October 8, 1997 [home]
Business like science utilizes measures to quantify and define reality. The problem is that past and present reality is not all that interesting. Science develops measures that define data that support theories that predict what should happen in the future. If we can describe reality with sufficient accuracy to understand and predict, we may be able to take the next step, which is to control what comes next. Therefore to be really useful business measures should be relevant to help mangers understand, improve, predict and eventually control. As early twentieth century physicist found, it is impossible to accurately define reality with precision. The closest they could achieve was a range of probabilities.
Management measurement tools come in two varieties, financial and nonfinancial. The non financial tools are further subdivided into the types of things that they are trying to describe, either the organization's customers (external) or the organization's employees (internal/business operations). According to Professor Marshal Mayer of Wharton "there are many more non-financial measures than financial measures. There are relatively few financial measures because most of them, financial ratios especially, are governed by accounting conventions and are standardized." [Mayer, Marshall, "Mastering Management," Financial Times, London Edition 2/9/96]. On the other had computers have given us the ability to monitor almost any non financial performance. For example, Chemical Bank had "an index that aggregates more than a hundred different measures of customer complaints and degrees of dissatisfaction" [Kaplan, Robert, and David P. Norton, Chemical Bank: Implementing the Balanced Score Card, Harvard Business School Case 9-195-210].
With the plethora of measures, which do we choose? Professor Mayer suggests some rules for choosing measures.
Rule 1. There should be more than one or two, but fewer than five or six. You need more than a few measures, because the measures should be designed to constrain and balance each other. For example time to order fulfillment must be balanced by cost of order fulfillment to prevent use of more expensive means of transport (air vs. surface) to meet goals. More than five or six measures become confusing and hard to communicate.
Rule 2. There should be a balance of financial and non financial indicators.
Rule 3. Non financial measures must meet three requirements:
a. There must be variance or room for improvement
b. They must be under the organization's control
c. They must be a clear correlation between the non-financial performance and the financial results so that improvement in the former produces improvement in the latter (predictive).
In the last few years several financial measures have become fashionable. Probably the best known is the concept of Economic Value Added (EVA). According to the Financial Times [Philip Coggan, 9/29/97 London Edition] "EVA, developed by the US group Stern Stewart, seeks to capture the difference between a company's return on capital and its weighted average cost if capital using both equity and debt. If the company is failing to deliver an adequate margin over the cost of capital, shareholder value will not be created." Or as stated by the Economist (8/2/97) "a company creates value only if the return on its capital is greater than the opportunity cost if it, or the rate that investors could earn by investing in other securities with the same risk. Far from novel, this is one of the oldest nostrums in business. Companies have long used hurdle rates of return to judge individual investment projects. The new measure extends the practice to the entire business."
Basically EVA is a measure of capital efficiency. Whether it is a measure of anything else is subject of some controversy. To supplement the EVA concept, Stern Stewart has come up with the concept of MVA or Market Value Added. Stewart Stern's Senior Vice President Al Ehrbar explains: "MVA is the market value of a company's debt and equity minus all the capital that lenders and shareholder have contributed over time. In other words the difference between cash in (what the investors gave contributed) and cash out is what the investors could sell their claims for today)." Mr. Ehrbar maintains that MVA is a measure that measures all the dynamics of corporate performance. He states that EVA is an invaluable management tool because it correlates better than any other measure with changes in MVA.
Other measures include CFROI cash flow return on investment, which is promoted by Boston Consulting Group (BCG). "Unlike EVA which is based on adjusted accounting profit and is therefore a near cash measure, CFROI compares a firm's cash flows with the inflation adjusted capital used to produce them" (Economist) BCG has also come up with a rival to MVA. Total shareholder return (TSR) is the change in a firm's market capitalization over a one year period plus dividends paid out to shareholders expressed as a percentage of its initial value.
But how well does the above alphabet soup help us define, understand, improve, predict and control? The major advantage to EVA is that cash is fact. Profit is opinion. EVA focuses on cash flow. It is harder to manipulate than profit or earnings, because it does not rely on accounting conventions like depreciation and goodwill. The other major advantage to EVA is that it is not subject to the variation of different accounting standards. For example when Daimler-Benz listed on the New York Stock exchange it reported a profit of $372 million under German rules and a loss of $1.1 billion under the U.S. rules.
EVA has many disadvantages as well. First, it is a backward looking measure and there is some question as to its ability to successfully predict corporate success or failure. Second, it is not suitable for certain types of industries. Specifically, financial institutions which are require to set aside capital for regulatory purposes or young companies where revenue calculations would be inaccurate. Third, it is difficult to calculate ratios in industries with large intangible assets such as brand names and marketing brains. Fourth, when compensation is tied to EVA "executives are discouraged from making large capital investments because of the upfront capital charge for them immediately depresses EVA" Eric Olsen. Also, executives could "milk" a business by slashing capital spending. Finally, according to Gary Hamel "the efficient use of capital is not the be all and end all for successful companies. Strategy and innovation count for more. He states "in the emerging knowledge economy, capital efficiency is even less of a wealth driver. In the industrial economy capital was everything. In the knowledge economy it often means nothing especially to companies like Microsoft and Amgen whose assets walk out the door every night." [Hamel, Gary, "Duking it Out Over EVA", Fortune Magazine 8/4/97].
So what kind of Non-Financial measure can we use that will complement EVA and successfully measure intangibles? What kind of nonfinancial measure will fit Meyer's criteria and fit on a Balance Score Card? In his excellent book The Loyalty Effect Fredrick F. Reichheld of Bain and Company puts forth the thesis that the loyalty of customers, employees and investors to a business are the essence of success. In order to keep track of their loyalty you must carefully measure the retention and defection rates. The advantages of these types of measurements are that they measure both the internal (employees) and external (customers) reality of the company. They offer an enormous ethical advantage and so are easy to communicate. They fit the criteria in that they are well within management's control and almost always subject to improvement. The links between loyalty and financial results are very well documented. The methods of measurements described in the book are involved but clear. Determining these important links can have a large impact on the success of the business. For example, Dayton Hudson, an American department store chain, discovered that just 2.5% of its customers bought 75% of its goods! Dorothy Lane, a grocery chain, discovered that 30% of its customers accounted for 82% of its sales.
Both the use of financial measures of cash flow by EVA and the nonfinancial measures of customer, employee and investor loyalty provide what appears to be exceptionally accurate methods of understanding, improving, predict and eventually controlling corporate reality. Whether these now fashionable management tools will endure, will be subject to the test of time. If nothing else they are intuitively attractive and hence comprehensible, which will probably result in their wide spread acceptance.
By: William Gamble
Emerging Market Strategies Company
281 Olney Street, Providence, Rhode Island, United States 02906
Tel. 401-454-5899, Fax 401-454-3888, Internet: 73243.2104@COMPUSERVE.COM
This article can also be found on the University of Virginia Darden School of Business Administration Alumni Forum and in the EMS Newsletter. Some of these articles are referenced in Professor Roubini of New York University Stern School of Business Administration Asia Crises Home Page and in the Providence Journal - Commentary Section.