Overcoming value barriers. (Value Creation).

Too often, companies have long-standing practices or metrics that don't add value -- and sometimes, they help destroy it. A look at several key barriers and how they can be sidestepped.

Every company has its sacred cows, those revered management practices that seem to hang around even as the company itself changes. These long-standing practices might be the way a product is marketed, the way an internal process is run or the habits of one or more influential managers. They might be a strategy that has served the company for years or a core competence that has been a source of enduring competitive advantage. What makes them endure is that they are usually based on accepted management practices that have been handed down from previous management generations. Unfortunately, these practices are not always aligned with the best interests of shareholders.

Maximizing shareholder value requires a reexamination of the company's most cherished business principles. Often, these most cherished ways of doing things are most likely to be at the root of a company's inability to generate higher returns. When companies fail to unburden themselves of pre-existing value-destroying habits -- be they processes, one or more influential managers, "commonly held beliefs" or unproductive customer or supplier relationships -- profitability improvements are unlikely. Without eliminating antiquated ways of doing business, a company can start to look like an archaeological site of management ideas, one generation laid on top of another.

There are five hard-to-identify barriers to value creation that, time and again, prevent companies from growing -- financially, strategically and organizationally -- in ways that maximize shareholder value. Experiences of some clients who have struggled with these barriers will shed light on how organizations have reacted to -- and sometimes overcome -- them.

The Hallowed Metric

Perhaps the most common sacred cow in a large company is the set of financial metrics that management uses to set goals and measure performance. Metrics often take on a life of their own and become set in stone -- be they earnings per share, return on investment or return on assets. When financial metrics become more important than the underlying economics of the business, the company needs to reassess how it measures success.

There are two ways in which these metrics can lead a company astray. First, the metric can exclude important economic facts about the business model. In the case of a telecommunications client, the sales force was compensated based on the size of the revenue stream from the customer contract, and salespeople freely extended credit and payment terms to facilitate and book sales. In many instances, the operating profit margin on these financed deals appeared higher than on those that weren't financed -- leading management to believe that it was pursuing highly profitable growth. However, when the capital costs for these deals were also included in profitability measures (including the risk of customer default), most of these "financed" deals were actually value-destroying. With the right metric, management would have seen the value destruction before the contract was signed and would have avoided the deal (or at least restructured the terms).

The second way that metrics can lead management astray comes when a financial ratio becomes more important than the old "king cash." One current consumer product client has focused on operating profit margin. This company has a strong competitive advantage and enjoys a margin twice that of competitors. Over the past few years, one of its business units had successfully introduced new differentiated products that had lower margins but much higher prices. Therefore, the total profits (revenue times margin) for the new products were much higher than the pre-existing products on an absolute dollar basis. But because of the focus on margin (percentage) rather than profit (dollars), senior management was pushing the business unit to change its successful marketing strategy in order to raise margins -- a strategic change that would have destroyed shareholder value.

In choosing metrics to plan strategies, assess performance or make investment decisions, companies should use a metric that includes all costs -- especially capital costs -- and doesn't put ratios ahead of profits. One of the best solutions is a simple value-based metric, such as "economic profit" (EP), or net operating profit after taxes, minus a charge for capital costs. More than any other measure, EP provides a realistic picture of whether a company is destroying or creating shareholder value.

"Sacrce but Free: Capital Planing

A second Barrier to value creation in most companies, ironically, is the capital budgeting process, whose main purpose is to create, not destroy, value. Because of its importance, tendency towards complexity and the seniority of managers involved, making the wholesale changes necessary to maximize value is even more difficult.

The basic problem underlying most budgeting systems is a "scarce but free" mindset. Companies create an atmosphere in which capital is considered scarce, and then, ironically, do not charge the operating units for its use on an ongoing basis. In such a system, a divisional manager interested in securing capital has an incentive to "low-ball" capital estimates at the outset of a project to create the impression of high profit potential. Then, once the project is underway, the manager secures additional infusions of capital as needed to keep the project alive, knowing there will be few penalties. Large U.S. parent corporations may be the only source of free capital for business units in the world today.

This is exactly what happened at a client in the forest and paper products industry, which was considering upgrading a paper machine to increase its speed. When planning the investment, a set amount of capital was requested for the initial upgrade. Management concluded that the improvement represented a positive net present value (NPV) project, and approved the capital.

In the first year after the upgrade, the mill requested additional capital because the sped-up machine had experienced greater wear-and-tear than expected. In the second year, the mill needed to expand its warehouse because the added capacity was overloading the current facility. Mill management did not include these additional investments in the initial capital request because they weren't needed at the time the improvements themselves were made, and they would have made the capital request look "too high." Furthermore, management did not have information on the economic profitability of the entire mill.

The solution: companies should take a "zero-based" approach to capital budgeting. In this approach, senior management annually reviews the future profitability of each profit center (divisions, product groups, plants, etc.), based on the amount of capital already invested, as well as that being requested.

In essence, management conducts an NPV analysis on the entire business, based on its strategy over the next five years. If the business is projected to be profitable, capital investments are made as necessary. If not, capital is no longer supplied unless the business can demonstrate that, overall, it can create value.

How Right Is the Customer?

Just as management has a hard time changing capital budgeting systems, it adheres to another golden rule of management: the customer is always right. While that may be true from a customer service standpoint, it is also quite likely that the customer is unprofitable -- and hurting company earnings. On average, for every value-creating customer that a company clings to, there are up to four other customers that are value-neutral or value-destroying. The logic behind the urge to acquire and retain customers is understandable: sales are vital, lost customers end up with competitors and long-standing personal relationships are hard to break. But in their drive to acquire and retain customers, many companies hold onto customers that do them little good.

For example, the forest and paper products client had a large number of unprofitable customers and had a poor understanding of which ones were adding value. As a result, the company did not prioritize customers and served them all in a similar way: every customer received gold-plated treatment, no matter how profitable or unprofitable. There were no penalties for customers who ordered multiple times in a month, even though this created havoc within the company's manufacturing planning and supply chain logistics -- and greatly increased costs.

Similarly, the company granted all customers similar shipping options, even though differences in order size and mode of transportation had major implications for freight costs. The end result: the company was under-performing its peers in almost every product-market situation and also under-performing them in the capital markets.

One of the main reasons for this poor reading of customer profitability is that in designing their marketing, sales and service campaigns, companies lack good information on the value-creating potential of targeted customer segments. The first step in overcoming this barrier is to be able to tell the difference between profitable and unprofitable customers. Some companies might have a rudimentary understanding of customer profitability, but rarely do their reports incorporate all the overhead and capital costs that provide a more complete view of customer economics over time.

Before ending unprofitable customer relationships, however, companies need to first be sure that the relationship can't be made profitable. This requires running different scenarios to see if lowering production and delivery costs or improving pricing would move the relationship into the black. Simply shifting a group of customers from one distribution channel to another may improve the profitability picture. But, in the end, if customer profitability cannot be salvaged, management needs to end the relationship.

Organizational Subgroups

Another sacred cow that is rarely challenged in large companies is the authority of powerful managers to use their influence (knowingly or unknowingly) to subvert value-creating capabilities. This can be seen, for example, at the actuarial function in an insurance firm; risk management in a bank; and corporate marketing at consumer goods companies. While such groups may have the company's best interests in mind, because of their status and prestige, they are often beyond reproach and remediation. When this happens, senior management must step in and take action.

At a former aerospace client, the senior management team had long been dominated by salesmen -- executives who had worked their way up from the field to the boardroom. Many of these managers did not appreciate the complexities of manufacturing or the important drivers of economic costs. As the industry became more competitive (prices fell) and costs grew in importance, senior management realized that these former sales-oriented managers were resisting the new strategies the company needed to compete. Here, senior management re-organized top management to signal the rest of the organization about the increased importance of manufacturing and costs in decision-making.

A similar story comes from a large telecommunications company that had been organized around product technologies for more than 20 years. Managers in the product units were compensated based on the performance of their individual unit. When it became increasingly important to offer integrated (i.e., multi-product and service) solutions to remain competitive, the company was slow to change its product units-based compensation plan. As a result, each product unit tried to sell its own product to the company's customers, making the sum of the individual product unit sales less than the company could have made by selling an integrated solution (and providing additional value by bringing together the disparate products).

How Economies of Scale Can Fail

One of the longest-standing beliefs of American capitalism is that higher market shares lead to large-scale production, which leads to lower costs and higher profits. While this is true in most cases, it is dangerous to assume it is always true -- and vitally important to know when it is not. The culprit, of course, is poor product-costing information, which can wreak havoc on a product or division's profit-and-loss statement -- and ultimately on value creation.

For years, most paper companies operated under the belief that running paper machines at full capacity was always a good thing from a cost perspective, and that every incremental ton was produced at an ever-lower cost. However, what the industry in general failed to understand was the true incremental costs for that "last ton." Incremental fiber costs, for example, are generally very high because the trees have to come from much further away from the paper mill. Often, the last ton is above "planned" production, so incremental chemicals and additives are often purchased on the spot market at much higher than planned costs.

In addition, when the machines are run at higher production levels, invariably there are incremental capital investment requirements and operating expenses associated with maintenance and wear-and-tear on the equipment. When these fiber and other costs are "averaged" into the cost of production, the true marginal cost for that "last ton" is above marginal revenue, a fact that gets "lost in the system" (see Product F in the chart on this page). Only when this economies of scale myth is debunked do mill managers seriously question the benefit of producing the last ton versus accepting a lower mill output.

Summary

What these five management issues have in common is that they can easily become conventional and unchallenged wisdom, leading to long-term under-performance -- barriers to value. The thread that ties them together is the need for clear linkage between all management behaviors, decisions and actions, and their impact on shareholder value.

Top management must demand and obtain nothing less than 20/20 vision to the shareholder, with the resolve to root out and break down these barriers. Only by undertaking this value-based house-cleaning can senior management ensure it will deliver the greatest returns over time on the capital that shareholders have entrusted to them.

[GRAPH OMITTED]

"EPS Game" Behavior     vs             "Value Game" Behavior

focusing on short-term                 focusing on the long-term
earnings per share                     economic profit growth

Improving operating     [right arrow]  Improving operating
margins through                        margins through elimination
corporate-wide cost                    of "bad costs" and pricing
reduction initiatives                  to get the return/market
and premium pricing                    share trade-off right

Investing to grow       [right arrow]  Improving asset efficiency
earnings ("capital                     to grow economic profits
is free" mindset)                      and generate cash
                                       ("capital is available,
                                       but expensive" mindset)

Driving short-term      [right arrow]  Maximizing the value of brand
volume gains through                   equities through the
promotion                              optimal mix of advertising,
                                       promotion and pricing

Using cash flow to      [right arrow]  Using cash flow to invest in
repurchase shares                      profitable growth (buy back
                                       shares as last resort)

RELATED ARTICLE: Are Your Meetings A Value Barrier?

Something as simple as meeting management style can also limit performance. Consider the two cases of a banking and a technology client. At a very large global commercial bank, top management had an insatiable desire and penchant for debate. Often, they used "stakeholder management" as an art form, and managed the minutes as a way of changing the meeting's outcome. If senior executives wanted to kill something, they would hide behind the process -- e.g., "Well, this seems OK, but make sure you clear it with A,B,C,D..." -- which, in effect, killed it because the needed round of edits and consensus-building would take forever, or was enough to scare off any attempt.

A large technology client, on the other hand, had a culture of inviting everybody and their maiden aunt to key meetings, which prevented focused, decisive discussions. The same client also suffered from cultural acceptance of "revisiting decisions" -- no one in management really believed that a decision had been taken, even when the most important decision-makers were in the room, because there was such a long track record of reversal.

Lee Mergy is a partner in the New York office of Marakon Associates (www.marakon.com), an international management consulting firm that advises CEOs and their executive teams on how to maximize the long-term value of their companies. He can be reached at [e-mail].