Summary of the mandatory literature of each week for the course Financial Management (Koller, Porter, Oostenbrink & Rutten, Chan, Young, Kleinmuntz & Kleinmuntz, Zimmerman, Barnum, Kutzin & Saxenian, OECD)
Summary Literature Financial Management
What is value-based management? – Koller (1994)
The cause of failure of many new management approaches is often unclear performance targets or
performance targets that are not properly aligned with the ultimate goal of creating value. Value-
based management (VBM) tackles this problem by providing a precise and unambiguous metric –
value – upon which an entire organisation can be built. The value of a company is determined by its
discounted future cash flows. Value is created only when companies invest capital at returns that
exceed the cost of that capital. VBM extends these concepts by focusing on how companies use them
to make both major strategic and everyday operating decisions.
VBM has its pitfalls. It can become a staff-captured exercise that has no effect on operating managers
at the front line or on the decisions that they make. It needs to take strategic or operating issues into
account at a business-unit level. VBM should also not focus on methodology. It should focus on the
why and how of changing your corporate culture (organisational behaviour).
Well working VBM provides decision makers with the right information and incentives to make value-
creating decisions. It creates targets and performance measures tailored to particular circumstances
but driven by the overall strategy.
VBM can be seen as a combination of a value creation mindset and the management processes and
systems necessary to translate that mindset into action. Each element apart is insufficient but
combining them, they can have a huge impact.
- Value creation mindset: the ultimate financial objective is maximizing value
o Clear rules for deciding when other objectives outweigh this imperative
o Analytical understanding of which performance variables drive the value of the
company
- Management processes and systems: planning, target setting, performance measurement,
and incentive systems tightly linked with value creation
o Encourage managers/employees to behave in a way that maximizes the value of the
organisation
To focus more directly on creating value, companies should set goals in terms of discounted cash
flow value, the most direct measure of value creation. Companies also need nonfinancial goals –
goals concerning customer satisfaction,
product innovation, and employee
satisfaction –to inspire and guide the entire
organization. These goals must however be
considered in the light of a company’s
financial circumstances. Objectives must
also be tailored to the different levels within
an organization.
The performance variables that actually
create the value of the business are called
the key value drivers. An organisation
cannot act directly on value, it has to act on
things it can influence (customer
satisfaction, cost, capital expenditures etc.)
A value driver is any variable that affects the
,value of the company. Value drivers need to be organized so that managers can identify which have
the greatest impact on value and assign responsibility for them to individuals who can help the
organization meet its targets.
Identifying key value drivers can be difficult because it requires an organization to think about its
processes in a different way. Often, existing reporting systems are not equipped to supply the
necessary information. A creative process with trial and error is needed. Value drivers can also not be
considered apart from each other. E.g. a price increase might, taken alone, boost value – but not if it
results in substantial loss of market share. Scenario analysis is a valuable tool to understand the
interrelationships among value drivers. It can assess the impact of different sets of mutually
consistent assumptions on the value of a company or its business units. Thinking about different
scenarios helps management avoid getting caught off guard and brings to life the relationship
between strategy and value.
Managers must also establish processes that bring the value-based mindset to life in the daily
activities of the company. There are four essential management processes that collectively govern
the adoption of VBM.
1. The company develops a strategy to maximize value.
2. The company translates this strategy into short- and long-term performance targets defined
in terms of value key drivers.
3. The company develops action plans and budgets to define the steps that will be taken over
the next year or so to achieve these targets.
4. The company puts performance measurement and incentive systems in place to monitor
performance against targets and to encourage employees to meet their goals.
Strategies and performance targets must be consistent right through the organization if it is to
achieve its value creation goals.
The strategy development process must always be based on maximizing value, but implementation
will vary by organizational level.
- Corporate level strategy is primarily about deciding what businesses to be in, how to
exploit potential synergies across business units, and how to allocate resources across
businesses
o The strategy should be built on a thorough understanding of business-unit strategies
- Business-unit level strategy development generally entails identifying alternative
strategies, valuing them, and choosing the one with the highest value
o The chosen strategy should spell out how the business unit will achieve a competitive
advantage that will permit it to create value
Once strategies for maximizing value are agreed, they must be translated into specific targets.
Targets are set to communicate expectations on what to achieve. Without targets, organisations do
not know where to go. Targets that are set too low will lead to mediocre performance. Targets that
are set too high will fail to provide any motivation. When applying VBM to target setting, several
general principles are helpful:
- Base your targets on key value drivers
o Financial and non-financial targets
- Tailor the targets to the different levels within an organisation
- Link short-term targets to long-term targets
o Short-term targets need a more immediate measure derived from actual
performance over a single year economic profit
o Economic profit: Invested capital x (Return on invested capital – Weighted average
cost of capital)
, It measures the gap between what a company earns during a period and the
minimum it must earn to satisfy its investors
Action plans translate strategy into the specific steps an organization will take to achieve its targets,
particularly in the short term. The plans must identify the actions that the organization will take so
that it can pursue its goals in a methodical manner.
Performance measurement and incentive systems track progress in achieving targets and encourage
managers and other employees to achieve them.
Key principles for a performance measurement system:
1. Tailor performance measurement to the business unit.
Generic measures do not allow for valid comparisons across business units.
2. Link performance measurement to a unit’s short- and long-term targets.
3. Combine financial and operating performance in the measurement.
An integrated report of financial and operating performance would better serve managers’
needs.
4. Identify performance measures that serve as early warning indicators.
E.g. market share, sales trends.
Next, the compensation system needs revision. Compensation design should provide the incentive to
create value at all levels within an organization.
It is vital for top management to understand and
support the implementation of VBM. Though active
top management support is a necessary condition for
the successful implementation of VBM, it is not
sufficient in itself. Value-based management, as we
have suggested, must permeate the entire
organization. Not until line managers embrace VBM
and use it on a daily basis for making better decisions
can it achieve its full impact as an aid to the long-term
maximization of value.
Value-based health care delivery – Porter (2008)
Value: health outcomes achieved per dollar spent.
Increasing value in healthcare will require a transformation in how healthcare is actually delivered.
Significant improvements in the value of health care delivered will require fundamental restructuring
of the system, not incremental improvement of today’s system. Consumers can play a more active
role in improving their health but empowering them is not the key to fixing the healthcare delivery
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