Transcript Overview of Fin Stat Analysis - ACCT 6700: Accounting for

Financial Reporting and
Financial Statement Analysis
Dr. Nancy Mangold
California State University, East Bay
Dr. Nancy Mangold, CSUH
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Financial Statement Analysis Purposes
 Making
an investment (common or
preferred stocks)
 Extending credit
– short-term (bank loan to finance receivables or
inventories)
– long-term (bank loan or public bond to finance
acquisition of property, plant, or equipment)
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Financial Statement Analysis Purposes
 Assessing
the operating performance and
financial health of a supplier, customer, or
competitor.
 Valuing a firm in settings such as
–
–
–
–
the initial public offering of its common stock
as an acquisition candidate
in court-directed bankruptcy hearings or
in liquidation actions
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Financial Statement Analysis Purposes
 Forming
a judgment about damages
sustained in a lawsuit
 Forming an opinion on a client’s financial
statements with respect to whether the
client is a “going concern”
 Assessing whether combinations in an
industry might generate monopoly returns,
thus prompting antitrust action by
government regulators
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Steps in
Financial Statement Analysis
1.
Identify
Economic
Characteristics
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2.
Identify
Company
Strategies
3.
Understand and
Cleanse the
Financial
Statements
4.
Analyze
Profitability
and Risk
5. Value the
Firm
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Overview of Financial Statement
Analysis
 Identify
the economic characteristics of the
particular industry
 Identify the strategies that a particular firm
pursues to gain competitive advantage
 Understand the financial statements of the
particular firm and cleanse them of
nonrecurring and unusual items
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Overview of Financial Statement
Analysis
 Assess
the profitability and risk of the firm
using information in the financial
statements
 Value the particular firm
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Identify the Industry Economic
Characteristics
 A large
number of firms selling similar
products
 Grocery stores
– Similar (non-differentiated) products
– Low barriers to entry (retail space & access to
food product distributors)
– Extensive competition
– Low assets invested and high asset turnover
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Identify the Industry Economic
Characteristics
 A smaller
number of competitors selling
unique products
 Pharmaceutical companies
– High entry barrier
» High R&D to create new drugs
» Lengthy government approval process to receive a
patent for a new drug
» Exclusive rights to manufacture and sell the product
for a long time
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Identify the Industry Economic
Characteristics
 Pharmaceutical
companies
– Higher profit margins
– Unique product liability risks
– Risk of competitor develop superior drugs that
make one firm’s drug obsolete
– Small debt financing
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Identify the Industry Economic
Characteristics
 Technological
change critical to a firm’s
maintaining a competitive advantage
 Computer software
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Identify the Industry Economic
Characteristics
 Rapid
growth in Industry sales
 Internet search services
– Yahoo, Excite, Lycos
 Internet
service providers
– AOL
– Earthlink
 E-commerce
– Amazon.com
– eBay
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Identify the Industry Economic
Characteristics
 Capital
intensive industry
 Electric utility
– Large investments in property, plant &
equipment
– Monopoly in a particular area
– Regulators set the rates
– High profit margins to offset low asset turnover
– High proportion of debt
– Deregulation and market rates will reduce
profit margins.
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Identify the Industry Economic
Characteristics
 Commercial
Bank
 Assets
– Investment in short-term financial securities
– Loans to businesses and consumers
 Financing
– Customer deposits
– Short-term borrowing
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Identify the Industry Economic
Characteristics
 Commercial
Banks
 Small profit margins on interest rate
difference between lending and borrowing
 Fee based financial service more profitable
– Arranging mergers and acquisitions
– Structuring financing packages for businesses
– Guaranteeing financial commitments of
business customers
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Tools for Studying
Industry Economics
 Value
Chain Analysis
 Porter’s five forces classification
 An Economic attributes framework
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Value Chain Analysis
 A value
chain for an industry involves the
creation. Manufacture, and distribution of
its products and services
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Value Chain
Pharmaceutical Industry
Research to
Discover
Drugs
Creation of
Demand for
Drugs
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Approval of
Drugs by
Government
Regulators
Manufactyre of
Drugs
Distribution to
Customers
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Value Chain
Pharmaceutical Industry
 Where
value gets added in an industry?
 Value of drug discovery
– Prices paid to acquire firms with promising or
newly discovered drugs
 Value
to test and obtain approval of new
drugs
– prices paid to clinical research firms to test and
to obtain approval of new drugs
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Value Chain
Pharmaceutical Industry
 Identify
the strategic positioning of a
particular firm within the industry
 Traditionally in
– Research discovery
– Manufacturing
– Demand Creation
 Not
in
– Distribution to customers to pharmacies
– Contract out drug testing and approval phase
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Value Chain
Beverage Industry
Creation of
Beverage
Product
Manufacture of
Concentrate
Containerizing
Beverage or Syrup
in Bottles, Cans or
other Container
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Mixing of
Concentrate,
Water, Sweetener
to Produce
Beverage or Syrup
Distribution to
Retail Outlets
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Value Chain
Beverage Industry
 Coke
engages in
– New Product Development
– Manufacture of Concentrate (secret ingredients
and formula)
 Contract
–
–
–
–
out bottling operation
15% subsidiaries
40% independent bottlers
45% noncontrolled affiliates
Bottlers ship beverages to retail stores
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Business Strategy Analysis
 Business
strategy analysis is an important
starting point for the analysis of financial
statements
 It allows the analyst to probe the economics
of the firm at a qualitative level
 It allows the identification of the firm’s
profit drivers and key risks
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Business Strategy Analysis
 Enabling
the analyst to assess the
sustainability of the firm’s performance and
make realistic forecasts of future
performance
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Business Strategy Analysis
 Useful
in guiding financial analysis
 Cross-sectional analysis
– expect firms with cost leadership strategy to
have lower gross margins and higher asset
turnover than firms that follow differentiated
strategies
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Business Strategy Analysis
 Useful
in guiding financial analysis
 Time-series analysis
– closely monitor any increases in expense ratios
and asset turnover ratios for low cost firms.
– monitor any decreases in investments critical to
differentiation for firms that follow
differentiation strategy.
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Industry Analysis
 In
analyzing a firm’s profit potential, an
analyst has to first assess the profit potential
of each of the industries in which the firm is
competing.
 The profitability of various industries
differs systematically.
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Industry Analysis
ROE - 1971-1990
 All US Mfg. Companies
 Food & kindred prod. ind.
 Paper & allied prod. ind.
 Iron & Steel ind.
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12.6%
15.2%
12.5%
3.9%
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Industry Analysis
 Industry
structure influences profitability of
firms in an industry
 Average profitability of an industry is
influenced by five forces.
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Porter’s Five Forces
Classification
 Degree
of actual and potential competition
– Rivalry among existing firms
– Threat of New Entrants
– Threat of Substitute Products
 Bargaining
power in input and output mkts
– Bargaining power of buyers
– Bargaining power of suppliers
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Industry Structure and
Profitability
Degree of Actual and Potential Competition
Rivalry Among
Existing firms
Threat of
New Entrants
Threat of
Substitute Products
Industry Profitability
Bargaining Power in Input and Output Markets
Bargaining Power
of Buyers
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Bargaining Power
of Suppliers
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Degree of Actual and Potential Competition
Rivalry Among
Threat of
Threat of
Existing Firms
New Entrants
Substitute Products
Industry Growth
Scale Economies
Concentration
First mover Advantage
Differentiation
Distribution Access
Switching Costs
Relationships
Scale/Learning
economies
Legal Barriers
Relative price and
performance
Buyers’ willingness
to switch
Fixed-Variable costs
Excess Capacity
Exit Barrier
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Bargaining Power in Input and Output Markets
Bargaining Power
Bargaining Power
of Buyers
of Suppliers
Switching costs
Switching costs
Differentiation
Differentiation
Importance of product for
cost and quality
Importance of product for
cost and quality
Number of buyers
Number of suppliers
Volume per buyer
Volume per supplier
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Degree of Actual and Potential
Competition
 Profits
in an industry are a function of the
max price that customers are willing to pay
for the industry’s product or service
 One of the key determinants of price is the
degree of competition among suppliers of
the same or similar products
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Degree of Actual and Potential
Competition
 Perfect
Competition
– Price = marginal cost
– few opportunities for super-normal profits
 Monopoly
– earn monopoly profits
 Most
Industry in between perfect
competition and monopoly
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3 Competitive Forces in an
Industry
 Rivalry
between existing firms
 Threat of entry of new firms
 Threat of substitute products or services
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Competitive Force 1:
Rivalry among Existing Firms
 In
some industries, firms compete
aggressively, pushing price close to
marginal cost
 In other industries, they find ways to
coordinate their pricing, or compete on nonprice dimensions (innovation, brand image)
 Several factors determine the intensity of
competition between existing players in an
industry
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Industry Growth Rate
 If
an industry is growing very rapidly,
existing firms need not grab market share
from each other to grow
 In stagnant industries, the only way existing
firms can grow is by taking share away
from the other players
– price wars
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Concentration and Balance of
Competitors
 The
number of firms in an industry and
their relative sizes determine the degree of
concentration in an industry
 The degree of concentration influences the
extent to which the firms in an industry can
coordinate their pricing and other
competitive moves
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Concentration and Balance of
Competitors

One dominant firm in an industry
– IBM mainframe computer ind. in 1970s
– it can set and enforces the rules of competition

Two or three equal-sized players
– Coke and Pepsi in US soft-drink industry
– can implicitly cooperate with each other to avoid
destructive price competition

Industry Fragmented
– Severe price competition
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Degree of Differentiation and
Switching Costs
 The
extent of competition depends on the
extent to which firms in an industry can
differentiate their products and services
 If the products in an industry are very
similar, customers are ready to switch from
one competitor to another purely on the
basis of price
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Degree of Differentiation and
Switching Costs
 Switching
costs determine customers’
propensity to move from one product to
another
 When switching costs are low, there is a
greater incentive for firms in an industry to
engage in price competition
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Scale /Learning Economies and
the Ratio of Fixed to Var. Costs
 If
there is a steep learning curve or there are
other types of scale economies in an
industry, size becomes an important factor
for firms in the industry
 In such situations, there are incentives to
engage in aggressive competition for
market share
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Scale /Learning Economies and
the Ratio of Fixed to Var. Costs
 If
the ratio of fixed to variable costs is high,
firms have an incentive to reduce prices to
utilize installed capacity
– Airline industry, price wars are common
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Excess Capacity and Exit Barrier
If capacity in an industry is larger than customer
demand, there is a strong incentive for firms to cut
prices to fill capacity.
 Excess capacity will be more problem if there are
significant barriers for firms to exit the industry
 Exit barriers are high when the assets are
specialized, or if there are regulations which make
exit costly.

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Competitive Force 2:
Threat of New Entrants
 The
potential of earning abnormal profits
will attract new entrants to an industry.
 The very threat of new firms entering an
industry potentially constrains the pricing
of existing firms within it.
 The ease with which new firms can enter an
industry is a key determinant of its
profitability.
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Competitive Force 2:
Threat of New Entrants
 Several
factors determine the height of
barriers to entry in an industry
– Economies of scale
– First mover advantage
– Access to channels of distribution and
relationships
– Legal barrier
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Economies of Scale
 When
there are large economies of scale,
new entrants face the choice of having
– either to invest in a large capacity which night
not be utilized right away,
– or to enter with less than the optimum capacity
 New
entrants will at least initially suffer
from a cost disadvantage in competing with
existing firms
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Economies of Scale
 Economies
of scale might arise from large
investments in
– research and development
» Pharmaceutical or Jet engine industries
– brand advertising
» Soft-drink industry
– physical plant and equipment
» Telecommunications industry
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First Mover Advantage
Early entrants in an industry may deter future
entrants if there are first mover advantages
 First mover might be able to

– set industry standards
– enter into exclusive arrangements with suppliers of
cheap raw materials
– acquire scarce government licenses to operate in
regulated industries
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First Mover Advantage
 If
there are learning economies, early firms
will have an absolute cost advantage over
new entrants.
 First mover advantages are also likely to be
large when there are significant switching
costs for customers once they start using
existing products. (DOS, Windows)
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Access to Channels of
Distribution and Relationships
Powerful barriers to entry
 Limited capacity in the existing distribution
channels
 High costs of developing new channels
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Access to Channels of
Distribution and Relationships
 Examples
 Formidable
barriers for a new entrant into
the domestic auto industry
– difficulty of developing a dealer network
 New
consumer goods manufacturer
– difficult to obtain supermarket shelf space for
their products
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Access to Channels of
Distribution and Relationships
 Existing
relationships between firms and
customers in an industry make it difficult
for new firms to enter an industry
– Auditing
– Investment banking
– Advertising
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Legal Barriers
 Patents
and copyrights in research-intensive
industries limit entry
 Licensing regulations limit entry into
– medical services
– broadcasting
– telecommunications
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Competitive Force 3:
Threat of Substitute Products
 Substitutes
for travel over short distance
– Airlines and car rental services
 Substitutes
as packaging in the beverage
industry
– plastic bottles and metal cans
 New
technology changes usage of product
– Energy conserving technology reduce
consumption of electricity and fossil fuels
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Competitive Force 3:
Threat of Substitute Products
 The
threat of substitutes depends on
– the relative price and performance of the
competing products or services
– on customers’ willingness to substitute
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Competitive Force 3:
Threat of Substitute Products
 Customers’ willingness
to switch
 A critical factor in making this competitive
dynamic work
– tap water and bottled water (price premium)
– designer label clothing (price premium),
customers place a value on the image offered
by designer labels.
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Relative Bargaining Power in
Input and Output Market
 On
the input side, firms enter into
transactions with suppliers of
– Labor, raw materials and components
– Finances
 On
the output side, firms either
– Sell directly to the final customers or
– Enter into contracts with intermediaries in the
distribution chain
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Relative Bargaining Power in
Input and Output Market
 The
relative economic power of the two
sides is important to the overall profitability
of the industry firms
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Competitive Force 4:
Bargaining Power of Buyers
Two factors
 Price sensitivity
– determines the extent to which buyers care to
bargain on price
 Relative
bargaining power
– determines the extent to which they will
succeed in forcing the price down
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Price Sensitivity
 Buyers
are more price sensitive when the
product is
– undifferentiated and
– there are few switching costs
– the importance of the product to their cost
structure
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Price Sensitivity
 When
the product represents a large
fraction of the buyers’ cost
– Buyer is likely to expend the resources to shop
for a lower cost alternative.
 If
the product is a small fraction of the
buyers’ cost
– Buyer may not expend resources to search for
lower cost alternatives
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Price Sensitivity
 The
importance of the product to the
buyers’ product quality also determines
whether or not price becomes the most
important determinant of the buying
decision
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Relative Bargaining Power
 Relative
bargaining power in a transaction
depends ultimately on the cost to each party
of not doing business with the other party
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Relative Bargaining Power
 The
–
–
–
–
–
buyers’ bargaining power is determined by
the number of buyers relative to the number of suppliers
volume of purchases by a single buyer
number of alternative products available to the buyer
buyers’ costs of switching from one product to another
threat of backward integration by the buyers
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Relative Bargaining Power
Automobile industry
 Car manufacturers have considerable power
over component manufacturers
– large buyers
– several alternative suppliers to choose from
– switching costs are relatively low
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Relative Bargaining Power
PC industry
 Computer makers have low bargaining
power relative to the operating system
software producers because of high
switching costs
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Competitive Force 5:
Bargaining Power of Suppliers
 Suppliers
are powerful when
– there are only a few companies
– there are few substitutes available to their
customers
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Competitive Force 5:
Bargaining Power of Suppliers
 In
the soft-drink industry
– Coke and Pepsi very powerful relative to the
bottlers
– metal can suppliers not powerful because
» intense competition among can producers
» threat of substitution of cans by plastic bottles
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Competitive Force 5:
Bargaining Power of Suppliers
 Suppliers
also have a lot of power over
buyers when the suppliers’ product or
service is critical to buyers’ business
– Airline pilots in the airline industry
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Competitive Force 5:
Bargaining Power of Suppliers
 Suppliers
also tend to be powerful when
they pose a credible threat of forward
integration
– IBM powerful relative mainframe computer
leasing companies because of IBM’s unique
position as a mainframe supplier
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The Industry Analysis:
The PC Industry
 The
PC industry began in 1981 when IBM
announced its PC with Intel’s
microprocessor and Microsoft’s DOS
operating system
 In 1997 US had an installed base of 100
million personal computers
 In 1997 shipments were 30 million units, up
21% from 1996
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The Industry Analysis:
The PC Industry
 Despite
this spectacular growth, the PC
industry in 1993 was characterized by low
profitability
 IBM, Compaq and Dell reported poor
performance in the early 1990s and were
forced to undergo internal restructuring
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Competition in the PC Industry
Reasons
 the
industry was highly fragmented
– many firms producing virtually identical
products
– Top 5 vendors controlling 60% market share
– Competition intense, leading to routine price
cuts on a monthly basis
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Competition in the PC Industry
Reasons
 Component
costs accounted for more than
60% of total hardware costs of a personal
computer
 Volume purchases of components reduced
these costs
 intense competition for market share among
competing manufacturers
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Competition in the PC Industry
Reasons
 Products
produced by different firms in the
industry were virtually identical and
 There were few opportunities to
differentiate the products
 Brand name and service customers value in
the early years
 Less important as PC buyers became more
informed about the technology
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Competition in the PC Industry
Reasons
 Switching
costs across different brands of
PCs were relatively low
 Vast majority of the PCs used Intel
microprocessors and Microsoft Windows
operating systems
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Competition in the PC Industry
Reasons
 Access
to distribution was not a significant
barrier
– Dell Computers distributed through direct mail
in 1980s and introduced Internet-based sales in
the mid 1990s
– Computer superstores, CompUSA, willing to
carry several brands
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Competition in the PC Industry
Reasons
 Virtually
all the components needed to
produce a personal computer were available
for purchase
 There were very few barriers to entering the
industry
– Michael Dell in early 1980s assembled PCs in
his Univ. of Texas dormitory room
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Competition in the PC Industry
Reasons
 Apple’s
Macintosh computers offered
significant competition as a substitute
product.
 Work stations produced by Sun, DEC, and
other vendors were potential substitutes at
the higher end of the PC market.
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The Power of Suppliers and
Buyers
Suppliers and buyers had significant power
over firms in the industry
 Key hardware and software components for
PCs were controlled by firms with virtual
monopoly
 Intel - microprocessor production
 Microsoft - DOS and Windows op. systems
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The Power of Suppliers and
Buyers
 Buyers
gained more power during the ten
years from 1983 to 1993
 Corporate buyers (a significant portion of
the customer base) were highly price
sensitive since the expenditure on PCs
represented a significant cost to their
operations
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The Power of Suppliers and
Buyers
 As
customers became knowledgeable about
PC technology, they were less influenced
by brand name in their purchase decision
 Buyers increasingly viewed PCs as
commodities and used price as the most
important consideration in their buying
decision
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The Industry Analysis:
The PC Industry
 Intense
rivalry and low barriers to entry in
the personal computer industry, there was
severe price competition among different
manufacturers
 There was tremendous pressure on firms to
spend large sums of money to
– introduce new products rapidly
– maintain high quality
– provide excellent customer support
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The Industry Analysis:
The PC Industry
 These
factors led to a low profit potential in
the industry
 The power of suppliers and buyers reduced
the profit potential further
 PC industry represented a technologically
dynamic industry, its profit potential was
poor.
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The Industry Analysis:
The PC Industry
 Few
indications of change in the basic
structure of the personal computer industry,
there was little likelihood of viable
competition emerging to challenge the
domination of Microsoft and Intel in the
input markets
 The profitability of the PC industry may not
improve significantly any time in the future
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Competitive Strategy Analysis
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Competitive Strategy Analysis
 The
profitability of a firm is influenced not
only by its industry structure but also by the
strategic choices it makes in position itself
in the industry
 There are two main competitive strategies
– Cost leadership
– Differentiation
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Competitive Strategy Analysis
Differentiation
Cost Leadership
Supply same product or service at a
lower cost
Supply a unique product or service at a
cost lower than the price premium
customers will pay
Economies of scale and scope
Superior product quality
Efficient production
Superior product variety
Simpler product designs
Superior customer service
Lower input costs
More flexible delivery
Low cost distribution
Investment in brand image
Little R& D or Brand advertising
Investment in R&D
Tight cost control system
Control system focus on creativity and
innovation
Competitive Advantage
Match between firm’s core competencies and key success factors to execute strategy
Match between firm’s value chain and activities required to execute strategy
Sustainability of competitive advantage
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Sources of Competitive
Advantage
 Cost
Leadership
 Differentiation
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Competitive Strategy 1:
Cost Leadership
 enables
a firm to supply the same product
or service offered by its competitors at a
lower cost
 When the product or service is a
commodity, cost leadership might be the
only way to achieve superior performance
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Ways to Achieve
Cost Leadership
 Economies
of scale and scope
 Economies of learning
 Efficient production
 Simpler product design
 Lower input costs
 low cost distribution
 Little R & D
 Little brand advertising
 Tight cost control systems
 Efficient organizational processes
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Cost Leader
Focus on tight cost control
 make investment in efficient scale plants
 Focus on product designs
 Reduce manufacturing costs
 Minimize overhead costs
 Make little investment in risky R & D
 Avoid serving marginal customers
 Have organizational structures focus on cost
control

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Cost Leaders
 Able
to earn above-average profitability by
merely charging the same price as its rivals
 The cost leader can force its competitors to
– cut prices and accept lower returns or
– exit the industry
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Differentiation
 Providing
a product or service that is
distinct in some important respect valued
by the customer
 Nordstrom- exceptionally high customer
service
 Filene’s Basement Stores - discount retailer
competing purely on a low cost basis
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Differentiation
 Seeks
to be unique in its industry along
some dimension that is highly valued by
customers
 Supply a unique product or service at a cost
lower than the price premium customers
will pay
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Differentiation
 To
be successful
– Needs to identify one or more attributes of a
product or service that customers value
– Position itself to meet the chosen customer
need in a unique manner
– achieve differentiation at a cost that is lower
than the price the customer is willing to pay for
the differentiated product or service
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Drivers of Differentiation
 Superior
product quality
 Superior product variety
 Superior customer service
 Bundled services
 Delivery timing
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Differentiation requires
Investment in R & D
 Investment in brand image
 Investment in product appearance
 Investment in reputation
 Investment in engineering skills
 Investment in marketing capabilities
 Organizational structure to foster creativity and
innovation

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Choice between Cost Leadership
and Differentiation
 Firms
target differentiation still need to
focus on costs, so the differentiation can be
achieved at an acceptable cost
 Cost leaders cannot compete unless they
achieve at least a minimum level on key
dimensions on which competitors might
differentiate, such as quality and service
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Achieving & Sustaining
Competitive Advantage
To evaluate whether a firm will achieve its
competitive advantage, Ask
 What are the key success factors and risks
associated with the firm’s chosen
competitive strategy?
 Does the firm currently have the resources
and capabilities to deal with the key success
factors and risks?
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Achieving & Sustaining
Competitive Advantage
 Has
the firm made irreversible
commitments to bridge the gap between its
current capabilities and the requirements to
achieve its competitive advantages
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Achieving & Sustaining
Competitive Advantage
 Has
–
–
–
–
–
–
the firm structured its activities
R&D
design
manufacturing
marketing
distribution
customer service
in a way consistent with its competitive
strategy?
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Achieving & Sustaining
Competitive Advantage
 Is
the company’s competitive advantage
sustainable?
 Are there any barriers that make imitation
of the firm’s strategy difficult?
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Achieving & Sustaining
Competitive Advantage
 Are
there any potential changes in the
firm’s industry structure that might
dissipate the firm’s competitive advantage
–
–
–
–
new technology
foreign competition
changes in regulation
changes in customer requirements
 Is
the company flexible enough to address
these changes?
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Competitive Strategy Analysis
Dell Computer
Michael Dell assembled IBM in 1984 and sell
directly to end users at a significantly lower price
than competitors
 Now

–
–
–
–
Fourth largest computer maker
18 billion in revenue
1.5 billion in net income
51% growth in sales and 78% growth in net income
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Dell
Low Cost Competitive Strategy
 Direct
selling to customers, saves on retail
markups
– As computer become standardized on the
Windows-Intel platform, the value of
distribution through retailers decline
– Began selling through Internet in 1996
– By 1999 generate several million dollars of
sales per pay through Internet
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DellLow-Cost Competitive Strategy

Made-to-Order Manufacturing
– Developed flexible manufacturing system that allowed
the company to assemble and ship computers very
quickly, usually five days of receiving the order
– Avoid large inventories of parts and assembled
computers
– Low inventories allowed Dell to save working capital
costs
– Reduced costly write-offs of obsolete inventories
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DellLow-Cost Competitive Strategy

Third-party services
– Low cost approaches to after-sales service
» Telephone based service
» Third-party maintenance service
– Several hundred technical support representatives
accessible to the customers by phone any time of the
day
– Using a comprehensive electronic maintenance system,
the service representatives could diagnose and help the
customer to resolve problems in the majority of cases
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DellLow-Cost Competitive Strategy
 Third-party
services
– When on-site maintenance is required, Dell
used 3rd party maintenance contracts with
office equipment companies such as Xerox.
– Dell avoid investing in an expensive field
service network without compromising on
service qulaity
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DellLow-Cost Competitive Strategy
 Low Accounts
Receivable
– Reduce its accounts receivable days to an
industry minimum by encouraging its
customers to pay by credit card at the time of
the purchase or through electronic payment
immediately after the purchase
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DellLow-Cost Competitive Strategy

Focused investment in R&D
– Recognized most of the basic innovations in the
personal computer industry were led by the component
suppliers and software producers
– Dell’s innovations were primarkly in creating a lowcost, high-velocity organization that can respond
quickly to these changes
– By focusing its R&D innovations, Dell was able to
minimize these costs and get high return on its
investments
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DellLow-Cost Competitive Strategy
As a result of the above strategy Dell achieved a
significant cost advantage over its competitors in
the personal computer industry
 This advantage resulted in a consistent pattern of
rapid growth increasing market share and very
high profitability in an industry that is
characterized by

– rapid technological changes
– significant supplier
– buyer power and intense competition
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DellLow-Cost Competitive Strategy
Dell’s strategy involved activities that are highly
interrelated and involved continuous
organizational innovations, Dell’s business model
was difficult to replicate, making Dell’s
competitive advantage sustainable
 No competitor today has been able to replicate
Dell’s business model
 The extraordinarily high earnings and book value
multiples is likely to be sustained

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Economic Attributes Framework
 Useful
in studying the economic
characteristics of a business because it ties
in with items reported in the financial
statements
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Economic Attributes Framework
Demand
 Customers
highly sensitive to price (autos)
 Customers insensitive to price (soft drink)
 Is demand growing rapidly (internet
service)
 Industry relatively mature (grocery stores)
 Does demand move with the economic
cycle (construction of new homes and
offices)
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Economic Attributes Framework
Demand
 Is
demand insensitive to business cycles
(food products and medical care)
 Does demand vary with the seasons of a
year (toys or ski equipment)
 Is demand relatively stable throughout the
year (office supplies)
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Economic Attributes Framework
Supply
 Are
there many suppliers offering similar
products?
 Are there few suppliers offering unique
products?
 Are there high barriers to entry?
 Are there low barriers to entry?
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Economic Attributes Framework
Manufacturing
 Is
the manufacturing process
 Capital intensive? (electric utility)
 Labor intensive? (advertising, professional
services)
 Combination of the two (auto
manufacturing or airline transportation)
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Economic Attributes Framework
Manufacturing
 Is
the manufacturing process
 Complex with low tolerance for error (high
tech, heart pacemakers)
 Simple with ranges of acceptable-quality
products (nonmechanized toys?)
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Economic Attributes Framework
Marketing
 Is
the product promoted
 To other businesses
– sales staff play a key role
 To
consumers
– advertising, coupons are principal promotion
mechanisms
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Economic Attributes Framework
Marketing
 Does
demand pull products through
distribution channels?
 Do firms have to create demand
continually?
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Economic Attributes Framework
Financing
 Are

the assets of firms in the industry
relatively short term
– commercial banks
 relatively
long term
– Electric utilities
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Economic Attributes Framework
Financing
 Relatively
little risk in the assets of firms in
the industry
– Firms can carry high proportions of debt
financing
 High
risks in the assets resulting from
– Short product life cycles
– product liability concerns
– Firms have low debt and high equity financing
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Economic Attributes Framework
Financing
 Is
the industry relatively profitable and
mature?
– Generating more cash flow from operations
than is needed for acquisitions of property,
plant, and equipment?
 Is
the industry growing rapidly and in need
of external financing?
 Example of Soft Drink Industry
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Framework for Strategy Analysis
 Nature
of Product or Service
 Degree of Integration within Value Chain
 Degree of Geographical Diversification
 Degree of Industry Diversification
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Coke
 Compete
broadly in the beverage industry
 Products
–
–
–
–
soft drinks
fruit juices
tonic waters
sport drinks
 Differentiated
product through
– Brand recognition
– Domination of distribution channels
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Degree of Integration within
Value Chain
 Vertical
integration strategy
– participating in all phases of the value chain
– or select only certain phases within the chain
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Degree of Integration within
Value Chain
 Manufacturing
– Conduct all manufacturing operations itself
(steel manufacturing)
– Outsource all manufacturing (athletic shoes)
– Outsource the manufacturing of components
but conduct the assembly operation in house
(auto, computer hardware)
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Degree of Integration within
Value Chain
 Distribution
– Maintain control over the distribution function
» Wendy’s - owns most of its restaurants
– Outsource distribution
» (McDonalds - independent franchisees
» Computer hardware firms

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use indirect sellers - value added resellers and systems
integrators
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Coke
Degree of Integration with Value Chain
 Engages
in
– New product development
– Manufacture its concentrate
– Promotes its products
 Outsource
– Bottling
– Distribution
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Coke
Degree of Integration with Value Chain
 Perceives
its value-added activities are
– Secret formula that makes up the concentrate
– Promoting its product for brand name and
brand loyalty
 Outsource
–
–
–
–
bottling operation
Not value enhancing
Capital intensive
Requires LT debt financing
Coke appears less risking with less debt
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Coke
Degree of Integration with Value Chain
 Seller
power over its bottlers
– maintain significant portion of profit margin
 Bottlers
accept smaller margin for
monopoly power in a particular area and
strong demand for Coke products.
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Degree of Geographical
Diversification
 Target
domestic market?
 Integrate horizontally across many
countries?
– Create opportunity for growth
– exposes to risks from
» exchange rate changes
» political uncertainties
» additional competitors
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Coke Geographical Diversification
 North America
– 6.6% growth rate
 Outside
North America
– 67% revenues
– 79% operating income
– 7.2% growth rate
 Central
Europe, Middle East and Far East
– 54% revenues
– 58% operating income
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Degree of Industry
Diversification
 Operate
in a single industry?
 Diversify across multiple industries?
– Moderate the product, cyclical, regulatory, and
other risks that it encounters when operating in
a single industry
– Need to understand and manage multiple and
different businesses effectively
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Coke
Degree of Industry Diversification
 Operates
exclusively in the beverage
industry
 Product line includes
–
–
–
–
Orange juice (Minute Maid)
fruit juices (Hi-C)
Iced tea (Nestea)
sports drinks
 Principal
products - soft drink
– Coke, Barq’s Root Beer, Sprite, Fanta)
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