bc
Corporate Performance
Measurement
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 2
Corporate Performance Measurement
Executive Summary (1 of 2)
• Corporate performance evaluation has evolved from the 1960s focus on ROE to the
current variations of economic profit that measure impact on shareholder value
–many firms have devised their own variations of economic profit
–Stern Stewart’s Economic Value Added (EVA)TM is best known of these measures
–Holt/BCG’s Cash Flow Return on Investment (CFROI) is a similar concept presented
in % return format
• Both ROE and EP are business metrics, tools used to measure the performance of the
business
–separate from fundamental business drivers, the actual factors that influence
shareholder value, and output measures the backward-looking records of overall
company performance
• Focusing on EP instead of ROE decreases the likelihood of destructive behavior by
managers
–By evaluating managers based on EP, manager behavior can be altered such that
only projects that add value (with NPV>0) are undertaken, which does not always
occur with ROE
bc
LON CorporatePerformanceMeasurement 3
Corporate Performance Measurement
Executive Summary (2 of 2)
• End goal of EP exercises is consistent with traditional Bain focus
of maximising shareholder value
–Bain has measured historical performance with Total
Shareholder Return
–Stern Stewart devised Market Value Added (MVA)TM as means
of measuring market expectations of EP that managers will add
in the future
–managers’ objective should be to maximise MVA
• All economic profit measures deduct charge for use of equity
capital from accounting’s typical net income or profit after tax to
reflect the opportunity cost associated with equity investments
–Stern Stewart has trademarked EVATM by specifying
adjustments to make to EP
bc
LON CorporatePerformanceMeasurement 4
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 5
Corporate Performance Measurement
Objectives
There are three objectives of the Corporate
Performance Measures Module:
• To define the most popular measures of corporate performance
• To explain the significance of these measures in the corporate
environment and potential applications in Bain’s strategy work
• To outline calculations of each performance measure
bc
LON CorporatePerformanceMeasurement 6
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 7
Corporate Performance Measurement Background
Corporate Performance Evaluation
Corporate performance evaluation has evolved from the
1960s focus on ROE to the current variations of economic
profit (EP) that measure impact on shareholder value
1960s/70s • With the rise of conglomerates, most companies focused on Return
on Equity, or ROE, as their primary measure of performance
–led most managers to undertake acquisitions solely to manipulate
accounting figures
1980s/90s • With the increased focus on delivering shareholder value, managers
have accepted systems that measure the change in value
–managers realised equity is not free
–economic profit (EP) meets these needs by telling managers
where value has been created and where it has been destroyed
• As aligning interests between owners and managers has become
more important, tying management compensation to EP provided a
popular solution
bc
LON CorporatePerformanceMeasurement 8
Corporate Performance Measurement Background
Relevance to Bain
• Bain was the first of major consulting firms to focus on creating
shareholder value
• To achieve this, Bain has used the output measure of Total
Shareholder Return and the accounting measures of ROE and ROI
• Modified accounting measures, such as EP, provide an alternative
means of measuring the creation of shareholder value
bc
LON CorporatePerformanceMeasurement 9
Corporate Performance Measurement Background
Link to Strategy
Marakon has made economic profit (EP) the central
focus of the ‘program’ they apply to every case
• To illustrate the role of corporate performance measures and resource
allocation to strategy work, an examination of Marakon’s “program” is useful
• Marakon applies the following program, which can take several years to
complete, to all of its clients:
–assess the economic profit of all customer segments and product lines
–compare company performance to industry performance
–investigate three or more strategies for each business every planning
cycle
–shift resource allocation from economically unprofitable
products/customers to economically profitable
–leads to yield loss for Marakon and clients since additional scenarios
frequently evaluated
bc
LON CorporatePerformanceMeasurement 10
Corporate Performance Measurement Background
Economic Value Added
EVATM is one variation of EP
How new is • A century ago, Alfred Marshall explained that for a company to have
Economic genuine profits, the profits must be sufficient to cover the cost of
Value Added capital as well as the firm’s operating costs
(EVA)?
• Stern Stewart has re-packaged the concept into EVA, which is
essentially a more palatable form of the same idea
• McKinsey has been using economic profit for many years
• BCG uses Cash Flow Return on Investment (CFROI) for a similar
analysis
• To avoid infringing upon Stern Stewart’s trademark, many consulting
firms have developed their own terms for the same concept
bc
EVA is a registered trademark of Stern Stewart LON CorporatePerformanceMeasurement 11
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 12
Corporate Performance Measurement Framework
Measures
EVA/MVA,EP,and CFROI are modified accounting
measures used to measure the performance of the
business
Fundamental
Business Business Metrics Output Measures
Drivers
Description: • Primary business- • Tools used to • Backward-looking
specific factors measure measures of overall
influencing performance of company
shareholder value business performance as
viewed by market
Inputs/ • Operating profits • Accounting • Total Shareholder
Measures: – volume – ROE Return (TSR)
– price – ROA • Total Business
– costs • Modified accounting Return (TBR)
• Financial Cost of – EVA/MVA
Capital Employed – EP
– fixed assets – CFROI
– working capital – CVA
– WACC*
bc
* For a discussion of WACC and discount rates, please see the Investment Appraisal Module in the BVU LON CorporatePerformanceMeasurement 13
Corporate Performance Measurement Framework
Fundamental Business Drivers
The fundamental business drivers provide a framework
for identifying the sources of shareholder value creation
or destruction
Shareholder Value
Creation/Destruction
Operating Cost of
Profit Capital
Volume Price Costs Fixed + Working WACC
X X
Assets Capital
Components: • # of • Average • Direct costs • Property, • Current • Weighted average
units selling – material plant & assets cost of capital
sold price – labour equipment less based on market
• Indirect costs • Intangibles current values of debt and
– SG & A liabilities equity
– Depreciation • Use after-tax cost
of debt
Issues: • LIFO vs FIFO • Intangible • Cost of equity
• Depreciation measurement for private firms
estimates bc
LON CorporatePerformanceMeasurement 14
Corporate Performance Measurement Framework
Accounting Business Metrics
ROE measures returns to shareholders, while ROA
measures returns to investors of all forms of capital
Return on Assets (ROA)* Return on Equity (ROE)
Formula:
Net Income Net Income
ROA = ROE =
Assets Equity
Measures: Profitability of all capital Profitability of equity
employed, including debt invested in business (net
equity issued plus retained
earnings)
Uses: Returns of enterprise as a Returns to shareholders
whole
bc
* Sometimes referred to as Return on Investment (ROI) LON CorporatePerformanceMeasurement 15
Corporate Performance Measurement Framework
Accounting Business Metrics - DuPont Formula
The DuPont formula is used to separate ROE into its
components in order to assess the performance of
the business
Net Income Net Income Sales Assets
ROE = = X X
Equity Sales Assets Equity
ROS Asset Leverage
Turnover
ROA
ROE = = Profitability X Asset Turnover X Leverage
bc
LON CorporatePerformanceMeasurement 16
Corporate Performance Measurement Framework
Modified Accounting Business Metrics
Many consulting companies attempt to brand the
modified accounting business metrics they use
Measure Consulting Companies
•Economic Profit •Bain
•McKinsey
•Marakon (through Value-Based
Management)
•LEK
•EVA / MVA •Stern Stewart
•AT Kearney
•Accounting firms
•Cash Value Added* (CVA) •BCG
•Cash Flow Return on •Holt
Investment (CFROI) •BCG
bc
* EVA=EVA with depreciation added back LON CorporatePerformanceMeasurement 17
Corporate Performance Measurement Framework
Role in Organisation
The modified accounting business metrics, which include EP, enable
relatively accurate levels of corporate performance measurement at
lower levels of decision making in the organisation
High TSR*
MVA
Modified
Accounting
Business
Accuracy as EP/EVA/CFROI Metrics
Measure of
Corporate
Performance
ROE/ROA
Fundamental Business
Drivers
Low
Low High
Level of Decision Making
bc
* only backward -looking LON CorporatePerformanceMeasurement 18
Corporate Performance Measurement Framework
Output Measures
While TSR calculates return to shareholders for
publicly-listed companies, BCG’s TBR calculation
estimates equivalent returns for privately-held firms
1
Market value of share number
Total at end of period *
= of years 1
Shareholder
Market value of share
Return (TSR)
at beginning of period
in CAGR
Format
1
Estimated market value of number
Total shares of privately-held of years 1
= company at end of period*
Business
Return (TBR) Estimated market value of shares
of privately-held company at
beginning of period*
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* Adjusted for all stock splits and assuming all dividends reinvested LON CorporatePerformanceMeasurement 19
Corporate Performance Measurement Framework
Bain’s client stock performance slide is
Output Measures
calculated using TSR, which is used to
measure the shareholder value created
3,500
3,000
2,500
Point Change in Indices (1980= 0)
2,000
1,500
1,000
Bain clients
500
S&P 500
0
‘80 ‘81 ‘82 ‘83 ‘84 ‘85 ‘86 ‘87 ‘88 ‘89 ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98
Note: Methodology and data attested to by Price Waterhouse LLP through December 1998
bc
LON CorporatePerformanceMeasurement 20
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 21
Corporate Performance Measurement Market Value Added
Definition (1 of 2)
Bain’s focus has always been to help the
management of the firm to maximise shareholder
value, which is equivalent to maximising MVA
100%
Market Goal of Managers
80 Value should always be to
Added create more
(MVA) shareholder value, or
60 maximise MVA
40
Invested
20 Capital
0
Total Market Value of Firm
(includes all debt and equity)
bc
LON CorporatePerformanceMeasurement 22
Corporate Performance Measurement Market Value Added
MVA equals the total market value of the company Definition (2 of 2)
less invested capital or net assets. Either the
Operating or Financing Approach can be used, but
Bain typically uses the Operating approach
100%
Excess Short-
ST NIBL* Cash Term
80 Working Debt
MVA Capital Long-
Requirements
60 Term
Net Fixed Debt
Assets (no
40 Net
distinction
Assets
Invested between Shareholders'
20 Capital tangibles Equity
and
intangibles)
0
Market Value Total Assets Net Assets Invested Capital
of Company or Capital
(Debt & Equity) Employed
Operating Approach (Typically used by Bain) FinancingbcApproach
Note: *Short-term non-interest bearing liabilities LON CorporatePerformanceMeasurement 23
Corporate Performance Measurement Market Value Added
Operating Approach - Excess Cash
The first step required to calculate Net Assets with the
Operating Approach is to identify excess cash, which is
total cash less cash required in the operating cycle
Amount ($)
Operating
Cash
Total Cash Cash Required in Excess Cash
Operating Cycle
bc
Note: *Short-term non-interest bearing liabilities LON CorporatePerformanceMeasurement 24
Corporate Performance Measurement Market Value Added
Operating Approach - Working Capital Requirements
Next, The working capital requirements are the firm’s net
investments in the operating cycle, or the net amount of
short-term investment required to fund operations
Operating Cash
Prepaid Expenses and Advance Payments
Other Current Assets
Amount ($)
Accounts
Payable
Inventories
Accrued
Expenses
and Other
Current
Liabilities
Receivables Working
Capital
Requirements
Total Investments Liabilities Implicit Net Investments
in Operating Cycle in Operating Cycle in Operating Cycle
bc
LON CorporatePerformanceMeasurement 25
Corporate Performance Measurement Market Value Added
Operating Approach - Net Fixed Assets
When calculating MVA, Net Fixed Assets is defined as Net PP&E
plus other Investment (tangible and intangible). The third and
final step to calculate Net Assets is Net PP&E, which is the
amount of long-term investment required to fund operations
Amount $
Net PP&E
Net Fixed Property, Accumulated Other
Assets Plant and Depreciation Investments
Equipment
bc
LON CorporatePerformanceMeasurement 26
Corporate Performance Measurement Market Value Added
Link to EP
Market value added (MVA) reflects the markets
expectations of the EP managers will add in the future
100%
PV of EPs
80 Beyond Year 5
Market Value
Percent of Total
Added (MVA)
60 PV of EP MVA is the
Year 5 market’s
PV of EP expectation
40 Year 4 of discounted
PV of EP future EPs
Year 3
Invested PV of EP
20
Capital Year 2
PV of EP
Year 1
0
Market Value of the Market Value Added
Company (Debt + Equity) (MVA)
bc
LON CorporatePerformanceMeasurement 27
Corporate Performance Measurement Market Value Added
Link to EP - Example
After extensive work by a diligent Bain team, Acme
Industries is expected to generate $25M in economic profits
next year, which is expected to grow at 3% forever. If the
cost of capital is 13% and the invested Capital is $100M,
what is the MVA and the market value of the company?
bc
LON CorporatePerformanceMeasurement 28
Corporate Performance Measurement Market Value Added
Link to EP - Solution
After extensive work by a diligent Bain team, Acme
Industries is expected to generate $25M in economic profits
next year, which is expected to grow at 3% forever. If the
cost of capital is 13% and the invested Capital is $100M,
what is the MVA and the market value of the company?
MVA = PV of EPs Market Value of = MVA + Invested Capital
the Company
= $ 25 M = $ 250 M + $100 M
13% - 3%
= $ 250 M = $350M
bc
LON CorporatePerformanceMeasurement 29
Corporate Performance Measurement Market Value Added
Link to EP (1 of 2)
EP measures managers’ performance in the past, since it
represents the market value added created over one year
Market Value Market Value Economic Profit
Added* Today Added* Last Year Over Last Year
bc
Note: *Assumes Invested Capital Constant
LON CorporatePerformanceMeasurement 30
Corporate Performance Measurement Market Value Added
Link to EP (2 of 2)
EP is used to evaluate manager
performance because the change in MVA
over a period of time is measured
• Goal of company’s managers should always be to
maximise MVA
• When managers make any investment decisions, if the
project is:
–value-creating NPV >0 MVA increases
–value-destroying NPV R0 but
ROE 0
bc
LON CorporatePerformanceMeasurement 50
Corporate Performance Measurement Economic Profit
Advantages (2 of 3)
A manager with low ROE will undertake any project that
increases ROE, even if it is below required level. If
project ROE is below required level, value is destroyed
NPV
• A manager with ROE
level of R2 will
0 undertake any project
that increases ROE
• If any projects with
ROE 0 bc
LON CorporatePerformanceMeasurement 51
Corporate Performance Measurement Economic Profit
Advantages (3 of 3)
By evaluating managers based on EP, their incentives
will be to focus on all projects that create value
EP 0 Under
undertake project* take project
NPV
• By evaluating
managers based
0 on EP, manager
behaviour can be
altered such that
only projects with
NPV > 0 are
undertaken
0 Ro
(After equity Charge)
ROE bc
PV
Note: * Some projects may have negative EP in early years but large positive EP in later years. To adjust for this, MVA, or LONand CorporatePerformanceMeasurement 52
EP can be used
Corporate Performance Measurement Economic Profit
Disadvantages
Critics of EP cite under-investment by managers
and size bias as reasons to use different
measures to evaluate managers
Under-investment by Managers • EP discourages new investments that do not
generate positive returns in initial phases because
manager will be charged for any capital used from
the start of project
– solution is to under-charge capital at start of
project
Size Bias • EP generally rewards larger divisions because
performance measured by $ generated, not %
• Divisional managers argue that % return is better
measure of their skills than $ return
–$ return is the important measure for shareholders
– Diageo looks at Operating Economic Profit per
case of spirits to normalise
ROCE basis
bc
LON CorporatePerformanceMeasurement 53
Corporate Performance Measurement Economic Profit
Beware: Capital is in the Ratio Formula
Even measures that tie in the asset side of a company's
financial performance need to be understood carefully...
• Asset revaluations (especially in Australia)
• In general accounting ratios will tend to bias performance
upwards in relation to true economic returns because they
ignore inflation, asset life and asset mix
• ROE tends to increase due to inflation, which may be
contrary to actual economic performance in real terms
• Furthermore, the other issue to be aware of is that older
PPE assets tend to generate higher returns (RONA, ROC,
even ROE) because they are more fully depreciated
• One consequence of this is that companies growing assets
quickly will appear to have a lower return than those with
slow growth
bc
LON CorporatePerformanceMeasurement 54
Corporate Performance Measurement Economic Profit
Common Pitfalls
By avoiding common pitfalls with EP, managers
can prevent significant over or under-investment
• Looking at absolute EP levels instead of changes in EP
–business with high EP may under invest and/or become
complacent
• Focusing on current EP levels in highly cyclical businesses
–may lead to significant over or under investment
• Ignoring natural trends in EP that occur in certain businesses
–e.g. high-tech startup would have low or negative initial EP
that increases over time
bc
LON CorporatePerformanceMeasurement 55
Corporate Performance Measurement Economic Profit
Agenda
• Definition
• Advantages/Disadvantages
• Framework
• Use in Strategy Work
bc
LON CorporatePerformanceMeasurement 56
Corporate Performance Measurement Economic Profit
Framework
Both the Operating and Financing Approaches can
be applied to the EP framework. These approaches
will give identical EP figures, but Bain typically uses
the Operating Approach
Calculate Adjust Balance Estimate Cost
Calculate EP
NOPAT Sheet of Capital
Operating • Adjust • Calculate Net • Estimate • EP = NOPAT -
Approach: Operating Assets Weighted (Net Assets &
Income (EBIT) Average Cost WACC*)
of Capital
(WACC)
Financing • Adjust Net • Calculate • Estimate • EP = NOPAT -
Approach: Income Capital Weighted (Invested
Employed or Average Cost Capital WACC*)
Invested of Capital
Capital
bc
Note: *Net Operating Profit After Tax
LON CorporatePerformanceMeasurement 57
Corporate Performance Measurement Economic Profit
NOPAT
The Operating and Financing Approaches adjust different
income figures to calculate the same level of NOPAT
NOPAT
Calculation
Operating Financing
Approach Approach
• NOPAT = Operating income (EBIT) • NOPAT = Net income
+ Non-operating income/(loss) + After-tax interest expense
+ Accounting adjustments* + Financing adjustments
- Cash operating taxes + Accounting adjustments
bc
Note: *Adjustment discussed in Accounting Adjustments section LON CorporatePerformanceMeasurement 58
Corporate Performance Measurement Economic Profit
Discount Rates - Framework
EP can be calculated beginning with either profits, NOPAT,
or returns, ROIC, depending on the availability of data.
The NOPAT method is more commonly used
EP Calculation
Using NOPAT Using ROIC
EP = NOPAT - Capital Charge EP = (ROIC - WACC) * Invested Capital
Invested Spread
Capital * between
WACC what is
achieved
and what is
required
bc
Note: NOPAT = Net operating profit after tax; Invested capital = All debt equity invested in format at book value; WACC = Weighted
average cost of capital ROIC = Return on invested capital = (NOPAT / invested capital) also known as: Return on Net Assets LON CorporatePerformanceMeasurement 59
(RONA) or Return on Capital employed (ROCE)
Corporate Performance Measurement Economic Profit
Discount Rates - Two Different Definitions of EP
There are two different frames of reference for calculating the
“economic value” of any business - analogous to the perspectives
used in ROI and ROE analysis
Total Capital Perspective Equity Capital Perspective
Stakeholder: Banks and Shareholders Shareholders
EP definition: EP = NOPAT - (Assets x WACC)
Key Ratio: Return on Assets (ROA)* Return on Equity (ROE)
Perspective: ... the "profitability" of the "... profitability" of the
business from the frame of business from the frame of
reference of the debt and reference of the equity
equity holders holders
. . . given that, Opportunity cost of the (blended) Opportunity cost of the
what is the frame debt and equity capital equity capital
of reference?
Accordingly: "Profitability" is measured "Profitability" is measured
as income earned less the as income earned less the
Performance opportunity cost of total opportunity cost of equity
Measurement capital invested capital invested
Linkages:
- Ratio: Total Capital Spread = ROA - WACC Equity Capital Spread = ROC - Ke
- EP: EP = Total Capital * (ROC-WACC) EP = Equity Capital * (ROC-Ke)
bc
* May be referred to as Return on Capital (ROC) or Return on Investment (ROI) LON CorporatePerformanceMeasurement 60
Corporate Performance Measurement Economic Profit
Discount Rates
Publicly traded:
Use
Published
Estimates of
b
Determine
Determine Determine Determine
Appropriate Calculate Firm Calculate
Appropriate Risk- Appropriate Market Value of
Market Risk Tax Rate WACC
Free Rate Cost of Debt, KD Debt and Equity
Premium • Take average of highest
quality sources
• For US firms BARRA
• Use WACC
publishes estimates of b
Non-publicly traded:
• Use long-term • KD is not necessarily • Book value of debt formula:
average of equal to coupon can generally be
difference rate of bond (e.g. used a proxy for
• Use 10 year T-Bond Re-Lever Target
between expected Calculate IBM 2005 7.5% market value of debt
or 30 Year T-Bond
less liquidity premium
market rate of Industry Average
Leverage for your
Firm to Calculate
does not necessarily • Market value of ( ) ( )
E
Ke +
D
KD (I-T)
(of 1.7% for US) for
return and risk- for Unlevered b have KD = 7.5% equity = current • Divide income tax Where :
D+E D+E
free rate E(Rm) - Ke • Must calculate or share price payable (not income E = market value of
appropriate country
Rf obtain yield on multiplied by # of tax expense) by net equity
• Only use government
• For US, Copeland, outstanding debt shares earnings D = market value of
bonds if little or no outstanding**
risk of default for
Koller and Murrin • If not available, use client
country in question
recommend 5% to KD of firms with • If firm not publicly KE = cost of equity
6% based on similar rating from traded use P/E
geometric average • Find comparable • Use target KD = cost of debt
agencies such as ratios of comparable
from 1926-1993 leverage in Moody’s or S&P firms T = corporate tax rate
firms for industry
formula* to
in question and
calculate b L
unlever b based
on formula* • Once b L
calculated, use
• Use average of bu
CAPM formula Ke
of comparable
= Rf + b L [E(Rm) -
firms
Rf] to calculate Ke
bc
*Bu = Unlevered Beta = BL
1 + (1 tax rate) (market value ÷ of debt market value of equity)
Note: ** Since invested capital is calculated based on book value of debt + equity, WACC LON CorporatePerformanceMeasurement 61
can be calculated for EVA purposes with book value weighting
Corporate Performance Measurement Economic Profit
Accounting Adjustments
EVA and MVA measures differ from other more
standard Economic Profit and Market/Book
measures primarily due to adjustments to book
capital and earnings advocated by Stern/Stewart ...
Stern Stewart’s Stated Objective Key Adjustments
• Make NOPAT a more realistic • Convert from accrual accounting to cash
measure of the actual cash accounting
yield from recurring business – Reserves, deferred taxes
activities
• Convert from successful efforts to full-cost
• Turn capital into a more accounting
accurate measure of the base – Cumulative unusual items
upon which investors expect • Do not discriminate between tangible and
returns intangible assets
– Capitalize R&D
– Value brand equity
• Capitalize goodwill (never write off)
• Convert off balance sheet financing to debt
bc
Source: The Quest for Value
LON CorporatePerformanceMeasurement 62
Corporate Performance Measurement Economic Profit
Accounting Adjustments - Stern Stewart
For instance, certain adjustments to capital and earnings may be
necessary to normalise industry-specific accounting treatments and
may make comparisons across industries more meaningful.
Key Adjustments Highest Impact Industries
Reserves • High inventory industries
• Consumer goods and services (bad debt)
• Industries with large deferred tax reserves
(eg. natural resources companies)
• Industries with short product life cycles
(inventory obsolescence)
Goodwill • Acquisitive industries
Capitalisation of Outlays • R&D intense industries
• Industries with large upfront marketing
investments (eg. development of
geographic markets)
Full-cost Accounting • Discovery industries (natural resources, research
- intense industries, entertainment, etc.)
Unusual Items • Restructuring industries
• Cyclical industries
Capitalisation of Leases • Capital intense industries
bc
LON CorporatePerformanceMeasurement 63
Corporate Performance Measurement Economic Profit
Accounting Adjustments - Stern Stewart’s Mechanics
Equity equivalent reserves gross up the standard
accounting book value for common equity; the period-
to-period change flows through the income statement
Additions to Book Capital: Additions to NOPAT:
Equity equivalents Change in Equity Equivalents
Deferred Tax Reserve
LIFO Reserve Increase (decrease) in Reserves
Other Reserves
Cumulative Goodwill Amortisation
Eliminate Goodwill Amortisation
Unrecorded Goodwill
(Net) Capitalised Intangibles Increase in (net) capitalised intangibles
Full-Cost Reserve Increase in full-cost reserve
Cumulative Unusual Loss (Gain) after Tax Unusual loss (gain) after tax
Non-capitalised leases are capitalised and form debt
equivalents; the interest expense is added back to NOPAT
bc
Note: NOPAT is net of depreciation; depreciation is considered a true conomic expense because assets need to be replenished
Source: ‘The Quest for Value’ LON CorporatePerformanceMeasurement 64
Corporate Performance Measurement Economic Profit
Accounting Adjustments - Selection Criteria
The following five criteria should be used to
determine whether an adjustment should be made
Basic Principle: Eliminate distortions to the extent that it is practical to do so
• Is it likely to have a material impact on EP?
• Can managers influence the outcome?
• Can operating managers understand it?
• Is the required information relatively easy to track or derive?
• If the adjustment is made, will manager behaviour improve ?
bc
Source: INSEAD
LON CorporatePerformanceMeasurement 65
Corporate Performance Measurement Economic Profit
Short-Cut Approach (Excludes Adjustments)
The following short-cut approach provides a quick
means of calculating EP, but does not include the
appropriate adjustments
Operating Income (EBIT)
+Interest Income
+Equity Income (or - equity loss)
+Other Investment Income
- Cash operating taxes
- Tax shield on interest*
=Net Operating Profit After Tax (NOPAT)
Total Assets
- Short-Term Non-Interest Bearing Liabilities (ST NIBL)**
=Invested Capital (IC)
Average IC = (IC Beginning + IC End) ÷ 2
Note: Sometimes IC Beginning, not IC Average used
NOPAT
- Capital Charges (Average IC * Cost of Capital)
=EP
bc
* Operating income x marginal statutory tax rate (gives no credit for tax shield on interest)
** STNIBL = Current liabilities less all interest bearing liabilities, such as short-term notes payable LON CorporatePerformanceMeasurement 66
Source: INSEAD
Corporate Performance Measurement Economic Profit
Agenda
• Definition
• Advantages/Disadvantages
• Framework
• Use in Strategy Work
bc
LON CorporatePerformanceMeasurement 67
Corporate Performance Measurement Economic Profit
Use in Strategy Work
EP works effectively for manufacturing companies,
but is generally not appropriate for service firms
Use of EP/MVA
Manufacturing Sector Service Sector
• Capital - intensive • EP generally not
industries benefit most appropriate due to
from EP difficulty in measuring
– forces managers to human capital
consider capital (typically most
invested in business valuable asset)
• e.g. Coca-Cola spinning • Structure of balance
off bottlers sheet precludes use
– UDV spinning off wine
of EP in Financial
production assets to Services sector
focus on blending bc
LON CorporatePerformanceMeasurement 68
Corporate Performance Measurement Economic Profit
Optimum Information Level
An organisation needs to establish the optimum level of
information complexity in order to create the most value
Value to the Maximum value to organisation
Organisation* from 'economic value-added'
Optimum level of
adjustment and analysis
will be determined by:
• Absolute sensitivity of value
Organisation measures to adjustments
Diminishing
below full value to • Level of the organisation
potential as a organisation as that is using the (economic
result of too cost of value added) information
simplistic a adjustment/analysis • Strategic use of information
measurement/ Outweighs
decision
• Ability of management to
incremental gain on
make decisions on the
making decisions made
information
process
Optimal Level of Complexity
Adjustments (Adjustment and
and Analysis Analysis) bc
Note: Value defined as incremental value created from management decision less cost of the information base/decion making process
LON CorporatePerformanceMeasurement 69
Corporate Performance Measurement Economic Profit
Use in Strategy Work
EP can be improved in a number of ways
Improving EP
Raising the Achieving
efficiency of current economically Exiting uneconomic
operations profitable growth activities
• Generating • Generating • Immediate exit from
incremental gains incremental activities generates
in EP from existing positive EPs from proceeds > subsequent
capital investments new capital cash flow foregone
investments
bc
LON CorporatePerformanceMeasurement 70
Corporate Performance Measurement Economic Profit
Guidelines
The following guidelines should be considered
when setting up EP
Link to Compensation • Senior Managers should be both evaluated and
compensated based on their EP results
• Aligns incentives of Shareholders and
Management
• Use change in EP as basis for evaluation to incent
managers to create additional value
• The more complex the EP system is, the less
likely it is to be used
Keep it Simple • Accounting adjustments must be sufficient to
eliminate major distortions from economic value,
but not too complicated for management to
understand or utilise on long-term basis
bc
LON CorporatePerformanceMeasurement 71
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 72
Corporate Performance Measurement CFROI
Definition
CFROI is an adjusted IRR that is compared to the
firm’s WACC
• Cash Flow Return on Investment (CFROI), also known as
the Holt method, is a return on investment measure that
adjusts for deficiency in typical IRR calculations
– CFROIuses cash flows and investments stated in constant
monetary units
• Once calculated, CFROI compared to benchmark, the firm’s
cost of capital to evaluate management performance
• Two firms use the Holt Method
– Holt Value Associates, LP for portfolio management
– BCG/Holt for Corporate Management
bc
LON CorporatePerformanceMeasurement 73
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (1 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Determine
average life
of firms
assets
• Approximate
by median of
Gross Plant
Depreciation
Expense
over last 3
years
bc
LON CorporatePerformanceMeasurement 74
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (2 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Start with Net
Income (after
taxes)
• Add back non
cash operating
expenses
• Add back
financing
expenses
• Use monetary
inflation
adjustment to
restate in
current dollars
bc
LON CorporatePerformanceMeasurement 75
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (3 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Gross up book
assets with
accumulated
depreciation of
value of
operating
bases
• Discount
operating
leases over life
of assets
period using
real rate of
interest of
firms’ debt
bc
LON CorporatePerformanceMeasurement 76
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (4 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Terminal value
consists of non
depreciating
assets,
including:
– land
– net working
capital
– investments
in marketable
securities
• Use inflation
adjustment to
restate in
current dollars
bc
LON CorporatePerformanceMeasurement 77
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (5 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Calculate CFROI
using IRR
methodology:
– Present Value =
Gross Cash
Investment
– Payments =
Gross Cash Flow
– Future Value =
Sum of
Nondepreciating
assets
– Number of
Periods = Life of
Assets
bc
LON CorporatePerformanceMeasurement 78
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - CFROI Framework (6 of 6)
Calculate
Calculate Calculate Calculate Compare
Sum of Non Calculate
Life of Gross Cash Gross Cash CFROI to
Depreciating CFROI
Assets Flow Investment Benchmark
Assets
• Use firms cost
of capital
(WACC) for
benchmark
• Must restate
WACC in real
terms to be able
to compare to
CFROI
bc
LON CorporatePerformanceMeasurement 79
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - EP/CFROI Differences (1 of 2)
Calculate Calculate Calculate
Calculate Compare
Target Methodology Life of
Gross Gross Sum of Non Calculate
CFROI to
Cash Cash Depreciating CFROI
Audience Assets
Flow Investment Assets
Benchmark
EP • Management • NPV • Add back • Add back • WACC in
• External goodwill accumulated nominal
Investors amortisation goodwill terms
• Adjust tax • Only use
expense to assets net of
actual cash depreciation
taxes
• Add back
interest portion
of operating
rental
expenses
bc
LON CorporatePerformanceMeasurement 80
Corporate Performance Measurement CFROI
Cash Flow Return on Investment - EP/CFROI Differences (2 of 2)
Calculate Calculate Calculate
Calculate Compare
Target Methodology Life of
Gross Gross Sum of Non Calculate
CFROI to
Cash Cash Depreciating CFROI
Audience Assets
Flow Investment Assets
Benchmark
CFROI • External • IRR • Add back • Accumulated • WACC
Investors goodwill goodwill is restated in
amortisation + normally not real terms
depreciation added back
• No tax • Assets
expense grossed up
adjustment for
• Add back accumulated
operating depreciation
rental
expenses
bc
LON CorporatePerformanceMeasurement 81
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 82
Corporate Performance Measurement MVA Exercise
Market Value Added Exercise (1 of 3)
Exercise: Calculate Harnischfeger’s MVA at October 31, 1996
Information • 47,598,340 common shares outstanding
Required:
• Market Value of common shares: $40
• Since Market Value of debt and minority interest not reported
assume market value = book value
• Assume operating cash equal to 1% of total sales
bc
Source: Harnischfeger’s 1996 Annual Report, INSEAD LON CorporatePerformanceMeasurement 83
Corporate Performance Measurement MVA Exercise
Market Value Added Exercise (2 of 3)
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Dollars amounts in thousands 1996 1995
Assets
Current Assets
Cash and cash equivalents 36,936 239,043
Accounts receivable – net 667,786 499,953
Inventories 547,115 416,395
Business held for sale 26,152 -
Other current assets 132,26 57,999
1,410,250 1,213,390
Property, plant and equipment
Land and improvements 48,371 31,571
Buildings 301,010 233,788
Machinery and equipment 776,332 676,546
1,125,713 941,905
Accumulated depreciation (491,668) (454,249)
634,045 487,656
Investments and other assets
Goodwill 512,693 147,943
Intangible assets 39,173 66,796
Other assets 93,868 124,982
645,734 339,721
$2,690,029 $2,040,767
bc
Source: Harnischfeger’s 1996 Annual Report, INSEAD LON CorporatePerformanceMeasurement 84
Corporate Performance Measurement MVA Exercise
Market Value Added Exercise (3 of 3)
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Liabilities and Shareholders’ Equity
Current Liabilities:
Short-term notes payable 49,633 22,802
Trade accounts payable 346,056 263,750
Employee compensation and benefits 160,488 100,041
Advance payments and progress billings 155,199 154,401
Accrued warranties 50,718 43,801
Other current liabilities 315,033 138,508
1,077,127 723,303
Long-term obligations 657,765 459,110
Other Liabilities:
Liability for post retirement benefits 78,814 101,605
Accrued pension and related costs 39,902 52,237
Other liabilities 14,364 20,820
Deferred income taxes 54,920 34,805
188,000 209,467
Minority Interest 93,652 89,611
Shareholders Equity:
Common stock 51,407 51,118
Capital in excess of par value 615,089 603,712
Retained earnings 148,175 53,560
Cumulative translation adjustments (37,584) (42,188)
Less: Stock Employee Compensation (61,350) (60,483)
Trust Treasury Stock (42,242) (46,513)
673,485 559,276
$ 2,690,029 2,040,767 bc
Source: Harnischfeger’s 1996 Annual Report, INSEAD LON CorporatePerformanceMeasurement 85
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Market Value)
Harmishfeger’s market value at 31 October, 1996 was $2,704.984 M
Short-Term Debt (49.633)
Minority Interest (93.652)
3,000
2,704.984
Market
Value 2,500
Long-Term Debt
($ M)
2,000 (657.765)
1,500
1,000 Common Shares
(1,903.934)
500
0
Market Value at 31 October 1996
bc
LON CorporatePerformanceMeasurement 86
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Excess Cash)
Harnishfeger’s excess cash at October 31, 1996 was $8,296 M
40,000 36,936 (28,640)
Amount
($ K)
30,000
Operating
20,000 Cash
10,000 8,296
0
Total Cash Cash Required in Excess Cash
Operating Cycle
bc
LON CorporatePerformanceMeasurement 87
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Working Capital Requirements)
Harnischfeger’s working capital requirements at October 31, 1996 were
$374.46 M Operating Cash
(28,640) Advance Payments
Prepaid Expenses & Other (155,199)
Current Assets (158,413)
1,500,000 1,401,954 1,027,494
Accounts
Payable
Amount ($ K)
1,000,000 Inventories (346,056)
(547,115) Accrued
Expenses and
Other Current
500,000 Liabilities
(526,239) 374,460
Receivables Working
(667,786)
Capital
Requirements
0
Total Investments Liabilities Net Investments
in Operating Implicit in in Operating
Cycle Operating Cycle Cycle
bc
LON CorporatePerformanceMeasurement 88
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Net Fixed Assets)
Harnischfeger’s net fixed assets at October 31, 1996 were $1.28 B
1,500,000
1,279,779 1,125,713
Amount ($ Thousands)
1,000,000 Net PP&E
491,668 645,734
500,000
0
Net Fixed Property, Accumulated Other
Assets Plant & Depreciation Investments
Equipment
bc
LON CorporatePerformanceMeasurement 89
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Invested Capital)
Harmishfeger’s invested capital at 31 October, 1996 was $1,662.535 M
Excess Cash
(8.296)
Working Capital
2,000 Requirements (374.460)
1,662.535
Invested Capital ($ M)
1,500
1,000
Fixed Assets
500 (1,279.779)
0
Invested Capital at 31 October 1996
bc
LON CorporatePerformanceMeasurement 90
Corporate Performance Measurement MVA Exercise
Market Value Added - Solution (Market Value Added)
Harnischfeger’s market value added at October 31, 1996 was $1042.44 M
$ Million at October 31,1996
2,704.98
1,042.44
(1,662.54)
Market Value Invested Capital Market Value
Added
bc
LON CorporatePerformanceMeasurement 91
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 92
Corporate Performance Measurement EP Exercise
Economic Profit Exercise
Exercise: Calculate Harnischfeger’s EP for the year ended October 31, 1996
Information Interest income $6.505 million
Required: WACC equals 12%
bc
LON CorporatePerformanceMeasurement 93
Corporate Performance Measurement EP Exercise
Economic Profit Exercise
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Assets 1996 1995
Current Assets:
Cash and cash equivalents $36,936 $239,043
Accounts receivable - net 667,786 499,953
Inventories 547,115 416,395
Business held for sale 26,152 -
Other current assets 132,261 57,999
1,410,250 1,213,390
Property, Plant and Equipment:
Land and improvements 48,371 31,571
Buildings 301,010 233,788
Machinery and equipment 776,332 676,546
1,125,713 941,905
Accumulated depreciation (491,668) (454,249)
634,045 487,656
Investment and Other Assets:
Goodwill 512,693 147,943
Intangible assets 39,173 66,796
Other assets 93,868 124,982
645,734 339,721
$2,690,029 $2,040,767 bc
Source: Harnischfeger’s 1996 Annual Report; INSEAD
LON CorporatePerformanceMeasurement 94
Corporate Performance Measurement EP Exercise
Harnischfeger Industries Inc. Economic Profit Exercise
Consolidated Balance Sheet - Year Ended 31 October 1996
Liabilities and Shareholders’ Equity 1996 1995
Current Liabilities: $22,802
Short-term notes payable $49,633
263,750
Trade accounts payable 346,056
Employee compensation and benefits 160,488 100,041
Advance payments and progress billings 155,199 154,401
Accrued warranties 50,718 43,801
Other current liabilities 315,033 138,508
1,077,127 723,303
Long-term Obligations 657,765
101,605
459,110
Other Liabilities:
Liability for post-retirement benefits 78,814 52,237
Accrued pension and related costs 39,902 20,820
Other liabilities 14,364 34,805
Deferred income taxes 54,920
209,467
188,000
Minority Interest 93,652 89,611
Shareholders’ Equity: 51,118
Common stock 51,407 603,712
Capital in excess of par value 615,089 53,560
Retained earnings 148,175
Cumulative translation adjustments (42,118)
(37,584)
Less: Stock Employee Compensation Trust (61,360) (60,483)
Treasury Stock (42,242) (46,513) bc
673,485
Source: Harnischfeger’s 1996 Annual Report; INSEAD 559,276
$ 2,690,029 LON CorporatePerformanceMeasurement 95
$ 2,040,767
Corporate Performance Measurement EP Exercise
Economic Profit Exercise
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Dollar amounts in thousands
Sales $2,887,570
Cost of Sales 2,166,775
Product Development, Selling and Administration Expenses 433,776
Restructuring Charge 43,000
Operating Income 244,019
Interest Expense - Net (62,258)
Income before Taxes and Minority Interest 181,761
Provision for Income Taxes (63,600)
Minority Interest (3,944)
Net Income $114,217
bc
Source: Harnischfeger’s 1996 Annual Report; INSEAD
LON CorporatePerformanceMeasurement 96
Corporate Performance Measurement EP Exercise
Economic Profit - Exercise Solution
Harnischfeger’s 1996 NOPAT was $162.857 M
$M
Operating Income $244.019
+ Interest Income 6.505
+Equity Income 0
+ Other Investment Income 0
- Income Taxes (63.600)
- Tax shield on interest* (24.067)
= Net Operating Profit After Tax (NOPAT) $162.857
bc
*Tax shield on interest = Provision for income taxes Net Interest Expense + 63.600 62.258
Income before taxes and x Interest Income = x = LON
24.067 CorporatePerformanceMeasurement 97
181.761 +6.505
minority interest
Corporate Performance Measurement EP Exercise
Economic Profit - Exercise Solution
Harnischfeger’s 1996 average Invested Capital was $1,501.40 M
$M
1996 1995
Total Assets 2,690.029 2,040.767
- ST NIBL* (1,027.494) (700.501)
= Invested Capital 1,662.535 1,340.266
Average Invested Capital 1,501.401
1996 1995
* ST NIBL = Current Liabilities - Short-Term Notes Payable = 1,077.127 723.303
(49.633) (22.802)
1,027.494 700.501
bc
LON CorporatePerformanceMeasurement 98
Corporate Performance Measurement EP Exercise
Economic Profit Exercise Solution
Harnischfeger’s 1996 EP was ($17.311 M)
$M
NOPAT 162.857
- Capital Charges* (180.168)
EP (17.311)
Harnischfeger was approximately value-neutral in 1996,
which contrasts sharply with the $1 billion MVA (see MVA
section). The discrepancy indicates that despite adding no
value in 1996, the market expects management to deliver
value in the future. The large MVA implies that future EPs
will be much higher than 1996.
bc
Note: * Capital Charges = Average IC * WACC = 1,501.401 x 12% = 180.168
LON CorporatePerformanceMeasurement 99
Corporate Performance Measurement
Agenda
• Executive Summary
• Objectives
• Background
• Performance Measurement Framework
• Market Value Added (MVA)
• Economic Profit (EP)
• Cash Flow Return on Investment (CFROI)
• Exercises
–MVA
–Economic Profit
• Case Study - Diageo
bc
LON CorporatePerformanceMeasurement 100
Corporate Performance Measurement Case Study - Diageo
The success of New World wine producers can be Drivers of Value
attributed to three initiatives, of which the reduction in
capital intensity was most closely linked to the EP analysis
New World Wine
Economics
Premium Positioning
Decreased Importance Reduction in
and
of Appellation Capital Intensity
Varietal Dominance
• Lower grape costs • Wider range of outsourcing • More premium the wine,
–purchasing on spot opportunities higher the returns
market –third-party grape sourcing
and production reduces • Scale achieved through
–long-term contractual varietal dominance leads
supply contracts need to own and operate
vineyards and production to higher returns
• Blending techniques facilities
used to ensure
consistent quality • New technology enabling
reduction in stock holding time
Link to EP
• High • Low
Analysis • Low bc
LON CorporatePerformanceMeasurement 101
Corporate Performance Measurement Case Study - Diageo
Brand Performance
By focusing solely on bottling, only Glen Ellen
generated positive economic profits for the wine
produced
As a
Cost per 100 $96.78 vertically
Capital
Case ($) integrated
Vintner with
As a non- 80 $74.42 vineyard and
vertically
crushing
integrated $60.98 SG&A facilities, BV
Vintner with 60 has a large
bottling AMP asset base
facility only,
40 and capital
Glen Ellen $33.43
charge
maintains a
COGS
$24.50 $25.33
low asset
base and 20
capital
charge
0
Glen Blossom M.G. BV BV BV
Ellen Hill Vallejo Beatour Estates Reserves
$ EP/Case: $1.00 ($1.80) ($0.80) ($6.60) ($2.38) ($16.28)
bc
Source: HWG Strategic Position Assessment
LON CorporatePerformanceMeasurement 102
Corporate Performance Measurement Case Study - Diageo
Asset Utilisation
The Glen Ellen system is more efficient than the BV system
1.5
0
8
% 5
.
1
Maturing 73% Total
Stock as Inventory
% of NSV Turns
0
%
6
1.0
51% 1
0
%
4
Maturing Total Maturing Total
Stock as Inventory Stock as Inventory 5
.
0
% of Turns % of Turns
0
%
2
NSV NSV
%
0 0
Glen Ellen System Beaulieu Vineyard
bc
Source: HWG Strategic Position Assessment
LON CorporatePerformanceMeasurement 103
Corporate Performance Measurement Case Study - Diageo
Components of ROCE
Analysis of the components of ROCE highlights
the different economics of the two systems
ROCE
NOPAT Capital Employed
Cash Other Net Other Net
Operating - Operating +/- Other
Adjustments Fixed + Inventory + Working +/- Adjustments
Profit Taxes Capital
Assets
Drivers: • Margins • Tax rate • Accounting • Degree of • Wine mix • Trade • Accounting
– price policies vertical – colour relation- policies
– mix integration – quality ships
– grape costs – dry vs.
– production costs sweet
– selling/ • Ageing
distribution costs technology
• Volume
bc
LON CorporatePerformanceMeasurement 104
Corporate Performance Measurement Case Study - Diageo
Breakthrough Strategies: Change the Rules
The traditional wine making process is very capital intensive.
Through selective outsourcing, New World wine producers
have been able to significantly reduce their asset base
Vineyard Vinification Ageing Process
Grapes Alcoholic Malolactic Bottle
Grapes Matur- Distri-
Culture & Harvest Fermen- Fermen- Ageing¹ Blending Bottling Stock
Crushing ation bution
Production tation tation Keeping
Traditional old world
wine producer activities
Vertically integrated New
World wine producer
activities (Robert Mondavi)
(Outsourced
Non vertically integrated
activities)
wine producer activities
(Glen Ellen) Activities systematically performed
Activities performed only for super/ultra premium wines
bc
Notes: ¹ Ageing can be done in oak barrels or in stainless steel vats
Source: Literature search, Expert interviews LON CorporatePerformanceMeasurement 105
Corporate Performance Measurement Case Study - Diageo
Lessons Learned
• Ignoring the capital requirements necessary under different
business models can mask the true profitability of each
product
–the only wine that was economically profitable was the
Glen Ellen product that Diageo bottled but did not grow
from the vineyard
• A fresh approach to the business may be necessary in order
to devise more economically profitable business models
–less prestige in only performing bottling, but many
vineyards driven by non-economic factors
bc
LON CorporatePerformanceMeasurement 106