CHAPTER

Competitive
Advantage and
Firm Performance

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Part 1 Strategy Analysis

5–2
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.

5–3
 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

5–4
 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).
5–5
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)
5–6
 How
How U.S.
U.S. Companies
Companies Perform
Perform Under
Under
Different
Different Profitability
Profitability Measures,
Measures, 1998
1998

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 21.4
General Electric 6,573 9.4 22.2 4,370 285,320 45.3
Exxon 6,370 6.3 14.6 -2,262 114,774 22.4
Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8
IBM 6,328 7.7 32.6 2,541 -5,878 77.5
Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3
Wal-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 15.9
Microsoft 4,490 31.0 27.0 3,776 328,257 37.5
Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7

7
 Linking
LinkingValue
ValueDrivers
Drivers to
to Performance
Performance Targets
Targets
Order Size
Customer Mix
Sales
Sales Sales/Account
Targets
Targets Customer Churn
Rate
cogs/
cogs/
Margin
Margin Deficit Rates
sales
sales
Cost per Delivery
Development Maintenance cost
Shareholder Development New product
Shareholder Cost/Sales
value Cost/Sales development time
value ROCE
ROCE
creation
creation Indirect/Direct
Labor
Inventory
Inventory Customer
Economic
Economic Turnover
Turnover Complaints
Profit
Profit Downtime
Capital
Capital Capacity
Turnover Capacity
Turnover Utilization Accounts Payable
Utilization
Time
Cash
Cash Accounts
Turnover
Turnover Receivable Time

CEO Corporate/Divisional Functional Departments & Teams

8
 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.

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?

5–11
 Economic Value Creation

• Pizza!
• Value: A dollar amount a
consumer is willing to pay • Value = $12
for a good or service • Price = $10
• Cost = $7 SOLD!
• Price: The dollar amount a
good or service is offered
for sale • Consumer Surplus
 $12 - $10 = $2
• Cost: The dollar amount to • Producer Surplus
make the good or service  $10 - $7 = $3
• Economic Value
 $12 - $7 = $5
5–12
EXHIBIT 5.2 Competitive Advantage & Economic Value

COMPETITIVE
HIGHEST
HIGHEST
ADVANTAGE =
VALUE
VALUE
––
COST
COST

5–13
 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

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 Discounting Cash Flows

Measures of Performance Horizon
 Economic Profits CF1 CF2 CF3
… +
CFt Valuet+1
NPV = 1+r + (1+r)2 + (1+r)3 + (1+r)t + (1+r)t+1
 ROA, ROE, ROC
NPV: Net Present Value

CFt: Cash Flow at time t

r: Discount rate
• Financial Measures Horizon Value: Value of of
Performance ongoing enterprise after time t

 NPV Methods
16
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

-
5–17
 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)
 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 .

19
 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).
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

21
 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

22
 Firms
Firmswith
withthe
theHighest
HighestRatios
Ratios of
of Market
Market Value
Value to
toBook
BookValue
Value
(December 2005)
(December 2005)

Company Valuation Country Company Valuation Country

ratio ratio

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.

5–24
 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)

1–25
EXHIBIT 5.3 Top 10 Fortune 500 Companies by Profits ($M)

5–26
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.
5–27
Profits vs. Return on Revenue (ROR)

Ranking changes markedly with

the use of different metrics

2010 Profits in $M

2010 ROR %
5–28
 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

5–29
EXHIBIT 5.5 Firm Performance - Pharmaceutical Industry by ROR

Pfizer performance declines as Merck improves and

takes the competitive advantage over this period
5–30
 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”
5–31
EXHIBIT 5.6 Declining Importance of Book Value in Stock Valuation

5–32
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.

5–33
 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

5–34
EXHIBIT 5.7 Normalized Stock Returns 2005–2010

5–35
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

• 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%.

5–37
EXHIBIT 5.8 Comparing Google and Microsoft Using ROE and ROA

Microsoft outperforms Google in 2010 based on this accounting data

5–38
EXHIBIT 5.9 Normalized Stock Returns 2005–2010

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

5–39
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.

5–40
 The Four Perspectives of the Balanced Scorecard
Perspective Assessed through analysis of:
EVA
Financial Profitability
Growth

Differentiation
Customer Cost
Quick Response

Product Development
Operations Demand Management
Order Fulfillment

Leadership
Organizational Organizational Learning
Ability to Change
Slide 4-5
Exh. 4.8
Irwin/McGraw-Hill 41
© The McGraw-Hill Companies, Inc., 1998
 THE BALANCED SCORECARD
• Advantages • Disadvantages
 Communicate vision  Tool for strategy
thru the organization implementation not
formulation.
 Translate vision into
measureable goals  Limited guidance on
selecting metrics
 Design business
processes  Limited insight on
how to get back on
 Implement track to meet goals
 Can be viewed as just
organizational
a tracking tool for
learning metrics
5-42
EXHIBIT 5.10 A Balanced-Scorecard Approach to Competitive Advantage

5-43
 Balanced Scorecard Example
STRATEGIC DIRECTION PERFORMANCE MEASUREMENT

Strategies & Current-Year Process

Objectives Initiatives Business Results Assessments

Financial Leadership
• Annual revenue - $X • Make improvement in work
Overriding Purpose: environment as measured by
• Profit before tax - $X
employee survey
• ROA - X% • Gain recognition for
• Revenue per employee - $X community relations
Customer/Consumer
• Improve customer delivery Strategic Planning
• Increase sales to Europe • Establish an effective strategy-
• Meet customer loyalty goals based M&A process.
• Reduce defects
Strategies & Objectives
Customer & Mkt Focus
Partner/Supplier/Operations • Complete market segment
• Develop strategy and plan to have analysis
suppliers own material inventory • Tie sales plan & budgets to group
regional goals
• Supplier contribution to cost reduction
• Achieve inventory turns goal
Information/Analysis
Human Resources • Provide IT support for
• Balance the Human Resource availability
decentralized operations
with initiative requirements, establish plans,
& execute
• Implement diversity plan
• Plan and execute strategic staffing plan Human Resources
• Develop a comprehensive college
recruiting strategy
SBU-Specific • Implement an employee feedback
• Develop rapid prototyping processes and
process
match prototype capacity to business needs
• Software process improvement to goal
• Acquire new services customers to meet
plans Process Mgmt
• Complete ISO 9000 tasks as
• Meet on-time product launch goal planned
• Improve overall new product
introduction process

Group SBU
5-44
 The Triple Bottom Line

• Financial, Social, and EXHIBIT 5.11

Ecological Considerations

 Also known as "People,

Planet, & Profits"

 BP oil spill had many

major effects

 BMW changed car

designs to enhance
recycling The Triple Bottom Line

 Integrative approach for

sustainable strategy
 STRATEGY
STRATEGY HIGHLIGHT
HIGHLIGHT 5.1
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
1–46
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.

5-47
EXHIBIT 5.12 How Do We Measure Competitive Advantage?

5-48
 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

5–49
Putting Performance in Perspective
Narrow
Stakeholder Perspective

Share Price
Accounting Profit
Past Future
Economic Profit Survival DCF

Balanced Scorecard

Stakeholders View

Broad
Stakeholder Perspective

50