Strategy - Chapter 5 Competitive Advantage and Firm Performance

Google vs Microsoft Understanding and measuring competitive advantage presents challenges Absolute firm measures (Are these valid comparisons?) a. Revenues b. Net Income c. Market Capitalization Financial ratios adjust for firm size and thus are often preferred over absolute measures when tracking firm performance. Competitive advantage leads to superior firm performance. Gaining and sustaining competitive advantage is the goal of strategic management.

Measuring Competitive Advantage Always measured relative to other firms How much economic value does the firm generate? What is the firm's accounting profitability? How much shareholder value does the firm create?

Economic Value Creation Value (V) The difference between a buyer's willingness to Price (P) pay for a product or service and the firm's cost Cost (C) to produce it is the economic value created. A firm has a competitive advantage when it is able to create more economic value than its rivals. $12 willing to pay; price - $10; cost $7 Value created = $5; $2 = consumer surplus, $3 = producer surplus Both transacting parties capture some of the overall value created. In an economic context, strategy is about creating economic value and capturing as much of it as possible. Profits = TR - TC where TR = P x Q and TC = Variable Costs + Fixed Costs Competitive advantage goes to the firm that achieves the largest difference between V, the consumer's willingness to pay, and C, the cost to produce the good or service A large difference between V and C gives the firm two distinct pricing options it can charge higher prices to reflect the higher product value and thus increase profitability it can charge the same price as the competitors and gain market share Objective is to maximize V-C Another aspect of how to measure economic value merits is by opportunity costs Opportunity costs capture the value of the best forgone alternative use of the resources employed

Drawbacks of Economic Value Creation 1. Determining the value of a good in the eyes of consumers is not a simple task a. To look at consumers' purchasing habits for their revealed preferences 2. Value of a good in the eyes of consumers changes based on income, preferences and time 3. To measure firm level competitive advantage, we must estimate the economic value created for all products and services offered by the firm The economic perspective is a powerful approach, however, falls short when managers are called upon to operationalize competitive advantage. Accounting Profitability Data such as income statements and balance sheets Public companies are required by law to release these data, which must comply with GAAP, set by the FASB and be audited by certified public accountants. Publicly traded firms are required to file Form 10 - K annually with the SEC More stringent legislation - Sarbannes Oxley Act 2002 Common metrics used: ROE, ROA, ROIC, ROR Strategy is about gaining and sustaining competitive advantage - analysis beyond one year Need to assess competitor's (relative) Competitive advantage is usually transitory, difficult to sustain

Limitations of Accounting data Accounting data are historical data and backward looking Shows us only the outcomes from past decisions and the past is no guarantee of future performance There is a significant time delay until accounting data becomes publicly available Accounting data do not consider off balance sheet items Off balance sheet items such as pension obligations and operating leases in the retail industry For instance, a lease would not be listed as assets, thus ROA is higher This shortcoming is adjusted to obtain an equivalent economic capital base to compare companies with different capital structures Accounting data focuses mainly on tangible assets, which are no longer the most important Accounting data still captures intangibles such as patents, trademarks.etc. Competitively important assets in the 21st century tend to be intangibles such as innovation and quality; importance of firm's book value has declined over time Intangibles that are not captured in firm's accounting data have become much more important to a firm's competitive advantage

Shareholder Value Creation Shareholders: individuals or organizations who own one or more shares of stock in a public company. From the shareholder's perspective, the measure of competitive advantage that matters most is the return on their risk capital. Investors are primarily interested in a company's total return to shareholders, which is the return on risk capital, including stock price appreciation plus dividends received over a specific period Unlike accounting data, total return to shareholders is an external performance metric, it essentially indicates how the stock market views all available information about a firm's past, current state and expected future performance All public companies in the US are required to report total return to shareholders annually in the statements they file with the SEC Companies must provide benchmarks with respect to industry average and broader market index such as S&P or NASDAQ Effective strategies to grow business can increase firm's profitability and stock price Growth is always measure with respect to market expectations Risk Capital - capital provided by shareholders in exchange for an equity share in a company, it cannot be recovered if the firm goes bankrupt Total return to shareholders - return on risk capital that includes stock price appreciation plus dividends received over a specific period

Drawbacks to Shareholder Value as a Competitive Advantage a. Stock prices can be highly volatile, making it difficult to assess firm performance, at least in the short term this volatility implies that total return to shareholders is a better measure over long term due to the noise introduced by market volatility, external factors and investor sentiment. b. Overall macroeconomic factors such as the unemployment rate, economic growth or contraction, and interest and exchange rates all have a direct bearing on stock prices it can be difficult to ascertain the extent to which a stock price is influenced more by external macroeconomic factors or the firm's strategy c. Stock prices frequently reflect the psychological mood of investors, which can at times be irrational stock prices can overshoot or undershoot expectations (internet boom/ 2008 crisis) The Balanced Scorecard The balance scorecard harnesses multiple internal and external performance metrics in order to balance both financial and strategic goals Managers use BSC to develop strategic objectives by answering 4 key questions 1. Customer perspective concerning company's products and services - linked to revenue and profits if customers view company favourably - company's competitive advantage is enhanced

managers collect data to improve on 2. Processes to create value challenges managers to come up with strategic objectives that ensure future competitiveness, innovation and organizational learning business processes and structures that allow a firm to create economic value percentage of revenue obtained from innovations; percentage of products originating from outside firm's boundaries 3. Internal Core Competencies for managers to identify the core competencies needed to achieve objectives and the accompanying business processes that support these competencies 4. Shareholder's Perspective Shareholder's view of financial performance Accounting data - Cash flow, operating income, ROE, Total returns to shareholders 4 BSC questions are directly linked to economic value creation they help managers increase the perceived value of their goods and services in the market place

Advantages of BSC allows managers to: o communicate and link the strategic vision to responsible parties within the organization o translate the vision into measurable operational goals o design and plan business processes o implement feedback and organizational learning in order to modify and adapt strategic goals when indicated BSC can accommodate both short term and long term performance metrics Compares them to target values; assess past performance, identify areas for growth Requires continuous tracking of metrics and updating of strategic objectives

Disadvantages of BSC It is a tool for strategy implementation, not strategy formulation o Up to firm's managers to formulate a strategy that will enhance the chances of gaining and sustaining competitive advantage BSC provides only limited guidance about which metrics to choose o 3 approaches + other quantitative and qualitative approach - helpful Does not provide insight into how metrics that deviate from the set goals can be put back on track, not providing new approach Managers need to know that failure to achieve competitive advantage is not poor framework but strategic failure - BSC is good as the skills of the managers use it o must first devise strategy that enhance odds of achieving competitive advantage o must translate strategy into objectives they can measure and manage within BSC approach

The Triple Bottom Line Ecological sustainable energy Social 3 dimensions - economic, social and ecological o leads to a sustainable strategy Like the BSC, the triple bottom line takes a more integrative and holistic view in assessing a company's performance

Economic

Using a triple bottom line approach, managers audit their company's fulfilment of its social and ecological obligations to stakeholders in as serious a way as they track its financial performance Triple line approach is related to stakeholder theory o understanding a firm as embedded in network of internal and external constituencies that each make contributions and expect consideration in return

Implications to Strategist Both quantitative and qualitative performance matter in judging how effective a firm's strategy is; those who focus on just one metric risk being blindsided by poor performance on another Since goal of strategic management is to integrate and align each business function and activity to obtain superior performance at company level, competitive advantage is best measured by criteria that reflects overall company performance rather than performance of specific parts; metrics that aggregate upward and reflect overall firm performance are most useful to assess the effectiveness of a firm's strategy Better strategy is our goal - no best strategy exists - we must interpret performance metric relative to industry competitors