Strategic Management: Chapter 5

Accounting profitability,
Shareholder value creation,
Economic value creation
To measure and assess firm performance, use (3)
The balanced scorecard
The triple bottom line
Integrative frameworks, combining quantitative data with qualitative assessments (2)
Accounting profitability
Helps assess competitive advantage:
Accurately assess firm performance.
Compare firm performance to competitors / the industry average.
Standardized accounting metrics
Form 10-K statements
Profitability ratios
Return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and return on revenue (ROR)
return on invested capital (ROIC)
One of the most commonly used metrics in assessing firm financial performance is….
ROIC = (Net profits/Invested capital)
ROIC formula
profitability, total invested capital
ROIC is a popular metric because it is a good proxy for firm _____. In particular, the ratio measures how effectively a company uses its _____, which consists of two components: (1) shareholders’ equity through the selling of shares to the public, and (2) interest-bearing debt through borrowing from financial institutions and bond holders.
(1) shareholders’ equity through the selling of shares to the public, and (2) interest-bearing debt through borrowing from financial institutions and bond holders.
total invested capital consists of two components
ROIC, ROE, ROA, ROR
Profitability ratios used in measuring accounting profitability (4)
10-K
The _____ is a form that companies are required by law to release and its the primary source of companies accounting data. (thanks to sarbannes oaxley act)
greater
As a rule of thumb, If a firm’s ROIC is ____ than its cost of capital, it generates value.
ROR, working capital turnover
ROIC is broken into what two constituents
ROR
ratio that indicates how much of the firm’s sales is converted into profit
working capital turnover
a measure of how effectively capital is being used to generate revenue.
1) COGS/revenue,
2) R&D expense/revenue
3) Selling, general &admin expense/revenue
Return on revenue can be broken into three additional ratios
net profits/revenue
ROR formula
COGS/revenue
ratio that indicates how efficiently a company can produce a good
R&D/revenue
ratio that indicates how much of each dollar that the firm earns in sales is invested to conduct research and development
SG&A/revenue
ratio that indicates how much of each dollar that the firm earns in sales is invested in sales, general, and administrative (SG&A) expenses
fixed asset turnover, inventory turnover, receivables turnover, payables turnover
Working capital turnover can be broken down into what other ratios? (4)
revenue/FA
fixed asset turnover formula
fixed asset turnover
ratio that measures how well a company leverages its fixed assets, particular property, plant and equipment
COGS/inventory
inventory turnover formula
inventory turnover
ratio that indicates how much of a firm’s capital is tied up in its inventory
revenue/accounts receivable
receivables turnover formula
receivables turnover
ratio that concerns the effectiveness of a company’s receivables and payables. These are a part of a company’s cash flow management and they indicate the company’s efficiency in extending credit, as well as collecting debts.
higher
____ ratios of receivables turnover imply more efficient management in collecting accounts receivable and shorter durations of interest-free loans to customers
revenue/account payable
payables turnover formula
payables turnover
ratio that indicates how fast the firm is paying its creditors and how much it benefits from interest-free loans extended by its suppliers
1) All accounting data are historical and thus backward-looking.
2) Accounting data do not consider off-balance sheet items, such as pension obligations and leasing obligations
3) Accounting data focus mainly on tangible assets, which are no longer the most important.
(Innovation, quality, customer experience are important.)
Limitations of Accounting Data (3)
Shareholders
Own one or more shares of stock in a company
The legal owners of public companies
risk capital
Money provided for an equity share in a company
Cannot be recovered if the firm goes bankrupt
total return to shareholders
Stock price appreciation plus dividends
Stock price appreciation plus dividends
total return to shareholders
market capitalization
the value of a company that is traded on the stock market (Dollar value of total shares outstanding)
Number of outstanding shares x share price
Dollar value of total shares outstanding
Number of outstanding shares x share price
market capitalization calculation
shareholder value creation
a second traditional way to measure and assess competitive advantage, attempting to overcome the short-comings of a backward-looking internal focus on mostly tangible assets inherent in accounting profitability
1) Stock prices can be highly volatile.
Makes it difficult to assess firm performance

2) Macroeconomic factors affect stock prices.
(Economic growth or contraction
Unemployment, interest and exchange rates)

3) Stock prices can reflect the mood of investors.
Can be irrational

Limitations of Shareholder Value Creation (3)
Economic Value Creation
The difference between value and cost (V-C)
superior product differentiation, a relative cost advantage over rivals
In Economic Value Creation, competitive advantage can be based on what two things
value, price, cost
In Economic Value Creation, in order to calculate CA, the three components needed are….
producer surplus
aka profit in economic value creation
Producer surplus (also called profit)
The difference between the price charged (P) and the cost to produce (C)
consumer surplus
The difference between what you would have been willing to pay (V) and what you paid (P)
consumer surplus, firm profit
Economic value creation is ____ + ____
V-C = (V-P) + (P-C)
Economic value creation formula using letter variables
total perceived consumer benefits, consumer’s maximum willingness to pay, reservation price
What three different things does the variable V denote?
opportunity cost
The value of the best forgone alternative use of the resources employed
opportunity
Rather than merely relying on historical costs, as done when taking the perspective of accounting profitability, in economic value creation perspective all costs, including _____ costs, must be considered
1) Determining value for consumers is not simple.

2) The value of a good in the eyes of consumers changes.
Based on income, preferences, time, and other factors

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

Limitations of Economic Value Creation (3)
The balanced scorecard
Strategy implementation tool that harnesses multiple internal and external performance metrics in order to balance financial and strategic goals
balanced scorecard approach
balanced scorecard approach
how do customers view us? how do we create value? what core competencies do we need? How do shareholders view us?
Four key questions in the balanced-scorecard framework
accounting profitability, shareholder value creation, economic value creation
By relying on both an internal and external view of the firm, the balanced-scorecard approach combines the strengths provided by what individual approaches to assessing competitive advantage discussed earlier? (3)
revenue, profit, customer satisfaction
Examples of Metrics for the following Balanced Scorecard Question:

how do customers view us? (3)

Competitiveness, innovation, organizational learning
Examples of Metrics for the following Balanced Scorecard Question:

how do we create value? (3)

Core competencies, supporting business processes
Examples of Metrics for the following Balanced Scorecard Question:

what core competencies do we need? (2)

Cash flow, operating income, ROIC, ROE, total returns to shareholders
Examples of Metrics for the following Balanced Scorecard Question:

how do shareholders view us?

Managers can:

1) Link the strategic vision to responsible parties
2) Translate the vision into measureable goals
3) Design and plan business processes
4) Implement feedback and organizational learning
(Modify and adapt strategic goals)

Advantages of the Balanced Scorecard (4)
1) Focused on strategy implementation. Not formulation
2) Limited guidance about which metrics to use
3) Only as useful as the managers apply it
4) Strategy must be translated into measurable objectives
5) Not much guidance on how to get back on track if setbacks occur
Disadvantages of the Balanced Scorecard (5)
The Triple Bottom Line
Combination of economic, social, and ecological concerns (or profits people and planet) that can lead to a sustainable strategy
profits, people, planet
According to the Triple Bottom Line, Three dimensions fundamental to sustainable strategy are…
profits
The economic dimension in the Triple Bottom Line

(the business must be profitable to survive)

People
The social dimension in the Triple Bottom Line
Planet
The ecological dimension in the Triple Bottom Line

(Emphasizes the relationship between business and the natural environment)

sustainable strategy
According to the triple bottom line, when profits, people and planet align, you have….
Interface, the world’s largest manufacturer of modular carpet

This industry typically has heavy reliance on fossil fuels and chemicals.
In 1994, they set a goal for 2020: No petroleum-based raw materials No oil-related energy
Between 1996 and 2008
Saved over $400 million due to its energy efficiency and use of recycled materials

Strategic intent is to be the world’s first fully sustainable company

According to the Strategy Highlight “Interface: The World’s First Sustainable Company” what makes this company unique?
Business Model
a _____ details the competitive tactics and initiatives
Explains how the firm intends to make money
Stipulates how the firm conducts its business
1) Details the competitive tactics and initiatives
2) Explains how the firm intends to make money
3) Stipulates how the firm conducts its business (buyers, suppliers and partners)
Business Model does what three things?
2 San Francisco friends
Rented out space on the mattresses
Served guests breakfast
First mover in the peer-to-peer rental industry
Unique accommodation offerings
Spring 2015: valued at $20 billion
Talk about “Airbnb: Tapping the Value of Unused Space” business strategy
Razor-razorblades,
Subscription,
Pay as you go,
Freemium,
Wholesale,
Agency,
Bundling
Popular Business Models (7)
Razor-razorblades
Business model where:

Initial product is often: Sold at a loss or Given away for free

Helps drive demand for complementary goods

Money made primarily on replacement parts

Example: HP
Charges little for its laser printers
Imposes high prices for replacement toner cartridges

As you might guess, this was invented by Gillette, which gave away its razors and sold the replacement cartridges for relatively high prices.
Who invented the Razor-razorblades model?
Subscription
Business model where:

Traditionally used for (print) magazines and newspapers

Users pay for access to a product or service

Examples:
Cable television
Satellite radio
Health clubs

Pay as you go
Business model where:

Users pay for only the services they consume

Examples:
Utilities providing power and water
Cell phone service plans

Freemium
Business model where:

Free + premium business model
Provides the basic features free of charge

Users pay for premium services
Such as advanced features or add-ons

Examples:
Software trials with an option to buy

Wholesale
Business model where:

The traditional model in retail
Products sold at a fixed price to retailers
Retailers mark up the prices to make a profit

Example:
Books are originally purchased from a publisher
Re-sold at 50% markup from a retailer

Agency
Business model where:

Producer relies on an agent or retailer to sell the product.

At a predetermined percentage commission

Producer may also control the retail price.

Example:
Entertainment industry
Agents place artists or artistic properties.
They then receive a commission.

Bundling
Business model where:

Products or services for which demand is negatively correlated at a discount

Example:
The Microsoft Office Suite
Instead of selling Word and Excel $120 each,
Microsoft bundles them at a discount, say $180

Business models can be combined.
Business models can evolve.
Business models can be disrupted.
Businesses must respond to disruption & adapt.
Legal conflicts can arise.
Ways that Business Models Evolve Dynamically (5)
Amazon disrupted wholesale models of publishers
Give an example of how Amazon disrupted a business model
1) Relative to a benchmark
Either using competitors or the industry average
2) It is a multi-faceted concept
3) By measuring accounting profit, shareholder value, or economic value
4) The balanced scorecard approach
5) The triple bottom line
How Do We Measure and Assess Competitive Advantage?(5)
1) No best strategy exists – only better ones

2) Competitive advantage is best measured by:
-Criteria that reflect overall business unit performance
-NOT the performance of specific departments

3) Both quantitative and qualitative performance dimensions matter.

4) A firm’s business model is critical to achieving a competitive advantage.

Managerial Implications of business strategy (4)
Prior focus: windows-only business model
New focus: “mobile-first, cloud-first”

Main changes:
Office suite now available on Apple iOS / Android
Office 365 available as a subscription service
Software can be accessed on any device.

How has microsoft shifted its focus?