Michael Dwayne Hahijary

1906455960
Chapter 5

COMPETITIVE ADVANTAGE, FIRM PERFORMANCE,

AND BUSINESS MODELS

COMPETITIVE ADVANTAGE AND FIRM PERFORMANCE

Standard performance measuring dimensions of a company are:

• How much shareholder value does the firm create?

• What is the firm’s accounting profitability?

• How much economic value does the firm generate?

Accounting Profitability
Accounting profitability uses financial data and ratios calculated from publicly available
financial data, such as income statements and balance sheets. When it comes to
profitability, managers have two tasks:

• Assessing the firm performance accurately

• Comparing and benchmarking firm performance to the competition in the same

industry, or against to the industrial average

Accounting profitability uses standardized financial metrics, of which are required to comply
with the generally accepted accounting principles (GAAP) set by the Financial Accounting
Standards Board (FASB). Publicly traded companies in the United States are required to file
a 10-K report with the US Securities and Exchange Commission to ensure their accounting
data is publicly available.

One of the most used metrics in assessing a firm’s financial performance is return on
invested capital (ROIC)

ROIC = Net profits / Invested capital

This is considered quite representative for the profitability of a firm, measuring the effectivity
of how a company uses its total invested capital. If the ROIC is greater than the cost of
capital, it generates value. Vice versa, the firm would tank its value.

Return on revenue (ROR) indicates how much of a firm’s sales is converted into profits,
which can be broken down into additional ratios:

Cost of goods sold / Revenue: measures how effective a firm produces goods

R&D expense / Revenue: measures how much sales revenue is invested to conduct R&D,
with a higher percentage indicating stronger focus on innovation for improvement.

Selling, general, & administrative expense / Revenue: measures how much sales revenue is
invested in sales, general, and administrative expenses.

Working capital turnover (Revenue / Working capital) measures how effectively a firm
uses its capital to generate revenue. This can be broken down into:

 • Fixed asset turnover (Revenue / Fixed assets): measures how well a firm leverage its
fixed assets, particularly the PPE

• Inventory turnover (COGS / Inventory): measures how much of a firm’s capital is tied up
in its inventory

• Receivables turnover (Revenue / Accounts receivable): a higher ratio implies a more

efficient management in collecting its receivable and shorter term interest-free loans

• Payables turnover (Revenue / Accounts payable): measures how fast a firm pays its
creditors and how much it benefits from interest-free loans, with a lower ratio indicating
more efficient management in doing so.

There are several limitations to accounting data, which are:

• All accounting data are historical and therefore backward looking

• Accounting data do not consider off-balance sheet items, such as pension obligations
or operating leases in the retail industry

• Accounting data focus mainly on tangible assets, which are no longer the most
important, with many key intangible assets not reflected in it

Intangible assets cannot be measured, but have become more important than the stock
market valuation. The firm’s book value captures the historical costs of a firm’s assets, but
its importance has declined over time. Intangibles determine 75% of a firm’s valuation.

Shareholder Value Creation

Shareholders are individuals or organizations that own one more share of stock in a public
company, and they act as legal owners of the company. A competitive advantage measure
that matters the most to them is the return on risk capital, which is the money provided by
shareholders to attain an equity share in return, however this cannot be recovered should
the firm go bankrupt.

Investors also turn a keen eye to total return to shareholders, which is the return on risk
capital, that includes stock price appreciation plus dividends received over a certain period.

Market capitalization (Outstanding shares * Share price) captures the total value of a
company’s total outstanding shares at any given point in time.

Measuring profitability through shareholder value creation has its own limitations:

• Stock prices are very volatile, making it difficult to assess performance, especially in the
short term, due to volatility, external factors and investor sentiment

• Macroeconomic factors, like economic growth or contraction, unemployment, interest

and exchange rates have a direct bearing on stock prices

• Stock prices reflect the psychological mood of investors, which can be irrational.

Economic Value Creation

Economic value created is the difference between the maximum price a buyer is willing to
pay and a firm’s total cost to produce it. This maximum price is also referred to as the
reservation price, which components could be split into the economic value created and
the firm’s total cost per unit.

In calculating competitive advantage, there are three components needed, which are value
(V), price (P), and cost (C). Value is the amount a consumer attaches to a good or service,
and the cost matters little to the customer in determining this, but crucial to the producer.

The difference between the price charged and the cost to produce is the profit/producer
surplus. The difference between what a consumer is willing to pay and what they paid is
called the consumer surplus. Trade happens because of a relationship established
between the consumer and producer surplus, with both parties capturing some of the
overall value created.

From the economic value creation framework, it is shown that strategy is about creating
economic value and capturing as much value as possible.

Competitive advantage goes to the firm that achieves the largest economic value created.
This is possible because the firm can charge higher price to reflect value and thus
increasing its profitability, and it can change the same price as the competitors and thus
gaining market share.

Revenues are a function of V and P, which together drive the volume of goods sold. In this
perspective, profit is defined as total revenues minus total costs.

Π = TR – TC

Opportunity costs capture the value of the best alternative use of the employed resources.

There are several limitations to economic value creation, which are:

• Determining the value of a good in the consumer’s eye is not a simple task

• The value of a good in the consumer’s eyes changes based on their income,
preferences, time, and other factors.

• To measure firm-level competitive advantage, economic value created must be

estimated for all products and services offered by the firm

Out of all the three performance measuring dimensions, each has its own unique insights to
assess competitive advantage. However, the metrics are more or less one-dimensional.

The Balanced Scorecard

The balanced scorecard is a framework used to assess strategic objectives by harnessing

multiple internal and external performance metrics. The key questions used are:

1. How do customers view us?
3. What core competencies do we need?

2. How do we create value?

4. How do shareholders view us?

The advantages of the balanced scorecard are:

• 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.

The balanced scorecard can accommodate short- and long-term performance metrics,
providing a concise report of metrics that are compared to target values.

The drawbacks of the balanced scorecard are:

• It only provides limited guidance about which performance metrics to choose

• It is only as good as the skills of the managers who use it

The Triple Bottom Line

Managers nowadays are encouraged to maintain and improve the firm’s social and
ecological performance on top of its economic performance. Those dimensions make up
the triple bottom line, which is fundamental to a sustainable strategy.

• Profits: this captures the necessity of businesses to be profitable to survive

• People: the social dimension emphasizes the people aspect

• Planet: the relationship between business and the natural environment

By achieving positive results in the dimensions above, this will lead to a sustainable
strategy that can be pursued over time without detrimental effects on society or the planet.

This framework is related to the stakeholder theory, an approach to understanding a firm

is embedded in a network of external and internal constituencies that each make
contributions and expect consideration in return.

BUSINESS MODELS: PUTTING STRATEGY INTO ACTION

The translation of strategy into action takes form in a business model, detailing the firm’s
competitive tactics and initiatives. There are several forms of business models, which are:

• Razor-razorblades: product is sold at a loss or given away for free in order to drive
demand for complementary goods (e.g. HP printers)

• Subscription: users pay for access to product whether they use it or not (e.g. Apple
Music)

• Pay as you go: users only pay for the service they consume (e.g. car rentals,
newspapers)

• Freemium: provides basic features for free, but charges for premium service (e.g.
Spotify)

• Wholesale: traditional model; publishers sell for a fixed price to retailer, retailer is free to
set own price (e.g. book publishers to stores)

• Agency: producer relies on agent or retailer to sell the product; sometimes producer
also controls price (e.g. iTunes Store)

• Bundling: sells product and services for which demand is negatively correlated at a
discount (e.g. Microsoft Office)

Business models evolve dynamically, and sometimes they are tweaked using the following
to respond to market disruptions:

• Combination: two existing business models are combined (e.g. AT&T combining Razor-
razorblade and Subscription model)
 • Evolution: freemium business model is an evolutionary variation on the Razor-
razorblade model, which is used to build a large consumer base when the marginal cost
of adding another user is low or zero (e.g. software sales)

• Disruption: through the introduction of agency model by Amazon (E-books), they

disrupted the traditional wholesale model for publishers. Amazon set a price that
devalued printed books, but also lost money on each book it sold, in order to increase
the number of Kindle e-readers sold.

• Response to disruption: book publishers worked on an agency approach to give

publishers the leverage to raise e-book prices of retailers. This way they could increase
their e-book profits and price e-book more closely to prices of print books.

• Legal conflicts: rapid development, especially in response to disruption can lead

producers to breach existing rules of commerce.

IMPLICATIONS FOR THE STRATEGIST

No best strategy exists, only better ones. True performance can be judged only in
comparison to other contenders in the field or industry average.

Competitive advantage is best measured by criteria that reflect overall business unit
performance, rather than performance of specific departments.

Both quantitative and qualitative performance dimensions matter in judging the

effectiveness of a firm’s strategy. Managers need to rely on a more holistic perspective

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

THE TRANSFORMATIVE BUSINESS MODEL

A business model describes describes how a company creates and captures value, whose
various features interact, often in complex ways, to determine the company’s success.

If new entrants use a dominant business model to displace incumbents, or if competitors

adopt it, then the industry has been transformed.

Transformative business models tend to have some of the following features:


1. A more personalized product/service
4. Usage-based pricing

2. A closed-loop process
5. A more collaborative ecosystem

3. Asset sharing
6. An agile & adaptive organization

All six features represent potential solutions for linking market demand and technological
capability. The more features a new business model has, the greater its potential to
transform its industry.

The success of an innovation cannot be guaranteed, but its odds to success can be
improved by ensuring that your business model links market needs with emerging
technologies. The more links can be made, the more likely industrial transformation can be
achieved.