Daniela Venanzi

Criticism of the Accounting-Based Measures of Performance

The traditional accounting-based metrics are not consistent with value creation and do not handle any of the four factors (i.e. investments, cash flows, asset’s economic life and cost of capital) on which value depends. Therefore, managing for short-term earnings compromises shareholder value. In this chapter, the fundamental shortcomings of the accounting-based metrics are discussed, focusing on the following aspects: subjectivity of the accounting figures, inconsistency with the goal of maximizing shareholder wealth, and short-termism of managerial decisions.

Competing Financial Performance Measures

The choice of financial performance measures is one of the most critical challenges facing organizations. Performance measurement systems play a key role in developing strategic plans, evaluating the achievement of organizational objectives, and rewarding managers. The measurement of financial performance in terms of accounting-based ratios has been viewed as inadequate, as firms began focusing on shareholder value as the primary long-term objective of the organization. Hence, value-based metrics were devised that explicitly incorporate the cost of capital into performance calculations. In this chapter, the following value-based measures are discussed, by focusing on their measurement logic: the economic value added (EVA), the cash flow return on investment (CFROI), the shareholder value added (SVA), the economic margin (EM) and the cash flow value added (CVA). The recently emerging emphasis on market value-based measures as the best metrics for value creation is also briefly analyzed.

Financial Performance and Sustainability of Strategy

Performance measurement plays a key role in developing and implementing strategic plans and evaluating the achievement of firm’s objectives, with crucial implications on rewarding managers and providing them the correct incentives. As firms began focusing on shareholder value as the primary long-term objective of the organization, the measurement of a strategy’s financial performance uses value-based metrics that explicitly incorporate the cost of capital into calculations. In this chapter, the most important value-based measures are discussed and compared, by focusing on their measurement logic and highlighting their differences and similarities. Their application in measuring the value creation of a strategy, developed consistently with the Strateco Dashboard approach, is therefore presented. Finally, the financial sustainability of a strategy is discussed, presenting the most widespread models that connect potentially conflicting strategic objectives such as profitability and growth.

Corporate Strategy: Diversification and Management of Multiple SBUs

This chapter, integrating more in depth the issue of corporate strategy, i.e. the company’s presence in multiple businesses, briefly discussed in the first book of this series, addresses the various forms of diversification that can shape the development of that presence over time, their advantages and disadvantages, and their implications for management. Specifically, it describes the most relevant differences among the main configurations of diversification (vertical, horizontal, geographic, and unrelated), and addresses in particular, with the support of several conceptual and operational models, the issue of geographic differentiation, that is becoming more and more important for most companies, constrained by the stagnation of their domestic markets. Finally, through a description of a simplified business simulation, it attempts to show how companies could manage, in practice, one of the most relevant strategic problems, i.e. the selective allocation of scarce resources among and within different businesses.

Organization, Ownership and Collaboration Strategies

This chapter analyzes the companies’ organizational and structural design, starting from the basic organizational structures that represent the firm’s architecture. Then, we highlight the essential elements for designing or upgrading an organizational structure, such as the division of labor, the coordination mechanisms, and the formation of organizational units. We also discuss how strategic choices and changes can affect structure, technology, human resources policies and interorganizational linkages. At the same time, we analyze how the current organizational contexts may affect and constrain the definition of goals and the related strategic decisions and changes. Finally, we address the issues of ownership versus transaction alternatives, and the various forms of agreements and cooperation among firms.

Introduction to the Second Volume

The first part of this second volume addresses more specifically the issue of “business strategy” (within a single strategic business unit), expanding the analysis of the strategic decisions, emphasizing the importance of a sustainable competitive advantage, and proposing an integrated conceptual and operational framework (the “Strateco Dashboard”), that complements and significantly improves the recent and well-known Blue Ocean approach to strategy development.

Business Strategy: Formulation, Development and Control

Focusing on the major issues related to strategic management of a single strategic business unit (SBU), the first part of this chapter will discuss the most relevant aspects that should be addressed in strategy formulation. After an overview of different perspectives on the behavioral process that conducts to the formation of strategies, we will then focus our attention on the importance of creating and maintaining a competitive advantage. We will finally present a systematic logical and operational framework for conceiving, developing and controlling a sound strategic plan that integrates and complements the famous Blue Ocean approach to strategy development.

External and Internal Analysis of the Environment

The environmental analysis is a precondition for the formulation of an effective strategy that can generate a competitive advantage. Its purpose is to identify strategic forces that may determine the present and future success of a company. In this chapter we present the basic concepts and tools for the study of the firm’s external and internal environment, with particular regard to the macro-economic environmental factors, the industry’s competitive forces and the firm’s internal strategic resources, capabilities and competencies.

Concluding Remarks: Strengths and Weaknesses of the Economic Value Measures

In this chapter some concluding remarks are given in order to summarize the main similarities and differences among the economic value measures analyzed in the previous chapters. Their strengths and weaknesses are discussed from the following standpoints: pitfalls in calculation, (in)consistency with value creation, pointing out the potential games which each metric can induce in managerial behaviors, and adequacy for managerial compensation in terms of clearness and verifiability.

The Metrics War

Consulting firms have been battling for the last two decades over the superiority of their value metrics, charging that competitors’ measures have flaws that compromise their evaluation ability. On the other hand, a growing number of firms have adopted various economic measures, moving from one metric to the other over the years, and often abandoning all of them in favor of traditional accounting measures. However, despite the increasing emphasis on these value measures, no definitive evidence exists of which metric works better than others, and research on the extent to which any of them is superior to the traditional accounting measures is limited and not yet univocal. In this chapter, we analyze the different economic value measures, by adopting different perspectives, from which their respective effectiveness can be evaluated: association with market financial performance, consistency with the discounted cash flow (DCF) approach in measuring value creation, and implications on managerial incentives. Metrics are compared from both a theoretical and an empirical standpoint, providing an updated synthesis of the main international evidence on their effectiveness.