Competitive Strategy from the Lens of Financial Data

Previously we went through how an industry's changes affect the financial statements of individual companies, including a paper manufacturer and a TV manufacturer. At the beginning of our discussions, we mentioned that any company's decision making will be affected by the environment it is in, and its own strategic choice. Next we are going to discuss how the strategic choices affect the financials of a company.

Cost Leadership Strategy - Small Profit High Volume

Generally, there are two types of strategic positioning. The first is cost leadership.

What is the cost leadership strategy?

If products of my company are not very different from other products, a very natural way to boost my competitiveness is to lower the costs. I can expand capacity, improve efficiency, or simplify my product design and so on. I will try all kinds of methods to lower my costs.

Once my costs are reduced, i will be in a better position to lower prices, making my products more attractive to customers. In our daily life,

there is a saying describing the cost leadership strategy, which is small profit high volume. This saying perfectly sums up the cost leaderhip strategy.

However, when we say a company employs a "small profit high volume" strategy, what is the profit that we are referring to? Is it gross profit or net profit?

Well, we already know that the reason such company has a small profit is that it purposefully sets the prices low. When it does, a direct result from such as strategy is a relatively lower gross profit ratio. From gross profit to net profit, there might be some expenses subtracted, and some income added. These expense/income items are not only the results from strategy choices, but also managerial performances. In other words, the "profit" in small profit high volume strategy refers to gross profit.

Now lets look at "high volume". Does "high volume" equal to high revenue? 

If you think about it, it is quite difficult to judge what qualifies as high revenue. The number is drastically different for different companies in different industries. From the literally sense, "high volume" is selling more products. However, we should always set a limit to such claims such as timeframe. In other words, "high volume" should mean selling more products faster than others; so "high volume" actually means rapid sales.

How is high volume represented on financial reports? 

Based on the descriptions above, we got the feeling that a faster sales is better efficiency, or faster turnovers. So "high volume" actually means high turnovers for the company. 

By now we have known that the normal expression of a cost leadership strategy is "small profit high volume", and the financial expression of it is "low gross profit rapid turnover". Because the company has low gross profit, it has a low effectiveness. To make up for the low effectiveness, it needs a high efficiency. The cost leadership strategy is a strategy that sacrifices some effectiveness to pursue high efficiency. The cost leadership strategy is winning by efficiency.

Differentiation Strategy - Big Profit Small Volume

Contrary to the cost leadership strategy, differentiation strategy is a strategy that improves product features to differentiate it from other competitors. For example, my company may have the broadest range of products; or my service is well-known in the industry, well above that of other companies; or my deliveries are flexible and on time, etc. This is what we call a differentiation strategy.

In any industry, we can always witness that some companies choose the cost leadership strategy, and some other companies choose the differentiation strategy.

For example, in the retail industry, we can find small convenience stores and large fancy shopping malls. The malls will have better decorations, more comfortable shoppingenvironments, and better services, all contributing to more expensive products sold at the malls. The convenience store, on the other hand, may be located in a rather remote location, provide limited services, but have lower prices for the same products. 

For companies that employ differentiation strategies, the gross profit ratios are normally higher from the higher prices. However, there won't be too much demand for high-end products, generally speaking. So naturally its turnover rate will be lower.

On financial reports, a company that employs differentiation strategy will show high gross profit ratio and low turnover. Because of the high gross profit ratio, its effectiveness is great, but because its turnover is lower, its efficiency is relatively slow. Therefore, we say differentiation is a strategy that sacrifices efficiency in exchange for effectiveness.

A company normally pursues premium pricing as part of its differentiation strategy. The company already knows its demand will not be as big as the low-end market; however, this is its own choice. We call the differentiation strategy winning by effectiveness.

From the above discussions, we see that different strategies bring different financial performances. However, their goals are the same - to create return on investment. It is the process of creating the desired ROIs that's different. Some companies choose to win by efficiency, while others by effectiveness. 

Paper Manufacturing Industry

Let's use the example of the paper manufacturing industry to illustrate how strategy is selected. 

In the paper manufacturing industry, there are a lot of companies adopting the cost leadership strategy. The reason is simple; even a very experienced professional may have a hard time guessing which company produced a specific piece of paper. The final products - paper - are very hard to differentiate. In addition, the paper manufacturing industry is capital-intensive. It requires huge amounts of investments for equipment. To make matters worse, almost every kind of paper needs a different piece of equipment, requiring even more investments if the company wants to expand the product line. 

Knowing this, it is not difficult to understand that the major costs of paper productions are fixed costs. Regardless of the actual output, fixed assets will have already been purchased. Therefore, the more paper the company products, the lower the per unit fixed cost will be. This is called economy of scale: if an industry requires siginificant levels of investments, only companies with large enough production outputs can break even by achieving economy of scale. This is why most paper manufacturing companies will choose the cost leadership strategy.

However, it is still possible that some paper manufacturers choose the differentiation strategy.

For example, a company may improve its paper quality and focus on a niche market to achieve differentiation. Here we are going to choose two paper manufacturing companies to illustrate the two strategies.

The first company only produces a particular kind of cigarette paper. The market demand for cigarette paper is really small, but the paper has a relatively high level of profits. The company adopted a differentiation strategy that focuses on making high profit products for only one segment.

The other company produces paper for newspapers. This company is really big, using a cost leadership strategy.

We will find that the company adopting the differentiation strategic position will have higher gross profit rates but lower turnover. By contrast, the company adopting the cost leadership strategy will have lower gross profit rates but higher turnover.

This verified one of our earlier analyses. 

However, we may not always find the desired results. 

Sometime we will find companies using the cost leadership strategy with low gross profit ratio AND low turnover, or companies using the differentiation srtrategy with low turnover AND a not-so-high gross profit ratio.

What might have gone wrong then?

Well, our definition of a strategy is that a company gives up one goal to pursue another goal tactically. However, if the execution of a strategy goes wrong, the company may find that even though it purposefully gives up one thing, it may not necessarily achieve the other. In other words, it may find a decreasing efficiency and effectiveness at the same time, and when it does, we can normally conclude that something has gone wrong with its execution on strategies.

The financials of a company not only bears the mark of its industry, but also show the company’s strategic positioning. In addition, they also show how the strategies are executed by the company.