BH011

A Value-Based Management
System
Stanley F. Slater and Eric M. Olson

Value for a firm and

T he fundamental
economic pur-
pose of a corpora-
tion is to create wealth for
that it coordinates and focuses the efforts of the
entire work force on activities that will create
value for shareholders and for themselves.

its customers should its owners. This has be-

come so powerful a moti-
VALUE-BASED MANAGEMENT

be created by the
entire organization,
with the rewards
vation that one might say
that “Create shareholder
value” has become man-
agement’s mantra for the
1990s. Because of the
being shared by all. development of analytical
techniques based on dis-
counted cash flow analy-
sis, equity spread, and economic value added,
managers now have an extensive set of tools for
determining which parts of their businesses add
to or subtract from shareholder value. They can
also use these tools to assess the value creation
prospects of new strategies or new lines of busi-
ness.
Unfortunately, as has been the case with
other management paradigms such as total qual-
ity management and reengineering, many firms
are finding that applying the tools of value-based
analysis and planning is not sufficient in itself to
increase shareholder value. These tools focus on
financial management and the actions of the top
management team, whereas value creation is the
result of the actions of individuals and groups
throughout the firm.
Thus, a comprehensive value-based manage-
ment (VBM) system must engage, motivate, and
reward the people throughout the organization
who create shareholder value. The system we
Business Horizons
present here is designed to accomplish that. In-
Copyright © 1996 stead of developing a new set of techniques to
by Indiana University implement VBM, we show how free-standing
Kelley School of management techniques can be combined into a
Business. For reprints, holistic VBM system whose strength is found in
call HBS Publishing
at (800) 545-7685. the synergy of its component parts. The benefit
of institutionalizing an integrated VBM system is
A VBM system, as depicted in Figure 1,
is initiated by conducting a thorough
assessment of where the greatest op-
portunities for creating additional value exist.
Based on this knowledge, a commitment is made
by managers from all functions to the goals of
VBM and a few high-impact stretch targets are
established. Line workers are then integrated into
the process, first through education on the pur-
pose, importance, and techniques of value-based
planning, and then by having broad access to
operating information. Using their knowledge
about current performance and the stretch goals,
employees are given the responsibility to develop
and implement improvement plans. The organi-
zation supports them by providing task-focused
training in key areas. The circle is made whole
when a follow-up value-based analysis is con-
ducted. Rewards are then shared and the process
continues. In the following sections, we describe
what occurs at each stage.
Stage 1: Value-Based Analysis
Value-based analysis and planning techniques are
built on modern financial tools that are routinely
used to evaluate individual projects or invest-
ments. However, they are applied at the business
unit level to evaluate new strategies, such as the
development of a new product or entry into a
new market, or to assess the effectiveness of the
current strategy or operations of an existing busi-
ness. The fundamental premise underlying all of
the various approaches to value-based planning
is that shareholder value is created when a firm’s
return on capital exceeds the cost of capital.

48 Business Horizons / September-October 1996

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 Because of their different objectives, we equity (ROE) and its cost of equity. The greater
separate the value-based approaches into tech- the spread, the greater the value that is created.
niques for (a) planning and evaluating new stra- Though this approach is also complicated by the
tegic initiatives and (b) analyzing and improving need to identify what should be considered capi-
current operations. Discounted cash flow (DCF) tal and what the cost of equity is, its virtue is that
techniques are most appropriate for evaluating it focuses management’s attention on determining
new strategic initiatives. This approach forces the and taking the steps necessary to improve ROE.
analyst to forecast all investments and other ex- ROE is too far removed from normal activi-
penditures that an initiative requires (cash out- ties to be useful to a marketing manager or an
flows) and all of the revenues generated by the inventory control manager. But it can easily be
initiative (cash inflows). All of the cash flows are decomposed into meaningful components using
discounted to their present value at the firm’s the Du Pont approach to financial analysis illus-
cost of capital. A positive net present value indi- trated in Figure 2. Of course, this is only the
cates that value is created; a negative net present broad outline of the Du Pont analysis. To be
value indicates that value has been destroyed. useful, it must be carried to an operating level
Forecast cash flows can be converted into spe- that is meaningful for managers as well as line
cific goals such as profit margins or asset turn- workers. For example, inventory turnover directly
over ratios, which then become the basis for affects asset turnover, which affects ROE and
operating targets. shareholder value. The same is true for general
Because of its focus on future cash flows, and administrative expenses as a percentage of
DCF analysis is very difficult to apply to the sales, which directly affect return on sales, which
analysis of current operations. Whereas financial in turn also affect ROE and shareholder value. At
ratios based on previous DCF analyses may be
used to rate progress toward a financial goal, the
economic value added (EVA) and equity spread Figure 1
(ES) models were developed specifically with Stages Of A Value-Based Management System
assessing the value-creating potential of current
operations in mind. Improvements in both EVA 1
and ES have been shown to be strongly related Value-based
to the creation of shareholder value. Analysis
EVA seems to be the more popular of the
two, having been adopted by such leading firms
as Coca-Cola, AT&T, and Quaker Oats. Very sim- 5 2
ply, EVA is a company’s net operating profit after Performance Evaluation Stretch Targets and
taxes and after deducting all costs of capital, both and Gainsharing Management Commitment
debt and equity. However, determining a firm’s
total cost of capital is not a simple matter. Deci-
sions must be made as to whether investments in
R&D, training, and advertising, among others, 3
4
should be treated in the conventional manner as Employee Empowerment VBM Training and
an expense or rather as capital. If they are treated and Task-focused Training Open-book Management
as capital, what are their useful lives and at what
rate should they be amortized? Once the total
investment in capital has been determined, the Figure 2
weighted average cost of debt and equity must The Du Pont Process
be applied against it. This too is tricky, particu-
larly for units of multibusiness corporations that
have no unique equity. On average, though, RETURN ON SALES
Net Income/
investors expect to earn about six percentage
Total Sales
points more on stocks than on government
bonds. With current long-term interest rates RETURN ON ASSETS
around 7 percent, the average cost of equity is x = Net Income/
about 13 percent—more if the business being Total Assets
analyzed is riskier than average. ASSET TURNOVER RETURN ON EQUITY
Total Sales/ x
We prefer the ES model because it is some-
what simpler to implement and because it lends
Total Assets = Net Income/
Owner’s Equity
itself to ratio analysis, which provides the founda- LEVERAGE
tion for setting improvement targets. The premise Total Assets/
of the ES model is that value creation is a func- Owner’s Equity
tion of the spread between a firm’s return on

A Value-Based Management System 49

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 this level, plant managers or human resources
managers can see the impact of their actions on
shareholder value.
To achieve a realistic understanding of where
the greatest opportunities for value creation exist,
the firm’s ratios should be benchmarked against
its own historical performance and against the
performance of a best-in-class peer. This peer
may be a direct competitor (Ford vs. Toyota), a
firm in the same broad industry that is not a di-
rect competitor (Continental Airlines vs. Singapore
Airlines), or a best-in-class firm in an industry
with similar operating characteristics (Coors vs.
Coca-Cola). Accessibility of the information gen-
erally determines which benchmark is used.
Detailed information on the operations of
direct competitors, of course, may be very diffi-
cult to obtain. Nevertheless, one of our clients
shares detailed operating information with similar
businesses operating in different geographic re-
gions. Such companies as Xerox, L.L. Bean, and
Lincoln Electric have shared information on some
key business practices rather freely.
Stage 2: Management Commitment
And Stretch Targets
A key objective of VBM is to motivate individuals
and groups throughout the company to find
more effective ways to accomplish their tasks. A
sophisticated financial analysis cannot create that
motivation by itself;
when it is combined
with a threat to the
“A key objective of VBM firm and its stakehold-
ers, though, motiva-
is to motivate individuals tion emerges as a
and groups throughout powerful force. An
obstacle to sustaining
the company to find momentum for change
more effective ways to is that without the
evidence of a real
accomplish their tasks.” threat, the push for
continuous improve-
ment may ultimately come to be perceived as top
management rhetoric. Information from a value-
based analysis can provide this evidence. Such
outstanding companies as Microsoft, Intel, and
PepsiCo have gone so far as to institutionalize a
belief that there is little time to enjoy past suc-
cesses because clever and strong competitors are
constantly searching for chinks in their armor.
To achieve a successful VBM system, all lev-
els of management must buy into it. First, VBM
will not work without top management’s com-
plete commitment and support. Then, the objec-
tive is to educate all managers about the meaning
of VBM, the operation of the analytical frame-
work, and the benefits that will accrue to organi-
zational members. Ultimately, the managers must
50
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become the disciples who carry the message of
VBM to all employees.
A key output of the financial analysis and the
dialogue among the management team is identi-
fying a few high-impact areas for the organization
to focus on. Instead of aiming for incremental
improvement in those areas, many highly suc-
cessful firms set stretch targets—extremely ambi-
tious goals that artificially stimulate and encour-
age the development of new ways to accomplish
a task. A stretch goal might be to increase asset
turnover by 50 percent. Obviously, tweaking
inventory management or capacity management
practices will not produce this type of result. A
new operating model must be designed.
Firms must be careful in using stretch goals.
The objective is to encourage people to find bet-
ter ways to work. But if employees feel they are
being “stretched” to achieve an artificial goal,
burnout and reduced morale can result. And it
may be that no one knows how to accomplish
this ambitious goal, so failure based on a sincere
and carefully considered approach to accomplish-
ing the goal should not be punished. It is essen-
tial that employees be given the information and
training necessary to try to achieve the goal.
Stretch targets may not be appropriate for all
parts of the organization. For instance, high per-
forming areas are already being stretched. The
benchmarking analysis should help focus the
stretch efforts.
A final but critical step in gaining total com-
mitment is to establish a process for sharing the
rewards associated with achieving the goal
throughout the firm. One way of doing this is
through a gainsharing program, which is a group
bonus plan that shares the financial fruits of an
improvement program between the responsible
work unit and the company.* Its objective is to
make all employees, not just managers, behave
as if they are owners. Owners recognize both the
importance of having a long-term vision and a
short-term sense of urgency about achieving re-
sults. Employees who have an ownership interest
also are more likely to view change as an oppor-
tunity than as a threat. To be an effective motiva-
tional tool, however, the payout formula must be
carefully constructed and clearly communicated.
Stage 3: VBM Training And Open-Book
Management
Gaining the commitment of management repre-
sents only the tip of the iceberg when it comes to
making VBM a key component of the organiza-
tion’s culture. VBM will achieve its potential only
*Editor’s note: See Woodruff Imberman, “Gainsharing:
A Lemon Or Lemonade?” in the January-February 1996
issue of BH.
Business Horizons / September-October 1996
when the creative potential of the entire work
force is unleashed. “Those that understand EVA
know how important it is to train everyone in the
organization,” maintains Stewart (1995), “because
even those with the smallest jobs can help create
value.”
This requires that all employees understand
VBM’s purpose, the mechanics of the financial
framework, the firm’s current financial situation
and its goals, and the benefits they will receive
when the firm achieves or exceeds its goals. The
result will be an all-around understanding of how
key operating metrics, such as inventory turns or
employee turnover, affect ROE. The next step is
to train all employees in value-based planning
and analysis and to provide information about
the firm’s performance and goals in key areas.
Managers and supervisors play an important
role at this stage. Rather than using outside con-
sultants or trainers, having the immediate super-
visors of line workers provide this training has
two important benefits. First, it ensures that they
themselves will develop an in-depth understand-
ing of the system. There is nothing like being
thrust into the role of instructor to help someone
gain a deeper understanding of the material.
Second, those sessions provide a constructive
forum for surfacing and testing ideas that have
the potential to improve performance or achieve
stretch goals.
An essential component at this stage is to
provide employees with key operating data. Too
many firms still operate under the “need to know”
principle. This says that employees should have
access only to information about their specific
jobs because being too open with information
would enable it to be leaked to competitors.
However, as more and more organizations move
from a functional orientation to a business pro-
cess orientation, they increasingly recognize the
interdependence of many jobs. Thus, to improve
their performance employees need to understand
how it both affects and is affected by the work of
others. This requires broad access to information
about many areas of the company. In most situa-
tions the potential advantages of sharing informa-
tion in the firm far outweigh the potential threats
from that information leaking to competitors. Of
course, sensitive information about new products
or acquisitions, for example, must be restricted.
The final step in gaining employee commit-
ment to a VBM system is to show how the system
can make jobs more secure and provide the op-
portunity for additional income. Just as with man-
agement, the objective is to change behavior.
Again, change is most easily motivated when a
threat to the organization or its stakeholders is
apparent. A business that is not earning its cost
of capital generally is in a weak competitive posi-
tion, and weak businesses often must respond by
A Value-Based Management System
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downsizing to improve profitability. VBM is in-
tended to avoid that situation.
It may be difficult to excite employees about
making more money for the owners of the busi-
ness. Hence, as explained earlier, profits in ex-
cess of the cost of capital and gains from achiev-
ing stretch goals
should be shared
with those respon-
sible for earning “The appropriate role for
them. If a firm’s cost
of equity is, say, 13 management, therefore,
percent, profits after is to set the firm’s goals
interest and taxes
that exceed the 13 and then give employees
percent figure should the tools necessary to get
be shared with em-
ployees. With such
the job done.”
an incentive, employ-
ees will act more like owners and will work to
enhance the wealth of the firm.
Stage 4: Employee Empowerment And
Task-Focused Training
After being trained in the principles of VBM,
workers closest to the customer or involved in
key operating processes generally know best
where the opportunities for value creation are.
Stewart tells the story of an inventory stockroom
manager who, after being trained in EVA, sug-
gested that his company put a lock on the ware-
house door and throw away the key. His obser-
vation was that the plant was using the space
because it was available. The appropriate role for
management, therefore, is to set the firm’s goals
and then give employees the tools necessary to
get the job done.
Additional tools that are required beyond
VBM training include training in the tasks that
have been identified as likely to produce high-
impact results. If analysis shows that the firm’s
customer retention rate is below target, training
in customer service might be required. If it takes
too long for the firm to bring new products to
market, training in product development process
management may be required. As Steve Kerr,
General Electric’s chief learning officer, puts it,
“We have a moral obligation to try to give people
the tools to meet tough goals” (Sherman 1995).
Stage 5: Sharing The Value
The VBM system has now come full circle. The
firm’s financial condition and progress have been
regularly monitored, all employees have been
kept knowledgeable about the situation, and a
formal financial report card must now be issued.
Based on the results reported here, decisions
about profit sharing or gainsharing can be made.
51
 Gainsharing is only one possible approach.
An innovative alternative that helps to avoid
short-term gaming is to construct a “bonus bank”
whereby some proportion of the financial gains
are banked forward with full payout contingent
on continued successful performance. Other ap-
proaches to profit sharing and bonuses may be
appropriate as well.
The VBM system continues with dialogue
among the management team about where stretch
goals should be focused in the future and the
involvement of all employees in determining the
best means for achieving those goals. Finally, it is
important that training in both VBM and the tasks
that derive from it become an ongoing organiza-
tional commitment.
A lthough the creation of shareholder
value is an imperative for a firm, value-
based management will not ensure an
optimal strategy. First, all of the techniques of
value-based analysis and planning have been
criticized for focusing too heavily on cost reduc-
tion rather than on revenue generation. A firm
can create only so much value by reducing in-
vestment in inventory or by outsourcing nonstra-
tegic activities. Eventually, value creation must be
the result of product development or new market
entry. The importance of these activities may not
be apparent from value-based analysis.
A related problem with the DCF approaches
to financial evaluation is that they undervalue and
discourage uncertain strategies with long-term
payoffs. When faced with uncertainty, many firms
add a risk premium to their required rate of re-
turn. This corruption of value-based analysis
almost ensures that opportunities with long-term
potential will be rejected. Paradoxically, uncer-
tainty often represents opportunity that can only
be exploited through investment. “In growing but
uncertain markets,” say Kogut and Kulatilaka
(1994), “a heuristic that says accept projects that
promise to pay 20 percent on invested assets
conveys the message, ‘Exit the market when un-
certain.’” Thus, improper reliance on DCF analy-
sis may lead to a “going out of business” sce-
nario.
Value-based analysis can evaluate only the
potential of known alternatives, and it can do
that accurately only when properly applied. It
cannot create a strategic vision for a company or
generate new strategy alternatives that fit an ex-
isting vision. The greatest value of a VBM system
is realized when it unleashes and focuses the
creative capabilities of employees throughout the
52
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organization on discovering new ways to create
superior value for customers. When VBM is fo-
cused on creating both economic value and su-
perior customer value, and is an integral part of
the culture, the firm’s future prospects will be
greatly enhanced. ❒
References
William Alberts and James McTaggart, “Value-Based
Strategic Investment Planning,” Interfaces, January-
February 1984, pp. 138-151.
Gary Hamel and C.K. Prahalad, Competing For The
Future (Boston: Harvard Business School Press, 1994).
Robert C. Higgins, Analysis For Financial Manage-
ment, 4th ed. (Chicago: R.D. Irwin, 1995).
Woodruff Imberman, “Gainsharing: A Lemon Or Lem-
onade?” Business Horizons, January-February 1996, pp.
36-40.
B. Kogut and N. Kulatilaka, “Options Thinking And
Platform Investments: Investing In Opportunity,” Cali-
fornia Management Review, Winter 1994, pp. 52-71.
S. Myers, “Finance Theory And Financial Strategy,”
Interfaces, 14, 1 (1984): 126-137.
Alfred Rappaport, Creating Shareholder Value (New
York: The Free Press, 1986).
Stratford Sherman, “Stretch Goals: The Dark Side Of
Asking For Miracles,” Fortune, November 13, 1995, pp.
231-232.
Joel Stern, G. Bennett Stewart III, and Donald Chew Jr.,
“The EVA Financial Management System,” Journal Of
Applied Corporate Finance, 8, 2 (1995): 32-46.
G. Bennett Stewart III, The Quest For Value (New York:
Harper Business Press, 1991).
G. Bennett Stewart III, “EVA Works—But Not If You
Make These Common Mistakes,” Fortune, May 1, 1995,
pp. 117-118.
Stanley F. Slater is a professor of busi-
ness administration at the University of
Washington-Bothell. Eric M. Olson is an
assistant professor of strategic manage-
ment and marketing at the University of
Colorado in Colorado Springs.
Business Horizons / September-October 1996