4a.2 making strategic decisions

1 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c

MAKING STRATEGIC DECISIONS OVERVIEW

1. DECISION MAKING MODEL

a. Use of Ansoff Matrix to communicate intended strategic direction. i. How the Ansoff Matrix can be used to show strategic direction of the business; e.g. if they're

expanding into new markets, this would be seen as Market development, which is more risky than Market Penetration.

2. DECISION MAKING TECHNIQUES

a. Investment Appraisal i. Simple Payback

ii. Average Rate of return iii. Discounted Cash-Flow (Net Present Value only)

b. Decision Trees i. Construction and interpretation of simple decision tree diagrams,

limitations of technique. c. Project planning and Network Analysis

i. Nature and purpose of Critical Path Analysis ii. Be able to draw simple networks

iii. Calculate Earliest Start Time and Latest Finish Time iv. Identify the critical path and calculate the total float v. Limitations of technique

d. Contribution and special order decisions, determining whether a special order is worth the effort.

3. CONTRIBUTION WITH RESPECT TO SPECIAL ORDER DECISIONS

a. Need for contingency planning b. Consideration of risk of operating in a country or seeking growth in

new overseas markets i. Use the Ansoff Matrix to consider why a company may

seek to invest in a factory overseas, for example to reduce dependence on domestic market through planning for growth.

c. Risk reduction through information from decision-making models


Figure 1 - Lay's XL Classic potato chips↑

DECISION MAKING MODEL

THE ANSOFF MATRIX

• The Ansoff Matrix is essentially a tool developed to help people chose what strategy they should use in order to successfully develop their product. Essentially, these are for growth through the development of marketing strategies new products and markets.

THE DIFFERENT MARKETING STRATEGIES FOR GROWTH

MARKET PENETRATION

• Concentrating on gaining greater growth in existing markets • This has the involved as the businesses has developed the product and knows the market least risk • Can be achieved through:

o Increasing brand-loyalty of consumers so that they use alternatives less o Encourage consumers to increase usage; instead of selling a pack of chips in a medium sized pack,

chips makers make large sizes available e.g. Lay’s Extra Large

MARKET DEVELOPMENT

• Finding new markets for existing products• This is expensive as there needs to be investment into market research. However,

there are considerable risks in understanding consumer behaviour as it is constantly changing.

• Can be achieved through: o Repositioning the product to target a different market segment o Moving into new markets, e.g. India, China etc.

Market Penetration

Product Development

Market Development Diversification

PRODUCTS

EXISTING NEW M

ARK

ETS

EXIS

TIN

G N

EW

INCREASING RISK

INCREASIN

G RISK

Figure 2 - With saturated markets in the west Vodafone developed markets in Africa and South Asia. Nokia simply added torchlight to its previous model to help its phone-users in South Asia cope with power outages.

3 | Q u a z i N a f i u l I s l a m – w w w . s t u d e n t t e c h . c o . c c PRODUCT DEVELOPMENT

• Launching new products into existing markets • One in five products succeed, even with heavy investment into R&D as well

as aggressive marketing o Even the best companies such as Sony (Sony Egg), L’Oreal, Walls,

Cadbury (Cadbury Aztecs) and Microsoft (Zune, Windows Vista) • Can be achieved through:

o Changing existing products Shampoos offering new and improved formulas Cars adding features to older models and releasing them

as new yearly models every year o Developing new products from scratch

DIVERSIFICATION

• When a business tries to market new products in absolutely new markets; making it a conglomerate

• This has the greatest risks involved in doing this, but successful . diversification has great rewards

• It gives the business greater stability as a recession in one market can be buffered by another.

• It gives businesses more room to make riskier decisions – which will ultimately reap greater rewards.

Figure 3 - Shampoo Companies always claim that their 'new and improved' formulas are really new and improved. But personally, no commercial shampoo has worked for me, only medicated shampoo.

Figure 5 - Nintendo was originally a card game making company and Nokia made tires. Successful diversification led Nokia to become the world's largest mobile manufacturers and Nintendo to become a successful console manufacturer.

Figure 4 - The successful development of the iPod propelled Apple into the music industry.


DECISION MAKING TECHNIQUES

INVESTMENT APPRAISAL

Investment appraisal is the evaluation of an investment project to determine whether or not it is likely to be worthwhile.

BUSINESS STUDIES 4TH EDITION, DAVE HALL

• Investment appraisal has a set of tools that we use in order to assess the return of an investment made by the company.

SIMPLE PAYBACK

• The payback period is essentially the time taken for a firm to cover its costs. Basically, if you invested $30,000 into a business, how long would it take the business to generator $30,000?

• Say, you have to invest $30,000 into capital and this capital is estimated to generate $10,500 a year and would take $3,500 to maintain. Calculate the pay-back period.

• Calculating payback: • As you can see,

that there is no clear year that the payment is made up. So, we are going to have to calculate it in months.

• We can see that up till the 4th year, there was still a cumulative cash-flow of $2,000.

• In the 5th year, $10,500 was generated. So we need to calculate how much was generated per month, $10,50012

= $875

• Therefore, we now need to calculate the number of months that it would take $2,000 to be generated,

$2,000$875

= 227

𝑚𝑜𝑛𝑡ℎ𝑠

• Therefore, the pay-back period is 4 years and 3 months. • Often directors will set a pay-back period for the managers to suggest a suitable investment, such as being less than 20

months. This is referred to the criterion level.

Advantages Limitations Easy to calculate and understand Ignores what happens after payback period. Essentially, there is more effort being put into calculating finances over a comparatively shorter period of time. So, it is likely to be more accurate.

The method ignores the profitability of the project, since the criterion used is the speed of repayment.

Takes into account timing of cash-flows. So the discounted cash-flow can be calculated to gain its NPV.

May encourage short-termism.

Businesses with weak cash-flows will be able to seek out quick payback investments.

It is of limited use on its own (because it does not pay attention to profits) and is therefore used together with the Average Rate of Return as well as the Net Present Value

This is useful for sectors with rapidly changing technology e.g. the electronics industry. New consumer electronics can be designed and introduced regularly. It is important to cover the cost of the investment before the new good is designed.

Year Cash In Cash Out Net Cash Flow Cumulative Cash FlowNOW -$ (30,000)$ (30,000)$ (30,000)$ YEAR 1 10,500$ (3,500)$ 7,000$ (23,000)$ YEAR 2 10,500$ (3,500)$ 7,000$ (16,000)$ YEAR 3 10,500$ (3,500)$ 7,000$ (9,000)$ YEAR 4 10,500$ (3,500)$ 7,000$ (2,000)$ YEAR 5 10,500$ (3,500)$ 7,000$ 5,000$


AVERAGE RATE OF RETURNS

• This is the profit an investment will give over the period of its lifetime. • How to calculate:

STEP 1 – IDENTIFY PROFITS AND INITIAL INVESTMENT

• Say, an investment will give $20,000 in profit over its lifetime. • The firm invested a total of $25,000 to make this project happen.

STEP 2 – DIVIDE THE PROFIT BY THE PERIOD OF ITS LIFETIME (IN YEARS)

• Say, the period is 5 years.

𝐿𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑓𝑖𝑡𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

=$20,000

5

= $4000

STEP 3 – CALCULATE ANNUAL PROFIT AS A % OF THE INITIAL INVESTMENT

𝐴𝑅𝑅 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

× 100

$4,000$25,000

× 100 = 16%

• Usually, the exam will give you table from which you are going to have to interpret this from. • However, there is another term that we must familiarise ourselves with, and that is ‘Reward for Risk’ • Basically, the business is taking a risk in order to make a profit. However, it can simply put the money in the bank and

get the interest out of it. Say the interest is 6%. • So, the business can make 6% profit without even having to take any risks. • The Reward for risk is the 𝐴𝑅𝑅 − 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡. • So, in this case, the Reward for risk would be10%.

ADVANTAGES AND LIMITATIONS

Advantages Limitations

Shows the profitability clearly and allows comparisons with other modes of investment such as interest etc.

Not as accurate as payback as it makes assumptions over a large number of years

Uses all the cash flows over the project’s life - Payback only considers cash flow up until the payback month - it might be that the project generates larger cash flows after this period, but the method ignores these. ARR looks at all the cash flow projections and included these, so it is fairer to projects that might generate large incomes in later years e.g. those that might require a lot of training and getting used to new equipment.

Ignores the timing of cash flows

Focuses on profitability Ignores the opportunity cost of the money invested


DISCOUNTED CASH FLOWS – NET PRESENT VALUE

• $100 today will be worth a lot less in 3 years’ time. This is because of inflation that reduces the value of money and makes goods more expensive as well as the interest that banks provide that increase the value of money.

• The ARR and payback methods provide insight into profitability and cash flow. But, what we need to now is the opportunity cost of making an investment. What are we throwing away in order to make an investment?

• The higher the rate of interest and the longer the waiting time for the money to come in, the less money it is actually worth in today’s term.

• The predicted value of money in today’s terms is calculated from discount tables that will be given to you in the examination. Here is an example:

Rate of interest Years Ahead 4% 6% 8%

0 1.00 1.00 1.00 1 0.96 0.94 0.93 2 0.92 0.89 0.86 3 0.89 0.84 0.79 4 0.82 0.8 0.75

• So the value of $200 in 4 years’ time at 6% interest would be $200 × 0.6 = $160

CALCULATING NPV

• Say a company has two projects, Projects X and Y. Say the rate of interest is 8%. • Their cash-flows and Discounted cash flows are given below:

Project X Project Y

Year Cash Flow Discount factor

Discounted Cash Flow Cash Flow Discount

Factor Discounted Cash Flow

0 ($250,000) 1.00 ($250,000) ($250,000) 1.00 ($250,000) 1 +$50,000 0.93 $46,500 +$200,000 0.93 $186,000 2 +$100,000 0.86 $86,000 +$100,000 0.86 $86,000 3 +$200,000 0.79 $158,000 +$50,000 0.79 $39,500

𝑁𝑉𝑃 = $40,500 𝑁𝑉𝑃 = $61,500

• Despite the fact that both projects have the same initial cost, and they bring in the same quantity of money over their lives, there is a large difference in the NVP, as project Y generates more income at the beginning, whereas project X generates more income towards the end. As the discount factor increases over time, the actual value of the money generated by X is reduced. Also, the predictions are less accurate the further we predict thus there is great uncertainty as to whether project X can generate the NVP even if the value of money decreases as expected.



Takes the opportunity cost of the investment into account Complex to calculate and communicate

A single measure that takes the amount and timing of cash flows into account

The meaning of the results is often misunderstood

Can consider different scenarios

Only comparable between projects where the initial investments are the same The rate of discount used is critical, if the rate is not accurate, the business could make big mistakes


DECISION TREES

• Decision trees offer a visual representation of the company’s possible choices that it can make. • There are four parts to a decision tree:

o Decision points are the decisions the business has to make; represented by boxes. o Outcomes are the possible outcomes of taking a decision; represented by circles.

Obtained often from back-data. o Expected Values are the financial outcomes of a decision i.e. how much profit or loss a decision will make.

• However, there is a term called the Expected Value – no s at the end.

• Calculating the expected value of B: o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) + (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) +

(𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑃𝑜𝑜𝑟 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (0.3 × £50,000) + (0.3 × £30,000) + (0.4 × £10,000) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = £84,000

• Calculating the expected value of C: o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) + (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑃𝑜𝑜𝑟 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (0.5 × £40,000) + (0.5 × £10,000) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = £25,000



Construction of diagrams may highlight decisions that we not previously considered

Much of the data including probability is estimated.

Putting numeric values on these choices tends to improve results.

Decisions often have several aspects. Decision tress only focus on the quantitative aspect. Qualitative data is also important, e.g. the effect on the environment of one particular decision.

Force management to take into account the risks involved in making these decisions. This helps to separate the important risks from the unimportant risks.

There are time lags in decision making, by the time a decision is finally made, some of the numeric information may be out of date. The process is quite time consuming. However, computers have now made this a lot faster. Managers may manipulate the probability of a decision to suit their preferences, distorting the final results. Decision trees cannot take into account the dynamic nature of a business. Sudden changes in the economic climate might render a decision based on the decision tree obsolete.

Expected Value Decision Point

Outcome


PROJECT PLANNING AND NETWORK ANALYSIS

• In a production line, there needs to be proper organisation in order for the production to go on smoothly. • In order to do this the needs to be a plan for the process to operate smoothly. • This is done through a model called ‘Network Analysis’.

A network path diagram helps to identify the critical path, which shows the activities that require the most careful management scrutiny.

BUSINESS STUDIES FOR A LEVEL, 4TH EDITION – IAN MARCOUSÉ

• There are different parts to a network diagram. The lines represent an activity: which is essentially that is a part of the process that requires time and/or resources; waiting for supplies is an example of an activity.

• A node (represented by circles) is the start of or end of an activity. • This is what a Network diagram looks like:

INSTRUCTIONS FOR DRAWING NODES 1. The network must start and end with a single node 2. No lines in the network can cross 3. When drawing an activity, do not draw the end

node, as you cannot calculate where the whole process is going to end, this is not exactly a rule but rather a precaution.

4. There cannot be any line that is not an activity. 5. It is helpful to draw nodes with large circles and

short lines, to save space and also because you

need to put figures in those circles. 6. The start nodes all have an EST and an LFT of 0.

• The Critical path will have the following characteristics: o The EST and the LFT will be equal o It will be the longest past through those nodes

• 𝐹𝑙𝑜𝑎𝑡 𝑇𝑖𝑚𝑒 = 𝐿𝐹𝑇 − 𝐸𝑆𝑇


Processes should be smoother as there is careful planning involved A complex process which will have many lines and will be long; computer rendering will be needed. Software may need to be made or bought which will be expensive.

It shortens the length of time taken to complete a project, as tasks are handles simultaneously – this can be very advantageous as getting a product first to the market can often be a positive factor, especially with technology.

Delays can be handled adeptly as time is accurately planned. Drawing a diagram does not ensure success; it will be the effort of the managers that ultimately brings the results. There is better time management, facilitating JIT management. Also,

due to better management, there is reduced pressure on Cash Flow.

Latest Finish Time

Start Node

Lines represent activity

End Node

Step Number

Earliest Start Time

The Critical

Path


CONTRIBUTION AND SPECIAL ORDER DECISIONS

• A business might get an unexpected order from a new customer. • In these cases the business has to consider whether the deal will be profitable and often this is done through contribution

costing. • A business will have both fixed and variable costs. • Based, on the contribution that each finished good

provides, the business will need to make this decision. • Say, there is a special order for 2000 extra laptops and the

company needs to decide whether or not to accept. The customer is willing to pay $670 for each laptop.

• The fixed costs are at $500,000 per year and the variable cost is $350 for a laptop

• So, the total cost for the laptop, for the manufacturer will

be $350 + $500,0002000

= $600.

• Thus, the business can take the order and still make a profit. However, this is on the assumption that fixed costs remain the same. If they were to increase, which they likely will, then the profit made from making laptops would be very small.

• If the fixed costs were to increase to $600,000, then the price of the laptop would become $350 + $600,0002000

= $650, the

business would be making very little profit. However, this might be a new customer that may become a regular customer for the business, like this there are many non-financial motives to take or decline an order:

o Capacity: Whether the business has the machinery and the labour to take the order. Will taking this order sacrifice something more profitable?

o Customer response: If existing customers find out that products were sold at a cheaper price to others, then it will damage the image of the business and may lead to a loss of customers.

o Future Orders: Unprofitable orders might lead to more profitable orders in the future from the customer. o Current Utilisation: An unprofitable order may be accepted in order to keep staff occupied. It’s better to have

permanent staff occupied with work that will give little contribution, than not working at all, because when permanent labourers have no work to do, the business is still paying for their wages.

o Retaining customer loyalty: A business may accept an un-profitable order as a favour to a loyal customer. Greater co-operation from the business to the customer will . increase brand loyalty


BUSINESS CONTINGENCY PLANNING

NEED FOR CONTINGENCY PLANNING

Contingency planning is the creation of plans of how particular crises which might affect a business will be dealt with should the arise

BUSINESS STUDIES 4TH EDITION, DAVE HALL

• Things do not always go according to plan, an employee might be sick – such as in a school, a class teacher may be sick and may not come to class. If this happens, then there needs to be a replacement teacher capable of taking the class. Contingency planning is essentially a back-up plan the business has.

• Similarly, in times of a crisis such as a fire or flood, the business will need a back-up plan to make sure that it can survive the crisis.

• But there are many other types of crises that may occur, and these may be financial, related to machinery, human resources, public relations etc. To combat all these problems, the business will need a contingency plan in place.


CONSIDERATION OF RISK OF OPERATING IN A COUNTRY OR SEEKING GROWTH IN NEW OVERSEAS MARKETS

• Developing a new market with existing products will fall into the market development category. Essentially, if the business fails to do well in the market, it will need a contingency plan to get itself out of the operations e.g. sell the operations, or go into a joint venture with a local firm in order to increase chances of survival and to gain additional knowledge about the market as well as getting information from the company.

• The extent of the risks will depend on how different the foreign market is in comparison to the domestic market.

• , as when Whirlpool set out to The product may need to be modifiedmake the world washer, when it sold the washer to India, people stopped buying it because some special types of Indian clothes got stuck in the washer. Also, when PEPSI started out in China, when it translated its logo, the literal translation was something very insulting in Chinese culture.

• There needs to be thorough market research done, both primary and secondary in order to gain a comprehensive understanding of the market. Even after thorough market research businesses fail because of the ever changing nature of consumer taste.


It gives the business some kind of plan as to what it can do in times of a crisis.

It can be argued that there are relatively few contingency plans that are effective as there are many unforeseen eventualities.


RISK REDUCTION THROUGH INFORMATION FROM DECISION MAKING MODELS

• Decision making models such as decision trees allow businesses to assess the risk of an operation, because it highlights the probability of both profits and losses.

• Investment appraisal shows how long a business will need to earn its investment back from the operation i.e. payback. Also, ARR will allow the business will allow the business to consider how much

. rewards it is getting for the risk it is takingo When TESCO set up ‘Fresh & Easy’ stores in America, it

calculated that the payback period would at least be 5 years. But it did so, in order to get a foothold into the lucrative American retailer market.

• Network analysis will make the business more efficient and will highlight critical paths, which have the most risks associated with them, so managers can proceed with more caution.

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4a.2 making strategic decisions

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