Chapter 5

Competitive Advantage, Firm Performance, and Business

Models
 The AFI Strategy Framework

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escription

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 Chapter 5 Outline

5.1 Competitive Advantage and Firm Performance

– Accounting Profitability
– Shareholder Value Creation
– Economic Value Creation
– The Balanced Scorecard
– The Triple Bottom Line
5.2 Business Models: Putting Strategy into Action
– Popular Business Models
– Dynamic Nature of Business Models
5.3 Implications for the Strategist

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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 Outline how business models put strategy into action.

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 Competitive Advantage and Firm Performance

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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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 The Multidimensional Perspective for
Assessing Competitive Advantage

• 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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 Accounting Profitability

• Helps assess competitive advantage:

– Accurately assess firm performance.
– Compare firm performance to competitors / the industry
average.
• Standardized accounting metrics
• 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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 Exhibit 5.1
Comparing
Apple and
Microsoft:
Drivers of
Firm
Performance

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escription SOURCE: Analysis of publicly available data.
 Limitations of Accounting Data

• All accounting data are historical and thus backward-

looking.
• Accounting data do not consider off–balance sheet
items, such as:
– Pension obligations
– Leasing obligations
• Accounting data focus mainly on tangible assets,
which are no longer the most important.
– Innovation, quality, customer experience are important.

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 Shareholder Value Creation

• Shareholders
– Own one or more shares of stock in a company
– The legal owners of public companies
• Risk Capital
– Money provided for an equity share in a company
– Cannot be recovered if the firm goes bankrupt
• Total Return to Shareholders
– Stock price appreciation plus dividends
• Market Capitalization
– Dollar value of total shares outstanding
– Number of outstanding shares x share price

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 Limitations of Shareholder Value Creation

• Stock prices can be highly volatile.

– Makes it 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.
– 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)
• Competitive advantage can be based on:
– Economic value creation because of superior product
differentiation
– A relative cost advantage over rivals

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 Exhibit 5.4 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 leading to higher

perceived value

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escription

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 Exhibit 5.5 Firm C’s Competitive Advantage:
Same Total Perceived Consumer Benefits as Firm D, but Firm C Creates More Economic Value

Firm C has a competitive advantage over Firm D because it has lower

costs.

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escription

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 Producer & Consumer Surplus

• Producer surplus (also called profit)

– The difference between the price charged (P) and the cost
to produce (C)
• Consumer surplus
– The difference between what you would have been willing
to pay (V) and what you paid (P)
• Both parties capture some of the value created

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 Exhibit 5.7 Competitive Advantage and
Economic Value Created

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escription

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 Opportunity Costs

• The value of the best forgone alternative use of the

resources employed
• Example: 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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 Limitations of Economic Value Creation

• Determining value for consumers is not simple.

• 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.

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 The Balanced Scorecard

• Helps managers achieve their strategic objectives

more effectively
• Uses internal and external performance metrics
• Balances both financial and strategic goals

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 Exhibit 5.8 The Balanced Scorecard Approach

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 Examples of Metrics for Each of the
Four Balanced Scorecard Questions

• How do customers view us?

– Revenue, profit, customer satisfaction
• How do we create value?
– Competitiveness, innovation, organizational learning
• What core competencies do we need?
– Core competencies, supporting business processes
• How do shareholders view us?
– Cash flow, operating income, ROIC, ROE, total returns to
shareholders

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 Advantages of the Balanced Scorecard

Managers can:
•Link the strategic vision to responsible parties
•Translate the vision into measureable goals
•Design and plan business processes
•Implement feedback and organizational learning
– Modify and adapt strategic goals

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 Disadvantages of the Balanced Scorecard

• Focused on strategy implementation

– Not formulation
• Limited guidance about which metrics to use
• Only as useful as the managers apply it
• Strategy must be translated into measurable
objectives
• Not much guidance on how to get back on track if
setbacks occur

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 The Triple Bottom Line

• Three dimensions fundamental to sustainable

strategy:
– Profits: The economic dimension
• The business must be profitable to survive.

– People: The social dimension

• Emphasizes the people aspect

– Planet: The ecological dimension

• Emphasizes the relationship between business and the natural
environment

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 Exhibit 5.9 Sustainable Strategy

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 Strategy Highlight 5.1

Interface: The World’s First Sustainable Company

•World’s largest manufacturer of modular carpet
•This industry typically has heavy reliance on fossil fuels
and chemicals.
•In 1994, they set a goal for 2020:
– No petroleum-based raw materials
– No oil-related energy
•Between 1996 and 2008
– Saved over $400 million due to its energy efficiency and
use of recycled materials

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 Business Models:
Putting Strategy into Action

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 What Is a Business Model?

• Details the competitive tactics and initiatives

• Explains how the firm intends to make money
• Stipulates how the firm conducts its business
– Buyers, suppliers, and partners

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 Strategy Highlight 5.2

Airbnb: Tapping the Value of Unused Space

•2 San Francisco friends
– Rented out space on the mattresses
– Served guests breakfast
•First mover in the peer-to-peer rental industry
•Unique accommodation offerings
•Spring 2015: valued at $20 billion

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 Popular Business Models

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

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 The Razor–Razorblade Model

• Initial product is often:

– Sold at a loss or
– Given away for free
• Helps drive demand for complementary goods
• Money made primarily on replacement parts
• Example: HP
– Charges little for its laser printers
– Imposes high prices for replacement toner cartridges

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 The Subscription Model

• Traditionally used for (print) magazines and

newspapers
• Users pay for access to a product or service
• Examples:
– Cable television
– Satellite radio
– Health clubs

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 The Pay-as-You-Go Model

• Users pay for only the services they consume

• Examples:
– Utilities providing power and water
– Cell phone service plans

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 The Freemium Model

• Free + premium business model

• Provides the basic features free of charge
• Users pay for premium services
– Such as advanced features or add-ons
• Examples:
– Software trials with an option to buy

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 The Wholesale Model

• The traditional model in retail

• Products sold at a fixed price to retailers
• Retailers mark up the prices to make a profit
• Example:
– Books are originally purchased from a publisher
– Re-sold at 50% markup from a retailer

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 The Agency Model

• Producer relies on an agent or retailer to sell the

product.
– At a predetermined percentage commission
• Producer may also control the retail price.
• Example:
– Entertainment industry
• Agents place artists or artistic properties.
• They then receive a commission.

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 The Bundling Model

• Products or services for which demand is negatively

correlated at a discount
• Example:
– The Microsoft Office Suite
• Instead of selling Word and Excel $120 each,
• Microsoft bundles them at a discount, say $180

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 Business Models Evolve Dynamically

• Business models can be combined.

• Business models can evolve.
• Business models can be disrupted.
• Businesses must respond to disruption & adapt.
• Legal conflicts can arise.

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 Implications for the Strategist

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 How Do We Measure and Assess Competitive Advantage?

• 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

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 Managerial Implications

• No best strategy exists – only better ones

• Competitive advantage is best measured by:
– Criteria that reflect overall business unit performance
– 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.

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 Chapter 5 Summary

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 Take Away Concepts (1 of 6)

LO 5-1 Conduct a firm profitability analysis using accounting data to assess

and evaluate competitive advantage.
•To measure competitive advantage, we must be able to (1) accurately assess firm performance,
and (2) compare and benchmark the focal firm’s performance to other competitors in the same
industry or the industry average.
•To measure accounting profitability, we use standard metrics derived from publicly available
accounting data.
•Commonly used profitability metrics in strategic management are return on assets (ROA), return
on equity (ROE), return on invested capital (ROIC), and return on revenue (ROR). See the key
financial ratios in five tables in the “How to Conduct a Case Analysis” guide.
•All accounting data are historical and thus backward-looking. They focus mainly on tangible
assets and do not consider intangibles that are hard or impossible to measure and quantify, such
as an innovation competency.

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 Take Away Concepts (2 of 6)

LO 5-2 Apply shareholder value creation to assess and evaluate competitive

advantage.
•Investors are primarily interested in total return to shareholders, which includes stock price
appreciation plus dividends received over a specific period.
•Total return to shareholders is an external performance metric; it indicates how the market views
all publicly available information about a firm’s past, current state, and expected future
performance.
•Applying a shareholders’ perspective, key metrics to measure and assess competitive advantage
are the return on (risk) capital and market capitalization.
•Stock prices can be highly volatile, which makes it difficult to assess firm performance. Overall
macroeconomic factors have a direct bearing on stock prices. Also, stock prices frequently reflect
the psychological mood of the investors, which can at times be irrational.
•Shareholder value creation is a better measure of competitive advantage over the long term due
to the “noise” introduced by market volatility, external factors, and investor sentiment.

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 Take Away Concepts (3 of 6)

LO 5-3 Explain economic value creation and different sources of

competitive advantage.
•The relationship between economic value creation and competitive advantage is fundamental in
strategic management. It provides the foundation upon which to formulate a firm’s competitive
strategy of cost leadership or differentiation.
•Three components are critical to evaluating any good or service: value (V), price (P), and cost (C).
In this perspective, cost includes opportunity costs.
•Economic value created is the difference between a buyer’s willingness to pay for a good or
service and the firm’s cost to produce it (V – C).
•A firm has a competitive advantage when it is able to create more economic value than its rivals.
The source of competitive advantage can stem from higher perceived value creation (assuming
equal cost) or lower cost (assuming equal value creation).

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 Take Away Concepts (4 of 6)

LO 5-4 Apply a balanced scorecard to assess and evaluate

competitive advantage.
•The balanced-scorecard approach attempts to provide a more integrative view
of competitive advantage.
•Its goal is to harness multiple internal and external performance dimensions to
balance financial and strategic goals.
•Managers develop strategic objectives for the balanced scorecard by
answering four key questions: (1) How do customers view us? (2) How do we
create value? (3) What core competencies do we need? (4) How do
shareholders view us?

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 Take Away Concepts (5 of 6)

LO 5-5 Apply a triple bottom line to assess and evaluate competitive

advantage.
•Noneconomic factors can have a significant impact on a firm’s financial performance, not to mention its
reputation and customer goodwill.
•Managers are frequently asked to maintain and improve not only the firm’s economic performance but also its
social and ecological performance.
•Three dimensions—economic, social, and ecological, also known as profits, people, and planet—make up the
triple bottom line. Achieving positive results in all three areas can lead to a sustainable strategy—a strategy that
can endure over time.
•A sustainable strategy produces not only positive financial results, but also positive results along the social and
ecological dimensions.
•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 in as serious a way as
they track its financial performance.
•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.

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 Take Away Concepts (6 of 6)

LO 5-6 Outline how business models put strategy into action.

•The translation of a firm’s strategy (where and how to compete for competitive
advantage) into action takes place in the firm’s business model (how to make money).
•A business model details how the firm conducts its business with its buyers, suppliers,
and partners.
•How companies do business is as important to gaining and sustaining competitive
advantage as what they do.
•Some important business models include razor-razorblade, subscription, pay-as-you-
go, and freemium.

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 Key Terms
• Balanced scorecard • Reservation price
• Business model • Risk capital
• Consumer surplus • Shareholders
• Economic value created • Sustainable strategy
• Market capitalization • Total return to shareholders
• Opportunity costs • Triple bottom line
• Producer surplus • Value
• Profit

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 Chapter 5 Cases & Exercises

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 Chapter Case 5: Consider This… (1 of 2)

• Microsoft is now in turnaround mode.

– Prior focus: windows-only business model
– New focus: “mobile-first, cloud-first”
• Main changes:
– Office suite now available on Apple iOS / Android
– Office 365 available as a subscription service
– Software can be accessed on any device.

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 Chapter Case 5: Consider This… (2 of 2)

• Why is it so hard to gain a competitive advantage?

• Does Apple have a competitive advantage over
Microsoft?
• Do you agree that Nadella has formulated a
promising strategy?
• How much longer do you think Apple can sustain its
competitive advantage?

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 My Strategy Exercise
What Is My Competitive Advantage?

• What are your strengths and weaknesses?

• What are you doing to ensure your capabilities are
dynamic?
– Skill upgrades, behavior modifications, etc.
• Are some of your strengths valuable, rare, and costly
to imitate?
• How could you persuade your boss that you could be
a vital source of sustainable competitive advantage

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 Small Group Exercise #1

• Create a balanced scorecard for the business school

at your university.
– Customer, innovation/learning, internal business, financial
• Questions to ask within your group:
– How do customers view us?
– How do we create value?
– What core competencies do we need?
– How do shareholders view us?

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 Small Group Exercise #2

• Prepare an informal 2-minute speech.

• Objective:
– Be persuasive
– Convince others that the triple-bottom-line approach is the
modern path to stronger economic performance.
• Materials to help:
– “The Bottom Line of Corporate Good” published in Forbes

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 End of Chapter 5

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 Strategy Smart Videos

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 Strategy Smart Videos (1 of 6)

• Robert S. Kaplan, Professor Emeritus at Harvard

• Communicating Strategy with the Balanced Scorecard
• Link:
– https://www.youtube.com/watch?v=QM9SLX4icu0
• 3:23 Minutes

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 Strategy Smart Videos (2 of 6)

• Dr. Karl-Henrik Robèrt

– One of Sweden's foremost cancer scientists
– Founder of The Natural Step, a non profit organization
• Sustainability, The Triple Bottom Line
• Link:
– https://www.youtube.com/watch?v=VvFRB7HuLgo
• 2:20 Minutes

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 Strategy Smart Videos (3 of 6)

• Investopedia
• How To Calculate Return On Investment (ROI)
• Link:
– https://www.youtube.com/watch?v=eoAR8ZyAyoc
• 1:31 Minutes

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 Strategy Smart Videos (4 of 6)

• Consumer and Producer Surplus

– Further explained
• Link:
– https://www.youtube.com/watch?v=jNdXt5GqoMI
• 3:22 Minutes

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 Strategy Smart Videos (5 of 6)

• Dollar Shave Club

• An example of the Razor-Razorblade business model
• Link:
– https://www.dollarshaveclub.com/
• 1:33 Minutes

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 Strategy Smart Videos (6 of 6)

• Airbnb Commercials
• Mentioned in Strategy Highlight 5.2
• Links:
– https://www.youtube.com/watch?v=sgQzE8gMdek
– https://www.youtube.com/watch?v=dA2F0qScxrI
• Each is 1 - 2 Minutes

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 Chapter Case 5

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 Chapter Case 5: Apple vs. Microsoft (1 of 2)

• Apple and Microsoft: fierce rivals since the ‘70s

• Microsoft was the early leader:
– Set the standard in personal computers
– 90% of all PCs run Windows
– Office Suite includes Word, Excel, PowerPoint, etc.
– Implemented a successful approach for Corporations
• E-mail systems, databases, and business applications
– By 2000, Microsoft was the most valuable company
globally
• $510 billion in market capitalization

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 Chapter Case 5: Apple vs. Microsoft (2 of 2)

• Apple overtook Microsoft

– At Microsoft’s peak, it had only 5% of the market
• Near bankruptcy in 1997
– Underwent a revitalization
• 2001: iPod released
• 18 months later: iTunes released / retail stores open
• 2007: iPhone released
• 2010: iPad released
• 2015: iWatch
– Fall 2012: most valuable company in the world
• Market capitalization: $620 billion
• Competitive advantage is dynamic

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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.”

Return to slide

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 Appendix 2 Exhibit 5.1 Comparing Apple and Microsoft:
Drivers of Firm Performance

On the left is a box that says ROIC, 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: COGS/Revenue, R&D/Revenue, SG&A/Revenue.
Working Capital Turnover points to four boxes that say: Fixed
Asset Turnover, Inventory Turnover, Receivables Turnover,
Payables Turnover.

Return to slide

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 Appendix 3 Exhibit 5.4 Firm B’s Competitive Advantage:
Same Cost as Firm A but Firm B Creates More Economic Value

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 – $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)
for Firm B over Firm A.

Return to slide

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 Appendix 4 Exhibit 5.5 Firm C’s Competitive Advantage:
Same Total Perceived Consumer Benefits as Firm D, but Firm C Creates More
Economic Value

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 – $300) than that of Firm B ($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, 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.

Return to slide

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 Appendix 5 Exhibit 5.7 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).

Return to slide

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