Chapter 6

Organizational Strategy,
Business Models, and Risk
Management
 Strategic Development and
Oversight
§ The primary responsibilities of the board is to ensure the
strategic guidance and oversight of the company.

§ NACD survey data: Directors consider strategic planning and

oversight to be their most important responsibility.

How exactly does the board perform this function?

Strategic Development and
Oversight
§ Strategy development and oversight can be divided into
four parts:

1. Define the corporate strategy.

2. Develop and test business model.
3. Identify key performance indicators.
4. Identify and develop processes to mitigate risk.

§ Board does not perform these tasks (management does).

§ Board evaluates and tests the work of management to

ensure that it appropriately builds and protects shareholder
value.
Strategic Development and Oversight

Management Board of Directors

Corporate Strategy
Proposes Reviews
“How will we create value?”

Business Model
Develops “How does strategy translate Tests
into value?”

Key Performance Indicators

Identifies “How will we measure our Monitors
performance?”

Risk Management
Identifies Reviews
“What can go wrong?”
 Corporate Strategy
The corporate strategy is how a company expects to create
long-term value for shareholders and stakeholders, within the
confines of the corporate mission.
´ “What business are we in?”
´ “How can we create value by being in this business?”
 Corporate Strategy

An organization considers multiple aspects when developing its

corporate strategy:
´ Scope: The activities the firm will participate in.
´ Markets: The markets it will participate in.
´ Advantage: The advantages that ensure it can compete.
´ Resources: The resources required to compete.
´ Environment: Market factors that influence competition.
´ Stakeholders: Internal/external constituents that
influence firm’s activities.
 Strategy Implementation Process
Strategy Implementation Process Examples

1. Establish the overarching Target long-term TSR of 10 percent

objective of the firm. per year.

2. Determine the outcomes that are Sales growth of 6 percent per year,
necessary to achieve the TSR free cash flow growth of 8 percent,
target. and return on equity of 15 percent.

3. Assess the viability of specific Develop a new product line.

strategies to achieve the
company’s economic
targets.

4. Assign targets (both financial and Financial targets: cash flow and
nonfinancial) that will enable the revenue growth from new products
company to measure the success Nonfinancial targets: market share,
of its strategy over time. brand awareness and strength
 Causal Business Model
§ A causal business model explains how the corporate
strategy translates into shareholder value.

§ A causal business model links specific financial and

nonfinancial measures in a logical chain to describe how the
corporate strategy translates into the accomplishment of
stated goals.

§ The business model lays out a concrete plans that can be

tested through statistical analysis.

§ It then provides the long-term basis for measuring

management performance and awarding compensation.
Example: Fast-Food Chain and
Employee Turnover
§ The company acted on this model even though it had not been
verified through formal data analysis.
§ The results were not what the company had expected.
§ The expected correlation between employee turnover and store
performance did not exist.
§ The true driver of store performance was not general turnover but
turnover among store managers.
Example: Investment
Advisory Firm
§ Customers invest more assets with the firm when they are
satisfied with their advisor.
§ What drives customer satisfaction?

Responsiveness
+

+
Trustworthiness

Knowledge
Considerations in Developing Business
Model
§ The business model is based on rigorous, statistical analysis
(not management intuition).

§ Board evaluates for logical consistency, realism of targets,

and statistical evidence that relationships are valid.

§ Board should be aware of challenges.

´ Management might take shortcuts.
´ Management might resist scrutiny.
´ Relevant data might be difficult to obtain.
 Key Performance Indicators
§ Key performance indicators (KPIs) are the financial and
nonfinancial metrics identified from the business model
process that validly reflect current and future performance.
§ The board also uses key performance measures to evaluate
management performance and award compensation.
´ For example, in the financial services firm example, the
business model highlighted the need to use investment
advisor turnover and satisfaction, as well as customer
satisfaction—in addition to traditional financial
measures—as KPIs.
 Key Performance Indicators
§ KPIs are roughly grouped into two categories: financial and
nonfinancial.

Financial KPIs Nonfinancial KPIs

include measures such as -
total shareholder return;
- revenue growth;
- earnings per share;
- earnings before interest,
taxes, (EBIT);
- return on capital;
- economic value added
(EVA);
- free cash flow.
include measures such as -
customer satisfaction,
- employee satisfaction,
- defects and rework,
- on-time delivery,
- worker safety,
- environmental safety,
- research and development
(R&D) pipeline productivity.
 Key Performance Indicators
§ Prevalence of Measures Used for Corporate Employees

Financial KPIs Nonfinancial KPIs

Earnings Per Share (29%) Customer Satisfaction (8%)

EBIT/EBITDA (19%) Service/Quality (6%)

Net Income (16%) Strategic Goals (6%)

Cash Flow (16%) Safety (3%)

Operating Income (15%) Employee Satisfaction (2%)

Economic Value Added (8%)

Confidential survey (2005). Sample includes 343 industrial and service companies.
Considerations in Developing KPIs
§ Sensitivity: How sensitive is the measure to performance?
§ Precision. How much measurement error is embedded?
§ Verifiability: Can measure be audited or verified?
§ Objectivity: Is measure objective (# of safety incidents) or
subjective (level of employee commitment)?
§ Dimension: Would measure be interpreted differently if
expressed differently (#, %, survey scale, yes/no, etc.)?
§ Interpretation: What attribute is measured (i.e., does
product failure rate measure quality of manufacturing or
design)?
 Key Performance Indicators

§ Research evidences found that companies that develop a

causal business model based on KPIs exhibit significantly
higher returns on assets and returns on equity during five-
year periods than those that do not.
§ Furthermore, it is important that companies consider using
both financial and nonfinancial measures.
§ Researchers have repeatedly shown that nonfinancial KPIs
can be a leading indicator of subsequent financial
performance.
´ For example, customer satisfaction was a leading
indicator of future financial performance in a sample of
banking and telecommunications companies and the
hospitality industry
 How Are Boards Doing?
§ There is a surprising disconnect between the metrics that
are important drivers of firm performance and the KPIs
companies actually use to track results.
´ >90% of directors believe nonfinancial KPIs are critical.
´ <50% get good information on nonfinancial KPIs.

§ There does not appear to be a good reason.

´ 59% say that the company has “undeveloped tools for
analyzing such measures.”

If true, this is a serious lapse in oversight by boards.

Deloitte (2004, 2007). Sample includes 250 directors and executives at large international corporations.
 Risk and Risk Tolerance
§ Risk represents the likelihood and severity of loss from
unexpected or uncontrollable outcomes.

§ Risk cannot be separated from the corporate strategy and

operations of the firm but instead is an integral feature of
organizational decision making.

§ Each company must decide its risk tolerance. This decision

should involve the active participation of the board.
´ The risks that the firm is willing to accept
´ The risks that the firm is unwilling to accept should be
hedged or transferred to a third party (insurance,
derivatives, etc.).

§ If the board is willing to accept greater uncertainty and

variability in future cash flows in exchange for potentially higher
economic returns, then a risky strategy might be appropriate.
§ If not, then either a safer strategy or an entirely new strategy is
appropriate.
 Risks to the Business Model
The risks facing an organization are comprehensive and touch
all aspects of its activities
§ Operational risk—This reflects how exposed the
company is to disruptions in its operations.
§ Financial risk—This reflects how much the company
relies on external financing (including the capital markets
and private lenders) to support its ongoing operations.
§ Reputational risk—This reflects how much the company
protects the value of its intangible assets, including
corporate reputation.
§ Compliance risk—This reflects how much the company
complies with laws and regulations that otherwise would
damage the firm.
If the company has a well-developed business model, it is
possible for the board and management to develop very
detailed risk-management analyses of key issues.
 Risk Management
§ Risk management is the process by which a company
evaluates and reduces its risk exposure.

§ COSO framework on risk management:

1. Internal Environment: Establish the organization’s
philosophy toward risk management and risk culture.
2. Objective Setting: Evaluate the company’s strategy
based on the risk tolerance
3. Event Identification: Examine risks of each opportunity.
4. Risk Assessment: Determine likelihood/severity of each.
5. Risk Response: Identify actions to deal with each.
6. Control Activities: Policies to support each response.
7. Communication: Create information system to track.
8. Monitoring: Review data from system and take action.
Committee of Sponsoring Organizations (1990).
Considerations in Risk Management

The board has four important responsibilities in this area:

1. The board determines the risk tolerance of the company, in

consultation with management, shareholders, stakeholders.

2. The board evaluates the company’s strategy and business

model in the context of the firm’s risk tolerance.

3. The board ensures the company is committed to operating at

an appropriate risk level. It relies on risk KPIs to help make
this assessment.

4. The board should satisfy itself that management has

developed necessary internal controls and that procedures
remain effective.
 How are Boards Doing?
§ Survey data suggests that boards could stand to improve.

´ Most companies do not integrate risk management and

strategy.
´ Instead, it is treated as an isolated function (internal
audit, risk management function, etc.).
´ 58% of companies consider risk when making decisions.
´ 84% of financial officers rate their risk management as
“immature” or “moderately immature.”
´ 44% of senior executives believe that their business
managers have “effective risk expertise.”

§ Risk management might be delegated to the audit or risk

committee, but it is likely best handled by the full board.

The Conference Board(2007); AICPA (2010); The Economist (2009)

Case study: HUDSON CORPORATION

§ Students work in groups of 4-5

§ Read the case study in the handout: A luxury luggage
manufacturer is facing increased competition from cheaper
imports. It must decide how to protect its brand and create
new markets for its products.
§ Analyze how each strategy helps create values for the firm?
Point out all possible risks of each strategy. Choose the best
strategy.
§ From the chosen strategy, create a causal business model to
describe what is the firm’s key success indicator and how
firm’s activities can jointly working on this key success
indicator to create values for the firm.
§ From the causal businesss model, determine the KPIs that
can be used to evaluate management performance and
award compensation.
§ From the causal businesss model, list of possible risks in all
aspects of the firm’s activities and propose ways to manage
those risks.
 Four of Hudson's American managers are talking about
the problems they could face in Europe.

§ C: OK everyone, we'll be getting a report soon from the consultants we've

hired, European Marketing. But let's think a bit about the problems we may face
entering the European markets. Diana, what do you think?
§ D: Well, one thing's for sure, we're going to have to do a lot of advertising to
establish our brand, and that's going to be expensive. And we may need to
adapt a lot of our luggage for European consumers - that could be very costly,
too.
§ C: Yes, but we've allowed for that in our budget. Ruth, what difficulties do you
think we'll have?
§ R: Well, we'll need to get the pricing of our products right. But European
consumers aren't as price conscious as we are back home, so pricing may not
be too much of a problem. I know for a fact people in Europe will pay high
prices for luxury goods if they like the design and it gives them status. So, I
think we have to develop the Hudson brand as an exclusive ‘Made in America'
product ... that'll mean high prices and a strong message that our luggage is
high quality and great value for money.
§ C: Mmm, that makes sense to me. Tom, what do you think?
§ T: I don't agree at all. I just don't think Ruth's right. I think we should go
downmarket, sell at very competitive prices, and aim to achieve high-volume
sales. To do that, we'll need to look carefully at our manufacturing costs. So, it's
probably time we stopped manufacturing in the US. The costs are just too high.
§ C: Thanks, Tom, that's an interesting point of view. I think we all feel that we
need to position Hudson right in European markets. Should we go upmarket or
downmarket? That’s an important decision we'll have to make.
 Bibliography
§ OECD. Principles of Corporate Governance. 2004. Available at:
http://www.oecd.org/dataoecd/32/18/31557724.pdf.
§ The Higgs Report on Non-Executive Directors: Summary Recommendations. 2003.
Available at: http://www.dechert.com/library/Summary%20of%20Recommendations1.pdf.
§ NACD. Public Company Governance Survey. 2009.
§ Deloitte. In the Dark: What Boards and Executives Don’t Know about the Health of Their
Businesses. 2004. Available at: http://www.deloitte.com/assets/Dcom-
NewZealand/Local%20Assets/Documents/In%20the%20dark(4).pdf.
§ Committee of Sponsoring Organizations. 1990. Available at: http://www.coso.org.
§ The Conference Board. Risky Business: Is Enterprise Risk Management Losing Ground?
2007. Available at: http://www.conference-board.org/.
§ AICPA cited it: Alix Stuart. They’ll Take Their Changes: Many Companies Have No Intention
of Adopting Enterprise Risk Management. 2010. CFO.com. Available at:
http://www.cfo.com/article.cfm/14524925/c_14524808.
§ Beyond Box-Ticking: A New Era for Risk Governance. 2009. The Economist. Available at:
http://www.kpmg.com/LU/en/IssuesAndInsights/Articlespublications/Documents/Beyond-
box-ticking.pdf.