Business risk: A company’s range of products
Category: Corporate Banking
Only products or services that can finally be sold in the market contribute to a company’s operating income. This may sound obvious and simple, but all too often companies produce rather what they like, and not what the market really wants. As new products appear, other products fade away. So, every product has a life cycle of its own. As soon as a product approaches the end of its life cycle, it will longer make money for the firm. Thus, it is important for a bank to know the product range of a corporate client, and each product’s proportion of total sales.
a. Product life cycle
A new product or service enters a market, then gains market share and turns to be come well-established before it finally disappears. Almost all successful products have been found to have a clearly structured life cycle. It consists of the four stages
— market entry
— market growth
— market maturity
— market decline.
A credit analyst has to know:
— which products or services a corporate client sells,
— what their proportion of total sales is,
— which stage of the product life cycle applies to each of these products,
— how management intents to adjust the firm’s strategy according to the insights gained from the product life cycle.
Market entry
Products that have only recently entered a market normally have a relatively small market share. New products are often introduced to selected, limited test markets to gain experience with market reactions. Modifications are made to better adjust the product to market demand. Sales are still low, but they may grow rapidly. Start-up investments, e.g. for research and development, or for advertising, must be made to conquer new markets. Since newly introduced products hardly yield much profit, losses are normal in this stage of the life cycle.
Market growth
As soon as new products become successful, they move to a stage of growth. Revenues from sales of these products and market share increase considerably. In this stage of the product life cycle, winning additional market share must be the top priority. Money must therefore be spent on advertising, marketing and so on. Profits — if they occur at all — are still meagre.
Market maturity
Mature products have already conquered a relatively large share of their market. Sales are high, and the product is well known. Market growth, however, is beginning to slow down. These well established products require hardly any new investments but yield high profits. They make the money that is needed for financing the research and development or marketing expenditures for the follow-up products in the first stages of the product life cycle. Now, the management challenge is to sharpen a product’s profile and to tightly control all costs attributed to this product. Mature products produce a lot of cash for the company. They are very profitable.
Market decline
Finally, both, market share and growth rates, decline. The product proves to be less attractive as markets turn to be saturated. New products substituting the old appear on the scene. Sales stagnate and decline, until the product may completely disappear in the end. Management focuses on the development of follow-up products.
These rules apply more or less to all products and services. Although they seem to be obvious, many bankers and business leaders tend to forget them in their daily work. Owner-operated medium-sized businesses particularly have a tendency to cling to products which have made the company successful many years ago, but which are outmoded today. A company must have a well balanced mix of products in each stage of the life cycle. It is crucial for its chances of survival to have enough products in the maturity stage to earn the money for fostering the newcomers. A study done among German medium-sized enterprises showed that more than 60 % of all products had at least once been redesigned and modernized during the past years, and that such new and modernized products contributed more than 33 % to total sales. But, if the sales breakdown of a company shows that most of its income is generated by products in the declining stage of their life cycle, severe problems lie ahead, and a bank should be very careful to hand out any loans to such a firm.
The right type of management for each stage
Another implication of the product life cycle concept is that each stage calls for a different type of management. The market entry stage requires a lot of research and development. Management has to be very creative and innovative in this stage. Marketing specialists are needed during market growth, as production experts are also important. When markets mature, attention is turned to the financing and controlling departments. Management must now focus on cost cutting. During market decline, sometimes it may become necessary to exercise some form of «crisis management». It is important that all these different types of attributes are represented in a company’s management team. Results can be disastrous, if cost cutting experts try to develop and to introduce a new product, or if marketing specialists are asked to try to steer a declining product out of production.
The product life cycle is a tool that makes bankers and managers think about the product range of a company, its sources and uses of cash, and about what can be expected in the future. There is no mathematical formula to calculate exactly when each product will earn so much money at which stage of the cycle. The concept of the product life cycle rather derives from the experience that what goes up, must come down.
It can, however, be misleading even to the most professional experts, as is illustrated by the case of the Coca Cola Company. Coca Cola was a one-product-company selling coca cola and a few other relatively insignificant soft drinks. Coca cola had been a mature product for so long, that managers felt sure that it was only a matter of time before it would start its descent. The rule of the product life cycle theory called for a new soft drink that would substitute the old coca cola. So they created a new soft drink called «New Coca Cola», launched an enormous marketing campaign and withdrew the old coca cola from the market. This was in accordance with theory, but not with real life. Consumers in America, where the Coca Cola Company sells most of its products, simply did not want to buy the new stuff. For them, the «classic» coca cola was not just another soft drink but an important part of their American way of life, and they wanted it back. So, the Coca Cola Company had no choice but to do what its customers wanted and produced the old coke again, now called «Classic Coca Cola». The «New Coca Cola» had a very short life span. The life cycle of the classic soft drink had been misjudged: Coca Cola was — and still is — a product that owns a large market share in a strong market and that seems to have a very long-lasting life cycle. As a matter of fact, as an already mature product it even entered new markets in the former USSR and China as these countries opened up.
b. Product portfolio
A comprehensive analysis of a company’s product range can assist in defining corporate strategy. The portfolio analysis is a proven tool to assess the product-related strengths and weaknesses of a firm, and to translate them into strategic planning. The portfolio analysis can provide answers to questions such as: does a company invest in the right products which will probably shape the company’s future, or does it waste its resources for old-fashioned and outmoded products? Does it neglect the products which contribute or will contribute most to total sales? Which products should be phased out? Are there any future-oriented products at all? Are the research-and -development efforts headed in the right direction? Does the current product range pose any risks — if yes, which ones — to the company?
Generally speaking, the portfolio analysis works in the following way. A system of coordinates consisting of relative market share and market growth shows the exact position of each product in its competitive environment. The most commonly used portfolio analysis was developed by the Boston Consulting Group and is made up of 4 segments with clearly defined characteristics — which makes it very easy to use. Each product fits into one of these 4 segments, which then show the strategies that must normally be followed in each respective segment. Thus, the portfolio analysis does not only give a better understanding of a company’s current situation, but helps develop strategies for future success.
As each product has its specific market, the first step is to find out about the growth of this market. If a product finds itself in a growing market, it will command a lot of resources, because considerable investments can be necessary to conquer market share. Detailed knowledge about a market is required to decide whether to enter this market or not. Are profits to be expected there? What are the threats and opportunities in this industry? What about the total volume of the market? How many competitors are already there? Is there any room left for another company? Many items that have already been considered in the above-mentioned SWOT-analysis can be helpful here.
The relative market share of a company is then determined by the relationship of its own market share to that of its largest competitor. Products that have succeeded in gaining a large proportion of the market should generate surplus cash. Items to consider are: what are the market shares of the own product and those of the competitors? what is the impact of the overall market situation on market shares? In a shrinking market, a company’s market share can rise without any further sales; this can even be a threat to a company if the market is in danger of crashing down. On the other hand, market share can be lost in a growing market if sales stagnate instead of growing with the market. This would be a warning sign for every credit analyst.
As a result of this analysis, one gets a complete overview of a company’s product range and the competitive positioning of each product as well as strategic suggestions that have proved to be successful in most cases:
Products which have gained a high market share in an attractive market are called «stars». They require substantial capital in order to further increase or merely hold their market share. Because they have already conquered a large portion of the market, they generate a considerable amount of revenue for the company. These revenues will certainly be consumed by the expenditures necessary to strengthen the market share. Thus, the cash flow coming out of stars is normally neutral or even negative for a certain period of time. But, if these products prove to be successful, they will turn into so called «cash cows» and earn the lion’s share of the company’s sales. Stars require investments in research and development, marketing, training and so on are necessary to ensure their future success.
«Cash cows» grow slowly, but they enjoy a high market share. They earn a lot of money, but require comparatively few little expediture. Thus, their cash flow is very high. The cash that is produced by «cash cows» is the lifeblood of the company: These revenues must be sufficient to finance all investments into research and development, new products, and the conquest of new markets. Investments into «cash cows» that exceed the mere holding of the already gained market share are normally not rewarding.
«Dogs» are found in unattractive, declining markets where they occupy only a limited market share. They don‘t cost much, they don’t bring much money — if any. These products ought to be phased out. They must not be allowed to consume fresh money.
Finally, there are the «question marks». Low market share in a fast growing market, low income, high costs. These are follow-up products, the future of which is most uncertain. One cannot yet say if they will turn out to become stars or dogs. If they are meant to turn to stars, heavy investments must be made to ensure their further development and to aggressively gain market share. But, if they fail, all these investments have been in vain. «Question marks» can become cash traps. Caution is necessary in deciding which strategy to follow concerning these products.
The product portfolio
It does make sense to test a number of different strategy scenarios by means of the portfolio analysis. A thorough and in-depth analysis of each product’s present position is the imperative condition for all portfolio planning. As most credit analysts have experienced, many corporate leaders have pretty good gut feelings about the comparative position of their firm. But they have difficulties in quantifying their assumptions, for example, because they lack detailed market research. Misjudgements are common, often leading to the wrong strategic decisions. Whenever a bank is asked to provide the financing for larger investments, especially for developing or introducing a new product or in the wake of a takeover or a privatization, the credit analyst should insist on conducting thorough portfolio planning analysis.
But portfolio analysis cannot replace sound management conclusions. It is only a helpful tool. It looks very simple and is easy to understand (this appears to be a main reason for its success), but conducting a thorough portfolio planning requires a profound knowledge of the respective markets, their trends, the competition and of the strengths and weaknesses of the company.
| The product portfolio: Strategies | ||||
| High | QUESTION MARKS
invest in R&D to become a star, or disinvest fast to avoid becoming a dog |
STARS
invest in marketing, production, sales force |
||
| Market Growth
Low |
DOGS
phase out, disinvest |
CASH COWS
hold, control costs, rationalize |
||
| Low Market | Share High | |||
The impacts on the cash flow: Sources and consumption of cash
| High | QUESTION MARKS
Consume much generate little cash flow negative |
STARS
Consume much generate much cash flow neutral or slightly positive |
| Market Growth
Low |
DOGS
Consume little generate little cash flow neutral or negative |
CASH COWS
Consume little generate much cash flow positive |
| Low Market | Share High |
C.2. Case studies:
a. Medium-sized machine tool manufacturer
The principle of portfolio analysis is illustrated by the following example from the mechanical engineering industry.
About 15 years ago, an entrepreneur had his first success in the market with his then unique electro-mechanically controlled machine tools. Due to these machine tools, his company had flourished but recently there has been a substantial drop in demand for this product.
Semi-automatic machines, however, are selling excellently. They are at present the top-selling product and have also become an export success. The rate of escalation in sales volume, however, is showing a downward tendency.
After some difficulties in the start-up phase, computer-controlled custom-made machines see an upswing in demand. The growth rates are promising. The outlook for the recently introduced robot system is good, although, the sales personnel feels that it is not yet able to fully cope with all the questions that customers might have about these robots; some customers have already made complaints. And the expenses for training and advertising are quite high.
From the portfolio analysis the entrepreneur expects to obtain the necessary information to assist with the development of his future product and sales strategy.
Financing the future with the help of the «top-selling item»:
The portfolio analysis informs the company about the different importance of its products according to their relative market share and the attractiveness of their respective market.
— The electro-mechanically controlled machine tools have become a problem product. Their market and their profit contribution are shrinking.
— Currently, the semi-automatic machines are in the maturity stage. They are the «cash-cows» that can be milkened right now in order to obtain funds for future investments.
— The custom-made machines have become the «stars». They excel through a combination of high market growth and by a high market share.
— Although, at the moment they are only incurring expense and inconvenience, the future belongs to the new robots. If they get the right support just now, they will become tomorrows «stars».
The entrepreneur decides that his company should withdraw from the electro-mechanically controlled machine tools market in the foreseeable future, and instead intensify the in the field of robot technology.
Portfolio analysis: Medium-sized machine tool manufacturer
The size of the circles shows
the contribution to total sales of each product
| High | Robot systems:
Investing in R&D, training, marketing |
Computer controlled machine tools:
Investing in marketing |
| Market Growth
Low |
Mechanically controlled machine tools:
Withdrawal within 1 year |
Semi-automatic machine tools:
Surplus cash earned here is redirected into robot development |
| Low Market | Share High |
b. Case study: Rockwell Corp. adjusts to a dramatically changed environment: SWOT-Analysis, product portfolio
Rockwell International Corp.: The Company
Rockwell International Corp. was one of Americas leading defence contractors. It relied heavily on government orders of military hardware and on the national space program. Fighter planes, bombers, rockets and spacecraft such as the Space Shuttle used to be the most important components of its product portfolio. Demand for military items declined enormously after the cold war, and Rockwell International Corp. successfully managed to shift from military to civilian business.
I. The Challenge: How Can Defence Contractors Beat Budget Cuts?
With the ending of the Cold War and the drive by both Congress and the White House at shrinking the ballooning federal deficit, the Department of Defense budget has been a prime target for cutting. But the impact on defence contractors is immense. How can companies that rely too heavily on one particular industry segment—such as those heavily dependent on revenues from defense production—best adjust to the new economic realities that have survived the cold war?
II. Case Study: From Defence to Commercial: Rockwell’s Big Shift
In 1985, when it was building the B-1 bomber at the peak of President Reagan’s defence buildup, Rockwell International Corp. stood firmly as the nation’s No. 2 military supplier, trailing only McDonnell Douglas Corp. Revenues from the Dept. of Defence accounted for more than 50% of the corporation’s business. Add contracts from the National Aeronautics & Space Administration, and the company was 63% dependent upon U.S. government sales.
Realizing the peril of being so strongly beholden to defence and government, Rockwell made a conscious decision to diversify. Ten years later, in fiscal 1995, defence accounted for only 15% of the company’s revenues; the overall government’s share, 23%. Rockwell has fully replaced $4 billion in defence and government sales with commercial business. All the while it has been consistently profitable, recently posting 11 straight quarters of double-digit earnings per share. As of late December its stock price was the highest in its history.
Rockwell’s strategy runs against the grain of most other defence contractors. Some firms have spun off their military businesses; some have remained in defence, but shriveled to a few select areas; some have strengthened their defence positions through acquisitions; and some are striving to diversify, but into markets that are related to their defence technologies. But only Rockwell, at least among major firms, deliberately has set out to diversify into unrelated fields. The company has become a conglomerate—at a time when it has become the strategic trend among conglomerates to dediversify and focus instead on related «core competencies.»
Led by Donald Beall, chairman and CEO since 1988, Rockwell has staked out a huge position in electronics—now 52% of its sales. It is a leading producer of industrial automation equipment (thanks largely to its purchase of Allen-Bradley Co. and Reliance Electric Co.), as well as semiconductor systems (it supplies chips for 80% of the world’s fax modems), and avionics. Otherwise, the company still is a major aerospace supplier (it has large contracts for the Space Shuttle and the International Space Station), is a manufacturer of automotive components, and builds printing presses.
In implementing its successful strategy, Rockwell owes a lot to its earlier experience as a commercially-oriented conglomerate in the 1970s—before its inundation with defence work with the early ’80s. The principal lesson the company learned from this earlier incarnation, Beall declares, is to: «Make sure every business you have is, or can be, a leader—with the kinds of returns a leader should produce.»
Believing that «Rockwell works better as an organic whole than as a collection of independent companies,» Beall is striving to make technology the common thread that unites his firm’s diverse units. «Our strategy,» he says, «is to use technology developed in one part of our business to stimulate the development of new products in other parts.»
To make technology the corporation’s unifying factor, Beall has set up 10 company-wide technical panels in which representatives of each business meet regularly to discuss key technology areas of common interest—for example, advanced control systems, materials, and computer-aided engineering. A central corporate science centre in Thousand Oaks, California, also plays an important role.
In other areas of the company, too, Beall stresses cross-fertilization. Among other things, Rockwell:
uses cross-functional advisory boards to share problems and solutions in such areas as human resources and manufacturing;
asks senior executives, when conducting strategic business reviews of individual company units, to be on the lookout for ideas that can be applied to other units;
requires executives of each business to be familiar with company units other than their own;
and rotates executives among assignments in diverse areas of the company.
Hanging over all of Rockwell’s strategy moves is its overarching vision to «be the best diversified high-technology company in the world.» Adopted in 1994, this vision—complete with a sublist of «action strategies» and «attitudes»—was developed through a months-long process that involved some 800 employees. The vision now is permeating throughout the entire company. Implementation of it occupies much of the attention of Beall, who now is freed of much of the company’s day-to-day operating responsibility after last year’s appointment of Don H. Davis to the new post of Chief Operating Officer.
Excerpts taken from Virtual Organization Inc.’s 27th Management Challenge & Case Study, Industry Week’s Interactive Forum on the Compuserve Network
Case Study: SWOT-Analysis Rockwell
SWOT-Analysis
Industry Analysis: The U.S. Defence Industry
| Opportunities | Threats | |
| Existing competition | — leaving defence sector
— de-diversifying — defence mergers — niche players |
more intense competition for the remaining government orders (price wars) |
| New Competitors | defence too risky a business to enter now | European defence contractors, but only in the far future |
| Bargaining power of customers | — 65% dependent on government orders
— declining need for defence products |
|
| Bargaining power of suppliers | ||
| Substitute products or services | much military hardware is no longer needed at all | |
| Conclusion:
The 3 most important opportunities and threats |
— diversification versus niche strategy
— no entries into the market |
— reliance on government
— sharply declining market — intensified competition |
Case Study: SWOT-Analysis Rockwell
SWOT-Analysis
Business Risk Analysis of Rockwell International Corp.
| Strengths | Weaknesses | |
| Supply | Labor force still has experience from a corporate history as a «civilian» conglomerate | |
| Production | — utilizing aero-space facilities for civilian use
— diversification — introducing new product range — acquisition of electronics company |
military production insensitive to costs |
| Demand | — broadened customer base, government only 15 % of sales
— good reputation |
|
| Collection | ||
| Conclusion:
The 3 most important strengths and weaknesses |
— utilizing former civilian experience
— diversification — customer base |
— cost structure |