Business leaders often complain that with today’s massive data loads, they can’t see the forest for the trees, and BPM practitioners are used to helping them gain the high-level overviews they need. But in the search for a clear understanding of business performance, decision-makers also face the opposite problem: They can’t see the trees for the forest.
The forest in this case is the financial performance of the entire business, as displayed through its income, balance sheet, and cash flow statements. While companies can derive important operating performance measures from these statements, such as return on investment (ROI) on total assets, total net assets, and net working capital, these metrics apply to the company as a whole. They don’t describe the individual components that drive the organization’s overall performance — namely, each product and service sold to each customer.
There’s a good reason for this. It can be difficult and prohibitively expensive to distribute each account in the income statement and balance sheet to each product or service that the organization sells. Most businesses use gross profit (sales minus the cost of goods sold) to measure product and customer performance. But this simple profit measure ignores a product’s specific effect on general and administrative (G&A) expenses and on the various balance sheet assets and liabilities. If you rely exclusively on the gross profit metric, you can’t see the ROI on the individual products and services you’re selling.
ROI is a fundamental tool in corporate performance management, but it’s one that’s often misunderstood and underused. A careful ROI analysis can show you whether a product, customer, or operating process is earning the company’s cost of capital — that is, the weighted average return expected by the providers of debt and equity financing to the company. While this is termed a “cost,” it’s really a profit goal; it’s the target rate of return (or hurdle rate) on investments in operating assets such as facilities, equipment, inventory, and accounts receivable. Earning or exceeding the cost of capital increases the economic value that the business provides to its shareholders.
In contrast, products and customers with ROI below the target cost of capital reduce business value. The challenge is: How do you identify them?
How VPA Works
Value point accounting (VPA) is a low-cost way to leverage ROI information and thereby secure an advantage over competitors who manage by gross profit. VPA views a business as a portfolio in which each investment — each “value point” — is a specific product sold to a specific customer. Exhibit 1 shows a simple value point grid of product and customer combinations. Of course, the number of products and customers can be extended indefinitely; depending on its size, a business can have dozens or millions of value points.
VPA considers each priced item on a customer’s invoice as a value point with its own income statement and balance sheet. It calculates the investment performance of each value point and uses that data to support better business decisions.
The critical difference between value point accounting and other approaches to business performance management is that, in VPA, balance sheet operating assets and liabilities are applied to products and customers along with income statement expenses. This enables you to calculate ROI performance and determine true economic value. VPA can bring out the numerous miniature financial statements embedded in the company’s product and customer data. Call it “nano-accounting.”
VPA uses concepts from modern cost accounting, financial analysis, and operations management — including activity-based costing, working capital turnover analysis, operating capacity analysis, and economic value measurement — to determine the total corporate performance of each value point. The key to cost effectiveness is to apply these concepts to a simple, rather than complex, business accounting structure. With VPA, there’s no need to explode the number of general ledger accounts or keystrokes in the accounting department. A VPA chart of accounts is built around a handful of costing objectives that are applied to the unique characteristics of each value point.
Exhibits 2a, 2b and 2c show how some basic financial and operating measures for a value point can be converted to unit investment dollars and the related profit requirement. Value point accounting addresses this question: What EBITDA (earnings before interest, taxes, depreciation, and amortization) is required by each value point to earn the company’s cost of capital? To answer this, we must find the accounts receivable, inventory, accounts payable, and fixed asset amounts that are logically related to each value point (and accurate enough for decision-making).
The working capital turnover ratios in these exhibits are readily available; they’re used here to determine a value point’s working capital components. If we take accounts receivable, for example, the unit price of $100, when divided by this customer’s actual receivables turns of 7.5, yields an annual investment in accounts receivable of $13.33 for this value point. The EBITDA required to earn a 20 percent pretax return on receivables is $13.33 multiplied by 20 percent, or $2.67 per unit. A similar turnover conversion/valuation process is used to determine this value point’s investment in inventory and the related inventory profit requirement.
Accounts payable serve as free financing from suppliers for some of the value point’s cost. Here again, a turnover conversion/valuation process is used to determine this value point’s “negative investment” in accounts payable and the related reduction in its overall profit requirement.
Next we turn to the fixed asset part of the conversion, as shown in Exhibit 2b. Fixed assets present a challenge with any costing methodology. Economic value is driven by the amount and timing of cash flows. Accordingly, value point accounting focuses on gross fixed assets (accumulated capital expenditures) and does not use book depreciation. What matters is the original amount invested in a fixed asset and its statutory tax deduction schedule, which provides a multiyear series of cash tax savings. How can we relate this to a specific value point?
One way is to convert fixed asset investments into a hypothetical “lease” that is priced to recover both the original asset acquisition cost and the company cost-of-capital requirement. You can use a basic lease-pricing model to calculate an annual “lease rate” that encompasses:
- the capital asset’s useful life (the “lease term”)
- the company’s tax depreciation deduction schedule for the asset class
- the company’s marginal income tax rate
- the company’s cost of capital/rate-of-return target
In our example, the cost of capital equivalent annual “lease rate” is about 21 percent of gross fixed asset dollars — the annual amount needed to earn a 20 percent pretax rate of return and recover the original fixed asset cost over 10 years. It assumes fixed asset equipment with an average useful life of 10 years and income tax depreciation deductions for 7-year property.
Applying this hypothetical lease rate to the gross fixed asset amount gives us the annual EBITDA needed to recover the acquisition cost of the asset and related cost of capital over its useful life. Here we “dollarize the hurdle rate” into a required EBITDA figure that operating managers can understand better than net present value or internal rate of return. In addition to this use for the purposes of VPA, dollarized hurdle rates can help operating managers with capital project analysis and lease-versus-buy decisions.
Capacity modeling of operations is needed to tie the required EBITDA on fixed assets to each individual value point. We need to know the annual operating capacity hours of a business process supported by fixed assets. Here accounting, operations, engineering, and information technology people work closely together to define, model, and measure operating capacity. Dividing the process gross fixed asset amount by process annual capacity hours gives us the fixed asset investment dollars per capacity hour. Each value point’s specific use of capacity drives its unique fixed asset investment and related cost of capital assets.
In Exhibit 2b, we see that processing for this value point uses 15 minutes of capacity, which is supported by $310 of gross fixed assets per annual capacity hour. The value point uses .25 hours, or $77.50, in fixed asset investment, which must earn $16.27 in EBITDA (the 21 percent “lease rate” applied to $77.50) to cover the cost of capital assets.
When all investment categories for a value point have been determined, the required EBITDA amounts on those investments can be added to find the total value point EBITDA necessary to earn the company’s cost of capital (Exhibit 2c). Comparing this target to the actual EBITDA reveals a value point’s economic value to the business. In our example, the value point exceeds its EBITDA requirement by $.95 per unit. This product sold to this customer at this price is currently a winner and a candidate for value-added growth.
|Exhibit 2c: A value point conversion to investment value (net economic value)|
|Value point EBITDA requirement: Receivables||$2.67|
|Value point EBITDA requirement: Inventory||$1.44|
|Value point EBITDA requirement: Payables||$(1.33)|
|Value point EBITDA requirement: Fixed assets||$16.27|
|Total net EBITDA per unit required to earn the Cost of Capital||$19.05|
|Value Point EBITDA ($100.00 price minus $80.00 CBITDA)||$20.00|
|Net Economic Value (Actual minus Required EBITDA)||$0.95|
Using Value Point Information
VPA adds greater resolution to product costing by including the cost of operating assets. The economic information from value point accounting can serve as a key input to BPM software solutions that report on the performance of products, customers, and operating processes.
Recognizing the economic impact of asset intensity for each product and customer can greatly improve business decisions and strategies. Two value points may have a similar unit cost but quite different asset requirements. A value point that uses more fixed asset capacity or that is held longer in inventory or carried longer in accounts receivable requires a higher price to meet the rate-of-return goal. VPA encompasses a value point’s total economic impact on the business, including how fast each customer pays invoices.
The method also identifies the products and customers that earn the company’s target return on capital — and those that don’t. You can easily assign each value point to a dashboardlike, color-coded performance class:
- Green: Earns or exceeds the target return on capital (value generator)
- Yellow: Profit insufficient to earn the target return (marginal business)
- Red: Fails to cover all cash costs (cash consumer)
It’s important to understand that a sales volume increase will not improve a red or yellow value point to green. A value point is charged only for the capacity it specifically consumes. Improving the performance of a value point requires increases in price or process productivity and/or reductions in input costs, capacity consumption, or working capital levels.
Business value can improve without additional growth or investment if the product and customer mix shifts toward 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. The product marketing manager is now armed with a comprehensive financial tool.
Value point accounting is particularly useful in managing profitable growth. Using VPA, you can measure the economic utilization along with the physical utilization of business capacity. Economic utilization is the percentage of current capacity that is used for green value points, i.e., those that earn the target rate of return. Capacity used for red and yellow value points is economically underutilized, even if physical capacity is fully utilized.
If you have red or yellow value points, you need to ask a strategic question: Should we reprice or redeploy this underperforming capacity before committing more capital for growth? A value point review of current capacity usage can help to optimize existing resources before assuming more business risk. VPA can serve as an economic-value-based growth regulator.
A good view of the forest is crucial for effective business performance, but so is the ability to zoom in on those value-generating trees. By helping businesses redeploy their resources to focus growth efforts on higher-value products, services, and customers, VPA provides a critical edge over competitors that base their performance management decisions on gross profit.
Tom Welsh is a certified management accountant and consultant who provides CFO services and profitability management services. His background includes cost system design and extensive experience as controller and CFO for high-tech, manufacturing, and service businesses. You can reach him via the Web site www.valuepointaccounting.com.