Kirk Klasson

Value Based Strategy Formulation

Techniques for Creating and Evaluating Strategic Options

About five years ago a couple of professors from INSEAD wrote a book about abandoning traditional approaches to strategy formulation in favor of using a white space, clean sheet approach whereby you set aside your current markets, value orientation, economic model, capital obligations, etc. to pursue strategies based on the conceptualization of completely uncontested, virgin markets. Places your competitors could not go simply because they lacked your imagination; success just waiting to be had on the exquisite ineffability that only you could conceive.

And that’s not to say that this can’t happen or shouldn’t at least be a factor in a portfolio of strategic options. After all, Nokia is famous for reinventing itself from a maker of galoshes to a maker of cell phones. Now the only question is can lightning strike twice since Nokia hasn’t been able to keep pace with its competition, not for lack of imagination, but simply for a lack of sound strategic thinking.

The problem with the white space approach is that established firms have already created a successful value proposition supported by a successful economic model or they wouldn’t exist in the first place. Next, most established firms that aren’t some kind of defacto monopoly appreciate that they need to evolve or will eventually expire so they are already exploring the frontiers, adjacencies in strategy speak, that surround them.

But the real challenge for established businesses isn’t one of re-conceiving and re-casting themselves as something entirely new or different but of evolving what they do in a way that leads to successful outcomes for both themselves as well as current and future customers. For most firms this will include some form of skunk works or strategic experimentation, a nursery where new ideas can grow away from the tyranny of making the next quarter’s numbers.

So the real challenge facing most firms is not how to reinvent themselves but rather how to refine their current portfolio of markets, offerings, resources and opportunities to create greater value from improved outcomes.

Refining Strategic Objectives and Initiatives

There are several tried and true techniques that can help to refine, adjust and advance a firm’s strategy and several of these will be reviewed here. However, to refine the overall strategic direction for any company, two components are necessary: future business goals and objectives, the outcomes the business hopes to realize, and value creation strategies and drivers that the company intends to implement that will lead to the realization of the business goals and objectives. The former sets the bar and the latter sets out how to clear it. Establishing one without the other can produce unrealistic expectations or ineffective decisions with respect to the allocation of resources and the alignment of business activities.

Most business organizations, with the possible exception of start ups, are currently pursuing some strategy. For these businesses the question is whether the current portfolio of initiatives and value creation strategies will meet the future expectations of the business. For example, in the face of terrorist attacks, mounting labor and fuel costs and declining passenger miles, domestic airlines have introduced low cost airlines. In the high tech industry, the acceptance of software as a service has led firms such as Siebel to revise their licensing practices and market rentable solutions. In doing so, Seibel has not only changed its offering but also changed the underlying economic basis for the production and distribution of that offer or its value creation system. So assessing strategic direction is not just about examining what the company intends to take to market but also about examining the underlying economic system that supports the way in which the value proposition is produced, marketed, delivered and profits are created.

Reviewing strategic objectives and refining value creation strategies can be accomplished in a relatively straight forward manner. First, for the given planning horizon, the basic business objectives for growth, profitability and returns should be examined and, if need be, revised in light of projected market, competitive and business conditions. Next, an assessment of current offerings and initiatives and their projected performance with respect to these objectives should be conducted. Since the economic performance of the offerings is rooted in the underlying value delivery system or the processes that support their production and delivery both the offerings and value delivery system need to be evaluated. This would amount to a baseline of the current strategy. If the projected performance of baseline initiatives indicates that the goals and objectives of the business will be realized over the time frame being considered, there should be no need to evaluate alternative strategic options or value creation strategies. If on the other hand there is deemed to be a gap between the desired objectives and the expected outcomes of current strategic initiatives, alternative options should be evaluated to determine their potential to address future business goals and objectives.

An overview of the process would look as follows:


Reviewing Primary Business Objectives

At the very highest level, the primary business objectives that form the basis for the value creation expectations of the business should be reviewed and reaffirmed in light of projected business conditions. These goals should measurable and expressed in either explicit terms (grow revenues 10% over the next three years) or as an achievable outcome relative to some accepted criteria such as industry or market based performance (market leader based on share). The expectations for the business can only be reviewed in the context of future business conditions which should be established as part of the overall the firm’s assessment of on markets, competition, technology, etc. Taken together these objectives should form a system of checks and balances whereby the realization of one goal is not at the expense of others that promote the overall creation of value by the business. Once established these primary objectives then become the yardstick against which both current initiatives and future strategic options can be compared to determine which have the greatest potential to meet the stated objectives.

Obviously, one of the key objectives of any public company is to generate an acceptable rate of return for shareholders. Since stock price is driven by a host of factors, many of them psychological rather than rational, targeting a specific price as a goal can prove a major imponderable. This is especially true for complex business made up of numerous operating units servicing markets at various points in their respective lifecycles. However, if the basic value orientation is well understood, focusing on one or two factors such as economic profit or return on invested capital can suggest a range of outcomes which can then be used to establish goals for revenue growth, profitability, etc.

Since most businesses can’t influence the psychology of the market, one practical approach to establishing value expectations is to focus on the internal value creating properties of the business or the projected return on invested capital. Since the allocation of capital to business activities is a direct reflection of the value orientation of the business, the realized returns from these activities can be compared to those of other businesses with similar models serving similar markets to arrive at an expected market value for the business. So, along with other explicit goals such as revenue growth or improvements in productivity, return on invested capital should be employed as a primary measure for the assessing the value creation performance of the overall business.

Base-lining Current Initiatives

As part of collecting and synthesizing the near term circumstances facing the business, each distinct operating unit such as a business unit or geography should project their expected top line performance along with additional investments that will result from the extension, augmentation or retirement of current offerings over the next three year horizon.

Since offerings are often nested, any changes to one offering need to be appropriately reflected in those that are attached or related to it. This is true for products and solutions that are dependent upon internal platforms as well as those dependent upon technologies produced by partners or upstream suppliers.

At the same time each offer creating unit should evaluate whether or not there are implicit or explicit changes to the way in which the offer is created, produced, marketed, distributed, supported and anticipate how these changes in the value creation system will impact the economics of the business. Again, this would apply to internal processes as well as to the overall ecosystem that supports the delivery of the offer to the market.

A summary of these projections will result in establishing a baseline for the expected performance of the business for current offerings and initiatives.

Value Orientation

In addition to reaffirming primary business objectives, the organization may need to re-examine the fundamental value creation strategies it intends to exploit in order to realize its primary objectives. These value creation strategies can be based on specific competencies or capabilities and outline how the business intends to create value for its customers and deliver value for its stakeholders.

Establishing the basic business value orientation is also critical for several reasons. First, it helps determine the allocation of resources to various value creating activities. Since resources allocated to one activity (R&D) can’t also be given over to another (Sales) the value orientation also outlines the basic economic model and value drivers for the business.

Next, it helps to establish how and where specific value creating activities might produce economies of scale and scope. If a given activity such as sales can generate greater returns through the addition of more offers then this activity has the potential to be extended into adjacent areas in order to create additional value.

Finally, the selection of a specific value orientation helps to focus the business, define its boundaries and limit the type of strategic options it can successfully pursue without making radical changes to its value creating activities.

Many noted business strategists have argued that there are three primary value orientations available to most businesses. They could either be highly efficient and therefore a cost leader; they could be extremely innovative and derive bargaining and pricing power from their ability to invent or they could be extremely knowledgeable about customers and from this intimacy create unique, customer-specific solutions. While it may be possible for any given business to straddle one or more of these dimensions simultaneously doing so usually results in sub-optimal resource allocation and a dilution of the overall value creating potential of the business. Similarly, businesses that seek to combine different value orientations into a single corporate structure often create separate business entities or divisions that provide for the discrete allocation of resources into specific value creating activities.

Within the high tech industry, it appears that only very large competitors such as IBM or HP can successfully straddle multiple value orientations and often do so through the creation of separate operating entities.

The selection of a specific value orientation in part dictates the economic model of the business and helps to determine its value drivers and how it will generate returns on invested capital. For instance, businesses focused on operational efficiency are often said to derive returns from structural capital, while those focused on innovation derive returns form intellectual capital and those focused on customer intimacy from relationship capital.

Similarly, a given value orientation will often determine how customers view the offers that a company produces and the way in which they incorporate those offers into their own value creating systems. Where you play in the value creating systems of your customers determines bargaining power and relationship values. If the offer constitutes a visible and substantial portion of the customers own value proposition then the go-to-market strategy and investments are likely to be vastly different than if the value proposition is merely a cost input that only merits additional buyer consideration when those costs can be substantially reduced.

Value Creation, Distribution and Consumption

Mapping the value system from how value is sourced through how it is distributed and consumed can provide some interesting insights into the company’s overall deployment and return on resources. This is especially true if you can apply activity based costing across the entire creation, distribution and consumption chain to determine if any particular activity is a net consumer versus a net producer of margins and cash flow.

For instance, a hypothetical view of the value delivery system for the firm’s products might appear as depicted below. In this example the first two window panes represent that portion of the originating or upstream firm’s value system, that produces and then distributes the value that the firm takes to market.

In this instance the firm produces value from a number of different offerings in the form of components, products or solutions (the horizontal axis) which are either obtained or produced through a proprietary, partner of OEM manner (the vertical axis). The last window pane represents the way in which the customer of these offers consumes the value produced by the upstream firm as part of its own value proposition. This is particularly important since the weight the consuming organization places on the upstream offer will change dramatically depending upon whether the upstream offer is consumed as part of the downstream firm’s infrastructure or as part of the value that it eventual takes to its own customers.

A simple example from the software industry can illustrate this concept.

Open source software, such as Linux, can be taken to market as a software offer supported by technical services. In the following graph let’s assume that Linux, represented by the red dot, is part of a broader portfolio of offerings. Since this offer is sourced from the open source community and therefore is “OEM’d” by the firm and transformed into a product offering which is then incorporated as a component into an broader offering, such as a software appliance, which is delivered to the customer to become a part of their IT infrastructure. As stated above, the way in which the value of this offer is consumed, as portrayed in the third window pane, is instrumental in determining whether or not the upstream providers will realize any economic gains.

In this instance, following the red dots, the value is consumed as part of the customer’s infrastructure, not as part of the customer’s own offering which they in turn would take to market. For our purposes the consumer here would be a user of information technology but not necessarily a provider of information technology such as a shop that would remarket the appliance as part of their own offer. An example of the latter type of consumer would be a firm using open source to construct a proprietary Software as a Service offering.

The consumption distinction is important because infrastructure consumers are focused on minimizing costs while offer consumers are focused on the creation of value for their own customers. This in turn should help shape the upstream value creation and distribution strategies. Upstream producers for cost focused consumers should seek to minimize all the costs between themselves and their customers. Consequently, the notion of value added indirect distribution of cost focused offers is for the most part a bankrupt concept from the start. Unless demand vastly out strips the ability of the producer to meet it independently, the addition of indirect distribution to this value proposition only weakens it in the eyes of the consumer.

Hence, for the most part, the idea of value added indirect distribution of open source solutions was going nowhere in the mind of the cost focused consumer. And that was pretty much reflected in the performance of those firms who adopted this model.

In contrast, a proprietary offering, the yellow dot, that is customized by value added delivery into a unique solution that can be consumed and incorporated into the offering of the down stream customer can absorb additional costs and still increase in value. In this instance, the additional cost of distribution and customization can afford upstream suppliers adequate economic returns as the offer becomes a critical part of the downstream customer’s value proposition.

This view is important as it can provide clues as to what the requisite gross margins and distribution costs are for each class of offer based on how they are produced, distributed and consumed. This is an important consideration when evaluating what options or adjacencies a firm might wish to pursue.

In theory, proprietary offerings obtained through R&D investments can command higher overall gross margins and distribution costs as they represent a significantly higher proportion of the value received by the customer. Adding distribution costs to offers that are consider cost inputs to downstream customers can cause those customers to simply go elsewhere.

Value Drivers

Generally, each value orientation has a unique set of value creating activities that result in a specific set of resource allocations and a differentiated economic model. There are numerous examples within the high industry that we can point to – Dell is acknowledged for its operational efficiency, IBM for its innovation and Accenture for its customer intimacy. While each of these businesses is large enough to span multiple value orientations, their basic allocation of resources and the economic models that result, help to illustrate this point.

However, understanding the allocation of resources to activities does not reliably predict how each of these businesses generates a return on invested capital and subsequently creates value. Since value ultimately results from the creation of free cash flow, value is driven by the rate at which the company can grow its revenue, profits and capital base while at the same time increasing the return on the capital invested in the business. Therefore, the measurement of return on invested capital or ROIC can be an objective means of establishing the value producing capabilities of the business that can be mapped to resource allocation and value creating activities.

Not all business can be uniformly measured on the basis of return on invested capital. Some business, manufacturing for instance, have higher capital requirements than others, such as software or services. So it is important to distinguish capital intensity of any given firm to determine when and where this measure is most important. This is especially true when making benchmark comparisons. Comparing the returns of a capital intensive firm to one that generally is not can often be misleading.

Given that value derives from generating increasing returns on capital there are four basic strategies that companies can exploit in order to realize higher rates of returns. They can:

• Increase the level of profit earned on existing capital
• Increase the rate of return from new capital investments
• Increase the rate of revenue growth but only so long as the return on new capital exceeds the weighted average cost of capital
• Reduce the cost of capital employed

Current and future initiatives often require the addition of capital. The termination of certain activities can also increase the amount of capital required. To achieve or sustain a targeted rate of return, additions to capital outlays need to be assessed within the context of the potential amount of net operating profits that they can generate. One way to establish what an appropriate goal for the growth of net operating profits is to review potential growth scenarios within the context of varying rates of return on capital to determine how overall enterprise value is enhanced or diminished. A simple table, similar to the one shown below, can then be used to evaluate and select goals for growth in revenues, profits and capital expenditures.

Once a specific approach to establishing enterprise value is selected there are a number of techniques that can be employed to determine the impact on overall share price. For instance, the projected growth or decline in enterprise value could be divided by the number of outstanding shares to provide a rough approximation for the resulting market value of the firm. Similarly, the calculated enterprise value could be compared to the total value of the available equity in the market for comparable companies to establish an approximation of market value.

Option Development and Evaluation

Regardless of the current strategic direction, product offerings or value creation system most organizations continuously scan and constantly re-evaluate the options they might pursue in order to meet established business objectives. This would also include a white space or clean sheet approach. If the current set of offerings and initiatives seem to have a high probability of achieving established business objectives then the need to propose and evaluate new options would be limited. However, if business circumstances indicate that the projected performance of current initiatives will not meet future objectives then new options need to be proposed and evaluated.

Often, the exploration of new options either extends or compliments current core capabilities. Usually these capabilities are grounded in and form the basis of the current value delivery system. The extent to which current core capabilities can be extended to new product, delivery and customer segments creates an opportunity to exploit existing economies of scale or scope that are already present in the current value delivery system. This is frequently referred to as exploiting adjacencies. Adjacencies exist along most of the dimensions that currently provide some form of strategic advantage to the organization and are therefore more easily obtained and incorporated into the current business model.

Circumstances in the form of industry or technology based discontinuities may necessitate a more radical exploration of future options including entry or exit from specific markets or a more aggressive restructuring of the current value delivery system. Often, these circumstances dictate moves such as mergers and acquisitions where the fundamental offer and value delivery system can be reconstituted to better serve newly targeted markets.

Again, the evaluation of options should be based on their ability to satisfy the value creation objectives of the business and a critical analysis (financial, marketing, etc.) of the projected outcome of any given option should be conducted prior to execution.

Appendix – Key Question and Considerations

1. What are the company’s business objectives and aspirations?

• Rate of revenue growth
• Rate of profit growth
• Return on Invested Capital
• Growth in market valuation and equity appreciation
• Category or industry leadership/recognition

2. What are the market threats and opportunities?

• Do imminent discontinuities exist in technology, costs or value delivery systems
• Can engagement be improved for different segments (decision maker, industry, geography, etc.)
• What are the primary factors that will increase or decrease the contestability of a given market

3. What is the primary value proposition the firm delivers?

• How does the buyer realize or experience the economic benefits from engaging the firm (costs, profits, continuity, etc.)
• Where in a continuum of needs does the offering fall (must have, nice to have)
• How many competitive alternatives are available

4. What are the critical things the business must do to deliver the value proposition and create or sustain competitive advantage?

• What is the primary value delivery system and how can it be leveraged to the firm’s advantage
• What competence or economic factors enhance the value proposition to the buyer
• What organization capabilities are needed to support future value orientations

5. What values reinforce the value orientation of the firm and guide the organization?

• Is the firm more focused on customer acquisition or customer retention?
• Does the firm forego investments in order to achieve specific economic goals and quarterly numbers?
• Does the firm unconsciously subsidize activities (geographic expansion, channel diversification, product development) in order to maintain cultural commitment or norms?

6. Does the firm possess the leadership to conceive, evangelize, establish and keep to a new strategic direction?

• Does the leadership have sufficient imagination to operate in new and unfamiliar ways?
• Does the leadership possess the political will to eliminate organizational objections to pursue new directions?
• Does the leadership have the ability to forgo immediate rewards to achieve potentially better returns in the future?

Further Reading:

The Discipline of Market Leaders: Choose Your Customers, Narrow Your Focus, Dominate Your Market, Michael Treacy and Fred Wiersema

Valuation: Measuring and Managing the Value of Companies, Fourth Edition, University Edition by McKinsey & Company Inc., Tim Koller, Marc Goedhart, and David Wessels

Profit From the Core : Growth Strategy in an Era of Turbulence, Chris Zook and James Allen

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