Chapter 5 Management.pdf

A business can increase its overall economic value primarily through two factors: Profitability and Growth. LG 5-1 Profitability is the ability ofthe business to generate long-term positive net cash flows sufficient to provide an appropriate risk-adjusted rate of return on capital employed. Unless a...

A business can increase its overall economic value primarily through two factors: Profitability and Growth. LG 5-1 Profitability is the ability ofthe business to generate long-term positive net cash flows sufficient to provide an appropriate risk-adjusted rate of return on capital employed. Unless a business can eventually generate positive net cash flows, its business model is not viable, and it will not continue to survive for very long. The more posi-tive net cash flow the business can generate, relative to the level of equity and long-term debt invested in the business, the more valuable the business. This presumes that the current, and projected future, cash flows generated represent a “good” rate of return for the equity invested, given the level of risk. (risk is the likelihood that the net positive cash flows projected for the future will actually be realized). The higher the risk, the higher the rate of returns that are required. Typically, a risk adjusted rate of return on equity invested should be at least 7%–10% for a business with average risk but can be much higher for more risky businesses with historically volatile or highly uncertain future cash flows. NOTE: this is a very condensed and simplified summary of key parts of an introductory finance course. As managers, it is important to know what drives value in a business and to have a basic understanding of financial profitability. If this concept is unclear based on this brief description, you may want to do more research on this topic on the internet. A business can increase its overall economic value primarily through two factors: Profitability and Growth. LG 5-1 Profitability is the ability ofthe business to generate long-term positive net cash flows sufficient to provide an appropriate risk-adjusted rate of return on capital employed. Unless a business can eventually generate positive net cash flows, its business model is not viable, and it will not continue to survive for very long. The more posi-tive net cash flow the business can generate, relative to the level of equity and long-term debt invested in the business, the more valuable the business. This presumes that the current, and projected future, cash flows generated represent a “good” rate of return for the equity invested, given the level of risk. (risk is the likelihood that the net positive cash flows projected for the future will actually be realized). The higher the risk, the higher the rate of returns that are required. Typically, a risk adjusted rate of return on equity invested should be at least 7%–10% for a business with average risk but can be much higher for more risky businesses with historically volatile or highly uncertain future cash flows. NOTE: this is a very condensed and simplified summary of key parts of an introductory finance course. As managers, it is important to know what drives value in a business and to have a basic understanding of financial profitability. If this concept is unclear based on this brief description, you may want to do more research on this topic on the internet. Growing a business can be a significant challenge for managers. As described in the overview to this chapter, growth is a key driver of economic value for a busi-ness and often necessary for the ongo-ing survival of the business. There are some basic options managers can use to address this challenge. These include: LG 5-2 5.1.1 – Selling more of a business’s existing products and services to existing customers 5.1.2 – Gaining new customers from your current market while retaining the ones you already have 5.1.3 – Selling new products and services to existing and new customers 5.1.4 – Selling existing products and services into completely new markets 5.1.5 – Entering completely new markets with new products and services Essentially, these are the primary options available for a business to grow sales, profits, and net cash flow. Let’s examine each of these options in more detail. 5.1.1 – Selling more of a business’s existing products and services to existing customers: As businesses create an expanded customer base there is the opportunity to encourage current customers to buy more of the business’s current products and services (a “market penetration” strategy). These customers already have a rela-tionship with the business and so it is easier to introduce these additional products and services to them, especially if they are pleased with their current interactions with the business. Often businesses will provide incentives to customers (e.g., discounts or free product) to encourage them to try previously unpurchased products/services. This is different than quantity discounts that are given for buying more of the same product/service. In the long run though, quantity discounts may not lead to addi-tional sales if the customer does not also increase their overall usage of those products/services. It only delays when they need to repurchase. Also, if the previ-ously unpurchased products/services sold to existing customers are a direct substi-tute for the products/services they were previously buying, this will have no effect on growth either. For “growth” to be successful under this option, customers must: Increase their usage of currently purchased products/services, Broaden the number of different products they routinely buy from the business (without reducing their level of purchases of previously bought products), or Upscale (buy more expensive versions of the products/services they were previously purchasing). The goal is to increase the amount of profits generated from each current customer year over year by one or more of these three mechanisms of growth. 5.1.2 – Gaining new customers from your current market while retaining the ones you already have This approach to growth is often called either a share-building or market development strategy. The goal is to add new customers who have not previously purchased any of your current products and services. These can either be new customers who were previously buying similar products from your competitors (“share building”) or acquir-ing new customers who have not bought such products in the past and are new to your market (“market development”). Share building is usually done through sales and promotion programs to attract these customers away from your competitors. Market development, on the other hand, often requires educating potential customers of the existence and benefits of your products/services through various forms of advertising, promotional, or informational programs targeted to reach current non-buyers. 5.1.3 – Selling new products and services to existing and new customers Developing or acquiring new products and services to sell to customers is another way to grow the business. New products and services can be internally developed through research and development or can be licensed or acquired from third parties outside the business. These products can be sold to the business’s existing customer base or used to expand that base to a completely new set of customers. This approach to cre-ating growth may require businesses to have several capabilities including: product/ service research and development, production and distribution development, new product/service launch/promotion, and regulatory and legal capabilities to assure proper approvals, contractual agreements, patenting/trademarking, and liability pro-tection. This approach to generating growth is generally a more expensive and riskier proposition than the previous two approaches. An example of this growth strategy was Apple successfully developing and selling cell phones after previously having sold primarily computers and music recording devices. 5.1.4 – Selling existing products and services into completely new markets This approach to generating growth requires searching potential new markets for existing products/services (a “market expansion” strategy). This could be in the form of new applications for existing products, which may require the business to develop new distribution or sales channels, or require joint venturing with an estab-lished business within those markets. Another form of market expansion is to pur-sue geographic expansion into regions or countries not previously served by the organization. An example was IKEA’s expansion into the United States market in 1985. The Scandinavian based company sold $50 million in merchandise to U.S. cus-tomers during its first year in this new market! 5.1.5 – Entering completely new markets with new products and services This approach can take a few different forms. First, a business may have some unique capabilities that they believe could be applied in other industries. It may be unique strengths in certain production methods or well-developed advertising capabilities in certain target markets. The opportunity is to take those capabilities and apply them in a completely different industry in order to create a competitive advantage in that industry vs. current participants, or to use these capabilities to simply par-ticipate successfully in an industry that offers good returns. The business may enter the market by acquiring or joint venturing with an existing business that is already in that new market or they may choose to develop the new business on their own. Another way businesses can approach this growth opportunity is if they have excess cash or low-cost borrowing power and are looking for ways to invest those available resources in an existing business in another industry or to create a new business in an industry they do not currently participate in. The new business creates value by using the existing business’s general managerial competencies in strategy development, business development, general management, or other administrative areas. The rationale for this approach is that the business has skills and available cash resources that will allow them to manage a business in that industry more effec-tively than current participants, or that they believe the industry offers good returns for most well-managed businesses. An often-cited example of this form of growth is General Electric (GE). GE built its reputation on having outstanding management practices and talent. They also made significant investments in research and develop-ment and relied on that technology to provide the competitive advantage for enter-ing new markets with innovative new products. GE then leveraged its management expertise and experience to build successful businesses in those new markets. Summary: Growth is key to enhancing the value of a business and protecting an organization’s competitive position. There are several approaches a business can take to grow including increasing sales to existing customers, developing new products and ser-vices, and expanding into new markets. Successfully growing a business is an impor-tant aspect of doing the “Right Work”. nnovation is executing an idea which addresses a specific challenge and cre-ates value for both the developer and the user Innovation can be used to create new/improved products or to create new/improved business processes. Not that long ago, Innovation was often associated with an inventor sit-ting in their garage coming up with a great idea. Stories of successful, randomly developed innovations abound but for businesses today, Innovation has become a much more deliberate process. Boston Consulting Group (BCG) publishes an annual survey of the most innova-tive companies. In 2019, for the first time in 13 years, Alphabet/Google displaced Apple as the most innovative company. What do these companies do to consistently be the most innovative companies year after year? Can innovation be accomplished through a systematic process or does it require more spontaneous creativity? What the most innovative companies have in common according to BCG is reli-ance on three mechanisms that greatly enable them to innovate. These are: 5.2.1 Use of artificial intelligence (AI) 5.2.2 Use of technology platforms 5.2.3 Use of collaborative ecosystems All of the top ten companies in the BCG survey use all three of these mechanisms to enable innovation. Let’s explore each of these mechanisms in more depth. 5.2.1 – Use of Artificial Intelligence (AI): Artificial Intelligence (AI) is the theory and development of computer systems able to perform tasks that normally require human intelligence, such as visual perception, speech recognition, decision-making, and translation between languages. You might be inclined to think that AI is only used in high tech businesses. Think again – McDonalds uses an AI algorithm to modify its digital menus, continuously changing them based on such factors as time of day, day of the week, restaurant traffic, and weather! Through use of AI tools like this, McDonald’s has enjoyed 13 quarters of continuous growth through the end of 2018. Machine learning (ML) is an application of artificial intelligence (AI) that pro-vides systems the ability to automatically learn and improve from experience with-out being explicitly programmed. Machine learning focuses on the development of computer programs that can access data and use it to learn for themselves. When AI is combined with machine learning (ML), it becomes a powerful tool for enabling innovation. BCG reports that 30% of the leading companies in their survey expect AI to be among the areas of innovation with the highest impact on their busi-ness in the next three to five years. While the majority of AI based innovations are directed at improving internal processes, nearly half of the leading users of AI say that 16% or more of their current sales are AI generated. The challenge for many businesses is building the internal capabilities to support development of AI applications. As a result, over half of the leading innovative com-panies use external vendors to assist them with AI projects. It seems that today, at least for these most innovative companies, AI has become a formidable rival to the inventor in the garage! 5.2.2 – Use of Technology Platforms: Technology Platforms (TPs) provide a foundation for developing other business offerings. Examples of TPs include: Computing – (Android operating system for cell phones which is used by several cell phone manufacturers as the base operating system for their phones), Technology – (The Cloud is a technology enabled platform for the storage of computer data by businesses and consumers), Service – (NETFLIX uses technology to enable consumers to access a wide variety of proprietary video content via the web), Content – (Google and Bing/Microsoft as technology enabled platforms for topically indexing information and making it easily accessible to consumers through sophisticated, algorithm-based search engines), and Marketplace – (Amazon as a platform for more easily linking buyers with sellers). By leveraging existing technology platforms, organizations are able to innovate faster by capitalizing on the capabilities that these platforms offer to assist in develop-ing better products and services, developing them more quickly, and making them more visible and easily accessible to customers. 5.2.3 – Use of Collaborative Ecosystems: Ecosystems are multiple organizations working collaboratively to enable rapid devel-opment of new technologies, products, and services. How do ecosystems help in the development of new technologies, products, and services? BCG sites several ways: Collecting and using data – Collecting data can be a time-consuming and expensive endeavor. By utilizing the collective capabilities of multiple organizations to collect data and sharing the costs, the time-required and the net cost for each organization can be significantly reduced. This can make sense particularly when the data itself is not the basis of competitive advantage but a starting point for pursuing research into proprietary applications of the data. Gaining access to Intellectual Property (IP) – IP is proprietary know-how or creative content that is protected through copyright, patents, trademarks, or secrecy. In collaborative ecosystems, sharing IP, and the rights to use the IP, among organizations can rapidly accelerate development of new technologies, products, and services to the mutual benefit of all the collaborating organizations. Merging physical and digital marketing channels – This one requires a more detailed explanation and example to fully appreciate the value that can be created: While many purely digital marketing channels enjoy near monopolies – think Google and Facebook --physical marketing channels are not so fortunate. Industries like real estate, automobiles, computer hardware, etc. tend to have many competitors with no one company being dominate. This is because these industries do not have comparable advantages available to digital marketing leaders such as the ability to expand their businesses with little or no incremental cost, access to large amounts of data about their customers and their business, and the ability to provide their customers with a comprehensive experience, i.e., the ability to satisfy their customers’ multiple needs on a single platform in a highly efficient manner. Therein lies the opportunity for the merging of physical and digital marketing channels. By bringing the advantages of digital marketing to traditionally physical orga-nizations, some of the same benefits can accrue to these physical businesses. For example, consider the impact the company Zillow has had on the real estate mar-ket. Zillow gives consumers online access to all the data that previously was only available to licensed real estate agents through the MLS (Multiple Listing Service). This includes information on all the houses for sale and the history of houses that had been recently sold. There are benefits to the real estate agents as well as they no longer have to print out reams of paper with listings to present to buyers nor do they need to be concerned that their “for sale” listings will not be given to pro-spective buyers by an agent in a rival sales office. All this information, and more, is now readily available to all interested buyers online, through Zillow, and can easily be sorted by any number of filtering options. This ecosystem between the digital player, Zillow, and the many physical business participants in the traditional real estate market greatly enhances the ease with which customers can access the information they require to make informed real estate sales and purchases. The net effect is that real estate agents can spend more time helping home sellers to realistically set their prices and offer tips for making their home more attractive to buyers, increasing the likelihood it will sell. At the same time the agent can help buyers more quickly evaluate various options by having the buy-ers use Zillow to access detailed listings in various areas and to provide virtual tours of the houses they are most interested in thus greatly reducing the amount of time required by the agent to help buyers make an informed decision. Creating an ecosystem between a digital player like Zillow and traditional physical marketers like real estate offices and their agents is a clear example of how collaborative ecosystems can create a more efficient marketplace for both the service provider (realtors) and their customers (home sellers and buyers). Advancing new technologies – Pursuing and sharing the results of simultaneous streams of research conducted in different organizations in order to explore the development and applications of new technologies can greatly reduce the cost and risk to any one organization. It can also significantly reduce the cycle time required to develop the technology and to identify promising applications to the mutual benefit of all the collaborating organizations. A final observation about innovation: innovation is not only about finding radical changes to products, services, and processes? BCG finds that companies split their investments roughly equally between pursuing radical innovations vs. seeking incre-mental improvements to existing products, services, and processes. Summary: Innovation is executing an idea which addresses a specific challenge and creates value for both the developer and the user Innovation can be used to create new/improved products or to create new/ improved business processes. The most innovative companies use three mechanisms to drive innovation: arti-ficial intelligence, technology platforms, and collaborative ecosystems Innovation is a key enabler of growth. Entrepreneurship is about acting to bring forth novel ideas and concepts that cre-ate value. To do this, entrepreneurs often act with urgency, in unorthodox ways, so as to address their immediate challenges, and generate opportunities amidst uncer-tainty. LG 5-4 There is much research and many views of what Entrepreneurship is and isn’t. For purposes of this textbook we will briefly focus on Entrepreneurship in the context of the larger business enterprise. Some refer to this as intrapreneurship, or how larger businesses are able to create new business ventures through the creative, and sometimes unorthodox, actions of their employees. NOTE: We are not covering the traditional notion of entrepreneurship that involves individuals starting up new small business ventures and the unique management related aspects of running those ventures. That would require at least another full chapter to do even partial justice to the topic and that is beyond the scope of this introductory textbook. Most colleges offer entire courses on entrepreneurship which is likely necessary to properly address the topic. We have previously discussed the imperative for growth to create value, but some businesses are unable to generate and sustain the desired rate of growth from their existing products and services or through incremental product development. For these businesses, the imperative is to find the opportunities that can create substantial increases in profitable growth. At the same time, many successful busi-nesses become more risk adverse and less willing to bet large sums of money on uncertain endeavors. The comfort they currently derive from having predictable quarterly earnings reports keeps their shareholders happy and their stock values high, yet they realize that sustaining such positive results will be more difficult later unless they build large new platforms for growth today In some cases, a promising new venture may even represent a threat to the company’s own currently successful business, further discouraging concerted effort to pursue the opportunity. Failure to act, however, may leave the door open to enterprising competitors to seize the opportunity at the company’s expense. What does it take to successfully implement “intrapreneurship” in larger busi-nesses? A review of the literature suggests the following: Top leadership commitment to supporting and funding multiple bets on new ventures by recognizing and accepting the likely failure rates (as high as 90%), as the price to pay for developing a few successful new ventures out of a portfolio that will include many unsuccessful ones. Creating a few targets areas, or domains of interest, and aligning them with core competencies of the business. Recognizing and finding ways to overcome and/or remove the typical obstacles that stifle internal new venture development such as risk aversion, short term budget controls, and restrictive approval processes. Creating separately funded business development organizations focused on external search for opportunities through use of seed funding, minority investments, and/or acquisition of promising startup businesses. Using some of the mechanisms discussed in the previous Topic 5.2 such as technology platforms and collaborative ecosystems to identify and pursue significant new opportunities more rapidly and to share the costs and risks of evaluation and development. Learning from both the successes and failures of prior ventures in order to improve the odds of success for new ones. Having the wisdom and the courage to recognize and terminate unsuccessful opportunities rather than continuing to pour good money after bad in a prolonged effort to continually justify prior investments and “save face”. Summary: Entrepreneurship in larger businesses, or intrapreneurship, is an important element in pursuing major growth opportunities outside of traditional incremental growth strategies described in Topic 5.1. Intrapreneurship is a high-risk endeavor and requires senior leaders to under-stand and accept these risks in order for the business to successfully pursue these new ventures with their significant growth potential. Learning from past successes and failures and using various proven approaches to identify and pursue new venture opportunities can increase the odds of success Growth, Innovation, and Entrepreneurship – In Practice Sutures are medical products used to close open wounds caused by trauma or following surgery (often referred to as stitches). Ethicon, a division of Johnson & Johnson, was the leader in the manufacturing and sales of sutures with a dominant market share and a very profitable business. In the late 1980s, some entrepreneurial firms began experimenting with ways to make surgery less invasive (requiring smaller incisions). There were many benefits to this approach including making surgery less traumatic for the patient, reducing the risk of infection, and allowing patients to recover faster. In some cases, rather com-plicated surgeries that previously required large incisions could now be performed by making a couple of small incisions each about the size of a medium-sized button. While there was general concern at Ethicon of the potential negative impact this new surgical approach could have on their business, a few researchers and market-ers at Ethicon were enamored with the prospect of less invasive surgery as a business opportunity and began to look into the technologies involved. Those technologies included use of sophisticated cameras and miniaturized instruments. These were not the technologies typically used to develop new or improved sutures so did not leverage the existing R&D capabilities at Ethicon. To enable further exploration of this significant opportunity for growth, the research and business development activities associated with this potential new venture were moved from Ethicon’s headquarters in New Jersey to a facility in Ohio and the exploration of this business opportunity was separately funded outside of the core Ethicon franchise to avoid any concerns about it impacting the profits of the Ethicon suture business. Within a few years, Ethicon Endo-Surgery in Ohio became a significant part of the medical device sector portfolio and a major contributor to the profitable growth of Johnson & Johnson. The President of Ethicon Endo-Surgery, William Weldon, later became the CEO of Johnson & Johnson.