1. VALUE BASED MANAGEMENT
Teemu Malmi
Accounting for Management Control -

2. Measuring profitability
Most firms aim for increasing profits
How should we measure profitability and does it matter?

3. Basic idea of VBM: Owner is a residual claimant
Company comprises of the contracts with stakeholders.
Each contract is a balance between risk and return
Owners receives the residual and faces the risk which remains after all other stakeholders  owners have a privilege to the excess return after other stakeholders, but also…
You give us your £10,000 nest egg that you need for your retirement and we, the directors of the firm, do not promise that you will receive a dividend or even see your capital again. We will try our hardest to produce a return on your money but we cannot give any guarantee. Sorry. (Arnold, 2002)
Tähän Carnaghan, Gibbins ja Ikäheimo (1996) jutun taulukko esitettäväksi.

4. Where does the shareholder value of company comprise of?

5. Shareholder value is the most commonly accepted corporate goal in text books
The objective of the firm is to maximise shareholder value. … Given this objective, any financing or investment decision expected to improve the value of the shareholders’ stake in the firm is acceptable. (Pike & Neale, 2006, for undergaduate and MBA students, UK)
Management must focus on creating value for shareholders. (Van Horne & Wachowicz, 2005, USA)

6. EVA for management control
Which profitability measure to choose?
Why EVA instead of ROI for performance measurement?
How to create measures based on EVA philosophy?
What are the challenges of using EVA? -

7. Challenges with ROI
Same measures are used for evaluating profit centres and management
ROI may lead to sub-optimal decision making
What about inflation and depreciation? -

8. Mutually Exclusive Capital Projects
NPV
X (€)
Y (€)
Z (€)
Machine cost initial outlay (time zero)
861
Estimated net cash flow (year 1)
250
390 50
Estimated net cash flow (year 2)
370
Estimated net cash flow (year 3)
540
330
1100
Estimated NPV at 10% cost of capital 77
(52) 52
Ranking 1 3 2
Profits
X (€)
Y (€)
Z (€)
Year 1
(37)
103
(237)
Year 2 83
Year 3
253 43
813
Total profits
299
109
339
Return on investment
X (%)
Y(%)
Z (%)
Year 1
(4.3)
11.9
(27.5)
Year 2
14.5
(6.4)
(41.3)
Year 3
88.1
15.0
283.2
Average
32.8
6.8
71.5 -

9. In Economic Value Added (EVA) cost of capital is deducted from profit
EVA is net operating profit after taxes minus a charge for the opportunity cost of the capital invested.
EVA = NOPAT – ((TOTAL ASSETS – CURRENT LIABILITIES) x WACC)
EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at comparible risk.

10. EVA in graph Turnover Expenses Net working capital Fixed capital
Net operating
income
EVA
Net working capital
Fixed capital
Capital employed
EVA:ssa mukana tuotto omalle pääomalle
Cost of capital
WACC

11. EVA Combines shareholder interest to the control systems.
Adds required rate of return into the calculations.
Absolut measure, which is compared with the budget/target.
Budget/target is defined based on the required rate of return. -

12. Macro Drivers
Micro Drivers
Market
Growth
Geographical positioning
Growth by Mergers & Aquisitioins
Growth
Growth by Investments
Market
Share
Customer Value Added
Agility to markets
Product mix
Corporate
Value
Revenues
Number of Big Accounts
Market Price
EBIT
Location of Mills
Expenses
Profitability
Product mix
Use of capacity
Efficient Use
Of Capital
Level of Technology
Timing of Investments
Growth Strategy
Leverage
Trust among investors
Cost of
Capital
Cost of equity
Business Risk

13. VBM IN PRACTICE
There is a huge variety of VBM applications in practice
We found:
Rhetoric use (signaling)
Increased attention to capital employed, i.e. by applying an additional capital charge
Full adoption, including compensation, throughout organization
Also those who have abandoned it

14. Dimension of VBM use
VBM solutions
Management control
Objectives and strategies
Maximisation shareholder wealth. EVATM metrics (or its value drivers) as a single goal throughout the organisation.
A value creating strategy is the only possible solution, though silent about the type of strategy per se. Business units are responsible for strategic planning.
Performance measurement
Performance measured using economic profit metrics and their value drivers from top to bottom. Other measures abandoned.
Target setting
Improvement in the current level EVATM. Zero-EVATM minimum acceptable level. Target setting linked to value drivers.
Compensation
Bonuses paid are based upon changes in EVATM. Bonuses have no caps. Banking to avoid myopia. Stock options only to top management with increasing target level in line with the cost of capital.
Influence on decision making
Strategic decisions
Based on EVATM calculations, no room for decision-making beyond; acquisitions, strategic capital investments and divestments are made accordingly. Strategizing within the business units.
Operational decisions
Both balance sheet and income statements are considered, leading to improved capital investments and more efficient working capital management.
Source: Malmi & Ikäheimo, Management Accounting Research, 2003

15. Dimension of VBM use
VBM practice
Management control
Objectives and strategy
Maximisation of shareholder wealth.
Both growth and efficiency strategies. Mainly used at the group level.
Performance measurement
EVATM metrics or its value drivers used at different organisational levels. Such measures are not the only ones throughout the organisation. Old measures are retained.
Target setting
Mainly negotiated, frequently other measures are used. Zero-EVATM does not have any major relevance.
Compensation
Bonuses paid based upon several financial metrics. EVATM has a minor role. No banking is present. Stock options mainly for the top management at a fixed price.
Influence on decision making
Strategic decisions
Still room for strategic judgement beyond VBM. Impact on acquisitions, strategic capital investments and divestments.
Operational decisions
Increased emphasise on balance sheet. Leads to lower hunger for capital investments and more concern about the cost of working capital.
Source: Malmi & Ikäheimo, Management Accounting Research, 2003

16. Discussion How EVA based performance measures are derived?
What are the major challenges in adopting and using EVA?
Technical
Organizational and behavioural -