CGA Magazine
Management Accounting
Face Value
Value-based management allows organizations to not only measure value, but also create it.
By Paul Sharman
If you ask a group of senior executives of a public company what drives them in their work, most will probably answer, “Creating value.” In other words, they want to ensure that they give company shareholders a financial return that exceeds not only the shareholders’ original investment, but also the amount they would have earned had they invested in another company. After all, in today’s climate of hot IPOs, there’s a lot competition for investment dollars.
Executives also have a vested interest in ensuring value creation. Executive compensation schemes today often include stock options. Plus, if their business track record shows they have accomplished growth in value, they will be able to command a premium with potential employers. Lastly, high records of value creation can help ensure executives’ professional longevity; for example, in the event of corporate mergers or acquisitions, executives in under-performing corporations are more apt to lose their jobs than those leading profitable ones.
Previously, the assessment of an executive’s performance was based on annual profit returns, but this is now viewed as a somewhat short-term and subjective assessment providing a poor indication of long-term financial return. Consequently, there has been a significant shift to measuring value creation instead. A variety of measures can assess value performance, however the simplest measure to describe is economic profit (EP). An executive’s compensation is often geared to his or her achieving an EP performance target.
To achieve this value creation, and thus a high EP, many executives are turning to value-based management (VBM) — the measures and methodologies with which organizations plan operations, make decisions and act in order to create value.
VBM is not a management methodology per se but rather it is an organization analyzing, planning, measuring and taking actions in order to achieve EP objectives. VBM can succeed where other methodologies fail because it provides an integrated framework focused on accomplishing the ultimate goal of value creation. For example, many organizations apply business process re-engineering, but fail to sustain it as a fundamental element in their continuing operations. Similarly, many organizations implement activity-based costing ineffectively. Organizations often apply these methodologies in an unsustainable fashion because they approach most new improvement initiatives as projects rather than continuums and, therefore, don’t weave them into the fabric of their performance management. Also, if they apply several of these methodologies, they don’t design them to work together; they approach each methodology as if it were a standalone and unique technology.
In contrast, VBM combines a number of operational and analytical methodologies together and applies them in an orchestrated, integrated and disciplined manner, focused ultimately on driving the creation of economic value. (See “Myriad Methodologies” for a listing of the various methodologies applied in VBM.)
Under VBM, managers select which methodologies to use, based on the status of their business and their needs, and then plan how the methodologies will work together. Applying VBM is not based on any formula; depending on the resources available, managers should custom design their own application of VBM to fit their business’s needs. The trick in VBM is to assemble the various methodologies in the right way by identifying the links between them. By themselves, these methodologies provide useful outcomes, for example, process improvement should yield reductions in cycle time, improvements in quality and hopefully, a lower cost. But, in combination, they create a natural and powerful management structure.
Through the use of VBM methodologies, managers will be able to analyze stakeholder needs and the critical success factors and business issues associated with achieving organization goals. For example, in order to increase gross margin it maybe necessary for an organization to increase revenue by obtaining a larger market share. Managers can analyze, design and budget for activities and processes, then cost out activities and assign them to processes and objects. They can examine people’s roles and responsibilities in the activities they perform within each process, which will lead to their developing performance measures and identifying internal and external benchmark comparisons. Managers will be able to assess job definitions and organizational design, then manage change and develop compensation and incentive schemes. Finally they will be able to develop information portals or Web-based distribution of performance data.
Now that executives or managers know what they can do with VBM, how do they go about implementing it?
Obviously, measuring value alone does not add value to an organization. But linking value-creation measures like EP to compensation will encourage employees to work toward achieving the best results. Therefore, managers must create measures and performance targets designed to deliver the desired value-creation goals. To do this, they must recognize influences on EP performance, namely value drivers.
EP performance increases or decreases based on the performance of value drivers, which are financial measures that represent the component elements of EP. The seven value drivers are sales growth rate, operating profit margin, cash income tax rate, working capital, fixed capital, the weighted average cost of capital (WACC), and growth duration period. A manager’s decisions influence the performance of each measure. For example, managers who invest in marketing initiatives, acquire distribution channels and increase sales efforts accomplish sales growth.
You can assist in the planning process by analyzing alternative management actions to determine which ones would have the most significant impact on increasing EP. Undertake sensitivity analysis of the effect of factoring up each value driver in, let’s say, 10-per-cent increments to determine which driver has the greatest impact on economic profit. For example, should managers plan to spend more money to increase sales revenue or to reduce cost? Which approach will deliver the most significant increase in EP?
Depending on the business circumstances, each value driver will have greater or lesser leverage impact on economic profit. For example, pensions and retirement investment funds would possibly obtain greater leverage from driving increased sales revenue than from reducing operating expenses. An auto parts manufacturer, however, is likely to gain a higher degree of leverage from managing expenses, inventory turnover and making sure that the factory is always full of work. For many other organizations, such as a software company, operating profit margin and sales growth are highly influential because software is relatively inexpensive to produce.
Rather than assuming that expense reduction is necessarily the right thing to do, analyzing EP will help prioritize expense reduction along with other opportunities to drive value. In one organization, for example, after a number of years of unsuccessful efforts to reduce expenses, value analysis caused management to re-prioritize efforts toward driving revenue growth instead.
Based on this initial EP calculation, analysts should then establish what is the most effective way to analyze value-driver measurements in order to ensure the greatest return on management efforts. Analyze the basic inter-relationships between the intellectual and physical components of the organization. At the intellectual level, managers define goals for the organization through strategy development and stakeholder analysis (see “Value-Based Management Framework”). Analyze stakeholder needs to obtain an external perspective on organization expectations. Once you review your strategy, identify critical success factors, such as an increase in market share. At the physical level, determine how processes convert inputs into outputs.
The next step is to assess which VBM methodologies exist in your organization. Taking into account the value driver with the greatest leverage, determine which VBM methodologies will most influence value creation. Consider how the VBM methodologies interact with each other and what needs to be done to create a complete measurement and management framework. Which of the VBM methodologies will provide the greatest payback? Implement that methodology, such as process improvement and management, first. Then develop a long-term integrated implementation plan for the remaining VBM methodologies you plan to use.
Now it’s time to actually implement the chosen VBM methodologies, including a measurement system and an appropriate compensation scheme. You need to approach each methodology individually, but with more discipline than is sometimes applied when the tools are implemented on a stand-alone basis. Design each tool to integrate tightly with the others you are deploying.
Identify the points of interaction between the different levels within the organization by using measures, such as sales revenue growth rate or market share, to define expectations for the performance of key processes. Also, determine what activities must be performed within each process and what technology, skills and resources you have to acquire. This leads to defining which department will supply each activity to each process and how people are expected to perform. Designing the right measures is particularly important because, when done properly, these measures provide analytic support to guide you on what people have to accomplish and how well they have done after the fact.
An opportunity exists for accountants to move the yardsticks of their organization by evolving from the somewhat passive role of calculating and reporting on financial performance to a dynamic role in promoting organizational change with value-based management.
When linked together in a holistic framework, VBM methodologies represent a way to make measures applicable to activities, processes and the organization as a whole. Financial reporting remains the most critical measurement system in an organization, and VBM provides the next step to driving value creation.
Paul Sharman is the president of Focused Management Inc. He can be reached at (905) 829-2658 or emailed at psharman@focusedmanagement.com. Visit his Web site at www.focusedmanagement.com.
VBM combines a number of operational and analytical methodologies in order to drive the creation of value. The various methodologies employed in VBM are the following.
Strategy development provides an analysis of stakeholder needs, strategy, organization goals, as well as critical success factors and business issues.
Activity and process analysis delivers disciplined information on what work is done and how.
Process improvement and management determines how well a process performs currently, how it should perform and what actions you need to take to achieve desired performance.
Performance measurement delivers pertinent information on goals, measures and current performance.
Benchmark performance measurement identifies internal and external best practices comparisons and actions to improve performance.
Activity-based costing provides activity costing and determines and assigns the cost of processes and cost objects, such as customers and products (see “Beyond Product Costing” — parts I and II, April 1996).
Role and responsibility determines what people are accountable for and what is expected.
Organization design provides job definition and functional design relative to the role and responsibility of each position.
Activity-based budgeting provides managers with budget accountability for activities and processes in addition to the traditional accounting responsibilities for lines of expense.
Capacity management provides appropriate technologies and personnel requirements in order to meet business volume levels.
Change management aligns personnel philosophically with new organization directions and approach.
Compensation and incentive schemes ensure people are compensated appropriately for their work within the new structure.
Information “portals” or Web-based distribution of performance data provides a common and consistent source of organization performance information.
(Profit +/– Interest and various accounting charges)
· less the cost of Capital Employed
(Capital Employed X Weighted Average Cost of Capital)
· equals Economic Profit
(Debt portion X after-tax interest rate %) + (Equity portion X shareholder expected return %)