4.5 The Balanced Scorecard and Amazon.com
The Balanced Scorecard approach (Arthur Schneiderman (1987), Kaplan and Norton (1992)) can be used within a firm as a method for communicating business strategy. It is a methodology that lets senior management communicate and implement business strategy at all levels of the organization. When an analyst outside the firm conducts financial statement analysis, the Balanced Scorecard provides a framework for gaining a better understanding of the firm’s business strategy. Some important underlying themes to this approach are:
- Describing business strategy requires multiple dimensions because of the varying emphasis given to different activities in the value chain
- There needs to exist some balance among these dimensions when an organization implements its business model via its strategy.
- Understanding major firm decisions in terms of these multiple dimensions and their balance is necessary for conducting meaningful financial statement analysis.
Specifically, the Balanced Scorecard views the firm’s business strategy from four perspectives:
Application to Amazon.com
In the 1990’s and up to the time of hiring Galli, Amazon’s business strategy was unbalanced from a balanced scorecard perspective. In particular Amazon was over-emphasizing the “Customer” and “Learning and Growth” to the detriment of the “Financial” and “Process” dimensions.
The “Financial” perspective requires looking at measures that are relevant to the valuation of the company by shareholders. These include items like return on equity, return on assets, and stock price. For Amazon the ROE was deteriorating from 1998 to 1999 and was not a meaningful measure in 2000 because both the numerator (Net Income) and denominator (Shareholders’ Equity) were negative by 2000. As a result, the DuPont decomposition of ROA (Return on Assets) provides a meaningful measure. In particular, the drivers of ROA (Profit Margin Ratio and Asset Turnover Ratio) were very unstable under the GBF and Customer Obsession strategy no matter what it costs strategy that was implemented in 1999. However, these ratios started to stabilize after traditional cost constraints were imposed via old economy techniques such as implementing a traditional master budget cycle at Amazon.
The “Process” perspective refers to the internal activities performed by a firm. This includes identifying activities for which it is important for the firm to excel and captures what in financial statement analysis is referred to as “business efficiency.” The most relevant item here to Amazon around 1998-2000 was the inventory ratios, such inventory turnover and days to sales inventory given Amazon’s warehousing expansion plans that were implemented in 1999. From 1998 to 1999 the days to sell inventory increased from 22.61 days to 59.69 days a whopping 264% increase in the time inventory stayed with Amazon. With the amount of capital tied up in inventory and warehouses it is not surprising that at this time Amazon’s related working capital ratios were also out of balance with days to pay payable increasing from 86.85 to to 125.27 days or just over 4-months on average to pay their creditors in 1999. The impact from imposing cost constraints upon their business strategy was almost immediate. In 2000 efficiency picked up and the days to sell inventory were almost halved to 30.26 days and days to pay payables were reduced to 84.13 which was around 1998 levels.
The “Learning and Growth” perspectives refer to employee and informational activities requiring innovation and continual improvement. For Amazon some relevant ratios are that Sales growth did decline from 1999 to 2000 (from 269% in 1999 to 168% in 2000) but 168% is still consistent with a strategy of GBF. In addition, the DuPont decomposition revealed that asset turnover was increasing which was a positive trend in the light of Amazon undertaking a significant expansion into warehousing. As a result, employees of Amazon had to go down the learning curve along this dimension. The positive trend in asset turnover provides evidence in support of this dimension.
Finally, the “Customer” perspective requires the identification of performance metrics that measure the company’s success in meeting customers’ expectations viewed from the customer or outsider’s perspective. Direct information on these is available in the supporting notes to the financial statements as well as other parts of the 10-K. For example, measures of customer service, customer ratings, customer loyalty or retention. For Amazon the word “customer” is used often in its 10-K. Further, in the supporting notes to their 1999 financials Amazon reveal the following metrics:
Amazon disclosed the following in their 2000 10-K footnotes to the statements. This description contains some performance metrics for the Customer’s perspective:
Amazon’s 2000 10-K was a little less forthcoming on the customer dimension although they reinforced their strategy in many parts of the 10-K. For example:
In summary, in 1999 Amazon pursued GBF and Customer obsession without imposing cost constraints on their strategy. As a result when viewed from a Growth and Customer perspective Amazon looked great. On the other hand when viewed from their Financial and Process perspectives Amazon did not look so good awful. So the implementation of their strategy was not in balance. However, with the steps taken in 2000, significant improvements were made in relation to both the Financial and Process dimensions. Ultimately, Amazon’s stock price reflected these steps.
Amazon has chosen to both perform similar activities to its rivals but in different ways. At the time, most of its competitors were traditional “bricks and mortar” stores. Choosing to be a virtual store on the World Wide Web allowed Amazon in principle to offer the “Earth’s Biggest Selection.” Conceptually this illustrates why Porter’s original description of a value chain was extended to embrace the world of electronic commerce by Rayport and Sviokla (1994). They observed that the traditional value chain model treated information processing as a supporting element of the value-adding process and not as a source of value itself. However, the information generated by customer-centric entities is a source of value for customer centric businesses such as Amazon and Netflix. This activity is driven by databases and predictive algorithms designed to make it easier for customers to find reliable product and service ratings.
In this development Rayport and Sviokla view the value chain as a pair of chains – the traditional physical chain operating in the physical world of marketplace and a virtual (or synthetic) chain that operates in the new information world referred to as marketspace. This categorization provides a better description of the business model for technology firms such as Amazon, versus a traditional bricks and mortar firms such as Wal-Mart and Barnes and Noble who choose to extend their businesses to have a presence in both spaces.
More recently Amazon has added to it’s revenue streams by offering e-commerce services to sellers and developers some of whom compete directly against Amazon.com. This item reflects another interesting extension of Porter’s original static framework to a dynamic and more “chainlike” in terms of linking back to itself, value chain.
Dynamic Value Chains and Amazon
The difference between a static and dynamic value chains is that in a dynamic chain different entities assume different positions on the chain depending upon things like the time of day and a customers’ location. For example Amazon and third party suppliers compete with each other on Amazon’s own platform. The dynamic dimension of Amazon’s value chain is communicated in Item 1 of Amazon’s 2010 10-K. Here they report two additional parts of their business model:
That is, seller services and order-fulfillment part of Amazon’s business essentially competes with Amazon’s own sales and procurement teams. Similarly, the Web Services division enables other businesses to compete with Amazon and others. These are examples of Amazon embracing a dynamic value chain in their business model.
Dynamic Value Chains and Risk
The risk facing entities in today’s dynamic value chains is that a company can suddenly drop out of the chain. This was a problem that Border’s bookstores faced when competing against Amazon and Barnes and Noble. Ironically, they were still the second largest “bricks and mortar” bookstore when they lost their position in the chain. This led to the recent bankruptcy court events for Borders:.
Both internal and external factors are blamed for Border’s demise. Clearly, online retailing and electronic book readers were major factors. For example, Border’s waited several years before it rolled out it’s version of an e-reader called Kobo. The other major “bricks-and-mortar” competitor, Barnes and Noble, were much more proactive in their response to the successes of Amazon’s Kindle. Barnes and Noble developed it’s e-reader, the Nook which today is competing successfully against the Kindle.
Borders also failed to adapt to a dynamic external environment and badly timed their expansion. They expanded excessively around the same time period when Amazon was generating significant performance gains from re-inventing the implementation of their business model. In addition, the world was rapidly embracing digital for books, music and movies around this time. Border’s ill-timed expansion resulted in relatively flat sales along with rising costs. The following table from a 2008 10-K reflects these problems.
Source: Borders 2008 10-K, Item 6