Business Strategy 101
In my experience, small businesses usually take one of the five following strategies:
- Revenue maximization
- Cost minimization
- Low cost production
The most frequent business strategy that I have encountered in my 21 years of consulting and advising owner-managers is one of revenue maximization. This is due, in my opinion, to an excessive focus on the income statement and the perception that revenue growth is the ultimate objective of a business. Maximizing the value of your business — and your personal wealth — may be achieved without revenue growth.
Revenue maximization is the most common strategy that I have observed in businesses that are under-performing compared to their potential. It exists because the business owner believes that any business is good business. This may have been true when the business was a start-up and hungry for cash. However, it is not supportable in the long term if the objective is to maximize ROI. In short, this business does anything it can, well or not, to earn revenues. Revenue is more important than quality, even though quality may be stated as important. All the team members are trying to do as much as they can. Weaknesses of this approach include a lack of specialization of skills, a lack of focus on profitable customers, a lack of focus on profitable product or service lines, and too many activities consuming too few resources (people, money, time). This business appears very busy, and it is, because it is trying to do the thing right (i.e. maximizing revenues), because it has not figured out the right thing (i.e. maximizing ROI) to do (Drucker, 1964).
Cost minimization, as addressed by Tom Peters in his popular book “You Can’t Shrink Your Way to Greatness” is, unfortunately, widely accepted even though it is ineffective. At meetings with clients to present the client’s year-end financial statements, I have witnessed some financial professionals offer the following comments regarding their analysis of the client’s income statement: “your revenues are holding their own in these tough times, so if you want to improve your bottom line, you are going to need to reduce your expenses” and the clients nod their heads in agreement.
This is wrong in both theory and fact. The objective of a business is not to reduce its expenses but to maximize its “economic performance” (Drucker, 1964). Return on Investment (ROI) is a measure of the overall profitability as a percentage of equity invested to earn those profits. ROI effectively ties in the balance sheet and the income statement. Exclusive focus on either financial statement is insufficient to make optimal decisions. Only the ROI focus will allow a business to evaluate its expenditures and investments in terms of their impact on ROI.
Outright reduction of expenses, through layoffs, cost-cutting and other forms of rationalization may generate short-term profit improvement. However, these strategies have been shown to reduce a company’s capacity and competitive advantages, resulting in long-term, irreparable declines in performance and value (Baron and Kreps, 1999).
The third, forth and fifth strategies, that of a low cost producer, a differentiator and focus, are highly regarded and effective strategies (Porter, 1980). The third strategy is that of a low cost producer. This means that you maximize your ROI by having a cost advantage over your competitors. For example, suppliers to Wal-Mart (it began as a small business) would be selected by Wal-Mart because they have cost advantages over their competitors. Realistically, it is difficult for many small businesses to have cost advantages due to the requirements for several factors including detailed cost information, cost systems and people to generate this information, and customers to purchase large quantities of homogeneous products or services.
The fourth strategy, differentiation, is highly effective for small businesses. Businesses practising differentiation are very good at a specific product or service, or at some part of the value chain that produces and distributes the product or service (Porter, 1985). Differentiation allows a business of any size, large or small, to add extra value to its customers and achieve higher prices, higher margins, higher cash flows and higher ROIs (ibid). This strategy is the most frequently found strategy in successful small businesses, in my experience.
Small businesses are well positioned to differentiate and obtain an advantage over larger competitors for several reasons. Small businesses and their owners and managers are usually closer to the action and have stronger relationships with their customers than large companies have with their customers. In turn, they can customize, adjust and modify products and services to meet a customer’s unique needs. Then, they can charge higher prices (this requires courage) and earn a higher ROI. Only about 10% to 15% of a business’ customers are price sensitive (Results Accountants Systems, 1997). Yet, business owners frequently discount their prices for the other 85% to 90% of the customers who are satisfied with prices. This is because the owners over-react to negative comments about prices from this 10% to 15% of their customers. Indeed, the author has successfully improved profitability and cash flow in a variety of businesses using a price increase within a differentiation strategy. Porter states that “Differentiation allows the firm to command a premium price” (1985: 120). As a result, “differentiation leads to superior performance” (ibid.).
A problem with the differentiation strategy that the small business needs to address is that it may still cause the business to focus on too many customers, perpetuating the problem of trying to be all things to all people and diluting the value of differentiation.
Although the differentiation strategy sounds simple, and it is, it is not easy. Increasing prices requires a strength of faith in the part of the owner who may have, for too many years, negatively reacted to price complaints. The most difficult area for any manager to manage is likely the six inch space between their ears, because we are all creatures of habit, and change (especially personal change) is painful and risky. Fortunately, a price increase can generate immediate improvements in profitability and cash flow, and these positive results are usually sufficient for the owner to continue to implement the price increase strategy (Results Accountants Systems, 1997). By differentiating their products and services, and using their knowledge of and relationships with their customers, business owners can be highly successful in implementing a differentiation strategy to maximize their ROI.
The focus strategy is aimed at “serving a particular target (market) very well” (Porter, 1980: 38). Although it is initiated as a marketing strategy, it may result in cost advantages, differentiation or both. The focus strategy of targeting a specific market, in concept, may be very effective for small businesses because it deals with the problems inherent in the revenue maximization strategy noted earlier of trying to be all things to all people. However, a small business with a limited geographic focus will not pursue a true focus strategy of market penetration because its focus is limited to the immediate market only.
The implementation of strategy.
Once the strategy is selected, or to enhance the existing strategy, the business needs to implement its strategy. The processes of strategic planning, clarifying the values, vision and mission of the company and communicating these with the employees is not only useful for large businesses, it is very useful for small businesses. Many owners think that their employees understand the owner’s perspectives on the direction of the company. However, it is my observation that most employees do not understand the strategy and often receive or perceive mixed messages from the owner.
These strategic planning practices appear to be more common in successful small businesses than in under-performing businesses, according to the author’s experience. There appears to be a reluctance to commit some things to paper by some owners, perhaps because they shun anything that they think will appear to be bureaucratic, or perhaps because they fear that it won’t make sense if it’s written down (Thurston, 1983). However, these processes are part of the discipline that successful businesses undertake (ibid.). It is healthy to put forth ideas and engage in debate about assumptions, expectations, opportunities and possibilities. It is not healthy to continue to do the same thing over and over and expect a different result – this is a definition of insanity.
To summarize strategy, small businesses will maximize their ROI if they implement either cost leadership, differentiation or focus strategies (Porter, 1985). Profitability is not a function of financial strategy, neither is profitability simply the mathematics of revenues minus expenses. Profitability is a function of business strategy where pricing and margins are dependent upon the selection of cost leadership, differentiation or focus strategies. This critical fact seems to be well-understood by successful small businesses and difficult to implement for under-performing small businesses. Differentiation is highly effective for small businesses. Strategic planning allows strategies to be formed, and to continue to evolve, because the implementation of strategy in an ongoing process.
Copyright Phil Symchych. 2012. All rights reserved.