7.1. A Conceptual Model of Market Growth and Capital Investment
Most new companies fail. Some grow for a while and then stagnate. A few manage to grow but experience periodic downturns leading to crises of confidence and turnover of top management. Only a very small number of firms seem able to grow rapidly for extended periods of time. A classic model in the field of system dynamics, known as the 'market growth model' (Forrester, 1968), directly addresses this issue and arose from Jay Forrester's experience advising entrepreneurs and fledgling companies in technology-based firms around Boston, Massachusetts. Though compact, the model contains nearly everything of interest in dynamical business models such as multiple interacting loops, non-linearities, expectation formation, delays, bias and distortion in management information channels, and bounded rationality in operating policies.
7.1.1. Background to the Case
Imagine a division of a medium-sized electronics company producing specialist navigation equipment for use in luxury yachts and light aircraft. The division has recently launched a new state-of-the art global positioning system and wants to explore the feasibility of various growth plans. The product is sold directly to firms that make luxury yachts and light aircraft rather than to the owners of boats and planes. Sales are generated by a direct sales force with the necessary technical knowledge to sell a sophisticated and expensive electronic product. The division is aiming for profitable growth while maintaining good service to customers. A sketch of future revenue time paths is shown in Figure 7.2. The plan is for steady revenue growth of about 50 per cent per year, but no one really knows if the plan is achievable. Less desirable trajectories are growth with repeated downturns or growth leading to stagnation and decline.
Figure 7.2. Future time paths for revenue
7.1.2. Adopting a Feedback View
Which circumstances might distinguish between these different outcomes? Downturns, stagnation and decline are often conveniently blamed on external factors such as a weak economy, aggressive rivals, limited market size or premature technology. However, we are looking for a different explanation involving factors within the control of management. Hence, we will assume there is a large potential market and that product quality is comparable to rivals, if not better. Our dynamic hunch is that the pattern of growth depends on the coordination of demand and supply. A sector map of suitable scope is shown in Figure 7.3. On the left is the firm represented in terms of sectors for sales force, production capacity and order fulfilment. Within these sectors are to be found operating policies such as hiring and investment. On the right is the market, represented in terms of customer ordering and the firm's influence on customers. Essentially, the task of the firm is to stimulate demand through sales effort and to adjust production capacity to satisfy the resulting customer orders.
The sectors are linked by four feedback loops as shown in Figure 7.4. At the top left is the sales growth loop involving the sales force and customer orders. At the top right is the customer response loop that depends on customers' perception of delivery delay. In the lower centre is the capital investment loop that expands capacity in response to the company's perception of delivery delay and on the lower right is a floating goal involving target delivery delay.
Figure 7.3. Sector map for dynamic hunch
Although it is not possible to infer market growth dynamics from the diagram alone, an inspection of the individual loops provides some useful insight into the main dynamic processes at work. We start with the sales growth loop and imagine the effect around the loop of an increase in the sales force. A bigger sales force wins more customer orders (all else equal), resulting in a larger order backlog. Assuming adequate production capacity, then a larger backlog results in a greater order fill rate, more revenue and an increase in the sales budget. With a larger budget the firm can afford to hire more salesmen. So there exists a reinforcing loop in which any increase in the sales force stimulates extra orders and revenue that in turn justify a further increase in sales force.
Meanwhile, the capital investment loop expands capacity if there is evidence of unfilled demand. An increase in the order backlog leads to a rise in delivery delay because the factory takes longer to fill orders. The company's perception of delivery delay eventually rises too and this is the signal for capacity expansion. More production capacity leads to a higher order fill rate that reduces the order backlog and delivery delay. The result is a balancing loop in which any increase in delivery delay (above the company's target) leads to a compensating reduction in delivery delay through capacity expansion. The target delivery delay itself depends on the company's perception of delivery delay. This floating goal is part of a reinforcing loop that works to relieve chronic pressure for capital investment arising from delivery delay by simply allowing the target delivery delay itself to rise.
Figure 7.4. Full causal loop diagram of Forrester's Market Growth Model
While the company is attempting to match capacity with demand, the customer response loop limits demand if the product is not readily available. An increase in delivery delay leads to an increase in the customers' perception of delivery delay and a reduction of customer orders. Fewer orders lead to a smaller order backlog and a reduction in the delivery delay thereby completing a balancing loop. If the company cannot fill customer orders quickly enough, then demand falls to restore a conveniently short delivery delay.
The four loops provide a good multi-function overview of product–market growth, but why these particular loops? This is an important question to ask of any model, because the more plausible the feedback structure the more likely it will provide a convincing explanation of dynamics and performance through time.