Over the last 20 years, the field of value-based management (VBM) has changed significantly. VBM began with a breakthrough performance metric and has matured into an entire management framework that focuses organizations around value creation. Companies such as Coca-Cola, DuPont, and Cadbury are often hailed for the great results they have achieved since implementing a VBM framework into their organization. Recently, studies have shown that VBM companies outperform their peers by 8.25% per year. Not surprisingly, many companies already have or are adopting a “Managing for Value” mindset hoping to achieve similar results. In fact, one is hard pressed to read through a company’s annual report and not find a reference to how the firm is managing for value.
There is a complication with value-based management, however. Doing it right is not easy. Recent reports have indicated that almost half of the companies that have adopted a VBM metric have had mediocre success. The difference between success and failure with VBM depends on how well a firm integrates VBM into the culture of the organization. A recent study by Haspeslagh, Noda, and Boulos touts that the difference between successful and unsuccessful companies is that successful companies realize that VBM is not simply about the numbers; it is about building a culture around value creation. In other words, VBM has to become a way of life in your organization. Anything less will lead to the creation of another tombstone in your company’s junkyard of failed initiatives.
What is VBM?
Value-based management is the alignment of key organizational processes such as strategic planning, budgeting, compensation, performance measurement, training, and communication around value creation. The organization needs this alignment and consistency to develop a culture whereby individuals, at all levels, will make decisions focused on sustainable long-term value creation. Value is created when owners receive a return that more than compensates them for the perceived risk of the investment. For example, if I offered you an investment opportunity that would pay $100 in one year, would you accept? Maybe, but you would first want to know at least two other pieces of information: required investment and estimated project risk. Then, if you deemed that the potential reward compensated you for the perceived risk, you would accept the investment opportunity. With VBM, employees need to engage in the same thought process when considering investment/allocation of the firm’s resources and ultimately when considering how to allocate their own time. The basic questions that need to be answered are:
- How much do I have to invest in this project/activity?
- What will my returns be for the project/activity?
- Do the returns from the project/activity compensate me for the perceived risk?
A few key events have shaped VBM into a financial management framework. The seminal event was the movement from accounting-based measures of performance such as net income to value-based metrics, such as economic profit. Traditional accounting-based measures such as net income provide information on a company’s book returns but do not address how much economic capital was invested, or amount of risk exposed to, to generate the returns on the investment. Economic profit addresses these shortcomings by including a capital charge. A capital charge is in essence a rental charge for the capital used to generate the firm’s profits. To calculate the capital charge, you multiply the investment in the business by the investors’ expected percentage returns. If your profits are more than the capital charge, then value is being created since investor expectations were exceeded. Alternatively, if the profits do not cover the capital charge then value is destroyed since the profits did not cover the capital charge.
Let’s take a quick look at a simple example to gain some insight into the benefits of economic profit. We will build on the example from above where we had the opportunity to earn $100. Let’s assume that instead of one opportunity that we actually have two opportunities to earn $100. Should we pursue one, both, or neither?
If we are just concerned with growing net income, then our decision is easy. We would pursue both projects if each had positive net income. However, if we are concerned with value creation, we must find out how much we have to invest in each project and the expected return. Suppose the first project requires an investment of $500 while the second project requires an investment of $1,500. We also find out that both investments are of similar risk and require a 10% return. Let’s now look at the analysis and make a decision:
Profit – Capital charge = Economic profit.
Profit – (Investment x investors’ return expectations) = Economic profit.
$100 – ($500 x 10%) = $50.
Since economic profit is positive, we should pursue project 1.
Profit – Capital charge = Economic profit.
Profit – (Investment x investors’ return expectations) = Economic profit.
$100 – ($1,500 x 10%) = ($50).
Since economic profit is negative we should not pursue project 2.
It did not take long for practitioners to realize that on its own, a performance-based metric was interesting, but for it to truly take hold, incentive programs would need to be redesigned. Thus, incentive plans were redesigned to pay people for value creation represented by improvement in economic profit.
Initially, companies thought that implementing a new metric, tying incentives to the metric, and providing some initial training was all that was necessary for a successful VBM program. These are all necessary but not sufficient conditions for VBM to be successful. Rather they represent the price of admission to developing a VBM culture. The true gains are made when companies integrate VBM into their culture. The HBR Study highlights this importance: 62% of the successful VBM companies report training more than 75% of their managers in VBM concepts, whereas only 27% of the unsuccessful companies trained that great a proportion of their management staffs. Realizing that VBM is a cultural change is the key to lasting change that will create sustainable improvements in shareholder value.
The Implementation Process
As a company implements VBM, it will need to accomplish three steps: gain senior team commitment; customize the VBM framework; and finally, make VBM a way of life in the organization. The chart below highlights that companies create the most value when VBM is integrated into the culture of the organization.
The remainder of this article provides an overview of these three steps with a detailed review of Step 2: Customizing the VBM Framework. This will provide insight into the changes required of key management to reach the ultimate goal of Step 3: Make VBM a Way of Life.
Step 1. Gain Senior Management Commitment: VBM is similar to all other initiatives in one respect: Senior management needs to support VBM with their words and ultimately with their actions. It is up to the senior team to create a sense of urgency around the initiative and clearly communicate a vision of the impact that VBM will have on the organization. In short, they must make the reasons for VBM simple, clear and compelling.
The following example illustrates the importance of senior management commitment. A CEO of a VBM company had done an excellent job of integrating VBM into all levels of the organization. His strong conviction and charismatic style had been one of the major reasons that the improvement of economic profit was being taking seriously at all levels of the organization. The company had seen excellent results in improved working capital management and even more impressive was the change in the sales team negotiation style from a volume focus to an account profitability focus.
The turning point came when the CEO was meeting with his senior team to decide whether or not to pursue a major acquisition. There was a lot of open debate around the synergies that might be realized in the merger and how to best integrate the target company. When all the financial analysis had been debated and modeled, the CEO was told that based on the current offer price the deal would most likely not create value. His response was simply, “I don’t care about the economic profit impact, is the deal accretive?” This one statement sent the organization back significantly in their effort to truly become a VBM company. As people in the company realized that the CEO was not making decisions based on economic profit, they no longer felt compelled to worry about economic profit. It took the company a considerable amount of time and effort to recover from the comments made by the CEO.
Implementation Tip: Anything less than the full commitment of the senior team will ultimately cause the initiative to fail and simply become another “program of the month” that does not achieve the intended results. If VBM does not have the backing of senior management and the Board of Directors, do not pursue it! Your organization will spend a lot of money, time, and energy without receiving adequate returns from your VBM investment.
Step 2. Develop a Customized VBM Framework: Implementing VBM requires an organization to redesign its management practices. The key management practices are performance measurement, compensation design, planning/budgeting, and training and communication programs. A brief overview of each of these areas along with some advice for each topic follows.
- Performance measurement. The first step in customizing a VBM framework is to abandon accounting-based metrics and define a value-based measure, such as economic profit, as the key performance metric of the company. The overarching goal is to improve economic profit over the long-term. When a firm takes the long-term view, it is imperative to act in an ethical and socially responsible manner. Anything less may improve short term prospects but will not lead to long-term success.
- Pay for performance. In the early days of VBM, companies tried to move to a value-based focus, but they did not achieve the expected improvement in results. It was soon realized that if you wanted people in the organization to focus on economic profit, then you had to compensate people for improvements in economic profit. Some key characteristics of value-based incentive plans compared to traditional plans are uncapped bonuses, targets based on market expectations, and the use of a bonus bank. A plan with these characteristics encourages participants to think like, act like, and be paid like owners.
- Integrate new performance measures into planning and budgeting: The new performance measure needs to be at the heart of key management processes, such as budgeting, planning, and capital allocation. The organization has to have consistency around all of its key management practices so that improvement in economic profit over the long-term is the goal of the organization. A good exercise during the budgeting and planning process is to have business units calculate what level of bonus will be paid out if projected performance is met. This is an excellent way to move from a “manager” mindset to an “owner” mindset.
- Develop initial training and communication plans: The organization needs to develop a plan and the necessary material to communicate the importance of managing for value and the basic concepts of VBM. People in the organization need to understand the basics of economic profit before they can be able to apply the concepts to daily decisions. Communication is the critical feedback loop so people can learn which actions are working and, just as important, which actions are not working so they can adjust what they do to create more value. An organization needs to develop a new reporting package that is easily understood by finance and non-finance employees alike. The results need to be communicated visually, timely, and accurately.
Implementation Tip: Less is more when defining the measure. While the measure needs to be grounded in financial theory, keep the complexities to a minimum. Remember, if improving economic profit is the goal of the organization, then people need to understand how it is calculated and ultimately how they can make decisions that improve economic profit.
Implementation Tip: If the incentive plan is not adequately tied to value creation then a disconnect will occur between the creation of shareholder value and the manager’s compensation. This disconnect may cause the actions of the managers to not be in the best interests of the shareholders.
Implementation Tip: When organizations do not consistently make decisions using the new performance measure, a mixed message is sent to the organization about the organization’s overarching goal. This mixed message will lead to confusion about what the key objective of the organization is.
Implementation Tip: Make sure your organization has a well-thought-out plan around both training and communication. The initial training provides the opportunity for employees to understand new concepts and begin to develop ideas around how they can make decisions that are more in line with value creation. Communication of results will provide the necessary feedback to the organization about how their actions are impacting shareholder value. Lack of feedback on how actions are impacting value will disrupt the learning process, signal a lack of importance around the initiative, and ultimately cause the initiative to lose momentum.
Step 3. Make VBM a Way of Life: The structure described above provides the necessary foundation for all organizations to begin the VBM journey. Now the hard work begins though. Companies must integrate VBM into their culture. VBM cannot be thought of as just an initiative but rather as a way of life. VBM needs to become a part of the drinking water, so to speak, meaning we have to turn our efforts to ensuring that everyone in the organization understands his o her role in creating value in the organization. This begins at the top of the organization and needs to be cascaded down the entire organization so each individual understands the big question, “How does our company create value?” — and the even more relevant question, “How does my role and the daily decisions that I make impact value?” To reach this level, the organization will need to devote a significant amount of resources to provide the necessary learning, tools and feedback required so all individuals can understand their role in value creation. If you can lead your company to a place where everyone in the organization can answer the above questions, you are well on your way towards developing a culture focused on value creation.
Implementation tip: Take this step seriously. It is easy to think the hard work is behind you after you have customized the framework. Haspeslagh, Noda, and Boulos in their article explain that this is the most critical portion of any VBM implementation and critical to a company outperforming its peers.
When done correctly, VBM provides an organization the opportunity to significantly improve performance by aligning the entire organization around value creation. In short, all employees will begin to make decisions like an owner of the firm. However, implementing VBM is not easy. In this article, we have highlighted three key steps for implementation:
- Gain Senior Management Commitment. Without this support, do not continue with the program.
- Customize VBM Framework. Be thorough and do not leave out any areas. Don’t get caught up in the numbers. The framework needs to be understandable at all levels. Strive to keep it simple, clear and compelling.
- Make VBM a Way of Life. Take this step very seriously because it will be the determining factor between the success or failure of VBM at your company.
By following these steps in an ethical and socially-responsible manner, your corporation will be well on its way to developing a successful VBM program, which can have a positive effect on the shareholders, employees, and the community in which the firm operates.
 Stern Stewart & Company website (sternstewart.com/evaabout/evaworks.shtml).
 Haspeslagh, P., Noda, T., and Boulos, F. “Its Not Just About the Numbers,” Harvard Business Review 79, (7) Cover Story.