Understanding the Drivers of Value

A company that has made a top-level decision to make value happen needs to understand what elements in its day-to-day operations, as well as in its major investment decisions, have the most impact on value. Properly done, the process of defining value drivers can help managers in three ways. First, it can help both business unit managers and their staff understand how value is created and maximized in the business. Second, it can help in prioritizing these drivers and thus in determining where resources should be placed (or removed). Third, it can align business unit managers and employees around a common understanding of top priorities.

As we will use the term here, a value driver is a performance variable that has impact on the results of a business, such as production effectiveness or customer satisfaction. The metrics associated with the value drivers are called key performance indicators (KPIs). Such metrics might be capacity utilization or customer retention rates. KPIs are used both for target setting and for performance measurement. Three principles are central to defining value drivers well:

1. Value drivers should be directly linked to shareholder value creation and cascade down throughout the organization. Linking value drivers to the overall objective of shareholder value creation has two benefits. First, it aligns different levels of the organization to a single objective. When front-line staff and business unit management agree on how front-line actions affect overall value creation, they can harmonize their goals and measures, instead of working at cross-purposes. Second, it allows management to objectively balance and prioritize different value drivers as well as short-term and long-term actions. When difficult decisions must be made, management can use long-term value creation as the criterion for the decision—and as a rationale to communicate the decision to a skeptical stock market.

Note that a shareholder value focus does not exclude other important objectives for a company, such as safety or environmental concerns. These constraints can also be included in the value driver definition and in performance scorecards. What is important is that there are clear rules about how and when these objectives take precedence over shareholder value maximization, so that the value focus isn't diluted.

2. Value drivers should be targeted and measured by both financial and operational KPIs. Companies frequently undertake value driver analysis by breaking down return on invested capital into its component financial measures (as discussed in Chapter 9 on return-on-invested-capital trees). This is a good beginning, but by itself doesn't provide a full understanding of value drivers. For one thing, management has no way to affect financial ratios directly; it can only do so by affecting operating factors. So management must go one step further. For example, if a hard goods retailer wants to analyze how it can increase the earnings-before-income-taxes (EBIT) margin, it needs to break down the EBIT margin into its components—gross margin, warehouse costs, delivery costs, and other selling, general, and administrative costs. It can then disaggregate the factors driving each kind of cost, so that delivery costs can be broken down into trips per transaction, the cost per trip, and number of transactions. This level of operating detail allows managers to analyze concrete improvement actions.

Operational numbers are particularly useful as leading indicators. Financial ratios alone can fail to alert managers that there are problems ahead. For example, a business unit's return on invested capital may improve on a short-term basis because the management team is failing to maintain assets or make needed investments. Asking managers to report on operational measures such as maintenance expense, uptime of machines, or plans to expand or replace assets would reveal that the improvement in return on invested capital is not sustainable.

3. Value drivers should cover long-term growth as well as operating performance. Although many companies focus their attention on current performance, as businesses mature and decline, successful companies must invent ways to grow. Therefore, value driver analysis should highlight drivers to grow at a return above the cost of capital as well as drivers to improve today's return on invested capital. For a retailer, this might include the number of stores to be opened in a given year or the number of new product categories introduced. Sometimes, though, growth does not come in easily measured units such as new stores. For some cases, the right answer is to use project-based measures. In a metals company, the source of growth might be the introduction of a new process, for which milestones in implementation might serve as the value drivers. In other cases, using qualitative measures is more appropriate. A consumer goods company may need to rate its own understanding of market trends as excellent, good, fair, or poor.

As a natural outcome of these principles, note that each business unit should have its own set of key value drivers and KPIs. Although a corporate center may be tempted to impose the same template on all business units in a company, this is often not meaningful for any measures beyond high-level financial numbers. Even when two business units are in the same industry, it may be best for them to focus on separate value drivers if their current performance is different. For example, a business unit with superior operating performance and margins should focus on growth-related KPIs while a low margin unit should focus on cost-related KPIs.

Also note that a business unit should limit the number of performance indicators. Managers should monitor these numbers regularly to obtain an overview of business performance, with other value drivers used as supplemental diagnostic indicators to understand underlying issues. Experience suggests that 5 to 10 KPIs are sufficient to provide a good overview, with 20 an upper bound. If a company tries to use more than 20, it will probably have difficulty deciding which numbers to focus on.

The process of value driver definition has three phases (which are described here sequentially, although in practice there is significant iteration): identification, prioritization, and institutionalization, as illustrated in Exhibit 6.4.

1. Identification. The first task is creating value trees that systematically link the operating elements of the business to value creation. While mathematical links are desirable, it is better to include a nonquantifiable link than to omit it. It is also helpful to draw trees in at least three different ways (see Exhibit 6.5) to provoke creativity and thoroughness. Management can then integrate these into a single tree that best reflects its understanding of the business. For this exercise to succeed, managers within the business unit must be directly involved in the brainstorming and debate.

Exhibit 6.4 Overview of Value Driver Analysis

Exhibit 6.4 Overview of Value Driver Analysis

2. Prioritization. Once managers have agreed upon an integrated tree, the next step is to determine which drivers could have the greatest impact on the value. The first part of prioritization is building a discounted cash flow model for testing the sensitivity of the business unit's value to changes in each of the value drivers, looking one by one at the effect that a small change in each driver could bring. The second part is analyzing a limited number of value drivers to determine the ''real life" potential and ease of capture for each improvement action. The end of this phase is a list of key value drivers and the potential associated with each one.

3. Institutionalization. Value drivers are incorporated into the targets and scorecards of on-going business performance management, as described in the next section. Note that value drivers should be reviewed periodically, as the highest-priority levers may change as market conditions or the company's skills evolve.

Exhibit 6.5 Value Driver Trees from Different Perspectives

Exhibit 6.5 Value Driver Trees from Different Perspectives

Managing Business Performance

Once a company understands how to create value in each business by influencing the value drivers, the next challenge is managing each business to attain results consistent with the top-down aspirations. Business performance management is the process of setting targets for a performance unit and regularly reviewing progress against them, with the goal that different layers of the company will work together for enhanced performance. Business performance management is often the crux of managing for value, as this is where value metrics, value drivers, and targets must translate into everyday actions and decision making.

When business performance management is working well, it helps different layers of the organization communicate frankly and effectively. In particular, effective business performance management greatly improves the dialogue between the corporate center and the business units. It gives managers space to manage, while assuring their bosses that the agreed-upon level of performance will be achieved. But when business performance management is done poorly, it can degenerate into piles of paperwork and much wasted time.

There are several components of successful business performance management. First, a business unit must have a clear strategy for creating value. Second, it should set targets with a clear link to specific value drivers.

Third, it needs a structured calendar of performance reviews to discuss results against value-linked KPIs.

Crafting Business Unit Strategy to Create Value

Crafting business unit strategy is a prerequisite for effective business performance management, even though it is not part of the process itself. We will not give a full description of strategic planning here, but rather point out how discounted cash flow analyses, such as those developed in value driver analysis, can greatly assist management in choosing a business unit strategy.

Applying valuation to strategy can produce significant insights:

• The retail banking division of a money center bank had been following a "harvest" strategy and taking cash out of the business. The division's new chief operating officer wanted to switch to an aggressive growth strategy to regain market share. This strategy had a price tag of $100 million for refurbishing branch bank facilities, installing automatic teller machines, better training for tellers, and a new advertising campaign. While the bank's CEO originally rejected the new strategy because it would lead to reduced return on equity in the first year, he changed his mind when a DCF valuation showed that the value of the aggressive growth strategy was 124 percent higher than that of the harvest strategy.

• A consumer products company determined that pursuing accelerated category growth had twice the potential value increase and a fraction of the downside compared with expanding the brand into new products.

Another benefit of making a direct link between strategy and valuation is that this explicitly links the strategy development process with other efforts to make value happen. If the business unit strategy process is not set up with a value creation focus, then performance management will be less meaningful, as its goals may not be congruent with the chosen strategy.

Setting Value-Linked Targets

Translating strategy into specific quantitative goals requires management to set value-linked targets. In this section, we will focus on the target-setting process for a business unit, but the principles can be applied to more specific targets such as those used for frontline performance.

A starting point is deciding what principles to use in setting targets. Typical approaches are to set targets on the basis of history ("we can get 3

percent more than last year") or a degree of stretch that has no basis in the underlying business ("everybody in this corporation has to get 15 percent growth"). We recommend looking at the actual opportunities available along each of the key performance indicators. Opportunities can be gauged by benchmarking competitors; industry analysis; theoretical limits such as capacity utilization, and, where appropriate, benchmarking against comparable business units within the same company. This process will generally create operating stretch, but one with a basis in reality.

A related issue is deciding how to deal with externalities. This is particularly important for businesses where one or more of the key drivers—commodity prices, for example—is influenced by factors outside of management's control. Generally the best approach is to adjust the targets to reflect the changing environment. The rules should be clearly stated ahead of the performance measurement period so that all parties can agree that they are fair.

Once the corporate center and business unit management agree on principles, they must also decide how to interact in setting targets. Getting a fit between top-down and bottom-up targets requires negotiation between the center and the business unit, which makes the target-setting process an iterative one. While this demands more time and energy than simply dictating targets from the top, the iterative approach draws more deeply on the business unit managers' expertise and is more likely to gain their true commitment.

A well-informed corporate center is the most important prerequisite for this dialogue. Top management, particularly the CEO, needs a good understanding of the economics and operating environment of each business, independent of the information provided by the business itself. Various approaches can make this happen, including having the corporate center operate as a kind of principal investing firm, or having an "equity analysis" function within the corporate center. When these approaches work well, they can provide useful support for the business unit as well as insight for the CEO.

After agreeing on a target, the corporate center and business unit can formalize this commitment in a performance contract. The contract should contain the milestones and quantitative and qualitative goals that the business unit intends to achieve throughout the performance period. The goals should be explicit enough to avoid ambiguities in expectations, but not so constraining as to hamper the manager's legitimate scope of action. Having the CEO and the business unit manager sign the contract gives symbolic weight to the commitment.

While we have focused on setting targets at the overall business unit level, targets should cascade throughout the organization just as the value drivers do. The CEO and the business unit head might discuss a few high-level operational and financial indicators. The business unit head would then discuss the key performance indicators at the next level of detail with his or her direct reports. On the frontline, managers and staff will discuss operational levers such as inventory turnover. If a company has organized into performance units and done a thorough value driver analysis, then creating cascading targets should be straightforward.

Regularly Reviewing Performance

To periodically check performance against targets, a company needs a structured calendar of performance reviews. These provide a series of forums throughout the year for managers and employees to evaluate and discuss performance and look for ways to improve. Some factors for success in performance reviews are the information used in the reviews, the timing of the overall calendar, and the tone of the discussions.

The best information base for the reviews is a scorecard incorporating value metrics and KPIs from the value driver analysis. It is tempting for managers to think that financial reports alone can serve as the basis for performance discussions. Accounting inputs are only part of the picture. A scorecard also should contain value metrics grounded in economic results and KPIs that reveal underlying performance. As a measure of value creation over a period of time, economic profit is widely used. For the drivers of value creation, historical KPIs show the operating performance behind the financial results. For example, if revenue is dropping, is the cause lower market share, more discounts than usual, or other factors? Additionally, leading indicators give a sense of future developments and may head off any negative trends. A sample of a scorecard that contains these elements is included in Exhibit 6.6.

While it can be tempting for the corporate center to impose one scorecard on all its business units, this is shortsighted. Any gains in comparability across businesses are more than offset by the losses in understanding the unique drivers of value in each unit. The ideal model is to have custom-tailored scorecards cascading down in each business, so that each manager can monitor the key value drivers most important to him or her. Once managers know what data they want to review in the scorecards, they need to establish how they will get the data in a timely, complete, and accurate way for each review. Companies differ in the degree to which they decide to automate this process. Some choose elaborate software solutions, whereas others get by with more informal systems. In either case, the process should be as streamlined as possible so that reviews do not precipitate a data collection crisis each time they occur. Accuracy of the data in the scorecards is critical so that people feel they are being measured fairly. Further, management must figure out how it will capture qualitative data on a continual basis.

Exhibit 6.6 Sample Performance Scorecard for a Business Unit


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