Students

Chapter 2

Chapter Outlines

Understanding Organizational Performance

Chapter 2 discusses the importance of performance to a firm, as well as the different factors and tools that go into measuring and predicting performance. It also examines the different cultures and environments businesses are subject to that can make gauging their performance more difficult than simply comparing and contrasting with other firms.

Understanding Organizational Performance

Businessdictionary.com Definition of Performance

Performance is the crux of strategic management. The ultimate goal of any business is to perform well, and businesses are judged by outsiders based on their past and present performance. Thus, it is vital in the process of strategic management to understand the true nature of performance.

Value as a Measure of Performance

Businessdictionary.com Definition of Value

Business Valuation: Three Approaches to Measuring Business Worth
Three ways to measure the approximate worth of a business

Value is one of the key factors to judging performance. The value of a business, however, is more than just the sum of its parts. Value is mostly focused on the future, or potential of a business. Value is also a very subjective measurement, and thus far from failsafe.

Profitability as a Measure of Performance

Businessdictionary.com Definition of Profit

The Social Responsibility of Business is to Increase its Profit
Milton Friedman article discusses the critical nature of profit in business

Profit is another important factor in performance, as profit is the end goal of any business venture. However, it can also be problematic in predicting performance as it can only tell you how a business has done, not how a business will do. There are also many different ways profits are reported and recorded from business to business, making them difficult to interpret. Profits may easily be misrepresented to either under or overvalue a firm in order to deceive investors, employees, or competitors. It is also inaccurate to assume management is good or bad based simply on a firm's profits as it may reflect popularity, or profit trends within the individual industry.

Performance over Time

Marketing Lessons from K-Mart
Kevin J. Clancy reveals how lacking a marketing strategy led to K-Mart's filing for bankruptcy

IBM Struggles to Slim Down as the Competition Heats Up
A 1991 Milwaukee Journal article recalls IBM's struggles to adapt with a changing computer market

A Final Accounting
Four part series reported by Delroy Alexander, Greg Burns, Robert Manor, Flynn McRoberts and E.A. Torriero documenting Arthur Andersen's decline

The Icarus Paradox
Danny Miller's article explaining how successful companies can be their own worst enemies

Performance is an ongoing pursuit. Firms cannot be satisfied with momentary success, or they may grow complacent and lose the edge which originally gave them a competitive advantage. Companies such as K-Mart, IBM, and Arthur Andersen are great examples that once dominated their respective industries, but have since lost footing. Danny Miller compares this fall from grace to that of Icarus in Greek mythology. Firms cannot rest on their success.

Performance from a Variety of Perspectives

Altman's Z Equation Breakdown and Explanation

Tobin's Q Equation Breakdown and Explanation

EVA: Introduction
David Harper of Investopedia.com gives a detailed overview of the EVA equation

Because no one factor can accurately measure a firm's performance, multiple sources must be used. Three measures commonly used are Altman's Z, Tobin's q, and Economic Value Added (EVA).

Altman's Z is designed to formulate a score which will predict the probability of failure within a firm. It can be very accurate in predicting a business' failure or success years in advance. The problem with this measurement is its reliance on information that could be inaccurate.

Tobin's q is designed to predict the value of a firm's intangible assets based on their future earning capacity. This can be a valuable tool as it helps take into consideration factors outside of the basic book value of a firm. This measurement's trouble is the factors in its equation are based on estimations not easily calculated.

EVA is a very powerful tool because it takes into account the cost of capital to a firm. It can help a manager predict whether or not a venture will truly be profitable to a business or not. It is, however, the most complicated of the three to calculate, and is based on some predicted factors that are difficult to accurately determine.

It is easy to become too focused on these and other measurements and their results. While they are all very useful in predicting performance, firms can misuse resources predicting and analyzing in order to meet expectations rather than focusing on future growth.

Performance in Context

The Purpose Driven Business
John Jantsch of Businessknowhow.com explains the importance of purpose in a business

Made in Germany: The Porsche Success Story
Al Bawaba explains Porsche's endured success

Chik-fil-A's Recipe for Success
In this video, Truett and Dan Cathy talk to Fox about the success of their business

The Global Success of Starbucks
About the Money's report on Starbucks' success

Whenever measuring performance one must set a realistic benchmark for an individual firm. Comparing one firm to another in the same industry is a much more accurate indication of performance than comparing it to a firm in an industry where profit is generally much higher or lower. Even in one industry, however, two firms may operate entirely differently, thus skewing a comparison between the two.

The historical context of a firm can also provide good insight into its performance. Is it trending upwards or downwards based on previous years?

Perhaps the most important measurement of a firm's success is its own purpose. If it meets its purpose, then no profit can be seen as too small because the firm did what it set out to do. Porsche, Chick-fil-A, and Starbucks are fine examples of companies who choose to leave profits on the table in pursuit of their ultimate company purpose, and thus cannot be seen as being less successful based only on the lost profits.

Taking Stock of Performance

There are many different parameters and factors to take into account when judging the performance of a firm. The key to good strategic management is recognizing these factors and knowing what type of measurements to employ accordingly. Performance is an ongoing, ever-changing thing. The pursuit of good performance then too must be ongoing and ever-changing.

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Key Terms

Altman's Z

A measure of financial performance that was developed as a tool to identify firms in danger of bankruptcy. The measure itself weights five common financial ratios to produce an index of overall financial health.

Economic Value Added

A measure of financial performance incorporating both accounting measures of profitability and the firm's overall cost of capital. The result is a measure that reflects economic profit or the return over the minimum required by investors.

GAAP, or “generally accepted accounting principles,”

Refers to the set of rules and guidelines that govern how accountants should record and report financial information. The GAAP framework is established and maintained by the FASAB — the Federal Accounting Standards Advisory Board.

Privately held firms

Those whose ownership stock is not traded publicly or listed or traded on any public exchange.

Publicly held firms

Those whose ownership stock is available to the public and is listed and traded on a public exchange.

Stakeholder

An individual or a firm holding a stake in an organization's future and performance. The term usually implies a set of interests beyond those that are purely economic, as would be characteristic of absentee stockholders.

Tobin's q

A measure of financial performance and is the ratio of the market value of a firm, divided by the replacement cost of its booked assets. To the extent that the ratio is greater than 1, it suggests that management and strategy are adding value to the firm's assets.

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