VALUE BASED MANAGEMENT

Value-based management (VBM) is a tool for maximizing the value of a corporation. VBM uses valuation techniques for performance management, business control and decision-making. The value of a company is determined according to its discounted future cash flows. Value is created when a company invests capital against returns that exceed the capital cost. All strategies and decisions are tested against potential value creation. There are several ways of using VBM. The simplest is the use of VBM for financial reporting. The earnings will be subjected to a capital charge (economic value added). VBM can also be used for capital budgeting and investment analysis. All investments are tested against the required capital charge. Properly executed, this approach aligns all activities and decision-making on the key drivers of value.

In corporate finance, Economic Value Added (EVA), is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. 

VBM is used to set goals, evaluate performance, determine bonuses and communicate with investors, as well as for capital budgeting and valuations. Traditional accounting systems determine the value of organizations based on performance measurements such as earnings per share and return on equity. However, they take no account of the effectiveness with which resources are deployed and managed, i.e. the cost of the opportunity to invest capital. As a result, many companies that appear profitable on paper are, in fact, considerably less so.

Attention must be paid to four areas for successful application:

Measurement

Management

Motivation

Mindset

The steps have to be taken regarding measurement. First, establish rules to convert accounting profit to economic profit (i.e. adjust conventional earnings to eliminate accounting anomalies affecting economic results). Second, identify VBM centers within the organization: these may be large or small, but must all be accountable for their own results. Finally, link these centers to harmonize decisions across the organization. This allows VBM to be tracked, unit by unit, on a monthly basis.

Measuring value is one thing – acting on the results is another. Management and value must therefore become inextricably linked. Budgeting and planning techniques must be adjusted to incorporate the concept, and a link must be established between the operating and strategic levers.

By basing incentive compensation on an increase in value, managers can be motivated to think and act as if they were owners because they are paid like owners by increasing shareholder wealth, they simultaneously increase their own.

Therefore, bonuses and other incentives must be linked to performance as opposed to budgets, allowing managers to focus on maximizing wealth rather than merely meeting corporate expectations. Of course, a certain degree of risk must be involved, including penalties for underperformance. An additional advantage is that shifting from the constant negotiation of financial targets to a one- time setting of bonus parameters greatly simplifies the planning process.

When using value-based management, the following issues have to be taken into account:

Focus on better operational decisions instead of calculating the exact value.

The true value of VBM is the interaction between the business issues and the value drivers.

Avoid accounting complexity to the smallest detail.

The absolute value is not important, but value creation is.

Do not use VBM as a stand-alone tool, but integrate it in strategic planning and the planning and control cycle.

Commitment and the active support of higher management are essential.

Despite being described as a measure of financial performance and, moreover, one which can be calculated theoretically, it is important to remember that VBM is not so much about generating a specific figure, as about capital growth in general, implementing VBM can be complex. In particular, information about future cash flows is needed. Within VBM there could be great emphasis on shareholder to go into detail too deeply or to use complex methods.

Value based management accounting framework

A. Overall objective: increase shareholder value

B. Identify specific organizational objectives

C. Develop strategies and select organizational design

D. Identify value drivers

E. Develop action plans select measures and set targets

F. Evaluate performance

We hope this summary is to your liking. We appreciate any suggestions and comments you want to do about it.

Lic. Claudio M. Pizzi

Director

www.dorbaires.com

https://en.wikipedia.org/wiki/Economic_Value_Added - Key management models - M.Van Assen - G.V. den Berg - P. Pietersma