Edición 59, Strategy

The strategic value of a straight line

By: Antonio Lloret, ITAM

It is common to find in articles and books about business strategy definitions of strategy that are intended to sustain a discipline. For example, according to Thompson, Strickland and Gamble (2008), “strategy consists of the competitive moves and business tactics that administrators employ to grow the business, attract and satisfy consumers and compete successfully through operations with which organizational goals are achieved.” For Barney and Hesterly (2010), strategy “is a theory of how to generate competitive advantages,” while Porter (1996) defines strategy as “the creation of a fit between the various activities of a company.” These definitions are very useful, but because they are so general, they don’t give us the simplicity needed to explain how strategy generates value. In fact, if we try to establish the link between a company’s business model and its strategy (Osterwalder and Pigneur, 2010), we find a conceptual void. This situation creates a dilemma, because it can discredit an entire discipline by its vagueness and relativism, instead of adding value to it.

How, then, can we simplify the concept of strategy to understand its importance in a simple, intuitive way?

One possibility (though not the only one) is thinking in terms of a linear function as a straight line. In geometry and algebra, a linear function is a first-degree polynomialfunction. In other words, a function whose representation on the cartesian plane is a straight line. The function can be written as:

f(x) = b + mx

where m and b are constant or parameters, and x is a variable. The constant m is the slope of the straight line and b is the point where the straight line cuts across the Y axis. If we modify m, the slope of the straight line changes, if we modify b, the straight line will shift up or down.

We can think of the concept of strategy in terms of a linear function, or a straight line. We just need to be creative, think about what the straight line means, what it relates, and that the strategy will be the set of actions that must be taken to move the parameters m and b. If we could map out the graph of a business situation, we can understand it. A linear function is very helpful in describing what we have to do, and that “we have to do” is in itself a strategy.

Think about the following situation: you’re the manager of a company and your boss tells you that you have to increase your sales margin (the margin is the difference between the price and the cost of the good sold), you probably only have one way to do this. Since the product price is given by the market (in other words, it’s constant), you have to lower the cost. The straight line can simplify the strategy you should follow. Let’s look at it in terms of a graph:

Step 1: Draw a cartesian plane.

Step 2: Label the vertical axis as margin (price less cost).

Step 3: Label the horizontal axis as products made or sold.

The graph would look like this:

Step 4. Establish the relationship you think should exist in terms of a straight line.

What this linear representation indicates is that the more products you sell, the higher the sales margin. The function is: Margin = b + m (products), where b takes a value of zero because it is at the origin, and m is the value of the slope that gives the level of the margin obtained for each product sold. As part of this example, the price is set by the market, so the only way to raise the margin is to reduce costs. Thus, the previous representation is similar to the following:

In other words, we have to reduce the cost of each product if we want to increase our margin. The linear function in this case is Costs = b – m (products). Here, b represents the costs independently of the product sold and m is the marginal (or variable) cost of each one of the products made or sold.

The mere representation should communicate that if the goal is to increase the margin, the only alternative is to act upon the slope, the value m, and that’s where strategy comes in, because there are countless ways to modify m, which is the ultimate purpose of the strategy. For example, we can think of economies of scale, in production efficiency, in increasing production capacity, or in resources to affect the value of m, reduce the cost and increase the margin.

Let’s look at a more simple and intuitive example. Suppose your level of profitability (vertical axis) depends on the number of clients you serve. Imagine a coffee shop in which just to open the place, without selling a single cup of coffee, you have to spend something. This situation can be represented graphically as we did in the preceding example:

If we express this representation as a function, it would be: Profitability = -b + m (cups of coffee). This means that if you don’t sell any coffee, there’s a loss equal to b, which might be the rent on the shop or the wages of your employees. You have to sell at least b/m coffees to break even, and any additional coffee after b/m would be the coffee shop profit. This b/m, in its simplest form, is the concept of the break-even point, where you neither make or lose money. Strategy then implies, for example, increasing the price of the coffee, reducing the cost of the coffee or modifying b to bring it closer to zero by reducing the costs of your shop, or even lower the wages or working hours of your employees to hire more people to work at the busiest hours, and less at other times.

These linear representations are very useful for understanding business situations; we can also make them more complex so we don’t leave them in these simplistic (which is not to say simple) terms.

One of the creators of strategy, Michael Porter, in 1980 conceptualized five forces of the industry to postulate that, based on a static analysis of the industry, it was possible to determine potential profitability based on two principles: 1) the relative power of suppliers and clients; and 2) the threat of substitutes, rivalry from competitors and threat of new participants coming in to the market. Figure 5 shows this model.

The analysis is very useful, but it’s still ambiguous. How does the straight line help us better understand such an important concept?

The simplest thing, once again, is to represent the concepts in terms of a linear function and see the effect of each of these forces on profitability. For example, let’s think about suppliers’ power of negotiation:

As we see in the graph, as suppliers’ power rises, profitability drops. The function would be: Profitability = b- mRPS. This representation indicates that as suppliers’ purchasing power rises, profitability is reduced. In strategic terms, we need to modify the rate at which the relative power of suppliers grows, and as a result, what the company should do is think of strategic actions to reduce that power ―for example, seek out more suppliers, renegotiate contracts, etc. All of these are highly important strategic decisions. The same is true for the client. The representation is practically the same, but this time the horizontal axis represents customers. The strategic movement should be to increase the company’s power vis-à-vis its customers, for example, with switching costs (that is, a client would lose something for no longer consuming) or differentiating itself enough so that the client, instead of seeking out alternatives, stays with the company.

As for the threat from substitute products, rivalry from competitors and the threat of new participants, we can group all of these into a single category called “competitors”:

Here, Profitability = b – m (competitors). This means that as the number of competitors (substitutes or new entrants) rises, profitability declines, unless ―strategically―the company makes decisions that raise entry barriers or create mechanisms to insulate it from the competition, like patents, exclusivity agreements or differentiation, which will modify m and increase profitability.

In conclusion, strategy has a graphic representation that can help us to understand and, more simply, intuit the decisions that need to be made.

We have to understand that even though reality doesn’t behave in a linear fashion, a conceptual approach like the straight line is useful for understanding the possible relationship between the company’s strategic decisions. We shouldn’t be afraid of graphs and mathematical functions. Rather, we should realize that what can be graphed out can be understood, and if it is understood, it can be acted upon and decided.

References

  • Barney, J. B., and Hesterly, W. S. (2012). Strategic management and competitive advantage (4th ed.), Pearson.
  • Osterwalder, A., and Pigneur, Y. (2010). Business model generation: A handbook for visionaries, game changers, and challengers, Wiley.
  • Porter, M. E. (1985). Competitive advantage (pp. 11-15), New York, The Free Press.
  • Porter, M. E. (1996). What is strategy? Harvard Business Review (November).
  • Thompson, Strickland and Gamble; 2008 “Crafting; executing strategy: Text and readings.

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