Is It a Tree ... or the Forest?

A colleague of mine recently intrigued me with his belief that many businesses "can't see the trees in the forest"! He contends that the “forest” in this case is the financial performance of the entire business which is displayed through its income, balance sheet, and cash flow statements. We would all agree that important "forest level" operating performance measures can be determined from these statements, including return on invested capital and cash flow return on investment. But what about how the "trees" (individual components such as business units, products, services, or customers) are performing?

Most businesses rely on “gross profit” (sales minus cost of goods sold) to measure product and customer performance. This simple profit measure ignores the product's specific effect on general & administrative expenses or on the various balance sheet assets and liabilities. Using just gross profit, we can't see the ROI (return on investment) on individual products, services, and customers. And there no doubt can be great difficulty and expense in distributing each account in the income statement and balance sheet to each product or service sold or to a customer.

Tom Welsh introduced me to his concept of Value Point Accounting (VPA) to address measuring performance at a more granular level. He believes that VPA is a low-cost way to get at ROI information and provide an advantage over competitors who manage by gross profit.

Picture your business as a portfolio where each investment is a specific product sold to a specific customer. Consider every priced item on a customer's invoice as a unique “value point” with its own return on capital. A business can readily have thousands or millions of these value points. The purpose of VPA is to determine the investment performance of each value point and use it for better business decisions. Concepts from operations management, modern cost accounting, and financial analysis come into play for VPA to determine the total economic performance of each value point. These include the theory of constraints, capacity0 based costing, activity-based costing, cost of quality, working capital turnover analysis, and economic value.

VPA's key to cost effectiveness is to apply these concepts to a simple rather than complex business accounting structure. There is no need to explode the number of general ledger accounts or keystrokes in the accounting department. The chart of accounts for VPA is built around a handful of costing objectives that are applied to the unique characteristics of each value point. The critical difference with value point accounting is that balance sheet operating assets and liabilities are applied to products and customers, along with income statement expenses. This is required to calculate economic value and ROI performance. Call it “nano-accounting.”

By recognizing the economic impact of net asset intensity on each product and customer, an organization might alter business decisions and strategies. For example, two value points may have a similar unit cash cost but quite different asset requirements. The value point using more fixed asset capacity, held longer in inventory, or carried longer in accounts receivable requires a higher price to meet the rate of return goal. VPA comprehends a value point's total economic impact on the business.

Using VPA, the profitability goal transforms to:

(1) Recovering all the cash costs consumed by each value point

(2) Earning the firm's target return on capital on the net operating assets supporting each value point

VPA can find out which products and customers do and do not earn the company's target return on capital. Accordingly, each value point resides in a performance class:

Green: Earns or exceeds the target return on capital (a value generator)

Yellow: EBITDA insufficient to earn the target return (marginal business)

Red: Does not cover all cash costs (cash consumer)

In order to improve the business's performance without additional growth or investment, the focus becomes shifting the product and customer sales mix toward the "green value points." Let competitors without value point visibility “win” more share of the low-performing red and yellow markets while you provide better service to the green markets. For each red or yellow value point, VPA calculates the higher unit price necessary for green status and thus the product marketing manager is armed with a new financial tool to guide decisions.

VPA is particularly useful in managing profitable growth because it can measure the economic utilization of existing business capacity and prompt a strategic question: Can we redeploy underperforming capacity before committing more capital investment for growth? Thus a value point review of current capacity usage can help to optimize existing resources before assuming more business risk.

Additional information on VPA is available at ###

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