BA449 - Chap005 - Fall 2020

Chapter 5: Competitive Advantage,
Firm Performance, and

Business Models
2
Chapter 5: Case Highlight

Apple vs. Microsoft
• Apple and Microsoft: fierce rivals since the 1970’s

• 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
Copyright © 2017 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution
in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Apple vs. Microsoft
• Microsoft is now in turnaround mode.

– Prior focus: windows-only business model
– New focus by Microsoft’s CEO,
Satya Nadella: “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.
Apple vs. Microsoft
• Apple has dominated the market in the decade

since the introduction of the iPhone in 2007.
• By the fall of 2018, Apple was the first company to

ever be valued at more than $1 trillion. However, by
the spring of 2019, its market capitalization had
fallen more than 21% (approximately $230 billion).
From 2009 to 2019, Microsoft’s market cap had
risen from a low of $145 billion to over $880 billion –
an increase of almost 500%.
Apple vs. Microsoft
• The comparison of Apple and Microsoft over time

shows that competitive advantage is transitory.
Given the rough and tumble competition combined
with relentless technological progress and
innovation, it is hard to gain a competitive
advantage in the first place, and it is even harder
to sustain it.
How Do We Measure Performance?
• “The strategic aim of a business is to

earn a return on capital, and if in any
particular case the return in the long run
is not satisfactory, then the deficiency
should be corrected or the activity
abandoned for a more favorable one.”
 Alfred P. Sloan
My Years with General Motors
5–6
2-20
Tradeoff Between Profitability

and Growth Rate
PMAX
Profitability
P1
P2
G0 G1 G2
Growth Rate
Copyright  1998 by Houghton Mifflin Company. All rights reserved.

8
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)
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.
Comparing Google and Microsoft on Different Dimensions
Performance viewpoint changes significantly when the

measurement changes from absolute to per-employee
figures (on the bottom)
5–9
Profits vs. Return on Revenue (ROR)
Ranking changes markedly with

the use of different metrics
2010 Profits in $M
2010 ROR %
5–10
Drivers of Firm Performance
Exhibit 5.1
Source: Analysis of publicly available data.
© McGraw Hill
12
Limitations of Accounting Data
• All accounting data are historical and thus

backward-looking (in rear-view
mirror)
• 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.
The Declining Importance of Book Value in a
Firm’s Stock Market Valuation, 1980–2015
Exhibit 5.2
Source: Analysis and
depiction of data from
Compustat, 1980–2015
© McGraw Hill
Linking
LinkingValue
ValueDrivers
Drivers to
to Performance
Performance Targets
Targets
Order Size
Customer Mix
Sales
Sales Sales/Account
Targets
Targets Customer Churn
Rate
cogs/
cogs/
Margin
Margin Deficit Rates
sales
sales
Cost per Delivery
Development Maintenance cost
Shareholder Development New product
Shareholder Cost/Sales
value Cost/Sales development time
value ROCE
ROCE
creation
creation Indirect/Direct
Labor
Inventory
Inventory Customer
Economic
Economic Turnover
Turnover Complaints
Profit
Profit Downtime
Capital
Capital Capacity
Turnover Capacity
Turnover Utilization Accounts Payable
Utilization
Time
Cash
Cash Accounts
Turnover
Turnover Receivable Time
CEO Corporate/Divisional Functional Departments & Teams

14
15
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
Stock Market Valuations of Microsoft and
Apple (in $ billion), 1990–2019
Exhibit 5.3
Source: Depiction of publicly available data
© McGraw Hill
17
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 (e.g., “Irrational exuberance”)
Firm B’s Competitive Advantage: Same Cost as
Firm A but Firm B Creates More Economic Value
Exhibit 5.4
© McGraw Hill
Firm C’s Competitive Advantage: Same Total
Perceived Consumer Benefits as Firm D but
Firm C Creates More Economic Value
Exhibit 5.5
© McGraw Hill
The Role of Consumer Surplus and
Producer Surplus (Profit)
Exhibit 5.6
© McGraw Hill
Competitive Advantage and Economic Value
Created: The Role of Value, Cost, and Price
Exhibit 5.7
Source: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.
© McGraw Hill
Economic Value Creation
• Pizza!
• Value: A dollar amount a
consumer is willing to pay • Value = $12
for a good or service • Price = $10
• Cost = $7 SOLD!
• Price: The dollar amount a
good or service is offered
for sale • Consumer Surplus
 $12 - $10 = $2
• Cost: The dollar amount to • Producer Surplus
make the good or service  $10 - $7 = $3
• Economic Value
 $12 - $7 = $5
5–22
Capital Market Approaches To Measuring Performance
• Market Value Added (MVA)

 Market Value less Total Investment
• Economic Value Added (EVA)

 Operating Profit (after tax) less annual capital costs; basically,
this is economic profit
• Tobin’s q (Market Value/Book Value)

 A firm’s market value divided by its “replacement” cost
• The Market Value of the Firm -

 Current Value of all securities issued by the firm
23
Economic Value Added (EVA)
• Anheuser-Busch: Operating profit $1,756 million -

taxes $617 million = $1,139 million
• WACC : 67% equity at 14.3%

33% debt at 5.2%
11.3% WACC
Capital of $8 billion
11.3% * $8billion = $904 million
$1,139 - $904 = $235 million EVA
24
How
How U.S.
U.S. Companies
Companies Perform
Perform Under
Under
Different
Different Profitability
Profitability Measures,
Measures, 1998
1998
Net Inc. ROS ROE EVA Market Return to

Value Added Shareholders
($m) (%) (%) ($m) ($m) (%)
General Motors 2,956 1.8 19.7 -5,525 -17,943 21.4
General Electric 6,573 9.4 22.2 4,370 285,320 45.3
Exxon 6,370 6.3 14.6 -2,262 114,774 22.4
Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8
IBM 6,328 7.7 32.6 2,541 -5,878 77.5
Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3
Wal-Mart 4,430 3.2 21.0 1,159 159,444 107.7
Procter & Gamble 3,780 10.2 12.2 61,661 102,379 15.9
Microsoft 4,490 31.0 27.0 3,776 328,257 37.5
Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7
25
Sustainable Competitive Advantage and the
Measurement of Performance
• While we have said that the objective of strategy is to
“create competitive advantage,” specifically we have
the goal to maximize economic return.
• Economic & Accounting Discounting Cash Flows

Measures of Performance Horizon
 Economic Profits CF1 CF2 CF3
… +
CFt Valuet+1
NPV = 1+r + (1+r)2 + (1+r)3 + (1+r)t + (1+r)t+1
 ROA, ROE, ROC
NPV: Net Present Value
CFt: Cash Flow at time t

r: Discount rate
• Financial Measures Horizon Value: Value of of
Performance ongoing enterprise after time t
 NPV Methods
26
Financial Measures of Performance: NPV or DCF Analysis
• The principle of discounted cash flow (DCF) analysis that

firms apply to their individual projects can also be applied
to the firm as a whole. Maximizing the net present value
of the firm’s cash flow (“sustainable competitive
advantage”) corresponds to maximization of its stock market
valuation and hence maximizes the wealth of its
shareholders.
5–27
Net Cash Flow
• EBT - t (EBT)
• EBT (1-t) = NET INCOME
• EBT (1-t) + depreciation - capital expenditures =
NET CASH FLOW

 (note we are assuming no change in accounts receivable, no
change in net working capital, no change in inventory)
• Equivalent concepts:
 Maximize NPV
 DCF Approach
 Maximize Economic Profits (EVA)
 Sustainable Competitive Advantage (SCA)
Limitations of Present Value Measures
• Projections are only as good as the ability of managers to

measure accurately the financial consequences of actions.
• An implicit assumption of value-based strategy was that

business units and all investment proposals were self-
contained. It was usually expected that divesting a business
or curtailing an investment project would have no financial
repercussions elsewhere in the corporation (e.g., ignores
knowledge transfers).
• Strict financial measurement of many long-term

investments, particularly in intangible assets,
is virtually impossible .
29
Limitations of Present Value Measures
• Investments in R&D typically do not offer direct returns; their

economic value is a strategic option to invest in new products
and processes that may arise from R&D. Narrowly-defined
DCF does not accurately value investments where there is
significant strategic options value.
 (Merck has been at the forefront of applying

strategic options theory to analyze
investments in R&D).
Balanced-Scorecard Approach to Creating and
Sustaining Competitive Advantage
Exhibit 5.8
© McGraw Hill
The Four Perspectives of the Balanced Scorecard
Perspective Assessed through analysis of:
EVA
Financial Profitability
Growth
Differentiation
Customer Cost
Quick Response
Product Development
Operations Demand Management
Order Fulfillment
Leadership
Organizational Organizational Learning
Ability to Change
Slide 4-5
Exh. 4.8
Irwin/McGraw-Hill 32
© The McGraw-Hill Companies, Inc., 1998
Limitations of the Balanced Scorecard
Focused on implementation
•Does not provide criteria for strategy formulation
•How to get back on track if deviations occur.
Lacks guidance: The Four Perspectives of the Balanced Scorecard
Perspective Assessed through analysis of:
•Which metrics to use?

EVA
Financial Profitability
Growth
•How to address setbacks?

Differentiation
Customer Cost
Quick Response
Product Development
Operations Demand Management
Order Fulfillment
Leadership
Organizational Organizational Learning
Ability to Change
Slide 4-5
Exh. 4.8
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998
© McGraw Hill
34
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
35
Strategy Highlight 5.1

PepsiCo’s Indra Nooyi: Performance with Purpose
• As CEO of PepsiCo from 2006 to 2018, Indra Nooyi,

led the company to reach $65 billion in annual
revenues in 2018, and over $160 billion in stock
market valuation, and close to 270,000 employees
worldwide
• Performance with Purpose:

– Human Sustainability
– Environmental Sustainability
– The whole person at work
• Be a place to make a living an make a life
Business Models:
Putting Strategy into Action
Strategy Highlight 5.2
Threadless: Leveraging Crowdsourcing
to Design Cool T-Shirts
1–37
38
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
39
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
40
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
41
The Pay-as-You-Go Model
• Users pay for only the services they consume

• Examples:
– Utilities providing power and water
– Cell phone service plans
– Cloud computing such as Microsoft Azure
42
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
– New York Times and Wall Street Journal
43
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
44
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.
45
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
46
Business Models Evolve Dynamically
• Business models can be combined.
• Business models can evolve.
• Business models can be disrupted.
• Businesses must respond to disruption and adapt.
• Legal conflicts can arise.

Evolving Business Models of Google and Microsoft
Multi-point Competition
Microsoft
Operating
Operating Software
Software Online
Online
Systems
Systems Apps
Apps Search
Search
Google
The Why, What, Who, and How of
Business Models Framework
Exhibit 5.10
Source: Adapted from
Amit, Raphael and Zott,
Christoph. “Creating
value through business
model innovation.” MIT
Sloan Management
Review 53, no. 3 (2012):
41–49.
© McGraw Hill
Putting Performance in Perspective
Narrow
Stakeholder Perspective
Share Price
Accounting Profit
Past Future
Economic Profit Survival DCF
Balanced Scorecard
Stakeholders View
Broad
Stakeholder Perspective
49

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Chapter 5: Competitive Advantage,

Firm Performance, and

Chapter 5: Case Highlight

• Apple and Microsoft: fierce rivals since the 1970’s

• Microsoft is now in turnaround mode.

• Apple has dominated the market in the decade

• By the fall of 2018, Apple was the first company to

• The comparison of Apple and Microsoft over time

• “The strategic aim of a business is to

Tradeoff Between Profitability

Copyright  1998 by Houghton Mifflin Company. All rights reserved.

• Helps assess competitive advantage:

Performance viewpoint changes significantly when the

Ranking changes markedly with

Limitations of Accounting Data

• All accounting data are historical and thus

• Accounting data do not consider

• Accounting data focus mainly on tangible assets, which

CEO Corporate/Divisional Functional Departments & Teams

Shareholder Value Creation

Limitations of Shareholder Value Creation

• Stock prices can be highly volatile.

• Macroeconomic factors affect stock prices.

• Stock prices can reflect the mood

• Market Value Added (MVA)

• Economic Value Added (EVA)

• Tobin’s q (Market Value/Book Value)

• The Market Value of the Firm -

• Anheuser-Busch: Operating profit $1,756 million -

• WACC : 67% equity at 14.3%

Net Inc. ROS ROE EVA Market Return to

• Economic & Accounting Discounting Cash Flows

CFt: Cash Flow at time t

• The principle of discounted cash flow (DCF) analysis that

NET CASH FLOW

• Projections are only as good as the ability of managers to

• An implicit assumption of value-based strategy was that

• Strict financial measurement of many long-term

• Investments in R&D typically do not offer direct returns; their

 (Merck has been at the forefront of applying

•Which metrics to use?

•How to address setbacks?

The Triple Bottom Line

• Three dimensions fundamental to sustainable strategy:

– Profits: The economic dimension

– People: The social dimension

– Planet: The ecological dimension

Strategy Highlight 5.1

• As CEO of PepsiCo from 2006 to 2018, Indra Nooyi,

• Performance with Purpose:

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

The Razor – Razorblade Model

• Initial product is often:

The Subscription Model

• Traditionally used for (print) magazines and newspapers

• Users pay for access to a product or service