1

Strategic Management/ Business Policy

Power Point Set #2Performance Measurement

2

Fundamentals of Competitive Strategy

Superior Long-Run Performance

Attractive Industry Structure

Competitive Advantage

Superior Competitive Position

Operational Effectiveness

Do different things than rivals

Do the same things as rivals but better

The central goal

High returns for the average participant

Outperform the average industry participant

3

Economic Profits and Competitive Advantage

Driving a wedge between revenues and costs is how competitive advantage is created.

In strategy, we need to think simultaneously about:

The value we create for our customer;How we appropriate some of that value in terms of higher prices; The costs we incur in creating that value.

Conceptual traps that managers fall into:

Accounting Costs versus Opportunity CostsMarket Share is not competitive advantage

4

The First Rule of Strategy

A Good Strategy Is “Coherent.”Functional pieces of strategy support the whole

(Michael Porter: HBR, 1996)

Oper.Strategy

Finance

Acctg. H.R.

Mktg.

5

Strategic Coherence

The Logic of How The Business Fits Together:

Southwest AirlinesLow PriceShort Routes

No FrillsPoint-to-PointOne Aircraft -- Boeing 737High number of Aircraft per RouteNo MealsFlexible/ Lower Staffing

American AirlinesPremium Price

Short, Long, & Int’l

Variety

Hub & Spoke System

Multiple Aircraft

Low number of Aircraft per Route

Meals & Service

Higher Staffing

6

Southwest Airline’s Activity System

Limitedpassengeramenities

Short-haul,point-to-pointroutes betweenmidsize cities

and secondaryairports

Highaircraft

utilization

Frequent,reliable

departures

Lean, highlyproductiveground andgate crews

Very lowticket prices

No meals

No seatassignments

No baggagetransfers

No connectionswith other

airlines

15-minutegate

turnarounds

Limited useof travelagents

Automaticticketingmachines

Standardizedfleet of 737

aircraft

Flexibleunion

contracts

High levelof employee

stockownership

“Southwest,the low-fare

airline”

Highcompensationof employees

7

SWOT Analysis

Strengths, Weaknesses, Opportunities, and Threats

Strengths &Weaknesses

Opportunities& Threats

Values OfManagement

Values OfStakeholder

s

StrategyInternalFactors

ExternalFactors

Objectives

Drivers

8

How Do We Measure Performance?

“The strategic aim of a business is to earn a return on capital, and if in any particular case the return in the long run is not satisfactory, then the deficiency should be corrected or the activity abandoned for a more favorable one.”

• Alfred P. Sloan My Years with General Motors

9Copyright 1998 by Houghton Mifflin Company. All rights reserved.

2-20

Tradeoff Between Profitability Tradeoff Between Profitability and Growth Rate and Growth Rate

G0

P1

P2

PMAX

G1 G2

Growth Rate

Profitability

10

Shareholdervalue

creation

Shareholdervalue

creation ROCEROCE

Economic Profit

Economic Profit

MarginMargin

CapitalTurnover

CapitalTurnover

Sales Targets

Sales Targets

cogs/sales

cogs/sales

DevelopmentCost/Sales

DevelopmentCost/Sales

InventoryTurnover

InventoryTurnover

CapacityUtilization

CapacityUtilization

CashTurnover

CashTurnover

Order SizeCustomer MixSales/Account

Customer ChurnRate

Deficit Rates

Cost per DeliveryMaintenance cost

New productdevelopment time

Indirect/DirectLabor

Customer Complaints

Downtime

Accounts PayableTime

Accounts Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

Linking Value Drivers to Performance TargetsLinking Value Drivers to Performance Targets

11

Sustainable Competitive Advantage and the Measurement of Performance

While we have said that the objective of strategy is to “create competitive advantage,” specifically we have the goal to maximize economic return.

Economic & Accounting Measures of Performance

Economic ProfitsROA, ROE, ROC

Financial Measures of Performance

NPV Methods

Discounting Cash Flows

NPV =CF1

1+r +CF2

(1+r)2 +CF3

+ …CFt

+ +

Horizon Valuet+1

NPV: Net Present Value

CFt: Cash Flow at time t

r: Discount rate

Horizon Value: Value of ongoing enterprise after time t

(1+r)3 (1+r)t (1+r)t+1

12

Financial Measures of Performance: NPV or DCF Analysis

The principle of discounted cash flow (DCF) analysis that firms apply to their individual projects can also be applied to the firm as a whole. Maximizing the net present value of the firm’s cash flow (“sustainable competitive advantage”) corresponds to maximization of its stock market valuation and hence maximizes the wealth of its shareholders.

-

+

0

Cash Flow

Time

13

Net Cash Flow

EBT - t (EBT) EBT (1-t) = NET INCOMEEBT (1-t) + depreciation - capital expenditures = NET CASH FLOW

• (note we are assuming no change in accounts receivable, no change in net working capital, no change in inventory)

Equivalent concepts:Maximize NPVDCF ApproachMaximize Economic Profits (EVA)Sustainable Competitive Advantage (SCA)

14

Limitations of Present Value Measures

Projections are only as good as the ability of managers to measure accurately the financial consequences of actions.

An implicit assumption of value-based strategy was that business units and all investment proposals were self-contained. It was usually expected that divesting a business or curtailing an investment project would have no financial repercussions elsewhere in the corporation (e.g., ignores knowledge transfers).

Strict financial measurement of many long-term investments, particularly in intangible assets, is virtually impossible.

15

Limitations of Present Value Measures

Investments in R&D typically do not offer direct returns; their economic value is a strategic option to invest in new products and processes that may arise from R&D. Narrowly- defined DCF does not accurately value investments where there is significant strategic options value.

(Merck has been at the forefront of applying strategic options theory to analyze investments in R&D).

16

Capital Market Approaches To Measuring Performance

Market Value Added (MVA)Market Value less Total Investment

Economic Value Added (EVA)Operating Profit (after tax) less annual capital costs; basically, this is economic profit

Tobin’s q (Market Value/Book Value)A firm’s market value divided by its “replacement” cost

The Market Value of the Firm -Current Value of all securities issued by the firm

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Economic Value Added (EVA)

Anheuser-Busch: Operating profit $1,756 million - taxes $617 million = $1,139 million

WACC : 67% equity at 14.3% 33% debt at 5.2%

11.3% WACC Capital of $8 billion

11.3% * $8billion = $904 million $1,139 - $904 = $235 million EVA

Company Valuation ratio

Country Company Valuation ratio

Country

Yahoo! Japan 72.0 Japan Coca-Cola 7.8 US

Colgate-Palmolive 20.8 US Diageo 7.4 UK

Glaxo Smith Kline 13.4 UK 3M 7.3 US

Anheuser-Busch 12.6 US Nokia 6.7 Finland

eBay 11.2 US Sanofi-Aventis 6.3 France

SAP 10.8 Germany AstraZeneca 5.9 UK

Yahoo! 10.7 US Johnson & Johnson 5.7 US

Dell Computer 10.0 US Boeing 5.7 US

Sumitomo Mitsui Financial 8.8 Japan Eli Lily 5.6 US

Procter & Gamble 8.4 US Cisco Systems 5.5 US

Qualcomm 8.3 US Roche Holding 5.5 Switz.

Schlumberger 8.2 US L’Oreal 5.3 France

Unilever 8.1 Neth/UK Altria 5.2 US

PepsiCo 8.0 US Novartis 5.1 Switz.

Firms with the Highest Ratios of Market Value to Book Value (December 2005)Firms with the Highest Ratios of Market Value to Book Value (December 2005)

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Net Inc. ROS ROE EVA Market Return to Value Added Shareholders

($m) (%) (%) ($m) ($m) (%)General Motors 2,956 1.8 19.7 -5,525 -17,943 21.4General Electric 6,573 9.4 22.2 4,370 285,320 45.3Exxon 6,370 6.3 14.6 -2,262 114,774 22.4Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8IBM 6,328 7.7 32.6 2,541 -5,878 77.5Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3Wal-Mart 4,430 3.2 21.0 1,159 159,444 107.7 Procter & Gamble 3,780 10.2 12.2 61,661 102,379 15.9Microsoft 4,490 31.0 27.0 3,776 328,257 37.5Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7

How U.S. Companies Perform Under Different Profitability Measures, 1998

How U.S. Companies Perform Under Different Profitability Measures, 1998

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Problems With Shareholder Wealth Maximization

Under what conditions does “maximizing shareholder wealth” not make sense? When do we need to pay attention to other “stakeholders?”

What are the social responsibilities of business to:

Employees?

Communities?

Customers?

The Issue: What are the “externalities,” and who bears the costs?

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The Four Perspectives of the Balanced ScorecardThe Four Perspectives of the Balanced Scorecard

© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill

Slide 4-5Exh. 4.8

Financial

Customer

Operations

Organizational

EVAProfitabilityGrowth

DifferentiationCostQuick Response

Product DevelopmentDemand ManagementOrder Fulfillment

LeadershipOrganizational LearningAbility to Change

Perspective Assessed through analysis of:

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Putting Performance in PerspectiveNarrow

Stakeholder Perspective

Past Future

Stakeholders View

Balanced Scorecard

Accounting Profit

Economic Profit DCFSurvival

Share Price

BroadStakeholder Perspective