Number 23: Summer 2003

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Seven Steps to a Winning Business Strategy

By K Tobias Winther

Editor's comment: Running a business is ultimately about creating value for shareholders. This article looks at ways in which business strategy can help to drive value creation.

Independent of the business or industry sector, executives are in a constant search for ways to increase shareholder value and optimize profits.  In the wake of the recent corporate scandals and stock market downturn stockholders are demanding more accountability and diligent analysis of proposed future business activities.  This article discusses a methodology consisting of seven steps for analyzing value creation and optimizing profits as means to identify and support a winning business strategy.  This method details a systematic way of analyzing business opportunities.  Each step is discussed further here.

1. Initial strategy

A conventional strategic plan is a good starting point for the analysis described below.  While the conventional strategic plan will capture the basic business ideas and build on the available market intelligence it may not necessarily have defined all the optimal product characteristics, the optimal price-volume evolution, or be equipped to deal with surprise attacks from competitors.  The following steps will provide the framework for dealing with those kinds of issues.

2. Value net

Every business operates in a complex value net that consists of all the constituencies that directly and indirectly influence the creation or destruction of value of the products and services delivered by the business.  The value net goes beyond the conventional value chain in that it also includes nodes that do not directly take part in the goods/service and money transaction line.  For example, a friend influencing the customer’s purchasing decisions is part of the value net.

3. Value drivers

Each node in the value net uses certain value drivers to either create or destroy value. They typically fall in three groups depending whether they relate to production, market interactions or consumptions.  Especially many of the modern products and services relay on value created through the consumption process (e.g. office software) or by other consumers (e.g. the Internet).  The value drivers can be anything from product features and brand name to payment systems and pier status obtained from the usage.  While we tend to seek out the positive value drivers, we cannot ignore the negative value drivers such as the disposal after consumption.

4. Potential market price

Based on all the value drivers we can estimate the value that the various customer segments obtain.  Measuring and quantifying this value can be challenging, but is often possible to arrive at some sort of estimate when historical data and information from other business sectors are taken into account.

Depending on the risk faced by the customers they will discount the value to a greater or lesser extent, just like we discount the value of risky cash flows more than less risky cash flows.  Companies have for a long time been reducing the risk by offering money back guarantees, warranties and customer help hotlines, but they usually don’t quantify the impact that these measures have on the value to the customer.  Given all the risk mitigating resources available to the customers, how much is the risk-adjusted value?

No business can charge the full risk adjusted client value, because they do not have the market power to do so.  Customers gain market power when competitors offer similar products, or when they have good negotiation skills or special legal rights.  By analyzing the market power balances in the value net we can estimate what fraction of the risk-adjusted value actually can be charged as a selling price.  The selling price has nothing to do with the cost, however, in a competitive market competitors will enter the market until the market force is so weak that the price is close to cost, at which point no more competitors will enter and no further dilution of market power will take place.

The market power based fraction of the risk adjusted value represent the highest possible price that a company can charge a customer.  However, companies tend to charge less than that, first of all because rather than charging a different price to each customer they may elect to have a list price.  In addition, without going through an estimation procedure like the one outlined here, it can be difficult to guess what the value actually is and how it changes across the customer population.

5. Cost

Cost is just as important for the bottom line as the selling price.  There are three different components of cost (1) fixed cost, (2) variable cost and (3) customer specific cost.  The balance between fixed and variable cost is important from the perspective of understanding the effects of economy of scale.  The customer specific cost is important for selecting which customers or groups of customers the company should target.

6. Profit

The profit potential can now be derived based on the potential price and the cost.  Pricing decisions will influence several factors such as market size and the value net. Based on those estimates a relationship between price, market size and profit can be found and the profit optimized.  Also, by going back and changing different assumptions in anything from the value net and product features to risk mitigating offers we can generate what-if scenarios illuminating the impact of different decisions.

7. Optimized strategy

Numbers are here to support strategic dictions, not to dictate them.  While the above steps provide useful insight, and can help take optimal choices, it cannot replace the creativity and foresight needed in a business strategy.  The last step is therefore to tie all the threads together into a strategy that can satisfy, budget constraints, investor expectations and personal preferences.  We also have to look at the likely changes over time, and select options that puts us in a strong position to respond to those changes.

Conclusions

The method discussed here can be used to estimate future cash flows associated with a new or existing product or a whole corporation.  This approach is relevant to new ventures where future cash flow estimates today are often derived in a fairly ad-hoc manner.  By taking it a step further it can be used in the valuation of public listed companies, thereby hopefully reducing some of the stock market volatility.  It can also be used to evaluate the potential impact of a specific risk or set of risks, such as assessing the impact of various social and economic climate changes, for example the impact of recessions or wars.  In that way this method can support estimates of the economic capital requirements.  Even for non-for-profit organizations the method offers the opportunity to identify ways of creating the largest positive impact on a community with the least resources.

Summary of the different components of a market price:

 

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