Over the last two decades, many companies have used value based management (VBM) system to evaluate and measure value creation and the performance of their businesses which focus on the systems, processes and activities with customers as the central principle rather than on departments, business units and accounting expense categories. This VBM system aligns the organizational levels,links systems, processes and activities to each other covering value chains in inbound logistics, internal operations, outbound logistics, marketing and sales and customer services to achieve superior corporate performance and optimize value for the shareholders and all stakeholders involved.
VBM strategically combines and linksprimary activities and support activities to measure business performance. Companies optimize value creation through primary activities which have an immediate effect on the supply source through production, supply chain, maintenance, sales and support of the products or services to be supplied to the customers. In addition, in optimizing value creation, support activities assist the primary activities and they collaborate internally and across geographies to form the basis of any organization that can act on the global scalesuch as firm infrastructure, human resource management, information technology, legal and procurement services. These support activities play a very important role within the primary activity operation as they strategically support other activities in optimizing the company business performance and maximizing shareholder value creation.
MichaelPorter in his book The Competitive Advantage of Nations (1990) as depicted in the Exhibit 1 - Michael Porter’s Value Chain below, explains that a value chain is a collection of activities that performed by a company to create value for its customers. Value creation creates added value for customers and stakeholders which ultimately leads to competitive advantage and create a higher profitability for an organization. The Value Chain Analysis Chart below shows the key value chain drivers and illustrates the primary activity operation and the support activitiesthat must be well integrated in developing the value creating capabilities.
Exhibit 1 - Michael Porter’s Value Chain
Value Based Management and Driving Value Creation
In order to succeed in optimizing value creation, VBM requires the entire organization’s participation and collaboration from the inbound logistics team through to the after-sales services team as outlined in the Exhibit 1 above. Recent studies have shown that VBM companies outperform their peers. Not surprisingly, many companies have adopted a shareholder value maximization culture and mindset hoping to drive business performance and achieve strong results through VBM.
The strategic thinking behind VBM in optimizing value creation is not complicated. It focuses on corporate strategy and the alignment of all stakeholders in the organization. In terms of corporate value, the value of a company is determined by its discounted future cash flows. Value is created only when companies invest capital at returns that exceed the cost of that capital.
VBM clearly articulates these concepts by focusing on how companies use them to make both major strategic and everyday management and operating decisions. Companies who properly execute VBM always adopt an approach to management that aligns a company's overall strategic objectives, goals, aspirations, analytical techniques, and management processes to focus on strategic management decision making as part of the key drivers of value.It can bring tremendous benefit. It is like financial restructuring to achieve maximum value on a continuing sustainable basis to realize improved economic value,
You Can’t Manage What You Can’t Measure
For the performance management to be effective, the focus of VBM should be on the why and how of changing your corporate culture and a value-based manager is interested in using valuation as a performance metric and decision-making tool.Though considered traditional, when VBM is working well, an organization's management processes provide decision makers at all levels with the right information and incentives to make value-creating decisions.
VBM would provide managers with the information to quantify and compare the value of alternative strategies and the incentive to choose the value-maximizing strategyandmost importantlythe strategy review process between manager and superiors that would be based on long- and short-term targets that measure progress toward the overall value creation objective.
VBM can operate at all levels in the value chain or at senior levels based the strategies established by the company. For example, in collaboration with the procurement team in sourcing raw materials and get competitive price, a production manager may work to target cost per unit (unit cost), product quality and turnaround time. On the other hand, line managers and supervisors, for instance, can have targets and performance measures that are tailored to their particular circumstances but driven by the overall strategy.
Importantly, at the senior leadership and corporate level, VBM provides the management tooland informs the board of directors about the value of their strategies and helps them to evaluate mergers, acquisitions, and divestitures. The Exhibit 2 below depicts corporate performance measures embedding a long-term view and the balance sheet management (McKinsey, 1994)
Value Drivers and Corporate Performance Measure
Companies strive to find the key value drivers and use performance measures in evaluating their business performance to maximize shareholder value creation which is the first step in VBM to embrace value maximization as the ultimate financial objective for a company. Traditional financial performance measures, such as earnings or earnings growth, are not always good proxies for value creation. To focus more directly on creating value, companies should set goals in terms of discounted cash flow value and economic profit, the most direct measure of value creation. Such targets also need to be translated into shorter-term, more objective financial performance targets as illustrated in the Exhibit 3 below (McKinsey, 1994).
Additionally, companies also need nonfinancial goals concerning market share, customer retention, new product launch, customer satisfaction, product innovation, talent retention and employee satisfaction, for example, to inspire and guide the entire organization as part of the entire value chain analysis. Such objectives do not contradict value maximization. On the contrary, successful companies are usually the ones that excel in precisely these areas. However, nonfinancial goals mustbe carefully considered in light of a company's financial circumstances and resources.
Economic Value Added as High-Level Organizational Performance Metric
According to Stern Value Management (SVM), Economic Value Added (EVA) measures the shareholder value an organization creates (or destroys) each year. It is basically a company’s after-tax-profit from operations (NOPAT) minus a charge for the cost of capital employed to produce those profits, not just the cost of debt, but the cost of equity as well. EVA is considered superior to all other financial measures such as EPS, ROI, ROA, ROCE and free cash flow.
Peter Drucker once wrote in his book, Managing for Results(1964) that until a business returns a profit that is greater than its cost of capital, it operates at a loss. Most successful EVA companies always want to improve and optimize its EVA each year as it will indicate whether a value is created or destroyed on a yearly basis. They strive for value creation and sustainable growth by increasing revenues, reducing operating costs or decreasing capital costs by increasing economies of scale and byimproving operational efficiency.
EVA demonstrates how and where a company creates shareholder value through the profit and loss statement and the balance sheet management. This strategic initiative forces senior managers to be aware of assets, revenues and expenses when making managerial decisions to create EVA as depicted in the chart below.
Embedding and Implementing Value Based Management
Based on our corporate experience in many years managing corporate performance measures, there have been plenty of barriers in implementing VBM as all levels in the organization have to get involved. Therefore, implementing an integrated VBM has to be the number one priority and needs the strongest possible buy in from the board right from the beginning to make VBM an operational reality for the organization.
A value mindset and well-managed stakeholder communication is critical for success. Of utmost importance, we need to strike the right balance between concept and reality too. It really needs to be presented in the down-to-earth context of business decision making. The real secret to winning the necessary commitment and ownership at all levels, lies in making it possible for people to participate in a way that connects the value agenda to their agenda. As illustrated in the infographic below, aligning the entire organization proves to be the way to significantly improve VBM performance results (Steve Chopp and John Paglia, 2002).
VBM takes and places the corporation and the CFO as its architect into a new and different world. The CFO and finance function as well as the information technology function must drive the VBM implementation through the following imperatives:
- Commitment to value creation and use of training to promote VBM;
- The shift from number crunching to partnering the business;
- The move from incremental DCF project appraisal to value based business appraisal such as EVA;
- Use incentive compensation to incentivise long-term value creation;
- Setting up enterprise-wide advanced information technology automation system and digitalization to enhance value creating capabilities.
