In this era of increasingly focused competition, the world is more demanding than ever before. Business performance is defined by expectations of rapid revenue growth and returns that exceed the cost of capital. Decision-makers are influenced by the information they have available to them, and, of course, trends in the market place that define their relative success. The current and very powerful influence on executive decisions is the performance of their corporations in the creation of value, relative to market expectations. Value based management relates to the deployment of planning and measurement systems that influence management decision and actions, in order to create value.

In this article, we describe how the planning and measurement of cost and profitability information using activity based costing (ABC) aids executives in making decisions that drive value creation.

It is evident that ABC is legitimized by the need to plan and measure the creation/destruction of value in a way that has not been previously understood. Executive emphasis on measuring value is a timely occurrence in the world of ABC, the validity of which has been increasingly questioned in practice, as thousands of applications have failed to meet expectations or provide significant benefit to organizations. In many cases, ABC initiatives have under-performed because they have not been properly linked to the overall measurement and management process of the businesses, nor have managers allowed ABC to influence annual planning and budgeting targets. Continued use of traditional measurement systems, due to a lack of a better alternative, has left managers unwilling to change. Value creation measures are offering an opportunity to change and focus measurement systems in a single integrating measurement framework, one that makes sense out of a number of recent management methodologies, including ABC.

Value creation measures, such as Economic Profit (EP) {also know as Shareholder Value Added (SVA) or EVA}, Cash Flow Return On Investment (CFROI), or Return On Net Assets (RONA), provide a most powerful and compelling aggregate measure of whether and to what degree an organization is creating value. There are differences in the way that these individual measures are calculated and what they portray, but in principal they depict different aspects of the same thing, value creation.

EP, for example, is a highly aggregate financial performance measure, which is calculated in total for a corporation (see figure 1). Investors and analysts use EP and other similar measures to assess how a corporation is performing, relative to other investment choices, which in turn influences what they are willing to pay for the shares. Value measures such as EP have gained increasing acceptance over the past ten years, to the point that stock markets are prepared to pay huge premiums for the opportunity to invest in corporations who promise rapid growth and high margins.

As agents of shareholders, executives are accountable for driving their organizations to deliver the highest EP possible. Compensation schemes that include stock options for executives are designed to influence them to act in the best interest of shareholders. There are two other influences on executives to drive EP. The first is their career path, whereby, if in their business track record potential employers can see that an executive has accomplished growth in EP, then they will be able to command a premium. Secondly, mergers and acquisitions are used by acquiring corporations to unlock hidden value, the effect of which is that executives in under-performing corporations that are purchased may lose their jobs.¹ Therefore, leaving EP performance to chance is a highly risky proposition for any executive.

¹ Creating Shareholder Value. A guide for managers and investors. Alfred Rappaport. The Free Press 1998

 

Value is created in commercial enterprises when Revenues are generated in excess of the economic costs to generate these Revenues. Economic costs include operating expenses, depreciation of assets, taxes, and the opportunity costs of capital employed.

Investors and managers are highly focused on the creation of value. Organizations are dramatically revamping operations, while demanding that staff change their attitudes to accommodate a more serious approach to doing business, in order to create value. It is evident to most business people that the purpose of doing business is to make money, and it is also evident that the people who are employed by a business should be held accountable for behaving in a way that will contribute to the ability of the business to make money.

If the purpose of measurement is to influence human behavior, then the purpose of measures of value creation is to drive people to create value. In order to drive value creation, managers need to decompose the measure into its component parts, more commonly known as value drivers.

There are seven value drivers:

• Sales growth rate
• Operating profit margin
• Cash income tax rate
• Working capital
• Fixed capital
• Cost of capital - (WACC)
• Growth duration period

Depending on the business circumstances, each value driver will have greater or lesser leveraged effect on the calculation of value created. For example, a retirement benefits organization (pensions and retirement investment funds) would probably have greater leverage from driving sales levels than managing operating costs. An auto parts manufacturer, however, is likely to gain leverage from managing expenses, inventory turn-over and fixed asset capacity utilization. For many other organizations, operating profit margin is a highly influential number.

As in accounting results, economic value measures are highly aggregate. Each driver value represents the sum of a number of accounting measures (with adjustments) that should be analyzed, decomposed into its component parts and managed in detail. Investment analysts also are constantly looking for insight on product and division financial performance, in order to get a sense of the strengths and weaknesses of every organization.

The opportunity for executives to manage EP is to drill into and manage the drivers of EP, to a much greater degree than is available simply from the financial records of the organization. In exactly the way that it is possible to calculate organization value creation (figure 2), it is also feasible to calculate the value created for the corporation by each of its individual products, customers or channels. ABC provides the mechanism to segment product/customer margin with much greater relevance than traditional cost accounting methods, employed for the purpose of creating externally-oriented financial reports.

Traditional Income Statement				Value-Based Income Statement
Revenues		$ 92.6		Revenues		$ 92.6
	Cost of Sales	21.9			Product/Customer Costs	57.2
Gross Margin		70.7		Operating Margin		35.4
	Selling, Admin.	45.1			Tax Impact	14.2
Net Margin		25.6		Segmented NOPAT		21.2
	Interest	2.5			Business Sustaining (tax adj.)	4.2
	Taxes	9.2			Value Adjustments (tax adj.)	(1.2)
Profit After Taxes		$ 13.9		Normal Operating Profit After Taxes		18.2
					Capital Charge	9.2
				Economic Profit		$ 9.0
	In the Value Based Income Statement we have added back interest expenses (tax adjusted), as they are reflected in the Capital Charge.
	Certain Value Adjustments are also shown. (For example Research 'expenses' have been recognized as generators of future value.)
	Business Sustaining expenses are activity costs NOT traceable to specific product/market segments
	The Capital Charge is determined by the $75.6MM Operating Capital x 12.2% WACC.
	Reference standard financial accounting texts for discussion of WACC determination.
	Figure 2

 

ABC and VBM

Activity-based costing (ABC) is an important component methodology for the measurement and management of almost any organization, as it goes about its business to create value. ABC alone provides relatively accurate information on which products/ services/ markets/ customers/ channels or market segments create or destroy value. ABC is an analytical methodology, which, when done properly, identifies work activities and assigns the cost of activities to cost objects, based on use. ABC provides more relevant cost information on the cost and profitability of products, services and customers. ABC also provides important performance information on cost and operational aspects of activities and processes, which can be used to influence operational productivity improvement. Therefore, ABC provides a crucial set of information on profit margins and its component parts, profit and cost, for the purpose of managing (planning, monitoring, adjusting and measuring) cost and profit margin.

 

In order to calculate value created by a product or customer there are a series of steps to be undertaken:

• Complete ABC analysis for the product/market segments of interest
• Calculate ABC product/market segmentation profit margin (Figure 3)
• Make appropriate accounting and valuation adjustments to calculate Normal Operating Profit After Taxes (NOPAT)
• Trace Working Capital and Assets use by product/market segment (CE)
• Determine the corporate Weighted Average Cost of Capital % (WACC)
• Economic Profit = NOPAT – (CE x WACC) (Figure 4)

 

In the context of value creation, ABC system design and implementation is not to be taken lightly. ABC applications need to be designed and implemented properly if they are to be of service in focusing the organization on creating value. This is because the decisions to be made with ABC data could have significant impact on stock market valuation. Acknowledgement and application of ABC as a critical component of VBM is very timely in the evolution of both measurement technologies.

The differences between accounting contribution by product and ABC contribution by product & customer are profound. ABC assigns the cost of resources to the objects of those activities only. For example, the cost of processing an invoice is treated as a customer-serving activity, and the cost is used to determine profit earned on that specific customer. Invoice processing cost is not assigned to a product. Therefore, profit earned on the products sold to a customer would be higher than financial accounting normally reports. Other activities performed by an organization used to forward long-term interests are referred to as sustaining activities, such as strategic planning or business development, which are not allocated to products. Financial accounting has no notion of customer profitability or sustaining cost, whereas ABC provides a more complete and accurate profitability picture by correcting managerial information inadequacies of financial accounting logic. ABC profit margin provides a relatively more accurate view of profitability by product, customer, market and channel. Often ABC provides substantially different profit information from that with which management are familiar.

Economic profit of products and customers/market segments provide a further step function shift in understanding sources of profits earned. From Figures 3 & 4, not only do we see a shift in our understanding of profit in aggregate due to the discounting of contribution, but, in addition, we see a redistribution of profit by product market segment, due to the relative weight of assets dedicated to the products. In effect, we see that cold and allergy medication, sold to a specific group of retail customers (Buyers), are destroying value. This is because of pricing practices, specifically discounts that were negotiated by the customers. It would be interesting to consider management’s motives in negotiating discounts that would cause value to be destroyed. Normal financial accounting data would suggest that marginal contribution to fixed cost would make such discounting a valid management choice. The logic being that volume increments would compensate for reduced margin in the long run, and that fixed cost would remain stable. Of course, in ABC there are no fixed costs, only the cost of capacity. With EP, serious questions need to be answered on pricing and market segment strategies.

EP of products and customers/market segments provides a very different standard of performance for all managers. Sales and marketing staff should understand the implications of EP in every deal they do and they should be using simulation modeling to understand the characteristics of desirable, value creating strategies by segment. Sales staff have the ability to significantly influence profitability, by structuring deals to provide value by drawing on ABC/EP knowledge. Marketing and financial staff should be working together to undertake simulation modeling of alternate EP scenarios, in which sales and marketing initiatives are focused on segments that offer the greatest value creation opportunities. Other scenarios and strategies can be explored in order to minimize value-destroying effects of under-performing segments.

Implementation Issues

A word of caution: many organizations are managed along product, brand or market lines. We hope that we have demonstrated that ABC is a useful tool for segmenting organization performance in the context of a Value Based Management framework. These techniques should be especially applicable when there is significant diversity in products/customers and their use of operating & capital assets. Particular care must be exercised when considering exit strategies (discontinue/divest) in response to value destroying products/markets. Such an exit strategy will only increase value creation if Operating and Capital resources can be reduced or redeployed faster than revenues are reduced. Care must be taken to consider shared resources when evaluating these scenarios.

Close enough is not good enough. Many theoreticians have accepted ABC as a valid and correct way to do managerial cost accounting. Sadly, many applications of ABC have been handled poorly because people confused the output of ABC with the needs of financial accounting. Hence, we hear of people talking about "ABC-like costing systems", "ABC is used to provide better cost allocation" or one more recent version "Hybrid ABC and Theory of Constraints cost of products". All of this has contributed to the epitaph on the grave of ABC that has been dug over the last ten years "we did ABC but didn’t know what we got or what to do with it". Of course, there are examples of well thought out ABC applications that have produced significant benefits for their organizations. These are the ones that have understood ABC as a managerial accounting methodology but few have taken full advantage of all of its benefits. EP/ABC contribution margin by product/customer/market and channel is the next obvious step, but it must still be tied into an overall measurement and management framework.

Conclusion/Summary

Demanding and changing business conditions necessitate increasingly more analytical discipline and the use of more sophisticated and better management methods. Innovations in measurement techniques, along with modern computing capabilities, have led to economic profit as the leading modern indicator for business performance, and Activity-Based Costing as the only reliable costing methodology with which to support the creation of value. In the past ten years we have seen implementation of these two measurement methods on a standalone basis. Now, we are beginning to understand the degree to which these mechanisms can not only co-exist, but actually create, very tightly integrated and complete measurement and management systems, which are more sophisticated than anything we have seen in the past. As managers, accountants and executives learn about these new methods and understand the importance to their personal performance, we expect to see economic profits increase in the corporations that deploy the tools.