Company information
Totaig manufactures high quality and innovative small electrical appliances such as hairdryers and vacuum cleaners. All of the board of directors, who are the strategic decision makers, have always worked in the business and are members of the Totaig family. Most of the operational managers joined as factory workers when the business started and have taken on more responsibilities as the business has grown.
Totaig has basic and outdated IT systems for a business of its complexity and has always used traditional financial performance measures such as return on investment (ROI) and operating profit margin.
Totaig has historically had few competitors and the directors have focused on improving financial results from one year to the next, with little long-term planning. A number of overseas competitors have, however, recently entered Totaig’s market. It is estimated that, within one year, these competitors will be able to produce at a similar unit cost to Totaig and that within three to five years, the quality of the competitors’ products will be comparable to the current quality of Totaig’s products. Totaig may have to invest heavily in product development and make acquisitions in the future in order to compete effectively.
Value based management (VBM)
A consultant has recently told the directors that implementing VBM may help Totaig to respond to the increase in competition over the next one to five years. The consultant has defined VBM as ‘the alignment of the business strategy, management processes and culture on maximising shareholder wealth by focusing on key drivers of value’. The directors have accepted this as a reasonable definition of VBM and most of them now agree that VBM would be useful, though others are not yet convinced.
The directors have, however, asked you for further advice on one aspect of the implementation of VBM at Totaig. At her recent presentation, the consultant presented a slide (Appendix 1) showing the four steps in implementing VBM. The directors want your advice on how to implement Step 2, which is defining performance targets. Your advice should focus on the following four areas:
1. Selection of appropriate measures and targets.
2. Timescales to which the targets should relate.
3. Management levels (strategic and operational) in the business to which the targets should relate.
4. Difficulties in measuring and managing performance using VBM.
Measuring value
The directors are unsure of a suitable financial performance indicator for them to use to measure whether Totaig is creating value. As an illustration, they have asked you to evaluate, by calculating economic value added (EVA™), whether Totaig has generated value for the year to 30 June 20X5. You should use the financial information given in Appendix 2, and advise on the difficulties of using EVA™ as a performance indicator at Totaig.
Required:
It is now 1 September 20X5.
(a) Advise the directors on the implementation of Step 2 of VBM as requested.
(b) Evaluate both whether Totaig has created value and the difficulties of using EVA™ as a performance indicator at Totaig.
Appendix 1
Appendix 2
Income statement for the year to 30 June 20X5
Notes:
1. During the year, $450,000 of advertising cost which will generate sales in future periods was expensed to the income statement.
2. The allowance for doubtful debts at the end of the period was $300,000, a reduction of $200,000 from the beginning of the period.
3. The capital employed at the beginning of the period was $88,944,000.
4. Totaig’s after-tax weighted average cost of capital (WACC) is currently 9%. The company is financed by a mixture of equity and fixed and floating rate loans.
5. The directors are considering changing Totaig’s policies for the depreciation of non-current assets for the year ending 30 June 20X6.
(a) Selection of appropriate measures and targets
Value drivers create long-term value. Totaig is facing competition from overseas businesses, which will soon be able to produce at a similar unit cost to Totaig and produce items of comparable quality. The unit cost of production and product quality would be value drivers for Totaig and targets should be set for these two measures.
Targets should be both financial and non-financial. This will ensure that there is not too much emphasis on financial targets, which tend to be backwards looking, rather than relating to the present value of future cash flows, which is the focus of value-based management (VBM).
The existing targets of return on investment (ROI) and operating margin are backwards looking. They will also discourage managers to make investments, for example, in product development, which might be detrimental to Totaig’s long-term performance. This is because investments in new products will reduce both of these measures in the short term.
Having targets related to product quality would ensure that the business does not focus too much on cutting the unit cost of production, for example, by using cheaper, lower quality materials. It appears that to create long-term value, Totaig must be competitive on both unit cost of production and product quality.
Timescales to which the targets should relate
Totaig must set short-term and long-term targets, which should be linked together, for key value drivers. Competitors will be able to produce at a similar unit cost to Totaig within a year. A suitable short-term target would therefore be to reduce unit production costs within that timescale. As VBM is concerned with long-term value, Totaig should set longer term targets relating to quality in anticipation of the new competitors’ ability to improve on this aspect within three to five years.
The possible need to invest heavily in product development and make acquisitions will probably require longer term targets to be set.
Levels in the business to which the targets should relate
Value can be created at all levels in the company and targets should be set according to the different layers of management. Targets relating to unit cost of production and product quality are under the control of operational managers and these would be suitable for this level of management.
Targets relating to possible future acquisitions are under the control of the directors, who are the strategic decision makers.
Difficulties in measuring and managing performance using VBM
Totaig will require good information to implement VBM. It may be difficult to identify value drivers and reporting systems need to be able to provide the information which is required. Currently, IT systems are basic and outdated for a business of its complexity. This may mean that it is difficult to identify value drivers for the setting of targets. The implementation of VBM may require significant investment in IT systems to measure performance against targets and take up management time. The costs of implementing VBM may exceed the benefits.
The operational managers are unlikely to have any experience of VBM since most of them joined Totaig, which itself has never used VBM, when the business first started. They will require training on VBM if they are to understand the targets set. For example, new value-based performance measures, such as EVA™, will be needed, which will be unfamiliar to directors and managers in the business.
Using VBM to manage performance at Totaig will require a culture change amongst all employees, who will need to work towards creating shareholder value. The directors will need to demonstrate commitment to the use of VBM in order to motivate operational managers to accept the change. Currently, some directors at Totaig seem not to be convinced of the usefulness of the approach.
It may be difficult to measure economic depreciation, for example, or to determine whether and for when the anticipated heavy investment in product development will create value. These difficulties will affect the reliability of performance measures for value, such as EVA™, in managing performance.
(b) Calculation of EVA™
As EVA™ is zero, Totaig has neither created nor destroyed value.
Difficulties of using EVA™ as a performance indicator
The cost of capital can be difficult to measure reliably and can change over time. Totaig’s current WACC is 9%, but due to the existence of floating rate loans and changes in the market value of debt, the WACC will not remain constant. The cost of equity may also change over time if shareholders require different levels of return to reflect changing business or financial risks, for example.
It is assumed, that at Totaig, economic depreciation and accounting depreciation are the same. A difficulty in using EVA™ is that it is hard to estimate economic depreciation. Also, as the directors are considering changing the depreciation policy for the year ended 30 June 20X6, this may distort comparisons of EVA™ between different years.
The calculation of EVA™ can be complex and poorly understood by managers. If managers do not understand the measure, they are less likely to be able to achieve targets for EVA™ as they will not know how. There may be a large number of adjustments to make in calculating EVA™. Currently at Totaig, only a few adjustments are required. If the business starts to make acquisitions and invest heavily in product development, there may be more adjustments to be made in future calculations.
As EVA™ is an absolute figure rather than a percentage, it is difficult to compare with businesses of different sizes, for example, if Totaig was to undertake financial benchmarking against its competitors.
EVA™ uses historical data which may not be relevant to future performance. It may be hard to determine if and when advertising expenditure is value adding, for example.