Blue Line Management S. David Young

INSEAD, April 2011 “Customers” B2B Firms B2C Firms Cash Value = Happiness Objective for Firms - Value Creation & Capture Raw Materials Value = The expected cash flows, discounted at the opportunity cost of capital

S. David Young INSEAD, April 2011 What is “value”?

S. David Young INSEAD, April 2011 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.

S. David Young INSEAD, April 2011 Two key lessons … We need to know the cash flow consequences of our decisions. We need to know the opportunity cost of capital.

S. David Young INSEAD, April 2011 Value creation requires … A sustainable competitive advantage Tools to identify +NPV projects Incentives to identify and implement +NPV projects, and to reject ‒ NPV projects

S. David Young INSEAD, April 2011 But managers often get in the way... The role of managers The “agency cost” problem

S. David Young INSEAD, April 2011 Value ≠ Price Blue line management

S. David Young INSEAD, April 2011 € t

S. David Young INSEAD, April 2011 € t

S. David Young INSEAD, April 2011 € t

S. David Young INSEAD, April 2011 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?

S. David Young INSEAD, April 2011 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

S. David Young INSEAD, April 2011 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.

S. David Young INSEAD, April 2011 The red line is seductive Toyota General Electric

S. David Young INSEAD, April 2011 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.

S. David Young INSEAD, April 2011 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.

S. David Young INSEAD, April 2011 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?

S. David Young INSEAD, April 2011 Value drivers vs. Indicators

S. David Young INSEAD, April 2011 How effective is organization at grasping and developing new ideas? How effective is organization at converting new tech. to actual application ? How effective is organization at implementing new technology / products? % ideas acted upon # ideas generated % conversion to patent/next step # ideas introduced x % convert tech. to application # ideas become actual technology x % launch to client / activity # new products / applications x revenues/ cost savings per idea # implemented products/activities x Value creation x How effectively do new products / technology generate revenues &/or cost savings? Survival! An illustration of how R&D and product development drives value Is organization actively encouraging idea generation? Time from idea generation to product launch / technology implementation How effective is organization at identifying and acting on new ideas? Identifying Value Drivers Value Drivers and KPIs: Understanding the difference

S. David Young INSEAD, April 2011 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?

S. David Young INSEAD, April 2011 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.

S. David Young INSEAD, April 2011 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.