MGT499- W3 Post And Response
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Roth4_SM_Lecture_PPT_C05_Final.pptxCHAPTER 5
Competitive Advantage, Firm Performance, and Business Models
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Be sure to see the NEW Teacher’s Resource Manual located in the Connect Library under Instructor’s Resources.
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The AFI Strategy Framework
Exhibit 1.3
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Learning Objectives
LO 5-1 Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage.
LO 5-2 Apply shareholder value creation to assess and evaluate competitive advantage.
LO 5-3 Explain economic value creation and different sources of competitive advantage.
LO 5-4 Apply a balanced scorecard to assess and evaluate competitive advantage.
LO 5-5 Apply a triple bottom line to assess and evaluate competitive advantage.
LO 5-6 Use the why, what, who, and how of business models framework to put strategy into action.
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An Overview of Frameworks Discussed
To measure and assess firm performance:
Accounting profitability
Shareholder value creation
Economic value creation
Integrative frameworks, combining quantitative data with qualitative assessments:
The balanced scorecard
The triple bottom line
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Three Standard Performance Dimensions
What is the firm’s accounting profitability?
How much shareholder value does the firm create?
How much economic value does the firm generate?
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Instructors:
The digital companion to this book McGraw-Hill Connect has an animated video on the drivers of profitability. It builds student confidence on the a variety of profit measures (LO 5-1).
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Accounting Profitability
Accurately assesses firm performance
Compares firm performance to competitors / industry average
Available through:
Standardized accounting metrics (GAAP, FASB)
Form 10-K statements
Profitability ratios
Return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and return on revenue (ROR)
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One of the most commonly used metrics in assessing firm financial performance is return on invested capital (ROIC), where ROIC = (Net profits/Invested capital). ROIC is a popular metric because it is a good proxy for firm profitability. In particular, 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 bond holders.
To explore further drivers of this difference, we break down return on revenue into three additional financial ratios:
Cost of goods sold (COGS) / Revenue.
Research & development (R&D) expense / Revenue.
Selling, general, & administrative (SG&A) expense / Revenue.
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Comparing Apple and Microsoft: Drivers of Firm Performance
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Instructors:
The digital companion to this book McGraw-Hill Connect has an application exercise on this section of the textbook. It I under “financial review” inside Connect and provides a variety of exercises around calculating financial ratios. These are intended as ‘refresher’ materials for students that have already had accounting and finance classes but still need or would like more practice.
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Elements of ROIC Explained
Return on revenue
How much of the firm’s sales is converted into profits
Working capital turnover
How effectively capital is being used to generate revenue
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Return on Revenue Elements
Cost of goods sold (COGS) / Revenue
How efficiently a company can produce a good
Research & development expense / Revenue
How much of each dollar earned is invested in R&D
Selling, general, & administrative expense / Revenue
How much of each dollar earned is invested in SG&A
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Working Capital Turnover Elements
Working capital / Revenue
How much working capital the firm has tied up in its operations
PPE / Revenue
How much of a firm’s revenues are dedicated to cover plant, property, and equipment
Critical assets and difficult to get rid of
Intangibles / Revenue
Intangibles include patents, copyrights, and trademarks, goodwill, and brand value
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Limitations of Accounting Data
Historical and backward-looking
Does not consider off–balance sheet items:
Pension obligations
Leasing obligations
Focuses mainly on tangible assets
May not be the most important
Consider: innovation, quality, customer experience
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The Declining Importance of Book Value in a Firm’s Stock Market Valuation
Exhibit 5.2
Source: Analysis and depiction of data from Compustat, 1980–2015
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In 1980, about 80 percent of a firm’s stock market valuation was based on its book value with 20 percent based on the market’s expectations concerning the firm’s future performance. This almost reversed by 2000 (at the height of the internet bubble), when firm valuations were based only 15 percent on assets captured by accounting data. The important take-away is that intangibles not captured in firms’ accounting data have become much more important to a firm’s competitive advantage. By 2015, about 75 percent of a firm’s market valuation was determined by its intangibles.
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Shareholder Value Creation - Definitions
Shareholders
Own shares of stock, are legal owners
Risk Capital
Money provided for an equity share
Total Return to Shareholders
Stock price appreciation + dividends
Market Capitalization
Dollar value of total shares outstanding
Number of outstanding shares x share price
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All public companies in the United States are required to report total return to shareholders annually in the statements they file with the Securities and Exchange Commission (SEC). In addition, companies must also provide benchmarks, usually one comparison to the industry average and another to a broader market index that is relevant for more diversified firm.
Investors also adjust their expectations over time. Since the business in the slow-growth industry surprised them by delivering higher than expected growth, they adjust their expectations upward. The next year, they expect this firm to again deliver 4 percent growth. On the other hand, if the industry average is 10 percent a year in the high-tech business, the firm that delivered 8 percent growth will again be expected to deliver at least the industry average growth rate; otherwise, its stock will be further discounted.
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Stock Market Valuations of Apple and Microsoft, 1990–2017
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Limitations of Shareholder Value Creation
Stock prices can be volatile
Difficult to assess firm performance
Macroeconomic factors affect stock prices
Economic growth or contraction
Unemployment, interest and exchange rates
Stock prices can reflect the mood of investors
Investors can be irrational
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Economic Value Creation
The difference between:
A buyer’s willingness to pay for a product / service
And the firm’s total cost to produce it
The difference between value (V) and cost (C)
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Competitive advantage can be based on: economic value creation because of superior product differentiation, or a relative cost advantage over rivals.
Instructors:
The digital companion to this book McGraw-Hill Connect has an application exercise on this section of the textbook. It builds student confidence on the economic value perspective (LO 5-3).
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Firm B’s Competitive Advantage
Same cost as firm A but firm B creates more economic value.
Firm B’s advantage is based on superior differentiation.
Exhibit 5.4
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Only Firm A and Firm B are competing in the market for laptops. Assuming that both Firm A and Firm B have the same total unit cost of producing the particular laptop models under consideration ($400) and the market at large has preferences similar to yours, then Firm B will have a competitive advantage. This is because Firm B creates more economic value than Firm A (by $200), but has the same total cost.
The amount of total perceived consumer benefits equals the maximum willingness to pay, or the reservation price. This amount is then split into economic value creation and the firm’s total unit cost. Firm A and Firm B have identical total unit cost, $400 per laptop. However, Firm B’s laptop (e.g., Apple’s MacBook Pro) is perceived to provide more utility than Firm A’s laptop (e.g., Dell’s generic laptop), which implies that Firm B creates more economic value ($1,200 – $400 = $800) than Firm A ($1,000 – $400 = $600). Taken together, Firm B has a competitive advantage over Firm A because Firm B creates more economic value. This is because Firm B’s offering has greater total perceived consumer benefits than Firm A’s, while the firms have the same total cost. In short, Firm B’s advantage is based on superior differentiation leading to higher perceived value. Further, the competitive advantage can be quantified: It is $200 (or, $1,200 – $1,000) per laptop sold for Firm B over Firm A.
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Firm C’s Competitive Advantage
Exhibit 5.5
Same total perceived consumer benefits as firm D, but firm C creates more economic value.
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In this image, two different laptop makers each offer a model that has the same perceived consumer benefits ($1,200). Firm C, however, creates greater economic value ($900, or $1,200 – $300) than that of Firm D ($600, or $1,200 – $600). This is because Firm C’s total unit cost ($300) is lower than Firm D’s ($600). Firm C has a relative cost advantage over Firm D, while both products provide identical total perceived consumer benefits ($1,200). In this example, Firm C could be Lenovo with lower cost structure than Firm D, which could be HP, but both firms offer the same value. As this image shows, Firm C has a competitive advantage over Firm D because it has lower costs. Firm C’s competitive advantage over Firm D is in the amount of $300 for each laptop sold. Here, the source of the competitive advantage is a relative cost advantage over its rival.
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Producer & Consumer Surplus
Producer surplus (also called profit)
Price charged minus cost to produce
Consumer surplus
What you were willing to pay minus what you paid
Both parties capture some of the value created.
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Value denotes the dollar amount (V) a consumer attaches to a good or service. Value captures a consumer’s willingness to pay and is determined by the perceived benefits a good or service provides to the buyer. The cost (C) to produce the good or service matters little to the consumer, but it matters a great deal to the producer (supplier) of the good or service since it has a direct bearing on the profit margin.
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Competitive Advantage and Economic Value Created
Exhibit 5.7
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Instructors:
The digital companion to this book McGraw-Hill Connect has an animated video on economic value creation. It builds student confidence on the a variety of value aspects (LO 5-3).
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Opportunity Costs and Limitations of Economic Value Creation
Opportunity costs
The value of the best forgone alternative
Limitations of Economic Value Creation
Valuing a consumer good isn’t easy
The value of a good changes in the eyes of consumers
Income, preferences, time, etc.
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Example of Opportunity Costs of an Entrepreneur: (1) forgone wages if employed elsewhere; (2) the cost of capital invested in the business vs. the stock market vs. U.S. Treasury bonds.
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The Balanced Scorecard
Helps managers achieve their strategic objectives
Uses internal and external performance metrics
Balances both financial and strategic goals
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Just as airplane pilots rely on a number of instruments to provide constant information about key variables—such as altitude, airspeed, fuel, position of other aircraft in the vicinity, and destination—to ensure a safe flight, so should managers rely on multiple yardsticks to more accurately assess company performance in an integrative way.
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The Balanced Scorecard Approach
Exhibit 5.8
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Examples of Metrics for Each Balanced Scorecard Section
Customers
Revenue, profit, customer satisfaction
Value Creation
Competitiveness, innovation, organizational learning
Core Competencies
Key business processes
Shareholders
Cash flow, operating income, ROIC, ROE, total returns to shareholders
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Customer view: In the air-express industry, for example, managers learned from their customers that many don’t really need next-day delivery for most of their documents and packages; rather what they really cared about was the ability to track the shipments. This discovery led to the development of steeply discounted second-day delivery by UPS and FedEx, combined with sophisticated real-time tracking tools online.
Value Creation: For example, 3M requires that 30 percent of revenues must come from products introduced within the past four years.
Core Competencies: Honda’s core competency is to design and manufacture small but powerful and highly reliable engines. Its business model is to find places to put its engines. Beginning with motorcycles in 1948, Honda nurtured this core competency over many decades and is leveraging it to reach stretch goals in the design, development, and manufacture of small airplanes.
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Advantages of the Balanced Scorecard
Links strategic vision to responsible parties
Translates vision into measurable goals
Designs and plans business processes
Implements feedback and organizational learning
Alerts to needed strategic goal adaptation
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Implementing a balanced scorecard allowed FMC’s managers to align their different perspectives to create a more focused corporation overall. General managers now review progress along the chosen metrics every month, and corporate executives do so on a quarterly basis. Implementing a balanced-scorecard approach is not a onetime effort, but requires continuous tracking of metrics and updating of strategic objectives, if needed. It is a continuous process, feeding performance back into the strategy process to assess its effectiveness.
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Disadvantages of the Balanced Scorecard
Focused on implementation
Not formulation
Managers must identify the right metrics to track
Lacks guidance:
Which metrics to use?
How to address setbacks?
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All of the three approaches to measuring competitive advantage—accounting profitability, shareholder value creation, and economic value creation—in addition to other quantitative and qualitative measures can be helpful when using a balanced-scorecard approach.
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The Triple Bottom Line
Focus: economic, social and ecological performance
Three dimensions:
Economic Dimension: Profits
Businesses must be profitable to survive
Social Dimension: People
Ecological Dimension: Planet
Considers the natural environment
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Rather than emphasizing sustaining a competitive advantage over time, sustainable strategy means a strategy that can be pursued over time without detrimental effects on people or the planet. Using renewable energy sources such as wind or solar power, for example, is sustainable over time. It can also be good for profits, or simply put “green is green,” as Jeffrey Immelt was fond of saying while CEO at GE. GE’s renewable energy business brought in more than $9 billion in revenues in 2016 (up from $3 billion in 2006). Immelt retired in 2017.
Instructors:
The digital companion to this book McGraw-Hill Connect has a video case exercise from a mining industry executive on this section of the textbook. It builds student confidence on the triple bottom line (LO 5-5).
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Sustainable Strategy
Exhibit 5.9
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What Is a Business Model?
Details competitive tactics and initiatives
Explains how the firm:
Intends to make money
Conducts its business
With buyers, suppliers, and partners
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How companies do business can sometimes be as important, if not more so, to gaining and sustaining competitive advantage as what they do. Indeed, a slight majority (54 percent) of senior executives responded to a recent survey stating that they consider business model innovation to be more important than process or product innovation.
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Why, What, Who, and How of Business Models (1 of 2)
Details competitive tactics and initiatives
Explains how the firm:
Intends to make money
Conducts its business
With buyers, suppliers, and partners
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How companies do business can sometimes be as important, if not more so, to gaining and sustaining competitive advantage as what they do. Indeed, a slight majority (54 percent) of senior executives responded to a recent survey stating that they consider business model innovation to be more important than process or product innovation.
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Why, What, Who, and How of Business Models (2 of 2)
Exhibit 5.10
Source: Adapted from R. Amit and C. Zott (2012), “Creating value through business model innovation,” MIT Sloan Management Review: 41–49.
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Popular Business Models
Razor-razorblade: pay for replacements
Subscription: pay for access
Pay as you go: pay for what you consume
Freemium: pay for extra features / add-ons
Wholesale: products sold at a discount
Agency: products sold on commission
Bundling: more than one product sold at a discount
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Razor-razorblade: was invented by Gillette, which gave away its razors and sold the replacement cartridges for relatively high prices. The razor–razor-blade model is found in many business applications today. For example, HP charges little for its laser printers but imposes high prices for its replacement toner cartridges.
Subscription: Microsoft uses a subscription-based model for its new Office 365 suite of application software. Other industries that use this model presently are cable television, cellular service providers, satellite radio, internet service providers, and health clubs. Netflix also uses a subscription model.
Pay as you go: most widely used by utilities providing power and water and cell phone service plans, but it is gaining momentum in other areas such as rental cars and cloud computing such Microsoft’s Azure.
Freemium: examples include Spirit Airlines (in the United States), Ryanair (in Europe), or AirAsia, which provide minimal flight services but allow customers to pay for additional services and upgrades à la carte, often at a premium.
Wholesale: book publishers 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 (or wholesaler).
Agency: long used in the entertainment industry, where agents place artists or artistic properties and then take their commission. More recently we see this approach at work in a number of online sales venues, as in Apple’s pricing of book products or its app sales.
Bundling: In the Microsoft Office Suite, a user might value Word more than Excel and vice versa. Instead of selling both products for $120 each, Microsoft bundles them in a suite and sells them combined at a discount, say $150.
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Dynamic Nature of Business Models
Business Models:
Can be combined
Can evolve
Can be disrupted
Businesses must respond to disruption & adapt
Legal conflicts can arise
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Examples:
Business models can be combined: AT&T uses both razor-razorblade & subscription models
Business models can evolve: Freemium is an evolution of razor-razorblade
Business models can be disrupted: Amazon disrupted wholesale models of publishers
Businesses must respond to disruption & adapt: Many book publishers worked with Apple on an agency approach, in which the publishers would set the price for Apple and receive 70 percent of the revenue, while Apple received 30 percent. Publishers inked their deals with Apple, but how could they get Amazon to play ball? For leverage, publishers withheld new releases from Amazon. This forced Amazon to raise prices on newly released e-books in line with the agency model to around $14.95
Legal conflicts can arise: In 2012 the Department of Justice determined that Apple and major publishers had conspired to raise prices of e-books. A year later, Apple was found guilty of colluding with several major book publishers to fix prices on e-books and had to change its agency model.
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Appendices Descriptions of Visual Graphics to Support Student Accessibility Needs
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Appendix 1 The AFI Strategy Framework
The important inside circle is titled "Gaining and Sustaining a Competitive Advantage" that is at the very center of the image, with five different circles on the outside of it. Arrows go back and forth from the center circle to each of the five outer circles. The five outer circles are labeled: (1) Getting Started, (2) External and Internal Analysis, (3) Formulation: Business Strategy, (4) Formulation, Corporate Strategy, and (5) Implementation.
Each of these outer five circles have a brief description beside them to explain what the circle means:
Under the first outer circle titled "Getting Started," it says: Part 1, Strategy Analysis, "What is Strategy (Chapter 1)" and "Strategic Leadership: Managing the Strategy Process (Chapter 2)."
Under the second outer circle titled "External and Internal Analysis," it says: Part 1, Strategy Analysis, "External Analysis: Industry Structure, Competitive Forces and Strategic Groups (Chapter 3)," "Internal Analysis: Resources, Capabilities and Core Competencies (Chapter 4)," and "Competitive Advantage, Firm Performance, and Business Models (Chapter 5)."
Under the third outer circle titled "Formulation: Business Strategy," it says: Part 2, Strategy Formulation, "Business Strategy: Differentiation, Cost Leadership and Integration (Chapter 6)" and "Business Strategy, Innovation and Entrepreneurship (Chapter 7)."
Under the fourth outer circle titled "Formulation: Corporate Strategy," it says: Part 2, Strategy Formulation, "Corporate Strategy: Vertical Integration and Diversification (Chapter 8)," "Corporate Strategy: Strategic Alliances, Mergers and Acquisitions (Chapter 9)," and "Global Strategy: Competing Around the World (Chapter 10)."
Under the fifth outer circle titled "Implementation," it says: Part 3, Strategy Implementation, "Organizational Design: Structure, Culture and Control (Chapter 11)," and "Corporate Governance and Business Ethics.”
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Appendix 2 Comparing Apple and Microsoft: Drivers of Firm Performance
This image shows the R O I C for Apple and Microsoft as of fiscal year 2016. It further breaks down R O I C into its constituent components.
On the left is a box that says R O I C, that points to two boxes on the right, one which says Return on Revenue, and the other says Working Capital Turnover. Return on Revenue points to three boxes that say: C O G S/Revenue, R and D/Revenue, S G and A/Revenue. Working Capital Turnover points to four boxes that say: Fixed Asset Turnover, Inventory Turnover, Receivables Turnover, Payables Turnover.
This image is intended to provide important clues for managers on which areas to focus when attempting to improve firm performance relative to their competitors.
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Appendix 3 The Declining Importance of Book Value in a Firm’s Stock Market Valuation
This image shows the firm’s book value (accounting data capturing the firm’s actual costs of assets minus depreciation) as part of a firm’s total stock market valuation (number of outstanding shares times share price).
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.
Out of a firm’s stock market valuation, this image shows that in 1980, about 80 percent of a firm’s stock market valuation was based on its book value with 20 percent based on the market’s expectations concerning the firm’s future performance. This almost reversed by 2000 (at the height of the internet bubble), when firm valuations were based only 15 percent on assets captured by accounting data. The important take-away is that intangibles not captured in firms’ accounting data have become much more important to a firm’s competitive advantage. By 2015, about 75 percent of a firm’s market valuation was determined by its intangibles.
©McGraw-Hill Education.
Appendix 4 Stock Market Valuations of Apple and Microsoft, 1990–2017
Exhibit 5.3 shows the stock market valuations for Apple and Microsoft from 1990 until 2017. Microsoft was once the most valuable company worldwide (in December 1999 with close to $600 billion in market cap), but its market valuation dropped in the following decade.
Since a low of about $220 billion in early 2013, Microsoft’s market cap more than doubled to over $500 billion by 2017. Nonetheless, Microsoft remains below Apple, using market cap as its metric.
The graph portrays that in the early 2000’s Microsoft had a competitive advantage over Apple, but that shifted and in the 2010 – 2015 range, Apple had a competitive advantage over Microsoft.
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Appendix 5 Firm B’s Competitive Advantage
Firm A and Firm B have identical total unit cost, $400. However, Firm B is perceived to provide more utility ($1,200) than Firm A’s ($1,000), which implies that Firm B creates more economic value ($1,200 minus $400 = $800) than Firm A ($1,000 minus $400 = $600). Taken together, Firm B has a competitive advantage over Firm A because Firm B creates more economic value. This is because Firm B’s offering has greater total perceived consumer benefits than Firm A’s, while the firms have the same total cost. In short, Firm B’s advantage is based on superior differentiation leading to higher perceived value. Further, the competitive advantage can be quantified: It is $200 (or, $1,200 minus $1,000) for Firm B over Firm A.
©McGraw-Hill Education.
Appendix 6 Firm C’s Competitive Advantage
In this example, two different producers each offer a product that has the same perceived consumer benefits ($1,200). However, Firm C's costs are only $300 whereas Firm D's costs are $600. Firm C creates economic value greater ($900, or $1,200 minus $300) than that of Firm B ($600, or $1,200 minus $600). This is because Firm C’s total unit cost ($300) is lower than Firm D’s ($600). Firm C has a relative cost advantage over Firm D, while both products provide identical total perceived consumer benefits ($1,200). In this example, both firms offer the same value, but Firm C has a competitive advantage over Firm D because it has lower costs. Firm C’s competitive advantage over Firm D is in the amount of $300 for each product sold. Here, the source of the competitive advantage is a relative cost advantage over its rival.
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Appendix 7 Competitive Advantage and Economic Value Created
On the left side of the graph is a rectangle which represents the total perceived consumer benefits (V), as captured in the consumer’s maximum willingness to pay.
In the lower part of the center bar, C is the cost to produce the product or service (the unit cost). It follows that the difference between the consumers’ maximum willingness to pay and the firm’s cost (V - C) is the economic value created, which is the upper part of the center bar.
The price of the product or service (P) is indicated in the dashed line, in between the consumer surplus at the top part of the right bar, and the firm's profit at the middle part of the right bar. The economic value created (V - C), from the center bar, is split between producer and consumer: (V - P) is the value the consumer captures (consumer surplus), and (P - C) is the value the producer captures (producer surplus, or profit).
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Appendix 8 The Balanced Scorecard Approach
This image consists of a series of arrows pointing towards the words “Competitive Advantage." There are four series of questions that point both towards the words “Competitive Advantage” and toward each other, and those are: “How do Shareholders view us?," “What Core Competencies do we need?," “How do we create value?” and “How do Customer’s view us?”
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Appendix 9 Exhibit 5.9 Sustainable Strategy
This image reflects the simultaneous pursuit of performance along social, economic, and ecological dimensions provides a basis for a triple-bottom-line strategy.
This is conveyed through three Venn diagram like circles, in the center of which are the words “Sustainable Strategy." The three individual circles are titled, “People," “Planet," and “Profits.”
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Appendix 10 Exhibit 5.10 Why, What, Who, and How of Business Models
This image represents framework that is intended to guide managers through the process of formulating and implementing a business model by asking the important questions of the why, what, who, and how.
At the center of the image is a circle which asks, “Why does the business model create value? (Revenue + Cost Models).”
Around this main center circle are three additional circles which each state, “What? What activities need to be performed to create and deliver the offerings to customers?," “How? How are the offerings to the customers created?," and “Who? Who are the main stakeholders performing the activities?”
©McGraw-Hill Education.
