Present Value

The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period.

Starting with the future value equation:

FV = PV ( 1 + i ) ^t

where

FV = future value
PV = present value
i = annual interest rate

we see that the present value is given by:

PV =	FV ( 1 + i ) t

The term 1 / ( 1 + i ) ^t is known as the discount factor.

If both the future value and present value are known, one can solve for the time or the interest rate using one of the techniques discussed in future value calculations.

Present Value of Multiple Future Cash Payments

When there is more than a single cash payment at a future date, the present value is calculated by taking the present values of the individual cash payments and summing them. It is helpful to draw a time line depicting the timing of the cash payments:

Time Line

0		1		2		3
PV		C1		C2		C3

In this model, the cash payment at each date may be either an inflow or an outflow; the direction is designated by the sign. The present value of the above cash flow is:

PV = C₁ / ( 1 + i ) + C₂ / ( 1 + i )² + C₃ / ( 1 + i )³

Discount Factor Table

The discount factor 1 / ( 1 + i ) ^t may be calculated for a range of time periods and interest rates and tabulated for quick reference.

Table of Discount Factors

t \ i	1%	2%	3%	4%	5%	6%	7%	8%	9%	10%
1	0.990	0.980	0.971	0.962	0.952	0.943	0.935	0.926	0.917	0.909
2	0.980	0.961	0.943	0.925	0.907	0.890	0.873	0.857	0.842	0.826
3	0.971	0.942	0.915	0.889	0.864	0.840	0.816	0.794	0.772	0.751
4	0.961	0.924	0.888	0.855	0.823	0.792	0.763	0.735	0.708	0.683
5	0.951	0.906	0.863	0.822	0.784	0.747	0.713	0.681	0.650	0.621
6	0.942	0.888	0.837	0.790	0.746	0.705	0.666	0.630	0.596	0.564
7	0.933	0.871	0.813	0.760	0.711	0.665	0.623	0.583	0.547	0.513
8	0.923	0.853	0.789	0.731	0.677	0.627	0.582	0.540	0.502	0.467
9	0.914	0.837	0.766	0.703	0.645	0.592	0.544	0.500	0.460	0.424
10	0.905	0.820	0.744	0.676	0.614	0.558	0.508	0.463	0.422	0.386
11	0.896	0.804	0.722	0.650	0.585	0.527	0.475	0.429	0.388	0.350
12	0.887	0.788	0.701	0.625	0.557	0.497	0.444	0.397	0.356	0.319
13	0.879	0.773	0.681	0.601	0.530	0.469	0.415	0.368	0.326	0.290
14	0.870	0.758	0.661	0.577	0.505	0.442	0.388	0.340	0.299	0.263
15	0.861	0.743	0.642	0.555	0.481	0.417	0.362	0.315	0.275	0.239

Future Value

The future value of a sum of money invested at interest rate i for one year is given by:

FV = PV ( 1 + i )

where

FV = future value
PV = present value
i = annual interest rate

If the resulting principal and interest are re-invested a second year at the same interest rate, the future value is given by:

FV = PV ( 1 + i ) ( 1 + i )

In general, the future value of a sum of money invested for t years with the interest credited and re-invested at the end of each year is:

FV = PV ( 1 + i ) ^t

Solving for Required Interest Rate or Time

Given a present sum of money and a desired future value, one can determine either the interest rate required to attain the future value given the time span, or the time required to reach the future value at a given interest rate. Because solving for the interest rate or time is slightly more difficult than solving for future value, there are a few methods for arriving at a solution:

1. Iteration - by calculating the future value for different values of interest rate or time, one gradually can converge on the solution.

2. Financial calculator or spreadsheet - use built-in functions to instantly calculate the solution.

3. Interest rate table - by using a table such as the one at the end of this page, one quickly can find a value of interest rate or time that is close to the solution.

4. Algebraic solution - mathematically calculating the exact solution.

Algebraic Solution

Beginning with the future value equation and given a fixed time period, one can solve for the required interest rate as follows.

FV = PV ( 1 + i ) ^t

Dividing each side by PV and raising each side to the power of 1/t:

( FV / PV ) ^1/t = 1 + i

The required interest rate then is given by:

i = ( FV / PV ) ^1/t - 1

To solve for the required time to reach a future value at a specified interest rate, again start with the equation for future value:

FV = PV ( 1 + i ) ^t

Taking the logarithm (natural log or common log) of each side:

log FV = log [ PV ( 1 + i ) ^t ]

Relying on the properties of logarithms, the expression can be rearranged as follows:

log FV = log PV + t log ( 1 + i )

Solving for t:

t =	log ( FV / PV ) log ( 1 + i )

Interest Factor Table

The term ( 1 + i ) ^t is the future value interest factor and may be calculated for an array of time periods and interest rates to construct a table as shown below:

Table of Future Value Interest Factors

t \ i	1%	2%	3%	4%	5%	6%	7%	8%	9%	10%
1	1.010	1.020	1.030	1.040	1.050	1.060	1.070	1.080	1.090	1.100
2	1.020	1.040	1.061	1.082	1.103	1.124	1.145	1.166	1.188	1.210
3	1.030	1.061	1.093	1.125	1.158	1.191	1.225	1.260	1.295	1.331
4	1.041	1.082	1.126	1.170	1.216	1.262	1.311	1.360	1.412	1.464
5	1.051	1.104	1.159	1.217	1.276	1.338	1.403	1.469	1.539	1.611
6	1.062	1.126	1.194	1.265	1.340	1.419	1.501	1.587	1.677	1.772
7	1.072	1.149	1.230	1.316	1.407	1.504	1.606	1.714	1.828	1.949
8	1.083	1.172	1.267	1.369	1.477	1.594	1.718	1.851	1.993	2.144
9	1.094	1.195	1.305	1.423	1.551	1.689	1.838	1.999	2.172	2.358
10	1.105	1.219	1.344	1.480	1.629	1.791	1.967	2.159	2.367	2.594
11	1.116	1.243	1.384	1.539	1.710	1.898	2.105	2.332	2.580	2.853
12	1.127	1.268	1.426	1.601	1.796	2.012	2.252	2.518	2.813	3.138
13	1.138	1.294	1.469	1.665	1.886	2.133	2.410	2.720	3.066	3.452
14	1.149	1.319	1.513	1.732	1.980	2.261	2.579	2.937	3.342	3.797
15	1.161	1.346	1.558	1.801	2.079	2.397	2.759	3.172	3.642	4.177

Chart of Accounts

The chart of accounts is a listing of all the accounts in the general ledger, each account accompanied by a reference number. To set up a chart of accounts, one first needs to define the various accounts to be used by the business. Each account should have a number to identify it. For very small businesses, three digits may suffice for the account number, though more digits are highly desirable in order to allow for new accounts to be added as the business grows. With more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts and require longer account reference numbers. It is worthwhile to put thought into assigning the account numbers in a logical way, and to follow any specific industry standards. An example of how the digits might be coded is shown in this list:

Account Numbering

1000 - 1999: asset accounts
2000 - 2999: liability accounts
3000 - 3999: equity accounts
4000 - 4999: revenue accounts
5000 - 5999: cost of goods sold
6000 - 6999: expense accounts
7000 - 7999: other revenue (for example, interest income)
8000 - 8999: other expense (for example, income taxes)

By separating each account by several numbers, many new accounts can be added between any two while maintaining the logical order.

Defining Accounts

Different types of businesses will have different accounts. For example, to report the cost of goods sold a manufacturing business will have accounts for its various manufacturing costs whereas a retailer will have accounts for the purchase of its stock merchandise. Many industry associations publish recommended charts of accounts for their respective industries in order to establish a consistent standard of comparison among firms in their industry. Accounting software packages often come with a selection of predefined account charts for various types of businesses.

There is a trade-off between simplicity and the ability to make historical comparisons. Initially keeping the number of accounts to a minimum has the advantage of making the accounting system simple. Starting with a small number of accounts, as certain accounts acquired significant balances they would be split into smaller, more specific accounts. However, following this strategy makes it more difficult to generate consistent historical comparisons. For example, if the accounting system is set up with a miscellaneous expense account that later is broken into more detailed accounts, it then would be difficult to compare those detailed expenses with past expenses of the same type. In this respect, there is an advantage in organizing the chart of accounts with a higher initial level of detail.

Some accounts must be included due to tax reporting requirements. For example, in the U.S. the IRS requires that travel, entertainment, advertising, and several other expenses be tracked in individual accounts. One should check the appropriate tax regulations and generate a complete list of such required accounts.

Other accounts should be set up according to vendor. If the business has more than one checking account, for example, the chart of accounts might include an account for each of them.

Account Order

Balance sheet accounts tend to follow a standard that lists the most liquid assets first. Revenue and expense accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, sales would be listed before non-operating income. In some cases, part or all of the expense accounts simply are listed in alphabetical order.

Sample Chart of Accounts

The following is an example of some of the accounts that might be included in a chart of accounts.

Sample Chart of Accounts

Asset Accounts

Current Assets

1000	Petty Cash
1010	Cash on Hand (e.g. in cash registers)
1020	Regular Checking Account
1030	Payroll Checking Account
1040	Savings Account
1050	Special Account
1060	Investments - Money Market
1070	Investments - Certificates of Deposit
1100	Accounts Receivable
1140	Other Receivables
1150	Allowance for Doubtful Accounts
1200	Raw Materials Inventory
1205	Supplies Inventory
1210	Work in Progress Inventory
1215	Finished Goods Inventory - Product #1
1220	Finished Goods Inventory - Product #2
1230	Finished Goods Inventory - Product #3
1400	Prepaid Expenses
1410	Employee Advances
1420	Notes Receivable - Current
1430	Prepaid Interest
1470	Other Current Assets

Fixed Assets

1500	Furniture and Fixtures
1510	Equipment
1520	Vehicles
1530	Other Depreciable Property
1540	Leasehold Improvements
1550	Buildings
1560	Building Improvements
1690	Land
1700	Accumulated Depreciation, Furniture and Fixtures
1710	Accumulated Depreciation, Equipment
1720	Accumulated Depreciation, Vehicles
1730	Accumulated Depreciation, Other
1740	Accumulated Depreciation, Leasehold
1750	Accumulated Depreciation, Buildings
1760	Accumulated Depreciation, Building Improvements

Other Assets

1900	Deposits
1910	Organization Costs
1915	Accumulated Amortization, Organization Costs
1920	Notes Receivable, Non-current
1990	Other Non-current Assets

Liability Accounts

Current Liabilities

2000	Accounts Payable
2300	Accrued Expenses
2310	Sales Tax Payable
2320	Wages Payable
2330	401-K Deductions Payable
2335	Health Insurance Payable
2340	Federal Payroll Taxes Payable
2350	FUTA Tax Payable
2360	State Payroll Taxes Payable
2370	SUTA Payable
2380	Local Payroll Taxes Payable
2390	Income Taxes Payable
2400	Other Taxes Payable
2410	Employee Benefits Payable
2420	Current Portion of Long-term Debt
2440	Deposits from Customers
2480	Other Current Liabilities

Long-term Liabilities

2700	Notes Payable
2702	Land Payable
2704	Equipment Payable
2706	Vehicles Payable
2708	Bank Loans Payable
2710	Deferred Revenue
2740	Other Long-term Liabilities

Equity Accounts

3010	Stated Capital
3020	Capital Surplus
3030	Retained Earnings

Revenue Accounts

4000	Product #1 Sales
4020	Product #2 Sales
4040	Product #3 Sales
4060	Interest Income
4080	Other Income
4540	Finance Charge Income
4550	Shipping Charges Reimbursed
4800	Sales Returns and Allowances
4900	Sales Discounts

Cost of Goods Sold

5000	Product #1 Cost
5010	Product #2 Cost
5020	Product #3 Cost
5050	Raw Material Purchases
5100	Direct Labor Costs
5150	Indirect Labor Costs
5200	Heat and Power
5250	Commissions
5300	Miscellaneous Factory Costs
5700	Cost of Goods Sold, Salaries and Wages
5730	Cost of Goods Sold, Contract Labor
5750	Cost of Goods Sold, Freight
5800	Cost of Goods Sold, Other
5850	Inventory Adjustments
5900	Purchase Returns and Allowances
5950	Purchase Discounts

Expenses

6000	Default Purchase Expense
6010	Advertising Expense
6050	Amortization Expense
6100	Auto Expenses
6150	Bad Debt Expense
6200	Bank Fees
6250	Cash Over and Short
6300	Charitable Contributions Expense
6350	Commissions and Fees Expense
6400	Depreciation Expense
6450	Dues and Subscriptions Expense
6500	Employee Benefit Expense, Health Insurance
6510	Employee Benefit Expense, Pension Plans
6520	Employee Benefit Expense, Profit Sharing Plan
6530	Employee Benefit Expense, Other
6550	Freight Expense
6600	Gifts Expense
6650	Income Tax Expense, Federal
6660	Income Tax Expense, State
6670	Income Tax Expense, Local
6700	Insurance Expense, Product Liability
6710	Insurance Expense, Vehicle
6750	Interest Expense
6800	Laundry and Dry Cleaning Expense
6850	Legal and Professional Expense
6900	Licenses Expense
6950	Loss on NSF Checks
7000	Maintenance Expense
7050	Meals and Entertainment Expense
7100	Office Expense
7200	Payroll Tax Expense
7250	Penalties and Fines Expense
7300	Other Taxes
7350	Postage Expense
7400	Rent or Lease Expense
7450	Repair and Maintenance Expense, Office
7460	Repair and Maintenance Expense, Vehicle
7550	Supplies Expense, Office
7600	Telephone Expense
7620	Training Expense
7650	Travel Expense
7700	Salaries Expense, Officers
7750	Wages Expense
7800	Utilities Expense
8900	Other Expense
9000	Gain/Loss on Sale of Assets

Reversing Entries

When an adjusting entry is made for an expense at the end of the accounting period, it is necessary to keep track of this expense so that the transaction will be allocated properly between the two periods. Reversing entries are a way to handle such transactions.

Consider the case in which a note is issued on the 16th of September, with interest payable on the 15th of October. If the total interest to be paid at the end of the 30 day period is $100, then half of the amount would be allocated to the month of September using the following adjusting journal entry:

Period-End Adjusting Entry

Date	Account Title	Debit	Credit
9/30	Interest Expense	50
	Interest Payable		50
	15 days of accrued interest.

On October 15, the 30 days of interest will be paid as a $100 lump sum. If the bookkeeper remembers that half of that interest already was recorded as an expense in September, then he or she can record only $50 as the interest expense for October. Alternatively, a reversing entry can be made at the beginning of October as follows:

Reversing Entry

Date	Account Title	Debit	Credit
10/1	Interest Payable	50
	Interest Expense		50
	Reversing entry for 15 days of interest accrued in Sep.

Note that the above journal entry is exactly the reverse of the adjusting entry made on September 30. Once this reversing entry is posted, the affected ledger accounts will appear as follows:

Ledger Accounts After Reversing Entry

Interest Payable Oct 1 50 Sep 30 50 Bal. 0

Interest Expense Oct 1 50 Bal. 50

The interest payable account carried a credit balance of $50 over to the new period, and this balance became zero when the October 1 reversing entry was posted. Because the interest expense ledger account was closed at the end of the reporting period on September 30 (as were all expense accounts), its balance was reset to zero at that time. After the posting of the reversing entry on October 1, the interest expense ledger account had a credit balance (i.e. a negative expense balance) of $50.

On Oct 15, the note matures and the $100 interest is due. Because the reversing entry was made on Oct 1, the Oct 15 entry is for the full $100 that is due on the note, and is recorded as follows:

October 15 Journal Entry

Date	Account Title	Debit	Credit
10/15	Interest Expense	100
	Interest Payable		100
	Interest for Sep 16 through Oct 15.

The ledger accounts will appear as follows once the journal entries through October 15 are posted:

Interest Payable Oct 1 50 Sep 30 50 Oct 15 100 Bal. 100

Interest Expense Oct 15 100 Oct 1 50 Bal. 50

The net interest expense for October then is $50, as it should be since the other $50 already was reported in September.

As can be seen in the ledger accounts, the net effect is that a $50 interest expense will be realized in October, and the full $100 of interest will be paid to the holder of the note.

Reversing entries are a useful tool for dealing with certain accruals and deferrals. Their use is optional and depends on the accounting practices of the particular firm and the specific responsibilities of the bookkeeping staff.

Closing Entries

At the end of the accounting period, the balances in temporary accounts are transferred to an income summary account and a retained earnings account, thereby resetting the balance of the temporary accounts to zero to begin the next accounting period.

First, the revenue accounts are closed by transferring their balances to the income summary account. Consider the following example for which September 30 is the end of the accounting period. If the revenue account balance is $1100, then the closing journal entry would be:

Date	Accounts	Debit	Credit
9/30	Revenue	1100
	Income Summary		1100

Next, the expense accounts are closed by transferring their balances to the income summary account. If the expense account balance is $1275, then the closing entry would be:

Date	Accounts	Debit	Credit
9/30	Income Summary	1275
	Expenses		1275

At this point, the net balance of the income summary account is a $175 debit (loss). The income summary account then is closed to retained earnings:

Date	Accounts	Debit	Credit
9/30	Retained Earnings	175
	Income Summary		175

Finally, the dividends account is closed to retained earnings. For example, if $50 in dividends were paid during the period, the closing journal entry would be as follows:

Date	Accounts	Debit	Credit
9/30	Retained Earnings	50
	Dividends		50

Once posted to the ledger, these journal entries serve the purpose of setting the temporary revenue, expense, and dividend accounts back to zero in preparation for the start of the next accounting period.

Note that the income summary account is not absolutely necessary - the revenue and expense accounts could be closed directly to retained earnings. The income summary account offers the benefit of indicating the net balance between revenue and expenses (i.e. net income) during the closing process.

Preparing the Financial Statements

Once the adjusting entries have been made or entered into a worksheet, the financial statements can be prepared using information from the ledger accounts. Because some of the financial statements use data from the other statements, the following is a logical order for their preparation:

• Income statement
• Statement of retained earnings
• Balance sheet
• Cash flow statement

Income Statement

The income statement reports revenues, expenses, and the resulting net income. It is prepared by transferring the following ledger account balances, taking into account any adjusting entries that have been or will be made:

• Revenue
• Expenses
• Capital gains or losses

Statement of Retained Earnings

The retained earnings statement shows the retained earnings at the beginning and end of the accounting period. It is prepared using the following information:

• Beginning retained earnings, obtained from the previous statement of retained earnings.
• Net income, obtained from the income statement
• Dividends paid during the accounting period

Balance Sheet

The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is constructed using the following information:

• Balances of all asset accounts such cash, accounts receivable, etc.
• Balances of all liability accounts such as accounts payable, notes, etc.
• Capital stock balance
• Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods:

• Direct method: cash flow information is derived by directly subtracting cash disbursements from cash receipts.

• Indirect method: cash flow information is derived by adding or subtracting non-cash items from net income.

Adjusting Entries

Adjusting entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the period in which they actually are applicable. Adjusting entries are required because normal journal entries are based on actual transactions, and the date on which these transactions occur may not be the date required to fulfill the matching principle of accrual accounting.

The two major types of adjusting entries are:

• Accruals: for revenues and expenses that are matched to dates before the transaction has been recorded.

• Deferrals: for revenues and expenses that are matched to dates after the transaction has been recorded.

Accruals

Accrued items are those for which the firm has been realizing revenue or expense without yet observing an actual transaction that would result in a journal entry. For example, consider the case of salaried employees who are paid on the first of the month for the salary they earned over the previous month. Each day of the month, the firm accrues an additional liability in the form of salaries to be paid on the first day of the next month, but the transaction does not actually occur until the paychecks are issued on the first of the month. In order to report the expense in the period in which it was incurred, an adjusting entry is made at the end of the month. For example, in the case of a small company accruing $80,000 in monthly salaries, the journal entry might look like the following:

Date	Account Titles & Explanation	Debit	Credit
9/30	Salary expense	80,000
	Salaries payable		80,000
	Salaries accrued in September, to be paid on Oct 1.

In theory, the accrued salary could be recorded each day, but daily updates of such accruals on a large scale would be costly and would serve little purpose - the adjustment only is needed at the end of the period for which the financial statements are being prepared.

Some accrued items for which adjusting entries may be made include:

• Salaries
• Past-due expenses
• Income tax expense
• Interest income
• Unbilled revenue

Deferrals

Deferred items are those for which the firm has recorded the transaction as a journal entry, but has not yet realized the revenue or expense associated with that journal entry. In other words, the recognition of deferred items is postponed until a later accounting period. An example of a deferred item would be prepaid insurance. Suppose the firm prepays a 12-month insurance policy on Sep 1. Because the insurance is a prepaid expense, the journal entry on Sep 1 would look like the following:

Date	Account Titles & Explanation	Debit	Credit
9/1	Prepaid Expenses	12,000
	Cash		12,000
	12-month prepaid insurance policy.

The result of this entry is that the insurance policy becomes an asset in the Prepaid Expenses account. At the end of September, this asset will be adjusted to reflect the amount "consumed" during the month. The adjusting entry would be:

Date	Account Titles & Explanation	Debit	Credit
9/30	Insurance Expense	1,000
	Prepaid Expenses		1,000
	Insurance expense for Sep.

This adjusting entry transfers $1000 from the Prepaid Expenses asset account to the Insurance Expense expense account to properly record the insurance expense for the month of September. In this example, a similar adjusting entry would be made for each subsequent month until the insurance policy expires 11 months later.

Some deferred items for which adjusting entries would be made include:

• Prepaid insurance
• Prepaid rent
• Office supplies
• Depreciation
• Unearned revenue

In the case of unearned revenue, a liability account is credited when the cash is received. An adjusting entry is made once the service has been rendered or the product has been shipped, thus realizing the revenue.

Completing the Adjusting Entries

To prevent inadvertent omission of some adjusting entries, it is helpful to review the ones from the previous accounting period since such transactions often recur. It also helps to talk to various people in the company who might know about unbilled revenue or other items that might require adjustments.

Trial Balance

If the journal entries are error-free and were posted properly to the general ledger, the total of all of the debit balances should equal the total of all of the credit balances. If the debits do not equal the credits, then an error has occurred somewhere in the process. The total of the accounts on the debit and credit side is referred to as the trial balance.

To calculate the trial balance, first determine the balance of each general ledger account as shown in the following example:

General Ledger

Cash Sep 1 7500 17 400 25 425 Sep 15 1000 28 500 Bal. 6825

Accounts Receivable Sep 17 700 Sep 25 425 Bal. 275

Parts Inventory Sep 8 2500 Sep 18 275 Bal. 2225

Accounts Payable Sep 28 500 Sep 8 2500 Bal. 2000

Capital Sep 1 7500 Bal. 7500

Revenue Sep 17 1100 Bal. 1100

Expenses Sep 15 1000 Sep 18 275 Bal. 1275

Once the account balances are known, the trial balance can be calculated as shown:

Trial Balance

Account Title	Debits	Credits
Cash	6825
Accounts Receivable	275
Parts Inventory	2225
Accounts Payable		2000
Capital		7500
Revenue		1100
Expenses	1275
	10600	10600

In this example, the debits and credits balance. This result does not guarantee that there are no errors. For example, the trial balance would not catch the following types of errors:

• Transactions that were not recorded in the journal
• Transactions recorded in the wrong accounts
• Transactions for which the debit and credit were transposed
• Neglecting to post a journal entry to the ledger

If the trial balance is not in balance, then an error has been made somewhere in the accounting process. The following is listing of common errors that would result in an unbalanced trial balance; this listing can be used to assist in isolating the cause of the imbalance.

• Summation error for the debits and credits of the trial balance
• Error transferring the ledger account balances to the trial balance columns
  • Error in numeric value
  • Error in transferring a debit or credit to the proper column
  • Omission of an account
• Error in the calculation of a ledger account balance
• Error in posting a journal entry to the ledger
  • Error in numeric value
  • Error in posting a debit or credit to the proper column
• Error in the journal entry
  • Error in a numeric value
  • Omission of part of a compound journal entry

The more often that the trial balance is calculated during the accounting cycle, the easier it is to isolate any errors; more frequent trial balance calculations narrow the time frame in which an error might have occurred, resulting in fewer transactions through which to search.

Target Market Selection

Target marketing tailors a marketing mix for one or more segments identified by market segmentation. Target marketing contrasts with mass marketing, which offers a single product to the entire market.

Two important factors to consider when selecting a target market segment are the attractiveness of the segment and the fit between the segment and the firm's objectives, resources, and capabilities.

Attractiveness of a Market Segment

The following are some examples of aspects that should be considered when evaluating the attractiveness of a market segment:

• Size of the segment (number of customers and/or number of units)

• Growth rate of the segment

• Competition in the segment

• Brand loyalty of existing customers in the segment

• Attainable market share given promotional budget and competitors' expenditures

• Required market share to break even

• Sales potential for the firm in the segment

• Expected profit margins in the segment

Market research and analysis is instrumental in obtaining this information. For example, buyer intentions, salesforce estimates, test marketing, and statistical demand analysis are useful for determining sales potential. The impact of applicable micro-environmental and macro-environmental variables on the market segment should be considered.

Note that larger segments are not necessarily the most profitable to target since they likely will have more competition. It may be more profitable to serve one or more smaller segments that have little competition. On the other hand, if the firm can develop a competitive advantage, for example, via patent protection, it may find it profitable to pursue a larger market segment.

Suitability of Market Segments to the Firm

Market segments also should be evaluated according to how they fit the firm's objectives, resources, and capabilities. Some aspects of fit include:

• Whether the firm can offer superior value to the customers in the segment

• The impact of serving the segment on the firm's image

• Access to distribution channels required to serve the segment

• The firm's resources vs. capital investment required to serve the segment

The better the firm's fit to a market segment, and the more attractive the market segment, the greater the profit potential to the firm.

Target Market Strategies

There are several different target-market strategies that may be followed. Targeting strategies usually can be categorized as one of the following:

• Single-segment strategy - also known as a concentrated strategy. One market segment (not the entire market) is served with one marketing mix. A single-segment approach often is the strategy of choice for smaller companies with limited resources.

• Selective specialization- this is a multiple-segment strategy, also known as a differentiated strategy. Different marketing mixes are offered to different segments. The product itself may or may not be different - in many cases only the promotional message or distribution channels vary.

• Product specialization- the firm specializes in a particular product and tailors it to different market segments.

• Market specialization- the firm specializes in serving a particular market segment and offers that segment an array of different products.

• Full market coverage - the firm attempts to serve the entire market. This coverage can be achieved by means of either a mass market strategy in which a single undifferentiated marketing mix is offered to the entire market, or by a differentiated strategy in which a separate marketing mix is offered to each segment.

The following diagrams show examples of the five market selection patterns given three market segments S₁, S₂, and S₃, and three products P₁, P₂, and P₃.

A firm that is seeking to enter a market and grow should first target the most attractive segment that matches its capabilities. Once it gains a foothold, it can expand by pursuing a product specialization strategy, tailoring the product for different segments, or by pursuing a market specialization strategy and offering new products to its existing market segment.

Another strategy whose use is increasing is individual marketing, in which the marketing mix is tailored on an individual consumer basis. While in the past impractical, individual marketing is becoming more viable thanks to advances in technology.

The Marketing Mix

(The 4 P's of Marketing)

Marketing decisions generally fall into the following four controllable categories:

• Product
• Price
• Place (distribution)
• Promotion

The term "marketing mix" became popularized after Neil H. Borden published his 1964 article, The Concept of the Marketing Mix. Borden began using the term in his teaching in the late 1940's after James Culliton had described the marketing manager as a "mixer of ingredients". The ingredients in Borden's marketing mix included product planning, pricing, branding, distribution channels, personal selling, advertising, promotions, packaging, display, servicing, physical handling, and fact finding and analysis. E. Jerome McCarthy later grouped these ingredients into the four categories that today are known as the 4 P's of marketing, depicted below:

The Marketing Mix

These four P's are the parameters that the marketing manager can control, subject to the internal and external constraints of the marketing environment. The goal is to make decisions that center the four P's on the customers in the target market in order to create perceived value and generate a positive response.

Product Decisions

The term "product" refers to tangible, physical products as well as services. Here are some examples of the product decisions to be made:

• Brand name
• Functionality
• Styling
• Quality
• Safety
• Packaging
• Repairs and Support
• Warranty
• Accessories and services

Price Decisions

Some examples of pricing decisions to be made include:

• Pricing strategy (skim, penetration, etc.)
• Suggested retail price
• Volume discounts and wholesale pricing
• Cash and early payment discounts
• Seasonal pricing
• Bundling
• Price flexibility
• Price discrimination

Distribution (Place) Decisions

Distribution is about getting the products to the customer. Some examples of distribution decisions include:

• Distribution channels
• Market coverage (inclusive, selective, or exclusive distribution)
• Specific channel members
• Inventory management
• Warehousing
• Distribution centers
• Order processing
• Transportation
• Reverse logistics

Promotion Decisions

In the context of the marketing mix, promotion represents the various aspects of marketing communication, that is, the communication of information about the product with the goal of generating a positive customer response. Marketing communication decisions include:

• Promotional strategy (push, pull, etc.)
• Advertising
• Personal selling & sales force
• Sales promotions
• Public relations & publicity
• Marketing communications budget

Limitations of the Marketing Mix Framework

The marketing mix framework was particularly useful in the early days of the marketing concept when physical products represented a larger portion of the economy. Today, with marketing more integrated into organizations and with a wider variety of products and markets, some authors have attempted to extend its usefulness by proposing a fifth P, such as packaging, people, process, etc. Today however, the marketing mix most commonly remains based on the 4 P's. Despite its limitations and perhaps because of its simplicity, the use of this framework remains strong and many marketing textbooks have been organized around it.

Chapter 1: Defining Marketing for the Twenty-First Century

Why Study Marketing?

• Needs describe basic human requirements such as food, air, water, clothing, shelter, recreation, education, and entertainment.
• Needs become wants when they are directed to specific objects that might satisfy the need. (Fast food)
• Demands are wants for specific products backed by an ability to pay.
  

What Can Be Marketed?

• Goods
• Services
• Experiences
• Events
• Persons
• Places
• Properties
• Organizations
• Information
• Ideas
  

Marketing Defined

Kotler's social definition:

"Marketing is a societal process by which individuals and groups obtain what they need and want through creating, offering, and freely exchanging products and services of value with others."

Marketing Management Defined

Marketing Management is the art and science of choosing target markets and

• Getting
• Keeping and
• Growing customers through
  


• Creating
• Delivering and
• Communicating
  

superior customer value.

The Changes In The Market: Customer

• Changes in Consumer/Customer by the information revolution
• Increased buying power
• Greater variety of goods and services
• Increased information
• Enhanced shopping convenience
• Greater opportunities to compare product information with others.
  

The Changes In The Market: Firm

• Changes in Firm way of operating due to digital/information revolution
• New promotional medium
• Access to richer research data
• Enhanced employee and customer communication
• Ability to customize promotions

Changes In Marketing Practices

• Marketing practices had pass through three stages
• Entrepreneurial marketing (individual success stories)
• Formulated marketing (now a formal marketing effort)
• Intrepreneurial marketing (too formulated)
• In Intrepreneurial marketing, as marketing becomes more formulated, creativity is inhibited.

Where one can shop?

• Shopping can take place in a:
• Marketplace
• Physical entity e.g. Bohari Bazar, Forum
• Market space
• Virtual entity e.g. Ebay, Amazon
  

Target Markets & Segmentation

• The customers served by the firm is called the target market
• Customers differences in needs, behavior, demographics or psychographics give rise to market segments.

Product vs Brand

• A Product is any offering that can satisfy a need or want
• A brand is a specific offering from a known source.

Success depends on when offerings deliver value and satisfaction to the consumer or customer.

Enhancing Value

• U can enhance the value of an offering to the customer by:
• Raising benefits
• Reducing costs
• Meta markets refer to complementary goods and services that are related in the minds of consumers.
  

The Environment

The environmental forces have a major impact on the marketing decisions.

The Competition

Four levels of competition can be distinguished by the level of product substitutability:

• Generic competition
• Form competition
• Industry competition
• Brand competition
  

Levels of Competition

• Generic competition—e.g. Honda against Dubai festival for the same consumer rupee
• Form competition—e.g. Toyota against manufacturers of other vehicles that provide the same service such as Yamaha (motorcycle)
• Industry competition—e.g. Honda against Toyota etc who make the same products or class of products (different prices)
• Brand competition—e.g. Honda Civic against Toyota Corolla who offer similar products and service to the same customers at similar prices.
  

The Marketing Mix

The marketing program is developed to achieve the company's objectives. Marketing mix decisions include:

• Product: provides customer solution.
• Price: represents the customer's cost.
• Place: customer convenience is key.
• Promotion: communicates with customer.

Company Orientations

The orientation or philosophy of the firm typically guides marketing efforts. Several competing orientations exist:

• Production concept – Widely available & inexpensive
• Product concept- Quality,performance & innovation
• Selling concept-will buy "enough"only if persuaded
• Marketing concept-Sense and respond
• Customer concept-Shaping separate offers
• Societal marketing concept-Preservation of consumer & society well being

The 4 Pillars of Marketing Concept

• Achieving organizational goals requires that company be more effective than competitors in creating, delivering, and communicating customer value.
• Four pillars of the marketing concept:
• Target market
• Customer needs
• Integrated marketing
• Profitability

Relationship Marketing

• Relationship marketing aims to build long-term mutually satisfying relations with key parties, which ultimately results in marketing network between the company and its supporting stakeholders.
  

Marketing Channels

• Communication channels
• Deliver messages to and receive messages from target buyers.
• Includes traditional media, non-verbal communication, and store atmospherics.
• Distribution channel
• Display or deliver the physical products or services to the buyer / user.
• Service Channels
• Carry out transactions with potential buyers by facilitating the transaction.
  

Supply Chain Concept

A supply chain stretches from raw materials to components to final products that are carried to final buyers.

Challenges in the Marketplace

• Globalization, technological advances, and deregulation have created many challenges:
• Customers
• Brand manufacturers
• Store-based retailers
• Both companies and marketers have been forced to respond and adjust.
  

Pakistani Marketing Environment

Learn how companies and marketers are responding to new challenges.

• Pakistani companies are slowly moving from sales to marketing.
• High dependence on advertising and earlier on sales promotion
• PR is being recognized as an important marketing tool and activities are now being planned.
• New technologies and process are being introduced to cut costs.

Financial Reports of KSE Listed Companies

1. Moonlite (Pak) Limited
2. Eco Pack Limited
3. Singer Pakistan Limited
4. Security Investment Bank Limited
5. PICIC Commercial Bank Limited
6. KASB Bank
7. Standard Chartered Bank (Pakistan) Limited
8. Bank Alfalah Limited
9. MyBank
10. The Bank of Khyber
11. Faysal Bank Limited
12. Al-Abbas Sugar Mills Limited
13. Noon Sugar Mills Limited
14. Shahmurad Sugar Mills Limited
15. Al-Noor Sugar Mills Limited
16. N.I.B. Bank Limited
17. Kohinoor Mills Limited
18. Ali Asghar Textile Mills Limited
19. Wazir Ali Industries Limited
20. Pakistan National Shipping Corporation
21. Escorts Investment Bank Limited
22. BOC Pakistan Limited
23. First Capital Securities Corporation Limited
24. Zulfeqar Industries Limited
25. Hinopak Motors Limited
26. Suraj Cotton Mills Limited
27. First Fidelity Leasing Modaraba
28. Pace Pakistan Limited
29. Worldcall Telecom Limited
30. Atlas Bank
31. Nishat Mills Limited
32. Pakistan Cables Limited
33. Fauji Cement Company Limited
34. Nimir Industrial Chemicals Limited
35. Al-Abbas Javedan Cement Limited
36. D.G.Khan Cement Company Limited
37. Hira Textile Mills
38. Chenab Limited
39. Millat Tractors Limited
40. Bolan Castings Limited
41. First Capital Mutual Fund Limited
42. Trust Investment Bank Ltd.
43. Pioneer Cement Limited
44. Allied Bank Limited
45. Ibrahim Fibres Limited
46. Standard Chartered Modaraba
47. Al-Abbas Cement Industries Limited
48. Pakistan Cement Company Limited
49. Kohinoor Textile Mills Limited
50. Otsuka Pakistan Limited
51. Trust Modaraba
52. NetSol Technologies Limited
53. Husein Industuries Limited
54. Gharibwal Cement Limited
55. BSJS Balanced Fund Limited
56. Babri Cotton Mills Limited
57. Tariq Glass Industries Limited
58. Thal Limited
59. Faisal Spinning Mills Limited
60. Blessed Textiles Limited
61. Bhanero Textiles Mills Limited
62. Colgate Palmolive Pakistan Limited
63. Belessed Textiles Limited
64. Dewan Farooque Spinning Mills Limited
65. Union Bank Limited
66. Mari Gas Company Limited
67. Shadab Textile Mills Limited
68. Sargodha Spinning Mills Limited
69. Maple Leaf Cement Factory Limited
70. Javedan Cement Limited
71. Bosicor Pakistan Limited
72. Kot Addu Power Company Limited
73. Fazal Cloth Mills Limited
74. JS Abamco Limited
75. Atlas Asset Management
76. Allwin Engineering Industries Limited
77. Meezan Bank
78. D. G. Khan Cement Company Limited
79. Faysal Bank Limted
80. Bank Al Habib Limited
81. AZ Gard-9
82. Prime Commercial Bank Limited
83. Trust Modaraba
84. Wyeth Pakistan Limited
85. BankIslami Pakistan Limited
86. Crescent Sugar Mills & Distillery Limited
87. Highnoon Laboratories Limited
88. Balochistan Glass Limited
89. Siddiqsons Tin Plate Limited
90. Pakistan Papersack Corporation Limited
91. (Colony) Thal Textile Mills Limited
92. Attock Petroleum Limited
93. BankIslami Pakistan Limited
94. Adamjee Insurance Company Limited
95. Fayzan Manufacturing Modaraba
96. First International Investment Bank Limited
97. Clover Pakistan Limited
98. Attock Cement Pakistan Limited
99. Maqbool Textile Mills Limited
100. Chaudhry Textile Mills Ltd.
101. Indus Motor Company Limited
102. Husein Sugar Mills Limited
103. Siemens Pakifstan Engineering Co. Limited
104. Baluchistan Wheels Limited
105. Pakistan International Container Terminal Limited
106. Automotive Battery Co. Limited
107. Al-Azhar Textile Mills Limited
108. The Hub Power Company Limited
109. Crescent Steel and Allied Products Ltd.
110. Saudi Pak Bank
111. Pakistan PTA Limited
112. International General Insurance (IGI)
113. Honda Atlas Cars (Pakistan) Ltd.
114. ICI Pakistan Ltd.
115. Koinoor Sugar Mills Limited
116. Sapphire Fibres Limited
117. Sapphire Textile Mills Limited
118. Reliance Cotton Spinning Mills Limited
119. Crescent Commercial Bank Ltd.
120. United Bank Limited
121. Metropolitan Bank Limited
122. IBL Modaraba
123. UDL Modaraba
124. Clariant Pakistan Limited
125. Al-Ghazi Tractors Limited
126. Pak Leather Crafts Limited
127. Japan Power Generation Limited
128. Zahid Textile Mills Ltd
129. Trust Securites & Brokerage Limited
130. Century Insurance Company Limited
131. Ghazi Fabrics International Limited
132. MCB Bank
133. Southern Electric
134. First Habib Modaraba
135. Fibre Limited
136. Worldcall Multimedia Limited
137. Worldcall Broadband Limited
138. Dewan Cement Limited
139. Dewan Hattar Cement Limited
140. Leiner Pak Gelatine Limited
141. Dawood Capital Management Limited
142. Providence Modaraba Limited
143. First Dawood Investment Bank Limited
144. Jahangir Siddiqui & Company Ltd.
145. Dawood Hercules Chemicals Limited
146. Tri-Pack Films Limited
147. Packages Limitd
148. Gul Ahmed Textile Mills Limited
149. Kohat Textile Mills Limited
150. Dewan Automotive Engineering Limited
151. Dewan Farooq Motors Limited
152. Murree Brewery Company Limited
153. Atlas Battery Limited
154. Agriauto Industries Limited
155. Attok Refinery Limited
156. Khoinoor Sugar Mills Limited
157. Engro Chemical Pakistan Limited
158. Pakistan Refinery Limited
159. Saudi Pak Company Limited
160. International Industries Limited
161. Indus Polyester Company Limited
162. Lucky Cement Limited
163. Balochistan Particle Board Limited
164. Pakistan International Container Terminal Limited
165. Ferozsons Laboratories Limited
166. Dowood Capital Management Limited
167. Security Leasing Corporation Limited
168. Searle Pakistan Limited
169. Century Paper & Board Mills Limited
170. Arif Habib Investments
171. Pakistan Premier Fund Limited
172. Arif Habib Securities Limited
173. First National Equities Limited
174. Pakistan Synthetics Limited
175. Fauji Fertlizer Company Limited
176. Nimir Industrial Chemicals Limited
177. Gadoon Textile Mills Limited
178. Pakistan Telecommunication Company Limited
179. Merit Packaging Limited
180. Atlas Honda Limited
181. Long Term Venture Capital Modaraba
182. NDLC-IFIC Bank Limited
183. First Interfund Modaraba
184. Pakistan Petroleum Limited
185. National Refinery Limited
186. Dawood Lawrencepur Limited
187. Oil & Gas Development Company Limited

Turnaround Management

Times of corporate distress present special strategic management challenges. In such situations, a firm may be in bankruptcy or nearing bankruptcy. Often turnaround consultants are brought into the company to devise and execute a plan of corporate renewal, assuming that the firm has enough potential to make it worth saving.

Before a viable turnaround strategy can be formulated, one must identify the root cause or causes of the crisis. Frequently encountered causes include:

• Revenue downturn caused by a weak economy
• Overly optimistic sales projections
• Poor strategic choices
• Poor execution of a good strategy
• High operating costs
• High fixed costs that decrease flexibility
• Insufficient resources
• Unsuccessful R&D projects
• Highly successful competitor
• Excessive debt burden
• Inadequate financial controls

While each case is unique, the turnaround process frequently involves the following stages:

1. Management change - consultants may be called in to manage the turnaround of the firm.

2. Situation analysis - a situation analysis is performed to evaluate the prospects of survival. Assuming the firm is worth turning around, depending on the root causes of the distress one or more of the following turnaround strategies may be selected and presented to the board:

   • Change of top management
   • Divestment of certain assets
   • Reformulation of strategy
   • Revenue increase
   • Cost reduction
   • Strategic acquisitions
   
   

3. Emergency action plan - achieve positive cash flow as soon as possible by eliminating departments, reducing staff, etc.

4. Business restructuring - once positive cash flow is achieved, the strategic plan is implemented, improving continuing operations, adjusting the product mix and repositioning products if necessary. The management team begins to focus on achieving sustained profitability.

5. Return to normalcy - the company becomes profitable and the changes are internalized. Employees regain confidence in the firm and emphasis is placed on growing the restructured business while maintaining a strong balance sheet.

Abandonment Strategy

In some cases the prospects of the firm may be too bleak to continue as an ongoing operation and an exit strategy may be appropriate. Different strategies may be pursued that vary in their immediacy. An immediate abandonment strategy exits the market by immediately liquidating or selling to another firm. In other situations, a harvest strategy is appropriate by which the firm plays the end-game, maximizing near-term cash flows at the expense of market position.

Scenario Planning

Traditional forecasting techniques often fail to predict significant changes in the firm's external environment, especially when the change is rapid and turbulent or when information is limited. Consequently, important opportunities and serious threats may be overlooked and the very survival of the firm may be at stake. Scenario planning is a tool specifically designed to deal with major, uncertain shifts in the firm's environment.

Scenario planning has its roots in military strategy studies. Herman Kahn was an early founder of scenario-based planning in his work related to the possible scenarios associated with thermonuclear war ("thinking the unthinkable"). Scenario planning was transformed into a business tool in the late 1960's and early 1970's, most notably by Pierre Wack who developed the scenario planning system used by Royal Dutch/Shell. As a result of these efforts, Shell was prepared to deal with the oil shock that occurred in late 1973 and greatly improved its competitive position in the industry during the oil crisis and the oil glut that followed.

Scenario planning is not about predicting the future. Rather, it attempts to describe what is possible. The result of a scenario analysis is a group of distinct futures, all of which are plausible. The challenge then is how to deal with each of the possible scenarios.

Scenario planning often takes place in a workshop setting of high level executives, technical experts, and industry leaders. The idea is to bring together a wide range of perspectives in order to consider scenarios other than the widely accepted forecasts. The scenario development process should include interviews with managers who later will formulate and implement strategies based on the scenario analysis - without their input the scenarios may leave out important details and not lead to action if they do not address issues important to those who will implement the strategy.

Some of the benefits of scenario planning include:

• Managers are forced to break out of their standard world view, exposing blind spots that might otherwise be overlooked in the generally accepted forecast.

• Decision-makers are better able to recognize a scenario in its early stages, should it actually be the one that unfolds.

• Managers are better able to understand the source of disagreements that often occur when they are envisioning different scenarios without realizing it.

The Scenario Planning Process

The following outlines the sequence of actions that may constitute the process of scenario planning.

1. Specify the scope of the planning and its time frame.

2. For the present situation, develop a clear understanding that will serve as the common departure point for each of the scenarios.

3. Identify predetermined elements that are virtually certain to occur and that will be driving forces.

4. Identify the critical uncertainties in the environmental variables. If the scope of the analysis is wide, these may be in the macro-environment, for example, political, economic, social, and technological factors (as in PEST).

5. Identify the more important drivers. One technique for doing so is as follows. Assign each environmental variable two numerical ratings: one rating for its range of variation and another for the strength of its impact on the firm. Multiply these ratings together to arrive at a number that specifies the significance of each environmental factor. For example, consider the extreme case in which a variable had a very large range such that it might be rated a 10 on a scale of 1 to 10 for variation, but in which the variable had very little impact on the firm so that the strength of impact rating would be a 1. Multiplying the two together would yield 10 out of a possible 100, revealing that the variable is not highly critical. After performing this calculation for all of the variables, identify the two having the highest significance.

6. Consider a few possible values for each variable, ranging between extremes while avoiding highly improbable values.

7. To analyze the interaction between the variables, develop a matrix of scenarios using the two most important variables and their possible values. Each cell in the matrix then represents a single scenario. For easy reference in later discussion it is worthwhile to give each scenario a descriptive name. If there are more than two critical factors, a multidimensional matrix can be created to handle them but would be difficult to visualize beyond 2 or 3 dimensions. Alternatively, factors can be taken in pairs to generate several two-dimensional matrices. A scenario matrix might look something like this:

   Scenario Matrix

   		VARIABLE 1
   		Outcome 1A V	Outcome 1B V
   V A R I A B L E 2	Outcome 2A -->	Scenario 1	Scenario 2
   	Outcome 2B -->	Scenario 3	Scenario 4

   
   One of these scenarios most likely will reflect the mainstream views of the future. The other scenarios will shed light on what else is possible.

8. At this point there is not any detail associated with these "first-generation" scenarios. They are simply high level descriptions of a combination of important environmental variables. Specifics can be generated by writing a story to develop each scenario starting from the present. The story should be internally consistent for the selected scenario so that it describes that particular future as realistically as possible. Experts in specific fields may be called upon to devlop each story, possibly with the use of computer simulation models. Game theory may be used to gain an understanding of how each actor pursuing its own self interest might respond in the scenario. The goal of the stories is to transform the analysis from a simple matrix of the obvious range of environmental factors into decision scenarios useful for strategic planning.

9. Quantify the impact of each scenario on the firm, and formulate appropriate strategies.

An additional step might be to assign a probability to each scenario. Opinions differ on whether one should attempt to assign probabilities when there may be little basis for determining them.

Business unit managers may not take scenarios seriously if they deviate too much from their preconceived view of the world. Many will prefer to rely on forecasts and their judgement, even if they realize that they may miss important changes in the firm's environment. To overcome this reluctance to broaden their thinking, it is useful to create "phantom" scenarios that show the adverse results if the firm were to base its decisions on the mainstream view while the reality turned out to be one of the other scenarios.

Recommended Reading

Wack, Pierre. "Scenarios: Uncharted Waters Ahead." Harvard Business Review 63, no. 5 (1985)

The BCG Growth-Share Matrix

The BCG Growth-Share Matrix is a portfolio planning model developed by Bruce Henderson of the Boston Consulting Group in the early 1970's. It is based on the observation that a company's business units can be classified into four categories based on combinations of market growth and market share relative to the largest competitor, hence the name "growth-share". Market growth serves as a proxy for industry attractiveness, and relative market share serves as a proxy for competitive advantage. The growth-share matrix thus maps the business unit positions within these two important determinants of profitability.

BCG Growth-Share Matrix

This framework assumes that an increase in relative market share will result in an increase in the generation of cash. This assumption often is true because of the experience curve; increased relative market share implies that the firm is moving forward on the experience curve relative to its competitors, thus developing a cost advantage. A second assumption is that a growing market requires investment in assets to increase capacity and therefore results in the consumption of cash. Thus the position of a business on the growth-share matrix provides an indication of its cash generation and its cash consumption.

Henderson reasoned that the cash required by rapidly growing business units could be obtained from the firm's other business units that were at a more mature stage and generating significant cash. By investing to become the market share leader in a rapidly growing market, the business unit could move along the experience curve and develop a cost advantage. From this reasoning, the BCG Growth-Share Matrix was born.

The four categories are:

• Dogs - Dogs have low market share and a low growth rate and thus neither generate nor consume a large amount of cash. However, dogs are cash traps because of the money tied up in a business that has little potential. Such businesses are candidates for divestiture.

• Question marks - Question marks are growing rapidly and thus consume large amounts of cash, but because they have low market shares they do not generate much cash. The result is a large net cash comsumption. A question mark (also known as a "problem child") has the potential to gain market share and become a star, and eventually a cash cow when the market growth slows. If the question mark does not succeed in becoming the market leader, then after perhaps years of cash consumption it will degenerate into a dog when the market growth declines. Question marks must be analyzed carefully in order to determine whether they are worth the investment required to grow market share.

• Stars - Stars generate large amounts of cash because of their strong relative market share, but also consume large amounts of cash because of their high growth rate; therefore the cash in each direction approximately nets out. If a star can maintain its large market share, it will become a cash cow when the market growth rate declines. The portfolio of a diversified company always should have stars that will become the next cash cows and ensure future cash generation.

• Cash cows - As leaders in a mature market, cash cows exhibit a return on assets that is greater than the market growth rate, and thus generate more cash than they consume. Such business units should be "milked", extracting the profits and investing as little cash as possible. Cash cows provide the cash required to turn question marks into market leaders, to cover the administrative costs of the company, to fund research and development, to service the corporate debt, and to pay dividends to shareholders. Because the cash cow generates a relatively stable cash flow, its value can be determined with reasonable accuracy by calculating the present value of its cash stream using a discounted cash flow analysis.

Under the growth-share matrix model, as an industry matures and its growth rate declines, a business unit will become either a cash cow or a dog, determined soley by whether it had become the market leader during the period of high growth.

While originally developed as a model for resource allocation among the various business units in a corporation, the growth-share matrix also can be used for resource allocation among products within a single business unit. Its simplicity is its strength - the relative positions of the firm's entire business portfolio can be displayed in a single diagram.

Limitations

The growth-share matrix once was used widely, but has since faded from popularity as more comprehensive models have been developed. Some of its weaknesses are:

• Market growth rate is only one factor in industry attractiveness, and relative market share is only one factor in competitive advantage. The growth-share matrix overlooks many other factors in these two important determinants of profitability.

• The framework assumes that each business unit is independent of the others. In some cases, a business unit that is a "dog" may be helping other business units gain a competitive advantage.

• The matrix depends heavily upon the breadth of the definition of the market. A business unit may dominate its small niche, but have very low market share in the overall industry. In such a case, the definition of the market can make the difference between a dog and a cash cow.

While its importance has diminished, the BCG matrix still can serve as a simple tool for viewing a corporation's business portfolio at a glance, and may serve as a starting point for discussing resource allocation among strategic business units.

The Value Chain

To better understand the activities through which a firm develops a competitive advantage and creates shareholder value, it is useful to separate the business system into a series of value-generating activities referred to as the value chain. In his 1985 book Competitive Advantage, Michael Porter introduced a generic value chain model that comprises a sequence of activities found to be common to a wide range of firms. Porter identified primary and support activities as shown in the following diagram:

Porter's Generic Value Chain

Inbound Logistics	>	Operations	>	Outbound Logistics	>	Marketing & Sales	>	Service	>	M A R G I N
Firm Infrastructure HR Management Technology Development Procurement

The goal of these activities is to offer the customer a level of value that exceeds the cost of the activities, thereby resulting in a profit margin.

The primary value chain activities are:

• Inbound Logistics: the receiving and warehousing of raw materials, and their distribution to manufacturing as they are required.

• Operations: the processes of transforming inputs into finished products and services.

• Outbound Logistics: the warehousing and distribution of finished goods.

• Marketing & Sales: the identification of customer needs and the generation of sales.

• Service: the support of customers after the products and services are sold to them.

These primary activities are supported by:

• The infrastructure of the firm: organizational structure, control systems, company culture, etc.

• Human resource management: employee recruiting, hiring, training, development, and compensation.

• Technology development: technologies to support value-creating activities.

• Procurement: purchasing inputs such as materials, supplies, and equipment.

The firm's margin or profit then depends on its effectiveness in performing these activities efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of the activities in the value chain. It is in these activities that a firm has the opportunity to generate superior value. A competitive advantage may be achieved by reconfiguring the value chain to provide lower cost or better differentiation.

The value chain model is a useful analysis tool for defining a firm's core competencies and the activities in which it can pursue a competitive advantage as follows:

• Cost advantage: by better understanding costs and squeezing them out of the value-adding activities.

• Differentiation: by focusing on those activities associated with core competencies and capabilities in order to perform them better than do competitors.

Cost Advantage and the Value Chain

A firm may create a cost advantage either by reducing the cost of individual value chain activities or by reconfiguring the value chain.

Once the value chain is defined, a cost analysis can be performed by assigning costs to the value chain activities. The costs obtained from the accounting report may need to be modified in order to allocate them properly to the value creating activities.

Porter identified 10 cost drivers related to value chain activities:

• Economies of scale
• Learning
• Capacity utilization
• Linkages among activities
• Interrelationships among business units
• Degree of vertical integration
• Timing of market entry
• Firm's policy of cost or differentiation
• Geographic location
• Institutional factors (regulation, union activity, taxes, etc.)

A firm develops a cost advantage by controlling these drivers better than do the competitors.

A cost advantage also can be pursued by reconfiguring the value chain. Reconfiguration means structural changes such a new production process, new distribution channels, or a different sales approach. For example, FedEx structurally redefined express freight service by acquiring its own planes and implementing a hub and spoke system.

Differentiation and the Value Chain

A differentiation advantage can arise from any part of the value chain. For example, procurement of inputs that are unique and not widely available to competitors can create differentiation, as can distribution channels that offer high service levels.

Differentiation stems from uniqueness. A differentiation advantage may be achieved either by changing individual value chain activities to increase uniqueness in the final product or by reconfiguring the value chain.

Porter identified several drivers of uniqueness:

• Policies and decisions
• Linkages among activities
• Timing
• Location
• Interrelationships
• Learning
• Integration
• Scale (e.g. better service as a result of large scale)
• Institutional factors

Many of these also serve as cost drivers. Differentiation often results in greater costs, resulting in tradeoffs between cost and differentiation.

There are several ways in which a firm can reconfigure its value chain in order to create uniqueness. It can forward integrate in order to perform functions that once were performed by its customers. It can backward integrate in order to have more control over its inputs. It may implement new process technologies or utilize new distribution channels. Ultimately, the firm may need to be creative in order to develop a novel value chain configuration that increases product differentiation.

Technology and the Value Chain

Because technology is employed to some degree in every value creating activity, changes in technology can impact competitive advantage by incrementally changing the activities themselves or by making possible new configurations of the value chain.

Various technologies are used in both primary value activities and support activities:

• Inbound Logistics Technologies
  • Transportation
  • Material handling
  • Material storage
  • Communications
  • Testing
  • Information systems
    
    
• Operations Technologies
  • Process
  • Materials
  • Machine tools
  • Material handling
  • Packaging
  • Maintenance
  • Testing
  • Building design & operation
  • Information systems
    
    
• Outbound Logistics Technologies
  • Transportation
  • Material handling
  • Packaging
  • Communications
  • Information systems
    
    
• Marketing & Sales Technologies
  • Media
  • Audio/video
  • Communications
  • Information systems
    
    
• Service Technologies
  • Testing
  • Communications
  • Information systems
    
    

Note that many of these technologies are used across the value chain. For example, information systems are seen in every activity. Similar technologies are used in support activities. In addition, technologies related to training, computer-aided design, and software development frequently are employed in support activities.

To the extent that these technologies affect cost drivers or uniqueness, they can lead to a competitive advantage.

Linkages Between Value Chain Activities

Value chain activities are not isolated from one another. Rather, one value chain activity often affects the cost or performance of other ones. Linkages may exist between primary activities and also between primary and support activities.

Consider the case in which the design of a product is changed in order to reduce manufacturing costs. Suppose that inadvertantly the new product design results in increased service costs; the cost reduction could be less than anticipated and even worse, there could be a net cost increase.

Sometimes however, the firm may be able to reduce cost in one activity and consequently enjoy a cost reduction in another, such as when a design change simultaneously reduces manufacturing costs and improves reliability so that the service costs also are reduced. Through such improvements the firm has the potential to develop a competitive advantage.

Analyzing Business Unit Interrelationships

Interrelationships among business units form the basis for a horizontal strategy. Such business unit interrelationships can be identified by a value chain analysis.

Tangible interrelationships offer direct opportunities to create a synergy among business units. For example, if multiple business units require a particular raw material, the procurement of that material can be shared among the business units. This sharing of the procurement activity can result in cost reduction. Such interrelationships may exist simultaneously in multiple value chain activities.

Unfortunately, attempts to achieve synergy from the interrelationships among different business units often fall short of expectations due to unanticipated drawbacks. The cost of coordination, the cost of reduced flexibility, and organizational practicalities should be analyzed when devising a strategy to reap the benefits of the synergies.

Outsourcing Value Chain Activities

A firm may specialize in one or more value chain activities and outsource the rest. The extent to which a firm performs upstream and downstream activities is described by its degree of vertical integration.

A thorough value chain analysis can illuminate the business system to facilitate outsourcing decisions. To decide which activities to outsource, managers must understand the firm's strengths and weaknesses in each activity, both in terms of cost and ability to differentiate. Managers may consider the following when selecting activities to outsource:

• Whether the activity can be performed cheaper or better by suppliers.

• Whether the activity is one of the firm's core competencies from which stems a cost advantage or product differentiation.

• The risk of performing the activity in-house. If the activity relies on fast-changing technology or the product is sold in a rapidly-changing market, it may be advantageous to outsource the activity in order to maintain flexibility and avoid the risk of investing in specialized assets.

• Whether the outsourcing of an activity can result in business process improvements such as reduced lead time, higher flexibility, reduced inventory, etc.

The Value Chain System

A firm's value chain is part of a larger system that includes the value chains of upstream suppliers and downstream channels and customers. Porter calls this series of value chains the value system, shown conceptually below:

The Value System

...

>

Supplier Value Chain

>

Firm Value Chain

>

Channel Value Chain

>

Buyer Value Chain

Linkages exist not only in a firm's value chain, but also between value chains. While a firm exhibiting a high degree of vertical integration is poised to better coordinate upstream and downstream activities, a firm having a lesser degree of vertical integration nonetheless can forge agreements with suppliers and channel partners to achieve better coordination. For example, an auto manufacturer may have its suppliers set up facilities in close proximity in order to minimize transport costs and reduce parts inventories. Clearly, a firm's success in developing and sustaining a competitive advantage depends not only on its own value chain, but on its ability to manage the value system of which it is a part.

The Experience Curve

In the 1960's, management consultants at The Boston Consulting Group observed a consistent relationship between the cost of production and the cumulative production quantity (total quantity produced from the first unit to the last). Data revealed that the real value-added production cost declined by 20 to 30 percent for each doubling of cumulative production quantity:

The Experience Curve

The vertical axis of this logarithmic graph is the real unit cost of adding value, adjusted for inflation. It includes the cost that the firm incurs to add value to the starting materials, but excludes the cost of those materials themselves, which are subject the experience curves of their suppliers.

Note that the experience curve differs from the learning curve. The learning curve describes the observed reduction in the number of required direct labor hours as workers learn their jobs. The experience curve by contrast applies not only to labor intensive situations, but also to process oriented ones.

The experience curve relationship holds over a wide range industries. In fact, its absence would be considered by some to be a sign of possible mismanagement. Cases in which the experience curve is not observed sometimes involve the withholding of capital investment, for example, to increase short-term ROI. The experience curve can be explained by a combination of learning (the learning curve), specialization, scale, and investment.

Implications for Strategy

The experience curve has important strategic implications. If a firm is able to gain market share over its competitors, it can develop a cost advantage. Penetration pricing strategies and a significant investment in advertising, sales personnel, production capacity, etc. can be justified to increase market share and gain a competitive advantage.

When evaluating strategies based on the experience curve, a firm must consider the reaction of competitors who also understand the concept. Some potential pitfalls include:

• The fallacy of composition holds: if all other firms equally pursue the strategy, then none will increase market share and will suffer losses from over-capacity and low prices. The more competitors that pursue the strategy, the higher the cost of gaining a given market share and the lower the return on investment.

• Competing firms may be able to discover the leading firm's proprietary methods and replicate the cost reductions without having made the large investment to gain experience.

• New technologies may create a new experience curve. Entrants building new plants may be able to take advantage of the latest technologies that offer a cost advantage over the older plants of the leading firm.

Competitor Analysis

In formulating business strategy, managers must consider the strategies of the firm's competitors. While in highly fragmented commodity industries the moves of any single competitor may be less important, in concentrated industries competitor analysis becomes a vital part of strategic planning.

Competitor analysis has two primary activities, 1) obtaining information about important competitors, and 2) using that information to predict competitor behavior. The goal of competitor analysis is to understand:

• with which competitors to compete,
• competitors' strategies and planned actions,
• how competitors might react to a firm's actions,
• how to influence competitor behavior to the firm's own advantage.

Casual knowledge about competitors usually is insufficient in competitor analysis. Rather, competitors should be analyzed systematically, using organized competitor intelligence-gathering to compile a wide array of information so that well informed strategy decisions can be made.

Competitor Analysis Framework

Michael Porter presented a framework for analyzing competitors. This framework is based on the following four key aspects of a competitor:

• Competitor's objectives
• Competitor's assumptions
• Competitor's strategy
• Competitor's capabilities

Objectives and assumptions are what drive the competitor, and strategy and capabilities are what the competitor is doing or is capable of doing. These components can be depicted as shown in the following diagram:

Competitor Analysis Components

What drives the competitor What the competitor is doing or is capable of doing Objectives Strategy Competitor Response Profile Assumptions Resources & Capabilities

Adapted from Michael E. Porter, Competitive Strategy, 1980, p. 49.

A competitor analysis should include the more important existing competitors as well as potential competitors such as those firms that might enter the industry, for example, by extending their present strategy or by vertically integrating.

Competitor's Current Strategy

The two main sources of information about a competitor's strategy is what the competitor says and what it does. What a competitor is saying about its strategy is revealed in:

• annual shareholder reports
• 10K reports
• interviews with analysts
• statements by managers
• press releases

However, this stated strategy often differs from what the competitor actually is doing. What the competitor is doing is evident in where its cash flow is directed, such as in the following tangible actions:

• hiring activity
• R & D projects
• capital investments
• promotional campaigns
• strategic partnerships
• mergers and acquisitions

Competitor's Objectives

Knowledge of a competitor's objectives facilitates a better prediction of the competitor's reaction to different competitive moves. For example, a competitor that is focused on reaching short-term financial goals might not be willing to spend much money responding to a competitive attack. Rather, such a competitor might favor focusing on the products that hold positions that better can be defended. On the other hand, a company that has no short term profitability objectives might be willing to participate in destructive price competition in which neither firm earns a profit.

Competitor objectives may be financial or other types. Some examples include growth rate, market share, and technology leadership. Goals may be associated with each hierarchical level of strategy - corporate, business unit, and functional level.

The competitor's organizational structure provides clues as to which functions of the company are deemed to be the more important. For example, those functions that report directly to the chief executive officer are likely to be given priority over those that report to a senior vice president.

Other aspects of the competitor that serve as indicators of its objectives include risk tolerance, management incentives, backgrounds of the executives, composition of the board of directors, legal or contractual restrictions, and any additional corporate-level goals that may influence the competing business unit.

Whether the competitor is meeting its objectives provides an indication of how likely it is to change its strategy.

Competitor's Assumptions

The assumptions that a competitor's managers hold about their firm and their industry help to define the moves that they will consider. For example, if in the past the industry introduced a new type of product that failed, the industry executives may assume that there is no market for the product. Such assumptions are not always accurate and if incorrect may present opportunities. For example, new entrants may have the opportunity to introduce a product similar to a previously unsuccessful one without retaliation because incumbant firms may not take their threat seriously. Honda was able to enter the U.S. motorcycle market with a small motorbike because U.S. manufacturers had assumed that there was no market for small bikes based on their past experience.

A competitor's assumptions may be based on a number of factors, including any of the following:

• beliefs about its competitive position
• past experience with a product
• regional factors
• industry trends
• rules of thumb

A thorough competitor analysis also would include assumptions that a competitor makes about its own competitors, and whether that assessment is accurate.

Competitor's Resources and Capabilities

Knowledge of the competitor's assumptions, objectives, and current strategy is useful in understanding how the competitor might want to respond to a competitive attack. However, its resources and capabilities determine its ability to respond effectively.

A competitor's capabilities can be analyzed according to its strengths and weaknesses in various functional areas, as is done in a SWOT analysis. The competitor's strengths define its capabilities. The analysis can be taken further to evaluate the competitor's ability to increase its capabilities in certain areas. A financial analysis can be performed to reveal its sustainable growth rate.

Finally, since the competitive environment is dynamic, the competitor's ability to react swiftly to change should be evaluated. Some firms have heavy momentum and may continue for many years in the same direction before adapting. Others are able to mobilize and adapt very quickly. Factors that slow a company down include low cash reserves, large investments in fixed assets, and an organizational structure that hinders quick action.

Competitor Response Profile

Information from an analysis of the competitor's objectives, assumptions, strategy, and capabilities can be compiled into a response profile of possible moves that might be made by the competitor. This profile includes both potential offensive and defensive moves. The specific moves and their expected strength can be estimated using information gleaned from the analysis.

The result of the competitor analysis should be an improved ability to predict the competitor's behavior and even to influence that behavior to the firm's advantage.

SWOT Analysis

SWOT analysis is a simple framework for generating strategic alternatives from a situation analysis. It is applicable to either the corporate level or the business unit level and frequently appears in marketing plans. SWOT (sometimes referred to as TOWS) stands for Strengths, Weaknesses, Opportunities, and Threats. The SWOT framework was described in the late 1960's by Edmund P. Learned, C. Roland Christiansen, Kenneth Andrews, and William D. Guth in Business Policy, Text and Cases (Homewood, IL: Irwin, 1969). The General Electric Growth Council used this form of analysis in the 1980's. Because it concentrates on the issues that potentially have the most impact, the SWOT analysis is useful when a very limited amount of time is available to address a complex strategic situation.

The following diagram shows how a SWOT analysis fits into a strategic situation analysis.

Situation Analysis
/	\
Internal Analysis	External Analysis
/ \	/ \
Strengths Weaknesses	Opportunities Threats
SWOT Profile

The internal and external situation analysis can produce a large amount of information, much of which may not be highly relevant. The SWOT analysis can serve as an interpretative filter to reduce the information to a manageable quantity of key issues. The SWOT analysis classifies the internal aspects of the company as strengths or weaknesses and the external situational factors as opportunities or threats. Strengths can serve as a foundation for building a competitive advantage, and weaknesses may hinder it. By understanding these four aspects of its situation, a firm can better leverage its strengths, correct its weaknesses, capitalize on golden opportunities, and deter potentially devastating threats.

Internal Analysis

The internal analysis is a comprehensive evaluation of the internal environment's potential strengths and weaknesses. Factors should be evaluated across the organization in areas such as:

• Company culture
• Company image
• Organizational structure
• Key staff
• Access to natural resources
• Position on the experience curve
• Operational efficiency
• Operational capacity
• Brand awareness
• Market share
• Financial resources
• Exclusive contracts
• Patents and trade secrets

The SWOT analysis summarizes the internal factors of the firm as a list of strengths and weaknesses.

External Analysis

An opportunity is the chance to introduce a new product or service that can generate superior returns. Opportunities can arise when changes occur in the external environment. Many of these changes can be perceived as threats to the market position of existing products and may necessitate a change in product specifications or the development of new products in order for the firm to remain competitive. Changes in the external environment may be related to:

• Customers
• Competitors
• Market trends
• Suppliers
• Partners
• Social changes
• New technology
• Economic environment
• Political and regulatory environment

The last four items in the above list are macro-environmental variables, and are addressed in a PEST analysis.

The SWOT analysis summarizes the external environmental factors as a list of opportunities and threats.

SWOT Profile

When the analysis has been completed, a SWOT profile can be generated and used as the basis of goal setting, strategy formulation, and implementation. The completed SWOT profile sometimes is arranged as follows:

Strengths	Weaknesses
1. 2. 3. . . .	1. 2. 3. . . .
Opportunities	Threats
1. 2. 3. . . .	1. 2. 3. . . .

When formulating strategy, the interaction of the quadrants in the SWOT profile becomes important. For example, the strengths can be leveraged to pursue opportunities and to avoid threats, and managers can be alerted to weaknesses that might need to be overcome in order to successfully pursue opportunities.

Multiple Perspectives Needed

The method used to acquire the inputs to the SWOT matrix will affect the quality of the analysis. If the information is obtained hastily during a quick interview with the CEO, even though this one person may have a broad view of the company and industry, the information would represent a single viewpoint. The quality of the analysis will be improved greatly if interviews are held with a spectrum of stakeholders such as employees, suppliers, customers, strategic partners, etc.

SWOT Analysis Limitations

While useful for reducing a large quantity of situational factors into a more manageable profile, the SWOT framework has a tendency to oversimplify the situation by classifying the firm's environmental factors into categories in which they may not always fit. The classification of some factors as strengths or weaknesses, or as opportunities or threats is somewhat arbitrary. For example, a particular company culture can be either a strength or a weakness. A technological change can be a either a threat or an opportunity. Perhaps what is more important than the superficial classification of these factors is the firm's awareness of them and its development of a strategic plan to use them to its advantage.

PEST Analysis

A PEST analysis is an analysis of the external macro-environment that affects all firms. P.E.S.T. is an acronym for the Political, Economic, Social, and Technological factors of the external macro-environment. Such external factors usually are beyond the firm's control and sometimes present themselves as threats. For this reason, some say that "pest" is an appropriate term for these factors. However, changes in the external environment also create new opportunities and the letters sometimes are rearranged to construct the more optimistic term of STEP analysis.

Many macro-environmental factors are country-specific and a PEST analysis will need to be performed for all countries of interest. The following are examples of some of the factors that might be considered in a PEST analysis.

Political Analysis

• Political stability
• Risk of military invasion
• Legal framework for contract enforcement
• Intellectual property protection
• Trade regulations & tariffs
• Favored trading partners
• Anti-trust laws
• Pricing regulations
• Taxation - tax rates and incentives
• Wage legislation - minimum wage and overtime
• Work week
• Mandatory employee benefits
• Industrial safety regulations
• Product labeling requirements

Economic Analysis

• Type of economic system in countries of operation
• Government intervention in the free market
• Comparative advantages of host country
• Exchange rates & stability of host country currency
• Efficiency of financial markets
• Infrastructure quality
• Skill level of workforce
• Labor costs
• Business cycle stage (e.g. prosperity, recession, recovery)
• Economic growth rate
• Discretionary income
• Unemployment rate
• Inflation rate
• Interest rates

Social Analysis

• Demographics
• Class structure
• Education
• Culture (gender roles, etc.)
• Entrepreneurial spirit
• Attitudes (health, environmental consciousness, etc.)
• Leisure interests

Technological Analysis

• Recent technological developments
• Technology's impact on product offering
• Impact on cost structure
• Impact on value chain structure
• Rate of technological diffusion

The number of macro-environmental factors is virtually unlimited. In practice, the firm must prioritize and monitor those factors that influence its industry. Even so, it may be difficult to forecast future trends with an acceptable level of accuracy. In this regard, the firm may turn to scenario planning techniques to deal with high levels of uncertainty in important macro-environmental variables.

The Strategic Planning Process

In the 1970's, many large firms adopted a formalized top-down strategic planning model. Under this model, strategic planning became a deliberate process in which top executives periodically would formulate the firm's strategy, then communicate it down the organization for implementation. The following is a flowchart model of this process:

The Strategic Planning Process

Mission

V

Objectives

V

Situation Analysis

V

Strategy Formulation

V

Implementation

V

Control

This process is most applicable to strategic management at the business unit level of the organization. For large corporations, strategy at the corporate level is more concerned with managing a portfolio of businesses. For example, corporate level strategy involves decisions about which business units to grow, resource allocation among the business units, taking advantage of synergies among the business units, and mergers and acquisitions. In the process outlined here, "company" or "firm" will be used to denote a single-business firm or a single business unit of a diversified firm.

Mission

A company's mission is its reason for being. The mission often is expressed in the form of a mission statement, which conveys a sense of purpose to employees and projects a company image to customers. In the strategy formulation process, the mission statement sets the mood of where the company should go.

Objectives

Objectives are concrete goals that the organization seeks to reach, for example, an earnings growth target. The objectives should be challenging but achievable. They also should be measurable so that the company can monitor its progress and make corrections as needed.

Situation Analysis

Once the firm has specified its objectives, it begins with its current situation to devise a strategic plan to reach those objectives. Changes in the external environment often present new opportunities and new ways to reach the objectives. An environmental scan is performed to identify the available opportunities. The firm also must know its own capabilities and limitations in order to select the opportunities that it can pursue with a higher probability of success. The situation analysis therefore involves an analysis of both the external and internal environment.

The external environment has two aspects: the macro-environment that affects all firms and a micro-environment that affects only the firms in a particular industry. The macro-environmental analysis includes political, economic, social, and technological factors and sometimes is referred to as a PEST analysis.

An important aspect of the micro-environmental analysis is the industry in which the firm operates or is considering operating. Michael Porter devised a five forces framework that is useful for industry analysis. Porter's 5 forces include barriers to entry, customers, suppliers, substitute products, and rivalry among competing firms.

The internal analysis considers the situation within the firm itself, such as:

• Company culture
• Company image
• Organizational structure
• Key staff
• Access to natural resources
• Position on the experience curve
• Operational efficiency
• Operational capacity
• Brand awareness
• Market share
• Financial resources
• Exclusive contracts
• Patents and trade secrets

A situation analysis can generate a large amount of information, much of which is not particularly relevant to strategy formulation. To make the information more manageable, it sometimes is useful to categorize the internal factors of the firm as strengths and weaknesses, and the external environmental factors as opportunities and threats. Such an analysis often is referred to as a SWOT analysis.

Strategy Formulation

Once a clear picture of the firm and its environment is in hand, specific strategic alternatives can be developed. While different firms have different alternatives depending on their situation, there also exist generic strategies that can be applied across a wide range of firms. Michael Porter identified cost leadership, differentiation, and focus as three generic strategies that may be considered when defining strategic alternatives. Porter advised against implementing a combination of these strategies for a given product; rather, he argued that only one of the generic strategy alternatives should be pursued.

Implementation

The strategy likely will be expressed in high-level conceptual terms and priorities. For effective implementation, it needs to be translated into more detailed policies that can be understood at the functional level of the organization. The expression of the strategy in terms of functional policies also serves to highlight any practical issues that might not have been visible at a higher level. The strategy should be translated into specific policies for functional areas such as:

• Marketing
• Research and development
• Procurement
• Production
• Human resources
• Information systems

In addition to developing functional policies, the implementation phase involves identifying the required resources and putting into place the necessary organizational changes.

Control

Once implemented, the results of the strategy need to be measured and evaluated, with changes made as required to keep the plan on track. Control systems should be developed and implemented to facilitate this monitoring. Standards of performance are set, the actual performance measured, and appropriate action taken to ensure success.

Dynamic and Continuous Process

The strategic management process is dynamic and continuous. A change in one component can necessitate a change in the entire strategy. As such, the process must be repeated frequently in order to adapt the strategy to environmental changes. Throughout the process the firm may need to cycle back to a previous stage and make adjustments.

Drawbacks of this Process

The strategic planning process outlined above is only one approach to strategic management. It is best suited for stable environments. A drawback of this top-down approach is that it may not be responsive enough for rapidly changing competitive environments. In times of change, some of the more successful strategies emerge informally from lower levels of the organization, where managers are closer to customers on a day-to-day basis.

Another drawback is that this strategic planning model assumes fairly accurate forecasting and does not take into account unexpected events. In an uncertain world, long-term forecasts cannot be relied upon with a high level of confidence. In this respect, many firms have turned to scenario planning as a tool for dealing with multiple contingencies.

Convert Yourself Into a Brand

Overview

• What is branding?
• Branding yourself
• Why branding today?
• Steps to Building your Personal Brand
• Conclusion: The importance of building

What Do These Things Have In Common?

• the Walls
• the Oral-B
• the Head & Shoulder
• and an apple icon?

These are all examples of brands of Unilever, P&G and Apple computers

Branding

When you see these brands somewhere, you associate them with a set of expectations or perceptions

• Walls = adds to the simple pleasures in daily life
• Oral B = the brand more dentists use themselves worldwide
• Head & Shoulder = best ever anti-dandruff formula
• Apple logo = cutting-edge technology.

You associate these concepts, thoughts, and images with the particular companies because of the brand each company has established.

Because of branding, you likely have certain images that comes to mind when you think of these products

A brand is a tool that is used in the business world to describe all the information or perceptions that are connected with a product or service.

What is Branding

Branding is…An image created in someone’s mindIt’s both tangible and intangible characteristics of a product or service that make it unique Products that are branded are often chosen over similar products because they somehow have a perceived value of being ‘better’

Example…
Think of the teenagers deciding between a name brand pair of blue jeans and an off-brand pair. Which do you think they will choose?
Why do they perceive one as better than the other than the other?

Branding is not just for products anymore…Use branding concepts for yourself.
Think about the way the following people have branded themselves:

• Shaukat Azizex Citibank Executive, ex Finance Minister, ex Prime Minister
• Larry Page & Sergey Brin Co-founders Larry Page, president of Products, and Sergey Brin, president of Technology, brought Google to life in September 1998
• Bill Gates (William Henry Gates III)chairman of Microsoft, the software company he founded with Paul Allen. The richest man in the world

Branding Yourself

• Helps to define who you are/what you are about (or why an employer should hire you
• Branding yourself is a way of associating great value with a product (the product being you)
• Branding yourself is not about getting an employer to choose you over your competition.
• It is about getting the employer to see you as the only solution to their problem
• Or why your current employer should turn to you for new projects or promotions

Why Branding Today?

Trust is essential in the corporate world

• People want to do business with and hire or promote people they know and feel good about

There has been change in what a traditional career path looks like

• People today change careers an average of 8 times during their lives
• Branding can be consistent throughout the changes (ex. Hard work and creativity can flow through to different occupations)

Steps to Building your Personal Brand

• Step 1: Self-reflection
• Step 2: Continuous Learning
• Step 3: Prepare marketing strategy
• Step 4: Build relationships
• Step 5: Prepare marketing pieces
• Step 6: Develop your pitch
• Step 7: Follow up

The Importance of Branding

• Creating a brand allows you to associate value with your product (you!)
• There are many competing brands…you must position yourself so employers choose you
• By branding yourself – you’ll stand out from other candidates
• If you don’t brand yourself, someone else will do it for you

The Product Life Cycle

A product's life cycle (PLC) can be divided into several stages characterized by the revenue generated by the product. If a curve is drawn showing product revenue over time, it may take one of many different shapes, an example of which is shown below:

Product Life Cycle Curve

The life cycle concept may apply to a brand or to a category of product. Its duration may be as short as a few months for a fad item or a century or more for product categories such as the gasoline-powered automobile.

Product development is the incubation stage of the product life cycle. There are no sales and the firm prepares to introduce the product. As the product progresses through its life cycle, changes in the marketing mix usually are required in order to adjust to the evolving challenges and opportunities.

Introduction Stage

When the product is introduced, sales will be low until customers become aware of the product and its benefits. Some firms may announce their product before it is introduced, but such announcements also alert competitors and remove the element of surprise. Advertising costs typically are high during this stage in order to rapidly increase customer awareness of the product and to target the early adopters. During the introductory stage the firm is likely to incur additional costs associated with the initial distribution of the product. These higher costs coupled with a low sales volume usually make the introduction stage a period of negative profits.

During the introduction stage, the primary goal is to establish a market and build primary demand for the product class. The following are some of the marketing mix implications of the introduction stage:

· Product - one or few products, relatively undifferentiated

· Price - Generally high, assuming a skim pricing strategy for a high profit margin as the early adopters buy the product and the firm seeks to recoup development costs quickly. In some cases a penetration pricing strategy is used and introductory prices are set low to gain market share rapidly.

· Distribution - Distribution is selective and scattered as the firm commences implementation of the distribution plan.

· Promotion - Promotion is aimed at building brand awareness. Samples or trial incentives may be directed toward early adopters. The introductory promotion also is intended to convince potential resellers to carry the product.

Growth Stage

The growth stage is a period of rapid revenue growth. Sales increase as more customers become aware of the product and its benefits and additional market segments are targeted. Once the product has been proven a success and customers begin asking for it, sales will increase further as more retailers become interested in carrying it. The marketing team may expand the distribution at this point. When competitors enter the market, often during the later part of the growth stage, there may be price competition and/or increased promotional costs in order to convince consumers that the firm's product is better than that of the competition.

During the growth stage, the goal is to gain consumer preference and increase sales. The marketing mix may be modified as follows:

· Product - New product features and packaging options; improvement of product quality.

· Price - Maintained at a high level if demand is high, or reduced to capture additional customers.

· Distribution - Distribution becomes more intensive. Trade discounts are minimal if resellers show a strong interest in the product.

· Promotion - Increased advertising to build brand preference.

Maturity Stage

The maturity stage is the most profitable. While sales continue to increase into this stage, they do so at a slower pace. Because brand awareness is strong, advertising expenditures will be reduced. Competition may result in decreased market share and/or prices. The competing products may be very similar at this point, increasing the difficulty of differentiating the product. The firm places effort into encouraging competitors' customers to switch, increasing usage per customer, and converting non-users into customers. Sales promotions may be offered to encourage retailers to give the product more shelf space over competing products.

During the maturity stage, the primary goal is to maintain market share and extend the product life cycle. Marketing mix decisions may include:

· Product - Modifications are made and features are added in order to differentiate the product from competing products that may have been introduced.

· Price - Possible price reductions in response to competition while avoiding a price war.

· Distribution - New distribution channels and incentives to resellers in order to avoid losing shelf space.

· Promotion - Emphasis on differentiation and building of brand loyalty. Incentives to get competitors' customers to switch.

Decline Stage

Eventually sales begin to decline as the market becomes saturated, the product becomes technologically obsolete, or customer tastes change. If the product has developed brand loyalty, the profitability may be maintained longer. Unit costs may increase with the declining production volumes and eventually no more profit can be made.

During the decline phase, the firm generally has three options:

· Maintain the product in hopes that competitors will exit. Reduce costs and find new uses for the product.

· Harvest it, reducing marketing support and coasting along until no more profit can be made.

· Discontinue the product when no more profit can be made or there is a successor product.

The marketing mix may be modified as follows:

· Product - The number of products in the product line may be reduced. Rejuvenate surviving products to make them look new again.

· Price - Prices may be lowered to liquidate inventory of discontinued products. Prices may be maintained for continued products serving a niche market.

· Distribution - Distribution becomes more selective. Channels that no longer are profitable are phased out.

· Promotion - Expenditures are lower and aimed at reinforcing the brand image for continued products.

Limitations of the Product Life Cycle Concept

The term "life cycle" implies a well-defined life cycle as observed in living organisms, but products do not have such a predictable life and the specific life cycle curves followed by different products vary substantially. Consequently, the life cycle concept is not well-suited for the forecasting of product sales. Furthermore, critics have argued that the product life cycle may become self-fulfilling. For example, if sales peak and then decline, managers may conclude that the product is in the decline phase and therefore cut the advertising budget, thus precipitating a further decline.

Nonetheless, the product life cycle concept helps marketing managers to plan alternate marketing strategies to address the challenges that their products are likely to face. It also is useful for monitoring sales results over time and comparing them to those of products having a similar life cycle.

Brand Equity

A brand is a name or symbol used to identify the source of a product. When developing a new product, branding is an important decision. The brand can add significant value when it is well recognized and has positive associations in the mind of the consumer. This concept is referred to as brand equity.

What is Brand Equity?

Brand equity is an intangible asset that depends on associations made by the consumer. There are at least three perspectives from which to view brand equity:

· Financial - One way to measure brand equity is to determine the price premium that a brand commands over a generic product. For example, if consumers are willing to pay $100 more for a branded television over the same unbranded television, this premium provides important information about the value of the brand. However, expenses such as promotional costs must be taken into account when using this method to measure brand equity.

· Brand extensions - A successful brand can be used as a platform to launch related products. The benefits of brand extensions are the leveraging of existing brand awareness thus reducing advertising expenditures, and a lower risk from the perspective of the consumer. Furthermore, appropriate brand extensions can enhance the core brand. However, the value of brand extensions is more difficult to quantify than are direct financial measures of brand equity.

· Consumer-based - A strong brand increases the consumer's attitude strength toward the product associated with the brand. Attitude strength is built by experience with a product. This importance of actual experience by the customer implies that trial samples are more effective than advertising in the early stages of building a strong brand. The consumer's awareness and associations lead to perceived quality, inferred attributes, and eventually, brand loyalty.

Strong brand equity provides the following benefits:

• Facilitates a more predictable income stream.
• Increases cash flow by increasing market share, reducing promotional costs, and allowing premium pricing.
• Brand equity is an asset that can be sold or leased.

However, brand equity is not always positive in value. Some brands acquire a bad reputation that results in negative brand equity. Negative brand equity can be measured by surveys in which consumers indicate that a discount is needed to purchase the brand over a generic product.

Building and Managing Brand Equity

In his 1989 paper, Managing Brand Equity, Peter H. Farquhar outlined the following three stages that are required in order to build a strong brand:

1. Introduction - introduce a quality product with the strategy of using the brand as a platform from which to launch future products. A positive evaluation by the consumer is important.

2. Elaboration - make the brand easy to remember and develop repeat usage. There should be accessible brand attitude, that is, the consumer should easily remember his or her positive evaluation of the brand.

3. Fortification - the brand should carry a consistent image over time to reinforce its place in the consumer's mind and develop a special relationship with the consumer. Brand extensions can further fortify the brand, but only with related products having a perceived fit in the mind of the consumer.

Alternative Means to Brand Equity

Building brand equity requires a significant effort, and some companies use alternative means of achieving the benefits of a strong brand. For example, brand equity can be borrowed by extending the brand name to a line of products in the same product category or even to other categories. In some cases, especially when there is a perceptual connection between the products, such extensions are successful. In other cases, the extensions are unsuccessful and can dilute the original brand equity.

Brand equity also can be "bought" by licensing the use of a strong brand for a new product. As in line extensions by the same company, the success of brand licensing is not guaranteed and must be analyzed carefully for appropriateness.

Managing Multiple Brands

Different companies have opted for different brand strategies for multiple products. These strategies are:

· Single brand identity - a separate brand for each product. For example, in laundry detergents Procter & Gamble offers uniquely positioned brands such as Tide, Cheer, Bold, etc.

· Umbrella - all products under the same brand. For example, Sony offers many different product categories under its brand.

· Multi-brand categories - Different brands for different product categories. Campbell Soup Company uses Campbell's for soups, Pepperidge Farm for baked goods, and V8 for juices.

· Family of names - Different brands having a common name stem. Nestle uses Nescafe, Nesquik, and Nestea for beverages.

Brand equity is an important factor in multi-product branding strategies.

Protecting Brand Equity

The marketing mix should focus on building and protecting brand equity. For example, if the brand is positioned as a premium product, the product quality should be consistent with what consumers expect of the brand, low sale prices should not be used compete, the distribution channels should be consistent with what is expected of a premium brand, and the promotional campaign should build consistent associations.

Finally, potentially dilutive extensions that are inconsistent with the consumer's perception of the brand should be avoided. Extensions also should be avoided if the core brand is not yet sufficiently strong.

Pricing Strategy

One of the four major elements of the marketing mix is price. Pricing is an important strategic issue because it is related to product positioning. Furthermore, pricing affects other marketing mix elements such as product features, channel decisions, and promotion.

While there is no single recipe to determine pricing, the following is a general sequence of steps that might be followed for developing the pricing of a new product:

1. Develop marketing strategy - perform marketing analysis, segmentation, targeting, and positioning.

2. Make marketing mix decisions - define the product, distribution, and promotional tactics.

3. Estimate the demand curve - understand how quantity demanded varies with price.

4. Calculate cost - include fixed and variable costs associated with the product.

5. Understand environmental factors - evaluate likely competitor actions, understand legal constraints, etc.

6. Set pricing objectives - for example, profit maximization, revenue maximization, or price stabilization (status quo).

7. Determine pricing - using information collected in the above steps, select a pricing method, develop the pricing structure, and define discounts.

These steps are interrelated and are not necessarily performed in the above order. Nonetheless, the above list serves to present a starting framework.

Marketing Strategy and the Marketing Mix

Before the product is developed, the marketing strategy is formulated, including target market selection and product positioning. There usually is a tradeoff between product quality and price, so price is an important variable in positioning.

Because of inherent tradeoffs between marketing mix elements, pricing will depend on other product, distribution, and promotion decisions.

Estimate the Demand Curve

Because there is a relationship between price and quantity demanded, it is important to understand the impact of pricing on sales by estimating the demand curve for the product.

For existing products, experiments can be performed at prices above and below the current price in order to determine the price elasticity of demand. Inelastic demand indicates that price increases might be feasible.

Calculate Costs

If the firm has decided to launch the product, there likely is at least a basic understanding of the costs involved, otherwise, there might be no profit to be made. The unit cost of the product sets the lower limit of what the firm might charge, and determines the profit margin at higher prices.

The total unit cost of a producing a product is composed of the variable cost of producing each additional unit and fixed costs that are incurred regardless of the quantity produced. The pricing policy should consider both types of costs.

Environmental Factors

Pricing must take into account the competitive and legal environment in which the company operates. From a competitive standpoint, the firm must consider the implications of its pricing on the pricing decisions of competitors. For example, setting the price too low may risk a price war that may not be in the best interest of either side. Setting the price too high may attract a large number of competitors who want to share in the profits.

From a legal standpoint, a firm is not free to price its products at any level it chooses. For example, there may be price controls that prohibit pricing a product too high. Pricing it too low may be considered predatory pricing or "dumping" in the case of international trade. Offering a different price for different consumers may violate laws against price discrimination. Finally, collusion with competitors to fix prices at an agreed level is illegal in many countries.

Pricing Objectives

The firm's pricing objectives must be identified in order to determine the optimal pricing. Common objectives include the following:

· Current profit maximization - seeks to maximize current profit, taking into account revenue and costs. Current profit maximization may not be the best objective if it results in lower long-term profits.

· Current revenue maximization - seeks to maximize current revenue with no regard to profit margins. The underlying objective often is to maximize long-term profits by increasing market share and lowering costs.

· Maximize quantity - seeks to maximize the number of units sold or the number of customers served in order to decrease long-term costs as predicted by the experience curve.

· Maximize profit margin - attempts to maximize the unit profit margin, recognizing that quantities will be low.

· Quality leadership - use price to signal high quality in an attempt to position the product as the quality leader.

· Partial cost recovery - an organization that has other revenue sources may seek only partial cost recovery.

· Survival - in situations such as market decline and overcapacity, the goal may be to select a price that will cover costs and permit the firm to remain in the market. In this case, survival may take a priority over profits, so this objective is considered temporary.

· Status quo - the firm may seek price stabilization in order to avoid price wars and maintain a moderate but stable level of profit.

For new products, the pricing objective often is either to maximize profit margin or to maximize quantity (market share). To meet these objectives, skim pricing and penetration pricing strategies often are employed. Joel Dean discussed these pricing policies in his classic HBR article entitled, Pricing Policies for New Products.

Skim pricing attempts to "skim the cream" off the top of the market by setting a high price and selling to those customers who are less price sensitive. Skimming is a strategy used to pursue the objective of profit margin maximization.

Skimming is most appropriate when:

· Demand is expected to be relatively inelastic; that is, the customers are not highly price sensitive.

· Large cost savings are not expected at high volumes, or it is difficult to predict the cost savings that would be achieved at high volume.

· The company does not have the resources to finance the large capital expenditures necessary for high volume production with initially low profit margins.

Penetration pricing pursues the objective of quantity maximization by means of a low price. It is most appropriate when:

· Demand is expected to be highly elastic; that is, customers are price sensitive and the quantity demanded will increase significantly as price declines.

· Large decreases in cost are expected as cumulative volume increases.

· The product is of the nature of something that can gain mass appeal fairly quickly.

· There is a threat of impending competition.

As the product lifecycle progresses, there likely will be changes in the demand curve and costs. As such, the pricing policy should be reevaluated over time.

The pricing objective depends on many factors including production cost, existence of economies of scale, barriers to entry, product differentiation, rate of product diffusion, the firm's resources, and the product's anticipated price elasticity of demand.

Pricing Methods

To set the specific price level that achieves their pricing objectives, managers may make use of several pricing methods. These methods include:

· Cost-plus pricing - set the price at the production cost plus a certain profit margin.

· Target return pricing - set the price to achieve a target return-on-investment.

· Value-based pricing - base the price on the effective value to the customer relative to alternative products.

· Psychological pricing - base the price on factors such as signals of product quality, popular price points, and what the consumer perceives to be fair.

In addition to setting the price level, managers have the opportunity to design innovative pricing models that better meet the needs of both the firm and its customers. For example, software traditionally was purchased as a product in which customers made a one-time payment and then owned a perpetual license to the software. Many software suppliers have changed their pricing to a subscription model in which the customer subscribes for a set period of time, such as one year. Afterwards, the subscription must be renewed or the software no longer will function. This model offers stability to both the supplier and the customer since it reduces the large swings in software investment cycles.

Price Discounts

The normally quoted price to end users is known as the list price. This price usually is discounted for distribution channel members and some end users. There are several types of discounts, as outlined below.

· Quantity discount - offered to customers who purchase in large quantities.

· Cumulative quantity discount - a discount that increases as the cumulative quantity increases. Cumulative discounts may be offered to resellers who purchase large quantities over time but who do not wish to place large individual orders.

· Seasonal discount - based on the time that the purchase is made and designed to reduce seasonal variation in sales. For example, the travel industry offers much lower off-season rates. Such discounts do not have to be based on time of the year; they also can be based on day of the week or time of the day, such as pricing offered by long distance and wireless service providers.

· Cash discount - extended to customers who pay their bill before a specified date.

· Trade discount - a functional discount offered to channel members for performing their roles. For example, a trade discount may be offered to a small retailer who may not purchase in quantity but nonetheless performs the important retail function.

· Promotional discount - a short-term discounted price offered to stimulate sales.

Market Analysis

The goal of a market analysis is to determine the attractiveness of a market and to understand its evolving opportunities and threats as they relate to the strengths and weaknesses of the firm.

David A. Aaker outlined the following dimensions of a market analysis:

• Market size (current and future)
• Market growth rate
• Market profitability
• Industry cost structure
• Distribution channels
• Market trends
• Key success factors

Market Size

The size of the market can be evaluated based on present sales and on potential sales if the use of the product were expanded. The following are some information sources for determining market size:

• government data
• trade associations
• financial data from major players
• customer surveys

Market Growth Rate

A simple means of forecasting the market growth rate is to extrapolate historical data into the future. While this method may provide a first-order estimate, it does not predict important turning points. A better method is to study growth drivers such as demographic information and sales growth in complementary products. Such drivers serve as leading indicators that are more accurate than simply extrapolating historical data.

Important inflection points in the market growth rate sometimes can be predicted by constructing a product diffusion curve. The shape of the curve can be estimated by studying the characteristics of the adoption rate of a similar product in the past.

Ultimately, the maturity and decline stages of the product life cycle will be reached. Some leading indicators of the decline phase include price pressure caused by competition, a decrease in brand loyalty, the emergence of substitute products, market saturation, and the lack of growth drivers.

Market Profitability

While different firms in a market will have different levels of profitability, the average profit potential for a market can be used as a guideline for knowing how difficult it is to make money in the market. Michael Porter devised a useful framework for evaluating the attractiveness of an industry or market. This framework, known as Porter's five forces, identifies five factors that influence the market profitability:

• Buyer power
• Supplier power
• Barriers to entry
• Threat of substitute products
• Rivalry among firms in the industry

Industry Cost Structure

The cost structure is important for identifying key factors for success. To this end, Porter's value chain model is useful for determining where value is added and for isolating the costs.

The cost structure also is helpful for formulating strategies to develop a competitive advantage. For example, in some environments the experience curve effect can be used to develop a cost advantage over competitors.

Distribution Channels

The following aspects of the distribution system are useful in a market analysis:

· Existing distribution channels - can be described by how direct they are to the customer.

· Trends and emerging channels - new channels can offer the opportunity to develop a competitive advantage.

· Channel power structure - for example, in the case of a product having little brand equity, retailers have negotiating power over manufacturers and can capture more margin.

Market Trends

Changes in the market are important because they often are the source of new opportunities and threats. The relevant trends are industry-dependent, but some examples include changes in price sensitivity, demand for variety, and level of emphasis on service and support. Regional trends also may be relevant.

Key Success Factors

The key success factors are those elements that are necessary in order for the firm to achieve its marketing objectives. A few examples of such factors include:

• Access to essential unique resources
• Ability to achieve economies of scale
• Access to distribution channels
• Technological progress

It is important to consider that key success factors may change over time, especially as the product progresses through its life cycle.

Market Segmentation

Market segmentation is the identification of portions of the market that are different from one another. Segmentation allows the firm to better satisfy the needs of its potential customers.

The Need for Market Segmentation

The marketing concept calls for understanding customers and satisfying their needs better than the competition. But different customers have different needs, and it rarely is possible to satisfy all customers by treating them alike.

Mass marketing refers to treatment of the market as a homogenous group and offering the same marketing mix to all customers. Mass marketing allows economies of scale to be realized through mass production, mass distribution, and mass communication. The drawback of mass marketing is that customer needs and preferences differ and the same offering is unlikely to be viewed as optimal by all customers. If firms ignored the differing customer needs, another firm likely would enter the market with a product that serves a specific group, and the incumbant firms would lose those customers.

Target marketing on the other hand recognizes the diversity of customers and does not try to please all of them with the same offering. The first step in target marketing is to identify different market segments and their needs.

Requirements of Market Segments

In addition to having different needs, for segments to be practical they should be evaluated against the following criteria:

• Identifiable: the differentiating attributes of the segments must be measurable so that they can be identified.
• Accessible: the segments must be reachable through communication and distribution channels.
• Substantial: the segments should be sufficiently large to justify the resources required to target them.
• Unique needs: to justify separate offerings, the segments must respond differently to the different marketing mixes.
• Durable: the segments should be relatively stable to minimize the cost of frequent changes.

A good market segmentation will result in segment members that are internally homogenous and externally heterogeneous; that is, as similar as possible within the segment, and as different as possible between segments.

Bases for Segmentation in Consumer Markets

Consumer markets can be segmented on the following customer characteristics.

• Geographic
• Demographic
• Psychographic
• Behavioralistic

Geographic Segmentation

The following are some examples of geographic variables often used in segmentation.

• Region: by continent, country, state, or even neighborhood
• Size of metropolitan area: segmented according to size of population
• Population density: often classified as urban, suburban, or rural
• Climate: according to weather patterns common to certain geographic regions

Demographic Segmentation

Some demographic segmentation variables include:

• Age
• Gender
• Family size
• Family lifecycle
• Generation: baby-boomers, Generation X, etc.
• Income
• Occupation
• Education
• Ethnicity
• Nationality
• Religion
• Social class

Many of these variables have standard categories for their values. For example, family lifecycle often is expressed as bachelor, married with no children (DINKS: Double Income, No Kids), full-nest, empty-nest, or solitary survivor. Some of these categories have several stages, for example, full-nest I, II, or III depending on the age of the children.

Psychographic Segmentation

Psychographic segmentation groups customers according to their lifestyle. Activities, interests, and opinions (AIO) surveys are one tool for measuring lifestyle. Some psychographic variables include:

• Activities
• Interests
• Opinions
• Attitudes
• Values

Behavioralistic Segmentation

Behavioral segmentation is based on actual customer behavior toward products. Some behavioralistic variables include:

• Benefits sought
• Usage rate
• Brand loyalty
• User status: potential, first-time, regular, etc.
• Readiness to buy
• Occasions: holidays and events that stimulate purchases

Behavioral segmentation has the advantage of using variables that are closely related to the product itself. It is a fairly direct starting point for market segmentation.

Bases for Segmentation in Industrial Markets

In contrast to consumers, industrial customers tend to be fewer in number and purchase larger quantities. They evaluate offerings in more detail, and the decision process usually involves more than one person. These characteristics apply to organizations such as manufacturers and service providers, as well as resellers, governments, and institutions.

Many of the consumer market segmentation variables can be applied to industrial markets. Industrial markets might be segmented on characteristics such as:

• Location
• Company type
• Behavioral characteristics

Location

In industrial markets, customer location may be important in some cases. Shipping costs may be a purchase factor for vendor selection for products having a high bulk to value ratio, so distance from the vendor may be critical. In some industries firms tend to cluster together geographically and therefore may have similar needs within a region.

Company Type

Business customers can be classified according to type as follows:

• Company size
• Industry
• Decision making unit
• Purchase Criteria

Behavioral Characteristics

In industrial markets, patterns of purchase behavior can be a basis for segmentation. Such behavioral characteristics may include:

• Usage rate
• Buying status: potential, first-time, regular, etc.
• Purchase procedure: sealed bids, negotiations, etc.

Market Definition

In marketing, the term market refers to the group of consumers or organizations that is interested in the product, has the resources to purchase the product, and is permitted by law and other regulations to acquire the product. The market definition begins with the total population and progressively narrows as shown in the following diagram.

Market Definition
Conceptual Diagram

Beginning with the total population, various terms are used to describe the market based on the level of narrowing:

· Total population

· Potential market - those in the total population who have interest in acquiring the product.

· Available market - those in the potential market who have enough money to buy the product.

· Qualified available market - those in the available market who legally are permitted to buy the product.

· Target market - the segment of the qualified available market that the firm has decided to serve (the served market).

· Penetrated market - those in the target market who have purchased the product.

In the above listing, "product" refers to both physical products and services.

The size of the market is not necessarily fixed. For example, the size of the available market for a product can be increased by decreasing the product's price, and the size of the qualified available market can be increased through changes in legislation that result in fewer restrictions on who can buy the product.

Defining the market is the first step in analyzing it. Since the market is likely to be composed of consumers whose needs differ, market segmentation is useful in order to better understand those needs and to select the groups within the market that the firm will serve.

The Marketing Process

Under the marketing concept, the firm must find a way to discover unfulfilled customer needs and bring to market products that satisfy those needs. The process of doing so can be modeled in a sequence of steps: the situation is analyzed to identify opportunities, the strategy is formulated for a value proposition, tactical decisions are made, the plan is implemented and the results are monitored.

The Marketing Process

Situation Analysis

V

Marketing Strategy

V

Marketing Mix Decisions

V

Implementation & Control

I. Situation Analysis

A thorough analysis of the situation in which the firm finds itself serves as the basis for identifying opportunities to satisfy unfulfilled customer needs. In addition to identifying the customer needs, the firm must understand its own capabilities and the environment in which it is operating.

The situation analysis thus can be viewed in terms an analysis of the external environment and an internal analysis of the firm itself. The external environment can be described in terms of macro-environmental factors that broadly affect many firms, and micro-environmental factors closely related to the specific situation of the firm.

The situation analysis should include past, present, and future aspects. It should include a history outlining how the situation evolved to its present state, and an analysis of trends in order to forecast where it is going. Good forecasting can reduce the chance of spending a year bringing a product to market only to find that the need no longer exists.

If the situation analysis reveals gaps between what consumers want and what currently is offered to them, then there may be opportunities to introduce products to better satisfy those consumers. Hence, the situation analysis should yield a summary of problems and opportunities. From this summary, the firm can match its own capabilities with the opportunities in order to satisfy customer needs better than the competition.

There are several frameworks that can be used to add structure to the situation analysis:

· 5 C Analysis - company, customers, competitors, collaborators, climate. Company represents the internal situation; the other four cover aspects of the external situation

· PEST analysis - for macro-environmental political, economic, societal, and technological factors. A PEST analysis can be used as the "climate" portion of the 5 C framework.

· SWOT analysis - strengths, weaknesses, opportunities, and threats - for the internal and external situation. A SWOT analysis can be used to condense the situation analysis into a listing of the most relevant problems and opportunities and to assess how well the firm is equipped to deal with them.

II. Marketing Strategy

Once the best opportunity to satisfy unfulfilled customer needs is identified, a strategic plan for pursuing the opportunity can be developed. Market research will provide specific market information that will permit the firm to select the target market segment and optimally position the offering within that segment. The result is a value proposition to the target market. The marketing strategy then involves:

• Segmentation
• Targeting (target market selection)
• Positioning the product within the target market
• Value proposition to the target market

III. Marketing Mix Decisions

Detailed tactical decisions then are made for the controllable parameters of the marketing mix. The action items include:

• Product development - specifying, designing, and producing the first units of the product.
• Pricing decisions
• Distribution contracts
• Promotional campaign development

IV. Implementation and Control

At this point in the process, the marketing plan has been developed and the product has been launched. Given that few environments are static, the results of the marketing effort should be monitored closely. As the market changes, the marketing mix can be adjusted to accomodate the changes. Often, small changes in consumer wants can addressed by changing the advertising message. As the changes become more significant, a product redesign or an entirely new product may be needed. The marketing process does not end with implementation - continual monitoring and adaptation is needed to fulfill customer needs consistently over the long-term.

Situation Analysis

In order to profitably satisfy customer needs, the firm first must understand its external and internal situation, including the customer, the market environment, and the firm's own capabilities. Furthermore, it needs to forecast trends in the dynamic environment in which it operates.

A useful framework for performing a situation analysis is the 5 C Analysis. The 5C analysis is an environmental scan on five key areas especially applicable to marketing decisions. It covers the internal, the micro-environmental, and the macro-environmental situation. The 5 C analysis is an extension of the 3 C analysis (company, customers, and competitors), to which some marketers added the 4th C of collaborators. The further addition of a macro-environmental analysis (climate) results in a 5 C analysis, some aspects of which are outlined below.

Company

• Product line
• Image in the market
• Technology and experience
• Culture
• Goals

Collaborators

• Distributors
• Suppliers
• Alliances

Customers

• Market size and growth
• Market segments
• Benefits that consumer is seeking, tangible and intangible.
• Motivation behind purchase; value drivers, benefits vs. costs
• Decision maker or decision-making unit
• Retail channel - where does the consumer actually purchase the product?
• Consumer information sources - where does the customer obtain information about the product?
• Buying process; e.g. impulse or careful comparison
• Frequency of purchase, seasonal factors
• Quantity purchased at a time
• Trends - how consumer needs and preferences change over time

Competitors

• Actual or potential
• Direct or indirect
• Products
• Positioning
• Market shares
• Strengths and weaknesses of competitors

Climate (or context)

The climate or macro-environmental factors are:

· Political & regulatory environment - governmental policies and regulations that affect the market

· Economic environment - business cycle, inflation rate, interest rates, and other macroeconomic issues

· Social/Cultural environment - society's trends and fashions

· Technological environment - new knowledge that makes possible new ways of satisfying needs; the impact of technology on the demand for existing products.

The analysis of the these four external "climate" factors often is referred to as a PEST analysis.

Information Sources

Customer and competitor information specifically oriented toward marketing decisions can be found in market research reports, which provide a market analysis for a particular industry. For foreign markets, country reports can be used as a general information source for the macro-environment. By combining the regional and market analysis with knowledge of the firm's own capabilities and partnerships, the firm can identify and select the more favorable opportunities to provide value to the customer.

The Marketing Concept

The marketing concept is the philosophy that firms should analyze the needs of their customers and then make decisions to satisfy those needs, better than the competition. Today most firms have adopted the marketing concept, but this has not always been the case.

In 1776 in The Wealth of Nations, Adam Smith wrote that the needs of producers should be considered only with regard to meeting the needs of consumers. While this philosophy is consistent with the marketing concept, it would not be adopted widely until nearly 200 years later.

To better understand the marketing concept, it is worthwhile to put it in perspective by reviewing other philosophies that once were predominant. While these alternative concepts prevailed during different historical time frames, they are not restricted to those periods and are still practiced by some firms today.

The Production Concept
The production concept prevailed from the time of the industrial revolution until the early 1920's. The production concept was the idea that a firm should focus on those products that it could produce most efficiently and that the creation of a supply of low-cost products would in and of itself create the demand for the products. The key questions that a firm would ask before producing a product were:

• Can we produce the product?
• Can we produce enough of it?

At the time, the production concept worked fairly well because the goods that were produced were largely those of basic necessity and there was a relatively high level of unfulfilled demand. Virtually everything that could be produced was sold easily by a sales team whose job it was simply to execute transactions at a price determined by the cost of production. The production concept prevailed into the late 1920's.

The Sales Concept
By the early 1930's however, mass production had become commonplace, competition had increased, and there was little unfulfilled demand. Around this time, firms began to practice the sales concept (or selling concept), under which companies not only would produce the products, but also would try to convince customers to buy them through advertising and personal selling. Before producing a product, the key questions were:

• Can we sell the product?
• Can we charge enough for it?

The sales concept paid little attention to whether the product actually was needed; the goal simply was to beat the competition to the sale with little regard to customer satisfaction. Marketing was a function that was performed after the product was developed and produced, and many people came to associate marketing with hard selling. Even today, many people use the word "marketing" when they really mean sales.

The Marketing Concept
After World War II, the variety of products increased and hard selling no longer could be relied upon to generate sales. With increased discretionary income, customers could afford to be selective and buy only those products that precisely met their changing needs, and these needs were not immediately obvious. The key questions became:

• What do customers want?
• Can we develop it while they still want it?
• How can we keep our customers satisfied?

In response to these discerning customers, firms began to adopt the marketing concept, which involves:

• Focusing on customer needs before developing the product
• Aligning all functions of the company to focus on those needs
• Realizing a profit by successfully satisfying customer needs over the long-term

When firms first began to adopt the marketing concept, they typically set up separate marketing departments whose objective it was to satisfy customer needs. Often these departments were sales departments with expanded responsibilities. While this expanded sales department structure can be found in some companies today, many firms have structured themselves into marketing organizations having a company-wide customer focus. Since the entire organization exists to satisfy customer needs, nobody can neglect a customer issue by declaring it a "marketing problem" - everybody must be concerned with customer satisfaction.

The marketing concept relies upon marketing research to define market segments, their size, and their needs. To satisfy those needs, the marketing team makes decisions about the controllable parameters of the marketing mix.

The Balanced Scorecard

Traditional financial performance metrics provide information about a firm's past results, but are not well-suited for predicting future performance or for implementing and controlling the firm's strategic plan. By analyzing perspectives other than the financial one, managers can better translate the organization's strategy into actionable objectives and better measure how well the strategic plan is executing.

The Balanced Scorecard is a management system that maps an organization's strategic objectives into performance metrics in four perspectives: financial, internal processes, customers, and learning and growth. These perspectives provide relevant feedback as to how well the strategic plan is executing so that adjustments can be made as necessary. The Balance Scorecard framework can be depicted as follows:

The General Ledger

The general ledger is a collection of the firm's accounts. While the general journal is organized as a chronological record of transactions, the ledger is organized by account. In casual use the accounts of the general ledger often take the form of simple two-column T-accounts. In the formal records of the company they may contain a third or fourth column to display the account balance after each posting.

To illustrate the posting of transactions in the general ledger, consider the following transactions taken from the example on general journal entries:

The above journal entries affect a total of seven different accounts and would be posted to the T-accounts of the general ledger as follows:

General Ledger (T-Accounts)

Note the direct mapping between the journal entries and the ledger postings. While this posting of journalized transactions in the general ledger at first may appear to be redundant since the transactions already are recorded in the general journal, the general ledger serves an important function: it allows one to view the activity and balance of each account at a glance. Because the posting to the ledger is simply a rearrangement of information requiring no additional decisions, it easily is performed by accounting software, either when the journal entry is made or as a batch process, for example, at the end of the day or week.

Finally, while such T-accounts are handy for informal use, in practice a three-column or four-column account may be used to show the running account balance, and in the case of a four column account, whether that balance is a net debit or credit. Additionally, reference numbers may be used so that each posting can be traced back to its original journal entry.

General Journal Entries

The journal is the point of entry of business transactions into the accounting system. It is a chronological record of the transactions, showing an explanation of each transaction, the accounts affected, whether those accounts are increased or decreased, and by what amount.

A general journal entry takes the following form:

Consider the following example that illustrates the basic concept of general journal entries.

Mike Peddler opens a bicycle repair shop. He leases shop space, purchases an initial inventory of bike parts, and begins operations. Here are the general journal entries for the first month:

Most of the above transactions are entered as simple journal entries each debiting one account and crediting another. The entry for 9/17 is a compound journal entry, composed of two lines for the debit and one line for the credit. The transaction could have been entered as two separate simple journal entries, but the compound form is more efficient.

In this example, there are no account numbers. In practice, account numbers or codes may be included in the journal entries to allow each account to be positively identified with no confusion between similar accounts.

The journal entry is the first entry of a transaction in the accounting system. Before the entry is made, the following decisions must be made:

• which accounts are affected by the transaction, and
• which account will be debited and which will be credited.
  

Once entered in the journal, the transactions may be posted to the appropriate T-accounts of the general ledger. Unlike the journal entry, the posting to the general ledger is a purely mechanical process - the account and debit/credit decisions already have been made.

Source Documents

The source document is the original record of a transaction. During an audit, source documents are used as evidence that a particular business transaction occurred. Examples of source documents include:

• Cash receipts
• Credit card receipts
• Cash register tapes
• Cancelled checks
• Customer invoices
• Supplier invoices
• Purchase orders
• Time cards
• Deposit slips
• Notes for loans
• Payment stubs for interest

At a minimum, each source document should include the date, the amount, and a description of the transaction. When practical, beyond these minimum requirements source documents should contain the name and address of the other party of the transaction.

When a source document does not exist, for example, when a cash receipt is not provided by a vendor or is misplaced, a document should be generated as soon as possible after the transaction, using other documents such as bank statements to support the information on the generated source document.

Once a transaction has been journalized, the source document should be filed and made retrievable so that transactions can be verified should the need arise at a later date.

The Accounting Process (The Accounting Cycle)

The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps:

• Identify the transaction or other recognizable event.
• Prepare the transaction's source document such as a purchase order or invoice.
• Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected and whether those accounts are to be debited or credited.
• Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order.
• Post general journal entries to the ledger accounts.

The Above Steps Are Performed Throughout The Accounting Period As Transactions Occur Or In Periodic Batch Processes. The Following Steps Are Performed At The End Of The Accounting Period:

• Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance.


• Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:
• posting of the wrong amount,
• omitting a posting,
• posting in the wrong column, or
• posting more than once.
• Prepare adjusting entries to record accrued, deferred, and estimated amounts.
• Post adjusting entries to the ledger accounts.
• Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.
• Prepare the financial statements.
• Income statement: prepared from the revenue, expenses, gains, and losses.
• Balance sheet: prepared from the assets, liabilities, and equity accounts.
• Statement of retained earnings: prepared from net income and dividend information.
• Cash flow statement: derived from the other financial statements using either the direct or indirect method.
• Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital.
• Post closing entries to the ledger accounts.
• Prepare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors.
• Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period.

Instead of preparing the financial statements before the closing journal entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.