Management 404- Chapter 5

-Accurately assess the performance of their firm. -Compare and benchmark their firm's performance to other competitors in the same industry or against the industry average

Since competitive advantage is defined as superior performance relative to other competitors in the same industry or the industry average, a firm's managers must be able to accomplish two critical tasks: Standardized financial metrics, derived from such publicly available accounting data as income statements and balance sheets, fulfill both these conditions. 10-K reports are the primary source of companies' accounting data available to the public

return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and return on revenue (ROR)

Some of the profitability ratios most commonly used in strategic management are?

-COGS/revenue -R&D expense/revenue -SG&A expense/revenue

What are the 3 additional financial ratios to break down ROR?

What is the firm's accounting profitability? How much shareholder value does the firm create? How much economic value does the firm generate?

What are the 3 standard performance dimensions? To address these questions, we will develop a multidimensional perspective for assessing competitive advantage

profits

Which "P" of the Triple Bottom Line addresses the economic dimension captures the necessity of businesses to be profitable to survive

planet

Which "P" of the Triple Bottom Line involves the ecological dimension emphasizes the relationship between business and the natural environment.

people

Which "P" of the Triple Bottom Line involves the social dimension emphasizes the people aspect, such as PepsiCo's initiative of the whole person at work.

Balanced Scorecard & Triple Bottom Line

Which 2 frameworks combine quantitative data with qualitative assessments?

fixed asset turnover, inventory turnover, receivables turnover, and payables turnover

Which 3 metrics is a measure of how effective a particular item on the balance sheet is contributing to revenue.

COGS/revenue

Which formula indicates how effectively a company can produce a good?

SG&A/revenue

Which formula indicates how much of each dollar that the firm earns in sales is invested in sales, general, and administrative (SG&A) expenses?

bundling

Which popular business model? sells products or services for which demand is negatively correlated at a discount

agency

Which popular business model? the producer relies on an agent or retailer to sell the product, at a predetermined percentage commission

Wholesale

Which popular business model? traditional model in retail; book publishers would sell books to retailers at a fixed price (usually 50 percent below the recommended retail price). Retailers, however, were free to set their own price on any book and profit from the difference between their selling price and the cost to buy the book from the publisher

fixed costs

costs that are independent of consumer demand—for example, the cost of capital to build computer manufacturing plants or an online retail presence to take direct orders

variable costs

costs that change with the level of consumer demand—for instance, components such as different types of display screens, microprocessors, hard drives, and keyboards

business model

details the firm's competitive tactics and initiatives; explains how the firm intends to make money; stipulates how the firm conducts its business with its buyers, suppliers, and partners

Key financial ratios based on accounting data give us an important tool with which to assess competitive advantage. In particular, they help us measure relative profitability, which is useful when comparing firms of different sizes over time. While not perfect, these ratios are an important starting point when analyzing the competitive performance of firms (and thus are a critical tool for case analysis).

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The amount of total perceived consumer benefits equals the maximum willingness to pay, or the reservation price

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The final set of financial ratios concerns the effectiveness of a company's receivables and payables. These are part of a company's cash flow management; they indicate the company's efficiency in extending credit, as well as collecting debts. Higher ratios of receivables turnover (Revenue / Accounts receivable) imply more efficient management in collecting accounts receivable and shorter durations of interest-free loans to customers (i.e., time until payments are due). In contrast, payables turnover (Revenue / Accounts payable) indicates how fast the firm is paying its creditors and how much it benefits from interest-free loans extended by its suppliers. A lower ratio indicates more efficient management in paying creditors and generating interest-free loans from suppliers.

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The firm's book value captures the historical cost of a firm's assets, whereas market valuation is based on future expectations for a firm's growth potential and performance; The important take-away is that intangibles not captured in firms' accounting data have become much more important to a firm's competitive advantage

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profit (π) is defined as total revenues (TR) minus total costs (TC)

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π = TR - TC, where TR = P × Q, or price times quantity sold

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Today, the most competitively important assets tend to be intangibles such as innovation, quality, and customer experience, which are not included in a firm's balance sheets

note about limitations of accounting data

When assessing competitive advantage by measuring accounting profitability, we use financial data and ratios derived from publicly available accounting data such as income statements and balance sheets

note about the "accounting profitability" performance dimension on assessing competitive advantage

Accounting profitability and economic value creation tend to be reflected in the firm's stock price, which in turn determines in part the stock's market valuation.

note about the 3 performance dimensions

the ratio measures how effectively a company uses its total invested capital, 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 bondholders. As a rule of thumb, if a firm's ROIC is greater than its cost of capital, it generates value; if it is less than the cost of capital, the firm destroys value. The cost of capital represents a firm's cost of financing operations from both equity through issuing stock and debt through issuing bonds.

note about the ROIC formula

-Stock prices can be highly volatile, making it difficult to assess firm performance, particularly in the short term. -Overall macroeconomic factors such as economic growth or contraction, the unemployment rate, and interest and exchange rates all have a direct bearing on stock prices -Stock prices frequently reflect the psychological mood of investors, which can at times be irrational

note about the limitations of shareholder value creation

•Relative to a benchmark -Either using competitors or the industry average •It is a multi-faceted concept •By measuring accounting profit, shareholder value, or economic value •The balanced scorecard approach •The triple bottom line

note- how do we measure and assess competitive advantage?

R&D/revenue

Which formula indicates how much of each dollar that the firm earns in sales is invested to conduct research and development?

revenue/fixed assets

Which formula measures how well a company leverages its fixed assets, particularly property, plant, and equipment (PPE)?

Razor-Razorblade

Which popular business model? Sells products at a loss or given away to drive demand for complimentary goods For example, HP charges little for its laser printers but imposes high prices for its replacement toner cartridges

freemium

Which popular business model? provides the basic features of a product or service free of charge, but charges the user for premium services such as advanced features or add-ons

subcriptions

Which popular business model? traditionally used for (print) magazines and newspapers. Users pay for access to a product or service whether they use the product or service during the payment term or not.

pay as you go

Which popular business model? users pay for only the services they consume; most widely used by utilities providing power and water and cell phone service plans

economic value created

the difference between a buyer's willingness to pay for a product or service and the firm's total cost to produce it

consumer surplus

the difference between what you would have been willing to pay (V) and what you paid (P)

market capitalization

(or market cap) captures the total dollar market value of a company's total outstanding shares at any given point in time (Market cap = Number of outstanding shares X Share price)

note on opportunity costs of an entreprenuer

-(1) forgone wages if employed elsewhere (2) the cost of capital invested in the business

limitations of economic value creation

-Determining the value of a good in the eyes of consumers is not a simple task -The value of a good in the eyes of consumers changes based on income, preferences, time, and other factors. -To measure firm-level competitive advantage, we must estimate the economic value created for all products and services offered by the firm

Razor-razorblades Subscription Pay as you go Freemium Wholesale Agency Bundling

7 popular business models

profit, or producer surplus

The difference between the price charged (P) and the cost to produce (C)

Creating economic value. Capturing as much of it as possible.

The economic value creation framework shows that strategy is about

efficient-market hypothesis

The idea that all available information about a firm's past, current state, and expected future performance is embedded in the market price of the firm's stock

working capital turnover

The second component of ROIC; a measure of how effectively capital is being used to generate revenue

note

Using a triple-bottom-line approach, managers audit their company's fulfillment of its social and ecological obligations to stakeholders such as employees, customers, suppliers, and communities as conscientiously as they track its financial performance.34 In this sense, the triple-bottom-line framework is related to stakeholder theory, an approach to understanding a firm as embedded in a network of internal and external constituencies that each make contributions and expect consideration in return

profits, people, planet

What are the 3 "P's" of the Triple Bottom Line?

value

denotes the dollar amount (V) a consumer attaches to a good or service

ROR

indicates how much of the firm's sales is converted into profits

shareholders

individuals or organizations that own one or more shares of stock in a public company—are the legal owners of public companies.

A firm's stock price generally increases only if the firm's rate of growth exceeds investors' expectations. This is because investors discount into the present value of the firm's stock price whatever growth rate they foresee in the future.

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Competitive advantage goes to the firm that achieves the largest economic value created, which is the difference between V, the consumer's willingness to pay, and C, the cost to produce the good or service. The reason is that a large difference between V and C gives the firm two distinct pricing options: (1) It can charge higher prices to reflect the higher value and thus increase its profitability, or (2) it can charge the same price as competitors and thus gain market share. Given this, the strategic objective is to maximize (V - C), or the economic value created

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Competitive advantage is transitory!

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Economic value creation therefore equals consumer surplus plus firm profit, or (V - C) = (V - P) + (P - C)

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The balanced scorecard can accommodate both short-and long-term performance metrics. It provides a concise report that tracks chosen metrics and measures and compares them to target values. This approach allows managers to assess past performance, identify areas for improvement, and position the company for future growth; It complements the common financial metrics with operational measures on customer satisfaction, internal processes, and the company's innovation and improvement activities.

note on the advantages of Balanced Scorecard

- No best strategy exists—only better ones - competitive advantage is best measured by criteria that reflect overall business unit performance, but NOT the performance of specific departments - Both quantitative and qualitative performance dimensions matter - A firm's business model is critical to achieving a competitive advantage

note- Several managerial implications emerged from our discussion of competitive advantage and firm performance:

-Communicate and link the strategic vision to responsible parties within the organization. -Translate the vision into measurable operational goals. -Design and plan business processes. -Implement feedback and organizational learning to modify and adapt strategic goals when indicated.

note- advantages of the Balanced Scorecard

-is a tool for strategy implementation, not for strategy formulation -provides only limited guidance about which metrics to choose -only as good as the skills of the managers who use it: They first must devise a strategy that enhances the odds of achieving competitive advantage. Second, they must accurately translate the strategy into objectives that they can measure and manage within the balanced-scorecard approach

note- disadvantages of Balanced Scorecard

- Combination: Telecommunications companies such as AT&T or Verizon, to take one industry, combine the razor-razorblade model with the subscription model. - Evolution: The freemium business model can be seen as an evolutionary variation on the razor-razorblade model. The base product is provided free, and the producer finds other ways to monetize the usage - Disruption: Amazon took advantage of the pricing flexibility inherent in the wholesale model and offered many books below the cost that other retailers had to pay to publishers. In particular, Amazon would offer newly released bestsellers for $9.99 to promote its Kindle e-reader. Publishers and other retailers strongly objected because Amazon's retail price was lower than the wholesale price paid by retailers competing with Amazon. Moreover, the $9.99 e-book offer by Amazon made it untenable for other retailers to continue to charge $28.95 for newly released hardcover books (for which they had to pay $14 to $15 to the publishers). With its aggressive pricing, Amazon not only devalued the printed book, but also lost money on every book it sold. It did this to increase the number of users of its Kindle e-readers and tablets. - Response to disruption - Legal conflicts

note- dynamic nature of business models

reservation price

the absolute maximum you'd be willing to pay for it

total return to shareholders

the return on risk capital, including stock price appreciation plus dividends received over a specific period; an external and forward-looking performance metric. It essentially indicates how the stock market views all available public information about a firm's past, current state, and expected future performance, with most of the weight on future growth expectations

Economic, Social, Ecological

what 3 dimensions make up the Triple Bottom Line?

Value (V) Price (P) Cost (C)

For ease in calculating competitive advantage, three components are needed. These will help us to further explain total perceived consumer benefits and economic value created in more detail:

risk capital

From the shareholders' perspective, the measure of competitive advantage that matters most; the money they provide in return for an equity share, money that they cannot recover if the firm goes bankrupt.

- are historical and thus backward-looking - do not consider off-balance sheet items -focus mainly on tangible assets, which are no longer the most important

Limitations of accounting data

-How do customers view us? (revenue, profit) - How do we create value? (competitiveness, innovation) - What core competencies do we need? - How do shareholders view us? (cash flow, ROIC, ROE)

Managers using the Balanced Scorecard develop appropriate metrics to assess strategic objectives by answering four key questions:

ROIC= (net profits/invested capital)

One of the most commonly used metrics in assessing firm financial performance; what's the formula? It is a good proxy for firm profitability

balanced scorecard

a framework to help managers achieve their strategic objectives more effectively. This approach harnesses multiple internal and external performance metrics in order to balance both financial and strategic goals.

sustainable strategy

achieving positive results in all three areas can lead to a? means a strategy that can be pursued over time without detrimental effects on people or the planet

opportunity costs

capture the value of the best forgone alternative use of the resources employed.