S. David Young Blue Line Management
B2B Firms B2C Firms Cash Cash Raw Materials “Customers” Cash Cash Objective for Firms - Value Creation & Capture Value = The expected cash flows, discounted at the opportunity cost of capital Value = Happiness
Value-driven capital investment:How can we distinguish good ideas from bad? Value creation occurs when the value of expected cash inflows is greater than the value of initial and subsequent cash outflows. We call this the Net Present Value (NPV) rule.
Two key lessons … • We need to know the cash flow consequences of our decisions. • We need to know the opportunity cost of capital.
Value creation requires … • A sustainable competitive advantage • Tools to identify +NPV projects • Incentives to identify and implement +NPV projects, and to reject ‒NPV projects
But managers often get in the way ... • The role of managers • The “agency cost” problem
Value ≠ Price Blue line management
Blue line management—Customers • What do you sell? • To whom do you sell it? • Why do they buy it? • What are the features/attributes they value? • How much are they willing to pay for them? • The customers who aren’t buying from you, who are they buying from? • Why are they buying from the competition? • What features/attributes/services do they offering that you don’t? • Why aren’t you offering comparable features/qualities/services/price? • If you decided to offer competitive features to win customers back, how much would it cost? • How many customers would come back? • How many more units would you sell? • Would you also be able to increase your price? By how much? • How quickly do your customers pay? What would be the impact of offering them 5 extra days to pay? Could you improve on the price? Sell additional units?
Common examples of red line management • Referring to share price impact in explaining or justifying business decisions • Buying back shares to boost EPS • Using hidden reserves to manage earnings • Sale and leaseback transactions to get debt off the balance sheet and to boost return on invested capital
Why is red-line thinking so persistent? • The red line is seductive. • Top management is paid to deliver growth, often at the expense of value. • The proper role of key performance indicators (KPIs) is not understood.
The red line is seductive • Toyota • General Electric
Compensation policies also play an important role • Directors are often confused about the nature of the incentives they create for top management. • Most top managers have stronger incentives to grow revenues than to create value.
Red-Line management isn’t just a corporate level problem • Red-line thinking can reach any level of an organization through the misuse of KPIs. • The problem is not with KPIs, but rather with the tendency to manage based on KPI targets.
Consider the following example: You are the managing director of a major operating unit. Return on Invested Capital (ROIC) features prominently in your evaluation and bonus scheme. Current ROIC is 15%. The opportunity cost of capital is 7%. A proposed investment is expected to yield 12%. Do you accept it?
Value Drivers and KPIs: Understanding the difference Identifying Value Drivers An illustration of how R&D and product development drives value How effectively do new products / technology generate revenues &/or cost savings? How effective is organization at implementing new technology / products? How effective is organization at converting new tech. to actual application ? How effective is organization at grasping and developing new ideas? How effective is organization at identifying and acting on new ideas? Is organization actively encouraging idea generation? # ideas generated Survival! x # ideas introduced x % ideas acted upon # ideas become actual technology x % conversion to patent/next step # new products / applications x % convert tech. to application # implemented products/activities x % launch to client / activity Value creation revenues/ cost savings per idea Time from idea generation to product launch / technology implementation
The dangers of paying managers for KPI outcomes • Targets can be reached by creating value or destroying it. The latter is nearly always easier. Example: Suppose you are set a 15% target for operating margin. You expect to earn 12%. What do you do? • When outcomes are managed, indicators are no longer “unbiased” measures. If managers get paid or evaluated based on KPI outcomes, the results will always be biased. • When KPIs are biased, how can we interpret them?
Lessons learned • Value creation is an imperative. • Value and price are not the same thing. • High performance is defined on a single dimension: an understanding of, and ability to deliver, value. • Every decision is either positive NPV or negative NPV. • Value drivers and KPIs are not the same. • Delivering on KPI targets is not value creation.
Some more lessons learned • Value creation is possible only when managers know their opportunity cost of capital, and the cash flow consequences of their decisions. • Value-driven organizations are learning based, and learning requires toleration of failure. • The most important attribute of any performance measurement system is whether it encourages truth telling. • Maintaining organizational focus on value creation requires constant vigilance.