Nine Basic Findings On Business Strategy
Sidney Schoeffler
PIMS = Profit Impact of Market Strategy
The study of the 1000-plus businesses in the PIMS data bank clearly establishes the following nine propositions:
Finding I: Business situations generally behave in a regular and predictable manner.
The operating results achieved by a particular business - its profit, cash flow, growth, etc. are determined in a rather regular and predictable fashion by the “laws of nature” that operate in business situations. (By a “business situation” we mean the competitive interplay among the various buyers and sellers of a particular product line or service in a particular served market.) This does not mean that we can foretell the exact results of every business in any given short period. It means that we can estimate the approximate results (within 3-5 points of after-tax ROl) of most businesses (close to 90%) over a moderately long period (3-5 years), on the basis of observable characteristics of the market and of the strategies employed by the business itself and its competitors.
Business situations can be understood by an empirical scientific approach, and therefore the process of formulating business strategy is becoming an applied science.
Finding II: All business situations are basically alike in obeying the same “laws of the marketplace.”
In the same way that all human beings, despite their many differences in appearance, personality, religion, behavior, state of health, etc., obey the same laws of physiology, all businesses, despite their many differences in product, company personality, state of profit health, etc., obey the same laws of the marketplace. The first fact makes possible the applied science of medicine, in which a trained physician can usefully treat any human being. The second makes possible the applied science of business strategy, in which a trained strategist can usefully function in any business. Of course, many physicians and many strategists elect to specialize; but that merely implements a division of labor, it does not argue against the principle.
Finding III: The laws of the marketplace determine about 80% of the observed variance in operating results across different businesses.
Some businesses are very profitable or have favorable cash flows; others are very unprofitable or have unfavorable cash flows. When we try to understand the variance between them, the laws of the marketplace account for up to 80% of that variance.
This means that the characteristics of the served market, of the business itself, and of its competitors constitute about 80% of the reasons for success or failure, and the operating skill or luck of the management constitute about 20%.
Another way of stating Finding III is to say that doing the right thing is much more important than doing it well. Being in the right business in the right way is 80% of the story; operating that business in a skillful or lucky way is 20% of the story.
Finding IV: There are nine major strategic influences on profitability and net cash flow.
These nine influences constitute most of the 80% of the determination of business success or failure. In approximate order of importance, they are the following:
1. Investment intensity
Technology and the chosen way of doing business govern how much fixed capital and working capital are required to produce a dollar of sales or a dollar of value added in the business. Investment intensity generally produces a negative impact on percentage measures of profitability or net cash flow; i.e., businesses that are mechanized or automated or inventory-intensive generally show lower returns on investment and sales than businesses that are not.
2. Productivity
Businesses producing high value added per employee are more profitable than those with low value added per employee. (Definition: “Value Added” is the amount by which the business increases the market value of the raw materials and components it buys.)
3. Market position
A business’s share of its served market (both absolute and relative to its three largest competitors) has a positive impact on its profit and net cash flow. (The “served market” is the specific segment of the total potential market - defined in terms of products, customers or areas - in which the business actually competes.)
4. Growth of the served market
Growth is generally favorable to dollar measures of profit, indifferent to percent measures of profit, and negative to all measures of net cash flow.
5. Quality of the products and/or services offered
Quality, defined as the customers’ evaluation of the business’s product/service package as compared to that of competitors, has a generally favorable impact on all measures of financial performance.
6. Innovation/differentiation
Extensive actions taken by a business in the areas of new product introduction, R&D, marketing effort, etc., generally produce a positive effect on its performance if that business has strong market position to begin with. Otherwise usually not.
7. Vertical integration
For businesses located in mature and stable markets, vertical integration (i.e., make rather than buy) generally impacts favorably on performance. In markets that are rapidly growing, declining, or otherwise changing, the opposite is true.
8. Cost push
The rates of increase of wages, salaries, and raw material prices, and the presence of a labor union, have complex impacts on profit and cash flow, depending on how the business is positioned to pass along the increase to its customers, and/or to absorb the higher costs internally.
9. Current strategic effort
The current direction of change of any of the above factors has effects on profit and cash flow that are frequently opposite to that of the factor itself. For example, having strong market share tends to increase net cash flow, but getting share drains cash while the business is making that effort.
Additionally:
There is such a thing as being a good or a poor “operator.”
A good operator can improve the profitability of a strong strategic position or minimize the damage of a weak one; a poor operator does the opposite.
The presence of a management team that functions as a good operator is therefore a favorable element of a business, and produces a financial result greater than one would expect from the strategic position of the business alone.
Finding V: The operation of the nine major strategic influences is complex.
Sometimes they tend to offset each other. For example, greater investment intensity (which tends to reduce earnings) often goes along with greater productivity (which tends to increase earnings). In that case, the net effect (which, in the present instance, is negative) is what matters.
Sometimes they reinforce each other. For example, strong market position (which by itself acts favorably on earnings) and high quality (which also acts that way) usually go together. In that case, a cumulative effect occurs.
Frequently the effect of a strategic factor reverses, depending on other factors. For example, a high level of R&D effort tends to increase earnings, if done by a business with strong market position, and to decrease earnings, if done by a business with weak position.
Therefore, when formulating business strategy, it is dangerous to use a simplistic logic.
Finding VI: Product characteristics don’t matter.
In making a strategic assessment of a business, it doesn’t matter if the product is chemical or electrical, edible or toxic, large or small, or purple or yellow.
What matters are the characteristics of the business, such as the nine cited before.
Two businesses making entirely different products, but having similar investment intensity, productivity, market position, etc., will usually show similar operating results.
And two businesses making the same products but differing in their investment intensity, etc., will generally show different operating results. (Characteristics of the product may, however, effect the speed at which strategic events occur.)
Finding VII: The expected impacts of strategic business characteristics tend to assert themselves over time.
This means basically two things.
First, when the “fundamentals” of a business change over time (for example, its quality level increases or its vertical integration goes down, whether by inadvertence or as a result of deliberate strategy) its profitability and net cash flow move in the direction of the norm for the new position.
Second, if the actually-realized performance of a business deviates from the expected norm (expected on the basis of the laws of the marketplace), it will tend to move back toward that norm.
Finding VIII: Business strategies are successful if their “fundamentals” are good, unsuccessful if they are unsound.
A good strategy is one that can confidently be expected to have good consequences; a poor strategy is one that can confidently be expected to have poor consequences. The laws of the marketplace are a reliable source of confidence in estimating both the cost of making a given strategic move and the benefit of having made it.
The fundamentals do not always operate in a simplistic way, as noted before. Thus, it is not always a good idea to expand a strong, wellsituated business, or to harvest or divest a weak one. The former business may well be on the verge of trouble; and the latter may be in a situation where a minor effort can produce a major improvement.
A model, firmly based in the empirical laws of the marketplace, is therefore a very helpful tool of strategy analysis.
Finding IX: Most clear strategy signals are robust.
Where a particular strategic move for a business is clearly indicated to be a good idea (i.e., where the cost/benefit projections look clearly favorable), that signal is usually quite “robust.” This means that moderate-sized errors in the analysis such as wrong assessments of current product quality or wrong estimates of future market growth - don’t usually render the signal invalid; and moderate-sized changes in the position of the business - such as its vertical integration or operating skill - don’t either.
One qualification: The PIMS data bank currently consists largely of manufacturing businesses located in the U.S., Canada, and the U.K. So, these findings most clearly hold true for those businesses. But, the somewhat limited data available for service businesses (such as financial businesses, merchandising businesses, or restaurants) and for other developed countries (such as in the Common Market) suggest that similar principles hold true there as well.
These nine findings, taken together, clearly say that it is productive to think about business strategy in a thoroughly professional manner, by supplementing the businessman’s imagination and creativity with a rigorous and science-based estimate of the probable consequences of his strategic moves.
The Strategic Planning Institute (SPI) is a nonprofit, tax-exempt membership organization, dedicated to the advancement of strategic business management. Its expanding member group of large and small corporations contains companies from many diverse industries and from several foreign countries. The PIMS Program is the major program of SPI.
The PIMS data bank currently contains the strategy experiences, good and bad, of over 1500 product and service businesses operated by the 200 present members of SPI. Each experience is documented in terms of the actions taken by the business, the nature of its served market, the kind of competitive environment, and the financial results. In all, over 200 separate characteristics of each business experience are available for study.
PIMS research is incorporated in a series of computer models which diagnose the strategic position and prospects of an individual business. The findings discussed in each PIMSLETTER represent only a part of the research results used in PIMS models. While the findings reported in this PIMSLETTER may offer insights on a specific area of strategic significance to a business, they cannot be used to evaluate a business as a whole. The overall evaluation can be performed only by the models.
Victoria Schwartz Manager of Publications
TLN Keywords: tlnkwpims
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