Talking about strategy » Ryanair

Briefings 9: Links to the ‘resource based view’ of strategy.

Kim Warren — Tue, 28 Dec 2010 09:00:53 +0000

Have you ever puzzled over academic concepts? …thought, “What does this mean? Should I be using this?“

This briefing discusses some academic stuff, which is important for teachers to understand. It’s useful for professionals too, because you may come across these concepts, puzzle about what they mean, and wonder if you should be using them. I have put a few key references at the end.

In very simple terms, the academic study of strategy and performance has shifted its attention in recent decades. From the early 1980s, people focused on how ‘industry forces’ [competitors, customers, new-entrants, suppliers and substitute products and services] impacted on the profits firms in an industry could achieve and how strategy could cope with those forces.

By the 1990s, though, it looked like these issues did not explain much about why some firms perform better than others. Research identified that things about the business itself seemed to be more important, e.g. how much they spent on R&D or marketing. [Translation "You can do well in tough markets, and mess up in attractive ones!"] Further investigation suggested firms could sustain strong performance by developing ‘strategic‘ resources that others could not copy. This idea has crystallized into as the so-called ‘resource-based view‘ of strategy – affectionately known as RBV.

Since we have repeatedly talked about the principle that resources drive performance, you might think that this idea and RBV are one and the same thing – they aren’t.

An accepted definition of RBV resources is

“…all assets, capabilities, competencies, organizational processes, firm attributes, information, knowledge, and so forth that are controlled by a firm and that enable the firm to conceive of and implement strategies designed to improve its efficiency and effectiveness.“

Management often blames any shortfall in performance on “inadequate resources“, so it may seem self-evident that resources are important, but RBV claims that only certain special items matter. Since many resources are easy to get – cash can be borrowed, production capacity can be bought, staff can be hired – any firm that gets behind on such things simply copies what its competitors have. [Yes I know, if the academics think it's so easy, they should go try it!] So the RBV asserts that any resource can only give sustained advantage if it is valuable, rare, hard to imitate, and works with other organizational factors – the so-called “VRIO criteria.”

To see if any resource will give you a competitive edge, RBV recommends you ask the following questions:

Is it durable? A resource that deteriorates or becomes obsolete quickly is not likely to provide sustainable advantage, e.g. production equipment wears out, and staff skills get out of date.
Is it mobile or tradeable? Many resources are easily bought or taken from other firms. Equipment suppliers may sell the latest technology to your rivals as well as yourselves, customer lists can be purchased, and staff can be attracted by better salaries.
Is it easy to copy? Many resources can be easily copied by rivals, so these too offer little scope for competitive advantage. You might launch a great new product but if it is easily copied the benefit will be short lived.
Can the resource be substituted? Even if you cannot buy or copy your competitors? resources, you may still be able to challenge them by using something else. A common example is firms who can?t persuade retailers to sell their products can use telephone or Web sales channels instead.

So what kinds of things fulfil these criteria? – certainly not the simple tangible factors discussed in earlier briefings. RBV focuses instead on more subtle and complex things, especially intangible resources, e.g. reputation or staff morale, capabilities (or competences), knowledge and processes. We will get to those later in the strategy dynamics story, but earlier briefings explained how performance depends directly and unavoidably on resources that do not fulfil those criteria? e.g. customers drive revenue, staff and capacity drive costs. The abstract intangible factors of the RBV are important, of course, but they can only affect performance by influencing the simple, tangible resources at the core of the business system.

DIFFICULTIES IN APPLYING THE RESOURCE-BASED VIEW

It is hard to disagree that intangibles, capabilities and knowledge are important, but applying these things as RBV suggests is tough. As described in the literature, they are abstract, ambiguous and qualitative, so management debate degenerates into semantic discussions about what the words really mean – hardly a solid foundation on which to build a strong strategy with confident outcomes. And it?s going to be hard steering strategy and performance into the future if you can?t work out what difference a decision makes to these squishy things.

There are even cases that don’t seem to need RBV-type resources at all. There is nothing unknown or mysterious about how Southwest, Ryanair or McDonald’s function. The two airlines pursue a completely transparent strategy, even signalling ahead how they intend to develop further. Just about every detail of McDonald’s operations is even written down and passed around in its franchise manuals! Many hundreds of executives have had experience in these companies during their long periods of success, and are deeply familiar with their inner workings. Why, then, have such individuals not been able to replicate that success elsewhere? The RBV says this is because of some still more abstract capabilities of the senior management – strategy dynamics says it’s because of the power of the system! So the approach differs from RBV in three main ways:

First, we don’t ignore the tangible factors that comprise the heart of any business or organization – we make them explicit, quantify them and connect them to the organization?s performance outcomes.
Secondly, we go beyond resources that are “owned or controlled“. To influence performance, you only need a resource to be somewhat reliable – “If it is there today, it is likely to be there tomorrow.” This means in particular that “customers” become part of the business system – newspapers and TV channels keep customers for many years, and customers’ relationships with sports clubs and banks often last longer than their marriages!
Thirdly, strategy dynamics makes explicit how exactly resources work together – but more on that in future briefings.

Until next time…

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“Ockham’s razor”

“What on earth is that?!” you may wonder. It is a rather simple idea, supposedly set out by a 14th-century friar, William of Ockham.

All it says is that, given a number of possible explanations for something, the simplest and most concrete explanation is likely to be the best. At the very least, a simple, concrete idea needs to be disproved before we go looking for abstract and complicated answers.

You might bear William in mind whenever you read articles and books about strategy and business.

Breifings 7: Problems with typical approach to business planning and forecasting

Kim Warren — Tue, 30 Nov 2010 09:00:41 +0000

Why is the typical approach to business planning and forecasting flawed?

Strategic planning generally aims to get to an estimate of future sales and profits, so how these items are estimated is critical. Typically, you would start with a forecast for demand, and by assessing how competition could affect prices, get a value-forecast for the market. Setting targets for increased market share would then give a forecast for sales volume and revenue. There are however problems associated with this typical approach to business planning and forecasting…
Applying this approach to low-fare airline Ryanair, for example, implies starting with a forecast for total air travel, targeting growth in market share to get the airline’s future passenger journeys, and then estimating the ticket prices it will be able to charge. Adding sales of ancillary items [ground transport, food etc] gives a forecast for total revenue [see Figure 1].

Figure 1: Market-based forecasts for Ryanair revenues

In practice, this process is not so simple. First, on which “market” is the forecast based – the total European market, or only that served by low-fare carriers? Where are the boundaries of that market? Does it include, for example, flights from Italy to Turkey or Israel, and if Ryanair starts to operate across those boundaries does the whole analysis have to be recreated to reflect this wider scope? Ryanair is relatively simple because it basically offers a single, clear service, but Amazon.com, for example, long ago diversified from selling books by adding music, software, games and so on. This kind of analysis would therefore have to be repeated for each product market, and the results added together.

Now you have a forecast for sales and revenue, you would set targets to cut the fraction of revenue spent on raw materials and operating costs (sales and marketing, distribution, product development, training, financial administration, etc.). From the revenue forecast and cost ratios, you can then project operating profit. You may want to go on to estimate any investment needed and the cost of capital, to arrive at your “economic profit” – the profit you will make after the cost of funding.

A forecast for Ryanair’s costs might assume, for example, that the company will be able to reduce airport costs as a fraction of revenue—perhaps due to scheduling more flights per week through each airport—but will need to sustain the percentage of revenue spent on staff, to ensure continuing service levels. Similar calculations can be made for costs of routes, aircraft, marketing and other items.

Problems with this typical forecasting approach

The logic of this process for forecasting revenues, costs and profit margins relies on some fundamental assumptions:

that market growth is ‘out there’ and independent of what the company or its competitors do
that competitive forces dominate the prices companies can charge, and the profit margins they can achieve … the focus on reducing cost fractions is a way of trying to make just a little higher profitability on each dollar or Euro of sales than the next guy.

Neither assumption stands up to scrutiny.

First, the airline market today is the size it is, and has grown at the rate it has, precisely because of the actions of Ryanair and others – opening new routes, offering lower fares than previously available, and so on. Other industries illustrate the same point – in IT, for example, the world is the way it is today because of what Microsoft, Dell, Google and a host of other companies have done, not because there was some independent force pushing demand for goods and services in certain directions and at certain speeds.

As regards prices, costs and margins, research now suggests, that the decisions of business executives have a larger influence on performance than do industry conditions. This implies it is possible to deliver strong performance [both profit margins and growth] in industries with tough competitive conditions—consider the airline industry where competitive forces are notoriously hostile, yet Ryanair, Southwest and a few other firms can be not just successful at a point in time, but sustain that performance over many years.

Resources will continue to drive revenues – and costs.

This will not take long to explain because briefing 5 showed the strong causal link from resources to profits. Ryanair’s performance up to 2006 demonstrated clearly that customers drive revenue, and other resources [staff, aircraft and so on] drive costs – and putting these two pieces together explains profits. Not only was that true throughout the company’s history, it will also continue to be true into the future [if the business continues the same activities].

Just continue that reasoning into the future. Ryanair’s fare revenues in years to come will be driven by growth in the number of customers using the airline, and changes in their journey frequency and fares. We still need to understand competitive pressures, which will affect both the frequency with which customers will choose to travel with this airline and the fares they are willing to pay. But customers’ willingness to choose this company is strongly affected by its own success in offering the routes and service they want, as well as by market conditions.

Figure 2: Customers will drive Ryanair future revenue

Adopting the same principle for the airline’s costly resources leads to the plausible projection for operating costs shown in Figure 3. If the company is to serve the number of customers above, then it will have to add airports to reach those customers, offer more routes to win their travel choice, add planes to carry them, and hire additional staff to serve them.

Figure 3: Resources will continue to drive Ryanair costs

As noted in a previous briefing, some other cost items must also be taken into account. In particular, it is costly not only to have resources but also to acquire them [opening a new route for example], and marketing may need to be spent to win customers. Nevertheless, starting with resources to estimate future revenues, costs and profits is a much more rigorous and practical approach than the broad-brush methods more commonly applied.

I hope you found this longer briefing to be worth the extra few moments of reading. In the next, we will show how exactly equivalent principles apply in non-business cases

Until next time…

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Not all heroes drive growth!

Although the general media and business case studies love to investigate and report on examples of outstanding business growth, there are other heroes out there whose achievements are usually ignored. Would you volunteer, for example, to run Kodak’s camera-film business when the world is switching to digital devices, or jump at the chance to run Blockbuster video stores as the performance and availability of video downloading rises?

But someone has to do those jobs. Nor can you escape this question by saying that these businesses should diversify or switch into something else, such as Kodak print-shops for producing hard copies of digital photos – someone still has the job of selling photo-film for traditional cameras. It seems that, during 2000 to 2005 at least, Kodak was not doing as well on this challenge as its arch-rival Fuji, whose sales of photo film declined at a much slower rate.

Don’t under-estimate the importance of this capability. As explained in an earlier briefing, business value reflects the stream of future cash-flows, so the ability to hold the rate of decline, say, to 10% a year when it would otherwise be 25% has considerable business value. So let’s recognise those unknown heroes.

Estimating future business performance is outlined in many sources; see for example:

Martin J and Petty J, Value Based Management, (2000), Harvard Business School Press: Cambridge MA, Chapter 4

Copeland T, Koller T and Murrin J, Valuation – Measuring and Managing the Value of Companies, (2000), 4th Edition, Wiley: Chichester, Chapter 8

This briefing topic is covered in more depth in Strategic Management Dynamics, pp 68-81

Briefings 4: What causes what and how?

Kim Warren — Tue, 19 Oct 2010 10:00:26 +0000

When is theory powerful?

Whether they like it or not, decision makers use theory all the time, even if it is only their own private beliefs about why things happen and the likely impact of their decisions. Theory does not need to be complex – it is simply an explanation for what causes what, and how – without which there can be little confidence in the likely effect of any strategy we develop or decisions we might take.Theory is powerful when it is general (works in a wide variety of situations) useful (tells us something we can affect) and true. We should be skeptical about supposed “rules” of successful strategy that might seem to make sense, but are not in fact reliable, such as “the first firm to enter a new market will always beat firms who follow later.” This would be a general rule, and useful, but is unfortunately not true.Confirming the soundness of management theory is far from easy. Large scale controlled experiments are generally not possible or desirable and management typically resists becoming a lab rat! Nevertheless, there is a strong case for at least some experimentation—as is commonly done for new product launches – and there is an increasing use of “business intelligence” and analytics to support decision making.Business school research often seeks to confirm theories about what causes what by collecting large quantities of data and looking for statistical correlation between possible causes and effects. Unfortunately, the uncertainty and complexity of real-world causality is often so severe, and difficult to trace, that even a strong correlation offers little more than mild support for any theory. As Professor Clayton Christensen of Harvard Business School has remarked, we can often say little more than the business equivalent of “most flying things have feathers and flap their wings.” Attempts to design flying machines based on that statistically significant observation were not notably successful!We can start to deal with this problem by identifying parts of the explanation for performance where concrete causal connections can be stated confidently. To do this we need to work back through the problem and identify the key resources that affect the system. Whether the outcome of concern is financial or non-financial, or a combination of both, the process is the same. Whatever the focus, the key issue remains identifying how performance is changing through time.

Taking the example of airline Ryanair — profit results from the revenue the company receives from the fares that passengers pay, and from other items, minus its operating costs. These are split into some major categories — staff costs, the costs of operating aircraft, airport operations and routes — plus marketing and other costs. The causal relationships here are clear and unambiguous:

profits = total revenue minus operating costs
total revenue = fare revenue plus ancillary revenue
operating costs = aircraft costs plus route costs plus airport costs plus staff costs plus marketing costs plus other costs

If that causal explanation for profits is accurate for y/e March 2006, and the business has been conducting the same activity in the past, it was also accurate for every previous year. It is therefore possible to join up time charts of those items in the same way, as shown in the figure above. Each chart in this figure portrays the historic values for the item named. Although this diagram may be an unfamiliar view of a company’s income statement, it is just showing in a graphical, causal layout the same data we normally see in spreadsheet form.

What these diagrams mean…

Since the approach relies heavily on diagrams such as the one above (this is Figure 2.3 from the book), it is important to be clear about their features. The box at the lower right of the diagram gives a detailed legend for the time charts in the figure. Every item includes a specific, quantified scale on the vertical axis, and a specific time scale on the horizontal axis. The current value “today” — usually the latest time for which data is known — is highlighted as the green value, just above a vertical dashed line for the time at which it applies. The time path of historical data is shown as the solid green line. When adding forecasts, these are denoted by a dashed green line.

It is also important to be clear about what is meant by the connecting arrows in these charts. Word-and-arrow diagrams are common throughout books on management and strategy and usually imply some kind of causal relationship between the factors that are linked by arrows. Often, such implied relationships encompass a whole chain of causality, with all the ambiguity and complexity discussed above. In SMD, every such link will have the more localized and precise meaning that ‘A’ can be calculated or estimated from the values of ‘B’ and ‘C’ at each point in time.” The figure above follows this rule — it displays the relationships in the company’s income statements in a graphical, time-based form. These relationships hardly merit the term “theory”, being simply the conventions by which we determine a company’s profits, but they are nevertheless rigorous, reliable and well understood.

Remember we welcome your comments at any time.

Until next time…

If you would like to receive the series from the beginning in your email inbox, please register on the strategy dynamics site and subscribe to Briefings in “My Account”A small, but critical change in perspective…

A common response to the principles described in chapter 2 is ‘but that’s obvious!’ – well yes it is, but if you don’t ask the right questions accurately, you are not likely to find the right answer. I pointed out to a consulting firm some time ago that their revenues come from the projects they do, and the fees for those projects, and that their profitability depends on pricing the staff time on each project correctly.

They had previously been exhorting their management to ‘improve staff utilisation’, but they had not appreciated that their people have no decision lever connected directly to this ratio [aside from simply firing people]. So a simple start-point was to put together a model of what a profitable project actually looked like – how many man-days by which types of staff, costing how much, and priced at what level. Their targets for growing revenue and profits therefore came down to how many clients had to be won, delivering how many projects, requiring how many staff.

Obvious, of course – but it was not laid out in existing plans.

Limits to growth

Kim Warren — Sun, 22 Nov 2009 16:24:04 +0000

I see that icon of ‘not even the sky is the limit’, Ryanair, is finding gravity still exists. In a curious ‘threat’ to curtail growth, lively CEO O’Leary says it’s not as easy to pick up dirt-cheap aircraft as he did in 2002. He’s not quite so open about the company’s experience of opening hundreds of routes between city-pairs. I’ve tried reconciling their statements of routes opened, operated and closed, and it’s not easy – lots of hype about huge numbers of new routes being started, but curious shyness about how many close.

It rather looks like the love-affair with flying everywhere for nothing – no matter the inconveniece involved - is fading, so both routes and service frequency might have to fall. The parallel with Starbucks over-expansion of stores is uncanny.