Competitive Advantage and Firm Performance

5CHAPTER

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Competitive Advantage and Firm Performance

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

Part 1 Strategy Analysis

LO 5-1 Describe and evaluate economic value creation when measuring competitive advantage.

LO 5-2 Describe and evaluate accounting profitability when measuring competitive advantage.

LO 5-3 Describe and evaluate shareholder value creation when measuring competitive advantage.

LO 5-4 Describe and evaluate the balanced-scorecard approach for assessing competitive advantage.

LO 5-5 Describe and evaluate the triple-bottom-line approach when assessing competitive advantage.

LO 5-6 Compare and contrast different approaches to measuring competitive advantage, and derive managerial implications.

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

Chapter Case 5 Chapter Case 5 Google vs. Microsoft

• Google and Microsoft in multipoint competition

How to measure success of this competition?

Revenues and net income?

Performance per employee?

• There are several ways to measure firm performance.

• The key idea is to “triangulate” (i.e., to use multiple measures of performance to evaluate the health of the organization).

EXHIBIT 5.1 Comparing Google & Microsoft on Different Dimensions

Performance viewpoint changes significantly when the measurement changes from absolute to per-employee figures (on the bottom)

8

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

9

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

10Copyright 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

11

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 capture some of the value in terms of higher prices; The costs we incur in creating that value.

• Conceptual traps that managers fall into:

Accounting costs versus Opportunity Costs Market Share is not competitive advantage

Measuring Competitive Advantage

• Always measured relative to other firms

• Three standards are typical by asking:

1. How much economic value does the firm

generate?

2. What is the firm’s accounting profitability?

3. How much shareholder value does the firm create?

Economic Value Creation

• Value: A dollar amount a consumer is willing to pay for a good or service

• Price: The dollar amount a good or service is offered for sale

• Cost: The dollar amount to make the good or service

• Pizza!• Value = $12• Price = $10• Cost = $7

• Consumer Surplus $12 - $10 = $2

• Producer Surplus $10 - $7 = $3

• Economic Value $12 - $7 = $5

SOLD!

EXHIBIT 5.2 Competitive Advantage & Economic Value

COMPETITIVE COMPETITIVE

ADVANTAGE = ADVANTAGE = HIGHEST

VALUE –

COST

HIGHEST

VALUE –

COST

Economic Value Creation

• Opportunity Costs

The next best alternative use for resources Pizza entrepreneur

Wages $40,000 employment salary Capital invested $25,000 interest on capital

If the restaurant made $60,000 in (accounting) profits… The owner actually had an economic LOSS of $5,000

Economic Value as Competitive Advantage

• If the economic value created is

greater than its rivals competitive advantage

equal to its rivals competitive parity

lower than its rivals competitive disadvantage

17

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 Profits ROA, 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

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

19

Net Cash Flow

• EBT - t (EBT) • EBT (1-t) = NET INCOME• EBT (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 NPV DCF Approach Maximize Economic Profits (EVA) Sustainable Competitive Advantage (SCA)

20

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..

21

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).

22

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

23

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)







Accounting Profitability

• Uses standard, publicly available metrics

• Permits direct firm performance comparisonsUsing standard ratios

• Regulated by: Accounting principles (GAAP)U.S. Securities & Exchange Commission (SEC)Sarbanes-Oxley Act (2002)

EXHIBIT 5.3 Top 10 Fortune 500 Companies by Profits ($M)

EXHIBIT 5.4 Top 10 Fortune 500 Companies by Return on Revenue

ROR measures the profit earned per dollar of revenue as a percentage. A size-adjusted measure of profits.

Profits vs. Return on Revenue (ROR)

2010 Profits in $M

2010 ROR %

Ranking changes markedly with the use of different metrics

Accounting Profitability

• Need to move beyond a “snapshot” metric Look at more than one year of data

• Permits direct firm performance comparisons Using standard ratios

• Competitive advantage is relative to competitors Study firms in the same industry “Apples to apples” comparisons

EXHIBIT 5.5 Firm Performance - Pharmaceutical Industry by ROR

Pfizer performance declines as Merck improves and takes the competitive advantage over this period

Drawbacks for Accounting Measures

• Does not consider “off balance sheet” items Health care, pension obligations

• Focuses on tangible assets, which may no longer be strategically relevant Key is intangible assets “Knowledge-based economy” Manufacturing vs. Services

• Historical data Backward-looking “Driving a car by looking in the review mirror”

EXHIBIT 5.6 Declining Importance of Book Value in Stock Valuation







Shareholder Value Creation

• Shareholders – legal owners of public firms

Total return to shareholders Return on risk capital + dividends

External performance metric Efficient-market hypothesis

All available information is embedded in the stock price

• SEC requires all public firms to submit shareholder returns

• Stock price based on expectations of performance

EXHIBIT 5.7 Normalized Stock Returns 2005–2010

Drawbacks to Shareholder Value as Competitive Advantage

• Stock prices can be highly volatile, which makes it difficult to assess firm performance (at least in the short term)

• Macro economic factors (e.g., unemployment rate, economic growth or contraction, interest rate and exchange rates…) all have a direct bearing on stock prices

• Stock prices frequently reflect the psychological mood of the investors, which can be at times irrational “Irrational exuberance” Alan Greenspan, former Federal Reserve Chair

Dan Ariely Video

http://www.youtube.com/watch?v=JhjUJTw2i1M

Google vs. Microsoft, Continued

• Accounting perspective shows Microsoft with an advantage over Google. But both firms have large intangible assets.

• BUT shareholder value favors Google over Microsoft! Microsoft stock is flat while Google is up 200%.

EXHIBIT 5.8 Comparing Google and Microsoft Using ROE and ROA

Microsoft outperforms Google in 2010 based on this accounting data

EXHIBIT 5.9 Normalized Stock Returns 2005–2010

Google is enjoying a sustained competitive advantage over Microsoft based on shareholder value.







42

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:

THE BALANCED SCORECARD• Advantages

Communicate vision thru the organization

Translate vision into measureable goals

Design business processes

Implement organizational learning

• Disadvantages Tool for strategy

implementation not formulation.

Limited guidance on selecting metrics

Limited insight on how to get back on track to meet goals Can be viewed as just

a tracking tool for metrics

EXHIBIT 5.10 A Balanced-Scorecard Approach to Competitive Advantage

Information/Analysis • Provide IT support for decentralized operations

Customer & Mkt Focus • Complete market segment analysis

• Tie sales plan & budgets to group regional goals

Strategic Planning • Establish an effective strategy-based M&A process.

Financial•Annual revenue - $X •Profit before tax - $X•ROA - X%•Revenue per employee - $X

Strategies &Objectives

Current-YearInitiatives

STRATEGIC DIRECTION PERFORMANCE MEASUREMENT

Strategies & Objectives

Overriding Purpose:

Process Mgmt•Complete ISO 9000 tasks as planned

• Improve overall new product introduction process

ProcessAssessments

Leadership•Make improvement in work environment as measured by employee survey

•Gain recognition for community relations

Human Resources•Develop a comprehensive college recruiting strategy

• Implement an employee feedback process

Business Results

SBU-Specific•Develop rapid prototyping processes and match prototype capacity to business needs

•Software process improvement to goal •Acquire new services customers to meet plans

•Meet on-time product launch goal

Customer/Consumer• Improve customer delivery • Increase sales to Europe•Meet customer loyalty goals •Reduce defects

Human Resources • Balance the Human Resource availability with initiative requirements, establish plans, & execute

• Implement diversity plan• Plan and execute strategic staffing plan

Partner/Supplier/Operations• Develop strategy and plan to have suppliers own material inventory

• Supplier contribution to cost reduction• Achieve inventory turns goal

Group

Balanced Scorecard Example

SBU

The Triple Bottom Line

• Financial, Social, and Ecological Considerations Also known as "People,

Planet, & Profits" BP oil spill had many

major effects BMW changed car

designs to enhance recycling

Integrative approach for sustainable strategy

EXHIBIT 5.11

The Triple Bottom Line

1–47

STRATEGY HIGHLIGHT 5.1STRATEGY HIGHLIGHT 5.1 Interface: The World’s FirstFully Sustainable Company• Interface is a global leader in modular carpet tiles

Business to business so not a consumer name

In 1994, founder & CEO set a BHAG

Highly industrial, petroleum-intensive business to go “off oil”!

By 2008, estimates savings at $400 million

Energy efficiency

Recycled raw materials instead of virgin material

Sustainability as a market differentiator

Employee motivation







EXHIBIT 5.12How Do We Measure Competitive

Advantage?

Implications for the Strategist

• Both quantitative AND qualitative performance dimensions matter. Managers need to have a holistic view

• Competitive advantage is best by criteria, reflecting overall company performance Metrics aggregate upward, useful to gauge firm's

strategy

• Only better strategy is our goal. No best strategy exists Strategic performance metrics must be relative

51

Putting Performance in PerspectiveNarrow

Stakeholder Perspective

Past Future

Stakeholders View

Balanced Scorecard

Accounting Profit

Economic Profit DCFSurvival

Share Price

BroadStakeholder Perspective


Three components are critical to evaluating any good or service: value (V), price (P), and cost (C). In economics, cost includes opportunity cost.

Economic value created is the difference between a buyer’s willingness to pay for a good or service and the firm’s cost to produce it (V - C).

A firm has a competitive advantage when it is able to create more economic value than its rivals.

To measure firm-level competitive advantage, we estimate the economic value created for all products and services offered by the firm.

Take-Away Concepts


To measure accounting profitability, we use standard metrics derived from publicly available accounting data.

Commonly used profitability metrics in strategic management are return on assets (ROA), return on equity (ROE), return on invested capital (ROIC), and return on revenue (ROR).

All accounting data are historical and thus backward-looking. They do not consider off–balance sheet items such as an innovation competency. They focus mainly on tangible assets, which are no longer the most important.

Take-Away Concepts


The measure of competitive advantage that matters from the shareholders’ perspective is the return on (risk) capital.

Investors are primarily interested in total return to shareholders, which includes stock price appreciation plus dividends received over a specific period.

Total return to shareholders is an external performance metric; it indicates how the market views all available information about a firm’s past, current state, and expected future performance.

Stock prices can be highly volatile, which makes it difficult to assess firm performance. Overall macroeconomic factors have a direct bearing on stock prices. Also, stock prices frequently reflect the psychological mood of the investors, which can at times be irrational.

Take-Away Concepts

LO 5-4 Describe and evaluate the balanced scorecard approach for assessing competitive advantage.

The balanced-scorecard approach provides a more integrative view of competitive advantage.

Its goal is to harness multiple internal and external performance dimensions to balance financial and strategic goals.

Managers develop strategic objectives for the balanced scorecard by answering four key questions:

1. How do customers view us?2. How do we create value?3. What core competencies do we need?4. How do shareholders view us?

Take-Away Concepts

LO 5-5 Describe and evaluate the triple-bottom-line framework when assessing competitive advantage.

Sustainable strategy refers to a firm’s ability to maintain its performance in the economic, social, and ecological context—called the triple bottom line.


Both quantitative and qualitative criteria matter when assessing the effectiveness of a firm’s strategy.

Competitive advantage is best measured by criteria that reflect performance of the company overall; the goal of strategic management is to integrate and align each functional-level activity to obtain superior performance at the company level.

Any performance metric must be interpreted relative to competitors and the industry average.

Take-Away Concepts

Documents

Competitive Advantage and Firm Performance