2 - Strategic Option Generation & Choice

Question 1

It is possible to analyse strategic choice into three categories:

Answer 1

 Competitive strategies – the strategies an organisation will pursue for competitive advantage. They determine how an organisation competes.
 Product-market strategies determine where an organisation competes and the direction of growth.
 Institutional strategies determine the method of growth, and how an organisation gains access to its chosen products and markets.

Question 2

Porter highlights three generic strategies for gaining competitive advantage:

Answer 2

 A cost-leadership strategy – the business seeks to be the lowest cost producer in the industry
 A differentiation strategy assumes that competitive advantage can be gained through particular characteristics of a firm’s products.
 Focus (or niche) strategy – In a focus strategy, a firm concentrates its attention on one or more particular segments or niches of the market, and does not try to serve the entire market with a single product. The firm must then choose to pursue a cost-leadership or differentiation strategy in that industry.

Question 3

Ansoff’s matrix shows the possible directions that a business may take in order to achieve growth:

Answer 3

Market Penetration Product Development
Market development Diversification (related or unrelated)

Question 4

Institutional strategies
The following are possible methods of expansion for a business wishing to grow:

Answer 4

 Organic growth
 Acquisitions and mergers
 Joint ventures
 Licensing agreement
 Subcontracting
 Franchising
 Alliance

Question 5

Organic growth - advantages and disadvantages

Answer 5

Advantages
Possibly the only way to exploit a new technology
No cultural clashes
Less disruptive
No need to raise large amount of finance for takeover

Disadvantages
Slow
Barriers to entry
Lack of expertise

Question 6

Acquisitions & mergers - advantages and disadvantages

Answer 6

Advantages
Gain existing products, customers and reputation
Synergies
Eliminate competition (if horizontal integration)
Safeguard supply chain (if vertical integration)
Risk spreading (if diversification)

Disadvantages
Large capital outlay
Change management issues
Duplication of resources
Conglomerate discount
Public reaction

Question 7

Joint ventures - advantages & disadvantages

Answer 7

Advantages
Shared costs
Shared risk
Access to local knowledge
Reduced risk of competition authorities becoming involved

Disadvantages
Shared profits
Potential disagreements/differing objectives

Question 8

Why might an assurance report be useful for a joint venture or franchise?

Answer 8

In either a joint venture or a franchise arrangement, profits have to be shared between the various parties. In this respect, it could be valuable for the parties to have assurance that profits have been calculated correctly.

Question 9

International Expansion: These are the main methods that a company might use if it wishes to expand into foreign markets:

Answer 9

Exporting
Outsourcing
Overseas manufacturing

Question 10

International expansion:

Exporting advantages & Disadvantages

Answer 10

Advantages
All production is in one factory therefore greater scope for economies of scale
No large, up-front costs
Better for small companies with limited finance
Local knowledge can be gained through distributors
A good way to test the market prior to a larger overseas expansion

Disadvantages
Import quotas/tariffs/taxes
No potential for cheaper overseas production
Foreign exchange risk is greater as costs are in £ and revenues aren’t

Question 11

International expansion:

Outsourcing advantages & Disadvantages

Answer 11

Advantages
Lower cost than setting up factory overseas
Quicker access to foreign market than setting up overseas factory
Use of existing competencies of outsource partner

Disadvantages
Product designs shared with a third party
Quality/control issues
Training costs
Need to find a valid outsource partner

Question 12

International expansion:

Overseas manufacturing Advantages & Disadvantages

Answer 12

Advantages
Potential for cheaper labour & factory costs
Reduction of foreign exchange risk as
currency of revenues and costs is matched
Enhanced understanding of local market

Disadvantages
Large up-front costs and high exit costs
Need to monitor quality
Need to adhere to local laws & regulations
Need to source and train staff

Question 13

How to evaluate a potential strategy

Answer 13

Suitability, feasibility, acceptability
 Suitability – does it fit with the mission and objectives of the company
 Acceptability – to our stakeholders, i.e. will it make enough money, ethical implications, etc.
 Feasibility – do we have the resources to make it happen e.g. money, materials and labour

Question 14

Strategic, operational and financial issues
Strategic

Answer 14

 Fit with chosen generic strategy
 Likely stakeholder reaction
 Diversification and impact on risk
 Lack of / access to expertise
 Reputational boost / damage
 Brand awareness or lack thereof
 Control / quality issues

Question 15

Strategic, operational and financial issues
Operational

Answer 15

Operational
 Impact on operational gearing
 Language barriers and time zones if expanding abroad
 Recruitment and training needs
 Redundancies or relocation of staff
 Lead times
 Spare capacity
 Compliance risk
 Time to implement change
 Need to source new suppliers
 Need to establish new distribution channels

Question 16

Strategic, operational and financial issues
Financial

Answer 16

 NPV and other calculations listed below
 Need to raise additional finance
 Impact on cost of capital
 Impact on revenue and profits
 Cash flows (consider any costs not factored in to NPV calculations)
 Foreign exchange

Question 17

Financial

Answer 17

 NPV and other calculations listed below
 Need to raise additional finance
 Impact on cost of capital
 Impact on revenue and profits
 Cash flows (consider any costs not factored in to NPV calculations)
 Foreign exchange

Question 18

Evaluating strategic options
When addressing acceptability above, particular consideration will be paid to shareholders – so it is key to be aware of traditional techniques, such as:

Answer 18

 Net Present Value
 Internal Rate of Return
 Payback Period
 EPS (see below)
 Return on Investment (see below)
 Residual Income (see below)
See chapter 17 for more details on investment appraisal techniques.

Question 19

IAS 33 requires that listed companies disclose EPS (see chapter 21), as it is considered an important ratio for investors to use when making investment decisions. It must therefore be borne in mind by companies when appraising investments.

It is calculated as……

Answer 19

EPS = earnings / number of ordinary shares in issue
Where earnings = profits after tax – preference dividends

Question 20

ROI has traditionally been the most widely used measure in divisional performance, largely due to its similarity to ROCE and the fact that it can be calculated by taking figures from the income statement and statement of financial position.

Answer 20

Calculated as
ROI = divisional profit / divisional investment

Should use profit before head office allocations, usually
before interest and tax, if you are assessing the manager’s
performance. If looking at the performance of the division, it
may be better to include centrally allocated costs as well.

May use capital employed (TALCL) or net assets (total assets –
total liabilities) depending upon what information is given in
the question.

Question 21

Problems with using ROI as a performance measure

Answer 21

It can be argued that using ROI will encourage divisional managers to make decisions that are in their best interests but not necessarily the best interests of the company as a whole. This is referred to as dysfunctional behaviour or non-goal congruent behaviour. For this reason, other methods such as
residual income have evolved.

Question 22

What’s Residual income (RI)

Answer 22

In simple terms this measure identifies the “net” profit of a division after having deducted a notional charge for interest based on the amount of investment tied up in the division. This notional charge is estimated with reference to the company’s overall cost of capital.

Question 23

How do you calculate residual income

Answer 23

Divisional profit (same definition as for ROI) X
Notional (imputed) interest =
divisional investment × cost of capital (X)
Residual income X

Question 24

Residual income compares the profit actually made with the…..

Answer 24

minimum acceptable profit to the investors.

For example, if you had invested £100,000 in some shares and to compensate you for the risk taken you want a 5% return, the minimum acceptable to you would be £5,000 pa. If in Year 1 you received a £7,000 return, then you have a residual income of £2,000

If RI is positive, it suggests that the division has generated a profit that is over and above that which would be required by the capital providers. Therefore, if RI is positive the division has performed well and value should be being added to investors.

Question 25

ROI & RI comparison
Which one is technically better?

Answer 25

Technically residual income is the better method because it is linked to cost of capital and should result in fewer dysfunctional decisions being made.

Question 26

ROI & RI comparison
Which one is more commonly used?

Answer 26

ROI is still preferred in the majority of businesses, largely because
 It gives a % answer and people understand % returns such as ROCE.
 Interdivision comparisons are easier to do since ROI is a relative measure, not an absolute one like RI. This makes it simpler to compare divisions of differing sizes.
 It is not felt that dysfunctional decision making happens often enough to be a real problem.
 RI needs an estimate of cost of capital to be made.

Question 27

Ultimately, both ROI and RI use similar information in their calculations. There are certain flaws/difficulties with identifying the relevant information. The following list will give you some ideas of what these difficulties are:

Answer 27

Which profit figure to use?
 Identifying what is controllable and what is not
 Pre or post tax figures?
 Attributable and non-attributable costs (including central spreading of overheads)

Which investment figure to use?
 Do we use opening, closing or average net assets?
 Use of statement of financial position values based on historic cost and NBV will make comparing divisions of differing ages hard. The solution is to use replacement cost for asset values.
 How do we include those assets that are not reflected on the balance sheet such as intangible assets (for example in a service or people orientated business)?

Question 28

There are several additional factors to consider if the proposed strategy involves an overseas expansion:

Which markets to enter
In making a decision as to which market(s) to enter the firm must start by establishing its objectives.

Some examples.

Answer 28

 What proportion of total sales will be overseas?
 What are the longer term objectives?
 Will it enter one, a few, or many markets?
 What types of country should it enter (in terms of environmental factors, economic development, language used, cultural similarities and so on)?

Question 29

There are several additional factors to consider if the proposed strategy involves an overseas expansion:

Risks of international expansion

Answer 29

Risks of international expansion
 Political risk – quotas, tariffs, etc.
 Business risk – cultural barriers, lack of expertise, lack of reputation
 Currency risk – transaction, translation and economic risk
 Profit repatriation risk

Question 30

Value for money:

In non-profit organisations it is important to be familiar with the 3Es approach to considering value for money:

Answer 30

 Economy – this is a measure of the inputs required for a project/entity. Funding is likely to be limited in non-profit organisations.
 Effectiveness – this is a measure of a project’s/entity’s outputs, i.e. whether the objectives are being met.
 Efficiency – this is a measure of outputs relative to inputs.