Answers
Professional Level – Essentials Module, Paper P3
Business Analysis June 2008 Answers
Tutorial note: These model answers are considerably longer and more detailed than would be expected from any candidate in the
examination. They should be used as a guide to the form, style and technical standard (but not in length) of answer that candidates
should aim to achieve. However, these answers may not include all valid points mentioned by a candidate – credit will be given to
candidates mentioning such points.
1(a)One possible approach to answering this question is provided by using Michael Porter’s five forces framework. The framework
is designed to analyse ‘the structure of an industry and its competitors’ (Porter, 2004). There are five inter-connecting forces
in the framework; potential entrants (the threat of entry), the bargaining power of suppliers, the bargaining power of buyers,
the threat of substitutes and the competitive rivalry that exists amongst existing organisations in the industry. Each of these
is now considered in turn in the context of AutoFone, focusing on those factors that have a significant effect on their industry.
It must be recognised that other models might have been used in framing this answer and credit will be given for using
appropriate models in the context of the AutoFone retail shops division.
Potential entrants (the threat of entry)
New entrants into an industry bring new capacity and resources with which they aim to gain market share. Their entry may
lead to price reductions, increased costs and reduced profitability for organisations already in that market. Potential entrants
may be deterred by high barriers to entry and by the threat of aggressive retaliation from existing competitors in the industry.
In the context of AutoFone’s retail sales business, the following barriers appear to be the most significant:
Access to supply channels
The retail outlets of AutoFone were established before the network providers developed their own retail outlets. At the time,
the network providers were sceptical that mobile phones could be sold through shops. Consequently, AutoFone was able to
negotiate favourable long-term supply deals. It now seems unlikely that the network providers would sign such deals (because
the new entrant will be a competitor of their own retail business) and, if they did, any deals would be at less favourable terms.
As the managing director of one of the networks suggested, ‘AutoFone had got away with incredible profit margins’ when they
signed the original deals in 1990. Improved supply terms would be attractive to the network provider and phone
manufacturers (who would increase their profitability on each unit sold) but it would also cause profitability problems for the
new entrant. Furthermore, the provision of networks is currently highly regulated, with licences still having thirteen years to
run. It seems unlikely that public policy restricting the number of network providers allowed to provide services will change
in the foreseeable future and so access to supply channels will remain a very significant barrier to entry.
Economies of scale deter entry by forcing the new entrant to come in at such a large scale that they risk strong reaction from
existing firms in the marketplace. In the context of AutoFone, these economies of scale are associated with purchasing, service
and distribution of products through a large scale retail network of 415 shops. Any new entrant would have to enter at a scale
that would incur relatively significant capital investment. Furthermore, evidence suggests that the AutoFone brand is well
known in the market place, with consumers identifying it, in 2005, as one of the ‘top 20’ brands in the country. New entrants
would not only have to fund a large number of retail outlets, they would also have to support their entry by investing heavily
in ‘un-recoverable up-front advertising’ (Porter, 2004). Capital will also be required for establishing significant inventories in
the large number of retail shops required to achieve the required economies of scale.
Bargaining power of suppliers
Suppliers exert bargaining power over participants in an industry by raising prices or reducing the quality of their goods and
services. Suppliers tend to be powerful when the industry is dominated by a few companies. This is the case with the mobile
phone industry where the supply of networks is dominated by relatively few suppliers. The potential role of suppliers restricting
the supply channel has already been recognised as a barrier to entry. However, when supplier power is high, there is a
possibility that the suppliers themselves will seek forward integration, with ‘suppliers competing directly with their buyers if
they do not obtain the prices, and hence the margins that they seek’ (Johnson, Scholes and Whittington, 2005). This is
exactly the situation affecting AutoFone, with network suppliers now running their own retail outlets.
There are two further elements of the retail phone market which encourage the supplier group to exert significant power. These
are:
– The supplier group does not have to contend with other substitute products for sale to the industry. There are few direct
substitutes for the mobile phone (see below).
– The supplier’s product is an important input to the buyer’s business. In AutoFone’s situation it is a vital input into the
business.
Hence the bargaining power of suppliers is extremely high in AutoFone’s retail industry, although this is reduced by AutoFone’s
long-term supply contracts.
Bargaining power of buyers
Buyers attempt to obtain lower prices or seek to get increased or better quality services or products. They do this by playing
competitors off against each other. Under certain conditions a buyer group can have considerable influence. Many of these
conditions only arise when the buyer itself is an organisation, not an individual consumer. For example, Porter suggests that
buyer power is high when there is a credible threat of the buyer integrating backwards into the market place and so becoming
a competitor. Such conditions do not appear to apply to the retail phone industry which is largely aimed at individual
consumers.
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However, some of the circumstances of significant buyer bargaining power do appear to exist in the industry. For example:
the products buyers purchase are standard or undifferentiated. Buyers are always sure that they can find an alternative
supplier and so they can play one supplier off against another. This is the case for sale of mobile phones as a whole, not just
the retail sector. Furthermore, buyers face few switching costs. The only real lock-in is the term of the contract, currently
twelve months long, after which buyers can switch to a competitor without penalty.
Threat of substitutes
Substitute products are usually products that can perform the same function as the product of the industry under
consideration. The threat to the mobile phone industry is largely from other products that support mobile communication,
such as Personal Digital Assistants (PDAs). However, the trend has been to integrate this technology into the offerings of the
industry. The products offered by AutoFone include phones that are also mp3 players, radios, cameras and allow email and
web access. Hence the industry appears to be relatively free of potential substitutes.
Competitive rivalry in the industry
Rivalry normally always takes place within an industry. Rivals jockey for position by reducing prices, launching advertising
campaigns and improving customer service or product warranty. In the context of the retail mobile phone industry, the
intensity of the rivalry is fuelled by:
Equally balanced competitors. The information in Table 2 suggests that the retail sales market is relatively equally divided
between the five main suppliers. Evidence suggests this creates instability in the market because the companies are ‘prone
to fight each other and have the resources for sustained and vigorous retaliation’. (Porter, 2004)
Lack of differentiation or switching costs. Mobile phones are largely perceived by customers as commodities. In such
circumstances buyer choice is based on price and service, and this results in intense pressure for price and service
competition.
Slowing industry growth. Evidence from Table 2 also suggests that industry growth is slowing considerably. There was less
than 1% growth in 2007. This means that competitors will increasingly pursue growth by increasing market share. This will
intensify the rivalry between the competitors.
(b) The two longest serving directors of AutoFone have suggested that the retail business should be divested and that AutoFone
should re-position itself as an on-line retailer of phones. They argue that an organisation concentrating solely on Internet sales
and insurance would be a ‘smaller but more profitable’ organisation. The CEO is vehemently opposed to such a strategy
because it was the shop-based approach to selling mobile phones that formed the original basis of the company. He has
strong emotional attachment to the retail business. The two directors claim that this attachment is clouding his judgement
and hence he is unable to see the logic of an ‘economically justifiable exit from the retail business’.
This question asks the candidate to draft a supporting case for the CEO’s position, so that his response is not just seen to be
based upon emotional attachment. The briefing paper should challenge the suggestion of the two directors and provide a
reasoned case for opposing the divestment of the retail sales business. Of course, divestment might be the best option. The
four network providers might pay a handsome price to remove AutoFone from the market. However, this is not the focus of
the question!
Briefing paper
Introduction
This paper begins by looking at the basis of the directors’ suggestion and claims that they have not interpreted the business
situation correctly. It then goes on to examine the exit barriers that AutoFone must consider if they are to seriously consider
moving out of the retail sales market.
Product and industry life cycles
It has to be recognised that industries and products move through life-cycles. The slow down in market growth documented
in table 2 suggests that, in the context of the product life-cycle model, the mobile phone market appears to be in either the
shake-out or maturity stage. This means that buyers will be increasingly selective and that for many buyers the purchase will
be a repeat event affected by previous experience. Companies in the market will have to fight to gain market share and the
emphasis will increasingly be on efficiency and low cost. Similarly, industries pass from rapid growth into the more modest
growth associated with industry maturity. Like most infant industries the mobile phone industry experienced rapid growth as
it developed. However, evidence from table 2 and table 3 suggests that both growth and profits are now reducing as the
industry matures. Slowing growth in the industry means that there is more competition for market share as companies seek
to maintain their own growth at the expense of others. The transition to maturity usually means that the old ‘way of life’ of
the company has to change. It is significant that the idea for divestment has come from the two longest serving directors.
They can recall the excitement associated with rapid growth and, in the case of AutoFone, the pioneering of a business idea.
In many ways the current expansion of AFDirect recalls the early period of AutoFone and so operating in the growing Internet
market appeals to them.
Financial analysis
An analysis of Table 3 shows how profitability has fallen. The ROCE has steadily declined from over 18% in 2003 to just
over 5% in 2007. Net profit margin has fallen from just over 12% in 2003 to just over 3% in 2007. Gross profit margins
have not fallen quite as much as this. However, liquidity has remained almost constant during this period and so the ability
of the company to meet its short term financial obligations has not been impaired by the fall in profitability. Gearing has risen
during the period, from just over 21% to just over 32% and this reflects increased dependence on borrowed money. However,
the absolute level of gearing should probably not be a cause for concern.
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Porter suggests that one of the issues of the transition to a mature market is that directors have to scale down their
expectations of financial performance. ‘If managers try to meet the old standards, they may take actions that are extremely
dysfunctional for the long-term health of the company.’ The concern is that the two directors are pursuing such a policy, giving
up too quickly and sacrificing a market and market share in favour of a course of action that they believe will deliver
short-term profits. Divestment means that they are avoiding the challenges of taking a business like AutoFone into its mature
stage.
Industry structure
Evidence from the analysis of AutoFone’s competitive position (part a) suggests that AutoFone is in a retail industry dominated
by powerful suppliers. Customer bargaining power is also relatively strong and reduced growth in the industry has led to
relatively fierce competition. However, there is little threat from substitutes or new entrants because of the high entry barriers.
Consequently, AutoFone is in a unique position based on its early entry into the market before the network providers became
aware of the potential of retail sales. Furthermore, the company’s uniqueness is enhanced by the fact that it is the only retail
outlet to offer genuinely independent advice. The two directors appear to wish to carry on in the old way rather than changing
strategy and expectations to reflect the maturing of the product and the industry. The real challenge for the board is to exploit
AutoFone’s unique market position in this changing landscape.
Exit barriers
Exit barriers are economic, strategic and emotional factors that keep companies competing in industries in which they are
earning low or even negative returns. These are the barriers concerned with preventing the company from leaving the industry.
In the context of AutoFone there are at least two potential non-emotional exit barriers which need to be considered.
Costs associated with leaving the industry
– The high cost of terminating shop leases. AutoFone achieved low start up costs by taking on very long leases. These
leases are often in areas just outside the main shopping areas and so may be difficult to re-let.
– The high cost of staff redundancies and the liquidation of stock. There are currently 1,400 employees in the retail shops
division.
Loss of strategic interrelationship with other parts of the company
The divestment of the retail shops business is likely to have an important effect on the two remaining divisions (AFDirect and
AFInsure) in at least two ways
Reduced brand perception. Research has shown that AutoFone is a well recognised brand. However, most of this brand
awareness was built by the retail shops division. The brand is also being constantly reinforced by consumers seeing and
visiting these shops. Removing these will lose this reinforcement. Indeed if shops lie empty (because of the difficulty of re-
letting shops with long leases) it could harm the brand. Customers may perceive that AutoFone is a company in trouble (or
indeed has ceased trading altogether) and so the Internet and insurance arms suffer as a result.
Reduced sell-on into related businesses. Evidence (from table 2) suggests that most insurance sales are in the age bands
which predominantly purchase from the retail shops. Hence it seems likely that most insurance sales result from the sales of
mobile phones in the retail sales operation. There are probably two reasons for this. Firstly, retail sales are mainly to customers
in a certain age group. These customers are less confident in their purchase (which is why they are visiting the shop) and as
a result can be guided in the purchase of insurance. Secondly, sales assistants giving this advice are given commission
incentives to sell insurance. Consequently, the closing of the shops may have a major effect on the income of the insurance
business.
There is also the issue of the cross-selling benefits between the retail sales and Internet sales business. There is evidence to
suggest that some customers visit a retail branch to physically see the phones and to get advice before ordering on the
Internet. This is currently an issue for staff in the shops who spend time explaining the features of a particular phone only to
see the potential customer leave and order the same item on the Internet. Of course not all of these Internet orders are made
through AFDirect because customers may take advantage of better offers from rival suppliers. However, a percentage of those
sales must be as a result of a shop visit and the company potentially loses the benefit of these goodwill sales as a result of
closing their shops. There is also evidence that Internet customers value the option of visiting a shop to get after-sales service
for a product bought from AFDirect over the Internet. Although sales staff currently dislike offering this service, removing it
may again hit Internet sales.
Conclusion
The company needs to recognise that the mobile phone market has matured and this has implications for both growth and
profits. However, AutoFone remains in good shape to exploit the opportunities, such as repeat buying, of a maturing market
place. Although profitability has declined, liquidity has remained constant. Gearing has increased but it has not risen to a
figure which would cause concern. There are significant exit barriers to leaving the market place. The most significant of these
is the loss of a strategic interrelationship with other parts of the company. The Internet division could suffer significantly if
AutoFone closed its retail shops division.
(c) There are a number of issues concerning the central business idea and its relationship to the rewards system currently in
place in the AutoFone retail shops division. Decline in profitability has led some to question whether the central business idea
that underpins the business is still appropriate in a maturing industry and product environment. However, if it remains
appropriate, it is currently being undermined by a reward system which focuses on profitability.
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Conflict between strategy and remuneration
The strategy has at its core the business idea that has driven the company since its inception. This is the giving of impartial
advice to customers so that they can select the best equipment and network for their needs. This business idea is prominent
in all of its promotional literature and is reflected in the company’s motto ‘ethical advice: the customer’s choice’.
However, the CEO also claims that the shops are autonomous, being given profit targets but not closely monitored within
those targets. He states that the company is ‘about providing opportunity to its employees, providing them with autonomy
and responsibility to achieve their goals’. To support this approach, sales staff are given a relatively low basic salary with a
substantial element of profit-related pay linked to the profit targets of the shop. Commission is also paid on sales of mobile
phone insurance to the customer.
Evidence from the scenario suggests a largely ‘hands-off’ approach to shop management based mainly on the achievement
of financial targets. The profitability of the central city branch was not fully understood until the activities of the branch were
investigated after the visit of three members of the strategic planning committee. Shops are monitored on achieving profit
targets, not on their adherence to the central business idea.
The central business idea is undermined by the remuneration package offered to employees. Significant elements of this
package are based on the profitability of the shop and so are very dependent on margins. It is clear from the experience of
the central city store manager that margins are not the same for all products and services. Hence to meet profit targets, he
abandoned the central business idea and steered customers towards products which had higher margins. As a result his shop,
himself and his staff achieved their targets and reaped financial rewards but at the cost of abandoning the central business
idea. Until he was investigated, he was held up as an example of what could be achieved. However, when his activities were
investigated and analysed he was formally disciplined and he left the firm soon after. The message was that adherence to the
business idea was more important than profitability, but this message is not supported by the current rewards system.
Impartial advice is likely to lead to reduced income.
Business strategy
The challenge now for AutoFone is to ensure that its business strategy makes sense in the current market place. The company
will have to consider whether its original business idea is still a basis for a viable business. Impartial advice was valued when
the company was first established. Information about competing products was difficult to gather and products and product
details were difficult to access. However, information about competing products is now readily available (on the Internet), rival
phone shops have been established and the consumer’s understanding of the product has increased.
The product has moved into a mature stage of its life cycle where competition often shifts towards greater emphasis on cost
and service. Companies are usually forced to rationalise the product mix. During the growth stage of the industry it may be
possible to support a broad product line with frequent introduction of new products and options. However, at the mature stage
it may be necessary to prune unprofitable items and to focus on products with the best margins. This, of course, is exactly
the policy pursued by the manager at the central city branch.
Increased emphasis on service may be something that AutoFone can exploit through its retail shops. In the mature stage of
the life cycle firms are increasingly selling to experienced, repeat buyers. Such buyers are more knowledgeable and their focus
is on choice between brands, not on whether to buy the product at all. This should suit the AutoFone business model which
is based on choice – a model that none of their network-based competitors can offer.
Reward management
AutoFone must also seek to align its business strategy with its reward management. If it maintains its original business idea
then it has to base its rewards system on factors that are not linked directly to profitability – such as turnover and customer
satisfaction. It also must recognise that the average wage of an employee in 2007 is less than what it was two years ago.
Finally, the company also has to tackle the thorny issue of the relationship of the shops with the Internet operation. Giving
impartial advice to customers who then place their order through the Internet and providing support for customers who have
purchased their phones through AFDirect are valuable services for the group as a whole but are currently irritating,
non-income generating activities for the sales staff in the shop.
AutoFone currently give staff a relatively low basic salary with a substantial element of profit-related pay linked to the targets
of the shop. It may wish to consider restructuring this to offer a higher base pay, with performance-relating pay reflecting,
perhaps in part, achievement of a target associated with the central business idea. However, it must be recognised that
devising a measure of ‘impartiality’ will not be straightforward. Another possibility, reflecting the concern about giving advice
to AFDirect customers, would be to include an element of performance related pay associated with the group as a whole.
Within the shop structure it would seem useful to explore a reward system that:
1. Provided higher basic pay to each individual working in the shop.
2. Provided performance-related pay associated with the shop itself. This may continue to be related, in part, to profitability.
However other measures more obviously associated with the central business idea must be considered.
3. Provided an element of performance related pay associated with the group as a whole.
The first and third elements of this suggested structure might also replace the commission-based sales of insurance currently
paid to retail sales staff. The ethics of the current approach and how it fits in with the central idea of the business seem open
to question.
It must also be recognised that the company may also have to adopt a more ‘hands-on’ approach to monitoring the
performance of the shops to ensure that the business idea is being adhered to. It is unlikely that the company can continue
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