Transcript CHAPTER Competitive Advantage and Firm Performance McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc.

CHAPTER
5
Competitive
Advantage and
Firm Performance
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Fundamentals of Competitive Strategy
Superior Long-Run
Performance
The central goal
Attractive Industry
Structure
Competitive
Advantage
High returns for the average
participant
Outperform the average
industry participant
Superior Competitive
Position
Do different things than
rivals
Operational
Effectiveness
Do the same things as
rivals but better
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
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
9
2-20
Tradeoff Between Profitability
and Growth Rate
PMAX
Profitability
P1
P2
G0
G1
G2
Growth Rate
Copyright  1998 by Houghton Mifflin Company. All rights reserved.
10
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
11
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
• Pizza!
• Value = $12
• Price = $10
• Cost = $7 SOLD!
• Consumer Surplus
 $12 - $10 = $2
• Cost: The dollar amount to
make the good or service
• Producer Surplus
 $10 - $7 = $3
• Economic Value
 $12 - $7 = $5
EXHIBIT 5.2
Competitive Advantage & Economic Value
COMPETITIVE
ADVANTAGE =
HIGHEST
VALUE
–
COST
Economic Value Creation
• Opportunity Costs
 The next best alternative use for resources
 Pizza entrepreneur
Wages
 Capital invested

$40,000 employment salary
$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
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
Discounting Cash Flows
Horizon
CFt
CF3
CF1
CF2
Valuet+1
…
+
+
+
=
+
+
NPV
1+r
(1+r)2 (1+r)3
(1+r)t
(1+r)t+1
NPV: Net Present Value
CFt: Cash Flow at time t
• Financial Measures
Performance
 NPV Methods
r:
Discount rate
Horizon Value: Value of
ongoing enterprise after time t
of
17
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.
Cash Flow +
0
Time
-
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)
19
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 selfcontained. 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.
20
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).
21
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
22
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 = $235 million EVA
23
Firms with the Highest Ratios of Market Value to Book Value
(December 2005)
Company
Valuation
ratio
Country
Company
Valuation
ratio
Country
Yahoo! Japan
72.0
Japan
Coca-Cola
7.8
US
Colgate-Palmolive
20.8
US
Diageo
7.4
UK
Glaxo Smith Kline
13.4
UK
3M
7.3
US
Anheuser-Busch
12.6
US
Nokia
6.7
Finland
eBay
11.2
US
Sanofi-Aventis
6.3
France
SAP
10.8
Germany
AstraZeneca
5.9
UK
Yahoo!
10.7
US
Johnson & Johnson
5.7
US
Dell Computer
10.0
US
Boeing
5.7
US
Sumitomo Mitsui Financial
8.8
Japan
Eli Lily
5.6
US
Procter & Gamble
8.4
US
Cisco Systems
5.5
US
Qualcomm
8.3
US
Roche Holding
5.5
Switz.
Schlumberger
8.2
US
L’Oreal
5.3
France
Unilever
8.1
Neth/UK
Altria
5.2
US
PepsiCo
8.0
US
Novartis
5.1
Switz.
LO 5-1 Describe and evaluate economic value creation when measuring
competitive advantage.
LO 5-2 Describe and evaluate accounting profitability when
measuring competitive advantage.
LO 5-3 Describe and evaluate shareholder value creation when measuring
competitive advantage.
LO 5-4 Describe and evaluate the balanced-scorecard approach for
assessing competitive advantage.
LO 5-5 Describe and evaluate the triple-bottom-line approach when
assessing competitive advantage.
LO 5-6 Compare and contrast different approaches to measuring
competitive advantage, and derive managerial implications.
Accounting Profitability
• Uses standard, publicly available metrics
• Permits direct firm performance comparisons
 Using standard ratios
• Regulated by:
 Accounting principles (GAAP)
 U.S. Securities & Exchange Commission (SEC)
 Sarbanes-Oxley Act (2002)
EXHIBIT 5.3
Top 10 Fortune 500 Companies by Profits ($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)
Ranking changes markedly with
the use of different metrics
2010 Profits in $M
2010 ROR %
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
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.
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
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.
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.
42
THE BALANCED SCORECARD
• Advantages
 Communicate vision
thru the organization
• Disadvantages
 Tool for strategy
implementation not
formulation.
 Translate vision into
measureable goals
 Limited guidance on
selecting metrics
 Design business
processes
 Implement
organizational
learning
 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
Balanced Scorecard Example
STRATEGIC DIRECTION
Strategies &
Objectives
PERFORMANCE MEASUREMENT
Current-Year
Initiatives
Business Results
Financial
• Annual revenue - $X
• Profit before tax - $X
• ROA - X%
• Revenue per employee - $X
Overriding Purpose:
Process
Assessments
Leadership
• Make improvement in work
environment as measured by
employee survey
• Gain recognition for
community relations
Customer/Consumer
• Improve customer delivery
• Increase sales to Europe
• Meet customer loyalty goals
• Reduce defects
Strategies & Objectives
Partner/Supplier/Operations
• Develop strategy and plan to have
suppliers own material inventory
• Supplier contribution to cost reduction
• Achieve inventory turns goal
Human Resources
• Balance the Human Resource availability
with initiative requirements, establish plans,
& execute
• Implement diversity plan
• Plan and execute strategic staffing plan
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
Group
SBU
Strategic Planning
• Establish an effective strategybased M&A process.
Customer & Mkt Focus
• Complete market segment
analysis
• Tie sales plan & budgets to group
regional goals
Information/Analysis
• Provide IT support for
decentralized operations
Human Resources
• Develop a comprehensive college
recruiting strategy
• Implement an employee feedback
process
Process Mgmt
• Complete ISO 9000 tasks as
planned
• Improve overall new product
introduction process
The Triple Bottom Line
• Financial, Social, and
Ecological
Considerations
EXHIBIT 5.11
 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
The Triple Bottom Line
STRATEGY HIGHLIGHT 5.1
Interface: The World’s First
Fully 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
1–47
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.
EXHIBIT 5.12
How 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
Take-Away Concepts
LO 5-1 Describe and evaluate economic value creation when
measuring competitive advantage.
 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
LO 5-2 Describe and evaluate accounting profitability when measuring
competitive advantage.
 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
LO 5-3 Describe and evaluate shareholder value creation when
measuring competitive advantage.
 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.
LO 5-6 Compare and contrast different approaches to measuring
competitive advantage, and derive managerial implications.
 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.