1. Answer these questions for chapter 2 (in 1 page) and chapter 5 (in 1 page)
1Find a key concept in the chapter lecture readings. Briefly explain it. (20 points)
2. Why have you picked this concept among others? (20 points)
3. Find a real company example related to the concept you explained in question 1 and share it with me. You can share the link if available, or copy-paste the content by providing the full citation. (20 points)
4. Apply the key concept you have chosen to this company example. In what ways does this example explain the concept well? (40 points
Microsoft Word - Chapter 2 Measuring Competitive Advantage_Prof Lecture Notes_Spring2022.docx 1 Chapter 2: Measuring Competitive Advantage Lecture notes by Dr. Ipek Koparan (Please do not distribute this document) As you know, we talked a lot about competitive advantage. What is it? How can it be gained and sustained? But we haven’t answered one of the most relevant questions about competitive advantage. How do we know that we have a competitive advantage? Equally saying, how do we measure competitive advantage? As we have talked many times before our main purpose is to be different from other firms in some good way. It is the state of having superior performance than others. But how do we know that our firm or other firms in the industry gain a competitive advantage? We need to be able to measure competitive advantage in some way. To have an insight on how we are doing compared to others and the industry average, we can measure our and others’ performance and compare these performance metrics. Thus, we technically are talking about how firm performance can be measured. We may measure our performance and compare it with rivals, and we nicely figure out that we are actually doing better than the rivals. Then, what? Why are we interested in learning whether we gain a competitive advantage vis a vis industry actors or not? Why is it important to measure our performance? As Peter Ducker wisely says “what gets measured gets done. To know how well you are doing, in what aspects of performance constituents you are doing better or worse than rivals, what are your future expectations about improvement opportunities or deterioration threats in these constituents, and many more questions about your current and future performance impact your performance. Without knowing where you are, where are you are headed to, and what destinations you can take, you may not be able to get there in the end. The following question then becomes: what are the relevant metrics to measure firm performance? There are a handful of methods and frameworks that you can use to measure your and your rivals’ performance. • Three traditional frameworks: • Accounting profitability. • Shareholder value creation. • Economic value creation. • Two integrative frameworks: • Balanced scorecard. • Triple bottom line. The three traditional quantitative methods that have been widely used and accepted are accounting profitability, shareholder value creation, economic value creation. More holistic ways to measure firm performance by integrating both quantitative and qualitative assessments are a balanced scorecard and the triple bottom line approaches. 2 Accounting Profitability Accounting profitability is the standardized financial metrics that you can derive from publicly available data such as income statements and balance sheets. You calculate profitability ratios such as ROIC (Return on invested capital), ROE (Return on equity), ROA (Return on assets), and Return on Revenue (ROR) for your firm and your rivals so you can assess how well you are doing on what. Source: Rothaermel, Strategic Management, 5th Edition Let’s look at the accounting data of the two long-held rivals: Microsoft and Apple. Return on invested capital is the first one to check. ROIC is basically how much you earn from your investments. What is the amount of return you generate out of one dollar of capital invested? Apple earns 1.17 dollars per for every dollar its capital providers have invested in Apple. On the other hand, Microsoft generates returns of 1.09 dollars for one dollar its stockholders and debt providers have invested in Microsoft. Apple clearly outperforms Microsoft in terms of how effectively it uses its total invested capital. To understand how Apple achieves this superior performance over Microsoft, we need to go into the details of this measure. ROIC consists of two components: Return on Revenue and Working capital turnover. Return on revenue (ROR) indicates how much of the firm’s sales are converted into profits. Both companies’ ROR figures are very close to each other around 16 percent. For every $100 in revenues, both Apple and Microsoft earn $16 in profit. However, we need to be aware that Apple is actually doing better in terms of total sales. It generates revenues double the amount that Microsoft generates. 3 As we investigate the differences in ROR further, we will discover that Apple has a higher cost structure than Microsoft and that Microsoft is able to charge a much higher margin for its products and services than Apple. Even though Apple is more than two times as large as Microsoft in terms of revenues, it spends much less on research and development or on marketing and sales. Both help Apple reduce its cost structure but still, Microsoft is doing better in terms of its cost of goods sold. This is probably because Microsoft is in the software business with lower manufacturing costs than Apple whose 60% of revenues come from a hardware device- namely, the iPhone. R&D / Revenue indicates how much of each dollar that the firm earns in sales is invested to conduct research and development. A higher percentage is generally an indicator of a stronger focus on innovation to improve current products and services. Interestingly, Apple’s R&D is much less intense than Microsoft’s. Apple spent 5.4 percent on R&D for every dollar of revenue, while Microsoft spent almost four times as much. For more than a decade now, Microsoft has generally spent the most on R&D in absolute terms among all technology firms. The ratio of sales, general and administrative expenses to the revenues is an indicator of how much priority the company gives to marketing and sales. Microsoft is way ahead of Apple on this indicator because Microsoft is rebranding its software products through increased cloud services in its business portfolio. Working capital turnover shows how effectively the capital is used to generate revenue. This part is where Apple outperforms Microsoft. Apple generates 107 dollars for every 100 dollars it invests in its business. However, Microsoft is well below this amount. It only generates 55 dollars for every invested 100 dollars of capital. Apple outperforms Microsoft in many of working capital turnover constituents, Apple ties up its 5% of working capital to generate revenue whereas Microsoft uses its 130% of working capital to generate revenue. Such a huge difference in the efficient use of working capital. One possible reason for Apple’s efficient use of its working capital is that it outsources its manufacturing activities in China. It does not perform the manufacturing itself, so it does not bear the manufacturing-related costs- facilities, personnel, and the like. However, being dependent on another company on iPhone production given that 60% of Apple’s total revenues are coming from iPhone, is a risky business. Consistent with this logic, plant property and equipment to revenue ratio also indicates that Apple is more efficient in producing its products. However, Microsoft is in a transition process. It makes significant investments in its cloud services. It has been building up mega data centers with huge data storage capacity. So, this signals that Microsoft invests in its future revenues. Overall, accounting data will let us assess the components of profitability. Red flags, strong features, or reasons for failure. These are publicly available data and as managers, you can find your weaknesses over your competitors by making a comparison of these ratios. Then you can formulate strategies to increase your company’s profitability. For example, what should Microsoft do by looking at this picture? -Reworking the cost structure? -R&D dollars can be spent more effectively -Although marketing and sales expenses are too high, it may need to decide if this much marketing spending is necessary to rebuild the brand image with a new focus on mobile and cloud computing. 4 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 and customer experience are important. There are some limitations of accounting data that we need to be aware of. Although the past may show the success capacity of a firm, the business environment is dynamic and past success is not a guarantee for future success. The opposite is also true. A past failure doesn’t necessarily make you lose in the future. By 2000, Microsoft was the most valuable company globally with $510 billion in market capitalization. On the other hand, at roughly the same time, Apple was struggling to survive and almost went bankrupt in 1997. iPod’s introduction to the market in 2001 made it revitalize. By the end of 2012, Apple became the most valuable company in the world with 620 billion dollars market capitalization. If you as an investor looked at Apple’s accounting data in 1997, you would not have been willing to buy its shares. Because Accounting data does not tell you anything about the future potential of Apple. Also, accounting data do not consider off-balance sheet items, such as leasing obligations. For example, two competitors in the same industry may have different asset structures. One leases its stores while the other owns them. So, the return on assets ratio does not reflect the asset structure and is not a good indicator to compare these two companies. Last, some very valuable intangible assets are not recorded and reported in accounting sheets such as innovation. For example, Tesla has a unique capability in producing electric cars, yet you cannot see it in the balance sheet. Source: Rothaermel, Strategic Management, 5th Edition 5 The above graph shows the declining importance of tangibles on a firm’s market valuation since 2000. In 1980, 80% of a firm’s market value was determined by its book value. But today, this is almost the opposite. Today, a firm’s market value is mostly determined by intangibles that are not included in accounting records. This