What drives the overall performance of an organisation, is it the organisation or is it the industry which the organisation operates in, well shockingly it's both. There are industries that are historically more profitable than others, but within each industry, regardless if it's a high or low margin industry there is always an industry leader who is more profitable than its competitors.
- Industry effects: Performance resulting from durable industry effects resulting from being in a high or low profit industry.
- Company effects: Performance resulting from the unique company attributes which result in the company out performing its competition.
Company effects are a significantly more important factor when it comes to overall profits, they account for approximately 80% of an organisations revenue, this follows common sense, since business is a zero sum game, and clients will generally choose the superior product or service at a 'Fair' value, that is to say customers have an expectation for the price of a good or service, an organisation that meets or exceeds that expectation is more likely to win the customer over even if their price is not the lowest.
Measuring performance
In all industries there are market leaders, these are the organisations who in the long run outperform their peers within a given industry or market, and are said to have a competitive advantage. To identify organisations which demonstrate better performance we can Accounting profitability indicators:
- Return on Assets (ROA = Net Income / Total Assets): is a financial ratio that measures a company's profitability in relation to its total assets. ROE measures how efficiently a company is using its physical assets to generate profits.
- Return on Equity (ROE = Net Income / Shareholder Equity): is a financial ratio that measures a company's profitability in relation to the amount of shareholder equity. ROE measures how much profit a company generates for each dollar of shareholder equity
- Return on Capital Employee (ROCE = (Earnings before interest and taxes (EBIT) / (Total assets - Current liabilities))/Number of employees): is a financial ratio that measures the profitability of a company in relation to the amount of capital employed in its operations. Return on capital employed per employee (ROCE/employee) is a variation of this ratio that indicates how efficiently a company is using its capital per employee.
These indicators are extremely accurate, because they are rooted in numeric values, however their downside is that they are historic indicators, and not necessarily indicators of future performance.
An alternative way to measure organizational performance would be to rely on a companies stock evaluation, which in theory should factor in a companies future prospects, however in practice this is rarely the case.
An organisation is said to have a high EVA if their cost of providing their goods or services is lower than the industry average, meaning that even if all the competitors price their goods at the industry average the organisation with the competitive advantage will be able to undercut them and still turn a profit. The EVA focuses on price and profit margin however it does not effectively measure value to customers.
- Privately held companies are not held to the stringent accounting benchmarks as publicly held companies and often time inflate their valuations.
- Publicly traded companies valuations are also often times subject to irrational swings in which they can be either under or over valued.
A more reliable marker for future performance is a companies Economic Value Added (EVA) measurement. The EVA is the difference between the sale price and the production price of the good or service.
Competitive advantage
Despite that fact the EVA is an imperfect measure of future performance, it is most likely the best approach, and can by augmented with other performance based measurements such as ROA, ROE, ROCE, Stock price, and so on. The goal is to identify organisations with competitive advantages or to identify the competitive advantages within an organisation. Once identified, the priority should be to bolster and sustain those advantages.
