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CHAPTER 2

Strategy and Performance

Introduction

How do we assess a strategy’s effectiveness? Performance! Most likely financial performance comes to mind immediately, and this chapter delves into proper analysis of financial data. It also gives additional tools for the student to consider when developing a multidimensional performance perspective of the firm and its competitors.

Chapter Objectives

  • Explain the value of using both financial and nonfinancial performance dimensions to measure strategy effectiveness.
  • Describe the relationship between financial performance and a sustainable competitive advantage.
  • Use financial analysis to examine company strategy.
  • Explain the economic logic of industries and companies.
  • Examine and explain the interaction between strategy formulation and financial analysis.

General Suggestions for Teaching

This chapter focuses on the financial performance measures used to assess the overall condition of the firm. It also addresses the necessity for social responsibility performance. It should be made clear that without adequate fiscal support, social responsibility tends to be thwarted. Finally, discussions of performance should bring out the importance of a long-term perspective, sometimes foregoing short-term profits to invest in future positions via such things as maintenance, research and development, capital expenditures, and a reward structure that keeps valuable human resources in the organization.

Opening Case Assessment: Competitive Turbulence in the Unfriendly Skies

  1. Since all domestic airlines confront identical industry conditions, why did certain airlines enjoy superior financial performance? Some of the older incumbent firms, despite reorganizations, still had legacy costs and asset constraints that choked off their ability to adapt and imitate the new strategic initiatives of the efficiency-driven airlines such as Southwest. Due to changes in the market condition, US Airways was able to reorganize under far more favorable terms and has used them to enter into some of their former competitors’ domains successfully. The shock of 9/11 really just hastened the problems of many of these airlines, and gave them an excuse to take a financial bath without having to take the blame for poor management decisions in the past. In short, some airlines were better positioned with a competitive advantage that the market moved towards. Others went about improving performance measures that really didn’t improve financial performance.
  1. What did Continental excel in that allowed it to produce an industry-leading return on equity? It would appear that a load factor issue allowed them to generate ample revenue (perform ratio of SMs to Revenue) in excess of competitors, leading to a higher net income. It is likely that their debt/equity ratio is higher than their competitors as well.
  1. How was Southwest able to report positive financial results despite one of the lowest industry load factors? Efficiency! They kept their costs significantly lower than most of their competitors and maintained a solid net income.

Chapter Outline

  1. Focus on Performance

As we discussed in Chapter 1, the objective of the firm is superior performance, but this may well be a multifaceted dimension to assess. The firm’s degree of success is constantly compared to the expectations of investors to see if their strategy is being realized or in need of adaptation. Financial performance and condition enable or limit a firm’s ability to make necessary adaptations to their strategic position.

  1. Figure 2.1: Key Strategy Performance Dimensions
  1. Summary Performance- Each functional (or business unit) area has performance measures that it seeks to maximize. However, in a strategic assessment of performance on the overall performance, we do not ignore the individual functions or units. They must be looked at as a part of the whole. To give an example, tell the students that a firm increased their market share to become the leader in the industry, but they did so by selling at a loss and increasing the length of their warranty. While we may have succeeded in three of four basic areas (increased revenues, sales, and market share), the overall effect would be a reduction of wealth for investors. Another example would be cost reductions that affect customer value, either in the short-run or the long-run, or devalue the company’s brand image that had been built over a long period of time.
  1. Relative to Competition- Important to note that we need to compare to competitors within our own strategic group and the industry as a whole. The comparison to your own strategic group will tell you how efficiently you are executing your strategy. Assessing the industry as a whole will tell you whether a consideration of new strategic positioning is in order.
  1. Over the Long Run- This element ties the other two together. We should be aware of the connections between our firm’s stage of development and that of our competitors, and the impact that may have on overall and unitary financial performance. Also, it has been noted that firms that invest in positioning for future growth during industry downturns (these may sometimes be different from overall economic downturns) tend to reap higher rewards during the rebound.
  1. Figure 2.2: Emerging Performance Dimensions-Stakeholders
  1. Internal
  2. Employees- Expect a “fair” wage for their contributions to the organization. Their definition of “fair” may well change if they perceive their value to be higher due to excessive profitability.
  3. Managers & Officers- Will seek to attain goals that benefit them financially and professionally, but will be reluctant to take on risky opportunities if it places their rewards at risk as well.
  4. Board of Directors- Seeks to bridge the desires of the investors with the control of the management to assure the direction of the firm is on solid footing for the future. They also are a key liaison to the external stakeholder groups.
  5. Stockholders- This is usually the most obvious, but keep in mind that their objectives are many times tempered by satisfying the demands of other stakeholders. Also, most compensation packages make managers & officers a powerful member of this group.
  1. External
  2. Suppliers- Cooperative relationship as products are taken from raw materials to the ultimate customer value is created and appropriated throughout the linked value chain.
  3. Unions- Want to ensure that employees perceive their involvement as crucial to an equitable reward and job security.
  4. Creditors- Want to assure that their shareholder’s investment is safe. Note: This group also includes suppliers.
  5. Customers- Addressing these needs is obviously critical. Understanding their value structure relative to your product allows a firm to make proper adaptations that meet their needs at a profit.
  6. Governments- Local, State, National, and International desires will be different. Protectionism can actually occur at all of these levels, although we only think of it at the international level.
  7. Communities- Companies tend to be involved in a variety of community endeavors such as schools (in most cases they recognize that this is where their employees send their children and their future employees will come from), social involvement (Relay for Life, United Way, Little League sponsorship, and others), and environmental awareness (they want to be perceived as good stewards). Communities are also becoming increasingly involved in developing local businesses. This is a result of the recognition that local businesses tend to give back to the community in numerous ways including keeping the profits in the local economy versus sending them to external company headquarters either domestically or overseas.
  8. Interest Groups- Environmental movement provides an excellent discussion here. Many firms want to be perceived as “Green” and tout their initiatives. It is important to note that many of these are merely cost-saving focused and have little to do with a concern for the environment. Some firms have targeted the customers that are willing to pay a premium for “Green” products. This works well as long as the value created exceeds costs.

Note that many of these are connected to each other. Some of our employees may well be customers, who live in our community, vote on our government, and belong to interest groups. The union may well hold a seat on our board of directors and donate heavily to government officials’ election/reelection campaign.

Also, entities are created with differential focuses. While consignment stores are designed to make a profit by being an intermediary between second-hand clothes sellers and customers, the Salvation Army uses it as a mechanism to fund its larger objective of helping the needy.

  1. Financial Performance and Competitive Advantage

Ask students to assess their likely relative performance if they were to play a round of golf with Tiger Woods. As with most of us, it is likely to be a very sound defeat. Now let’s say that Tiger shanks a few drives into the water. Will we defeat him now? Likely not, but it will be closer! Competitive advantage (as Tiger has over us) will ultimately lead to better performance than the normal firm. Even with inefficiencies in certain sectors, an overall competitive advantage will generally lead to victory if it has high value.

Normal Profits- Minimum return earned by a company that is necessary to attract and secure the owners’ inputs.

Economic Profits- The residual income above and beyond normal profit that accrues to owners, deriving from the prowess of management in planning, supervision, and control.

Where in this mix does the fact that investment in some industries is more risky than others? The answer is in the Normal Profits section as investors will factor in the riskiness to reach their minimal return.

Once investment is made, what role do the “sunk costs” in prior investment play? They are just that, “sunk.” Therefore, they play no role other than to change the perceived risk profile.

As we look at Figure 2.4 note the affect of capital structure on ROE. Ask students what impacts this structure. Such things as age of business (affects age of assets and other issues relating to initial founding conditions such as availability and costs of attaining investment vary over time) and prior performance (can impact cost of debt and availability of internal funding) come into play as well as competitive advantage.

Figure 2.5 provides us with a breakout of the components that address effectiveness and efficiency as well as financial condition to respond and adapt to shortcomings, or take advantage of new opportunities. They can provide information to decision-makers on where inefficiencies may be thwarting maximization of effectiveness. They may also indicate when the degree of effectiveness has diminished to the stage that new sources may need to be developed.

  1. Insights form Detailed Financial Analysis

As with other analyses, it is always important that you recognize that there is rarely a one step method of getting an accurate picture of a firm or its competitors. This text does an excellent job of saying that we should perform the same analysis across our focal firm and its relevant competitors. However, there are numerous difficulties to getting an accurate comparison such as companies are not involved in the exact same industry you are, or are involved in other unrelated industries. The numbers from these industries may exaggerate the good or the bad comparisons that you make to those competitors (some of this can be alleviated by using 10-k breakouts). In addition, key competitors may be privately held as in the case with Cargill in the agricultural realm.

Figure 2.6a and 2.6b bring out the point that we need to look at common-sized statements. This does not mean that the nominal values are not important--we know that size matters--but an accurate depiction of potential advantages and disadvantages and a better picture of scalar effects can be attained by looking at both. The text does a good job of pointing out some of the insights gained, but then the text turns to the often overlooked fact that current financial statements are just that, a picture of annual performance and the condition at the beginning and end of the period. How the firm arrived in this position has occurred over time and how the performance has changed over time will give us a means by which to evaluate the need, willingness, and the ability to make adjustments for our focal firm and their competitors.

Turn to page 48 and note what type of retail stores they are. Are they really “competitors”? Well, a case could be made that supermarkets are beginning to extend into drugstores and drugstores sell some groceries as well, but overall their primary arena of operation differs. We will be addressing some of the other differences that lead to differential performance within these sectors when we study the Five Forces model later.

Trend Analysis-

Financial statements are often accompanied by historic data related to the items being evaluated. These should be evaluated to properly address the firm’s trajectory and better understand the changes in competitive dynamics. Trend is not as simple as drawing a line. For example, looking at revenues on Figure 2.7 tells us that the growth has been geometric and not linear (it has also flattened out a bit). Relative change in the other components will tell you about the variability of these expenses (some change little with increases in revenue while others tend to mirror it). In addition, there may well be time lags attached. For example, marketing expense incurred in 2008 may well not benefit the firm until 2009. The same sometimes holds true with expenses such as Research and Development.

Downward trends, even for a market leader, imply a greater willingness to alter current strategic positioning. In a struggling firm it may well lead to a dramatic “last gasp” effort to reposition strategically, even illegally. These firms tend to take on risk simply to survive. It is the same as a person that has $1 left with no prospects of earning more standing in line to either buy a candy bar or a Lotto ticket. The odds of winning the Lotto jackpot are horrible, but the alternative of action is guaranteed long-run defeat.

  1. Economic Logic and Operating Characteristics

As noted in the text, some industries offer a wide variety of profiles for differential Economic Logic of which several can be successful, while other industries may be constrained to competing on the same basic parameters and vary tactics to gain temporary short-term advantage (or disadvantage if erroneous). Ask the students about the oil and gasoline industry. Do they believe that any truly profound differences in Economic Logic exist between the competitors in this field? How about the automobile manufacturing industry? Do these constraints stay consistent over time? In the automobile industry, the firms that are looking at the most dramatic changes are those that were in the most trouble, but their ability to undertake such a massive move is questionable. Firms with the ability to make dramatic changes (Toyota, Honda, Kia, for example) want a steadier pace of change to allow for maintenance of their overall competitive position.

  1. Strategy Planning

Throughout this chapter you have talked about the signaling and information contained in the financial (and sometimes nonfinancial) performance of the firm. These performance issues indicate when strategic alterations are needed and to what degree the firm is capable of undertaking these changes. Later chapters will discuss the resources that must be in existence or acquirable to facilitate changes that will allow a firm to continue in an industry over time.

Strategic Moves, Pg. 50

1./2. Differing capital structures drive some of this as Chain B is highly leveraged. The smaller return is spread over less equity investment and they seem to have some efficiency advantages that enhance this affect. Chain A is more equity driven, but several of its efficiency measures are suspect. Chain C does a good job with efficiency, but seems to have a high cost of goods sold, which would imply a differentiator.

Short Answer Review Questions

1. What three dimensions of performance are most critical?

Summary Performance, Relative to Competition, and Over the Long-Run.

2. What is the most common performance measure used by executive management? Why? What components make this particular measure so useful?

Return on Equity (ROE). It answers the basic question, what is the return to investors? Profitabllity, Asset Productivity, and Financial Leverage.

3. What are nonfinancial performance measures?

Social, Cultural, and Knowledge Value.

4. What three methods provide the greatest insight into company strategy? 1. Detailed Financial Analysis including common-sized statements; 2. Economic Logic within an industry. 3. Identification of operational characteristics within the companies that allow them to address the economic logic.

5. Explain the performance considerations necessary when we involve stakeholder’s desired outcomes.