Lecture 9 - Lehrstuhl für Controlling - Technische Universität München

Technische Universität München 

Value-Based Management 

Lecture 9: 

Implementing Value-Based Management: 

Identifying the Drivers of Value Creation 

Prof. Dr. Gunther Friedl 

Lehrstuhl für Controlling 


Email: gunther.friedl@wi.tu-muenchen.de


Overview 

1. Value Maximization and Corporate Objectives 

2. Measuring Income: Financial Statements 

3. Measuring Value Creation: Value-Based Performance Measures 

4. Management Compensation: Objectives and Alternatives 

5. Calculating the Cost of Capital 

6. Accounting Adjustments: Overview 

7. Accounting Adjustments: Goal Congruent Performance Measures 

8. Valuing and Managing Real Options 

9. Identifying the Drivers of Value Creation 

Value-Based Management: Lecture 9 2 

© Gunther Friedl – SS 2013


Required readings 

 

Young, S. David and O‘Byrne, Stephen F.: EVA and Value-Based Management: A 

Practical Guide to Implementation, New York et al. 2001, chapter 3 and 7. 

Suggested readings 

 

Kaplan, Robert S. and Norton, David P. (1996): Linking the Balanced Scorecard to 

Strategy, California Management Review 39, No. 1, pp 53-79. 

Value-Based Management: Lecture 9 

3 



Outline 

Implementing 

VBM: Identifying 

the Drivers of 

Value Creation 

9.1 Synergies and controllability 

9.2 Financial and non-financial value drivers 

9.3 Process-based performance measurement 

9.4 The implementation process 


4 



Calculating EVA for divisions assumes the independence of the 

divisions and neglects synergies 

 

 

 

Calculating EVA at the business unit level or even deeper in the organization 

requires that one can construct an income statement and a balance sheet for the 

considered unit. 

To create value companies try to achieve synergies through interaction of their 

divisions in two possible ways: 

• Several divisions share facilities like R&D, IT, 

Human resource management, product design, 

marketing. 

Problem of the allocation of costs (and 

shares of the invested capital) to the divisions. 

• Vertical integration to help the company 

better control its value chain. 

Product Line A 

Purchasing 

Company 

R & D 

Production 

Product Line B 

Requirement of transfer prices for assets and services to establish business 

unit revenues (always arbitrary to a certain degree). 

EVA implementation therefore is of little use when large percentages of the business 

unit assets are shared facilities or a large part of the costs of goods sold is 

represented by intercompany transactions. 

Sales 


5 



EVA of the sales divisions of the Metro Group – based on own balance 

sheets and income statements 

Development of EVA (Source: Metro Group Annual Report 2008, p.81) 




ThyssenKrupp AG - Annual Report 2009 / 2010 

Components of ThyssenKrupp Value Added (TKVA) 




Some practices representing potential “solutions” to the synergy 

problem 

Solution approach 

• Creation of groups of divisions 

• Linking part of the EVA bonus 

to EVA in another division 

• Cost allocation on the basis of 

divisional profitability 

• Activity-based costing 

• Other approaches to transfer 

pricing like an internal auction 

Idea and drawbacks of the approach 

• Solves partly the allocation or transfer pricing 

problem between the grouped divisions but not 

between different groups 

• Measurement problem remains for divisional 

manager’s performance 

• New bureaucratic hurdle for divisional managers 

and free-rider problem 

• Encourages cooperation and reduces the conflicts 

due to overhead allocation or transfer pricing 

• Addresses cost allocation and transfer pricing 

problem by rewarding cooperation 

• Might give incentives not to care enough for the own 

division’s profitability 

• Identifies cost drivers to better allocate overhead 

costs 

• Tries to more accurately capture the prices that the 

units would observe if they were truly independent 


8 



Outline 

Implementing 









9 



Managers cannot be judged for decisions they are not responsible for: 

the controllability problem 

 

 

Companies engage in operating, investing, and financing activities 

The manager of a responsibility center has significant decision-making authority 

over some aspects of these activities: 

Cost center Profit center Investment center 

Decision-making 

authority 

Controls only 

inputs/expenses 

Controls input and 

output 

Controls operating 

profit and capital used 

Performance 

evaluation 

Input-output 

productivity measures 

Operating profit, gross 

margin 

RONA, EVA 

 

EVA is a “total factor” measure of performance as it incorporates the income 

statement as well as the balance sheet 

EVA is fully appropriate only as a performance measure for investment centers 

When EVA is inappropriate management must use value drivers that are 

strongly correlated with EVA, easier to measure and more controllable by the 

unit manager to evaluate the business unit’s value creating performance 


10 



Financial and non-financial value drivers – identifying the Key 

Performance Indicators (KPIs) (1/3) 

 

Financial drivers: Components of EVA like RONA or components of RONA itself 

like working capital ratios (for example the DuPont Analysis) 

EVA 

( RONA – WACC ) ∙ invested capital 

„Profit margin“ 

(profitability) 

x 

Asset turnover 

(activity) 

Financing decisions 

(optimal capital structure) 

Investment decisions 

(capital allocation) 

NOPAT 

: Sales 

Sales : 

Invested capital 

Contribution 

(margin) 

Sales – 

– 

Fixed costs 

• production overhead 

• administrative overhead 

• distribution and 

marketing overhead 

Variable costs 

Fixed assets 

• fixed asset turnover 

Working capital 

• inventory period 

• receivables period 

• payables period 


11 





 

Some shortcomings of financial drivers: 

• Short-term performance might be achieved at the cost of the long run 

(maximizing the present value of future EVAs must be the objective) 

• “milking assets”, reduced production quality at the cost of customer satisfaction 

and future revenues etc. 

• Financial ratios are of historical nature (lagged indicators) 

 

Non-financial drivers might help to cope with these problems: 

• Leading indicators of future EVA like market share, customer satisfaction, 

product innovation, the number of new customers or employee skills and 

employee satisfaction… 

• …might be more under control of operating managers and 

• …capture problems quicker (customer complaints as signal of problems of 

product quality or distributional problems). 






 

 

 

While business unit managers rely on more global performance measures, 

department managers need more specific work flow measures which they can 

control on a day-to-day basis. 

Production employees, for example, should be given rather weekly incentive 

bonuses (based on productivity targets, for instance) for an immediate feedback 

than yearly bonuses based on profit measures 

Examples of value drivers / KPIs for different departments of a company which 

usually are not organized as investment centers: 

• Materials department: order fill rate, time from receipt of material to delivery to 

production, damaged scrap, obsolete excess etc. 

• Production department: production cycle time, inventory, in-process scrap etc. 

• Distribution department: percentage of problem-free installs and deliveries (time 

and quantity), number of returns etc. 

• Marketing department: sales per product / employee, customer satisfaction and 

customer loyalty, market share per region etc. 




A balanced scorecard combines financial as well as non-financial 

value drivers 

 

Apart from the financial perspective (with the EVA as the top level performance 

measure, for instance) other, non-financial perspectives are explicitly taken into 

account as a means of supporting shareholder value creation 

Financial Perspective 

To succeed financially, 

how should we appear to our shareholders? 

objectives measures targets initiatives 

Customer Perspective 

To achieve our vision, 

how should we appear to our customers? 


Vision and 

Strategy 

Internal Business Process 

To satisfy our shareholders and customers, 

what business processes must we excell at? 


Learning and Growth 

To achieve our vision, how will 

we sustain our ability to cange and improve? 



14 

Figure adapted from Kaplan / Norton (1996) 



Examples of possible performance measures in the four „classic“ 

dimensions of the balanced scorecard 

 

Financial Perspective 

 

Customer perspective 

• Economic value added 

• Customer profitability 

• Market value added 

• Repeat customers 

• Return on investment / return on 

net assets 

• Growth in sales 

• Customer surveys 

• Number of customer complaints 

• On-time delivery 

• Service response times 

 

Internal business process 

 

Learning and growth 

• Dealer quality 

• Employee motivation 

• Process cost 

• Employee empowerment 

• Nb. of units requiring reworking 

• Information systems capabilities 

• Length of operating cycle 

• Employee capabilities 

• Volumes of goods shipped 

• Number of employee suggestions 

• Optimal asset utilization 

• Hours spent on training employees 



Leading Lagging 

The Leading-Lagging Continuum 


The „strategy map“ presents the Key Performance Indicators in a 

causal chain 

Financial 

Accounts 

receivable 

Economic value added 

Operating 

expenses 

Customers 

Customers 

satisfaction 

On-time delivery 

Internal 

Business 

Processes 

Shorter 

cycle time 

Process quality 

Lower 

rework 

Learning 

and Growth 

Employee 

skills 

Employee morale 

Employee 

suggestions 


16 



Use of non-financial performance measures even in top management 

compensation 

Study of Ittner / Larcker / Rajan (1997): 36 % of the firms in their sample (114 of 317 

US companies) employ non-financial measures in evaluating CEO performance 

 

 

Non-financial performance measures of those 114 firms: 

Choice of performance measure 

depends on the corporate strategy 

of the firm: 

• Cost leadership (importance of 

operating efficiency) 

Operating profit, RONA 

and EVA are relatively 

informative measures 

• Differentiation (importance of 

long-term value creation for 

innovators and prospectors) 

Leading indicators of longterm 

value creation necessary 

Performance measure 

Percentage 

Customer satisfaction 36.8 % 

Employee satisfaction 8.7 % 

Product or service quality 21.0 % 

Efficiency or productivity 14.9 % 

Employee safety 16.6 % 

Market share 11.4 % 

Non-financial strategic objectives 28.0 % 

Process improvements and re-engineering 8.7 % 

New product development 6.1 % 

Innovation 2.6 % 

Employee development and training 7.0 % 

Other non-financial measures 65.5 % 


17 



Outline 

Implementing 









18 



Processes involving several operating units require performance measures 

focusing on processes instead of organizational boundaries 

 

The performance measurement system for so called “core processes” must 

consider the critical elements of the process by setting concrete operating objectives 

• “Core Processes” are processes that cut horizontally through a company and 

have no organizational boundaries like profit centers: 

• “Core Processes” are, for example, new product development, customer service, 

supplier management or order fulfillment 

 

Developing a performance measurement system for a core process 

• Map the process, identify the sequence of activities and the key players 

• Determine the areas where performance indicators are critical to the success of 

the process 




Example: Performance pyramid for a computer manufacturer 

Vision: 

„To provide fault-tolerant computer 

solutions to financial service companies“ 

Corporate 

Vision 

Objectives defined on 

business unit level 

Market (i.e. 

Share 

Growth) 

Financial 

(i.e. EVA) 

Core processes 

Critical elements of a core 

process (customer 

satisfaction, flexibility, 

productivity) and their 

global measures 

Customer 

satisfaction 

No. of 

complaints 

Survey results 

Repeat sales 

Flexibility 

Responsivene 

ss to order or 

configuration 

changes 

Productivity 

Inventory 

turns Cycle 

Times 

Goals on 

department 

level 

Quality Delivery Cycle Time Waste 


20 


Department measures 


The core process „order fulfillment“: Specific workflow/operating 

measures for each department with a key role in the process 

Core process 

„order fulfillment“ 

Customer 

satisfaction 

Flexibility 

Productivity 

Quality Delivery Cycle Time Waste 

Materials 

department 

Good parts 

Cycle count 

accuracy 

Order fill rate (no 

line outs) 

Time from receipt 

of material to 

delivery to 

production 

Incoming inspection 

Scrap, damaged 

Rehandling 

Load on the plant 

Excess, obsolete 

Production 

department 

% functional 

% with 

complete 

information 

% on time: 

to schedule 

to special request 

Production cycle 

time 

Rework 

Inspection 

Inventory 

In-process scrap 

Distribution 

department 

% problem-free 

installs: 

„plug and play“ 

% problem-free 

deliveries (time, 

quantity, place): 

to schedule 

to special request 

Material throughout 

time 

Order throughout 

time 

% rework time 

Number of returns 

Penalties for late 

delivery 


21 



Outline 

Implementing 









22 



EVA is an instrument for changing managerial behavior and corporate 

culture 

 

Implementation of VBM requires acceptance and understanding of sound financial 

theory and value-based principles like NPV by all managers 

 

Value creation is everyone’s responsibility in the company 

Finance departments should 

• provide transparency in the finance and accounting functions in order to help the 

operating departments understand and achieve their financial goals and 

• communicate clear goals to the employees and achieve their “buy-in” because 

the real value creators are the operating divisions 




The EVA implementation process is intensely company-specific and 

might follow 4 steps 

Step 1: 

 

Establish total acceptance at the board and top management levels as basis 

for further implementation 

Step 2: 

Major 

strategic 

decisions 

on the 

EVA 

program 

 

 

 

Define the EVA measurement centers, for example on the basis of existing 

profit centers with the advantage that 

• profit centers have the necessary responsibilities 

• the required financial reporting systems exist 

Fix the frequency and the way of how to calculate EVA: 

• Possible adjustments to the company’s accounting system for a “better“ 

EVA (attention to also growing complexity!) 

• Consideration of IT constraints 

• Divisional versus corporate cost of capital 

Design the management compensation system (decision to be made by top 

management): 

• Who will be covered initially and at a later date? 

• Sensitivity of bonuses to EVA performance 

• Will there be a deferred component? 

• Role of stock options in the compensation program 

• Divisional versus company-wide or group EVA bonuses 

• Relation to nonfinancial measures 


24 



The EVA implementation process is intensely company-specific and 

might follow 4 steps 

Step 3: 

 

Development of an implementation plan 

 

working out the technical details 

Step 4: 

Set up a 

training 

program 

 

 

 

Necessary to get the commitment to value creation from the company’s 

employees 

Select the persons that need the training 

Number and concept of training sessions, for example: 

• First session to introduce the employees to the concept of EVA 

• Second session to give more details about the calculation and 

interpretation of the EVA numbers and some ideas of how to increase the 

EVA of the divisions 

• Subsequent sessions to introduce the compensation plan 


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Lecture 9 - Lehrstuhl für Controlling - Technische Universität München

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