Strategic Management - Chapter 1, "What is strategy and the strategic management process?"

What Is Competitive Advantage?

A firm has a competitive advantage when it is able to create more economic value than rival firms Economic value is simply the difference between the perceived benefits gained by a customer that purchases a firm's products or services and the full economic cost of these products or services The size of a firm's competitive advantage is the difference between the economic value a firm is able to create and the economic value its rivals are able to create Temporary competitive advantage is a competitive advantage that lasts for a very short period of time. A sustained competitive advantage, in contrast, can last much longer. Firms that create the same economic value as their rivals experience competitive parity Firms that generate less economic value than their rivals have a competitive disadvantage

Accounting Measures of Competitive Advantage

A firm's accounting performance is a measure of its competitive advantage calculated by using information from a firm's published profit and loss and balance sheet statements One way to use a firm's accounting statements to measure its competitive advantage is through the use of accounting ratios - accounting ratios are simply numbers taken from a firm's financial statements that are manipulated in ways that describe various aspects of a firm's performance These measures of firm accounting performance can be grouped into four categories:(1) profitability ratios, or ratios with some measure of profit in the numerator and some measure of firm size or assets in the denominator; (2) liquidity ratios, or ratios that focus on the ability of a firm to meet its short term financial obligations; (3) leverage ratios, or ratios that focus on the level of a firm's financial flexibility, including its ability to obtain more debt; and (4) activity ratios, or ratios that focus on the level of activity in a firm's business. Its accounting ratios must be compared with some standard. In general, that standard is the average of accounting ratios of other firms in the same industry A firm earns above average accounting performance when its performance is greater than the industry average; a firm earns average accounting performance when its performance is equal to the industry average; a firm earns below average accounting performance when its performance is less than the industry average

Defining Strategy

A firm's strategy is defined as its theory about how to gain competitive advantages Each theory of how to gain competitive advantages all theories—is based on a set of assumptions and hypotheses about the way competition in this industry is likely to evolve, and how that evolution can be exploited to earn a profit If these assumptions and hypotheses turn out not to be accurate, then a firm's strategies are not likely to be a source of competitive advantage Usually very difficult to predict how competition in an industry will evolve, and so it is rarely possible to know for sure that a firm is choosing the right strategy

Summary

A firm's strategy is its theory of how to gain competitive advantages; based on assumptions and hypotheses about how competition in an industry is likely to evolve The strategic management process begins when a firm identifies its mission, or its long-term purpose Mission statements, by themselves, can have no impact on performance, enhance a firm's performance, or hurt a firm's performance. Objectives are measurable milestones firms use to evaluate whether they are accomplishing their missions. External and internal analyses are the processes through which a firm identifies its environmental threats and opportunities and organizational strengths and weaknesses. Strategies can be classified into two categories: business level strategies (including cost leadership and product differentiation) and corporate-level strategies (including vertical integration, strategic alliances, diversification, and mergers and acquisitions). The ultimate objective of the strategic management process is the realization of competitive advantage - creating more economic value than its rivals Economic value is defined as the difference between the perceived customer benefits from purchasing a product or service from a firm and the total economic cost of developing and selling that product or service (can be temporary or sustained) Two popular measures of a firm's competitive advantage are accounting performance and economic performance - a firm's accounting performance is compared with the average level of accounting performance in a firm's industry and economic performance compares a firm's level of return to its cost of capital (rate of return it had to promise to pay to its debt and equity investors to induce them to invest in the firm) Although many firms use the strategic management process to choose and implement strategies, not all strategies are chosen this way. Some strategies emerge over time, as firms respond to unanticipated changes in the structure of competition in an industry. Students need to understand strategy and the strategic management process for at least three reasons. First, it can help in deciding where to work. Second, once you have a job it can help you to be successful in that job. Finally, if you have a job in a small or entrepreneurial firm you may become involved in strategy and the strategic management process from the very beginning.

Economic Measures of Competitive Advantage

Accounting measures of competitive advantage have at least one significant limitation: one important component of cost typically is not included in most accounting measures of competitive advantage—the cost of the capital a firm employs to produce and sell its products The cost of capital is the rate of return that a firm promises to pay its suppliers of capital to induce them to invest in the firm Economic measures of competitive advantage compare a firm's level of return to its cost of capital instead of to the average level of return in the industry. There are two broad categories of sources of capital: debt (capital from banks and bondholders) and equity (capital from individuals and institutions that purchase a firm's stock). The cost of debt is equal to the interest that a firm must pay its debt holders (adjusted for taxes) in order to induce those debt holders to lend money to a firm The cost of equity is equal to the rate of return a firm must promise its equity holders in order to induce these individuals and institutions to invest in a firm. A firm's weighted average cost of capital (WACO is simply the percentage of a firm's total capital, which is debt times the cost of debt, plus the percentage of a firm's total capital; that is, equity times the cost of equity. A firm's cost of capital is the level of performance a firm must attain if it is to satisfy the economic objectives of two of its critical stakeholders: debt holders and equity holders Earning above normal economic performance - be able to use its access to cheap capital to grow and expand its business; firm that earns above its cost of capital is likely to be able to attract additional capital, because debt holders and equity holders will scramble to make additional funds available for this firm Normal economic performance - earns its cost of capital; able to gain access to the capital they need to survive, although they are not prospering Below normal economic performance implies that a firm's debt and equity holders will be looking for alternative ways to invest their money Measuring a firm's performance relative to its cost of capital satisfies two of its most important stake holders—debt holders and equity holders but has some important limitations as well (can sometimes be difficult to calculate a firm's cost of capital (privately held) and exaggerate the importance of these two particular stakeholders)

Measuring Competitive Advantage

Despite the very real challenges associated with measuring a firm's competitive advantage, two approaches have emerged. The first estimates a firm's competitive advantage by examining its accounting performance; the second examines the firm's economic performance.

Emergent Versus Intended Strategies

Emergent strategies are theories of how to gain competitive advantage in an industry that emerge over time or that have been radically reshaped once they are initially implemented. it will often be the case that at the time a firm chooses its strategies, some of the information needed to complete the strategic management process may simply not be available A firm's ability to change its strategies quickly to respond to emergent trends in an industry may be as important a source of competitive advantage as the ability to complete the strategic management process - emergent strategies may be particularly important for entrepreneurial firms

External and Internal Analysis

External and Internal Analysis occur simultaneously External analysis - a firm identifies the critical threats and opportunities in its competitive environment; examines how competition in this environment is likely to evolve and what implications that evolution has for the threats and opportunities a firm is facing Internal analysis - helps a firm identify its organizational strengths and weaknesses; helps a firm understand which of its resources and capabilities are likely to be sources of competitive advantage and which are less likely to be sources of such advantages; used by firms to identify those areas of its organization that require improvement and change

Objectives

Objectives are specific measurable targets a firm can use to evaluate the extent to which it is realizing its mission Possible to link specific objectives to each of the elements of this mission statement - i.e., for the Investor Mission, possible objectives might include; growth in earnings per share averaging 10 percent or better per year, a return on employed capital of 27 percent or better, at least 30 percent of sales from products that are no more than four years old, and so forth High-quality objectives are tightly connected to elements of a firm's mission and are relatively easy to measure and track over time Low-quality objectives either do not exist or are not connected to elements of a firm's mission, are not quantitative, or are difficult to measure or difficult to track over time One indication that a firm is not that serious about realizing part of its mission statement is when there are no objectives, or only low quality objectives, associated with that part of the mission

A Firm's Mission

Strategic management process begins when a firm defines its mission - its long-term purpose Missions define both what a firm aspires to be in the long run and what it wants to avoid in the meantime - often written down in the form of mission statements Most mission statements in corporate common elements, i.e. define the businesses within which a firm will operate, how a firm will compete in those businesses, define the core values that a firm espouses Often contain so many common elements that some have questioned whether having a mission statement even creates value for a firm Visionary firms, or firms whose mission is central to all they do - an investment of $1 in one of these firms would have increased in value to $6,536 (same dollar invested in an average firm over this same time period would have been worth$415 in 1995) Visionary firms earned substantially higher returns than average firms even though many of their mission statements suggest that profit maximizing, although an important corporate objective, is not their primary reason for existence Missions can hurt a firm's performance - sometimes a firm's mission will be very inwardly focused and defined only with reference to the personal values and priorities of its founders or top managers, independent of whether those values and priorities are consistent with the economic realities facing a firm Missions by themselves do not necessarily lead a firm to choose and implement strategies that generate competitive advantages - while defining a firm's mission is an important step in the strategic management process, it is only the first step in that process

Strategy Implementation

Strategy implementation occurs when a firm adopts organizational policies and practices that are consistent with its strategy Three specific organizational policies and practices are particularly important in implementing a strategy: (1) a firm's formal organizational structure, (2) its formal and informal management control systems, and (3) its employee compensation policies

Strategic Choice

The Strategic choices available to firms fall into two large categories: business level strategies and corporate-level strategies Business-level strategies - actions firms take to gain competitive advantages in a single market or industry Corporate-level strategies - actions firms take to gain competitive advantages by operating in multiple markets or industries simultaneously Common corporate-level strategies include vertical integration strategies, diversification strategies, strategic alliance strategies, merger and acquisition strategies, and global strategies Underlying logic of strategic choice is not complex - the objective when making a strategic choice is to choose a strategy that (1) supports the firm's mission, (2) is consistent with a firm's objectives, (3) exploits opportunities in a firm's environment with a firm's strengths, and (4) neutralizes threats in a firm's environment while avoiding a firm's weaknesses.

The Relationship Between Economic and Accounting Performance Measures

The correlation between economic and accounting measures of competitive advantage is high it is possible for a firm to have above average accounting performance and simultaneously have below normal economic performance (when a firm is not earning its cost of capital but has above industry average accounting performance) It is possible for a firm to have below average accounting performance and above normal economic performance (when a firm has a very low cost of capital and is earning at a rate in excess of this cost, but still below the industry average)

Why You Need to Know About Strategy

There are at least three very compelling reasons why it is important to study strategy and the strategic management process now. (1) it can give you the tools you need to evaluate the strategies of firms that may employ you; (2) once you are working for a firm, understanding that firm's strategies, and your role in implementing those strategies, can be very important for your personal success; (3) in smaller and entrepreneurial firms many employees end up being involved in the strategic management process

The Strategic Management Process

Usually difficult to know for sure that a firm is pursuing the best strategy, but possible to reduce the likelihood that mistakes are being made Strategic management process is a sequential set of analyses and choices that can increase the likelihood that a firm will choose a good strategy