Using System Dynamics to Identify Competitive ...

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

Using System Dynamics to Identify Competitive Movements. A Case Study in a Small Hardware Manufacturer Fernando José Barbin Laurindo (POLI/USP) [email protected] Cláudio Roberto Leandro (POLI/USP) [email protected]

Summary The effectiveness of strategy management depends on how the company understands its external environment and how it creates strategic policies to adapt the organization to this environment. This paper discusses, through a case study, how system dynamics can help to identify the variables that stimulate the main forces on the company performance.. Keywords: Competitive Movements; Strategic Movements; System Dynamics. 1. Introduction Frequently, companies have difficulty to identify how new competitors can enter in their market. When emerging strategic policies do not contemplate preventive actions, companies can notice late that their market has been disrupted by other companies. This paper aims to explore how the variables from the external environment influence the five competitive Porter´s forces on the business dynamics of an industry. Through a case study, system dynamics is presented as a support model to help the diagnosis. 2. Literature Review The current dynamic competition has forced many companies to intensify their methods of market analysis, trying to identify a better position in their industry. According to Porter (1987), companies use strategy to reach a right position within their industry. Mintzberg et al (2000) define strategy as a pattern, which can be understood as a set of activities that determines a consistent behavior through time. These authors still complement that companies, during the process of strategy modeling, develop plans for the future and also extract relevant information from past data. Within this context, strategy reflects companies’ intention of reaching their market goals; this situation was defined as deliberate strategy by Mintzberg et al, 2000. After this strategy definition, it is deployed into decisions and actions and companies expect to obtain a superior result over their competitors. The process of deliberate strategy is developed from the managers’ perception of future situation of external and internal environment. As this process is a forecasting, it can require corrections due the market dynamics and, very often, previous strategy process can not reach its objective. In this situation, companies need to define an emerging strategy to adapt previous plans to the new reality (MINTZBERG ET AL, 2000, ANDERSEN, 2004). Andersen (2004) describes that both deliberate and emerging strategy must be taken into account in process management. The author still complements that due to the turbulence of the environment with multiple pressures, the emerging strategy process becomes very important to sustain companies’ position in their industry. The environment turbulence is simultaneously empowered by the combination of social and economic variables. Porter (1996) advocates that companies performance in their industry depends on the interaction and the intensity of five forces: (I) potential entrants, (II) bargaining power of

ICIEOM 2006

ABEPRO

1

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

suppliers (III), substitute products, (IV) bargaining power of buyers and (V) rivalry among existing firms. These forces are stimulated by social and economic variables, and they determine the level of competition within the industry. Rafii and Kampas (2002), discuss that managers have difficulty to identify market signals or to understand how the forces acts over companies dynamics. These authors still explain that competitive movements can represent a genuine threaten or simply an also-ran and it is very important to distinguish both. The authors affirm that competitive movements can occur in six stages: a) First, potential entrants or new competitor scan access marginal market. Due to the unexplored needs, new competitors can offer products and services to customers for a lower price and inferior quality level. b) Second, new competitor enters in the main market. It occurs if there are no barriers to avoid new competitors intention. Lack of patents, easy access to suppliers and to distribution chain and low level of capital investments can facilitate new competitor’s strategy. c) Third, new competitors begin a process of accessing customers, disputing each single customer purchase order. d) Fourth, customers can change from current suppliers to the new competitors if the costs to migrate from one to another were irrelevant. e) In the fifth moment, the company under threaten can begin a process of retaliation against new competitors and if the retaliation is not favorable to the company, it give up from its current market. f) In the last stage, the company under threaten is moved its position within the market. When the competition occurs in a low level, the new competitor acts as complementary, or, in a high level of competition, the new competitor substitutes the current company. How intense and how fast these six stages develop in a industry, depends on the interactions of the social and economic variables that stimulate the Porter´s five competitive forces. One of the biggest challenges for managers is to identify what variables shape competitive forces and how theses forces interfere in its business dynamics. 2.1 System Dynamics Forrester (1961) affirms that companies live within complex systems. In order to be efficient, decisions and actions defined by theses companies, depend on the right interpretation of the dynamic of these systems. Forrester still complements that companies do not live in a unidirectional world, where a problem requires an action and a solution. In reality, companies live in a continuous circle, where actions are based on the current conditions, and later, these actions affect future conditions. There is no beginning or end for this process, just a continuous circle. In 1956, Forrester developed a field of study called system dynamics, where the main objective was to understand the behavior of complex systems. A project of system dynamics begins from a problem that needs to be solved or from an undesirable behavior that needs to be avoided or corrected. Forrester (1971) apud Fernandes (2003), Sterman (2000) e Warren (2004), affirmed that there are basically two types of systems: open cycle systems and feedback systems. According to these authors, a system can be seen as an open cycle if the outputs react to the inputs, but the outputs are isolated from the inputs and there is no influence of the output over the input. This type of system does not react from its own performance; it means that the latest action

ICIEOM 2006

ABEPRO

2

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

does not control the future action. The relationship between cause and effect is linear. Feedback system reacts from its own performance. This system has a closed circle and it is influenced by past behavior, i.e., it means that the outputs have impacts on the inputs. Sterman (2000) and Warren (2004), affirmed that in feedback system, decisions are taken from the information about system current status. Once the decision is taken, an action occurs provoking a result. But the information about the new status of the system becomes an input for new decisions. Goodman (1989) apud Fernandes (2003), advocate that behavior of a system is determined by its own structure and this structure is composed by feedbacks and delays. Two or more variables can represent a closed looping of interactions. The first variable interferes over the second variable that interferes over the third variable that interferes over the n-variable that interferes over the first variable again, beginning a loop of feedbacks. Sterman (2000), Lyneis (2003), Utterback (2005), complement that the loops of feedbacks are responsible for the mechanism of self-reinforcement (or positive) and self-correcting (or negative). Goodman (1989) apud Fernandes (2003) and Warren (2004), still define that the structure of the feedback system is a circular representation of interconnected causes that due its structure and activities produce, as response, determined behavior. If the system presents a selfreinforcement feedback, the action from one variable over another, produces a variation to the same direction. If the action produces a variation to the opposite direction, the system has a self-correcting feedback. The figure 1 illustrates the feedback system and loops:

Profits Participation +

+ +

Sales Volume

Price of Substitute Product

Figure 1 - Causal Map. Profits Participation, Sales volume and Price of Substitute Product (source: author)

Sterman (2000), affirms that is possible to identify all system elements and identify how the dynamic of the system occurs. a) System Variables are the relevant agents of the system or the factors responsible for the system dynamic. In figure 1, agents are profits participation, sales volume and price of substitute product. b) Relationships are represented by the arrows that indicate the influence from one variable over another variable. The signal or polarity besides the arrow represents how variables interacts with another: When the signal is positive (+), the variation of one variable occurs in the same direction, for example, if the profits participation increase, the sales volume also increase and if the profits participation decrease, the sales volume also decrease. If the signal is negative (-), it means that the variation of one variable occurs in the opposite direction, for example, when the price of substitute product increases, the sales volume of the company decrease and if the price of substitute product decrease, the sales volume of the company increase.

ICIEOM 2006

ABEPRO

3

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

c) Feedback is a circular interaction of causes among variables. If the effect over the variable itself occurs in the same direction, the system has a positive feedback or self-reinforcement. But if the effect over the variable itself occurs in the opposite direction, the system has a negative feedback or self-correcting feedback. In figure 1, if profit participation increases the sales volume, there is a positive feedback. But, there is another system that interferes in the dynamic of this system: price of substitute product. If this price increases, it will have a negative impact over sales volume. Using system dynamics principles, the company can understand the whole system that determines business dynamics. Through a correct business dynamics modeling, the company can identify the variables and the interactions among them. It can be useful as a decision support model to identify how forces arise in the market and how they shape strategy. 2. Research Methodology Yin (2001) defines a case study as the chosen research strategy to analyze a current behavior. The adopted research methodology in this paper is a unique case study. Yin (2001) and Martins (2006) advocate how important is the method of collecting relevant data for a case study. The data collected data for this case study has a qualitative aspect, whose objective was only to understand company’s environment. The technique used to collect data was participant observation, where the company’s team (with customers) tried to understand customer’s perceived value of supplied products. Company competitive movements in the market were analyzed according to the following steps: a) Qualitative research with customer in order to identify perceived value of products supplied by the company; b) Modeling causal map of the company business dynamics; c) Analysis of the causal map and how the disruptive process happened in the company’s market; d) Analysis of the way that competitive forces arise in the company’s market. 3. The Case Study Norma Ind. e Com. Ltda, is a Brazilian small hardware manufacturer located 120 Km from São Paulo. The company produces cutters and blades since 1960 and it is the first and unique manufacturer of this type of product in Brazil. The company is responsible for projecting, producing and distributing products in domestic market. Since its beginning, this company offers its products to end consumer through distributors. The distribution chain was always the stationery market, the cutters and blades were developed to be used in offices. The deliberate strategy of the company was driven to control distributors, according to the company top managers, avoiding the access of the distribution chain by its competitors. By this behavior, the market share of this company was ensured. From 1990, when Brazilian market was opened to world economy (protection barriers were reduced), the company faced problems to map competitors movements. In 2000, the company started to lose its market share to international producers. Even keeping a strong policy of relationship of its distributors, five years later (2005), the company’s market share had been reduced to 25%. 3.1 The first attempt to emerging strategy During this time, top managers invested in new emerging strategies, in a attempt to improve the relationship with distributors. Decisions such as prices discounts, better payment conditions, and packaging customization were among the main alternatives used by the

ICIEOM 2006

ABEPRO

4

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

company. But the result of this first attempt of emerging strategy was not totally efficient. The company just kept its new 25% market share. 3.2 The Competitive Moving Study After several attempts of emerging strategies, company managers decided in 2005 to start a process of analyzing the market to understand the competition dynamics. In the first step, the objective was to get information about the perceived value by the customer’s chain involving the distributors, small stores and the end customers. During 120 days, the company kept a small group of technical salesperson visiting these customers and searching for information organized according the following aspects (understood as quality requirements): a) Product performance: customer opinion about the handle and about the sharpness of the blades and if it lasts as long as customer needs. b) Special features: any special features important to the customer and if this features were taken into account to purchase a product. c) Reliability: probability of having problem during the use of the products. d) Price: price elasticity and price discrimination. e) Appearance: if the design of the product was taken into account during purchase process. f) Technical Support: if customers consider technical support important, i.e., how the lack of orientations could influence in purchase process. g) Safety: if the risk of having accidents with cutters and blades were taken into account during purchase process. Company’s team visited 350 customers during 4 months divided into three groups: 150 distributors, 100 office users and 100 industrial users. Based upon the seven quality requirements listed above, the research was directed to get the perceived value about each quality requirement. According to table 1, customers could determine the level of importance of each item in three levels: − A = High. The item is taken into account during the purchase process and it determines the satisfaction of consumers. − B = Moderate. The item is desirable, but it is not relevant to interfere in purchase process. − C = Low. The item is not important for customers. Quality Feature Performance Special Features Reliability Price Appearance Technical Support Safety Source : Author

Distributors C C C A C C C

Office Users C C C A B C C

Industrial Users A B A A B A A

Table 1 - Perceived Value by customers

After identification of perceived value by customers, the next step was modeling the causal map to investigate the dynamic system that involves the business of the company. The objective of this step is to recognize how the system works and what variables should be monitored. Top managers wanted to understand the whole system, to create a new emerging strategy. The figure 2 shows the variables and the feedback system that shape the business dynamics of the company.

ICIEOM 2006

ABEPRO

5

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

3.3 Understanding the Causal Map and the Competitive Movements Through the causal map, top managers could understand how the whole company interacts with the external environment. Especially how the variables determine Porter´s five competitive forces. The analysis of the causal map was made following the steps proposed by Rafii and Kampas (2002), where the authors indicate the process of disruptive threaten. The elements or variables presented in causal map were defined according to company’s business dynamics from a social and economical perspective. From an economical perspective, the variables identified were those that stimulate or make more difficult the access of new competitor to the market. From a social or cultural perspective, only the variables related to perceived value were used.

exchange rate + + + protection barriers

taxes on international trade

substitute products

-

-

potential entrants

perceived value by customers

hardware production

+ -

Hardware inventory

price + +

Hardware sales

Distributors +

-

+ Hardware inventory - in the market +

+ bargainning power of buyers

Figure 2 – Causal Map – Company Business Dynamics (source: author).

a) Potential entrants and marginal market. As the company was only concentrated in its distribution chain, this attitude allowed the new competitors or entrants to have access to end customers offering products for a lower price. After starting purchasing products for a low price, end-customers put the whole distribution chain under pressure to get products for a lower price. Another variable that influenced the participation of new competitor was the low perceived value by customers and the reduction of protection barriers. b) Potential Entrants and the main market. After accessing the marginal market, new competitors have difficulty to enter in the distribution chain due to the aggressive sales policy of the company. But later, the stores and end-customers put these distributors under pressure to offer products for lower price. Clearly, it was a market tendency. The pressure

ICIEOM 2006

ABEPRO

6

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

for lower prices becomes so high that the distributors, later, decided to sell products to end-customers. c) Access to Customers. During the research, due the new dynamic competition one problem could be noticed: end-customers started to analyze price with another type of products and their perception was that products with a low perceived value should be cheaper. Stores and distributors are offering a package of benefits with many types of products, trying to reduce the value of the whole purchase order. d) Customer Migration. Due to the low perceived value of the products by customers, endcustomers did not have any problem to change manufacturer brand. No perceived value meant lower prices in this case. e) Retaliation. After disrupting the market by the new competitors, the company was not motivated to create new emerging strategy to face the new competitive dynamics. It happened because the prices difference was intense: about 45%, and any level of discount could provoke serious economical losses. f) Strategic Moving. The causal map could show that the low perceived value by the customers was one important variable to facilitate the new entrants in the company’s market. Analyzing table 1, the company could notice that the industrial customers have unexplored needs. As this type of users is always under risk of having accidents and they are paying attention on productivity, current products were not fulfilling their needs. Within this context, top management could understand that the company could move strategically in the same market offering new products to industrial customers. The old policy oriented to distributors had made them be completely out of reality, unaware of the changes that happened. Another recent study with mature market such as European market could prove this previous evidence, since the European hardware manufacturers were using high technology to develop new products oriented to the industrial users. 4. Conclusion This study could demonstrate that strategy process is not a easy task for top managers. Even using modern strategy concepts, it is very important to understand how the company interacts with the external environment. Using dynamic system, managers can identify all variables that influence in the business performance and how they interact with others variables. A company can keep a self-reinforcing feedback system, but normally in touch with a selfcorrecting feedback system. It means that external market can find equilibrium with substitute products or with competitors. It was the most important point in the learning process. After this study, the company created a new deliberated strategy where it started to work with industrial users and special products for specific needs. Some examples can be mentioned: − One of the biggest supermarket chain in Brazil was having problem with conventional cutters and blades. Besides accidents, during the process of cutting boxes, cutters frequently damaged products inside them. With the new strategic policy, the company developed a specific cutter whose blade exposed edge was exactly the boxes thickness. Cutter was designed within safety concept to avoid accidents. − Fiberglass, plastic, rubber, leather and textile industry always use cutters and blades in their production process to remove burrs, finishing and for cutting materials. These companies were not satisfied with products available in the market. As the materials are too abrasive, the common blades made the production process slower; due the strength of the cutters were submitted, they used to break easily and accidents always happened. Company deployed all customers needs and designed new products using resistant materials, such as aluminum

ICIEOM 2006

ABEPRO

7

XII ICIEOM - Fortaleza, CE, Brasil, October 9 - 11, 2006

instead of plastics and new blades were incorporated to the company’s products portfolio for different applications: new blades made of high speed steel, stainless steel and blades coated with hard layers. The company, nowadays, after this study, follows some steps to validate its strategy: − Company need to go on investing in new products oriented to industrial users; − The distribution chain continues to be important, but it is seen only as place where the products can be purchased. Company maintains technical salespeople training users in how to avoid accidents, analyzing the restrictions of the products and feeding the project department with information about the products performance. − The process of the brand management is now evaluated by the company to make Norma recognized as a specialist of technical cutting needs. After studying the company’s market, top managers could understand how strategy interacts with external environment. They also understood that before determining any new emerging strategy is very important to analyze the system where the company lives using principles of system dynamics. Future studies should encompass a larger number of cases, in order to deepen the analysis of the main aspects pointed out in this paper. 5. Acknowledgements Special thanks to Norma Artefatos de Metais and Mrs. Laurette Nüssli (0xx15 3363.4900), for authorizing the information here presented e for allowing the author to have access of the company’s strategic planning.. 6. References ANDERSEN, T.J. Integrating the Strategy Formation Process: An International Perspective. European Management Review, vol. 22, num.3, p. 263-272, 2004. FORRESTER, J.W. Industrial Dynamics. Cambridge, MIT Press, 1961. FORRESTER. J.W. Principles of Systems. Portland, Productivity Press, 1971. FERNANDES, A.C. Scorecard Dinâmico – Em Direção à Integração da Dinâmica de Sistemas com o Balanced ScoreCard.Tese de Doutorado. Rio de Janeiro: UFRJ, 2003. GOODMAN, M.R. Study Notes in System Dynamics. Portland, Productivity Press, 1989. LYNEIS, J.M. Systems Dynamics for business Strategy: a phased approach. System Dynamics Review; Spring, ed. 15, p.37-70, 1999. MARTINS, G.A. Estudo de Caso.São Paulo: Atlas, 2006. MINTZBERG, H, AHSLSTRAND, B, LAMPEL, J. Safári da Estratégia. Porto Alegre: Bookman, 2000. PORTER, M.E. Estratégia Competitiv. Técnicas para análise da Indústria e da Concorrência. Rio de Janeiro: Campus, 1996. PORTER, M.E. Competição. Rio de Janeiro: Campus, 1999 RAFFI, R, KAMPAS J.P. Como Identificar seus Inimigos Antes de Ser Destruído.Harvard Business Review. Ed. Novembro p. 87-95, 2002. STERMAN J.D. Business Dnamics. New York: Mc Graw Hill, 2000. YIN, R.K. Estudo de Caso: Planejamento e Métodos. Porto Alegre: Bookman, 2004. WARREN, K. Improving Strategic Mangemement with the fundamental Principles of System Dynamic.System Dynamics Review, vol.21, Num 4. p. 329-342, 2005.

ICIEOM 2006

ABEPRO

8