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

Read more about the book on our website

1. “sensing” to detect changes and assess their likely impact, then
2. “adjusting” policies to keep the strategy and performance on track.

Some sensible examples illustrate the approach, such as anticipating staffing needs in a cyclical business – though one wonders what on earth the companies discussed were doing before if they didn’t do this! It contrasts sense-and-adjust with reactive styles (do nothing until forced to) and programmatic change (keep changing as you planned, regardless of changed circumstances).

The article unfortunately misses the “Create” step – strong firms don’t just ‘sense’ the environment to see what might happen to them; they decide how they want their world to change and make it happen. This may be radical innovation, but is more likely to be just the relentless pursuit of known resource- and capability-building. 

Shame, too, to see these sound basics of strategy buried in more nonsense about ‘constant transformation’ with the unsubstantiated claim that “… companies must be ready to repeatedly transform themselves” and that “A review of businesses faced with burning platforms (enterprise-threatenting events) would reveal that most have failed to make the transformations required”. Sense-and-adjust is just the minimum of decent strategic management, and if properly performed would avoid most burning platforms in the first place.

strategydynamics.com

“When this investment [in strategic planning] is successful, the result is strategic management: the melding of strategic planning and everyday management into a single, seamless process. In this phase, it is not that planning techniques have become more sophisticated than they were in phase three but that they have become inseparable from the process of management itself. No longer is planning a yearly, or even quarterly, activity. Instead, it is woven into the fabric of operational decision making.” It goes on to point out that virtually no companies have reached this point, except perhaps some in the electronics sector, where very fast changes across multiple products and highly segmented markets make it imperative.

… but surely this should be our aspiration for all organizations? though as I have noted before, we are not likely to get to this point with strategy tools that are simply incapable of ever delivering this result.

1. Don’t skip rigorous analysis.
2. Don’t think strategy can be built in a day.
3. Take care to link strategic planning to strategy execution.
4. Make sure to hold robust strategy review meetings.

This may all seem verypedestrian in these exciting times of strategic innovation and reinventing your business model – but no less critical than it always was.

NEW: join strategy dynamics on LinkedIn

Seven Ways Forward from Booz & Co’s strategy+business on, with specifics for Manufacturing, Consumer Products, Aerospace and Defense, Telecom, Finance, and general guidance on rebuilding capabilities for long-term growth.

Surviving the Downturn: Lessons from Emerging Markets from Sloan Mgmt Review [title self-explanatory]

Three Opportunities to Seize in the Downturn a blog post from Harvard Business Publishing [HBP] makes the case for two points I’ve raised before [a] that there’s cheap talent on the market right now, and [b] there are cheap opportunities to acquire key assets or entire businesses … which leads to the 3rd point, that there will be new winners and losers out of all this.

How Recessions Shake Up Industries in the Daily Stat from HBP [their link takes you to a different article] reports studies from McKinsey and BCG on how industry leaders fall and new leaders emerge in downturns – a reminder for your strategy to be intentional and targeted about challenging specific existing and new rivals, not just trying in some vague way to do better than others [a shortpiece on this at the end of chapter 5 in my book].

Timing Strategic Moves in the McKinsey Quarterly explains how scenario approaches can help avoid moving too soon or too late in these uncertain times. It’s rather focused on macro-economic and stock-market indicators, rather than [I'd prefer a more assertive stance be taken - choosing what to do and when in order to make the future play out as you want, rather than the passive response implied if not actually stated in this.]

Strategic Planning: Three Tips for 2009 from McKinsey Quarterly explains the value of scenario-based planning, the need to intensify monitoring to detect how the recovery is changing things, and the need I have emphasised to look beyond the crisis. [Shame most firms were not doing enough monitoring before the recession!]

Also some good content in Taking Advantage of Tumultuous Times from Monitor.