impact of strategic planning on profit performance

8/12/2019 Impact of Strategic Planning on Profit Performance

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IMPACT OF STRATEGIC PLANNING ON PROFIT PERFORMANCE

Study of 57 corporations, with 620 diverse businesses, establishes relationship between strategic planning and profit performance

Sidney Schoeffler, Robert D. Buzzell, and Donald F. Heany

One of the most significant research projects undertaen by the !areting Science "nstitute is the ongoing profit impact of maretstrategies #$"!S% study& 'he basic idea behind $"!S is to provide corporate top management, divisional management, maretinge(ecutives, and corporate planners with insights and information on e(pected profit performance of different inds of businessesunder different competitive conditions& )mong the *7 factors investigated and analy+ed are maret share, total maretinge(penditures, product uality, -./ e(penditures, investment intensity, and so on& 'hese factors account for more than o1 of thevariation in profit in the more than 600 business units analy+ed& "n this article, the authors describe the highlights of their researchfindings&!r& Schoeffler, director of applications for the $"!S project, is a senior visiting research fellow at arvard 3usiness School4 !r&3u++ell, $"!S research director, is professor of business administration and chairman of mareting at 3S4 !r& eany, managerreports and liaison for the $"!S program, is a visiting research fellowat 3S&

What rate of return on investment (RO! is "normal" ina #iven ty$e of business, under #iven mar%et andindustry conditions& What factors e'$lain differences inty$ical levels of RO amon# various %inds ofbusinesses&

Ho ill RO in a s$ecific business be affected by achan#e in the strate#y em$loyed& By a chan#e incom$etitive activity&

)any cor$orate $residents and $lannin# directors ishthey had more reliable ansers to these %inds of*uestions, for they are at the heart of strate#ic $lannin#in the modern cor$oration. +onsider some of the ays

in hich these *uestions arise

Forecasting profits n a diversified com$any, the usual$ractice is for business $lans to be $re$ared by each$roduct division or other o$eratin# unit. -hese $lans arethen revieed by cor$orate e'ecutives, often ith theassistance of cor$orate staff s$ecialists. mon# the %eyelements of each unit/s $lan are, of course, estimates ofinvestment re*uirements and $rofits for future $eriods.

Often these forecasts are sim$ly $ro0ections of locale'$erience. But hen mar%et conditions are e'$ected tochan#e, or hen a chan#e in strate#y is contem$lated,

ho reliable is the $ast as a #uide to the future&

)uthors note 8e wish to acnowledge the contributions to thisarticle of Our associates on the $"!S $roject 'eam& -alphSultan, who is now chief economist, -oyal 3an o 9anada,served at project director of $hase " of $"!S during :;7s andwas responsible for much of the basic design of the study&3radley


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Allocating resources: ma0or $ur$ose of reviein#divisional $lans at the cor$orate level is to ma%eeffective allocations of ca$ital, man$oer, and otherscarce resources amon# divisions. Often the ca$itala$$ro$riation re*uests of the divisions add u$ to morethan head*uarters can $rovide.

-he $roblem, then, is one of em$hasis Which $roductsand mar%ets $romise the #reatest returns& Here,es$ecially, the $rofit estimates su$$lied by divisionalmana#ers are li%ely to be of doubtful reliability, sinceeach division is in the $osition of $leadin# its on case.

Measuring management performance +losely related tothe $roblem of forecastin# $rofits is the need to evaluateactual $rofit results. Su$$ose Division earns 123 onits investment ($reta'!, hile Division B achieves anRO of only /43. s /s mana#ement tice as effectiveas B/s, and should it be rearded accordin#ly&

5'ecutives of Division B ould no doubt ob0ect to this.-hey ould attribute differences in RO to differencesin conditions such as mar%et #roth rate and stren#th ofcom$etition. 6erha$s they are ri#ht. What cor$oratemana#ement ould li%e, in this situation, is some ayof determinin# hat level of RO is reasonable or"normal" for different o$eratin# units under #ivencircumstances.

Appraising new business proposals: Still anothercommon $roblem in strate#ic $lannin# is that ofestimatin# RO in a $ros$ective ne business hich isbein# considered for either internal develo$ment or

ac*uisition. When the business is ne to the com$any,actual e'$erience, by definition, cannot be consulted.5ven hen entry is $ro$osed via ac*uisition, the current$erformance of the e'istin# business may be of doubtfulreliability as a #uide to its future.-he common thread runnin# throu#h the four ty$es ofstrate#ic $lannin# situations 0ust described is the needfor some means of estimatin# return on investment in a#iven business, under #iven industry and mar%etconditions, folloin# a #iven strate#y. 5verye'$erienced business e'ecutive and cor$orate $lanner%nos that RO varies enormously from one business toanother and from year to year in an individual division

or $roduct line. Ho can these variations be e'$lainedand $redicted&

Some ansers to these *uestions are be#innin# toemer#e from a uni*ue research $ro0ect called 6)S 7astudy of actual e'$eriences of hundreds of businesseshich is aimed at measurin# the $rofit im$act of mar%etstrate#ies. Buildin# on or% that has been under ay atthe 8eneral 5lectric +om$any for more than 92 years(see accom$anyin# ruled insert!, the 6)S $ro0ect is a

sharin# of e'$erience amon# 4: ma0or ;orth mericancor$orations.

6)S as or#anized in early 9 cor$orations su$$liedinformation on some 142 businesses. -he informationincluded descri$tions of industry and mar%etcharacteristics, as ell as selected o$eratin# results andbalance sheet fi#ures for the years 9


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billion& ow could corporate officers lie himself stay in touchwith so many diverse businesses, ranging all the way fromturbine generators to toastersD

)fter months of e(ploration, !c@itteric became convinced thatthe best way to address the uestion was to do some basic

pioneering wor on the apparent causes of s ownsuccesses and failures& 3orch agreed and authori+ed a major

research project to probe for Alaws of the maret place&A $roject$-O! #profitability optimi+ation model% was organi+ed underthe direction of coauthor Sidney Schoeffler&

)fter five years of intensive research and testing, $roject$-O! produced a computerbased model that captured themajor factors which e(plain a great deal of the variability inreturn on investment Since this model reflects data from diversemarets and industries, it is often referred to as a AcrosssectionalA modelas contrasted to a timeseries model based ondata over a series of years for a single business&

8ith the help of this model, could estimate the AaverageAlevel of profit or investment or cash flow that went with variouscombinations of the success determinants& 'he model did notand could not predict the ApreciseA -O" of any one of sbusinesses in a given year&

8hen 3orch became s chief e(ecutive officer in :;6C, hefound the $-O! model to be #a% a tool for detecting highrisstrategic moves, #b% a rich source of uestions for the review ofstrategies proposed by divisional managers, and #c% a means ofcomputing the differential between the entire companysfinancial goals and the e(pected aggregate earnings of itscomponents& #"f the model predicted a shortfall, it could then beused to display the future implications of Abelt tightening,Acomponent by component%

"n addition to maing e(tensive use of the model himself, 3orchalso encouraged his group e(ecutives and division managers touse it e supported followon research to improve the coverageand predictive powers of the early models&

'oday, crosssectional models are standard elements of scorporate planning system&

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-he $rimary $ur$ose of 6hase as to establish thefeasibility of obtainin# reasonably com$arable datafrom a lar#e number of diverse com$anies. lthou#hdifferences in accountin# systems and terminolo#y did$ose $roblems, the $ro0ect as successful $rofit resultsere e'$lained and $redicted ith considerableaccuracy. )oreover, the $rinci$al results of 85/s earlieror% ere confirmed. By and lar#e, the same factorsthat influenced RO in 85 businesses also shoed u$ inthe analysis of $rofitability amon# the 1> diversecor$orations.

-hus, in late 9=2 businesses inthe 6)S data base.


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-his $rofit level e*uation includes more than >2 termscom$osed of various combinations of 1: basic factors.s mi#ht be e'$ected, $rofitability is related to manydifferent factors. Some of the most im$ortant ones arelisted and defined in 5'hibit .

-he 6)S $rofit level e*uation and a se$arate e*uationhich $redicts chan#es in RO have been used toconstruct se$arate re$orts for each business in the data$ool. -hese re$orts "dia#nose" the factors influencin#RO in a business, #iven all of its s$ecific characteristicssuch as its mar%et, com$etitive $osition, ca$italintensity, and so on.

Because every business is, in some res$ects, uni*ue,these dia#nostic re$orts vary enormously. But bycom$arin# businesses that are similar in terms of one ormore basic $rofit7influencin# factors ith businessesthat have different characteristics, e can identify some#eneral $atterns or relationshi$s.

For e'am$le, e can determine an avera#e relationshi$beteen mar%et share and $rofitability by com$arin#avera#e levels of RO for #rou$s of businesses ithdifferent mar%et shares. -his is the a$$roach e haveused in subse*uent sections of this article.

Profit determinants

s e mentioned a moment a#o, our $rofit modelincludes 1: distinct factors hich, in variouscombinations, are si#nificantly related to $rofitability.

Hoever, e shall limit our discussion to 0ust 1 ma0ordeterminants of return on investment revealed by ouranalysis of the 6)S data base7namely, mar%et share,investment intensity, and com$any factors.

MARKETSHARE

Our analyses #ive stron# su$$ort to the $ro$osition thatmar%et share is indeed a ma0or influence on$rofitability. s shon in 5'hibit , RO #oes u$steadily as mar%et share increases. On the avera#e,businesses ith mar%et shares above 1>3 earned morethan three times as much, relative to investment, asbusinesses ith less than :3 share of their res$ective

mar%ets. (5ach of the five mar%et share cate#oriesshon in this e'hibit re$resents a$$ro'imately one fifthof the sam$le.!

-he relationshi$ beteen mar%et share and $rofitabilityhas been idely discussed since the ince$tion of 6ro0ect6RO) at 8eneral 5lectric, hen the idea as relativelynovel. But ho and hy mar%et share affects$rofitability is not fully understood as yet.

Our findin#s su##est that businesses ith relativelylar#e mar%et shares tend to have above7avera#e rates ofinvestment turnover, $articularly or%in# ca$ital. lso,the ratio of mar%etin# e'$ense to sales is #enerallyCoer for hi#h7share businesses than for those ithsmall mar%et shares. -hese differences are indicationsof economies of scale that may #o alon# ith stron#mar%et $ositions.

Hoever, much remains to be done, both in e'$lorin#the connection beteen mar%et share and RO and indeterminin# ho the relationshi$ varies for differentty$es of businesses or for different mar%et conditions.

Whatever the reasons, the data in 5'hibit 999 clearlysho that it is very $rofitable to have a hi#h share ofmar%et. Beyond this, the 6)S $rofit model sheds someli#ht on ho mar%et share and other factors or%to#ether to influence RO.

5'hibit Relationshi$ of mar%et share to $rofitability


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-(er 26" 195 219 2!;

-he best of all $ossible orlds is to have both hi#hmar%et share and su$erior *uality businesses in thiscate#ory avera#ed =A.13 return on investment. Buteven hen *uality as relatively inferior, avera#e RO

for hi#h7share businesses as a res$ectable /3 Over =2 3

nferior *uality :3 113 =23vera#e *uality 12 1> 12Su$erior *uality =1 19 42

;umber of businesses 9>< 9:> 9:>

5'hibit m$act of e'$enditures on $roduct *uality and mar%etshare

A

Hi#h mar%etin# e'$enditures dama#e $rofitability hen*uality is lo

6roduct*uality

Ratio of mar%etin# e'$enditures to sales

Co vera#e Hi#hEnder >3 >37993 Over 993

nferior 94.3 9.A3 =.:3vera#e 9:.A 9>.< 9.=Su$erior =4.= =4.4 93 ==.1 =1.9 =>.1

While it is not sur$risin# that both mar%et share andrelative *uality influence RO, in the short term theremay be relatively little that mana#ement can do tochan#e these factors. re some strate#ies more

$rofitable than others, #iven the basic com$etitive$osition of a business& nalysis of the results achievedby the businesses in the 6)S sam$le su##ests thatsome #uidelines can, indeed, be formulated forbusinesses in different $ositions.

+onsider, for e'am$le, the data in 6art of 5'hibit .Here, as in 5'hibit , the sam$le has been divided intothree rou#hly e*ual #rou$s, this time in terms of (a!relative *uality, and (b! the ratio of mar%etin#e'$enditures to sales.

When *uality is relatively lo 7 e'actly e*uivalent tocom$etition or somehat inferior7there is a stron#ne#ative relationshi$ beteen mar%etin# e'$endituresand RO. n effect, these fi#ures confirm the old ada#ethat "it doesn/t $ay to $romote a $oor $roduct."

RO is somehat diminished by a hi#h level ofmar%etin# e'$enditure for businesses ith "avera#e" or

"su$erior" relative $roduct *uality7but not nearly to thesame e'tent as for com$etitors ith loer7*uality$roducts. -his mi#ht su##est, further, that sellers ofhi#her7*uality $roducts or services could inflict severeshort7term $enalties on ea%er com$etitors byescalatin# the level of mar%etin# costs in an industry7and that loer7*uality $roducers should avoid suchconfrontations li%e the $la#ue.

nother due to ho $rofit influences vary, de$endin#on com$etitive $osition, is #iven in 6art B of 5'hibit .-his shos, for businesses in the same mar%et sharecate#ories as in 5'hibit , the relationshi$ of RO to

RD s$endin# levels. When mar%et share is hi#h,avera#e RO is hi#hest hen RD s$endin# is alsohi#h7above 13 of sales.

-hese fi#ures do not, of course, sho hich is causeand hich is effectG $ossibly businesses that are hi#hly$rofitable7for hatever reason7are inclined to investmore of their earnin#s in research. )ost li%ely, the$ositive relationshi$ beteen RO and RD s$endin#reflects both this %ind of "reverse causation" and a$ositive im$act, in the other direction, of RD on$rofits.

When mar%et share is lo, the relationshi$ beteenRD and $rofitability is e'actly the reverse of thate'$erienced by those ith stron# $ositions. -he hi#herthe level of RD s$endin#, the loer $rofits ere, onthe avera#e. Here, there a$$ears to be little doubt aboutcause and effect lo $rofits ould be very unli%ely tolead to hi#h RD s$endin#.

We should em$hasize, hoever, that these datare$resent short7term effects. Since the 6)S

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$artici$ants su$$lied information only for a three7year$eriod, it may ell be that 6art B of 5'hibit reflects a"transitional" cost of innovation. Some su$$ort can be#iven for this inter$retation amon# businesses ith lomar%et shares, RO as hi#her (99.>3! hen ne$roducts com$rised a relatively hi#h $ro$ortion of totalsales than hen ne $roducts re$resented only a smallfraction of sales (avera#e RO, 4.13!.

-hus, hen and if RD s$endin# is successfullyconverted into ne $roducts, it can $ay off. But themost $rofitable course of all, for businesses ith ea%mar%et $ositions, may be to see% ne $roducts ithoutinvestin# in research and develo$ment 7via imitation,for instance.9

INVESTMENTINTENSITY

$art from mar%et share and $roduct *uality, the mostim$ortant determinant of return on investment that asrevealed by our analysis of the 6)S data $ool is

investment intensity, hich is sim$ly the ratio of totalinvestment to sales.

5'hibit shos the overall relationshi$ beteen ROand investment intensity the hi#her the ratio ofinvestment to sales, the loer RO tends to be.$$arently businesses ith hi#h investment intensitiesare not able to achieve $rofit mar#ins sufficient to offsetthe #reater amounts of investment they re*uire tosustain a #iven volume of sales. We sus$ect that a $rimereason for this may be the heavy em$hasis $laced onachievin# hi#h volume, and thus hi#h ca$acityutilization, in investment7intensive industries.

Since both mar%et share and investment intensity arema0or determinants of $rofitability, it is not sur$risin#that the combination of the to factors accounts for asubstantial $ortion of total variation in RO. s shonin 5'hibit , avera#e RO for businesses that en0oyedboth a hi#h mar%et share and a lo de#ree of investmentintensity as 1.>3 7 more than 9: times the avera#ereturn earned by the unfortunate businesses ith hi#hinvestment intensity and small mar%et share.

n most cases, the basic level of investment intensityre*uired for a #iven business is $robably not sub0ect to

much control by mana#ement. -he amount of ca$italre*uired to su$$ort a s$ecified amount of sales isdetermined $rimarily by the technolo#y of the businessand by traditional terms of trade.

9 For further thou#hts on this to$ic, see -heodore Cevitt,"nnovative mitation," HBR Se$tember7October 9>,

$. >1.

Hoever, very often mana#ement does have somechoices that affect investment intensity7such as thede#ree of mechanization or com$uter utilization. Ourdata indicate that these ty$es of investments should becarefully controlled if mar%et $osition is ea%. Beyondthis, hat can mana#ers do about investment intensity&s a business that re*uires a hi#h investmentsales ratiosim$ly doomed to e'ist ith lo rates of return&

+om$arison of various #rou$s of businesses ithin theinvestment7intensive cate#ory shos that somestrate#ies are li%ely to be more $rofitable than others.+onsider, for e'am$le, the data in 5'hibit . mon#businesses in the hi#hest investmentsales #rou$, ROas stron#ly7and ne#atively7related to the level ofmar%etin# e'$enditures. For businesses ith loinvestment intensity, the relationshi$ of RO tomar%etin# e'$enditures as *uite different avera#e$rofitability as actually hi#her hen mar%etin#e'$enditures ere "moderate" in relation to sales than

hen they ere lo.

5'hibit Relationshi$ of investment intensity to $rofitability

3 >37993 Over 993

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Ender 43 = 91.= 9A.1Over :93 92.< 92.9 1.

impact of strategic planning on profit performance

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