Being able to evaluate and improve a company’s performance using new performance management systems is an important capability that you should develop during your APM studies and is also an often-examined topic. Value-based management (or VBM) is one such system in the syllabus which often creates trouble for APM candidates.
This article aims to demystify the topic of VBM by looking into its background, key ideas, problems, and steps for implementation. Finally, this article will give advice on how to tackle VBM requirements.
If we go back in time to the 1970s and earlier, companies usually measured performance with profit-based metrics, such as Earnings per Share ('earnings' is a synonym for profit), Return on Capital Employed (ROCE), or Net Profit Margin. The source of information for these metrics was the company’s financial statements. These metrics are referred to as 'traditional performance metrics' in your APM syllabus.
Then, in the 1980s, leaders in business strategy and performance management began to challenge this approach. While recognising that increasing shareholder wealth is the ultimate goal of a company, a paradox was observed: a company's profits could be increasing, while at the same time, total shareholder return could be decreasing. They concluded that the link between the objectives of ‘maximising profit’ and ‘maximising shareholder value’ is actually tenuous. Other problems with profit-based measures were also highlighted at this time:
It was in this period that alternative approaches to performance management were developed (which you will be familiar with as many are covered in APM), ideas such as the Balanced Scorecard, Total Quality Management, and Value-Based Management, the subject of this article.
To illustrate the problem described above, imagine we have a fictitious, listed company Omega Co. Omega Co has numerous divisions, including Alpha and Beta, which are treated by management as autonomous investment centres. Omega’s weighted average cost of capital is 13%.
Division Alpha is an underperforming division in a declining market—a ‘Dog’ according to the BCG Matrix model. The manager of Alpha is assessed on ROCE, which is currently 5%. She has the option to invest shareholder funds in a project that will improve her division’s ROCE to 7%. She accepts the project.
Division Beta is the leader in its fastest-growing market. This is a ‘Star,’ according to the BCG model. The manager of Division Beta is currently achieving a ROCE of 21%. She has the opportunity to invest in a new project. However, when the profits and investment of this new project are added to her divisional ROCE, she calculated that it would fall to 19%. Hence, she rejects this investment.
Both managers made decisions based on accounting profit measures rather than value-based measures. If a manager uses ROCE to make decisions, they are ignoring cash flows, the impact of tax, and the effect their actions have on the value of the company. Division Alpha’s project, while delivering increased profits to XYZ Co, most likely did not exceed the company’s cost of capital. Division Beta’s potential project might have exceeded the cost of capital, however, she rejected it.
This problem is also known as ‘goal incongruence,’ which you first encountered on your Performance Management studies. How could we know if the two divisions are growing or eroding shareholder wealth? Is there a better way? Yes, adopt the principles of Value-Based Management (VBM).
As you learned in Financial Management, it is a company’s discounted future cashflows that determine its value. And, value is created when the cash flows returned from invested capital exceed the expected returns of the company’s capital providers, measured by the weighted average cost of capital. This is the idea of ‘value’ in VBM, and the VBM approach puts maximising shareholder value (as opposed to maximising profit) as the high-level objective of a company.
In order to achieve this, the company’s strategy, objectives, and processes should be aligned with the generation of shareholder wealth.
To measure performance under VBM, a single, over-arching organisational performance metric is established, such as Economic Value Added (EVA). Then, ‘value drivers’ are identified: these are activities linked to shareholder value which managers in the company can influence. This system of value drivers cascades throughout all levels of the company, linking to objectives for managers and staff. VBM is a hierarchical system that connects all levels of a company to shareholder value, not just a framework for board-level evaluation. Under an effective VBM system, individual employee objectives should be connected with the high-level company objective of increasing shareholder value. This is the core idea behind VBM.
It is important to emphasise that this system of value drivers is matched to the specific activities that management can control at each level of the company. Value drivers often cascade in a ‘tree’ diagram and cover both financial and non-financial performance areas of performance.
For example, employee satisfaction and employee training are value drivers that have a direct impact on customer satisfaction. Customer satisfaction, in turn, directly impacts customer retention. Improved customer retention will then (combined with revenue per customer) positively affect revenue, which will directly impact operating profit. These value drivers move up from operational to strategic level and cover financial and non-financial areas of operation.
Make sure you understand the difference between VBM and EVA: VBM is an approach to performance management that improves shareholder value, while EVA is one performance metric that measures shareholder value. While EVA is an often-used metric and covered by the APM syllabus, there are others as well, for example, Net Present Value, Market Value Added and Shareholder Value Analysis (the last two won’t be specifically examined in APM). In other words, EVA is a high-level performance metric appropriate to use under the VBM approach.
VBM can be implemented using a four-step approach:
Step 1: Strategy development
At the corporate level, a strategy is developed with the high-level objective of maximising shareholder value. This strategy can span operations, financial management, and buying and selling of business units.
Value drivers are then created for business units and all levels of the company. For example, a telecom company could have a business unit objective, ‘reduce call centre costs.’ Value drivers linked to this could be ‘personnel costs’ and ‘premises costs,’ which cascade down the organisational pyramid to operational drivers such as ‘average time per call’ (for personnel costs) and ‘equipment maintenance costs’ (for facilities costs). Similar value drivers would be defined for all business units and at all organisation levels.
Step 2: performance targets are created
After value drivers are defined, they should be translated into specific targets. Following on from the example above, a target for ‘personnel costs’ could be ‘personnel cost reduction of 18% over three years.’ For ‘average time per call,’ a target could be, ‘maintain six minutes per call’ for the current year. Note that VBM promotes linking short term targets to long-term ones, and all the targets should be connected to say the EVA metric at the top of the organisational pyramid.
Step 3: Operational plans
Next, the performance targets defined above should be assigned to and ‘owned’ by specific employees. For example, the business unit manager might be responsible for reducing personnel costs, and a customer service team leader might be responsible for maintaining six minutes per call. Specific operational plans are then defined that will help employees take actions that will help them achieve their individual targets.
Step 4: Performance measurement
As with all modern performance management systems, VBM promotes the creation of key performance indicators for all members of staff, and a shift will be required from financial metrics to the inclusion of management-driven, non-financial metrics (yes, this idea overlaps with the Balanced Scorecard). Under VBM, ‘economic profit’ will be a short-term financial measure used to measure performance over a single year, but other metrics should be tailored to specific business units and the activities of individual managers. Depending on the value driver being measured, the metric may be non-financial in nature (for example, customer satisfaction level), and focused on the long-term, rather than short-term (for example, customer lifetime value).
VBM overlaps with HR Management Issues (also in your APM syllabus). Successful VBM implementation will require linking management remuneration to key value drivers and objectives, ideas covered by the Building Block Model.
Spreadsheet modelling
Spreadsheet modelling is a critical tool for the management accountant in VBM as there will be many forecast variables involved in calculating EVA (or other value-based metrics), such as growth in revenue, forecast capital expenditure and depreciation, corporate tax rate, interest rate on issued debt, etc. With a spreadsheet it will be possible to conduct scenario analysis and see how different economic assumptions impact different value drivers, and in turn, impact the value of the company.
Also, a spreadsheet will help the management accountant combine performance metrics from many business units and management processes into a unified financial model and this can drive a dashboard to monitor performance. For example, a dashboard could be designed to present operational-level metrics such as receivables and payables timing, percentage of billable hours to total hours, or percentage of capacity utilised. Managers at different levels of the company can use this information for improved decision making and performance management.
Now that you understand the concepts of VBM, you need to be able to apply these ideas to your upcoming APM exam, and this topic often causes trouble for APM candidates. One examiner’s report said the problem for most candidates was a lack of knowledge about the subject. Next, many candidates talked about VBM in general terms without showing an understanding of it in the context of the scenario.
If VBM comes up on your exam, you might be asked to ‘evaluate whether the VBM approach is an appropriate approach.’ To avoid the problems mentioned above, ensure your answer is linked to evidence from the scenario. Without doing this, you will certainly not gain passing marks. Next, if you are ‘evaluating’ or ‘assessing,’ make sure you are stating whether VBM will help or hurt the company for specific reasons. To generate ideas that are linked to the particular company given, you can ask yourself these questions:
Another requirement you might be asked is, ‘what changes to the business will be required to adopt VBM?’ Again, to gain passing marks, your ideas need to be linked to the scenario. Here are some ideas you could develop (of course, related to the scenario):
This article has examined the topic of VBM and its links with other syllabus areas. With a practical approach that answers the question asked, further question practice, and an answer this is linked to the scenario, you should be able to successfully tackle any VBM requirement on your upcoming exam.
To see how VBM has been examined in the past, please see Question 2 of the March 2020 exam.
Written by a member of the APM examining team