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Strategic Modelling for Competitive Advantage
R.Y.Cavana
Graduate School of Business and Government Management,
Victoria University of Wellington, PO Box 600, Wellington, New Zealand
R.D. Hughes
R.D. Hughes Consulting Ltd, PO Box 41-084, Wellington, New Zealand
Abstract
This paper provides an interim report of the work of the authors in developing a framework for
analysing strategic and policy decisions within organisations. To explore frameworks a system
dynamics model is developed which draws upon Michael Porter's approach to assessing industry
profitability, Alfred Rappaport's method for measuring value creation and Oliver Williamson's
approach for aligning management structures with the nature of the service being provided that
promote economic efficiency. The framework is empirically tested based on the development of a
dynamic simulation model of a subsidiary of a large private sector company in New Zealand. A
number of scenarios are provided illustrating the use of the model.
Introduction
Recent work of the authors has been to identify the actions available to managers to increase the
value of organisations. This paper describes the initial framework and model developed to
evaluate value creating actions.
Porter (1991, 98) identified two approaches to theory building, that of developing models and
frameworks:
“These two approaches to theory building are not mutually exclusive. Indeed, they should
create a constructive tension with each other. Models are particularly valuable in ensuring
logical consistency and exploring the subtle interactions involving a limited number of
variables. Models should challenge the variables included in frameworks and assertions
about their link to outcomes. Frameworks, in turn, should challenge models by highlighting
omitted variables, the diversity of competitive situations, the range of actual strategy choices,
and the extent to which important parameters are not fixed but continually in flux.”
These approaches to theory building have been employed by the authors to develop frameworks
for understanding the sources and methods of exploiting competitive advantage available to
managers. This paper is an interin report of the authors’ work in the area.
This paper is organised into five further sections. The next section covers the overview of the
framework. This is followed by a discussion of the model; then the key components of the model.
Next some scenarios illustrating the use of the model are provided. Finally, some concluding
comments are presented.
Overview of the framework
The framework is based on a view of the organisation as a coalition of management units and/or
independent parties, that co-operate to manage the flow of products and services along the entire
chain of activity to meet client needs. This chain of activity covers all the stages in the service
delivery process. (Further details of this approach are provided in Hughes (1993)). The entire
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System Dynamics '95 — Volume II
workflow is managed - from service development to delivery to end users. Management units are
seen to operate in competitive markets in which customers and investors can choose who they
want to buy from, or where to invest. Viewing an organisation in this way, emphasises the
following decisions faced by managers: the need to demonstrate value for money; the problem of
how to stay close to the customer; how relationships with suppliers can best be managed; how
competitive advantage can be maintained; and what return on investment will be achieved for
shareholders, and how.
The key assumptions, based on Williamson (1991), on which this approach rests are:
Competition is the best mechanism for ensuring that an organisation remains efficient.
The strongest incentive to achieve on going efficiency gains is the requirement to prove to
owners that the cost of producing a service internally, is no greater than the cost of
purchasing the service on the open market.
Managers who do not evaluate the effectiveness of their operations by making comparisons
m against external standards, run the risk of developing high cost structures and over time
ry creating unviable organisations.
n's All outputs are supplied to meet customer needs.
aat The boundary of any organisation is defined by the market.
fa
A
iew of the model
trategy Simulation Model has been developed within a system dynamics framework
ster, 1961; Coyle, 1977) using the dynamic simulation software ithink (Richmond et al.,
The suitability of system dynamics as a method for policy and strategy analysis has also
liscussed by Cavana (1981) and Morecroft (1984).
Strategy Simulation Model provides a tool for the assessment of an organisation in a
setting. The framework of the dynamic simulation model is presented in Figure 1.
tions which are implicit in this model include:
possible to simplify the description of a business to a form which allows the application
system dynamics modelling tool. This assumes that the boundary of any management
is defined by what products and services can be purchased on the open market.
isations can be viewed as a network of business units with customer and supplier
nships. Value drivers are developed at business unit level.
drivers are associated with factors such as asset utilisation, reduced transaction costs
tegration, and retaining control of the economic rent from information.
Simulation Model has been designed for use by managers and executive staff with
entary knowledge of ithink . The interface to the model guides the user through the
lefined control panels for specifying key variables and generating standard reports.
agram should contain all the variables that will be used to construct the model. The
shown in the diagram will reflect current management strategies. In the case of the
‘organisation in New Zealand where this framework was tested, for example, a key
current management strategy was the delay time to complete a job. Managers were
iow changes in strategy would impact on the economic value and competitive
ir business unit by changing delay times. They found that reducing these delays
impact on the economic value of the unit and its competitiveness. Potentially, the
‘Manage this variable could provide a strategic advantage to the organisation.
Figure 1, the Strategy Simulation Model comprises the control panels plus four
luding: the industry and market sector, the product & service delivery sector,
d strategic performance indicators.
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Control panels
Variables set through the control panels listed in Table 1
Industry and Product & Financial
market service measures
delivery
Model of the [qump! Modelofthe {¢——»! Model of the
competitive sources of capital and
world a competitive financial flows
business must advantage. of the
survive in. business,
i
Strategic performance indicators
Maps listed in Figures 5 - 7
Figure 1. Structure of the Strategy Simulation Model
Feedback loops
A significant feature of the modelling approach is the representation of the major relationships as
feedback loops, which are closed chains of cause and effect relationships that generate dynamic
behaviour over time. For example, Figure 2 illustrates major feedback loops operating through
changes in price and quality of service on the firms market share through changes in win ratio and
addressable market. Based on the actual demand products and services are delivered following the
transformation of inputs of staff, resources, assets and managerial skills, etc. After a delay the
service is provided, which depending on the quality, determines the price of the service and
subsequently effects the addressable market and win ratio (which determines market share). These
variables influence the future demand for products and services, which determines the level of
activity that the firm is engaged in.
|» Addressable Product and service delivery
market
Te Actual mmm Transformation mame
demand & delays ¥
a Sa 4 Price
Win ratio Staff and other
rc resources
System Dynamics '95 — Volume II
Control panels
The control panels cluster the variables into the main areas of strategic decision making: industry,
operational efficiency, scope of business, finance, indifference curves, and indices. The variables
shown in the control panels in Table 1 have been selected for illustrative purposes. These variables
and parameters can be altered by managers or analysts without much previous experience in ithink
modelling to examine the behaviour of the system under different scenarios.
Table 1. Variables available in the control panels
Operational efficiency _
Average contractor cost per job
ipplier bargaining power . Material costs per job
yer bargaining power Management emphasis index
reat of new entrants & exit barriers Hours available per person
Average hours per job
Fraction hours recovery
Hire delay
discount premiums Firing delay
al industry price per job Average salaries
al industry lead time Support staff costs
labour productivity Regulatory delays
apital productivity Other delays
Finance
Tax rate
Debt equity ratio
Interest rate
Discount rate
Average receivable delays
Average payable delays
Indices
or premium Quality index
on win ratio Labour productivity index
on price Capital productivity index
on addressable market Financial strength index
Addressable market index
and market sector links the variables in the wider market to the actual market share
organisation. This sector links the main variables of industry profitability with the
market size and growth rate, the addressable market and win ratio. For example, the
t’s (1980) five competitive forces of: rivalry among competitors, supplier and
'§ power, and threat of new entrants and substitutes on industry profitability are
ink flow diagram in Figure 3. An additional variable, government action, is also
fect on industry profitability. These variables (effects) are modelled as graph
n take on a different value each year for the five year simulation run. The
Managerial judgement or are the result of further analytical studies on behalf of
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rivalry among competitors
‘supplier bargaining power
Industry Profitab\ity
threat of substitutes
government actions
Figure 3. Sources of industry profitability
Strategic performance indicators
The performance indicators sector contains the calculations for the performance indices including:
the quality index, labour and capital productivity indices, financial strength index and addressable
market index. These indices are used in the calculations of the key model outputs, viz. the market
positioning map, economic value map and competitive advantage map, which are discussed below.
The ithink diagram for the calculation of shareholder value is provided in Figure 4. This
incorporates Rappaport’s (1986) concepts of value creation, whereby shareholder value is defined
as the difference between the corporate value less the market value of the debt. The corporate value
is based on the present value of the operating net cash flows plus the present value of the residual
value of the entity.
Operating net cash flow
Cum PV oMopertting cash flows
iscounk rate
Residual value Ratio BYp cash flow to res val
Cash PV of residual value COR! \TE VALUE
Long term debt
Market value of debt | SHAREHOLDER VALUE
atinn af charehalder value
System Dynamics '95 — Volume II
Key model outputs
Experience has confirmed that it is possible for managers unfamiliar with simulation modelling to
work with these tools and quickly gain important insights into their businesses from them. With
this analytical framework and the strategy simulation model, the user will be able to set their own
input parameters, and evaluate the impact of different decisions in order to identify and understand
the unique value drivers of their business unit. The three key diagnostic outputs of the Strategy
Simulation Model are: the market positioning map, the economic value map, and the competitive
advantage map.
Market positioning map
Figure 5 shows the market positioning map. Where the result is close to the origin a weak market
position exists. Managers would be expected to respond to this by taking steps to clearly position
the business in the market. This mapping tool enables managers to evaluate how the business unit
is currently positioned in a competitive environment, and whether the current competitive strategy
is the most appropriate option for the future.
Market leadership
Focus Differentiation
Defensive
Figure 5. Market positioning map
Economic value map
The economic value map, shown in Figure 6, traces out the present value of expected future
earnings. The final value is the present value of all expected future earnings (following Rappaport
(1986)). Also incorporated into this map is the weighted average cost of capital faced by the
organisation. Where the economic value is greater than the cost of capital, the business is
generating a positive return to shareholders. Where it is below, a negative return is being
generated and it can be expected that shareholders will seek to redress this position.
The slope of the economic value curve indicates the rate at which value is being added by the
business. From this map, managers can determine whether the bulk of the value of their business
is being generated within the planning horizon, or in the far future.
Operating net cash flow
Economic value
V Time
Figure 6. Economic value map
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Competitive advantage map
The competitive advantage index is a measure of how effective current policies, strategies, systems
and procedures are at positioning the business to compete. This measure does not tell us anything
about the quality of management. Management commitment is a subjective assessment of the
quality of management. It assesses management’s commitment to long term issues requiring
investment, where the benefits may not be immediate, but which reflect management’s vision of
the future.
Competitive advantage index
High
Low
Low High
Management commitment
Figure 7. Competitive advantage map
Scenario analysis
The aim of managers is to target key areas of the business to improve economic value. There are
many underlying factors that directly influence competitiveness and which therefore underpin the
success of the business. The Strategy Simulation Model was used to improve the understanding of
the relationships between key factors and how these factors influence the business’s economic
value. This knowledge would enable management policies to be improved.
To illustrate the output of the Strategy Simulation Model the graphs from the following
indicative issues are attached:
. Impact of a sudden increase in work load, see Figure 9.
° Impact of change in delays, see Figure 10.
° Impact of the introduction of competition, see Figure 11.
The impact of these changes can be gauged by how the economic value added changes, this is
shown in the four graphs attached. For comparison purposes Figure 8 shows the base case
performance of the organisation under good management practices.
Figure 9 indicates that if the organisation is operating at full capacity, then taking on unplanned
extra work can result in deteriorated performance if resources are stretched, extra delays in
completion occur, and quality suffers thus affecting market position, prices and Jong term
profitability. This behaviour was contrary to what was expected by the managers advocating
taking on the extra work!
Figure 10 shows the effects of increased processing delays, raw material delivery times and/or
regulatory delays. Service quality and economic performance clearly deteriorate with increased
Aslove ant avnerienced by competitors.
System Dynamics '95 — Volume II
Figure 11 demonstrates the levelling off of the economic performance of the organisation
following the introduction of a major competitor.
1: Cum PV of operating cash flows 2: Operating net cash flow
4: 2000000.00
2: “100000.00
val
. ra
4: 1000000.00 Pa
2: 50000.00 _
1
Vv
4 0.00
2: 0.00
0.00 15.00 30.00 45.00 60.00
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Figure 8. Base case which assumes a well managed business
1: Cum PV of operating cash fl... 2: job arrivals 3: Operating net cash flow
1: 2000000.00
2: 100.00
3: 100000.00
BIR
aa
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Ld
0.00
0.00 1
0.00
0.00 15.00 30.00 45.00 60.00
8 Graph 1: Page 2 Months 5:50AM 17/3/94
Figure 9. A temporary increase in workload of 10%
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4: Cum PV of operatin... 2: Cum PV of operatin... 3: Cum PV of operatin...
4: Cum PV of operatin...
4: 2000000.00 —
ee
ed
ft ee
oe —
|
peo a
—
ae _—
1 0.00 4 SE 4 ie
4: 2000000.00
0.00 15.00 30.00 48.00 60.00
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Figure 10. Change in delays ( 0.5, 0.75, 1.5 and 3 months)
4: Cum PV of operating cash flows 2: Cum PV of operating cash flows
4: 2000000.00
Lt
- en |
we .
a . ”
1: 0.00 4 2
4: -2000000.00
0.00 15.00 30.00 45.00 60.00
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6:34 AM 17/3/94
Figure 11. Introduction of competition
System Dynamics '95 — Volume II
Conclusions
This paper has discussed the development of an integrative framework for analysing strategic and
policy decisions within organisations. In particular, it has discussed the development and
utilisation of a strategic simulation model which incorporates frameworks outlined by Porter
(1980, 1985), Rappaport (1986) and Williamson (1991). In this sense the paper provides a
contribution to the development of a dynamic theory of strategy outlined by Porter (1991) utilising
both approaches to theory building. This has involved developing a model to improve
understanding of how sources of competitive advantage can be managed, and developing a
framework to improve understanding of how competitive advantage is created and maintained.
We plan to report our views on what we have learnt about frameworks for competitive
advantage in a forthcoming paper.
In conclusion, we have found that models were an extremely useful enabling and facilitating
device. In particular, our experience has been when managers had access to the Strategy
Simulation Model that:
. it was an effective way of communicating the scope of strategy analysis to busy managers;
* the framework and the ability to quickly explore scenarios proved influential in gaining their
involvement in exploring strategy and testing intuitive understanding, and examining the
operational aspects of strategy alternatives; and
managers’ knowledge of the value and applicability of strategy is considerably enhanced by
being able to illustrate that different strategies have different outcomes.
The use of this type of framework in a planning process which involves managers could help to
tem the current fall in strategic planning that has been so widely observed in organisations and
liscussed particularly by Mintzberg (1994). In a previous paper (Cavana and Hughes 1995) we
ave also discussed ways in which these methods could be used to overcome the current crisis in
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