Analyzing the Underlying Dimensions of Firm Profitability Author(s): Rajiv D. Banker, Hsi-Hui Chang and Sumit K.

Majumdar Source: Managerial and Decision Economics, Vol. 14, No. 1 (Jan. - Feb., 1993), pp. 25-36 Published by: Wiley Stable URL: . Accessed: 20/03/2013 08:07
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USA and Sumit K..returnon sales.MANAGERIAL AND DECISION ECONOMICS. and thus productivity and its price recovery ability (APC.00 ?D 1993 by John Wiley & Sons. The new measures are used as an illustration to explain changes in the performance of firms in the US telecommunications industryfollowing deregulation. interested in the performance evaluation of firms to link a firm's operating or strategic decisions. that have occurred as a consequence of deregulation. with an extension of the APC method. on a firm's the productivity of firms and the price-recovery formance measurement methodologies further.University of Michigan. to such undermeasure the financial performance of firms. public policy decisions such as deregulation. 25-36 (1993) Underlying Analyzing the Profitability Dimensions of Firm Rajiv D. product mix and capacity utilization. however. into four components that capture the impact of productivity. Banker and Hsi-Hui Chang Carlson School of Management. University of Minnesota. These factors can be first describe a multiperiod. Thereby. product-mix maximization and capacity utilization. 1989.161. Minneapolis. van Loggerenberg and Cucchiaro. This has been a time of attributes of the operations of firms have on profit.following deregulation. new frameworks sumption underlying deregulation is that firm perand tools have been developed recently. To obviate such a lacuna. enables us to evaluate the detailed outcomes of 1981. of the industry as a whole. MN. USA In this paper we decompose a traditional measure for firm's performance. We stance. its of changes in a firm's profitability. the American Productivity Center (APC) show how our highly integrated approach yields formula disaggregates changes in a firm's profitab. By the very way in which the profitis ability ratio constructed. and then integrates profitability ratio analysis. Ann Arbor. Majumdar School of Business Administration. We use the model in an illustrative manner to turnover ratio. Miller. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . Ltd.82 on Wed. The new measures enable us not only to illustrate relative differences between firms in a given cross-section but also to shed light on how changes take place over time in the differentcomponents that underlie firms' profitability. 14. VOL. The a profitability ratio. or The Dupont ROI formula has long been used to exogenous and endogenous events. respectively. For in. While the APC method has model we describe disentangles further the sources received considerable attention and acceptance. 1981-2). price recovery. Changes in the overall profitabilitymargin of these firms are explained by substantial but offsetting changes in their productivity. the return on investment (ROI) is sub-analyzed into model also supports decision making for operaa ratio of profitability (return on sales) and an asset tional and strategic purposes. INTRODUCTION This content downloaded from insights into the performance of firms within ility into two components capturing changes in its the industry.formance on various dimensions will improve. Banker et al. as noted linking them to the Dupont ROI formula via above. We ability that they possess.considerable change for the industry. Kendrick. 1984. It enables those measures of productivity and price-recovery 0143-6570/93/010025-12$1 1. multiproduct model that gauged by calculating the APC ratios. 1984.101. it provides analyze the performance of the US telecommunicaa only gross aggregate measure and does not easily tions industry during the period of transition shed light on or capture the impact that the micro. A major asability. Profitability can be affected by many factors such In this paper we extend such micro-level per. price recovery ability. The lying components of its profitability. MI.

and holds input prices constant at current period levels while capturing changes in input quantities. The first ratio measures a firm's ability to generate profits related to its sales revenue attainments.. we describe in the next section an alternative set of ratios to quantify the impacts that changes in a firm's overall productivity. To conduct a multiperiod analysis of profitability.1 is the reciprocal of the profitability marThe APC productivity change ratio covery. D. we use the APC method as a point of departure. .. PM= price per unit of output m during period t. K. period t. divided by the ratio defined as: of the values of current period inputs to base period t yt /(. the base level 0 may be defined as either the firm's own performance during some earlier base period.. Fixed inputs are invariant with respect to output level changes. price recovery. Wf= price per unit of fixed inputf during period t. EmPmY Y-nl/m PmYm wt xt + . 2. .82 on Wed. Therefore. F. xt =actual quantity of variable input v during -(. MAJUMDAR change can be confounded by changes in the product mix and capacity utilization of firms. M. In the fourth section we analyze our findings and the final section contains a summary and conclusions. 1989. Extending previous work (Banker et al. as some prior technically determined standard. 1989). . . The first is a ratio of profits to sales and the second a ratio of asset turnover. The profitability margin for a period t is comis the ratio of the values of current period (APRDT) puted as revenues divided by costs and can be to base outputs period outputs. gin. . . . Xt = actual quantity of fixed inputf. .26 R. There can be multiple time periods over which analysis can be undertaken as given by t=1. The second is a measure of the extent to which the firm has been able to generate revenues with its assets. again there may be several categories of fixed inputs as given byf= 1. . T. as the profitability performance of another firm. In the third section these ratios are applied to explain changes in the performance of firms in the US telecommunications industry following deregulation. or as the average performance of the industry as a whole over a given time period. APC Ratios (1) The profitability change ratio as developed in Eqn (3) can be decomposed further into two measures of changes in productivity and price rewhere z. . there can be several categories of variable inputs as given by v= 1. wt Xt + If Wt Xt . used during period t. CHANG AND S.2. a profitability change ratio may be defined as a ratio of ratios: the ratio of profitability for the period t to the profitability ratio for a base level 0. product mix and capacity utilzation have on the changes in a firm's overall profitability. H-H. It is expressed thus: where APRDT = actual quantities of outputs during period t. Banker and Johnston. The Dupont formula has been traditionally expressed as follows: ROI = profits/assets = (profits/revenues)x (revenues/assets) = (1 -1 ) x (revenues/assets) Xt + Y2Wf _ Yt/(Evwt MPY V ~fWfXf x0 Wu X? (3) + Ef EPmY/(Ev wvo 3 xt) Depending on the purpose of the analysis.. Ym there can be multiple products factored into the analysis as denoted by m= 1..t=1 (2) inputs. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . It can be expressed as: Profitability (PFTBLT) = FORMULAE FOR PROFITABILITY RATIO ANALYSIS Antecedents The Dupont ROI formula decomposes the return on investment of a firm into two ratios. .161. 2. BANKER. 2.f Wtf Xtf )/(v Wtv Xo + if W f Xf 4 ) The above ratio holds output prices constant at base period levels while capturing changes in output quantities. Variable inputs are those that vary in proportion to output level. w V=price per unit of variable input v during period t. V. .. This content downloaded from 203.101.

101. The standard quantity qt of fixed input f required (2) A price-recoverychange ratio. Additionally. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions .. we gain a richer understanding of the different components of a firm's profitability. yield the profitability change ratio in Eqn (3). Banker et al. Thereby.82 on Wed. Banker and Johnston. additionally. but. which captures the This content downloaded from 203. The base period can be defined in many ways. is then defined as: and inputs constant at base levels. and thereby signal productivity changes when there are really none (Banker et al.=f kt (7) where kt denotes the actual quantum of physical plant capacity provided during period t for producing the various outputs. divided by the ratio of the value of inputs at current period prices to the value at base level prices. based on prevriouswork on the subject (Banker. and this will not be discernable as standard input and resource consumption patterns are not factored into the ratios in Eqns (4) and (5). (1) A productivity change ratio. 1988. We choose to define the base period in terms of the average output and capacity over all firms and time periods. Therefore.161. while holding both outputs eral.. is defined as: Zt =mCLmvY mPm Ymm Pm Ym5) WE Xf)/(V WOXO + Ef W X) This ratio holds output constant at current period levels while output prices are allowed to vary. we describe an alternative set of ratios. It is expressed thus: APRCR (E wt XO+ Ef profitability impact of changes in the mix of actual outputs and output capacities of the products or services dealt with by the firm. The ratio in Eqn (4) can be influenced by changes in product mix and volume. The standard quantity of plant capacity in period t is defined to be Ut=O E yt (8) In this sub-section we describe the preliminary as. when multiplied together.That is. impacts on profitability due to changes in the product mix and capacity utilization of firms. based on the input requirement f3fper the values of outputs and inputs at current and standard unit of output capacity provided in genbase level prices. to enable us to gain insights into what is technically feasible versus what is really attained. The standard quantity ztfof fixed input needed in period t.and (4) A capacity-utilization change ratio. based on the standard input requirement cxmvper unit of actual output of product m. as the APC formulation enables us to do. is defined as: zt = . for computation of our proposed ratios. load factor Q? by dividing the sum of the base period outputs (Emy') by the base period capacity The ratios comprise: available (kV). based on the standard input requirement f3fper unit of actual output capacity. We estimate the standard industry be defined. 1989). The proposed ratios.UNDERLYING DIMENSIONS OF FIRM PROFITABILITY 27 The APC price recovery ratio (APRCR) is the ratio of the value of outputs at current period prices to the value at base level prices. To operationalize the ratios we need to first define standard quantities. 1989). The ratio in Eqn (3) is decomposed into a set of four ratios that reflect not only changes in productivity and price recovery. which captures the profitability impact of deviations in current period capacity utilization from standard levels of capacity utilization. the standard industry load factor is also subject to definition in many ways. which compares actual input usage to standard input require(9) = mYm QO2 ments given actual outputs and output capacities.where T0 is the inverse of the standard industry sumptions about technical standards that need to load factor Q2. These incorporate technical standards. We estimate standard and f3fby regressing each input requirements OLmv input on outputs or capacity for our pooled sample of observations over multiple firms and time periods. capacity utilization can furtherimpact the productivity ratio. To address these problems. and inputs are held constant at base period levels while input prices vary.. which compares in period t. 1989. qt =ff ut=ff To EmY m (10) (3) A product-mixchange ratio. The standard quantity ztvof variable input v needed in period t. Assumptions Underlying Proposed Ratios (6) where Oxmv>O and yO >.

and the relevant math- 19 This content downloaded from 203. given current t= 1. the divisor in Eqn (18) equals one and the ratio reflects only deviations between current period actual usage of inputs vis-a-vis the standard usage of inYm (11) NT puts. while the standard inputs for fixed inputs are used in the divisor as shown below: CAPUTIL EVWvZt+EfWf qft /ErvwOzt +fw WOt V V f f Xf Ev Wv Xt + Ef Wt (18) EvW v + fWf q/ ~~~+foo Ss?v? W EVWO?Z?+EfW5fZf (2 The productivity change ratio can next be defined as the ratio of the raw productivity ratio for period t to the corresponding ratio for a base period 0. are incorporated into the divisand. and the 4PMYM (20) mPmYm base actual output and output capacity. as: measure of change in productivity for the period. K. . as: preceding ratios described. the capacity utilization change ratio reflects current period deviations between qt and zt .161. The productivity ratio for period t is defined as the ratio of standard to actual quantities: PRDTVT= XV These same standard inputs. 2. given actual outputs and the standard capacity factors for fixed inputs. N denotes individual firms and ates standard input requirements. that Zf W?z + Ef Wof wo Ev wtVzt + Ef Wf Ztf lv ~VW?Z?Vf f (19) is. CHANG AND S. .82 on Wed. and shows the only by Xf=z =#f ko (14) composite ability of firms to maximize output pri=f f mm)q flfTo ( o)=q ces relative to input prices. H-H.28 R. Because of the normalization in Eqn (13).. The definition of the PRDTVT ratio in Eqn ktm ko En t (12) is the (19) identical to that in Eqn (18). and in doing so provides a purer Theoretical considerations.101. D... standard usages.period outputs and capacities: tual and standard input quantities are then calculated using the estimated standard inputs. qf =Zf and therefore: CAPUTILV t + f f (23) Thus. The base ac. between the input requirements given the Xf EWVXV+TEWf v W EV wv Xt + Ef W X standard capacity factor as given by qf and input The ratio captures deviations between actual and requirementsgiven actual capacities as given by zt. MAJUMDAR The base output and capacity quantities are calculated as averages over all firms and all time periods. The product-mix change ratio incorporates the The base output and input prices are calculated same standard inputs for variable inputs as do the as weighted averages over all time periods. to disentangle the t t m in product mix from changes in effects of change (15) PmO= Eng-t capacity utilization. based on the actual output of the current period. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . T denotes time periods.. But. 2. NT The price recovery change ratio also incorporwhere n= 1. . BANKER. . PRCREC is driven difference in prices. for fixed inputs the standard inputs given actual outputs and standard capacity n v v (16) factors are also incorporated: = XvZvm mvYm (13) Since zt and En Et xtv PRODMIX wo EnEtWtf Xtf n tf (17) Xpot ~ Pm Emw~z~+Xfwfqf Ymz/ Ev W v+ Wf f / 20y0 EmPmYm V Wv??+E f (21) f? Specification of the Ratios We now use the above definitions of standard quantities and prices to specify the set of four ratios that we referredto in the beginning of the previous sub-section. as described below: PRDTVT As a result of the normalization in Eqn (12). as follows: / E Zt v+ sv v? WfZf +f If zt are functions of yt. the PRCREC estimated standard industry load factor..

can no longer occur in a garding the provision of services to business cusderegulated environment (Avcrch and Johnson. tomers. Bailey et al. . bebeen made gradually permissible in many sub-seccause rate-base padding. Stevenson. is expected to ing data problems. Concomitantly. Perl. with prices. Hence. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . Morrison in several of the critical inter-state long-distance and Winston. and this has opened up the market to competition. which thereby leads to a reduction 1987. 1984 and which to choose. The ratios that we calculate Description of the Data thus reflect the performance of firms in regulated.others are not used in the sample because of misscreasingly competitive environment. Selten. We evaluate AfterDeregulation Expectations Performance the performance of 39 of these companies. underlying the derivation of these ratios are described in Banker (1988). Simtry thus provides an apposite setting for the use of ilarly. 1985. the existvested to newly established regional holding coming resource base of firms has to be better utilized. behavior and performance of firrhs.rations can no longer be passed on to consumers. 1980.101.system or other telecommunications groups such as This content downloaded from 203. and wastage and slack in input utilization is no Such competition was expected to influence the longer tolerable (Crew et al.82 on Wed. Shep(American Telephone and Telegraph Company). Thus. analysis of the performance of firms in the US 1988.. Prior to deregulation in 1984 have several impacts on the performance of firms in these companies were part of either Bell operating general. 1982). Courville. exploiting EMPIRICAL ILLUSTRATION newly opened-up opportunities and improving efficiency. once feasible in a regutors of the local exchange market. We choose 1981 as it represents the time in the ability of existing firms to recover premium when moves to deregulate the industry began. the firms had operated in a fully While price recovery declines. deregulation-induced decreases in monopoly our profitability ratios in illustrating changes in power and new product introductions lead to ina firm's performance. as the ucts that have the highest margins (Porter. had annual revenues in 1987 of $100 million or more. concentrating industry was put into effect. The year 1984 was their resources and attention on that mix of proda period of major change for the industry. 1978. creases in the price elasticity of demand for existing We undertake our analysis with observations customers who have more product substitutes from from three specific time windows: 1981. Thus. since higher costs caused by inefficient opperiments have been undertaken in regulating it.' eously efficient and innovative. telecommunications services industry before and Under deregulation productivity is likely to inafter deregulation. Spann. in the intra-state long-distance market. 1986. cream-skimming regulated environment. 1971. the years 1981.161. over time the price recovery ratio is the revival of the anti-trust suit against AT&T expected to decline (Bailey. 1978. 1987). Spence.UNDERLYING DIMENSIONS OF FIRM PROFITABILITY 29 ematical assumptions. The lowering of entry barriers is expected to increase the number of competitors. firms have to taken.. 1985. 1978). Between 1981 and 1984 and cross-subsidization is also no longer possible in several steps to deregulate the industry were undera deregulated milieu and. operating companies owned by AT&T were diSmith and Grimm. While existing firms may show shortterm gains in profitability margins by being first movers on the emerging market scene. therefore.and the indus1975. particularly related environment. 1986. markets. overall profit margins are expected to deIndustry The Telecommunications cline in the long term with the advent of more We illustrate the application of the ratios with an competitors seeking the same customers (Kahn. Since 1984 competition has also resulting in a higher-capacity utilization ratio. Prior to this. with pressures on firms to be simultan. herd. 1974. Leibenstein. The Deregulation. panies (RHCs). and 1962. respecpanies in the US telecommunications industry that tively. 1983). There are approximately 50 local operating comtransitory and deregulated environments. and in 1984 a reorganization plan for the adopt focused strategic behavior. and the steady influence of an in. 1986). In this industry a series of excrease. 1984 and 1987 capture the operations of firms in this industry in three dissimilar time periods. these are large firms and many of them belong in the Fortune 100 list. 1988. Primeaux.

Though the profitability change curve may itself look flat for some companies or display a decline in the post-deregulation This content downloaded from 203. Hence. Two input cost categories are defined as fixed. The production and delivery of telecommunications services is characterizedby several varieties of costs. Therefore. they vary with plant capacity which is fixed in the short run. BANKER. Southwestern Bell and US West. We obtained data.Our physical output measures are the total minutes of local and toll calls for each firm in each time period. to both business and residential users. These are traffic. we divide the deflated depreciation amount (again deflated by the producer price index for electrical plant and machinery) by the total number of access lines. but either stays at the same level or generally declines with the advent of furthercompetition in 1987.101. and hence a precedent does not exist for classifying costs into such categories. Physical outputs and inputs yield only physical productivity measures. K. fixed inputs are a function of the available plant capacity as measured by access lines. There is only one category of physical plant capacity. Central Telecommunications (CENTEL). two principal types of physical outputs and two principal physical inputs. which are used to generate both of these revenue outputs. general office. or evaluated price-recovery ratios. These expenses vary more or less directly with the volume of actual revenue-generating outputs. that is. The profitability of firms increases with deregulation in 1984. First. namely access lines in service. (1981) and Waverman (1989). Our calculations include all former Bell operating companies. Telecommunication service firms earn revenues by providing two basic types of output: local calls and toll calls within defined intra-state areas of operation. to obtain a measure of price per unit for these cost elements.82 on Wed. Again. Southern New England Telephone (SNET) and United Indiana. Pacific Telephone (which in 1983 changed its name to Pacific Bell). H-H. After 1984 the Bell operating companies were split into seven regional groups: Ameritech. commercial. These are GTE Northwest (officially called General Telephone of the Northwest). To obtain a measure of price per unit of capital consumption. from an annual publicly available publication of the Federal Communications Commission titled Statistics of Communications CommonCarriers. as comprehensively documented and evaluated in Courville et al. Rochester Telephone or Cincinnati Bell. by each company for each year. Rochester Telephone Company and Southern New England Telephone (SNET). Our choice of physical inputs and outputs is consistent with other past studies of the industry. While past studies have looked at physical outputs and physical inputs of telecommunication systems. To obtain output prices we divide the annual dollar revenues for each output category (deflated by the implicit price deflator for GNP) by the total minutes of calls for that category. and is more fine grained. D. Each of these belongs to a different ownership group. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . all the independent companies such as Cincinnati Bell. or were independent frims such as Southern New England Telephone. Variable cost inputs are a function of the volume of these categories of outputs.161. and is thus also representative of how differences in ownership may have an impact on firm performance. to calculate performance changes due to price recovery and overall product-mix changes we need to derive the output and input prices. We obtained these data from a publicly available ad hoc FCC survey. We identify four input costs as being variable. the data on costs for each firm in each time period are obtained from the FCC Common Carrier Statistics. 1. and a majority of the operating companies belonging to the other groups. MAJUMDAR GTE. Recall our interest in generating richer measures of changes in profitability. and other miscellaneous expenses. Bell Atlantic. Bell South. none have used the accounting framework of fixed or variable costs. To obtain input prices we divide the variable costs for each category (deflated by the implicit price deflator for GNP) and the maintenance cost (deflated by the producer price index for electrical plant and machinery) by the number of employees. United Telecommunications and Continental Telephone (CONTEL). we discuss some general findings as presented in Fig. CHANG AND S. FINDINGS ON FIRM PERFORMANCE To illustrate what insights might be obtained from our analysis we focus on the performance of four firms from the sample of 39..30 R. Pecific Telesis. Nynex. Our physical input measures are employees and total number of access lines. which we do in the following manner. They are maintenance costs and depreciation costs.

05 . however.21.E. This figure reveals the wide divergences in the adaptive . however. SAMPLE AVERAGE o 1- . and declines for the other two firms.8 0 0. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . Ratio trends: individualfirms.95 TELEPHONE ~~~~~~~~~~~~~~~~~~PACIFIC (5 Z < 0. that make up the bulk of the local exchange telecommunications industry. as can be seen from Fig..2--.T.25 1. ET. as a whole does. Z X 1.11 .. It is an issue that we tackle subsequently. UNITED INDIANA -X- ~0. the underlying components of profitability have each moved spectacularly.7 1981 1984 YEARS 1987 firms.- ? 0. We expected productivity to increase across the board.8- 1981 3. show an increasing trend. .82 on Wed.95 . 2. 1984 YEARS 1987 Figure1.UNDERLYING DIMENSIONS OF FIRM PROFITABILITY 31 period for others.161. UNITED INDLANA 0 jS0.-5 0.05. 1.85 0. rises and then declines for GTE 1..3e-------. Ratio trends:individual This content downloaded from 203.90 0.850.101. \ \GTE %% SAMPLE AVERAGE NORTHWEST PACIFICTELEPHONE 15 S. it increases significantly for only one company. The average for the 39 firms.9- -N -Eli- S. Pacific Telephone.' Northwest.N. Figure2. ' GTENORTHWEST F: 0.

K.6 SNET. To offset these partially. 3.4> 1. BANKER. what are the changes in the other components like? Price recovery falls very steeply from 1981 to 1984. there is improvement in both the product-mix ratio and in capacity utilization. as can be seen from Fig. This is consistent with our contention that firms in a deregulated environment can no longer charge former monopoly prices. Figure 6 shows this trend for each ratio. If productivity changes are not entirely as expected for the individual firms we look at. Table 1 shows how the various performance ratios changed from 1981 to 1987 for the four firms and also for the industry as a whole.8- GTENORTHWEST PACIFIC TELEPHONE (9 1. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions .82 on Wed. do not have the wherewithal to change internal systems immediately to improve productivity. we consider the overall pattern of changes in the individual firms' ratios.101. firms will concentrate on their more profitable products. INDIANA ~~~~~~~~~~~~~~UNITED z ~1. with the advent of a more competitive environment. Finally.As we also noted in the cases of the four individual firms we looked at. 4. firms would be motivated to be efficient in the utilization of their assets.161. and capacity utilization ratios improve in the period between 1981 and 1984 but stabilize and drop marginally thereafter. then firms have to undertake steps to counteract such a factor. but less steeply so than between 1981 and 1984. MAJUMDAR responses of firms to an environment where efficiency concerns are of much importance. with the onset of deregulation. 2SAMPLE AVERAGE 0 1. D. It does rise again from 1984 to 1987. Ratio trends: individual firms. a principal factor underlying such a trend being the decline in its price-recovery ability.6- 1981 1984 YEARS 1987 Figure 3. productivity and product-mix ratios rise monotonically as expected. to examine the overall industry trend in performance. This content downloaded from 203. Based on all the companies in the sample we also calculated a simple average of all five ratios for each of the three years.0. CHANG AND S.21 0 X - w a. the change is large from 1981 to 1984 but only marginally positive between 1984 to 1987. Figure 5 shows that this ratio does improve for all four companies. The overall profitability for GTE Northwest declines between 1981 and 1987. though its productivity also declines. If the price-recovery ability decreases as a result of competition. We see that the product-mix performance ratio improves from 1981 to 1984.--~Fgr Rai trns iniiulfrs 0.8 - o ~~~~ ----3. Next. otherwise this may lead to an overall profitability decline. This is consistent with our contention that. as. It can be seen that while profitability rises and then falls. we expected capacity utilization to improve. the price-recovery ratio has fallen monotonically in the period after deregulation. U. as can be seen from Fig.This trend is noted for all the four firms in our sample. and less steeply from 1984 to 1987. H-H. Some of the firms seemingly.32 R.

INDIANA ~~~~~~~~~~~~~~~~~~~UNITED 0.K -El- 5 INDIANA UNITED z I I / ? 1. Contributing to such an overall increase are rises not only in its productivity but also in product mix and capacity utilization. 1984 YEARS 1987 Figure 4.2- o 2: | AVERAGE | SAMPLE -0-GTENORTHWEST TELEPHONE 1 1 CB-- --------------- El Z < 10.N. 1.ET. Pacific Telephone's overall profitability increases in the 1981-87 period. which more than offset the decline in the price recovery that it suffers.ET.8 -0.25- - X AVERAGE SAMPLE GTENORTHWEST PACIFIC TELEPHONE W 1. There is. 0.15 ~~~~~S.N.9- X'~~~~~~~~~~~~~~X 0.82 on Wed. 1981 . the major source of improvement in This content downloaded from 203. however.UNDERLYING DIMENSIONS OF FIRM PROFITABILITY 33 1.050 a.101. For Southern New England Telephone there is also an improvement in overall profitability between 1981 and 1987.7 I w(5 ------------PACIFIC ~~~~~~~~~~~~~~~~~~-El- ~~~~~~~~~~~~~~~~~~~~~~~~S. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions .6- 1981 1984 YEARS 1987 Figure 5.95U . a decline in both its productivity and price recovery. -~~~~~~~~~~~ U. Therefore. Ratio trends: individual firms. Ratio trends: individual firms.161. and only a marginal increase in the product-mix ratio.

The case of United Indiana is similar to GTE Northwest. Direction of Changes in the Performance Ratios between 1981 and 1987 GTE Northwest Pacific Telephone Southern New England Telephone United Indiana Average for 39 firms PrQfitabilitychange ratio Productivitychange ratio Price-recovery change ratio Product-mix change ratio Capacity-utilization change ratio - + + + - + + - - + + + + + + + + + + profitability has been the improvement in capacity utilization during the period. both GTE Northwest and United Indiana are not either part of the Bell grouping or Bell affiliates.101. these improvements are not enough to offset either the decline in price recovery or productivity. Overall profitability declined between 1981 and 1987. and two of its key components. CHANG AND S. While the product-mix ratio and the capacity utilization improve. We can surmise that the trauma of deregulation and divestiture are not as severe for GTE and United companies as it has been for the Bell operating companies and affiliates. BANKER.161. D. Table 1. Unlike Pacific Telephone and Southern New England Telephone. As a result.34 R. these companies have not been as strongly induced to improve their performance. K.80.9 0. Average performance ratios: all firms.2cc --1 ------ 0. namely productivity and price recovery.5 PROFITABILITY 0 i C) 1. however.4| PRODUCTIVITY 1.82 on Wed. MAJUMDAR 1.3- PRICE RECOVERY PRODUCT MIX CAPACITY UTILIZATN wIJ z 1. and with the advent of a more competitive environment they find themselves declining in overall profitability. These surmises.78 1981 l 1984 1987 YEARS Figure 6. can be tested in This content downloaded from 203. H-H. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . also decline.

These ratios can be further decomposed to facilitate performance evaluation. it gives decision makers a clear sense of where strategic decisions are impacting. it is apparent that great potential exists for firm-level studies that can identify the endogenous and exogenous forces impacting various attributes of performance. The social welfare consequences of such results are evidently positive.101. and the allocative efficiency of price-setting mechanisms seems to be increasing. our anlysis also shows different dynamics at work at the firm level. a point to which we have already alluded. Thereby. Similarly. applicable to many contexts resulting from market-liberalization measures being taken in various places around the world. 20 Mar 2013 08:07:01 AM All use subject to JSTOR Terms and Conditions . the price-recoverychange ratio may be further decomposed into measures of changes in both input and output prices. in this paper we illustrate a multi-period. a ten-year period 1981 to 1990 to truly understand the temporal dynamics of how telecommunications firms have behaved in what has been a very turbulent decade for them. SUMMARY AND CONCLUSIONS Finding useful components of performance measures is a relevant area for research. Based on such considerations. The existence of such inter-firmpatterns suggests that firm and ownership-group-specific factors are also likely determinants of profitability. Productivity in general has shown a slightly increasing trend as a result of deregulation. our method enables us to examine the impact of deregulation on the performanceof US telecommunications firms. multi-product method to measure changes in the performance of firms. A major difficulty has been in defining the appropriate components and showing whether the interpretations that result are reasonable and applicable elsewhere.Why some firms are continuously better than others and can sustain such excellence in performance can be identified only through the use of decomposed ratios. and how they might need to make micro adjustments to operational areas within the firm. and also improve the utilization of their fixed capital resources. Overall profitability increased immediately. We. Thus. a gross measure is certainly useful for relative comparison among firms. Nevertheless. while others are consistent in the patterns of improvement of the various components of their performance. 1984 and 1987) in analyzing trends in firm performance. are likely to have a positive impact. the foundations of which can be the changes in profitability and other ratios serving as variables to be explained. For example. Why is such fine-grained decomposition useful? First. we analyze changes in productivity.82 on using the ratios as dependent variables in a regression where explanatory variables are measures capturing these forces. while overall impacts have been positive. and thus support the view that public policy decisions. empirical perspect- ive. then. product mix and capacity utilization to examine how each contributes to changes in a firm's profitability. This method extends the profitability ratio analysis of the APC method. This content downloaded from 203. however. Second. the productivity change ratio can be further decomposed into partial productivity change measures for each input. In an effort to disentangle micro-analytic components that impact a firm's profitability. we looked at three discrete points in time (1981. Some firms seem to have had difficulty adjusting to a deregulated environment and improving their profitability and productivity in a sustained manner. price recovery. the resultant ratios allow more microanalytic details of performanceto be evaluated. but thereafter started declining as competition grew. It is entirely conceivable that performance trends of the firms reviewed may have changed considerably as a result of further marketliberalization measures taken since 1987. Second. To counter the forces described above. A richer study. implications for external parties who do evaluations as to whether profit performance of some firms is merely because of chance or whether there are strong microeconomic and organizational factors underlying a firm's performance can be ascertained. When combined with the APC method.UNDERLYING DIMENSIONS OF FIRM PROFITABILITY 35 more micro-level studies. the foundations can be laid for a rich stream of empirical performance analysis. such as deregulation. The profitability component (profit to revenues ratio) of the Dupont ROI formula provides a starting point for performance analysis of firms. Given our framework for analyzing profitability ratios into their components. From a contextually driven. go further. say. will involve a continuous study of all years in. Declines in price recovery suggest that competitive market forces have decreased the possibility of monopoly rent extraction. firms have had to concentrate their resources on the more profitable product lines.

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