame. IhavetosaythatIhavenotyetcomeacrosssuchacomprehensivemarket- ingfinancemodel. Arapidlychangingcompetitiveenvironment As a way of trying to illustrate how a marketing finance system needs to be both tailored and responsive to the changing needs of a business I am using anotherstructuredexampleliketheprevioussuchexamplesthisoneisbased onrealitybutthenumbershavebeenchangedtoprotectboththeinnocentand theguiltyandtokeeptheanalysisrelativelystraightforward. Asurething plc a risk averse large diversified group develops a new prod- uct but in order to minimise its perception of the associated risk it only initially invests in capacity for 50000 units p.a. It takes the view that it could subsequentlyinvestinadditionalcapacityifdemandfortheproductreallytakes off.Itscoststructureandoriginalfinancialevaluationusingitscostofcapital of20percentas thediscountrateare showninTable11.2.In ordertocreate shareholder value the company needs to achieve a rate of return in excess of 20percentthataccordingtothefiguresinTable11.2thisprojectshoulddo. TheproblemforAsurethingisthatthetechnologyusedinthisnew product is generally available and its product is not strongly branded. Once the poten- tially high ‘super profits’ become known other companies are likely to be attractedtothisnewmarketparticularlyasdemandisforecasttogrowrapidly.

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ExercisingControlover theFuture 309 Indeed the marketing director of Asurething is soon hired by some venture capitalists to start a direct competitor The new company Becopied Ltd is startedoneyearlatertoproducethesameproductwithexactlythesameplant specificationasA. However as a small focused company B is able to keep its manufacturing costslowerthanAalthoughitsfixedcostbaseperunitisslightlyhigherasit is a completely stand-alone business. In order to generate demand for the increased industry total of 100000 units annual output selling prices have to be reduced to £9 A has no real choice but to follow this reduction in general selling prices. Becopied’s cost structure and initial financial evaluation are showninTable11.3asbeforeitsfinancialprojectionsindicateapositiveimpact onshareholdervalueevenwiththeassumptionofthereducedsellingprice. Asurething has generated some efficiency gains during its first year of operations so that its variable costs per unit have reduced to £4 from £4.50. Unfortunately this gain is more than offset by the reduction in selling prices Table11.2 CompanyA’sinitialcoststructureandprojectevaluation Capacityinvestedin–50000unitsperyear. Investmentrequired–Plant£500000. Itisassumedthatthisproductisneutralintermsofworkingcapitalinvestment. Plantlifeisestimatedtobe10yearswithnilresidualvalue.Allcompaniesuse straightlinedepreciation. Perunit Peryear £ £000’s Sellingprice 10 500 Variablecost 4.50 225 Contribution 5.50 275 Fixedcosts–exc.depn 1.5 75 –depreciation 1 2.50 50 125 Profit 3 150 Investmentatcost– £500 Year1accountingROI 30usingcostoffixedassets Discountedcashflowanalysis20 Year Cashflow Discountfactor Present value 0 £500k 1 £500k 1–10 £200k 4.192 £838.4k NPV +£338.4k Note:TheDCFanalysisusesthecashflowgeneratedeachyearignoringanytime lagsasbeingprofitsplusdepreciation.Nilresidualvaluefortheplantattheendof 10yearshasbeenassumed.

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310 Marketing Finance caused by Becopied’s entry into the market as is shown in Table 11.4. A’s efficiencygainsgiveitthesamevariablecostsasBthelearningcurveadvantage of being first in the industry. Thus given its lower fixed cost base A is making a higher net return than B and still should be creating shareholder value over the product’s life cycle albeit not as much as originally predicted. Table11.3 CompanyB’scoststructure Capacityinvestedin–also50000unitsperyearYearofentry–Year2 Investmentrequired£500000. Perunit Peryear £ £000’s Sellingprice 9 450 Variablecost 4 200 Contribution 5 250 Fixedcosts–exc.depn 2.00 100 –depreciation 1.00 3 50 150 Profit 2.00 100 Investmentatcost– £500 FirstyearaccountingROI 20 Discountedcashflowanalysis20 Year Cashflow Discountfactor Present value 0 £500k 1 £500k 1–10 £150k 4.192 £628.8k NPV +£128.8k Note:Thispositivenetpresentvalueisbasedontheimportantassumptionthatthe sellingpriceremainsat£9perunitthroughoutthe10yearsorthatitonlyreducesin linewithefficiencyimprovements. Table11.4 CompanyA’srevisedcoststructureaftertheentryofBi.e.Year2of production Perunit Revised Original Revised peryear Sellingprice 10 9 450 Variablecost 4.50 4 200 Contribution 5.50 5 250 Fixedcosts–exc.depn 1.5 1.5 75 –depreciation 1 2.50 1 2.5 50 125 Profit 3.00 2.5 125 Thevariablecostperunithasreducedduetotheexperiencecurveeffect e.g.learningcurvebenefitsgainedduringthefirstyearofproduction.

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ExercisingControlover theFuture 311 Indeedevenifthereductioninsellingpriceto£9inYear2hadbeenpredicted theprojectwouldstillhavebeenfinanciallyattractiveasisshowninTable11.5. However the changed competitive environment may make Asurething wanttoreviewitsfuturestrategy.Theentryofonenewcompetitormaymake itconcernedaboutthepossibilityoffurthernewentrantsparticularlygiventhe priceelasticityofthisproductdemandhasdoubledfora10percentdecrease inselling price.Infuture investmentsAsurething may seek to develop strong entrybarriersmorequicklyorreviewitslaunchpricingstrategieswhenexperi- ence curve benefits can be expected. A lower more aggressive penetration pricingpolicyatlaunchmayhavediscouragedBfromenteringtheindustryso rapidly.ItisnowclearthatA’sinitialfinancialevaluationwasoversimplistic andoveroptimistic. Unfortunately neither A nor B reviewed their strategies quickly enough as CostcutterIncenterstheindustryatthebeginningofYear3.Thisnewentrant focusesontherapidgrowthindemandcausedbysmallpricereductions.Also quadrupling output capacity only doubles the required capital investment so thatCisabletogenerateeconomiesofscaleonitsinvestmentin200000units of annual capacity. Thus despite having to reduce the unit selling price to £7 in order to generate demand for the industry total output of 300000 units Costcutter is able to generate a very significant level of shareholder value as isshowninTable11.6. This more substantial decline in selling prices affects Asurething as is shown in Table 11.7. Clearly the financial return is now unattractive and if thispositionhadbeenforecastbeforemakingtheinitialinvestmentthedecision to launch would not have been taken. However A now faces a possible exit decision not a hypothetical entry decision. The net realisable value of the plantisonlyitsscrapvaluewhichis£50000.Andtheoriginalinvestmentcost of £500000 is now irrelevant as is the net book value of £400000 £500000 less 2 year’s straight line depreciation. Asurething should include the oppor- tunity cost on this scrap value in its exit decision evaluation it foregoes the receipt of a £50000 cash inflow if it decides to stay in the industry. However the company has identified some fixed cost savings and should achieve further experience curve reductions in its variable costs over the next year. Table11.5 UpdatedprojectevaluationforCompanyA’s investment20 Year Cashflow Discountfactor Presentvalue 0 £500k 1 £500k 1 £150k 0.833 £125k 2–10 £125k 3.359 £420k NPV +£45k

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312 Marketing Finance These restated costs as is shown in Table 11.8 show that Asurething is still betteroffstayingintheindustryratherthanexitinghowevertheexpectations ofshareholdervaluecreationhavedisappeared. Worse is to come for Asurething and its existing competitors as Develop- ments GMBH enter the scene at the beginning of Year 4 with a new patented Table11.6 CompanyC’scoststructure Capacityinvestedin–200000unitsperyear Yearofentry–Year3 Investmentrequired£1000000. Perunit Peryear £ £000’s Sellingprice 7 1400 Variablecost 3.2 640 Contribution 3.8 760 Fixedcosts–exc.depn 0.8 160 –depreciation 0.5 100 1.3 260 Profit £2.5 £500 Investmentatcost–£1000000 FirstyearaccountingROI 50 Discountedcashflowanalysis20 Year Cashflow Discountfactor Present value 0 £1000k 1 £1000k 1–10 £600k 4.192 £2515k NPV +£1515k Note:ThisDCFcomputationalsoignorestheprospectofreducingvariablecostsand sellingpricesoverthelifeoftheproject. Table11.7 CompanyA’srevisedcoststructureafterC’sentry Perunit Peryear £000’s Sellingprices 7 350 Variablecost 4 200 Contribution 3 150 Fixedcosts –exc.depn 1.5 75 –depreciation 1.0 2.5 50 125 Profit 0.5 25

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ExercisingControlover theFuture 313 methodofmakingtheproductthuscreatingapotentiallysustainablecompet- itive advantage. This technology significantly reduces both variable costs and capitalcoststhroughlargeeconomiesofscalehenceDevelopmentsalsodecides to go for high volume with an initial investment in 250000 units of annual capacity. Its cost structure is shown in Table 11.9 which also shows that the selling price is now driven down to £5 per unit. This reduction has dramatic impacts on all the existing competitors in the industry none of whom could havejustifiedtheirinitialinvestmentifthisprospecthadbeenforeseen. Asurething and Becopied should now rework their exit decision evalua- tionsasisdoneinTable11.10.Becopiedshouldleavetheindustrybecauseof its higher fixed cost base which is dedicated to its only product and is hence fully avoidable if the business closes down. This would be the best financial decision even if the plant had no residual value however as previously dis- cussed some industries have net costs associated with exiting and this can make it less financially unattractive to stay in an industry even though cash flowsarenegative. Asurething is somewhat in a dilemma because if Becopied closes down the selling price may rise sufficiently to make it just worthwhile to stay in. It decides to stay in for a year and see what happens B leaves the industry and thesellingpricerisesto£5.50thustemporarilyvindicatingitsdecision.How- ever at £5.50 Developments may expand its capacity as this would be share- holdervalue-creatingforit. BeforethiscanhappeninYear5EverlastingFarEastLtdenterstheindus- try with another large scale investment. It is using a cheaper version of the original technology and has much lower production costs than even the Table11.8 CompanyA’sexitdecisioncomputation Perunit £ Peryear 000’s Sellingprice 7 350 Variablecost 3.61 180 Contribution 3.4 170 Fixedcosts 1.22 60 NetContribution 2.2 110 Exitevaluation Presentvalueofopportunitycostofsalvagevalue £50000 Benefitoffuturecashflowbystayinginindustry Years1–7£110000p.a. ×3.605 £396000 Annuityfactor Decisionisclearlytostayintheindustry 1Thevariablecostwillreduceduetotheexperiencecurveeffect. 2Fixedcostsareincludedattheiravoidablelevelonlysomecosts arenowsharedwithotherproducts.

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314 Marketing Finance Table11.9 CompanyD’scoststructurenewpatentedtechnology Capacityinvestedin–250000unitsperyear Yearofentry–Year4 Investmentrequired–£750000 Perunit Peryear £ £000’s Sellingprice 5.00 1250 Variablecost 3.00 750 Contribution 2.00 500 Fixedcosts–exc.depn 0.70 175 –depreciation 0.30 1.00 75 250 Profit 1.00 250 Investmentatcost–£750000 FirstyearaccountingROI 33.3 Discountedcashflowanalysis20 Year Cashflow Discountfactor Present value 0 £750k 1 £750k 1–10 £325k 4.192 £1362.4k NPV +£612.4k Table11.10 CompaniesAandB–exitoptionsafterD’sentry AB Perunit Peryear Perunit Peryear Sellingprice 5 250 5 250 Variablecost 3.6 180 3.2 160 Contribution 1.4 70 1.8 90 Fixedcosts 1.2 60 2.0 100 Netcontribution 0.2 10 0.2 10 Discountedcashflow20 Bisclearlybetteroff leavingasitisgenerating anegativecashflowata £5sellingprice. Scrapvalue–presentvaluenow£40000. BenefitoffuturecashflowsYears1–6 £10000 ×Annuityfactorof3.326 £33260 OnthiscashflowanalysisAisalsobetteroff leavingtheindustry However: 1Itsvariablecostwillcontinuetodecline. 2IfBleavestheindustrythecapacitywillbe reducedandthesellingpricewillrise–thus givingAanincentivetostayin.

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ExercisingControlover theFuture 315 patented process of D. Also it is prepared to take a longer-term view. Thus it usesa15-yeartimescalecomparedto10yearsforalltheexistingcompanies andithasalowercostofcapital15percentversus20percenttheresultis shown in Table 11.11. As is shown this drives the selling price down to £4 perunitandthisforcesAsurethingtofollowBecopiedoutoftheindustryA’s cash flow is now negative as well. A’s departure does not affect the selling price as it had already been predicted by Everlasting in deciding on the scale ofitsinvestmenti.e.itknewthatitwouldforcethesellingpricedown below A’sexitpoint. The relative positions of the three remaining players after A B’s depart- ures are shown in Table 11.12. Costcutter is making a small loss but will stay intheindustryuntilitsplantneedsreplacingitscashflowi.e.inthisexample profit excluding depreciation is still slightly positive. Developments is not generatingtheshareholdervaluethatithopedforfromitspatentedtechnology butitwillcertainlynotleaveandcouldtrytosegmentthemarket.Everlasting has thereforeselected an entry strategy that should produce a period of stabil- ity for the industry until it is potentially supplanted as the low-cost producer byanevenlowercost-basedcompetitor Table11.11 CompanyE’scoststructurecheaperversionoforiginaltechnology andlonger-termview Capacityinvestedin–250000unitsperyearYearofentry–Year5 Investmentrequired–£750000 Lifeofassetsassumedtobe15years Perunit Peryear £ £000’s Sellingprice 4.00 1000 Variablecost 2.50 625 Contribution 1.50 375 Fixedcosts–exc.depn 0.8 200 –depreciation 0.2 1.00 50 250 Profit 0.50 125 Investmentatcost–£750k FirstyearaccountingROI 16.67 Discountedcashflowanalysis15–lowercostofcapital Year Cashflow Discountfactor Present value 0 £750k 1 £750k 1–15 £175k 5.847 £1023.2k NPV +£273.2k

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316 Marketing Finance Thisexamplehastriedtoillustratethecriticalneedbothtoincludepotential competitor reactions and to use the decision relevant financial information in any strategic marketing finance evaluation. It also highlights the need to developatrulysustainablecompetitiveadvantageevenD’spatentedtechnol- ogy left it open to pure price competition. This chapter ends with a brief case studytotrytobringtogethersomeotherimportantelementsofagoodmarket- ingfinancecontrolprocess. Casestudy–McDonald’s Background McDonald’s was founded by Ray Kroc in Illinois USA in 1955 when he opened the first restaurant. Now the chain has 30000 restaurants in over 100 countriesandtotalannualsalesrevenuesincludingfranchisees’salesofover 40 billion. Ray Kroc initially built a dominant domestic market share and thentookthesuccessfulproductformulainternationalthefirstBritishrestaur- antwasopenedin1974. The use of franchisees to own and operate the vast majority of the restaur- ants made this rapid growth much easier to finance. However McDonald’s is unusual in that it owns many of the sites that are occupied by its franchisees rentalincomethussupplementingthefranchisefeespaidbyoperatorsaswell as safeguarding these now prime locations whose potential McDonald’s was often the first to identify. During the 1990s McDonald’s was still opening over1500newstoresperyearbutsomemarketsmostnotablytheUSAwere becoming saturated. Thus new store openings had an increasing cannibalisa- tioneffectonexistingrestaurantsinthesamearea. Oneofthekeystothegroup’ssuccesswasthedevelopmentofthebrandas epitomisedbythe‘goldenarches’andRonaldMcDonaldsupposedtobesecond Table11.12 RelativecoststructuresafterdepartureofCompaniesAandB Company C D E Total Capacity000s 200 250 250 700 Perunitdata£s Sellingprice 4 4 4 Variablecostinc.learning curveforCD 2.75 2.8 2.50 Contribution 1.25 1.20 1.50 Fixedcosts –exc.depn 0.8 0.7 0.8 –depn 0.5 1.30 0.3 1.00 0.2 1.00 Netprofit 0.05 0.20 0.50

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ExercisingControlover theFuture 317 only to Santa Claus in terms of children’s recognition. However the brand also meant the product i.e. ‘burgers and fries’. This enabled competitors to enter the market with look-alike products Burger King and Wendy’s or with variants on the concept of fast food KFC Taco Bell and a variety of Pizza chains.OfcourseBurgerKingandWendy’swouldarguethattheyhaveabet- terproductthanMcDonald’sbuttheystillfocuson‘burgersandfries’. McDonald’s has launched different products but the last really successful trueinnovationwasChickenMcNuggetsin1983withtheBigMachavingbeen around since 1968. The problem for the group is that its business is maturing and the previous high rates of growth are no longer achievable. Indeed USA sales per store have not been rising for over 10 years and actually started to fall in 2002. The international growth has not been able to fill this gap and earnings fell in 2001 then for the last quarter of 2002 the group announced a lossof343.8million. This led to the removal of the chief executive officer and the recall from retirement of Jack Cantalupo as chairman and chief executive officer. At the time of writing he is developing his plans for the group it will be interesting to see how well his proposals based on his 28 years experience with the companyfitwithamarketingfinance-basedanalysis. Strategicanalysis McDonald’s was very clearly developed as a brand-based business its strong brandwasusedtoattractgoodqualitywell-trainedfranchiseesallHamburger Universitygraduatesandmadeitanattractiveanchoroccupantfornewretail and leisure developments. The corporate centre set out very strong rules as to how each restaurant should look be laid out and be run as well as providing access to centralised sourcing of key raw materials. Most importantly though it managed the brandand itsinitial key differentiation attributes were consist- entproductqualitywhetherornotanindividuallikestheproductithastobe accepted that it is consistent and service. Service was a key element and this meant minimal waiting for customers to be achieved without serving up a productthathadbeensittingaroundbeingkeptwarmforages.Itcouldachieve allthis by keepingitsproductrangeincrediblysimplecomparedwithapizza restaurantwithvastnumbersofdifferenttoppingsetc. It took competitors some time to catch up with these brand attributes and mostoftheindividualfastfoodrestaurantswereforcedoutofbusinessbythe expansionofthebrandedchains.Alsoduringthisperiodtheoverallfastfood sector was growing rapidly in many countries and this clearly helped with McDonald’soverallrateofgrowth.Itwasatthisstageamajoradvantagefor McDonald’s to be seen as overtly American the home of the hamburger and fastfoodingeneralwritingthisbookduringtheIraqinvasionmeansthatthis strongUSAconnectioniscausingdifferentissuesforthechainatpresent.

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318 Marketing Finance AstheindustrystartedtomatureintheUSAandcompetitorsbecamebetter organisedMcDonald’s earlierbrandadvantages had less significance and the market became much more price conscious for some time now McDonald’s andBurgerKinghavebeencompetingwitheachothertodiscounttheirburgers tolowerandlowerprices.Thisintroducesproductcross-subsidisationbecause most of the profit from each customer is then generated from the ‘fries’ that theybuy.In2002salesoffriesintheUSAfellforthefirsttimewithacorres- pondingly amplified impact on McDonald’s profitability possibly customers who are buying a heavily discounted burger are not prepared to pay out for ‘fullpricedfries’togowithit. This could also be caused by a trend towards ‘healthier eating’ there are nowmoresandwichshopsintheUSAthanburgerrestaurants.Ifthisistrueit signals a longer-term problem for the group because its ‘product’ may have moved into the decline phase of its life cycle. McDonald’s has tried to reduce its dependence on this ‘burger fries and service’ mix but none of the new ‘productconcepts’hasreallybeensuccessful. Indeed it can be argued that McDonald’s have been under a false impres- sion that it owns a customer-led brand which would enable it to launch new productsthatitsexistingloyalcustomerswouldbewillingtobuy.Thealternative viewisthatthesenewproductsappealtocompletelydifferentcustomerse.g. chicken sandwiches and ‘bacon butties’ from the regular McDonald’s burger eaterthusthebrandingislessrelevantandalsolessappropriateasitisassoci- ated with ‘burgers and fries’ and children through Ronald McDonald in the mindsofthesepotentialnewcustomers. Even worse this product range diversification may have reduced the appeal of McDonald’s to its traditional customers rather like the earlier illustration of Levi’s ‘why are old people sitting in my restaurant’ and also it could reduce the previously key benefit of service quality. There is no doubt that consumers’perceptionoftheservicelevelinMcDonald’shasdeclinedsignifi- cantly and in the USA it now regularly ranks not only below its direct competitorsbutalsobelowmanyotherindustriesthatarecertainlynotknown fortheircustomerserviceexcellence. Themostlogicalstrategicoption is thereforefor McDonald’s to go back to its core strategy burgers fries and service which would mean that its future growth prospects are reduced. The key question that it needs to answer is whether its brand is still a potential source of super profits or whether price competitionhasbecomethenormforitsendoftheindustry.McDonald’sdoes have another much smaller business Partnership Brands that owns other res- taurant groups. To most consumers these are not associated with McDonald’s and the combination of McDonald’s original management skills location identification franchisee development brand building and consistent service delivery together with more modern branding and product concepts could be a potentially powerful strategic option using the profits and cash flow from are-focusedandpossiblerationalisedMcDonald’srestaurantchain.

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ExercisingControlover theFuture 319 However whatever marketing strategy it does follow there is a definite needforMcDonald’stoimplementanappropriatelytailoredmarketingfinance control system. The issues of developing appropriately tailored control measures for different stages of the life cycle are discussed in the following chapter which also concludes with a case study on a very closely related brandedproductscompanyCoca-Cola.

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12 EstablishingPerformance Measures Overview Performance measures are needed at three levels each with a different focus andthismakesitvirtuallyimpossibleforanysinglemeasuretoworkeffectively in all these roles. A wide range of performance measures can be used in most businesses some should be externally focused and may require the objective andconsistentapplicationofmanagerialjudgement. A hierarchy of performance measures is required so that each level in the organisation is given specifically relevant measures it is critically important that such a hierarchy is internally consistent so that everyone is aiming at the samesetofobjectives. Economicperformancemeasuresareveryimportanttoshareholdersasthey indicate whether shareholder value is being created. However they are not normally a good indicator of managerial performance this requires a relative performance measure. At the very top of a company e.g. the main board of directors it may be reasonable to use primarily economic performance measures but even here they should be placed in an appropriate context by referencingthemagainstapeergroupofothercompaniesorthestockmarket intotaletc. As you go lower down the organisation there are greater restrictions on managerialdiscretionanditisimportantthatthereisadirectlinkagebetween effectivemanagerialcontrolandtheperformancemeasuresused.Itmayseem more efficient to use the same performance measure e.g. ROI for all man- agers but it normally has a dramatically adverse impact on the effectiveness ofthe performance measures in influencing managerial behaviour. Managerial performancemeasuresrequirethetruecostdriverforallcoststobeidentified and the accountability should stay at this level of the organisation. Far too often this identified cost driver is then used as the basis for apportioning the total costs across lower levels in the organisation thus destroying the direct accountability/controllabilitylinkage. Key performance indicators KPIs are leading indicator measures of per- formance that focus on the key strategic thrusts at the particular level of the business. There should be a limited number maximum of five of KPIs for

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EstablishingPerformanceMeasures 321 each manager because no one can focus on a vast range of measures. The challengefortheorganisationistodevelopaninterlinkedsetofKPIsforeach levelinthebusinesssothateachsetisconsistentwiththeoverallobjectivesof the company but relates to decisions and actions relevant to each managerial level. Products customers and brands all follow some form of life cycle and different performance measures may be needed for each stage. These tailored performance measures should include both financial and non-financial meas- uresthatshouldbeclearlylinkedtothekeystrategicthrustsateachstage. If all these different ways of looking at the business are put together auniquesetofperformancemeasurescanbedevelopedforeachbusiness.How- ever this set fits the current strategy and the current business environment if either of these changes significantly the set of performance measures should bereviewedandmodifiedifnecessary. Introduction As stated at the beginning of the book the strategic challenge for most busi- nesses is changing and becoming more demanding. Increasingly the focus for businesses is changing away from ‘outperforming the internally established performancemeasure’whatIhavereferredtoasthe‘budgetactualvariance’ syndrometo‘outperformingtheexternalcompetition’inordertocreateshare- holdervalue.Asdiscussedinmoredetailinthischapterthisrequireseachbusi- nesstodeveloptailoredperformancemeasuresatthreelevelsinordertoindicate: 1 Theeconomicattractivenessoftheindustryorsector 2 Therelativecompetitiveperformanceofthebusiness 3 Theperformanceofeachkeystrategicthrustofthebusiness Unfortunately there are no simple solutions to this challenge as no single performancemeasureperformswellatallthreelevels.Afurthercomplication is that even more specifically tailored performance measures are required at eachdecision-makingleveloftheorganisation. Alongside this challenge for business the finance function faces its own strategicchallenges.Finance functionscanoftenbe perceivedparticularlyby their marketing colleagues as constraining due to an excessive emphasis on internallyfocusedhierarchicallydeterminedfinancialcontrolprocedures.They are also often regarded as uninvolved and uncommitted because their object- ivity and emphasis on rigorous evaluation and control can be interpreted as aloofnessarroganceorjustdisinterest.Alsothefinancialcontrolsappliedwithin many businesses are almost completely unaffected by major changes in other areas of the business. As a consequence the overall view of financial control isthatitiscostincreasingratherthanvalue-addingwhereunnecessarycontrols

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322 Marketing Finance are imposed that often increase the workloads of parts of the business that do notreceiveorperceiveanydirectbenefits. However if a well-designed marketing finance system is put in place at least part of finance except that it is now likely to be regarded as part of marketing can be regarded as enabling rather than constraining through its positive contributions to strategic decision-making. The desired integration into marketing makes marketing finance much more participative because marketing finance managers are closely involved in marketing decisions and physically work alongside marketing managers most particularly the market- ingresearchmanager.Thisshouldmakemarketingfinanceagenuinelyvalue- addingactivityfortheorganisationwherethebenefitsofhavingactivefinance involvementinmarketingdecisionsclearlyoutweighthecostincurred.Sucha value-addingstrategicallyenablingparticipativemarketingfinancerolemust obviouslybeachievedwithoutlosingfinancialcontrolofthebusiness.Thisis whythedevelopmentofatailoredsetofperformancemeasuresissocritical. Newperformancemeasures A wide range of performance measures can and should be used to assess the overallperformanceofabusinessitscomponentelementsanditskeystrategic thrusts and the managers who are running the business. The three levels of performance measurement require both internal and external comparisons to beincorporated.Someofthesecomparisonswillinevitablyrequiretheexercise of judgement in the absence of absolute factual information these required judgements should be and should be seen to be objectively and consistently applied. Alltheperformancemeasuresshouldbedecision-orientedandanycompari- sons should highlight actionable differences. The very practical ‘so what’ question should always be asked so what action do we take if the perform- ance measure is not what we expected If there is no action we have either selected the wrong performance measure or it is being applied at the wrong levelintheorganisation. Both financial and non-financial performance measures are needed but theyshouldbedesignedtocomplementeachotherratherthanrepeatthesame measure in financial values as well as physical terms. Innovative measures should be used whenever they add value this added value can be because attentionisnowfocusedonthemoststrategicallyrelevantareaofthebusiness ratherthanonthemostobviousandeasiestareatomeasure.Thisissueisillus- tratedinPracticalInsight12.1. Thesetofperformancemeasuresusedbyanybusinessshouldthereforenot only be integrated with the specific marketing strategy of the business but alsotailoredtotheparticularneedsoftheprocessthatisbeingmeasured.The challenging‘sowhat’questionmeansthattheseperformancemeasuresshould primarilybeleadingratherthanlaggingindicatorsandtheremustbeabalance

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EstablishingPerformanceMeasures 323 oflong-termandshort-termmeasures.Thisisrelativelysimpletostateintheory butmuchmoredifficulttoachieveinpractice. PracticalInsight12.1 Refocusingattentionawayfromtonnage The Tissues Unlimited case study from Chapter 10 introduced a need to alter the performance measures used and the associated bonus system for the employees at the bulk tissue mill. In the past the emphasis had been on the total tonnage of tissue produced each week as this was felt to be the most controllable and meas- urableoutputfromthetissuemill.Unfortunatelyitwastoocontrollable Thisperformancemeasuremeantthatduetotheverydifferentmachineoutput rates per hour depending on the type of tissue being manufactured the mill employees were delighted whenever the production schedule showed that high outputs of kitchen towel were to be produced. They were therefore getting very depressedaboutthetrendtowardsproducingmoreandmorefacialtissuethatwas discussed in the case study. This made it very difficult for them to achieve their production targets and hence their expected bonus payments. Ideally production departments should be motivated to produce all products with similar levels of enthusiasmifthereisadifferenceitshouldbemotivatedbythesuperprofitabil- ity of the product rather than its weight Further this tonnage-based performance measure encouraged behaviour that was against the interests of the company. Almost all automated manufacturing processes have a tolerance built into the systeminthiscaseeachproducthadaspecifiedbasisweightpersquaremetreof tissuebuttherewereacceptablerangeseithersideofthistarget.Itwasclearlyin the interests of the tissue mill to set their machines at the heavier end of this acceptablerangethusmaximisingthetotaltonnageproduced.‘Runningthemachines heavy’ also meant that the machines could be run at slightly faster speeds again givinganincreasedtonnageoutput. Thebasicperformancemeasureandbonussystemdidnotincludevariablecost levels and so these were of much less interest. Profits were a performance meas- ure for the senior managers at the mill but they also participated in the tonnage- basedsystem. The new transfer pricing system based on contributions per hour provided a perfect opportunity to introduce a new performance measurement system and bonus scheme for the tissue mill. The objectives of the new system were to motivate the mill employees and managers to optimise the time for which the machines were available for production as production hours were the limiting factor at present to produce the required tonnages in the shortest times possible while maintaining the required quality levels to minimise changeover times between products some quite minor capital investment achieved significant reductions and corresponding improvements in flexibility and to minimise con- trollable variable costs per unit of output. Some of these measures are mutually conflicting which forces the mill managers and senior operators to make the tradeoffs that they should understand better than anyone else in the organisation. An example is whether to increase the weight setting on a particular product the machinescouldberunatfasterspeedsthusreducingruntimesbutvariablecosts would be increased. The standard costing system also had to be amended to ensure that up-to-date costs of raw materials were used in assessing the economics ofthistradeoffpulppricesandparticularlywastepaperpricesarehighlyvolatile.

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324 Marketing Finance Another key issue for the performance measures used within any business istheconceptof‘goalcongruence’.Ashasbeenmentionedbeforethissimply meansthateachpartoftheorganisationshouldbemotivatedtoactinthebest interestsofthetotalorganisation.Clearlymotivatingthetissuemilltoincrease theweightofthebulktissuethatitproducesisnotgoalcongruentifthegroup sellstheconvertedproductexternallybasedonlengthsheetcountetc.Ihave yet to find a consumer who buys a toilet roll box of facial tissues or kitchen towel based primarily on how heavy it feels Similarly incentivising a sales forcetosellvolumee.g.casestonnesmillionsofunitsetc.isnotnecessar- ily goal congruent with an overall objective to create shareholder value. It is frequently easiest to sell the ‘best value’ product in the range and this not surprisingly is often the one that generates the lowest rate of contribution. However transfer pricing systems in large groups are probably the greatest sourceofdysfunctionalbehaviourbyspecificpartsofanorganisation.Acting inlinewiththetransferpricingruledoesnotnecessarilymakeforoptimalper- formance for the overall group particularly when the transfer pricing system is established primarily for external fiscal e.g. tax authority acceptability reasonsasisillustratedbyPracticalInsight12.2. PracticalInsight12.2 Notforcostplus10 Onevery largemultinational likemanyothers as has beenmentionedbefore had establishedaglobaltransferpricingsystemforproductsproducedbyonebusiness for eventual sales by another business unit in a different end market. The system which had agreement from the tax authorities was that goods should be sold at cost plus 10 per cent. There were obviously rules that established how ‘cost’ was tobecalculatedalthoughthereweremanyexamplesofdifferentinterpretationsof these rules. The objective of the tax authorities was to ensure that taxable profits weregeneratedinboththeproducingcountryandtheexternalsalescountry. However most of this group’s products generated far higher cost markups than 10 per cent and therefore internal transfers within the group were relatively unattractive. This was particularly true for the USA-based subsidiary whose main strategic focus was on its high-volume domestic business. It found the relatively smallexportordersverycostlyparticularlyasitsmanufacturingprocesswasgeared to long production runs and changeovers were very time-consuming. The ‘costs’ allowed in the transfer pricing system did not fully enable the USA operation to recover all of these added inefficiencies although in reality its costing system couldnotcalculatethetruecostsofproductionofthesesmallexportquantities. Therefore the USA business which was under severe profit pressure from the group centre unilaterally decided that it would no longer produce small order quantitiesfor other parts of the group.Althoughsmallby USAmarketstandards some of these quantities were both significant and highly profitable to the ultim- atesalescountries.ConsequentlythisdecisionmadetheUSA’sperformancelook potentially marginally better in fact it got worse as it could not reduce its fixed costsbutadverselyaffectedthegroup’sperformance.

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EstablishingPerformanceMeasures 325 Accountabilityandcontrollability As stated earlier in the book it is a fundamental tenet of good management practice and hence of sound performance measures that managers should onlybeheldaccountableformattersoverwhichtheycanexercisesomedegree of control. However shareholders want managers to be motivated to create shareholdervalueandthisisonlyachievedbyabetterthanrequiredeconomic performance. Economic performance assessment must take into account all therelevantinternalandexternalfactorsimpactingonthisperformancewhether ornotthesefactorscanbecontrolledbytheorganisation. Thismeansthatinmanycaseseconomicperformanceisnotagoodindica- torofrelativemanagerialperformance.Inaneconomicallyattractiveindustry all the players in the industry could generate super profits and thus create value for their shareholders. Conversely in an economically very depressed industryallthecompaniesmayfailtodeliverthereturnrequiredbytheirshare- holdersinfactthebestcompanymaysimplymakeasmallerlossthanallthe rest. Therefore from a shareholdervalueperspectiveitis much better to have invested in a below average performing company thathappens to be in a very financiallyattractiveindustrythantohaveselectedthebestcompanyinavery depressedindustry. Economic performance measures are thus very important to shareholders andshouldformpartofthetotalperformancemeasuresusedbyanycompany particularly at the very top of the company. Shareholders feel that they have the righttoholdtheboardofdirectors accountable forthe economicperform- ance ofthe total businesseven though the directors cannot control all aspects of the external environment. However shareholders seem to believe that as thedirectorsdointheoryatleastcontrolwhatareasofactivitytheircompany chooses to operate in they should be able over time to move the business away from any unattractive current areas of activity into more likely sources of shareholder value creation clearly life is not really quite as simple as that becauseofexitandentrybarriersrelevanceofcorecompetencesetc.Theend result nonetheless is that very senior managers are often largely judged by economicperformancemeasures. In an increasing number of cases this economic performance measure is placedintoarelativecontextbycomparingtheparticularcompany’sperform- ance against an appropriate peer group e.g. the industry sector or comparable alternativestockmarketinvestmentsinthecaseofapubliclyquotedcompany. This still leaves the question of what actual form of economic performance measure should be used. Throughout this book the focus has been on creating shareholdervaluei.e.makingsuperprofitsratherthanmerelymakingaprofit. HoweverinPartOneIexplainedthateconomicprofitwhichshowstheannual excess return achieved after allowing for the required rate of return on the capital invested in the business is not necessarily a good indicator of the long-termhealthofthebusiness.Fromtheshareholders’perspectivesthemost

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326 Marketing Finance relevant economic measure is total shareholder return for the year i.e. divi- dend yield plus or minus the annual change in share price as this represents theiractualeconomicreturn.Thisobviouslyneedstobeadjustedbytherequired rateofreturnfortheparticularcompany buteventhenthis isnotnecessarily ameasureoftheperformanceofthetopmanagementteamasdiscussedearlier inthebook. Unfortunatelytheverycommonuseofstocki.e.shareoptionsinpublicly quoted companies can make this problem even worse. The normal system is that senior executives are given the right to buy shares but not the obligation to buy the shares because it is an option in the company at a fixed price duringsomefuturetimeperiode.g.starting3yearsfromnowandexpiringin 5 or 7 years time. The idea is fairly obviously that if the share price grows during this period the executives will gain from exercising their options and this puts them in a similar position to the shareholders. There are of course some quite serious differences between an executive stock option holder and acurrent shareholder. The current shareholders have invested money in buy- ing their shares and therefore require a return on those funds the opportunity cost concept part of this return may be received in the form of dividends whicharenotpaidtooptionholders.Thiscanbetakenintoaccountsimplyby setting the exercise price of the executive stock options above the current share price the percentage increase for each year is the total required rate of returnforequityintheparticularcompanylesstheannualdividendyieldpaid inthoseyears.Veryfewcompaniesmakethissimplecorrectionpreferringto set stock option exercise prices at or near today’s share price so that execu- tivesgetalloftheupsideinthesharepriceperformance. However they do not suffer all of the downside if there is any they simply would not make a gain on their options and therefore they do not exercise them. This is where the long-time period over which these options can be exercised is of significant value the share price may fall below today’s price forawhilebutitmightbebackwellabovethislevelbeforethestockoptions have expired. Indeed as discussed in Chapter 7 a key value driver for stock options is the volatility of the share price a more volatile share generates a morevaluableoption.Itseemsslightlyperversethatshareholdersshouldincen- tivisesenior executives for increasing the volatility i.e. the risk profile of the companythattheyarerunningontheshareholders’behalf. Is there a sensible alternative The problem is as stated way back in Chapter 1 that shareholder value is calculated using discounted cash flows over long periods of time and this can make it difficult to translate it into a periodic e.g. annual measure of performance. This is why companies and theirremunerationcommitteesfallbackontotalshareholderreturnmeasures stock options and heaven forbid accounting measures such as earnings per shareandreturnoninvestmentROI.Itispossibletocarryoutafullshareholder valuecalculationforthecompanyonanannualbasisi.e.aneconomicvaluation

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EstablishingPerformanceMeasures 327 of the business using the discounted value of the expected future cash flows. Theshareholdervaluecreatedintheyearisclearlytheadjustednetdifference between two successive such calculations as discussed in Chapter 1 this cal- culation may give a significantly different answer to the total shareholder return generated for that year. The concern that most people have with using such a measure as the basis for assessing performance is that it is based on forecasts of future expected cash flows. However it is actually based on the difference between two forecasts of future expected cash flows and therefore as long as both forecasts are done on a consistent basis the movement should bemuchmoremeaningfulthaneitherabsolutevalue.Thisisreinforcedbecause a high value this year thus apparently showing good shareholder value cre- ationbecomesthestartpointfornextyear’scalculation. Theimportantissueaboutconsideringsuchaprocesswhichwouldobviously onlybeusedinternallywithinthecompanybytheremunerationcommitteeof the board is that it starts to focus attention on the real value drivers of the business. The analysis of each year’s evaluation should concentrate on the changes in existing and potential future sustainable competitive advantages rather than on the resulting cash flows. The logical next stage therefore is to usetheseleadingindicatorsoffutureshareholdervaluecreationasthebasisof performance evaluation. It is these key value drivers that shareholders should reallywantthetopmanagementteamtobuildandthenexploitwhiledevelop- ing their replacements these top managers should not be able to claim that these areas are outside their control even if ‘their true value’ is not currently reflectedintheshareprice. Certainlyasperformancemeasuresaredesignedfurtherdowntheorganisa- tion normally starting with the business divisions’ management teams and central functional areas it is critically important that this linkage between accountability and controllability is clearly maintained. As stated above if managers are to be held accountable for a certain level of performance they shouldbeabletoexertinfluenceontheoutcome. Accountability/controllability gaps frequently occur as a result of sophisti- cated cost apportionment or cost recharging systems as opposed to proper ‘pricing systems’. The ultimate recipients of such a shared out cost may be held accountable for their proportions of the total cost e.g.€100000 being 20 per cent of a total cost of€500000 but they do not feel responsible for this cost as they cannot influence it. In many cases the major arguments regardingsuchcostsrevolvearoundtheproportioni.e.the20percentofthe cost that a particular department or area is being charged for rather than the actual amount managers feel that they may have some influence over this element if they complain loud and long enough. Of course reducing their proportion to say 15 per cent does not actually save the company money it is still spending €500000 and usually results in someone else within the companybeingchargedahigherproportion.

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328 Marketing Finance Arealconcernisthatsuchasystemcanendupwithnoonefeelingrespons- ibleforthetotalamountspenti.e.the€500000thetotalisrechargedoutto arangeofmanagerswhodonotfeelitistheirresponsibilityandthemanagers whospentitinthefirstplacefeelthatithasallbeenrechargedsotheyhaveno net responsibility or possibly and worryingly accountability. It is important thatnosuchgapsareallowedtodevelopinthecoststructurewherean‘itsnot myresponsibility’attitudecanbeexpressed. These gaps can be avoided if the true cost driver is identified for all the costsincurredbythebusiness.Thesedirectcausesofthecostsrememberthat a cost driver causes the cost to be incurred and changes the level of the cost must be held responsible and thus the appropriate managers must be held accountable for the total level of the costs. If the accounting system confuses orhidesthesecostdriverrelationshipsascanbeachievedthroughapportion- ing out the total costs managers may not be motivated to challenge the total costlevelsortakeupallthepotentialopportunitiesforcostreductions.Some- timesitmaynotbeimmediatelyobviouswhatthecontrollablecostdriverisin a particular area but this must be identified and then used as the focus of aperformancemeasureforthatarea. Salesforceperformancemeasurescanprovidetwoexamplesofthistypeof problem. Any sales manager with responsibility for a normal field sales force has quite surprisingly little discretion in terms of the total cost of that sales force.Salesforcetotalcostsaremadeupofalargenumberofdifferentitems as illustrated in Table 12.1. At first sight therefore it appears that the Table12.1 Fieldsalesforcecoststructure Atpresent100salespeopleareemployedbythecompany. Salaries x Otheremploymentcosts x Commission x Recruitment x Carexpenses x Telephones x Petrol x Accommodation x Subsistence x Entertaining x Samples x Consumables x Training x Supportcosts x £10million

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EstablishingPerformanceMeasures 329 accountable manager can influence the total costs of £10 million in a number of ways. However on closer examination it becomes clear that there is only onerealcostdriverforthefieldsalesforce. If salaries per employee are reduced to levels below those prevailing in the industry this is likely to result in the loss of the best sales people. Similarly attempting to reduce petrol or car expenses per head or accommodation and subsistence per sales person will also reduce the effectiveness of the sales force if these relationships have been properly established in the past. There is a quite well-defined ‘engineered cost’ relationship for many of these costs thisrelationshipisitselfslightlydynamicastheengineeredcostsperemployee will change ifthe size ofthe sales force changes significantly.Thishighlights that the only real controllable variable is actually the number of sales people employedbythecompany.FortheillustrationinTable12.1itcosts£100000 per year to have a properly equipped effective field sales person the key question therefore is ‘is it worth that much money to have all these people’ ratherthan‘canwemakethepeoplecheaper’Themarketingfinanceevaluation andcontrolprocessshouldfocusonjustifyingtheactualnumberofsalespeople by considering the relative financial contributions that would be generated by different sized sales forces and on validating the engineered cost relationship beingusedforthissalesforce. The other performance measure issue for this field sales force is how the performance of an individual sales person should be assessed. In many com- panies this is done by setting sales revenue targets or sales volume targets against which each sales person is measured. The problem is that such an exclusive focus on short-term sales revenues or volumes may be counter productivetotheachievementofthelong-termobjectivesofthebusiness.The performance measures used need to be specifically tailored to the particular aimsandobjectivesofthesalesforceasisillustratedinPracticalInsight12.3. PracticalInsight12.3 Productspecialistoraccountmanager In financial services most large banks have had ‘account managers’ for their corporateandbusinesscustomersformanyyears.Intheorythisroleistoprovide a single point of contact for the customer with the bank and thus the account managersshouldfacilitatethesaleofthewholerangeofbankingservicestotheir customers. However in practice most of these account managers were credit specialists i.e.theyknewalotaboutdebtproductssuchas overdraftstermloansetc. and so they were more comfortable selling whatthey knew. This behaviour was rein- forced by their performance measures which in most cases heavily emphasised their sales of these debt products they possibly got some small credit if the customeractuallyboughtsomeotherservicesfromthebank.Stillworseinseveral

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330 Marketing Finance For branded fast moving consumer goods companies there is a slightly dif- ferent form of the same problem. Many such companies consider improving thequalityoftheproductreceivedbytheconsumerasbeingveryimportantto theirlong-termsuccess.Formanyproductcategoriessuchasfoodthefreshness oftheproductisasignificantfactorintheoverallperceptionofitsqualitybut many of these companies still incentivise their sales forces to sell as many goodsaspossible.Wherethesesalesforcesdonotselldirectlytotheconsumer but to the channel of distribution e.g. retailers or wholesalers that then sup- plies the consumer there is the risk of ‘stuffing the pipeline’ that has been referred to in earlier case studies. More sales into the channel of distribution donotautomaticallyleadtomorepurchasesoutofthechannelbyconsumers thus there is the potential for holding increasing stock levels in the channels and consequently delivering less fresh poorer quality product ultimately to theconsumer.Onceeffectivedistributionhasbeenachievedthereneedstobe a target for trade stock levels in the channel expressed in days or weeks of sales out of the channel. This would stop the sales force achieving their sales targets by overfilling the trade pipeline. Their focus should be on increasing off-take by consumers but if they are given the wrong performance measure itshouldnotcomeasasurpriseiftheytrytoachievetheirobjectives.Whatis needed is a set of performance measures that are completely in line with the long-termobjectivesofthebusiness. Keyperformanceindicators Thethirdlevelofperformancemeasuresisthereforeveryspecifictotheparticu- lar business and its long-term objectives. These measures must be appropri- ately tailored to the business and the level within the business at which they are being applied. It has already been established that there is a vast range of potentially successful competitive strategies that are based on a specific mix of sustainable competitive advantages. Several of these different strategies may be implemented in various segments of the same industry at the same ProductspecialistoraccountmanagerContinued banks these account managers saw their customers as ‘theirs’ and so acted as ‘gatekeepers’ effectively controlling access to their customers by other product groupswithinthebank.Thismadeitverydifficultformanyotherservicesforeign exchange cash management corporate advisory securitisation etc. to generate businessfromexistingcustomershencetheytendedtodeveloptheirowncustomer relationshipswhichgoestotallyagainstthelogicofa‘customer-led’strategy. More recently most banks have recognised the problem and now include the cross-selling of products to key customers as an important performance measure for their account managers some are now deliberately using account managers whodonothaveadebtproductspecialism.

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EstablishingPerformanceMeasures 331 time this means that different companies in the same industry may need very different performance measures and that the same company may need differ- entperformancemeasuresinvariouspartsofitsorganisation. Also the assessment of managerial performance at different levels in an organisationrequiresthedevelopmentofaninterlinkedsetofappropriateman- agerial performance measures. At each level these measures should identify and focus on the key areas over which the managers exert control or have discretion. However the levels must be integrated to ensure that no account- ability/controllability gaps are created and that the overall objectives of the organisationarenotcompromisedbythesehierarchicalperformancemeasures. In order to create real focus at each level in the business all organisations need to develop a cascading pyramid of interlinked key performance indica- tors. KPIs are meant to be leading indicators of the success or failure of the criticalstrategicthrustsateachparticularlevelinthebusiness.Nolevelarea manager or individual employee can focus on a vast array of performance measures and I have found over many years that a maximum of five KPIs at each level is optimal. Recently I have been working with a large group that is trying to introduce this concept of a cascading pyramid of KPIs the problem isthattheyhavedevelopedaninitialsetof37 measuresfortheir topmanage- mentteamtofocuson.Thisisbetterthanthecompanythatinallseriousness presented the 147 KPIs that were used in the sales and marketing area of the business. It is in fact quite possible to have a large number of KPIs in use across a business but no person should be focusing on more than five of these. The trick is to link each of the levels together and ideally this should be done by moving progressively back along the leading indicator causality factors.As is shown in Figure 12.1 the 5 KPIs used at the top of the business by the main board or executive committee can each be expanded into five more KPIs for A cascading pyramid Figure12.1 Keyperformanceindicators–creatingfocus

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332 Marketing Finance thelevelbelowandsoondowntheorganisation.Theoreticallythismeansthat evenatthethirdleveldownthepyramidanybusinesscouldbeusing125KPIs i.e. 5 3 . However in practice the total number will be significantly lower as many of the KPIs at each lower level will be relevant and interrelated to severalKPIsinthelevelabove. HowevernoindividualmanagerisfocusedonmorethanfiveoftheseKPIs. For any manager’s performance assessment the 5 KPIs that are selected need notallcomefromthesamelevelinthepyramidandwillprobablynotallcome from one particular grouping of KPIs. They must all at least partly be con- trollable by the individual whose performance is being assessed. This means thatmorethanoneindividualcanhavethesameKPIandthatdifferentpeople can have KPIs that relate to different aspects of the same strategic thrust. In businessmanyresponsibilitiesaresharedandobjectivescanonlybeachieved by a team effort this reality should be reflected in the KPIs used within the business. Whatismeantbylinkingeachofthelevelsandmovingbackwardsinterms ofleadingindicatorsIhavealreadystatedthathighprofitsarealaggingindi- cator of the success of a marketing strategy i.e. a business makes a profit becauseitsmarketingstrategyhasprovedsuccessful.Yethighprofitsparticu- larly super profits can be a leading indicator of shareholder value creation if they lead to increasing share prices as the stock market comes to expect these super profits to be achieved in the future. Thus measures can be lagging indi- cators at one level but leading indicators at another level. It is also true that possible management action differs at the various levels within any business the top management team establish the mission the long-term objectives and set out the overall strategy but they cannot micro-manage all the details of howthisstrategyisimplemented.Thereforetherecanbeleadingindicatorsof howtheoverallstrategyisgoingthatarelaggingindicatorsatamoredetailed level of implementing this strategy. We need a leading indicator at each particular level of the business that is being considered so what tells us in advance that the marketing strategy is going to work and then what tells us thatthatfactorwillbesuccessfulandsoonAnexamplemaymakethisclearer andoneisshownasFigure12.2. Thisexampleusesarepeatpurchasebrandedconsumerproductsoldthrough retail distributionwhere the business has a key overall objective of increasing its market share. At the top of the company this value market share becomes oneofthefiveKPIsbecauseifitisachieveditisexpectedtoleadtoincreased profits and hence shareholder value creation i.e. it is a leading indicator of shareholdervaluecreation.Howeverusingtheachievementofanobjectiveto control achieving that objective is counter-intuitive it is by definition alaggingindicatorbecauseyouonlyknowaftertheeventiftheobjectivewas achieved and we cannot control the past. Therefore the next stage is to try to identify what will lead to this desired increase in market share. For this

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EstablishingPerformanceMeasures 333 company the five key factors are shown as the next level of KPIs. If market share is to grow this company needs to win new consumers and this requires new triallists who must re-purchase the product after trying it and then adopt itaspartoftheirnormalconsumption.Targetsforeachofthesefactorscanbe established that if achieved should result in the overall value market share objective also being achieved they are leading indicators of the ultimate objective. Of course the relative overall usage rate of these new consumers and our share of this usage will influence the ultimate market share gained and winning new consumers could be outweighed by losing more existing consumers this explains the other three KPIs at this level. Each of these five KPIs would then be further analysed into its own leading indicators some of which may be common. Taking one element the critical new triallists KPI it is possible to analyse how new triallists are acquired in this market. One importantfactoristhetotalpotentialnewuserpopulationwhichisafactorof our existing market share how many consumers can we get to switch from competitive offerings and the rate of new entrants into this market. Another linked element is the proportion of this potential new user population that is actuallytryingourproductthesearelinkedbutoneismuchmorecontrollable thantheotherandconsequentlytheconversionratiotoactualtriallistsisabet- ter managerial performance measure. How are these potential triallists won over is a mixture of knowing about the brand wanting to try the brand and then being able to buy the brand each of these is again linked but different sales and marketing managers will have specific responsibilities for only one elementofthismix. Breaking down advertising awareness shows that there are again still more specific leading indicators of whether the advertising message will work and Advertising awareness Attitudinal measures Potential new users Potential conversion triallists Value distribution in targetted outlets Opportunities to see Recall rating Decay rating Attitude to advertising Accumulated weight i.e. consistency New triallists Repeat purchase rate Rate of usage Share of usage Volume share KPI’s Top level Value market share Figure12.2 AnexampleforaparticularFMCGcompanywithakeyobjectiveto increasemarketshare

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334 Marketing Finance hence whether enough new triallists will be achieved so that the desired market share growth will be achieved. If many consumers have seen the adverts remember them but do not like them i.e. we get a poor response on the attitude to advertising there is no point in increasing advertising spend because overall trial rates are below plan the company needs to fix the prob- lem with its advertising communication. It should be clear that this process enables a much clearer focus at each level in the organisation but also shows managers where their KPIs fit into the overall objectives of the organisation. This can be far more motivating than giving all managers the KPI of increas- ing profit by 10 per cent simply because that is the organisation’s overall objectiveformostmanagerstheonlydirectactiontheycantaketoaffectthat measure is to reduce their own levels of expenditure which may or may not be in the long-term interests of the business. Managers need to be given per- formance measures where theirpossible actions are in line with the long-term interestsoftheorganisationasisillustratedinPracticalInsight12.4. PracticalInsight12.4 Tailoredfinancialcontrolmeasures As already stated a strategically focused marketing finance system should be tailoredtothespecificrequirementsoftheorganisation’scompetitivestrategy. Anannuitystreamoffutureprofits LifeAssuranceisaclassicexampleofanindustrywherecurrentandfutureprofit levels are largely the result of strategic actions taken some considerable time in the past. When a long-term life assurance policy is sold the future premium incomeisknownasistheactuariallycalculatedprobabilityofpayingoutearlyon the policy life assurance is all based on the law of large numbers of policies so thatstatisticaldistributionsdoapply.Thuslifeassurancecompaniescannormally predict very accurately what their profit contributions will be each year from existing business it is just an unwinding of the discounted cash flow calculation doneattheinceptionofthepolicy. This means that current profit levels are not a meaningful measure of real per- formance this year. One focus should be on the level of new business generated thisyearnetofpolicycancellationsandmaturitiesasthisindicatesthelong-term sustainabilityofthebusiness.Howeverforcertaintypesoflifebusinessthevery high up-front commissions paid to generate new business mean that newpolicies can actually produce an accounting loss in their first 1 or 2 years despite being highly profitable over the life of the policy. If the performance measures over- emphasise this year’s level of profitability a bonus-focused manager may decide to curtail the writing of these long-term profitable classes of business in order to achievetheshort-termtarget.

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EstablishingPerformanceMeasures 335 Ifthecompetitivestrategychangesthemarketingfinancesystemanditsassociated performancemeasuresshouldbereviewedandamendedaccordingly.Thisclearly means that businesses that have customer-led strategies should use different performance measures from those used by businesses that are implementing product-led strategies also brand-based strategies which can beusedbyboth customerandproduct-ledbusinessesrequiretheirowntailoredperformancemea- sures.Eachofthesestrategicthrustsrequiresthattheperformancemeasuresfocus onthekeylong-termassetsofthebusinessi.e.customersproductsorbrands. Howeverthereisonetypeofchangethatwilleventuallyaffectallcompeti- tive strategies and that is the progress of the business over time through the life cycle for its industry. The normal phrase used is ‘product’ life cycle and this will be used in this section of the chapter but the life cycle concept is equallyapplicabletocustomerandbrand-ledstrategies.AsshowninFigure12.3 the risk profile of a business reduces over its life cycle as the main risks i.e. volatilitiesareassociatedwiththelaunchandgrowthstages.Tomanypeople thisseemscounter-intuitivebecauseinthedeclinephasethebusinessisgetting smaller but it is predictably getting smaller and thus the perceived risk is reduced because of this level of expectation. This idea of a reducing risk pro- fileoverthelifecycleissimplyrepresentedbya2 ×2matrixinFigure12.4as thismakesthediagrammaticdevelopmentoftheargumenteasier. The key idea now is to identify how the critical success factors change as thebusinessmovesthroughthelifecycleandthisisshowninFigure12.5this concept was developed for customer-led strategies in Chapter 9. In the very high-risklaunchstagethefocusshouldclearlybeondevelopingandlaunching the product. A critical success factor for many new product-based businesses is ‘time to market’ i.e. how long does it take to turn a concept or idea into asaleableproduct.Thereisasignificantriskthatacompetitormaygetitsprod- uct launched more quickly but in any case an excessive delay is normally Decline Key elements of business risk Product risk Market acceptance Market share Size of market at maturity Length of maturity period Maintenance of market share Rate of eventual decline Length of maturity period Maintenance of market share Rate of eventual decline Rate of eventual decline Launch Growth Maturity Stage of life cycle Market share Size of market at maturity Length of maturity period Maintenance of market share Rate of eventual decline Figure12.3 Changingbusinessriskprofileovertheproductlifecycle

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336 Marketing Finance using up the limited competitive advantage period during which super profits can be generated. Once the product is launched this risk is removed and the business passes into the growth phase as previously discussed the key objec- tive is to grow market share to its optimum level during this rapid growth periodascompetitiveresponsestosharegainsarelikelytobelessaggressive. Growth Business risk high Launch Business risk v. high Maturity Business risk medium Decline Business risk low Direction of life cycle Figure12.4 Businessrisk–asitwillchangeoverthelifecycle Business risk high CSF: Growth in market share and development of total market Launch Business risk v. high CSF: Development and launch of new product Maturity Business risk medium CSF: Maintenance of market share at minimum cost Decline Business risk low CSF: Cost minimisation and/or asset realisations Growth Figure12.5 Changingcriticalsuccessfactorsoverthelifecycle

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EstablishingPerformanceMeasures 337 However if the company was first to launch the product it should start out as market leader and its strategy will normally be to maintain this market leadershipduringthegrowthstage.Aspreviouslydiscusseditistheresponsi- bility of the market leaders to ensure that the total market fulfils its full potential and this gives two critical success factors for this phase: growth in marketshareanddevelopmentofthetotalmarket. Oncetheproductmaturesthefocusofthestrategyshouldchangeasaggres- sivemarketsharegrowthcanresultinvaluedestroyingresponsesfromcompeti- torsi.e.the startofprice wars resulting in a lose–losegame for theindustry. Thecriticalsuccessfactorforthemarketleaderistomaintainitsmarketshare attheminimumcostpossiblewithoutopeningupopportunitiesforcompetitors to steal significant share Chapter 9 showed that it was during this maturity phase that the benefit of sharing cost savings with customers was particularly valuable. Of course smaller competitors may be less worried about entering intovaluedestroyingcompetitionastheyhaveasmallershareoftheexisting industryvaluechainbutitisstillintheinterestsofthemarketleadertomanage theprofitabilityofthetotalindustry.Eventuallytheproductwillmoveintoits decline stage where sales volumes reduce albeit slowly and it is important that the business does not try to avoid this by over-investing in marketing activities. The focus should be on downsizing the business to match the new levels of demand so that asset realisations and cost reduction activities become more important. It is quite common that by this stage the basis of competitionhasbecomesellingpricesothattherelativecostlevelswillbeof increasing importance. These critical success factors can themselves be trans- lated directly into tailored leading indicator performance measures with a particularlyvaluablemeasurebeingaleadingindicatorofwhentheproductis movingintothenextphase. However these non-financial measures also help to highlight what type of financial control measures should be applied to each stage of development. It is only during the maturity phase as shown in Figure 12.6 that the very common accounting-based ROI is at all valid. Even here I much prefer the residual income measure discussed earlier in the book although as shown in Figure 12.7 the best financial performance measure for mature products is sustainableoperatingcashflowsasitavoidthepotentialconfusionthatcanbe caused by ‘Mickey Mouse’ accounting presentations. The reason that ROI is acceptable for mature businesses is that the business is focused on producing good profits now while maintaining the asset base for the future and ROI gives a reasonable view as to whether that is being achieved. Unfortunately it is still a lagging indicator for the current year but this year’s profits can be usedasareasonableleadingindicatorforfuturesustainableprofitlevels. None of the other stages is either steady state or stable and therefore using ROIwilleitheroverstateorunderstatethefuturepotentialofthebusiness.Dur- ing the launch phase there is almost no meaningful financial control measure due to the very high business risk and associated very high level of volatility.

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338 Marketing Finance The financial evaluation that should have been done prior to committing the funds to develop and launch the product would have been based on the expected future cash flows but as discussed in Chapter 7 these ‘expected’ cashflowswillprobablyhaveaverywiderangeofpossibleoutcomes.Typically Growth FCM: DCF evaluation of investments in growth in market and market share Launch FCM: RD milestones decision focused reviews probability assessments Maturity FCM: accounting return on investment or residual income Decline FCM: free cash flow from operations Figure12.6 Tailoredfinancialcontrolmeasuresoverthelifecycle Growth CSF: market dominance Focus: marketing FCM: DCF of marketing investments Launch CSF: time to market Focus: RD/ market research FCM: Maturity CSF: maintenance of position Focus: supply chain FCM: Decline CSF: controlled exit Focus: FCM: total free cash flow including asset realisations sustainable operating cash flows/ROI /RI RD milestones decision-focused reviews risk management asset management cost control Figure12.7 Illustrationofmatchingfinancialcontrolmeasurestostrategicthrusts overtime

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EstablishingPerformanceMeasures 339 this would include some chance of complete failure with no resulting cash inflows and some chance of very high cash inflows if the product ultimately proves to be very successful. Thus while the ‘expected’ cash flows can and indeed must be used for evaluating the investment they cannot be used as a meaningful ‘control’ measure during the development and launch stage. Con- trolshouldinsteadfocusonmanagingtheveryhigh-riskprofile oftheproject andthis includesusing milestones forthe researchand developmentactivities and marketing research carrying out decision-focused reviews before com- mitting the next phase of expenditure and as discussed in depth in Chapter 7 trying to increase the probability of success of later stages before committing significantamountsofmoneytotheproject. Once the growth phase has been reached much more information on the market and the relative strength of the company’s product will have been obtained. Thus the total range of the expected outturns should have reduced significantlysothatthediscountedcashflowevaluationscannowalsobeused as a meaningful financial control measure. It is vital that such a long-term control measure is used if the product is to achieve its full potential as much of the marketing expenditure during this growth stage will be development spendwhichhasalong-termreturn. Duringthedeclinestagethebusinessislookingtoreduceitsinvestmentin the product by recovering some working capital as volumes drop and by not reinvestingalltheaccountingdepreciationexpenseinnewplantandmachinery. Thismeansthatthecashgenerationfromtheproductshouldbehigherthanits accounting profit level and this makes free cash flow from operations a good performance measure. The drawback is that actual cash flow is once again a lagging measure but targets can be set both for releasing working capital and for the reinvestment rate in fixed assets and this can produce a more leading indicatoroftheactualcashgeneration. This process can therefore be developed to produce a balance of financial andnon-financialmeasuresthatlinktogetherthecriticalsuccessfactorsofthe strategic thrust at each stage with the focus of the marketing finance system andtheappropriatetypeofperformancemeasureasshowninFigure12.7. Anotherwayofdevelopingasetoftailoredperformancemeasuresfordiffer- ent types of organisation has already been discussed in Chapter 6 where the Rainbow Model showed that the specific role of the corporate centre in large groupscanhaveasignificantimpactontheperformancemeasuresthatshould beusedacrosssuchagroup. If all the relevant various factors are combined for any particular business itshouldbecomeclearthatauniquesetoftailoredperformancemeasurescan be developed for each business depending on its specific needs. Thus as discussed in the Rudolph and the Elves case study at the end of Part One these tailored performance measures may well have more in common with abusinessapplyingasimilarstrategicthrustinacompletelydifferentindustry

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340 Marketing Finance than with a business in the same industry that is employing a very different strategy. Casestudy–Coca-ColaInc. It was very tempting to try to write a final case study that covered all the issues addressed in the book but I soon gave this up as too ambitious. How- ever I decided to finish by discussing a company that consistently delivered very high levels of shareholder value over quite a long period from a clear marketing focus in other words it achieved the sub-title of the book by ‘turn- ingmarketingstrategiesintoshareholdervalue’.Itschallengeistocontinueto dothisinthefuture. Background Coca-Cola Inc. was able to grow initially in the USA very rapidly by focusing on the manufacture of its syrup concentrate and the brand advert- ising for its soft drink product. The actual production of the finished con- sumer product was outsourced to bottlers spread across the USA. These bottlers were set up with territorial exclusivity by 1920s there were 1200 franchised Coke bottlers perpetual contracts and a fixed syrup price. The bottlers did very well as the market grew rapidly but as the USA market maturedinthe1970swithvolumegrowthratesofonly3percenttheylooked on Coke bottling and distribution as a good profit generator but no longer a high potential business. Also Coke’s bottlers were by definition locally based and therefore were not structured to do regional and national deals with the rapidly expanding retail chains. Pepsi–Cola could do this as it owned many of its larger bottlers by 1977 Pepsi had an equal share to Coke in the USA supermarkets. In the early 1980s Pepsi moved into snack foods and restaurants acquiring Pizza HutTacoBellandKFCallofthesechainsnotsurprisinglyswitchedtosell- ing Pepsi. Coca-Cola already had McDonalds but then won Burger King and Wendy’saswell.Therestaurantsectorandvendingmachinesarehighlyprof- itablechannelsofdistributionforsoftdrinkscompaniespricingishighandso are consumption levels thus exclusive distribution can be a major advantage. Unusually grocery distribution in this industry is more a method of brand building rather than a source of super profits it is in the grocery channel that both Coke and Pepsi have faced their most severe competitive pressure from retailerbrandsandgenericcompetition. Coca-Cola wanted to restructure its bottlers but the perpetual contracts and fixedpricesyrupmadethispotentiallyveryexpensive.ThenewCEORobert

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EstablishingPerformanceMeasures 341 Goizueta used a product development to achieve this in 1981. The company haddevelopedahighfructosecornsyrupasanalternativetosugarinthesyrup which reduced the cost by 20 per cent Goizueta made the lower cost product availabletobottlersonaconditionofamendingtheoriginalcontracts.During theearly1980sCokethenacquiredmanyofitsbottlingfranchiseesandfocused ondevelopingtheareasofothergoodbottlers. Unfortunately this significantly increased its asset base and made its return onequitylookmuchlowereventhoughthesebottlerswerethemselveshighly profitable. In 1986 Coca-Cola Enterprises was set up as a holding company fortheseownedbottlersandamajoritystake51percentwasfloatedontothe USAstockmarket.ThisachievedtwothingsoneCokenolongerhadtocon- solidate its remaining 49 per cent minority stake so its return on equity rose back to its old levels and two it generated over 1 billion in cash that could be spent on acquiring more bottlers. This model was replicated as Coca-Cola grew rapidly internationally during the 1980s and 1990s with its large anchor bottlers that effectively controlled a region or large country being partially ownedbyCoca-ColaEnterprisesCCE. By themid-1990s Coca-Colahadadominantsharein theinternationali.e. to them non-USA sales soft drinks market and 80 per cent of its 4 billion operating profitwas madeoutsidetheUSA.ThegrowthrateoutsidetheUSA was still significantly greater than the now very mature USA market. Coke’s marketcapitalisation hadgrownastronomicallyfromunder5billionin 1981 to around 150 billion in 1996. Coca-Cola had thus generated significant shareholder value over a 15-year period by being a focused branded beverage producerlinkedtoanetworkofbottlersthatareitskeydirectcustomers. Pepsi–Cola on the other hand had moved into other product areas includ- ing snack foods e.g. Frito Lay and fast food restaurants now sold off but 90 percentofitsprofitscamefromtheUSAnotleastbecauseithadlessthan half Coke’s market share outside the USA 45 per cent versus 21 per cent. Pepsihasalsonowspunoffitsbottlingoperations. In the second half of the 1990s Pepsi mounted an aggressive marketing campaign in the USA it doubled its annual marketing spend based on blind taste tests that indicated consumers actually preferred Pepsi to Coke. This closedthemarketsharegaptoitssmallestlevelsince1980andresultedinthe launchofNewCokewhichwassupposedtotastebetterthaneitherOldCoke orPepsi.Thiswell-documenteddisasterwasrapidlyreplacedbyClassicCoke i.e. Old Coke again but Coca Cola also faced other problems not helped by theeconomicslowdownanditsownqualityissues:growthofcompetitorbrands e.g. Dr Pepper now owned by Cadbury Schweppes continuing growth of retailerbrandsandagrowingrangeofalternative‘healthier’drinks. Another new CEO Douglas Ivester tried to change the corporate culture andrefocusthecompanyoncreatingshareholdervalue.Heintroducedeconomic

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342 Marketing Finance value as the group’s main financial performance measure and radically over- hauled the company’s planning and control process. This tried to bring about morecreativityfromlowerlevelemployeesthroughagreaterlevelofdelegated authority so as to reduce the perceived arrogance and bureaucracy that had builtupwithinthecompany.Unfortunatelythestockmarketlowereditsfuture growth expectations for the shares as the company showed that it could not sustainitsprevioussalesgrowthrates.Itsdominantmarketsharemeantthatit couldstillachieveprofitgrowthbynotspendingonitsbrandmarketingthere were no high-profile marketing campaigns during this period but this was alsoseenasalonger-termthreatbystockmarketanalysts.Ivesterleftin1999 and was replaced by Douglas Daft as stated earlier he has recently curtailed Coke’s short-term profit estimates in an attempt to ensure that the focus is on thelong-termstrategy. Strategicanalysis Coca-Cola made a very early key strategic decision that was to try to gain a dominantmarketsharewhileitsmarketwasinitsinfancyhencetheuseof exclusive franchised bottlers that gave it national coverage very quickly. It focused on controlling the brand imagery and the product quality the syrup concentrate and the product’s packaging including its unique bottle shape. This enabled it to develop an incredibly strong consumer franchise despite having at least two intermediaries between it and the consumer the bottler andtheretailchannelofdistribution.Thestrategyalsominimiseditsrequired investmentinbothcapitalandpeoplesothattherateofpotentialsuperprofits wasveryhighoncestrongmarketsharewasachieved. However it also restricted its strategic flexibility if its bottlers were not as committed to the brand and the consumer as Coca-Cola was. It needed more negotiating power once the channels of distribution became more concen- trated and its consumer branding potentially became less powerful. Exclusive distribution in restaurants bars clubs etc. is a potentially double-edged marketingsworditisasourceofbrandtrialasmanyconsumerswillnotleave just because the restaurant serves Pepsi rather than their normal Coke or vice versa hence they get to try the competitive product and may get to like it. However a request for one brand which gets automatically replaced by the No.1 rival brand may damage the perceived brand differentiation ‘its all reallythesamestuffbutwehappentosellonlyPepsi’. Coca-Cola has proved several times by launching other products that it is virtually impossible to replicate the strength of a brand like Coke which makesitavictimofitsownsuccess.ThepotentialmarketforCoca-Colamay be very large but it is definitely finite and sustaining high growth when you have a dominant share of a maturing market becomes more and more difficult.Theriskisthatthebrandstrengthandthepressureforprofitsleadto

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EstablishingPerformanceMeasures 343 a strategy of trying to keep increasing profit margins not surprisingly there are many similarities between the Coca-Cola story and Marlboro cigarettes. These increasing profit margins make it easier for competitors to offer better valueformoneyproductsandstillmakeamorethanacceptablereturn.Thisis particularly true when the total size of the market makes it possible to be financially viable with only a very small market share. The consequence is that it is vital that the company can continually refresh its brand imagery but this becomes increasingly difficult as the brand gets older with the result that the age profile of Coca-Cola drinkers gets much broader. Also as the market share of the grocery channel increases the visibility of the leading brand’s pricepremiumbecomesgreaterandthereisthesignificantadditionalriskthat theeconomicbuyerthesupermarketshopperisnottheactualendconsumer andhe/shemaydecidetobuythemuchcheaperalternativecolabrand‘because itsallreallythesamestuff’and‘itsprobablymadebythesamepeopleanyway’. Another problem for the market leader in a maturing market is that it has themajorroleindefendinganddevelopingthetotalvalueofthemarketwhile the small competitors can simplylook to gainmarket share even at the risk of damagingthetotalreturnfortheexistingleaders. For several years Coca-Cola offset its maturing USA market by growing internationally eventually taking an even greater share of the world market outside the USA than it has inside the USA. While this overall market and Coke’s share of it was growing rapidly the overall group’s profit could sustainastrongrateofgrowth.Asthismarketslowsthefuturerateofgrowth becomesmuchmorequestionableandinevitablythiswouldleadtoare-rating ofthegrowthexpectationthatisincorporatedintotheshareprice.Shareholders tendtoextrapolateexistinggrowthratesintothefuturesometimesseemingly to infinity and accordingly bid up the share price. They then require that the company achieves these growth expectations that they have by now already paid for if the company fails the resulting fall in the share price can be both very rapid and very large. It is therefore important that the company manages the expectations of the stock market so that its share price does not rise too far i.e. well beyond what can actually be sustainably delivered by the com- pany’slong-termstrategy. Coca-Cola undoubtedly turned its fantastically successful original brand- based marketing strategy into a massive amount of shareholder value the challenge is now to sustain and build on this in a much more mature market withamoresophisticatedsetofcompetitorsmoreaggressiveotherstakehold- ers and potentially less loyal consumers. If it is to do this it will need a very tailored set of marketing finance generated performance measures but they willnotbethesameonesthatserveditsowellinthepast.

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Index Accountability/controllabilitycost apportionment/rechargingsystems327–8 economicperformancemeasures325–6 FCMG330 gaps327–8 necessityof325 salesperformance328–30 shareholdervalue326–7 stockoptions326 Aircraftindustry274–5 Ansoffmatrix44–6161163 Assets17–19 management250 researchinvestmentmaintenance expenditure250 BainCo.251 BATBritishAmericanTobacco109122124 134–5239–40 BostonMatrix129143–4 BPBritishPetroleum139 Brandattributes2147 commitment/involvement234–5 concept230–1 customerloyalty232–6 functional/representational231232 importanceof232 linkedbranding232–3 Brand-basedstrategiescasestudy239–40 creatingawareness223–4 customer-based217–18222 evaluationprocess47–8236–9 financialcontrol/evaluation219221–2225–6 marketingbudgets228–30 newusertrials224–5 product-based216 rateofregularusage226 re-purchasephase226 riskassessment226–7 SOV/SOMratio230 superprofits48215219220–2 targetsetting/planning225 useofdiscountedcashflow47–8 value-weightedlevelofdistribution223–4 Brandsconcept215 asintangibleassets219–20 customerloyalty217–19222233–6 definition221 developmentof215–16222–7 dominant37–8 evaluation216297 lifecycle217–18 loyalty216 positioningof216 realisingassetvalue220–2 strengthof221 umbrellabranding232–4 valueformoney221 Budgeting172–4238–9 CapitalAssetPricingModelCAPM11 Carindustry88–96100–1232244303 Casestudiesbiscuitmanufacturer132–4 competitoranalysis118–27 customer-based259–61 financialcontrol316–19 fiveforcesmodel135–42 KnightFoods174–6249265268 marketingfinance52–8 multinationals87–96 performancemeasures342–3 PeterPiper207–14 planning174–8 product-based282–9 productlifecycle142–9 Rudolph/Elves52–8 Scrooge/Shylock145–9 strategicinvestment207–14 strategicmanagement77–80 sub-assemblers282–5 TissuesUnlimited285–9323 transferpricing285–9 varianceanalysis282–5 Cashflowforecasts22–3 Cigaretteindustry18 Co-opetition114 Coca-ColaInc.2122 background340–2 strategicanalysis342–3 Commoditysuppliers37–8 Competitiveadvantage3 andcompetitorcomparisons99–100 distributionchannels258 ingrowthphase111 investment277–9 newsourcesof102 product-basedstrategies263 reinvestmenttoreplaceexisting277–9 sustainable13–141617–182037175–6 302–3

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Index 345 Competitivestrategy68334–5 brand-based215 co-operative45 long-term111 Competitoranalysis302 andvaluecreation114 asdecision-makingaid103–4 asforwardlooking97 astwo-stageprocess104–10 businessincontext104–5 casestudy118–27 classificationinnon-mutuallyexclusive categories105–10 company/competitorscomparison98 competitor/competitorcomparison99–100 core/peripheralbusiness108–9 costbenchmark116–17 customer-leddefinitions101 destructive/constructivecompetition114 detailedbuttailored115–17 entry/exitbarriers105–8 existingcompetitors101–2 focused/defined115 futurefocus104 gametheory98110–15 identificationofcompetitors97100–3105 internalperspective100 life-cycleanalysis107 performancemeasures109–10 predictionofstrategicinitiatives97 principaldecision-maker110 risk-taking110 sourcesofinformation98117–18 strategicposition105 timing115 usableinformation115 value-in-use115–16 verticalintegration109 Consumerassociations4 Contingencyplanning35–638153164173 Corporatecentres62158168 benefits72 controlsconfiguration74–5 corporateconfiguration7476 direct/indirectinvolvement7475 scale/scopeconfiguration76 underattack74 valuecreation74757677 Corporatevalues157–8 andcorporateculture158 andcorporatestyle158159 communicationof158 definition157–8 derivedfrom/consistentwithvisionstatement158 Criticalsuccessfactorscontrolinadvanceof financialcommitment306–7 developoverallinvestmentplanning/control process308 financial/non-financialperformancemeasures 307–8 focuson/measureintangiblemarketingassets306 managementdiscretion307 marketingobjectives/engineeredrelationships307 marketing/financecommunicationgap305 objectivesstrategiesmarketingfinance systems304 relevantinformation306 strategicmarketingdecisions305–6 CustomeraccountprofitabilityCAPanalysis 48–9243247–53266 designof247 example248 importanceof246 levelofattributablecost249–50 lifecycle254–9 objectives247 product-costingsystem248–9 realcostdrivers247–8 Customer-ledstrategiesassessmentofcustomer value48–50 builtaroundexistingcustomers48 CAPanalysis48–9242–3247–50 casestudy259–61 concept241 directattributablecosting49 financialanalysis241 futuregrowth48 lifecycleprofitabilityanalyses254–9 long-termrelationships241–2250–3 marketingsegmentation243–7 relationshipmarketing49 retention/development49 superprofits48 Customerlifecycleprofitabilityanalyses254 companystrengths254 competitorrisk257 concept254 customercompatibility255–6 DCFevaluation256 directionalpolicymatrix254–5 distributionchannels258 lifetimeeconomicvalue258 marketingfinancemeasures255256 shareofcustomerbusiness256–7 strategicthrust255–6 structureof254 TPM/FECtechniques256 useofdatawarehouses/datamining techniques257–8 Customervalue49–50243253266 Customersbrandloyalty19217–19222 233–6 habituals236 lost251 retaining/developing251 switchers234–5 varietyseekers235 DMConfectioneryLtdcasestudy background259 newbusinessopportunity259–61 DellComputers245 DirectproductprofitabilityDPP50–1262 basedonexistingproducts264–6 costings264268 decisionrelevantcosts267–8 developmentof266 exampleof266–7

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346 Index DirectproductprofitabilityDPP–continued groupingproducts268 loss-makingproducts267 objective264–5 productdefinition264–5 rateofsale266 relationshipmarketing/customervalue266 underrecovery/overrecovery264 value-addedcomponent270 DiscountedcashflowDCF326–7 andshareholderrateofreturn185–6192 argumentsagainstusing186 brandevaluation237–8 CAPanalysis258 concept185 criterionrateof185–6 implementationof186 IRRmethod186–9 Economicprofitresidualincome23–4 EconomistIntelligenceUnitEIUReport34–5 Enron26 Entry/exitbarriers16105–8 againstcompetitors251 askeyassets18 finiteeconomiclife17–18 Esso139 Existingpositionappraisal6399128 5forcesmodel128135–42 externalenvironment129–30 internalposition130 productlifecycle129142–9 reviewcurrentposition129 SWOTanalysis128130–5 techniques128–9 Experiencecurve51262270–5 Externalfactors3536386898–9129–30 131–2322 FastmovingconsumergoodsFCMG122126 224226296–7298330 Feedbackloops4041156162–3176 294300 Finance/accountingactual/plannedperformance comparison99 efficiency/effectivenessmeasures7 evaluation6–719338 forecastoutcomebenefits99 involvementwithmarketing5–8 roleof5 traditionalsystem98–9 Financialcontrolbrand-basedstrategies294–7 casestudy316–19 changesto40 changingcompetitiveenvironmentexample 308–16 commitmentprocess293–4 competitivestrategy334–5 concept33 constraining321 costincreases321–2 differentialadvantage302–3 enabling322 evaluation294 exports/imports298 feedbackloops4041294300 focusondecision-making293 historicalanalysis293 impactoforganisationstructure303–4 internal/externalenvironment343638 keylearningsaboutfuture300–1 linkwithplanning39–46153159–60293 294300–3 objectives39–40 performancemeasures40–4297 pricing295 promotions298–300 prudentview295 retailerresponse295–7 risks294 ROIratio295 SLAs293 strategic294321–2 successfactors293304–8 sustainabilityofpresentsituation302 tailored334–40 two-stageprocess294 uninvolved/uncommitted321 Financialservices102218 productspecialist/accountmanager329–30 Fiveforcesmodel128135–7 casestudy137–42 FordMotorCompany100–1244 cross-bordersourcingdecisions90–4 overseasinvestments88–90 strategicopportunity94–6 Gametheory3645–6 applicationof112–14 valuechain110–15 GapAnalysisachievementof targets/objectives162 applicationof161–2 benefitsof163–4 BHAGbighairyaudaciousgoals162 concept161 feedbackloops/performancecriteria162–3 GeneralElectricCompanyGEC28–9 GreenspanA.25 Growthstrategy1546 andcompetitiveadvantage111 customer-led48 increasemarketshare111 product-based143–4263337–8 IBM37–8142232 analysisof81–7 fallof78–9 riseof77–8 secondrising79–80 verticalintegrationof84–7 Inflation191–2 Insurance15–16 InternalrateofreturnIRR179309 applicationof186 flawsin187–8 popularityof186–7 profitabilityindex188–9

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Index 347 KeyperformanceindicatorsKPI320–1 advertisingawareness333–4 cascadingpyramid331 concept331 creatingfocus331–2 leading/lagging332–4 linkinglevels332–3 repeatpurchase332–3 KnightFoodscasestudy249265268 background174 cannedmeatproducts174–5 post-launchdevelopment176–8 sustainablecompetitiveadvantage175–6 Levi’s218 LifeAssurance334 McDonald’sbackground316–17 strategicanalysis317–19 Marketsegmentationbiographics246 degreeofcompatibility246 degreeofloyalty246 delivery/distributionrequirements246 differentialadvantages/positioning strategy244 geo-demographicanalyses246 innovation/flexibility246 masscustomization244–6 massproduction244 objective/subjective246 productdifferentiation244 productimportance246 psychographics246–7 situationalcontext247 styleofdecision-makers246 systemscompatibility246 trendsin244 Marketingexpenditureabovetheline/below theline19–20 challengesto4–5 control294–5 decline20–1 extensionoflifeofasset21 maintenance/development2021216227–30 238–9 planning22 proportionoftotalexpenditure21 Marketingfinance5–819 analysis34–5 budgetactualvariancesyndrome33–4321 casestudy52–3 competitoranalysis36–8 competitorrisk257 controlprocess3638–9250293–4 criticalsuccessfactors304–8 customervalue253 development2021 discussionofcasestudy53–8 externalenvironment34 gametheory3645–6 internal/externalcosts98–9 participative322 perceivedusevalues52 planninginterface36–8156–7 roleof301 shareholdervalue253 tailored44308–19 Marketingandadvertising7–8 brandawareness7–8 branddevelopment222–7 creatingassets17–22 customerdiscounts16 financialevaluation226–7 findingnewcustomerssegmentsmarkets46 reductioninriskperception16 strategy30–246 success/failure227 Seealsobrand-basedstrategies MarksSpencer217218 MarlboroFriday118–27135142 Mars223 Milkmarket102 Missionstatements616466–76869100 ModelTFord245 Multinationalscasestudy88–96 cross-bordersourcingproblems90–4 overseasinvestments88–90 risk-taking87–8 strategicopportunity94–6 NoordaR.114 Oilindustry109 background137–9 strategicanalysis139–42 supermarketcompetition138–9 OldMutualassurancecompany166 Optionsadvantagesofrealoptionvaluedrivers 201–2 call199 concept199 lifeof200–1 models199 put199 real203–6258 useofrealoptions202 valuedrivers199–202 volatilityofinvestmentreturns201 Organisationalstructurescombinationof159 controlprocess303–4 corporatecentres74–7168 corporateconfigurationmodel76159 divisional70–2168 functional70 geographic/strategicmove158–9 matrixtype73 mixed72–3 Rainbowdiagram159160339 separateinternalservicecentres169–70 verticalintegration109 Pareto80:20rule300 Paybackmethodadvantages182 concept182 discounted184–5 inpractice182–7 problemswith183–4 relevanceof183

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348 Index Perfectcompetition13105 Performancemeasures294 accountability/controllability325–30 achieving43 actual/plannedcomparison99 altering323 asleadingindicators322 casestudy340–3 committed/discretionaryexpenditure307 competitoranalysis109–10 concept320 customerneeds252 decision-oriented322 developingappropriate41 economic41–3320325–6 efficient/effective320 financial/non-financial322339 goalcongruence43324 hierarchyof320 identifyappropriatefinancial307–8 internal/external4244322 keyindicators30–4320–1 machineutilisation297 managerial42–3320333 new322–4 relativecompetitiveperformance4243 salesforce328–30 shareholdervalue326–7 short-term/long-termbalance40–1323 tailored297321322334–40 transferpricing323324 PhilipMorris109135239–40 competitorreactions124–5 marketbackground119–21 pricereaction122–4 resultingimpact125–7 understandingbusinessof121–2 Planningandassessmentofrisk154–5 andchoosingcoursesofaction154 budgetobjectives172–4 bureaucraticapproach156 casestudy174–8 competitivestrategy153167–8 complexityof155–6 conservative/extreme153 contingency153 corporate158–9167 creative160–1 directinvolvement161 financial32–339–46 gapanalysis153161–4 groupactivities168–9 incontext155 integratedprocess165–6 linkwithcontrolprocess39–46153159–60 293300–3 marketingfinanceinterface36–8 156–7 performancemeasurementsystems153 portfolioofbusinesses153 preparation39 Rainbowdiagram159–61 strategiclevels167–70 top-down/bottom-up153–4170–2 unexpected/unplanned165 PorterM.128135–7 Pricingstrategies323 penetrationvsskimming275–6 reduction271273–4 short-rundecisions301–2 transfer285–9 value-in-use115–16 Probabilityestimates179–80 advantagesof197–8 assessmentof198–9 inhigh-riskstrategicinvestmentdecisions 196–8 revisinginitial195 useof194–9 ProcterGamblePG233266 Productattributes262268–9 costadvantage269–70 differentialadvantage270 matrix269 Product-basedstrategies31–2 casestudies282–9 competitiveadvantage263277–9 competitoranalysis52 concept262 costingtechniques263 crosssubsidisationofproducts262–3276–7 DPPanalysis50–1262264–8 experiencecurve51262270–1 focusonexistingproducts263–4 growthobjectives263 lifecycleprofitabilityanalysis262270–5 marketshare44–5 penetrationvsskimmingpricing275–6 perceivedusevalues52 productattributes262268–70 profitgeneration262 promotions298–300 reinvestment277–9 standardcostingtechniques279–82 superprofits50263 sustainablecostadvantage51–2 transferpricing263 useofpredictiveknowledge51–2 varianceanalysis263 Productlifecycle20129142–3 casestudy145–9 criticalsuccessfactors335–7 declinephase338–9 developmentof143 growthphase143–4337–8 risk335–6 Productlifecycleprofitabilityanalysis262 asymptoticexponentialcurve271–2 experiencecurve270–5 sellingprice271273–4 shorttermlossperunit273–4 Profitabilityindex179188–9 RappaportA.22 RateofreturnRoR19185–6192207212 RealoptionsSeeoptions Relationshipmarketing49241–2 administrativesupport251 conditionalprobability258 dealingwithcomplaints252 DPPanalysis266 entrybarriers251

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Index 349 financial/controlprocess250 indirectbenefits258 internalcosts251 keyperformancemeasures252 lifetimeeconomicvalue258 lostcustomers251 productinnovation258 recoveryofcosts251 referrals/referencability258 retaining/developingcustomers251 satisfying/anticipatingcustomer expectations/requirements252 simulation/realoptions258 superprofits253 RentokilInitialplc68–9 ReturnoninvestmentROI189–90295 326–7337 ReturnonTotalAssetsROTA43 Risk110 assessment154–5 business/financialcombination26–9 investment181185–6192–9 multinationals87–8 perceptionof16 probabilityof179–80194–9 shareholdervalue9–1114 timelydecisionsupport294 Scenarioanalysis164 ServicelevelagreementSLA87293 Shareofvoice/shareofmarketSOV/SOM 229–30 Shareprices25–6 Shareholdervalue297 analysisof23–5 anddominantmarketshare111 andmakingaprofit11–16 asaimofcompany3 brands215 bubbleeffect26 calculation326–7 capturing46 creating3–48–912–134546253321327 definition22–5 focus8–916 risk/returnrelationship9–1114 sustainable/real425–6 Shell139–41 Standardcostingdevelopmentof279–80 engineeringtyperelationships280 input/outputrelationship280 priceperunit280 usageperunit280 varianceanalysis280–2 StrategicbusinessunitsSBUs71158 Strategicinvestmentaccountingreturnon investment189–90 asone-offopportunities181 casestudy206–14 characteristicsof181 concept179 definition180 discountedcashflowtechnique179185–9 discountedpayback179184–5210 financialevaluation181 internalrateofreturn179 long-termaspects181 netpresentvaluemethod179 optionvaluationmodels180 paybackmethodofevaluation179182–4 personalapproachtoevaluation190–1 practicalimplementationissues191–4 probabilityestimates179194–9 realoptions194–206 success-basedcashflows180 Strategicmanagement30–1 analysisofcasestudy81–7 casestudy77–80 competitivestrategies62–3 corporatecentres6274–7 corporatestrategy63 definition63 flexibilityof74 focusonbusinessprocesses62 goals/objectives6167–869 influenceson64 missionstatement616466–76869 mixedstructures61 movefrompublictoprivate65 multilayeredprocess69–73 multinationals/globalbusinesses62 organisationstructure70–3 stakeholder/shareholderconflict64 verticalintegration62 visionstatement61666769 Superprofits141618 andrelationshipmarketing253 brand-based47215219220–2 customer-based48 importanceof22 maximisationof21 product-based5052263 sourcesof111 sustainablecompetitiveadvantage68 Supermarkets109 SWOTstrengthsweaknessesopportunities threats128130–1154 casestudy132–4 goodnews/badnews134–5 honestanalysis131 Tangibleassets18–19 Technologyproducts273 TechnologymediaandtelecomsTMT25 Tesco140–1 TotalshareholderreturnTSR24–5 Transaction-ledstrategy250 Transferpricing168285323324 casestudy285–9 implementation293 Value-addedstrategies14–16 Varianceanalysis280–2 casestudy282–5 Virgingroup219 Visionstatement61666769 andcorporatephilosophy158159 VolkswagenVWGroup101 Wal-Mart253 whisky231–2 WorldCom26

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