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Corporate Strategy and Long-Range Planning (With Diagram)

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The below mentioned article provides a complete overview on Corporate Strategy and Long-Range Planning.

Corporate Planning and Strategy:

Long-range planning and strategy formulation is of recent origin. Since the early 1950s some large U.S. companies have introduced formal (strategic) corporate planning. At present such planning has matured to the point that firms of all sizes in the profit, as well as the not-for-profit area, make use of it routinely. In fact, the practice of corporate planning is now well established on a global scale and it continues to grow rapidly.

Virtually every re­puted company in the USA and UK has a corporate planner and in the leading companies—e.g., IBM, Shell, ICI, ITI, Fiat, Ciba-Geigy corporate planning has been practiced for quite some time. It is felt that in future, corporate planning will become as much a part of management in a growing (progressive) organization as budgetary control is today.

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Various benefits can be derived from a formal approach to planning. It forces a manager to think forward and make anticipatory calculations regard­ing the future. It provides a detailed forecast and plan that makes it easier to discover why the action taken did not produce the expected results. Also, de­tailed company planning enables a manager to del­egate with more confidence.

As Bernard Taylor has put it, “within the framework of the plan, a subor­dinate can be given a fair amount of autonomy and independence, while the superior, on the other, hand retains general control”.

Concept of Corporate Planning:

Planning is a natural part of the whole man­agement process. However, corporate planning has a special meaning inasmuch as it lays emphasis on the regular view of strategy. It can be thought of as ‘planning systematically the total resources of the company, for the achievement of quantified objec­tives within a specified period of time’.

However, the above definition does not prop­erly emphasize the relation of corporate planning to strategy. In this context, Peter Drucker’s defini­tion of corporate planning is perhaps relevant.

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He defines corporate long-range planning as a continu­ous process of making entrepreneurial decisions sys­tematically, and with the best possible knowledge of their futurity; organizing systematically the effort needed to carry out these decisions; and measuring the results against expectations through organized systematic feedback. Thus, corporate planning has come to mean a systematic approach to strategic decision-making.

According to the Institute of Cost and Manage­ment Accountants (England), “corporate planning represents a systematic attempt to influence the medium and long-term future of the enterprise by defining company objective; by appraising those factors within the company and in the environment which will affect the achievement of these objectives; and by establishing comprehensive but flexible plans which will help ensure that the objectives are in fact achieved”.

In a progressive company corporate planning attempts to search-out or identify new areas of in­vestment. It also makes the future a part of the cur­rent planning process so as to eliminate uncertainty. Herein lies the importance of long-range forecasting in corporate planning.

The time span covered by a corporate plan does vary from company to company and is largely influ­enced by such factors as the time it takes to bring new plant into operation, or develop and launch a new product. Most such plans, however, involve looking ahead by five to ten years.

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Corporate planning should not be reduced to mere paper work. The whole logic of going through the detailed process of planning is to emerge with guidelines for action in the immediate future. The basic question to be answered is:

What should management be doing now to enable it to reach the position it wants to be in, five or ten years’ hence?

Objectives and Goals:

The starting point of the whole process is a clear definition of company objectives. Companies en­gage in such planning just to enhance the probabil­ity that they will achieve their desired goals. If ob­jectives cannot be clearly defined planning becomes meaningless.

There is considerable use of long-range fore­casts in strategic planning. Long-range forecasting and strategy formulation usually take place at the highest levels within the organization. For strat­egy within the organization to be successfully imple­mented, the firm must have goals and objectives.

According to Drucker objectives may be set out un­der such headings as market standing profitability and growth, innovation, productivity, resources, per­sonnel and community relations. Objectives may be set out in the form of performance targets for a par­ticular function or position and may be analysed into an objectives hierarchy, or objectives and their contributory sub-objectives.

Once objectives are set and the need for goals is realized, the organization has to develop a specific strategy for reaching specific goals.

For instance, time allotments are made, budgets are fixed, ma­chinery and equipment are acquired and installed inside the plant and all ideas of the planner are syn­chronized in an overall strategy that is considered to be workable at the time. At this stage the planner makes use of long-range forecasts.

As T. J. Coyne put it, “Long-run forecasting comes into being as executives attempt to determine how well and how promptly their goals will be met. It is through the forecasting process that one can determine the effi­ciency and effectiveness of the firm’s overall corpo­rate strategy”.

Environmental Planning:

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Once objectives have been set, there is need to scan the environment in order to identify potential threats on the one hand, and potation opportunities on the other. Forecasting environmental change is, of course, a complex exercise.

In fact, short term predictions by experts often prove to be wrong. A systematic searching of the environment ensures that unforeseen circumstances do not adversely affect the planning process.

i. Internal Appraisal:

Environmental scanning must be balanced by an appraisal of strengths and weaknesses within the company. This should be done in an objective man­ner, preferably by involving outsiders in the corpo­rate planning team so that no biased view is taken of the company’s strengths and weaknesses.

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However, there is no tailor-made procedure for carrying out this appraisal which all companies can adopt. It is necessary for each company to find “its own route to sound and objective appraisal of its own strengths and weaknesses, having regard to the critical factors on which business success depends in its own particular situation”.

ii. Revision:

At this stage it may be necessary to modify the original statement of company objectives in the light of what has been discovered. This modification is di­rected toward making these objectives more realistic and hence more capable of achievement.

iii. Other Steps:

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The remaining steps in the whole process of planning are summarized in Fig. 26.1.

Structuring a strategic environmental analysis

The revised corporate objectives must be related to a forecast as to where the company is likely to be n year’s hence, after taking note of threats and oppor­tunities existing within an organization and its in­ternal strengths and weaknesses. The forecast must then be compared with the declared corporate ob­jectives with a view to identifying gaps or shortfalls.

At this stage the corporate plan has to be developed in such as way that it gives a clear indication of the future course of actions, including sets of sub- objectives or goals designed to close the gaps and eliminate the shortfalls.

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Evaluation of Alternatives:

Effective corporate planning is dependent on the development of a corporate strategy. In real­ity there is often more than one possible strategy for achieving a given end result. The corporate planner is usually required to assemble the divisional plans or regions on the same basis, so that they can easily be consolidated into a five or ten years plan for the company as a whole.

But this practice robs the com­pany of the major benefits of long-run planning—the opportunity to make a critical reappraisal of some major decisions that can exert considerable influence on the company’s future survival, profitability and growth. Therefore, at this stage, alternative strate­gies should be generated and compared in terms of their financial and other implications.

An example of this may be comparison of the advantages and disadvantages of achieving growth in a given mar­ket by adopting three alternative strategies:

(1) Ac­quisition,

(2) Joint venture, or

(3) Investment in ad­ditional plant.

i. Synergy:

At this stage, concept of synergy can be intro­duced. The basic idea is that combining two or more courses of actions is more effective than pur­suing them individually. In marketing, this implies that the marketing mix will make for overall effec­tiveness.

For example, by seizing an opportunity which makes it possible to gain increased utiliza­tion of existing marketing and distribution facilities it may be possible to raise sales revenue without causing a proportionate increase in costs. Moreover, at this stage careful consideration has to be given to the level of risk associated with alternative courses of actions.

After selecting an appropriate strategy, manage­ment must translate it into specific short-term goals or targets, for the company as a whole and for its various divisions or sub-units.

ii. Feedback:

Since planning is a continuous exercise the pro­cess does not come to a halt with the evaluation of alternatives. As the results of each year become available, or as significant changes occur in the exter­nal environment, or internally within the company, the plan has to revised, modified and updated.

Objectives of Planning:

Most companies introducing corporate plann­ing have four objectives in mind:

1. To improve co-ordination among divisions.

2. To achieve successful diversification.

3. To ensure a rational allocation of resources.

4. To anticipate technological changes.

Benefits of Planning:

A number of benefits can be derived from a for­mal approach to corporate planning.

Firstly, it forces a manager to think forward and anticipate problems before they occur.

Secondly, it provides a detailed forecast and plan that makes it easier to discover why the ac­tion taken has failed to produce the expected re­sults.

Thirdly, detailed operational planning enables a manager to delegate with more confidence.

Finally, within the overall framework of the plan, a subordi­nate can be given sufficient autonomy and indepen­dence, while his superior retains overall control of a department or division.

Strategic Planning:

A distinction may now be drawn between op­erational planning as described above and strategic planning which is a systematic process for guiding the future development of an enterprise.

As B. Tay­lor argues. “The most important elements in strate­gic planning are the long-term goals set by top man­agement and the plans to achieve those goals in a thorough and systematic way. Strategic planning helps top management, on the one hand, to anticipate and so lessen the adverse influences of a rapidly changing business environment and, on the other, to take advantage of opportunities occurring in the en­vironment”.

The following elements of strategic planning have been identified:

1. Firstly, objectives have to be set.

2. Secondly, there is need for appraising the com­pany’s resources and capabilities.

3. Thirdly, trends in the commercial, technological, social and political environment must be analysed.

4. Fourthly, there is need to assess alternative paths open to the business and define strategies for future development and growth.

5. Fifthly, detailed operational plans, programmes and budgets are to be produced.

6. Finally, there is need to evaluate performance against clear criteria in the light of the goals, strategies and plans established.

The strategic planning process has three distinct characteristics:

Firstly, it is not simply concerned with a partic­ular department or division. Rather it is concerned with the development of integrated plans for the en­terprise as a whole.

Secondly, it emphasizes long-term ‘strategic’ considerations as opposed to short-term ‘opera­tional’ ones.

At this point a distinction has to be drawn between:

(a) Budgets and forecasts and

(b) Strategy which implies a thorough appraisal of the business in relation to its environment.

Finally, it envisages the setting up of formal procedures for strategic planning which run parallel to the short-term budgeting operations. Objectives, strategies and plans are put in black and white and reviewed at periodic intervals, and outside special­ists are appointed to coordinate the whole planning process.

Cyone has argued that “for corporate strategy to be effective in the long-run the strategic plan (i.e., budgets, equipment, and so forth) must be devised and put in place by the manager responsible for the overall performance of a particular profit centre or plant”.

Moreover, the manager entrusted with the overall responsibility for carrying out the strategic plan must be the person most qualified to intro­duce needed changes over time. Therefore, the art of strategic planning is “one of setting or establish­ing a long-term objective that may, at the time it is set, be thought to be unreachable”.

The corporate planning manager must realize that goals, objectives and strategies are interrelated. He (she) must understand this interrelationship on the basis of which he has to develop a cohesive state­ment that can be readily understood by sharehold­ers as well as divisional managers, up and down the traditional lines of authority.

This process demands constant attention and a proper sense of direction, without it scarce and costly resources of the firm have a strong chance of being misallocated. There is need for proper communication among divisional managers, functional department heads and subor­dinates.

Formulation of Strategy:

We have noted that corporate strategy relates to the long-term objectives and policies of the or­ganization. It is not concerned with matters of de­tailed day-to-day administration, but with the over­all nature of the business and how it can adapt to changing circumstances.

It has been defined as: ‘the pattern of objectives, purposes, or goals and major policies or plans for achieving these goals, stated in such a way as to define what business the company is in or is to be in and the kind of company it is or is to be’.

In fact, the determination of strategy has to be based on the existing environment of the organiza­tion and its current performance as well as on fore­casts about the future.

Organizations of all types, whether explicitly or implicitly, do have a corporate strategy. For instance, an organization that wishes to secure a successful fu­ture will seek to anticipate events in both its existing and potential markets and to review the available al­ternatives.

Fig. 26.2 illustrates the so-called wheel of cor­porate strategy. The broad aims or objectives of the company lie at the centre of the wheel. The spokes of the wheel are the major policy alternatives that are available to management for achievement of the objectives.

Once the policies have been specified, and their relative importance determined, they in­fluence, through strategy, the overall behaviour of an enterprise. As M.E. Porter puts it, “like a wheel, the spokes (policies must radiate from and reflect the hub (goals), and the spokes must be connected with each other or the wheel will not roll”.

Wheel of Competitive Strategy

H.I. Ansoff, the doyen of strategic writers, treats strategy as “almost exclusively concerned with the relationship between the firm and its environment and hence with the selection of the product it pro­duces and the market it sells them in”.

However, since the range of issues considered strategic is really wide, there is need for a wider defi­nition, too. It is in this context that Chandler defined strategy as “the determination of the basic long-term goals and objectives of an enterprise, the adoption of courses of actions and the allocation of resources necessary for carrying out these goals”.

This defi­nition is based on his 1962 study of growth of the multi-divisional form or organization in large U.S. corporations, in response to strategic change and thus, covers diverse strategic issues.

In recent years Ansoff and others have broad­ened the scope of the term ‘strategy’ to cover all aspects of the relationship between the firm and its environment, rather than just the product or market mix, and thus allow a wider range of issues to be considered as strategic. For example, C. W. Hofer and D. Schendel define strategy as ‘the basic charac­teristics of the match an organization achieves with its environments’.

This approach enables us to consider the supply aspect of a firm’s relationship with its environment, but it fails to recognize explicitly major strategic is­sues that can crop up within the firm, such as its manpower and production policies.

Quite recently J. G. Smith has highlighted the point that a firm’s strategy must be implicit rather than explicit. This point has already been made by K. R. Andrews whose definition of strategy is per­haps the most comprehensive of all.

In his words, “Corporate strategy is the pattern of decisions in a company that determines and reveals its objectives, purposes, or goals, produces the principal policies and plan for achieving those goals, and defines the range of business the company is to pursue, the kind of economic and human organization it is, or in­tends to be, and the nature of the economic and non-economics contribution it intends to make to its shareholders, employees, customers and communities”.

In business, strategy formulation involves mak­ing decisions about the general direction and scope of their desired growth. In the words of Ansoff, “Strategic decisions are primarily concerned with ex­ternal, rather than internal, problems of the firm and specifically with selection of the product-mix which the firm will produce and the markets to which it will sell”.

This is based on the assumption that the objective of the firm is to achieve a target rate of growth or to attain a certain size (as can be mea­sured by its assets or sales turnover).

The firm has also to select the ‘business to be in’. For this, it has to set priorities for its existing resource allocations to R & D, market development, management recruiting and training, expenditure on plant and equipment, merger and acquisition.

Formulating Strategy:

The problem of strategy formulation differs from company to company. But there are certain elements or steps that can be applied in most situa­tions.

These steps are as follows:

The on-going process of strategy formulation in­volves the following six steps:

1. Specification of objectives;

2. Establishment of goals;

3. Evaluation of the firm’s strengths and weak­nesses;

4. A forecast of trends in the environment;

5. Delineation of economic opportunities and threats and;

6. A search for synergy (i.e., economic complemen­tarity among potential activities of the firm).

The traditional objective of the business firm is profit maximization.

However, modern writers have pointed out that there are alternative objectives of business firms such as:

1. Sales maximization (or maximization of total revenue)—W. J. Baumol (1951);

2. Satisficing (reaching a satisfactory acceptable level of sales and profits)—H. A. Simon (1954);

3. Survival—P. F. Drucker (1958);

4. Growth for survival—J. K. Galbraith (1971).

For formulation purposes goals must be spe­cific. A broadly-stated goal like long-term profit maximization is not very helpful. For instance, a firm’s objective may be to achieve a target rate of re­turn on investment for the next 5 to 10 years.

How­ever, as Ansoff has argued, even this specific goal has to sub-divided into a set of subsidiary objectives relating to external competitive strengths and inter­nal operating efficiency. Fig. 26.3 illustrates an oper­ationally useful set of long-range objectives. These goals are quantifiable. Therefore, the firm has to measure and forecast the extent to which these goals are being satisfied.

Set of long-range objectives

Ansoff has also referred to a related point. Profit-maximization is related to an additional ob­jective, viz., flexibility: internal and external.

While internal flexibility is provided by liquidity, external flexibility is gained through diversification. Risk re­duction is achieved through both the methods. These two methods help to ensure that profits are not wiped out by a single adversity (such as a sud­den fall in the demand for a single product).

The loss incurred due to fall in the demand for one product is recouped by a steady rise in the sale of other prod­ucts in the product line. Moreover, a firm having unutilized borrowing power can meet the threat of a sudden and unexpected product improvement by a competitor.

A closer scrutiny however, reveals that the two objectives, viz., profitability and flexibility are often conflicting in nature. So a compromise has to be reached between the two. Moreover, flexibility can be attained only at the cost of profit. Agreement has to be reached within the business firm regard­ing these two objectives.

For instance, a reduction in investment expenditure, i.e., expenditure on plant and equipment will allow an increase in assets that can be quickly converted into cash so as to improve the liquidity position of a firm in a year of bad busi­ness (when there is temporary demand recession).

Both objectives may be subject to self-imposed re­sponsibilities and institutional constraints. In some situations management may discharge its social re­sponsibility of providing steady employment and job security to old employees even at the cost of profitability.

Selecting the ‘business to be in’:

Choosing ‘the line of business to be in’ is one of the most important strategic decisions. A firm also strives to evolve a product-mix and a corresponding set of markets that seem to offer the best prospects for achieving its objectives. It has to compare var­ious possible ways to utilizing its limited (but to some extent unique) resources and organizational competences.

Strategy formulation is based on:

(1) Appraisal of the firm’s strengths and weaknesses,

(2) Determi­nation of the particular business competence that are essential for success in various growth areas, and

(3) Forecasts of the results of successful operations in a line of activity.

There are two ways of appraising:

(1) The firm’s relative strengths and weaknesses by an examination of past performance to identify areas of success or failure and

(2) By direct compar­ison of the firm’s skills and competence with those of major rivals.

In the words of J. B. Quinn, “The purposes of such exercises, to marshall sufficient re­sources into specific sub-areas of the company’s op­erations, to dominate them, to recognize where com­petitive strengths allow the company wider latitude in pricing or product policies than competitors, and to pinpoint the company’s own weakness for more aggressive action or purposeful withdrawal”.

There are five key areas in which most com­pany’s strengths and weaknesses can be assessed:

1. Use of financial resources;

2. Profitability;

3. Functional strengths and weaknesses;

4. Product range; and

5. Human resources and organization.

This process should cover all of the resources and competences required in the present business of a company, as also other capabilities that it has or can reasonably expect to acquire. The table below presents a list of a various factors to be considered in such an appraisal.

Outline for internal appraisal and industry analysis:

1. Product-market structure:

a. Products and their characteristics.

b. Product missions.

c. Customers.

2. Growth and profitability:

a. History.

b. Forecasts.

c. Relation to life cycle.

d. Basic determinants of demand.

e. Averages and norms typical of the industry.

3. Technology:

a. Basic technologies.

b. History of innovation

c. Technological trends-threats and opportu­nities.

d. Role of technology in success.

4. Investment:

a. Cost of entry and exit—critical mass.

b. Typical asset patterns in firms.

c. Rate and type of obsolescence of assets.

d. Role of capital investment in success.

5. Marketing:

a. Means and methods of selling.

b. Role of service and field support.

c. Roles and means of advertising and sales promotion.

d. What makes a product competitive.

e. Role of marketing in success.

6. Competition:

a. Market share, concentration, dominance.

b. Characteristics of outstanding firms.

c. Trends in competitive patterns.

7. Strategic perspective:

a. Trends in demand.

b. Trends in product-market structure.

c. Trends in technology.

d. Key ingredients in success.

Such a systematic and through appraisal serves four essential purposes in the corporate planning process. Firstly, it enables management to identify potential assets and opportunities that can be ex­ploited. Secondly, it helps management to deter­mine the basic immediate changes in structure and policies necessary if long-term objectives are to be achieved.

Thirdly, it makes possible an increase in immediate profitability and liquidity by the more ef­fective use of the company’s existing resources, thus providing a more stable base for the development and achievement of long-term objectives. Finally, it helps planners prepare defensive strategies by which the risk to earnings, and cash-flows through external factors, can be minimized.

These methods can be adopted for determining business success in various industries:

(a) Prepar­ing a exhaustive list of technological, marketing, fi­nancial and management capabilities required by the nature of each industry and

(b) By developing com­petitive profiles of the most successful firms in each industry.

Then, as Ansoff argues, “Superimposition of one firm’s competence profile with the competi­tive profiles measures the ‘fit’ with each new indus­try, and hence the chances of a successful entry”.

Finally there is the obvious need to forecast the results of successful business operations in the var­ious industries in order to choose a ‘portfolio’ of businesses-to be in. Such forecasts are to be based on estimates of growth prospects, return on assets used, and year-to-year variability in sales and income, as­suming that the firm is a competent organization, in each line of activity (business).

Such estimates, in their turn, are based on “projections and analysis of trends affecting demand for products and services, competition, the institutional and legal environment, timing and nature of technological changes, avail­ability and relative cost of resources, and increases in industry capacity.”

Technological Planning:

Formal methods of technological forecasting have been developed very recently. Most of these techniques have been developed in the 1960s.

In fact, technology is nothing but systematic ap­plication of knowledge. This knowledge does im­prove in small increments, or scientific breakthrough is just an accumulation of small advances that add up to a significant change.

Two Views:

There are two different views on technological change. The scientists view inventions as occur­ring independently of external circumstances or needs. Consequently they rely on exploratory forecasting. They start with existing technology and on the ba­sis of it, project potential progress and then consider how these changes may affect the nontechnical busi­ness environment.

In other words, such forecasting starts by mapping technological possibilities out to­ward their limits. Non-technical people hold an op­posite, view of technological progress. They see it as a response to external non-economic forces that create new demands for goods and services to sat­isfy new wants.

They rely on normative forecasting, in which forecasters start by predicting the future needs and objectives of society. They then work back to the current state of technology with a view to de­termining the gaps that have to be closed so as to satisfy emerging needs and aspirations of society.

Normative forecasts are often criticized on the ground that even the most widely recognised needs of society do not always call forth an invention. But such forecasts have the obvious advantage that they extend further into the future than do exploratory methods. On the contrary, exploratory forecasts are criticized on the ground that they fail to take ac­count of the probable further desires of the society.

But such forecasts have two major advantages:

(1) They are relatively simple and

(2) They do focus on technological issues. So it is always better to com­bine the two methods so as to achieve the best result.

As E. Jantsch has pointed out, “A complete techno­logical forecasting exercise . . . always constitutes an interactive process between exploratory and norma­tive forecasts . . . it constitutes a feedback cycle in which both opportunities and objectives are treated as adaptive inputs”.

Forecasting Techniques:

There are two major techniques of technologi­cal forecasting whose primary interest is to deter­mine the probability that selected end results will be achieved, and to evaluate their significance.

Two intuitive forecasting techniques are: the Delphi method and scenario writing.

The Delphi Technique:

Technological forecasting is a term used in connec­tion with the longest term predictions and the Del­phi technique is the methodology often used.

The objective of the Delphi technique is to probe into the future in the hope of anticipating new prod­ucts and processes in the rapidly changing environ­ment of today’s culture and economy. In the shortest range covered by this technique, it can also be used to estimate market sizes and timing.

The technique draws on a panel of experts and attempts to gain the benefit of expert opinion in the form of a consensus rather than a compromise. The result is pooled judgement showing the range of ex­pert opinions and the reasons for differences of opin­ions.

The Delphi technique was first developed by the RAND Corporation as a means of eliminating the undesirable effects of group interaction that may oc­cur in conferences and panels where the individuals are in direct communication.

The panel of experts can be constructed in vari­ous ways and often includes individuals both inside and outside the organization. It may be true that each panel member is an expert in some aspect of the problem, but no one may be an expert on the entire problem.

In general, the procedure involves the following:

1. Each expert in the group makes independent forecasts in the form of brief statements.

2. A coordinator edits and clarifies these state­ments.

3. The coordinator provides a series of written questions to the experts that combine the re­sponse of the other experts.

One of the most extensive probes into the tech­nological future was reported by TRE, Inc. The project involved the coordination of 15 different pan­els corresponding to 15 categories of technologies and systems that were felt to have an effect on the company’s future. Anonymity of panel members was maintained to stimulate unconventional think­ing.

The Delphi method was then used to question and re-question the experts. The result was a com­posite rating of each event on the basis of its desir­ability, its feasibility, the probability that the event would occur, and probability estimates of the tim­ing of occurrence.

The extensive results of the project were then formed into logic networks. One such network shown by North and Pyke shows the milestone events that had to precede the technical achievement of holographic color movies.

Holography is an op­tical projection technique that gives the viewer the illusion of the third dimension. The network also showed events that were likely to occur, as “fallout” from the basic developments.

Scenario Writing:

Scenarios are predictions rather than forecasts because they are expressed in ‘if’, ‘then’ form. Sce­nario writing produces “narrative, time-ordered, logical sequences of events. Each such scenario is a description of a possible evolving future environ­ment.

Scenarios can be used as inputs to a forecast­ing technique or vehicles for communication among forecasters”. Corporate planners must use some form of tech­nological forecasting that involve technological de­velopments within the relevant planning horizon.

Pitfalls:

However, technological forecasting is not free from defects.

J. B. Quinn has identified major pitfalls of such forecasting:

1. Unexpected interactions of various coincidental and apparently unrelated advances;

2. Unexpected demands, such as new sources of energy for industrial use;

3. Major discoveries of entirely new phenomena; and

4. Inadequate data concerning scientific resources committed to various lines of R & D.

Technology and Resources:

However, changes in technology are very much responsive to changes in relative prices of natural resources. If prices of some major resources rise be­cause of relative scarcity, there is search for substi­tutes and for other methods for economizing the use of such scarce resources.

On the contrary, if prices of certain other resources start falling because of abundance, there is thorough-going search for new tech­nological uses of the plentiful inputs. Thus, resource forecasting and technological forecasting go hand in hand.

Resource Forecasting:

Since business firms make use of various re­sources it is necessary to forecast, in economic terms, demands and supplies of various resources. The needs and availabilities of various resources de­termine their relative prices and thus affect the choice of methods of production and finally relative prices of final goods (because prices of commodities and resources are interrelated).

The cost and prices of various products are affected by energy costs inas­much as various types of energy, and sources of en­ergy at different places, will affect choices of plant lo­cations, production techniques, and product mixes.

Corporate planners are especially interested in forecasts of changes in relative prices of inputs. Since the demand for resources in derived demand, if the demand for motor cars in India increases, there will be more demand for steel (and thus of iron are, coal, coke and heat).

There will also be rise in the demand for electric power from diverse sources as hydroelectric generators, coal and nuclear energy. A substantial amount of power is required in steel pro­duction. If steel production declines, the demand for electricity and for electric power-generating plants will also fall.

Merger and Acquisition:

On the basis of competitive strategy and long- range planning a firm is able to determine the proper ‘business to be in’.

Two major factors influence this decision:

(1) The maturity of the industry and/or

(2) The maturity of the particular product being manu­factured.

Industry Maturity:

Every industry passes through four distinct, but interrelated phases as illustrated in Fig. 26.3, viz.,

(1) Embryonic,

(2) Growth,

(3) Mature, and

(4) Aging.

In fact, the maturity of an industry is calculated by comparing cash outlay to cash inflow, expressed as a percentage. This figure is called a Ronagraph and is presented in a simple form in Fig. 26.5.

Return on net assets over time

Ronagraph showing industrial maturity

The Ronagraph is a very important concept inasmuch as it highlights the point that in business or industry everything passes through an evolution­ary process. Products which were extremely valu­able for a company a decade ago may not be that attractive today.

From the profitability points of view copyrights and patents are obvious examples of very profitable, or at least potentially profitable, items having a lim­ited life cycle. Fig 26.6 illustrates the position of a firm whose performance has been quite satisfactory in the past but now finds itself in the latter phase of the mature stage or the beginning phase of the aging stage, as Fig. 26.4 and 26.5 indicate.

Strategic gap

The Strategic Gap:

Consider a progressive organization whose ob­jective is to emerge as the most profitable firm in the industry. Suppose it has set for itself a corporate goal of obtaining a corporate annual growth rate of 15% measured in terms of earning per share.

If the product of the firm has already reached the mature stage of its growth cycle, the state of firm’s recent operations can be illustrated by the shaded area in the bottom half of Fig. 26.6. Even if the firm is efficient and its products are of high quality, its earnings per share must decline simply because its product(s) has (have) reached its (their) aging stage.

To overcome this problem the firm may try and succeed in achieving as much inter­nal development as possible. But this may be far from adequate and a wasteful strategic gap may de­velop within the enterprise. This gap arises because the firm is unable to achieve its target of a 15% growth rate.

A pragmatic solution to the problem lies in acquiring another firm or merging with an­other firm. Mergers and/or acquisitions are directed toward raising the returns to the corporation thereby closing the strategic gap.

The acquisition need not necessary be in the same industry. A company can diversify its activi­ties as well. And diversification is an important and effective component of a company’s strategic plan.

Nevertheless acquisition may raise the return to a firm in one or more of the following ways:

Merger and/or acquisition often brings with it special skills and knowledge of the industry pos­sessed by one partner, who can apply this knowl­edge and these skills to the competitive problems and opportunities facing the other partner. Conse­quently there is an improvement in the productivity of capital.

If investments are made in markets closely re­lated to the current filed of operation of the most powerful partner, long run average cost of produc­tion will fall with an expansion in the scale of oper­ation of the larger firm.

A corporation can beat the competitors if ex­pansion in one area of competence leads to develop­ment of critical resources. If for instance, a cement manufacturing company acquires another company producing limestone, it will enjoy cost reducing advantages.

It is possible to make optimum utilisation of working capital by shifting cash from units having cash surplus to units having cash deficits.

A new diversified firm can switch its cash re­sources from old and well-established products to new products that might be in the growth stage of its life cycle. This strategy might improve the long- run profitability of the new firm.

Finally, risk reduction can be achieved through diversification. By pooling risks a company can re­duce its cost of debt and, consequently, its overall cost of capital. At the same time financial and oper­ating leverage considerations can be made to operate for the benefit of the new diversified company.

If the operation of the new company goes well, its profitability or return on investment, as shown in Fig 26.7, can be improved.

Return on investment

If return on investment rises and if the dividend policy of the firm is not materially and adversely affected, the earnings per share can be improved and strategic gap closed. A basic point about acquisition is that control over a larger amount of resources by heading a lar­ger firm is likely to confer direct benefits to man­agers in terms of their emoluments and industrial and social standing.

Conversely, the top manage­ment in the company acquired may lose their inde­pendence of action. Ambitious managers, however, see take-over as a quick route to expansion, with all the potential managerial benefits involved, rather than internal investment.

For the employees’ point of view the benefits of acquisition depend on whether any such advantage takes the form of economies of scale and manpower saving, as opposed to more rapid expansion through faster and more successful development.

Diversification:

Diversification occurs “when the firm moves into new areas of activity which are not vertically related to each other. There may, however, be links between the activities in that they have common in­puts or the same distribution channels”.

J. Bates and J. K. Parkinson have distinguished between two broad types of diversification:

1. Narrow spectrum—where the activities have close production or marketing links:

2. Broad spectrum—where the new activity is completely unrelated to the acquiring of other companies, already engaged in other fields.

Diversification is simply the process of expand­ing the business activity into related, or previously unrelated, areas. Diversification should serve to cre­ate additional value for the shareholders. It can be accomplished via vertical or horizontal integration, as depicted in Fig. 26.8.

The combined resources of two companies should give rise to a net cash flow and/or income stream for the combined company, that is significantly greater than the flows or income that could be realized from the two companies if viewed separately. Theoretically, a corporate acqui­sition programme results from the corporate strate­gic planning effort.

Diversification

The incentive to diversify exists only if the firm happens to possess an asset or assets such as capi­tal, managerial expertise and innovative ability that provide the capacity to operate in more than one in­dustry. Many modern economists see diversification merely as one aspect of the reasons for the emer­gence of multi-product firms.

Often technological factors account for the emergence of multi-product firms, or multi-industry production, incurring lower costs than under specialization. Bates and Parkin­son have called these economies ‘economics of scope’ which are different from ‘economics of scale’.

Such scope economies occur “when joint production of two goods by one firm is less costly than the com­bined costs of production by two specialized firms . . . if such economics exist it is cheaper to add an ad­ditional product to an existing range (through, e.g., diversification) than to produce that particular prod­uct on its own”.

For such economies to exist two conditions must be satisfied:

(1) Firstly, there must exist some resources that can be shared by more than one product; and

(2) Secondly, “either the input in­volved must be large and indivisible, so that they cannot be fully utilized by one product alone, or an input brought for the production of one product must be available for use in another. In the latter category, skilled general management is perhaps the most obvious example.”

Most modern business firms are multi-product firms. In such firms scope of economies are univer­sal. The existence of such economies creates a strong incentive for diversification if the main product of the firm cannot fully utilize these assets.

There are three major arguments for diversifica­tion: growth, market power and risk avoidance.

Growth:

Diversification for growth or even to preserve the existence of the enterprise may be linked to the life cycle of a product. Thus, as the company’s main product reaches the maturity stage and profit and sales potential decline, it becomes necessary to con­sider the possibility of introducing new products in the product line.

In this context one may distinguish between two types of diversification: Cost-push and market-pull. Cost-push diversification occurs when the primary activity of a firm is unable to use fully the capital resources of the firm, without a sharp fall in profitability.

Thus, if sufficient investible re­sources are available and are not required for the de­fence of an existing market position, the incentive to diversify will grow with a fall in the growth rate of the firm’s primary activity.

On the contrary, market-pull diversification oc­curs “when the firm perceives an opportunity for di­versification before it is forced to a reappraisal of its market position by declining profitability. The per­ception and realization of such opportunities may be greater, the higher the importance of research and marketing functions within the organization”.

There are various possible effects of diversifi­cation on market power. Suppose a company al­ready possesses market power in one activity. It may then be able to extend its power into other markets through such devices as tie-in sales, cross- subsidization and reciprocal buying.

Tie-in sales (also known as full-time forcing) re­fer to the practice of selling new products of a com­pany to the intending purchaser of its well estab­lished product. In other words, the purchase of an old product is made conditional on the purchase of a new product. For example, Godrej may force its distributors to buy its shaving cream along with Cinthol.

The Horlicks Company may force consu­mers to buy biscuits along with Horlicks. This prac­tice often enables the diversified firm to introduce some sort of differential pricing and extract greater profit from the market.

Cross-subsidisation involves the use of profits in one market to subsidize sales in another market with the objective of driving other producers out of the market and achieving greater profit and sales in the long run. For example, a company can sell pressure- cookers or bicycles at lower prices in rural areas and may charge higher prices for the same products in urban areas.

Finally, reciprocal buying arise when two diver­sified firms reach a mutual agreement to buy from each other rather than from a third party. No doubt, the above three practices do provide some incentive for a diversification strategy when a firm already possesses some market power.

The strategy of diversification is often support­ed on the ground that by spreading the company’s activities, it may provide greater long-run security and a more stable cash flow. But this is achieved at the cost of greater returns that could be earned by the adoption of greater specialization in activi­ties with the largest potential returns.

However, the decision to diversify or specialize largely depends on the attitude of management toward risk. One strong argument in favour of diversification is that “it can help to even out cash flow that is affected by seasonal or cyclical factors, where the timing in the two or more activities is complementary.”

A final point may be noted in this context. The shareholders, the ultimate owners of the company, can reduce the risk to which they are subject to by buying the shares of a number of companies and holding a mixed portfolio. But, unlike shareholders, the management of a company is not, in general, able to spread their risks by switching the company’s portfolio of assets so easily and quickly.

Vertical Integration to Gain Market Power:

Firms may choose to integrate vertically to achieve market power. Some firms choose to pro­duce some of their own inputs rather than rely on markets for two reasons: the pursuit of market power and cost reduction. In the first hypothesis, firms may seek market power in order to engage in monopoly-like behaviour.

In the second, firms may produce some of their own inputs because the costs of market transactions exceed the benefits of using the market.

When a firm produces some of its own inputs, say iron-ore, it is a vertically integrated firm. Vertical integration is the consolidation of production of inputs and outputs under the control of the same firm. The second hypothesis focuses on the cost- reduction potential of vertical integration.

Market Foreclosure:

The following figure shows how vertical inte­gration can increase the costs of entry and lead to market foreclosure. Market foreclosure is said to oc­cur when a firm or group of firms succeed in creating insurmountable barriers to market entry.

Let us consider a market in which there are five firms supplying an input to an industry that also contains five firms using this specialized input. If the two groups of firms maintain their separate iden­tities, there may be sufficient competition among the suppliers to insure a competitive price for the input. Such a possible pattern of trade is shown in Fig. 26.9.

Market foreclosure

As a result of the merger of a supplier and a buyer there is loss of opportunities for the remaining independent firms. If each of the firms supplying the input merges with a firm in the other industry, no independent suppliers or purchasers will be left in the market.

A new entrant to the market may find it not only difficult, but virtually impossible, to enter the market, either as a supplier or as a buyer of the input. A new firm is left with only one option: to enter as a fully integrated firm operating at both levels in the vertical chain.

Since this larger-scale operation will involve a greater investment, this added cost erects an extra barrier to entry. Furthermore an entrepreneur with expertise in only one area of the vertical process may be reluctant to enter without expertise in the other area.

Bilateral Monopoly:

An extreme form of imperfect competition is bi­lateral monopoly which refers to the situation when there is a single seller of a product who faces a single buyer in the market.

As James Mulligan has commented, “when there is a sole supplier and a sole buyer there is no unique market-determined output or price. Instead, there is a negotiated market solution. While bilat­eral monopoly represents the purest form of market imperfection, the following analysis will be relevant as long as both buyer and seller have some market power relative to one another”.

It is quite reason­able to assume that there are strong barriers to entry, since we have to firms with established monopoly position. The following diagram shows that the two firms have an incentive to coordinate their output levels.

Consider the Indian car market. Suppose Hin­dustan Motors discovered that PAL makes its own car bodies but buys its other inputs, such as tires, from other firms.

To see why PAL has chosen to make its own car bodies, let us assume for a mo­ment that PAL does not make its own car bodies, but buys them from another firm, Standard Motors Ltd. Assume that Standard Motors has a monopoly on the sale of this type of car body, and that PAL is the only buyer.

We will assume that PAL buys all of its in­puts except car bodies in perfectly competitive mar­kets. The marginal cost of producing the sports car excluding the cost of the car body, is MC*. For the sake of simplicity let us assume that MC* is con­stant at all output levels and is equal to the average total cost, ATC*.

In Fig. 26.10, we assume that PAL faces de­mand curve D for its sports car. For purposes of comparison assume that Standard Motors sells its car body to PAL at price PX1, which equals the average and marginal cost of producing a car body. The marginal and average total cost of producing the sports car is the sum of MC* and Px1 = MC1. If PAL produces the car with marginal cost MC1, it produces output Q1 and charges price P1.

Cost-reduction potential of vertical ingration

Being able to recognize its potential market power, Standard Motors (SM) is not content to charge a price that just covers its average cost of production. Assume that it decides to maximize its profits by raising its price. We will ignore the details of how SM is not content to charge a price that just covers its average cost of production.

Assume that it decides to maximize its profits by raising its price. We will ignore the details of how SM determines this price, and simply assume that it decides to raise its price to Px2. The marginal cost of producing the car now increases to MC2 = MC* + Px2. Hin­dustan Motors produces output Q2 where marginal revenue equals the new marginal cost.

PAL’s economic profits is the difference be­tween total revenue and total cost. For example, since area HCQ20 measures total revenue at out­put level Q2 (the area under the marginal-revenue curve), profits will be area HCD (area HCQ20 mi­nus area DCQ20). SM receives (PX2 – PX1), SM’s profits equal area CDEF.

If the two firms operate independently, there combined profits will be less than if they merge. By merging they will consider the true cost of produc­ing the car to be MC1: the actual production cost the car body (PX1) plus the cost of the other in­puts (MC*).

Profit maximization will occur at Q1. Since total revenue is the area under the marginal- revenue curve, the net gain in overall profits for the new vertically-integrated firm will be the triangle, FCG, i.e., the difference between the changes in total revenue (area CGQ1Q2) and total cost (area FGQ1,Q2).

By merging, the two firms may succeed in elim­inating market imperfection caused by the market power of the two firms. The combined firm will produce cars where MR equals the true marginal cost of Q. The merger will benefit customers buy­ing cars, due to the fall in the market price of cars, and the increase in quantity sold.

It may, however, be noted that if neither firm has any market power, the markets for car bodies and cars will be perfectly competitive, with a much greater market output of Q3 and a lower price equal to marginal cost MC1.

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