We have previously laid out a rigorous, logical description of an organization as a system of tangible resources that enable pursuit of its purpose by supporting each others’ development. The strategic architecture is, if you like, “the machine” designed for that purpose, so this question is effectively whether it is possible for that machine to exist at all. For that to be true, its resources must be capable of generating sufficient cash flow to fuel their own development, as well as delivering cash-flow or whatever other output is desired. Two inter-related problems could cause this requirement to be missed:

• there could be too few potential customers to generate adequate cash flows, and/or
• it could be too costly, or require too many supply-side resources to win and sustain those customers.

This principle can be demonstrated with the basic consumer brand model from Briefing 21, though other models we have examined would do equally well. The potential market in that case offered 3 million possible consumers, each willing to buy 0.8 units per month at a retail price of $11.25 — higher prices reduce this purchase rate and lower prices raise it.

It’s a rather simple point that a smaller potential market offers lower potential sales, and thus makes it harder to build a profitable business. With a potential of only 1 million consumers, the brand grows very slowly can never become profitable. Consider, though, how this situation would seem to the management concerned. They might conclude that a slow early sales rate is not due to the smaller potential market, but to insufficient advertizing spend. A reasonable response would be to increase advertizing spend, but even if this leads to faster early growth, the ultimate potential would be too small for the product to become profitable. The brand seems to need a potential of 2 million consumers or more to be viable.

The smaller than expected market potential has further implications, however. This example was chosen because it demonstrates a simple case of interdependence between resources — consumers are won more quickly because of increasing product availability in stores, and stores are won more quickly because of growing demand from consumers. Figure 1 shows the impact when sales success depends on consumer demand. This causes a far more serious under-performance, so that the brand fails to become profitable even with a potential market of 2 million consumers. Interdependence amongst resources substantially amplifies the consequences of either over- or under-estimating the scale of a strategic opportunity.

Figure 1: How growth of a brand in a limited market is held back by interdependence. (Click image to view larger)

Until next time…

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Sensitivity analysis for new business opportunities

It is common practice when evaluating a new business opportunity to include a sensitivity analysis. This is useful whether the opportunity comes from an entrepreneur seeking funding for a new venture, or a corporate executive seeking approval to develop a new line of business. Typically, such a business case will justify the estimated potential market and likely sales, lay out the resources and costs needed to develop the opportunity, and show a “central forecast” for the expected profit outcomes. It will also include some analysis of the sensitivity of this forecast to uncertainties in the underlying assumptions, e.g. what if sales turn out to be +/ 20 % vs. the central estimate, or costs required are 10% higher or lower than expected. Such sensitivities are easy to test with the spreadsheet models on which business cases are usually evaluated.

Interdependence in the strategic architecture suggests that such simplistic sensitivities can be badly inadequate – the impact on performance of an error in estimating one resource in the system can be multiplied substantially by interactions with other resources. Sensitivity analysis should therefore be explicit both about the assumptions regarding underlying resources and about the interdependence between them.

This briefing summarises material from chapter 8 of Strategic Management Dynamics, pages 518-521.

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