In hand

It's different at the top. While your subordinates are in the pharmaceutical market and measure success in sales and profits, the board has to think differently. You are in the capital market and success is measured in shareholder value created.

Shareholder value is not the same as profit; it is a function of both returns and risks. So main board directors concern themselves with the risk-adjusted return on capital, a worry their subordinates are generally free from.

Unfortunately, the tools for assessing business risk are inadequate. They are either uncomfortably qualitative, based on vague assessments of intangibles, or hopelessly general, based on broad extrapolations of industry, rather than company, performance. What business leaders need is a way of assessing business risk both quantitatively and specifically. We need a tool that can objectively assess the probability of a business plan delivering the profits it promises.

Moreover, we need a process that can be applied specifically to any business, and just such a process has emerged recently from years of research at Cranfield, one of Europe's top business schools.

In short, marketing due diligence is a process that assesses the probability of a business plan delivering on its promises. It then adjusts the promised profit to reflect that probability and calculates if, for the firm's cost of capital, the plan would create or destroy shareholder value. It is a sophisticated process built on years of detailed research, but it can be understood in quite simple terms.

In this article, the marketing due diligence process is described for a single, simple, strategic business unit (for instance, a disease or therapy area), but the same principles work for a complex global business. 

What makes strategy risky
Once the hype and jargon is cleared away, all business plans say the same thing: 'We're going to do these things in this market and make this much profit.' Digging deeper, we can discern three fundamental assertions that lie at the root of all business plans:

• The market we are going for is this big
• Our strategy will achieve this much share
• That share will result in this much profit.

It is these three assertions that give rise to the three components of business risk:

• Market risk: the risk that the market is not as big as you think it will be
• Share risk: the risk that your strategy will not deliver the share it promises
• Profit risk: the risk that you will not make the margins you promised.

Cumulatively, these three component risks add up to business risk. If all three are certain, then there is no risk and the plan will deliver what it promises. To the extent that there is some uncertainty in one or more areas, the plan is risky and the promised returns must be higher to compensate for the risk.

If we could objectively assess business risk, using data in a specific and systematic way, it would help us to create shareholder value in two ways. Firstly, it would allow us to identify the main areas of risk in our strategy and act to reduce that risk.

Secondly, it would give us a tool to sell our strategy to investors, demonstrating in detail that our plan is well-thought out and creates shareholder value. The challenge lies in accurately assessing each of those three areas of risk.

Market risk
It takes little business sense to appreciate that a minority of strategies have very high market risk (for instance, a brand new therapy area and a novel molecule), while others have very low market risk (for instance, well established, mature disease areas with little turbulence). The test for marketing due diligence is to differentiate between the large mass of strategies in the middle; to compare the market risk of two or more strategies of moderate market risk.

Cranfield research found that market risk itself was made up of five sub-component risks:

1: Five subcomponents of market risk

• Product category risk
  Product category risk is lower if the product category is well established, and higher for a new product category
• Segment existence risk
  Segment existence risk is lower if the target segment is well established, and higher if it is a new segment
• Sales volumes risk
  Sales volumes risk is lower if sales volumes are well supported by evidence and higher if they are guessed
• Forecast risk
  Forecast risk is lower if forecast growth is in line with historical trends, and higher if it exceeds them significantly
• Pricing risk
  Pricing risk is lower if the pricing assumptions are conservative relative to current pricing levels, and higher if they are optimistic.

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The business plans studied showed that each of these five sub-components of market risk could be measured on an objective scale using data related to the plan. For instance, strategies that assume a much higher market price than the competition with little substantiation in the way of new product claims are riskier than those with some evidence, while the lowest pricing risk of all is to plan for me-too or lower pricing.

It is impossible to describe all of the scales in depth in this single article, but in practice they prove both accurate and effective at identifying actions to reduce business risk. Low market risk was not found to be synonymous with success, but a good appreciation of the true level of market risk is a prerequisite to creating shareholder value.

Share risk
Once the risk associated with the business plan's assertions of market size is accurately assessed, the next key question concerns whether or not the intended strategy will deliver the promised share of that market.

Share risk is inversely proportional to strategy strength - the likelihood that the strategy will create a more compelling proposition than that of competitive therapies.

In the blizzard of promotional hype and detailed product claims, this is not easy to discern. However, our research revealed five key tests that could be applied to any strategy to reveal its strength and, therefore, the share risk associated with it. Just as with market risk, share risk has five subcomponent risks:

2: Five subcomponents of share risk

• Target market risk
  Target market risk is lower if the target market is defined in terms of homogenous segments, and higher if it is not
• Proposition risk
  Proposition risk is lower if the proposition delivered to each segment is segment-specific, and higher if all segments are offered the same thing
• SWOT risk
  SWOT risk is lower if the strengths and weaknesses of the organisation are correctly assessed and leveraged by the strategy, and higher if the strategy ignores the firm's strengths and weaknesses
• Uniqueness risk
  Uniqueness risk is lower if the target segments and propositions are different from that of the major competitors, and higher if the strategy goes head on
• Future risk
  Future risk is lower if the strategy allows for any trends in the market, and higher if it fails to address them.

The assessment of share risk proved to be an especially useful tool for separating strong strategies from weaker, high risk ones. This was because it revealed that failure to win desired market share was due most often to how resources were applied to the market, rather than based on the product features and benefits.

Companies which were found to destroy shareholder value tended to attack broadly defined markets (eg all prescribers of SSRIs) with a single proposition and offered much the same thing to the same customers as the competition. Such strategies depended on brawn, not brains, and failed to use distinctive organisational strengths.

By contrast, strategies that created shareholder value defined novel segments based on unmet customer needs and focused tightly on those segments with distinctive propositions. In doing so, they used their strengths and avoided head on competition.

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Profit risk
Profit risk is the third component of business risk and arises during the implementation of strategy. It is the risk that the planned margins are not realised either because of higher than anticipated costs, or lower than anticipated prices. By contrasting cases in which the planned profit was realised and those in which it was not, our research identified a number of key factors which were indicative of profit risk.

Usefully, these risk factors could be sought and found prior to strategy implementation, enabling modification of the strategy to reduce implementation risk. As with market risk and share risk, profit risk can be described best in terms of five subcomponents:

3: Five subcomponents of profit risk

• Profit pool risk
  Profit pool risk is lower if the targeted profit pool is high and growing, and higher if it is static
  or shrinking
• Competitor impact risk
  Competitor impact risk is lower if the profit impact on competitors is small and evenly distributed, and higher if it threatens the survival of a competitor
• Profit sources risk
  Profit sources risk is lower if the source profit is growth in the existing profit pool, and higher if the profit is planned to come from the market leader
• Internal gross margin risk
  Internal gross margin risk is lower if the internal gross margin assumptions are conservative relative to current products, and higher if they are optimistic
• Other costs risk
  Other costs risk is lower if assumptions regarding other costs (including marketing support) are higher than existing costs, and higher if they are lower than current costs.

Also, as with market and share risk, profit risk can be assessed by the objective judgement of each of its fivesubcomponents against a graduated scale. The practicality of the tests lies in the fact that they use available data, such as internal costs from other products, or readily available market research.

Using the profit risk tests allowed companies that were entering shrinking profits pools with the intention of severely damaging a major competitor to see that they naively assumed no competitor response. Equally, the tests illuminated the unrealistic cost assumptions often built into plans in order to get funding,
or approval.

The profit risk test revealed the flaws in the strategy, allowing the plan to be revised on the basis of an objective knowledge and reduced the subjectivity of a significant proportion of the business planning activity.

Knowledge is power
The marketing due diligence process does not end with the objective assessment of each of the components of business risk. The three assessments are used to revise the plan's three principal assertions of market size, share and profit.

Simply put, low risk assessments leave the assertions unchanged while high risk assessments lead to a reduction in the promised numbers. This combination of revised business plan promises leads to a revised calculation for the return on capital employed.

Importantly, this calculation uses the firm's own cost of capital, and counts both tangible assets and intangible assets, such as brands employed.

Gaining advantage
The end result is a statement of marketing due diligence: 'this plan either will, or will not, create shareholder value'. The board can then either revise the strategy, armed with knowledge of where the plan is weak, or use positive results to help manage relations with investors.

Where the process shows different businesses having different risks, the board can make more informed decisions about how to fund those businesses, thus avoiding the lethal combination of high business risk and high financial risk.

Marketing due diligence is a new, well-founded and much- needed tool for leaders of the pharmaceutical industry. In time, we expect it to become used as commonly as its financial counterpart. Until then, however, it will be a source of competitive advantage to the early adopters.

The Author
Dr Brian Smith is a visiting research fellow at Cranfield School of Management and runs PragMedic, a specialised strategy consultancy for medical markets. Professor Malcolm McDonald is Emeritus Professor of Marketing Strategy, and Professor Keith Ward is Visiting Professor of Strategy Finance, both at Cranfield. The authors welcome comments or questions on this article at: brian.smith@pragmedic.com, or via www.pragmedic.com