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Wednesday, September 28, 2005

Value Chain Analysis

For a company to survive in today’s highly flooded markets a company must, at least temporarily, achieve a competitive advantage. There are many ways for a firm to achieve this advantage and two generic ones are: price leadership and differentiation. Price leadership is simply when a company keeps prices below those of his competitors. Differentiation occurs when a company creates a distinctive position in the market through product functionality, service, or quality.
If either of these two management strategies are chosen to be implemented by a company, value chain analysis can help the firm focus its plan and thus achieve a competitive advantage. There are two components of value chain analysis: the industry value chain and the company’s internal value chain. The industry value chain includes all of the value-creating activities within the whole industry, beginning with the basic raw material and finishing with the delivery of the product. The internal value chain of a company includes all the value creating activities within that specific firm.
The Company’s Internal Value Chain
A firm’s internal value chain includes all the physical and technological activities within the company that add value to the product. The key to evaluating a company’s internal value chain is to understand the activities that give that company a competitive advantage, and then pin point and exploit those advantages better than other companies in the industry. This evaluation is done in four steps:
1. Identify value chain analysis
Look for discrete activities. These create value in different ways. They will include different costs, different cost drivers, separable assets, and different personnel involved. For example, contrast product design activities with advertising activities.
Identify structural, procedural, and operational activities. Structural activities determine the basic economic nature of the company. Procedural activities include all aspects of the firm's operations and reflect the company's ability to carryout the processes efficiently and effectively.
Focus on structural and procedural activities. Most companies emphasize operational activities, but proponents of value chain analysis say that focus is too narrow and only deals with the short run and will not be able to give the company an overall competitive advantage.
2. Determine which activities are strategic
To determine which activities are strategic a company must identify which product characteristics are valued by existing customers.
A company should then find characteristics that it can exploit, and thereby create value for future customers. Examples of these characteristics are quality, service, or any tangible or intangible product features.
3. Trace costs to activities
The company needs an accounting technique that traces costs to different value chain activities. This is important for a company to focus on these value-added processes, so they will be able to manage them more efficiently.
4. Improve management of value chain activities
To achieve a competitive advantage a company must manage their value chain better than their competitors. This means reducing a company's total cost while enlarging the competitive advantage. This does not however mean that all costs have to be reduced, it means that all costs that do not adversely affect the competitive advantage can and should be reduced.
The Industry Value Chain
The value chain of an industry starts with the raw material manufacturer and finishes with the delivery of the final product to the customer. The key to analyzing the industry value chain is to comprehend and use the advantage of a company’s comparative strength within the industry.
All industries begin with a raw material and end with a sale to a customer. There are many links within this process. There are upstream links and downstream links. Each separate link stands for an independent, economically viable segment of the industry. To establish which links in the industry value chain are separate, assess these two questions:
1. Is there a market for the output of this link in the industry value chain, or can a market price be determined objectively?
2. Are there any companies that produce and sell only within this link of the chain?
If the answer is “yes” to either of these questions, then the industry under consideration may be a separate link in the industry value chain. Then, after the industry value chain is determined, a company should examine the relative strength of its position, in any separate link, in the industry value chain. A company’s position within the industry link can be found by using a myriad of measurements, including industry margins, return on assets, benchmarking, and capital budgeting. When a company then finds where it has deficiencies in relative industry strength, it can go back to the internal value chain activities to improve its standing with its competitors and then gain a competitive advantage.
Conclusion
Value chain analysis comes with a few challenges. First, accounting systems are not designed to assign costs to value-added activities, but when ABC is implemented that problem can be solved. Second, it can be difficult to find accurate return on sales and return on asset data to determine the value chain. But, rough estimates still can be used to give some insight into the value chain. Lastly, not only do estimates make the value chain difficult to determine, but many industries have very complex value chains. Even though there are some challenges to a value chain approach it can be a very effective strategic management tool. When competition is fierce, firms must very precisely manage their activities and costs to continue their competitive advantage.

Reconfiguring the Value Chain - Summary (Authors:Carr, L.P. and Lawler. W.C.)

This article provides an illustration of how strategic cost management can make financial analysis a more powerful decision making tool. This idea is illustrated through the examination of the Levi Strauss Company’s past initiative to “lean thinking.”
The lean initiative was part of an overall strategy of sustaining a competitive advantage. Beginning in the mid-1980s, starting with the automobile industry, companies have studied techniques on how to achieve sustained competitive advantage. Companies strove to create substantial increases in wealth by challenging the ways they implemented their strategies. One such process called value-chain-based analysis was achieved by performing these five steps:
Value: The value chain must be identified from the customer viewpoint at a disaggregated level - a specific product must be developed from the perspective of a specific target customer, at a specific price, at a specific place and time.
Value stream: Three elements of the value chain must be mapped - the physical stream originating with the first entity that supplies any raw input to the system, and ending with a specified customer (regardless of legal boundaries); the information stream that enables the physical stream; and the problem-solving/decision making stream that develops the logic of the physical stream.
Continuous flow: The focus must be on ensuring continuous flow and minimizing disruptions, such as those in a typical push-based batch-and-wait system.
Pull: To ensure continuous flow and to minimize disruptions, companies must create pull where the customer initiates the value stream.
Perfection: Finally, companies must strive for perfection by creating the virtuous circle, in which transparency in the system enables all members of the value chain to continually improve the system.
The remainder of the article examines the success Levi’s Strauss has had by implementing value-chain-based analysis and focuses of their “Levi’s Personal Pair” program which was the product of their analysis.
Levi’s Strauss was the market leader for women’s jeans in 1995. However its position as leader was coming under heavy attack. Focusing on size combination (which they offer 51), Levi’s was losing ground as more styles, more colors, and better fit became more important to its customers. Market research showed that only 24% of women were completely satisfied with their jeans purchase, at $50 a pair they were becoming a tough sell. Levi’s responded by recognizing a need to be in closer touch with their customers. They began to open stores to sell directly to their customers (rather then trough another retailer). They also implemented new technology such as EDI to help their supply chain. Unfortunately the lag time for their products was still 8 months.
Levi’s was a company that needed a way to strengthen their business. Using the value chain analysis Levi’s was a prime textbook case of a company that needed to improve its value chain in order to sustain a competitive advantage. The results of their value chain analysis are as follows:
1. Value: only 24% satisfaction rate.
2. Value stream: ROE average more then 38% lead to little improvement in their cumbersome value chain.
3. Continuous flow: 8 month lag time.
4. Pull: The customer initiated nothing, activity was driven by sales forecasts.
5. Perfection: A good ROE led management to miss opportunities in improvement.
In addition, use a pull driven distribution strategy Levi’s lost big profits when retailers had to markdown their products in order to make them more appealing. Levi’s often made good on these markdowns to their retailers. Although the opening of Original Levi’s stores helped eliminate some of these losses, it was clear Levi’s need a “better fit” with their customer.
In 1994 they were approached by Custom Clothing Technology Corp. (CCTC) with a business proposal. Specializing in client/server applications linking point-of-sale, customer-fitting programs directly with single-ply cutting programs in apparel factories, CCTC suggested a joint venture to introduce woman’s “Personal Pair” kiosks in the Original Levi’s stores. These kiosks, using a customer pull ideal, would begin the process of ordering a custom fit pair of jeans in an eight step process:
1. The Personal Pair kiosk would be a separate booth in the retail store, staffed by trained sales clerks equipped with touch-screen PCs.
2. A sales clerk would take three measurements from each customer (i.e., waist, hips and rise) and record them on the touch screen. Working from these three measurements, 4,224 combinations would be possible.
3. The computer would then flash a code corresponding to one of 400 prototype pairs that are stocked at the kiosk, and the sales clerk would retrieve the prototype pair for the customer to try on.
4. With one or two tries, the customer would be wearing the best available prototype. Then the sales clerk would take the final exact measurements for the customer (out of the 4,224 possible combinations) and note the length required (i.e., inseam).
5. The sales clerk would enter four final measurements on the touch screen and record the order. Initially, the system would be available for only the Levi’s 512 style; however, five color choices would be offered in both tapered and boot-cut legs.
6. The customer would pay for the jeans and choose either Federal Express delivery (addition $5 charge) or store pickup. A maximum three week delivery would be promised.
7. Each customer order would be transmitted by modem from the kiosk to CCTC, where it would be logged in and transmitted daily to Tennessee (Where each pair is cut, hand sewn, inspected, and packed for shipment.) Each pair would include a sewn-in bar code unique to the customer for easy reordering at the kiosk-store that stored the bar code.
8. A money-back, full-satisfaction guarantee would be provide with every order.
Levi’s cautiously accepted CCTC’s proposal, choosing to enter a test phase before proceeding with a full scale project. This was a radical new way to retail apparel and given that this model did not have an established record in retail merchandising Levi’s was cautious. Levi’s initially price each Personal Pair at a rate of $15 more than an off-the-shelf product. The program was still popular almost immediately despite the increased price. As a result of the Personal Pair concept implementation Levi’s experiences the following positive effects:
· For the styles affected unit sales were up 49%.
· Distribution costs and distribution investment per pair were virtually eliminated.
· Nonmaterial manufacturing and distribution costs were cut by 47%.
· The price increase of the Personal Pair coupled with the cost reduction resulted in a 467% increase in pretax profit (i.e., from $6 to $34 per pair).
· Asset investment was remarkably reduced: inventory of $12 per pair of woman’s jeans sold (reflected an 8-month pipeline) was reduced to $1 reflecting only raw materials requirements.
· Accounts receivable were negative since all pairs were prepaid.
· The kiosk yielded a greater than tenfold increase in profitability.
· By 1997 the program was responsible for 25% of the sales of the 30 U.S. company-owned stores.
Levi’s Strauss can attribute all of these gains to CCTC’s approach to improving their value chain. The fundamental ideal in this approach is customer satisfaction. By creating a system driven by customer demand and specific to the exact needs of their customers CCTC sold Levi’s a way of doing business that ultimately made their business leaner and more focused on fulfilling their customer’s needs. Without the help of and outside value-chain-analysis and improvement like CCTC (which was eventually acquired by Levi’s in 1995) Levi’s could have never grasped the scope of the opportunities they were missing.

Tuesday, September 27, 2005

Everyone Plays, Nobody Wins - HBR: 65-74

"The Earnings Game" refers to the desire companies have and the actions they take to meet their quarterly earnings predictions. The author uses the terms "earnings management" and "creative accounting" in describing how companies play the game. The players in the game include companies, their accountants, analysts, and Wall Street.
The idea of the game is for the companies to meet the analysts’ earnings per share predictions. Even a penny more or a penny less can lead to disaster. The reason this goal is referred to as a "game" is because it is not always attained in a manner as straightforward as one might think.
There is no actual beginning or end to the game. It is more of a continuous circle. One part in the circle is the analysts predictions of earnings for the next quarter. These predictions can be easily influenced. Companies can influence analysts by keeping them supplied with company data, to ensure that the analysts’ main source of information comes from the company itself. A second way to influence the analysts is for an executive to speak with them in an indirect manner. The regulations prevent analysts from specifically speaking of a forecast, but nothing stops them from giving hints. An executive could ask what kind of forecasts the analyst’s rivals are making. The analyst’s reply might be that he’s seen forecasts as high as 27 cents a share. Then the executive could say that 27 cents seems high and the analyst might ask if 24 cents seems like a better number. These numbers can go back and forth until it’s clear that 25 cents is the number the company expects.
The next part of the game is related to what number the company actually earns as apposed to the number the company reports. Most companies want to earn exactly what the analysts predicted. In order to attain the exact prediction, regulations are sometimes stretched and actual numbers are distorted. Large public accounting firms will sometimes stretch the regulations to keep a good relationship with a client.
One way to distort current earnings is referred to as "channel stuffing" - to borrow from future sales to increase current results. Sunbeam, referred to in the article as the champion of channel stuffing, sold millions of grills (to customers like Sears and Wal-Mart), stored the grills in warehouses, and deferred payments until spring. This was done to boost sales in the winter months. One problem with this, from the earnings management perspective, is that sales must improve in later months to cover loans. Sunbeam’s sales never grew enough to cover their loans and they eventually had to restate several quarter’s of revenue and earnings. The CEO, "Chainsaw Dunlap", lost his job and reputation in the process.
A second way to pad current earnings is premature revenue recognition. This, as it states in the article, "involves recording a highly contingent transaction as a firm sale". An example given was when MicroStrategy recorded not only the actual sale of software, but also future revenue that it "expected" to collect from software upgrades. MicroStrategy was eventually forced to admit it had overstated sales.
A third way to enhance current earnings at the expense of future earnings involves creating innovative organization structures. Boston Chicken's exotic structure is used as an example. Boston Chicken's hundreds of restaurants were owned by independent (in name only) regional franchisees who borrowed the funds needed to start the businesses from Boston Chicken. The company recovered most of these funds in fees, royalties an interest that created a very favorable profit trend for Boston Chicken as more stores were opened. Eventually the system collapsed, the company filed for bankruptcy protection and McDonald's purchased it "on the cheap" according to the author.
Another part of the "game" is the reaction on Wall Street. If a company reports a penny less or a penny more than predicted, there could be a large market reaction. The reason for this is because Wall Street understands what goes on in the "earnings game." As one stockbroker quoted in the article stated, "Things must be pretty bad if Cisco can’t manage to come up with one lousy penny". The attitude by companies is that, "if they’re going to miss by an inch, they might as well miss by a mile". If a company realizes that it is going to miss the prediction, it may use it as an opportunity to write off bad debts or to sell unwanted assets for a loss. This gives the company a reason for missing the prediction. It also makes it easier for the company to look good in following quarters.
Investors are a very important part of the game and an industry has developed to provide the so-called consensus earnings per share estimate. One website provides a whisper number developed from searching electronic chat rooms and message boards.
Overall, the earnings game does more harm than good (e.g., distorts decisions, causes a guessing contest, compromises the integrity of corporate audits and undermines the capital market). The problem is that the quarterly earnings report is of no actual use in predicting the future cash flow and performance of a company and these two items determine the basis for the value the company's stock. With the penny pinching and regulation stretching that goes on, the actual numbers become even more useless. If nothing changes, investors may eventually lose faith in all the numbers affected by the quarterly earnings reports, including stock prices. If this occurs, the capital markets will not be able to survive.
Unfortunately, the only way to completely end the game is for companies themselves to abandon it. Until then, the "Earnings Game" will continue to be a part of our live

Benchmarking

Benchmarking is a tool used by companies to identify areas of an operation which may need attention or correction. Benchmarking is done by comparing a companies own financial and operational information against that of a similar company or comparing internal operations of different departments within their own company. The idea is, if the numbers are off between the comparisons, then the company will be able to compare the differences in an effort to identify those factors that contribute to the discrepancies.
There are about four steps involved in benchmarking. First is to analyze your own company and gather the information you hope to benchmark. Second is the selection of the benchmark or benchmarks that you will be comparing your company or department against. Selection of the correct benchmarks is crucial due to the idea that an incorrect selection can result in inappropriate procedures or unrealistic comparisons. Step three is the collection of information on the benchmark that you decided on. The final step is the analysis of the data collected for both your own company or department and the data collected on the benchmark. This is where you will set your goals and determine policies and procedures which you hope to implement. It is important here that you do not set goals that are too high or too many goals so that they are unmanageable.
Where to Compare
When determining your benchmark, you can choose to go either internal or external in your search for comparison. Internal comparisons are often the easiest way to benchmark. You will need to decide which departments are performing the best, analyze their strategies, and then implement suggestions that you think would best assist the other units in the company in meeting those benchmarks. Internal comparison does lead to drawbacks. Complacency is a large drawback, where you are working toward benchmarks that may be far less than others in the industry because even your best departments are performing below industry standards.
The other source for benchmarking is external companies. Often external benchmarking is against the top competitors in the industry. This choice has major complications however. The most difficult of which is the collection of information on the benchmark or benchmarks.
Another form of benchmarking is to compare your company against the best in class. These are the top performing companies that share comparable functions or philosophies. A benefit of this approach is that it can often lead to policies and procedures that had not previously been seen in your own industry. This can often be a drawback as well though. Careful consideration must be given, due to the fact that practices that are successful in one industry do not always carry over to new industries with the same level of success.
Where to Get the Information
When gathering data for comparison on your chosen benchmark, it is often difficult to find reliable and complete information for external companies. You may start at University libraries to see if the information you need is currently available. Also look for information clearing houses, companies that are in the business of collecting and selling information such as that needed for benchmarking. Other sources listed included consulting firms, industry or professional organizations, state or national government agencies, or industry specific publications.
Using the Benchmark Information
There are usually three phases to optimize benchmark results. The first phase is the identification of the issues. This is where you identify and summarize the issues that you hope to correct from you benchmark results. The second phase is the strategic planning phase. Here you should summarize your goals and objectives that you deem necessary to place you company in the competitive position you are working towards. This is also the phase where service companies should work to write their mission statement. The final phase is the tactical planning phase. This is where you break down the strategic planning into manageable pieces for follow up actions and delegate the responsibility to key individuals. Throughout the complete analysis you should continue to compare your results and practices to those of your benchmark.

A Fresh Look on Corporate Planning

“One size does not fit all.” This describes the limitations of external benchmarking. The article, Tailored, Not Benchmarked: A Fresh Look at Corporate Planning, describes the potential results of benchmarking and three companies’ corporate planning strategies. Generalized planning and standard benchmarking commonly employed by many corporations typically fail to add the desired value to a firm. Andrew Campbell noted that benchmarking would most likely negatively impact a company by mismatching it’s own internal environment to another company’s incompatible planning methods. Consequently, companies should look internally to understand what value they wish to add and whether their current planning processes are designed to achieve their goals.

Campbell described the corporate planning process as a series of interactions between the business units and the corporate center where planning originates at the corporate center and comes to fruition by corporate working closely with the business units. A good planning process would carefully tailor processes to the needs of the business and skills, insights and experiences of corporate management. In essence, only unique planning processes can create success for the company.

One South African conglomerate, mentioned in the article, experienced poor results due to benchmarking. The company subsequently replaced management, decentralized operations and abandoned benchmarking processes altogether. They had attempted to model themselves after the “best-in-class” models, only to find that the model did not correspond to the company’s goals.

Campbell mentioned that Granada, Dow Chemicals and Emerson Electric each use distinctly different methods of corporate planning and find success for their individualized goals. They focus on internal strengths and exploit them for corporate benefits rather than gathering information from the external environment through benchmarking.

Granada, a hotel and entertainment conglomerate, strives to increase profits. The CEO, Charles Allen, constantly pushes his employees to achieve better than average returns. Consequently, performance is measured by profits. Allen encourages people through a laid-back sell approach and setting “unreasonable” goals.

Dow Chemicals, a plastics and chemicals company, strives to reduce costs within the operational units. The main performance measure is economic profit, which incorporates the cost of capital. The main planning technique is bottom-of-the-cycle planning, which exploits the cyclical nature of the chemicals industry. Managers must understand that the decisions for building new capacity, entering new markets and reacting to price changes may adversely affect the company in a downturn in the cycle. Therefore, managers are encouraged to improve processing costs, i.e. maintenance, to meet return-on-assets targets during the bottom of the volatile chemical industry cycle.

Emerson Electric focuses on incremental profit improvements. The CEO, Chuck Knight, has a hard-edged approach to motivate managers. He becomes somewhat confrontational, playing the devil’s advocate, during planning sessions. His managers generally develop a plan based on the confrontations with Knight. However, Knight generally develops the main thrust of the plans. As Campbell noted in the article, “Knight’s ability to argue with his subordinates without undermining their authority is key to getting them to change their plans.” Knight provides a somewhat unorthodox, yet effective method to corporate planning.

Granada, Dow and Emerson all use uniquely tailored methods to corporate planning. Consequently, these companies have experienced operational success and increased firm value. However, the planning process also needs to be evaluated for its effectiveness during planning review. The plan should have a clearly defined purpose. It should also be evaluated by how it effects managerial decisions. The main goal of corporate planning is to add value. Since value is specific to each company, external benchmarking may prove ineffective or even disastrous. Campbell noted that companies should “focus on the bird in hand rather than the birds in the bush.”