Strategic Analysis: Diversification Part III

Evaluating Diversification Strategy

Six Steps to Evaluate a Diversification Strategy

1. Assess Industry Attractiveness: Evaluate the industries the company has diversified into, both individually and as a group.
2. Assess Competitive Strength: Evaluate the competitive strength of the company’s business units (BUs).
3. Evaluate Strategic Fit: Determine the extent of cross-business strategic fit along the value chains of the different business units.
4. Check Resource Fit: Ensure that resources and capabilities (R&C) fit the requirements of each business unit.
5. Rank and Allocate: Rank the performance of different BUs and determine where to allocate resources.
6. Craft Strategic Moves: Develop new strategic moves to improve overall performance.

Step 1: Evaluate Industry Attractiveness

• Market Size and Projected Growth Rate: Larger and faster-growing industries are generally more attractive.
• Competition: Industries with weak competitive pressures are more attractive.
• Emerging Opportunities and Threats: Industries with good opportunities and few threats are more attractive.
• Cross-Industry Strategic Fit: Greater fit increases attractiveness.
• Resource Requirements: Industries where resource needs are within the company’s reach are more attractive.
• Social, Political, Regulatory and Environmental (SPRE) Factors: Industries with fewer challenges in these areas are more attractive.
• Industry Profitability: Healthy profit margins and high ROI industries are more attractive.

Assigning Weights

• Assign a weight to each measure reflecting its relative importance in determining industry attractiveness. Weights should add up to 1.

Rating Industries

• Rate each industry on each measure using a scale of 1 to 10 (1-4: low attractiveness, 5: medium, 6-10: high).

Calculating Weighted Attractiveness Scores

• Multiply the industry’s rating on each measure by the corresponding weight to get the weighted score.
• Formula: $Importance Weight \times Attractiveness Rating = Weighted Attractiveness Score$

Interpreting Scores

• Industries with a score below 5 may not pass the attractiveness test.
• If a company’s industry attractiveness scores are all above 5, the group of industries is considered attractive as a whole.

Step 2: Evaluate Business Unit Competitive Strength

• Relative Market Share: Ratio of its market share to the market share of the leading rival (if a lot below 1, very weak competitive strength).
• Costs Relative to Rival’s Costs: Lower costs are generally better, unless higher costs are justified by differentiation.
• Ability to Match or Beat Rivals on Key Product Attributes: Satisfying buyer expectations regarding features and performance.
• Brand Image and Reputation
• Other Competitively Valuable Resources & Capabilities
• Ability to Benefit from Strategic Fit with Other Business Units
• Bargaining Leverage with Key Suppliers or Customers
• Profitability Relative to Competitors

Assigning Weights

• Assign weights to each measure, indicating its importance. The weights must add up to 1.

Rating Business Units

• Rate each business unit on each measure using a scale of 1 to 10 (high rating = strong, low rating = weak).
• Business units with competitive strength ratings above 6.7 are strong contenders.

Calculating Weighted Strength Scores

• Multiply the business unit’s rating on each measure by the corresponding weight.
• Formula: $Importance Weight \times Strength Rating = Weighted Strength Scores$

Nine-Cell Matrix

• Industry attractiveness and competitive strength scores are used to determine the strategic position of each business unit.
• The size of each circle in the matrix represents the percentage of revenues the business generates relative to total corporate revenues.

Resource Allocation

• Upper Left Portion (High Attractiveness, High Strength): High priority for resource allocation.
• Diagonal Cells: Intermediate priority.
• Lower Right Portion (Low Attractiveness, Low Strength): Lowest claim on resources; consider divestment or harvesting.

Step 3: Evaluate Cross-Business Strategic Fit

• Sharing or transferring valuable specialized resources and capabilities along the value chains of different business units.

Step 4: Checking for Good Resource Fit

• Financial Resource Fit: Ensuring the company can generate sufficient internal cash flows to fund business requirements, dividends, and debt obligations while remaining financially healthy.
• Portfolio Approach: Using a portfolio approach to balance cash flow and investment characteristics across different businesses.

Portfolio Approach: Boston Consulting Group (BCG) Matrix

• A portfolio management framework created in 1968 to help companies prioritize businesses by profitability.

Dimensions of the BCG Matrix

• Relative Market Share (Internal Dimension)
• Market Growth Rate (External Dimension)
• Circle Area: Represents the contribution of the business to total sales

Importance of the BCG Matrix

• Cash flow :reveals the contribution of single business in terms of revenues
• Strategic Implications: provides information about positioning of the business respect to attractiveness degree of industry and its internal competitive ability

Relative Market Share

• Indicator of profitability: high market share = high cumulative volumes = lower unit costs = increased profitability.
• Measured relative to the firm’s main competitors.
• The vertical line is conventionally fixed at 1.5 units
• Ratio: $\frac{Sales \ of \ Target \ Firm}{Sales \ of \ Main \ Competitor}$

Market Growth

• Measures the attractiveness of the competitive environment.
• Directly linked to the business life cycle (Vernon, 1966).
• Formula: $\frac{Total \ annual \ Mkt \ X - Total \ annual \ Mkt \ X-1}{Total \ annual \ Mkt \ X-1}$

Business Life Cycle

• Introduction Stage
• Growth Stage
• Maturity Stage
• Decline Stage
• Strategic Implications:
  • Introduction and Growth Stages: Implement aggressive penetration strategies
  • Maturity and Decline Stages: There is an increase of competitiveness among firms to obtain market share

Market Growth Rate

• The horizontal line divides businesses that have a higher growth rate than others.
• Often fixed at the average growth rate of the businesses of the firm.

Business Contribution

• Measured in terms of revenues and represented by the areas of the circles.

BCG Matrix Categories

• Stars:
  • High attractiveness and strong competitive position.
  • Generate high cash flows but need high investments to sustain their competitive force.
  • Cash flow is limited (positive or negative)
• Question Marks:
  • Low relative market share in a high-growth market.
  • Negative cash flows due to high investment needs.
  • Represent potential opportunities.
• Cash Cows:
  • High market share in a low-growth market.
  • Generate more cash than they need for investment.
  • Source of cash for developing other businesses.
• Dogs:
  • Low market share in a low-growth market.
  • Limited cash flows, barely sufficient to maintain themselves.
  • Implement an harvesting strategy or a divestment strategy

BCG Matrix – A summary

BCG Matrix – A dynamic perspective

• “All products eventually become either cash cows or pets. The value of a product is completely dependent upon obtaining a leading share of its market before the growth slows.” Bruce Henderson, BSG Henderson Institute, 1970

BCG Matrix – A balanced portfolio

• Businesses that are “stars” and that can assure the future through high growth and high relative market share

• Businesses that are “cash cows” and that provides the funds needed to fuel that future growth

• Businesses that are “question marks” that, through the funds coming from cash cows businesses, can be converted into “stars”

  • “Pets are not necessary. They are evidence of failure either to obtain a leadership position during the growth phase, or to get out and cut the losses.“ Bruce Henderson, BSG Henderson Institute, 1970

BCG Today

• Rapidly changing circumstances due to technological advances.
• Market share is no longer a direct predictor of sustained performance; adaptability is also important (Reeves et al., 2014).
• BCG 2.0 Imperatives:
  • Accelerate: Shorter planning cycles.
  • Balance exploration and exploitation.
  • Select rigorously: Leverage data and predictive analytics.
  • Measure and manage experimentation: Maintain growth.

Exercise Example: A&E Company

Company Overview

• A&E is a company operating in the food industry, managing activities in different countries.
• Main business: Frozen Food
• Other businesses: Ice-cream, Pastry, and Ready-meal

Using the BCG Matrix

• Decision made at the end of 2020 to use the BCG matrix for future strategic planning.

Data

• Total Annual Market (MKT)

  	Frozen	Ice-creams	Pastry	Ready-meal
  2017	1,200,000	550,000	250,000	80,000
  2018	1,440,000	605,000	300,000	100,000
  2019	1,728,000	665,500	315,000	105,000
  2020	2,073,600	732,050	330,750	120,750

• Sales

  	Frozen	Ice-creams	Pastry	Ready-meal
  A&E	100,000	50,000	20,000	80,000
  Gourmet Gimmy	110,000	300,000	-	170,000
  Perola foods	30,000	2,000	350000	30,000
  Aunt Emy familyfoods	75,000	15,000	80,000	50,000

Step 1: Calculate Market Growth Rate for Each Business

• Formula: $\frac{Total \ annual \ mkt \ X – tot \ annual \ mkt \ X-1}{Tot \ annual \ mkt \ X-1}$
• Frozen: $\frac{2073600 – 1728000}{1728000} = 0.2 = 20\%$
• Ice-creams: $\frac{732050 – 665500}{665500} = 0.1 = 10\%$
• Pastry: $\frac{330750- 315000}{315000} = 0.05 = 5\%$
• Ready-meal: $\frac{120750 – 105000}{105000} = 0.15 = 15\%$

Step 2: Determine Low or High Growth

• Average Growth Rate of the Businesses: (20 + 10 + 5 + 15) / 4 = 12.5%
• Based on 12.5%
  • Ready meal – 15% (HIGH)
  • Frozen – 20% (HIGH)
  • Ice cream – 10% (LOW)
  • Pastry – 5% (LOW)

Step 3: Calculate Relative Market Share for Each Business

• Formula: $\frac{Sales \ X \ Target \ Firm}{Salex \ X \ Main \ Competitor}$
• Identify the main competitor:
  • Frozen:
    • A&E Sales: 100,000
    • Main competitor: Gourmet Gimmy 110,000
    • $\frac{100,000}{110,000} = 0.9$
  • Ice-creams:
    • A&E Sales: 50,000
    • Main competitor: Aunt Emy family foods 15,000
    • $\frac{50,000}{15,000} = 3.3$
  • Pastry:
    • A&E Sales: 20,000
    • Main competitor: Perola foods 80,000
    • $\frac{20,000}{80,000} = 0.25$
  • Ready-meal:
    • A&E Sales: 80,000
    • Main competitor: Perola foods 50,000
    • $\frac{80,000}{50,000} = 1.6$

Step 4: Understand Business Contribution to Firm Performance

• Measured in terms of revenues and is represented by circle areas.

Step 5: Insert the Businesses Within the Matrix

• Positioning the businesses within the BCG matrix based on growth rate and relative market share.

Step 5: Ranking BUs and Assigning Priority for Resource Allocation

• Rank business units and allocate resources based on industry attractiveness, competitive strength, strategic fit, and resource fit.
• Top priority for allocation goes to business subsidiaries with the brightest profit and growth prospects, attractive matrix positions, and solid strategic and resource fit.

Step 6: Crafting New Strategic Moves

• Four categories of actions:
  1. Stick with existing businesses and pursue related opportunities.
  2. Broaden the company’s scope (e.g., through M&A).
  3. Divest certain businesses and narrow the scope of business operations.
  4. Restructure the company’s lineup.