Means of Company's Driving Superior Shareholder Value - Coursework Example

Critical Examination of The Present Business Environment In The Context Of The Investor And The Drive For Shareholder Value Executive Summary The aim of this paper was to study how the current business environment has become characterised by the importance of the investor and the drive for shareholder value. I began by briefly discussing what shareholder value is and how it is calculated. I also discussed a bit on how executives today have lost trust in financial measures of performance due to the inability of these measures to provide the true economic value of the firm. The managers feel that only operational measures should be used in measuring performance since these measures focus on the activities that create value in the organisation such as focusing on customers, employees, and quality control. However, I found that both operational and financial performance measures were necessary if a company wants to create sustainable value for its shareholders. I therefore introduced the balanced scorecard which is a performance report based on a broad set of both financial and non-financial performance measures as the best strategic management accounting tool to be employed in the current business environment today. I also focused a bit on how shareholders could align their interests with those of shareholders since present compensation plans such as the granting of stock options to CEOs have been unable to motivate managers to create value for shareholders. I therefore recommended that managers should be compensated based on the amount of shareholder value that they generate and that it is also necessary for managers to be evaluated based on the amount of long-term economic value that they generate since evaluating them based on short-term performance measures can make them to be myopic and as a result engage in short-term activities to generate higher short-term results for the short-term financial performance measures. INTRODUCTION Today, the current business environment has become characterised by the importance of the investor and the drive for shareholder value. Shareholder value is the value of a firm minus future claims (debt). Shareholder value is given by taking the net present value (NPV) of all future free cash flows to the firm plus value of non-operating assets minus future claims (debt).1 Non-operating assets include marketable securities, excess real estate and over-funded pension plans, whereas future claims include interest bearing long-term and short-term debt, capital lease obligations, under-funded pension plans and contingent liabilities. Only when a firm earns a return on invested capital (ROIC) above the cost of capital can that firm be said to be creating economic shareholder value.2 However the concept of shareholder value is somehow controversial. For example, according to Best of Harvard Business Review3, many executives wanted to replace financial performance measures with operational measures on the grounds that traditional financial performance measures did not allow them to manage properly and it has long been argued that current measures of financial performance do not reflect the importance of current resource decisions for future financial decisions4. Other studies have blamed accounting education for focusing so much on shareholder wealth creation. Ferguson et al5 blames accounting education for generally assuming that the only participants in the wealth creating process that should have their interests maximised are shareholders. They emphasise that the value of the society as a whole should be maximised. The fact that ownership is also separated from control creates some degree of information asymmetry between the manager and the shareholder. That is the managers because they control the business have more information than the shareholders and as a result shareholders have always searched for the best method of compensating managers so as to bring the interests of both parties into alignment. Despite the criticisms for financial performance measures and attempts to replace them with operational measures, it turns out that both measures of performance are necessary if superior shareholder value is to be created. The focus should be on maximising shareholder since it is the shareholders who risk their money by contributing capital for the conduction of business. The particular motive of project fundraisers especially in commercial ventures is to create value greater than their initial investment. This is the central objective of any shareholder irrespective of the type of investment6 Operational measures alone cannot measure performance; as well as financial measures alone cannot provide enough information about the success of the organisation in the future. Strategic management accounting recommends a combination of both sets of measures if the organisation is to succeed in the long run. The aim of this study is therefore to analyse a broad set of both financial and non-financial performance measures so as to understand how business managers and other executives can better put them into practice. The main focus of the study will be on the balanced scorecard. The study will also make use of previous literature on financial performance measures and how managers’ interests can be aligned with those of shareholders so that managers can focus on generating superior shareholder value rather than focus on satisfying their selfish interests. THE BALANCE SCORECARD The balance scorecard is a performance report based on a broad set of both financial and non-financial measures7. It tracks all the important elements of a company’s strategy from continuous improvement and partnerships to teamwork and global scale. It also allows companies to excel. According to Malina and Selto8, the balance scorecard (BSC) as specifically designed and implemented, is an effective device for controlling corporate strategy. Malin and Selto regard the BSC as one of the most significant developments in Management Accounting and estimate that 60% of the US FORTUNE 500 companies have implemented or are experimenting with a BSC. The balanced scorecard is a report that includes the firm’s critical success factors in four areas including financial performance, customer satisfaction, internal business processes and innovation and learning9. Table 110 below presents the layout of a typical balance scorecard as implemented by WorkWear. It can be observed that the four measures of performance outlined in Blocher et al have been used in the scorecard. For example under the financial perspectives the company considers return on sales, revenues per sales visit, sales growth and catalogue sales as measures of performance. Under customer relations it takes into consideration the number of customers retained, the number of repeated sales referrals and customer satisfaction rating as critical success factors. Orders filed within one week, average markdowns and catalogue orders filed are critical success factors for the internal business perspectives, whereas the learning and Growth perspective considers MBA degrees, hours of employee, training per employee and employee suggestions and metrics for measuring performance. According to Best of HBR, time, quality, performance and cost are the primary concerns of customers. Lead time measures the time required for the company to meet its customers’ demands. Lead time can be measured from the time the firm receives an order to the time it actually delivers it in the case of existing products, whereas in the case of new products lead time measures the time to market or the length of time it takes from product definition stage to start of shipment. Quality refers to the defect level of incoming products as perceived and measured by customers. On time delivery and accuracy of an organisation’s forecasts can be considered as measures of quality. How the firm’s products contribute to customer value is a measure of both performance and service. While considering the importance of customer-based measures, the company must focus its lens on what it must do internally to meet its customers’ needs. This is where the internal business perspectives come into play. The manager’s lens should be focused on those critical internal operations such as quality, productivity, flexibility, equipment readiness and safety. Quality is measured by the number of defects, number of returns, customer survey, amount of scrap, amount of rework, field service reports, warranty claims and vendor quality defects11. Productivity is measured by cycle time (from raw materials to finished products), labour efficiency, machine efficiency, amount of waste, rework and scrap12. Flexibility is measured by set-up time and cycle time. Equipment readiness is measured by downtime, operator experience, machine capacity, and maintenance activities whereas measures of safety include number of accidents and effects of accidents. Under learning and innovation we have product innovation, timeliness of new products, skill development, employee moral and competence. See Blocher et al. (2005: Pp38). As earlier mentioned, the operational measures identified above must be blended together with the financial performance measures so as to drive superior shareholder value. This is in contrast to the school of thought that feels that given today’s business environment, senior managers should not even look at the business from the financial perspective13. However, an organisation’s total quality management program (TQM) can actually be improved by using a well-designed financial control system. For example if a company’s outgoing defect rate drops from 300parts per million to say 30 per million, on time delivery improves from 80% to 98%, and yield rises from 20% to 50%, and the company suffers poor financial performance which results in a drop in the share price from say £25 to £20 over a three year period, then the improvements in operational measures has not provided the company with any substantial benefits. Therefore both operational and financial performance measures must be integrated together to achieve superior shareholder value, which is measured by a rise in share price. Using the balance scorecard requires some basic understanding of how the various financial measures can be interpreted so as to avoid trade offs between the different measures. Application of the balance scorecard depends on the size of the organisation, industry, and nature of products. For example a retailer does not set up machines and therefore will not have number of set-up times in his/her balance scorecard. HOW TO ALIGN MANAGER’S INTEREST WITH THOSE OF SHAREHOLDERS. Another important way of driving superior shareholder value is by aligning the interests of managers with those of shareholders by providing them with incentive schemes that motivate them to work in the best interest of the managers. The question that arises here is that what is the best compensation plan that can be given to managers to enable them work in the interest of the shareholder? To answer this question we take a closer look at previous literature on this topic. Murphy and Kevin14 identify the granting of stock options, which are either linked, to the stock price or to a stock index as incentive schemes but they conclude that the incentives from stock options do not, however reconcile the incentives from the stock options for several reasons. They further explain that since options reward only stock price appreciation and not shareholder returns (which include dividends), executives holding stock options have incentives to avoid dividends and favour only share repurchase. This gradually shifts the ownership of the company away from original shareholders to the current management. Also, executives with options have incentives to engage in riskier adventures because the option value depends on the volatility of the stock price. Also, a survey “Executives Excess” conducted by the institute of policy research during the 1990s, C.E.O pay rose by 570% whereas profits rose only by 114% and in 1999, while median shareholder returns fell by 3.9%, C.E.O direct compensation rose another 10.8%.15 Another study by Morgan et al16 concludes that the increased emphasis on option contracts and other forms of performance pay has led to excessive compensation and manipulative actions. From the foregoing, it is evident that managers are not provided the right incentives to create value for shareholders. To improve on shareholder value creation, the manager’s compensation needs to be linked directly to shareholder value created. That is managers should be compensated when they articulate all the perspectives outlined in the balance scorecard including the financial and non-financial measures of performance. BIBLIOGRAPHY Best of HBR. (1992). The High Performance Organisation. Harvard Business Review. Pp 172-180 Blocher E., Chen K., Cokins G., Lin T. (2005). Cost Management A strategic Emphasis. 3rd Edition McGraw Hill. Ferguson, J. et al. (2006). Exploring lecturers’ perceptions of the emphasis given to different stakeholders in introductory accounting textbooks, Accounting Forum, doi:10.1016/j.accfor.2006.11.003 Hart S. L., Milstein M. B. (2003). Creating Sustainable Value. Academy of Management Executives. Vol. 17(2), pp 56-57. Libby, Theresa, Salterio, Steven E. and Webb, Alan (2002). "The Balanced Scorecard: The Effects of Assurance and Process Accountability on Managerial Judgment" Available at SSRN: http://ssrn.com/abstract=317486 or DOI: 10.2139/ssrn.317486 Malina, Mary A. and Selto, Frank H. (2001). "Communicating and Controlling Strategy: An Empirical Study of the Effectiveness of the Balanced Scorecard" Available at SSRN: http://ssrn.com/abstract=278939 or DOI: 10.2139/ssrn.278939 Mekonnen Akalu, Mehari, (2002) "Evaluating the Capacity of Standard Investment Appraisal Methods: Evidence from the Practice". Tinbergen Institute No. 2002-082/1. Available at SSRN: http://ssrn.com/abstract=324841 or DOI: 10.2139/ssrn.324841 Mintzberg H., Simon R., Basu K. (2002). Beyond Selfishness. Mit Sloan Management Review. Massachusetts Institute of Technology. Morgan A., Poulsen . A., Wolf J. (2006). The evolution of shareholder voting for executive compensation schemes. Journal of Corporate Finance. Vol. 12, Pp 715-737. Mekonnen Akalu, Mehari and Turner, John Rodney, "Adding Shareholder Value Through Project Performance Measurement, Monitoring & Control: A Critical Review" (April 2002). ERIM Report Series Reference No. ERS-2002-38-ORG. Available at SSRN: http://ssrn.com/abstract=370985 Top of Form Libby, Theresa, Salterio, Steven E. and Webb, Alan, "The Balanced Scorecard: The Effects of Assurance and Process Accountability on Managerial Judgment" (June 16, 2002). Available at SSRN: http://ssrn.com/abstract=317486 or DOI: 10.2139/ssrn.317486 Top of Form Murphy, Kevin J.(1998)."Executive Compensation" Available at SSRN: http://ssrn.com/abstract=163914 or DOI: 10.2139/ssrn.163914 http://www.valuebasedmanagement.net/faq_shareholder_value.html http://www.valuebasedmanagement.net/faq_shareholder_value.htmlhttp://www.valuebasedmanagement.net/faq_shareholder_value.htmlhttp://www.valuebasedmanagement.net/faq_shareholder_value.htmlTop of Form Bottom of Form Bottom of Form Bottom of Form Bottom of Form Dhyani, Anil, Sarkar, Saukhin, Saxena, Amit and Moeller, Martina, "Making OutSourcing happen with Balanced ScoreCard – A Unification Approach Paper" (January 1, 2003). MIT E-commerce Research Forum. Available at SSRN: http://ssrn.com/abstract=310139 or DOI: 10.2139/ssrn.310139 Dhyani, Anil, Sarkar, Saukhin, Saxena, Amit and Moeller, Martina, "Making OutSourcing happen with Balanced ScoreCard – A Unification Approach Paper" (January 1, 2003). MIT E-commerce Research Forum. Available at SSRN: http://ssrn.com/abstract=310139 or DOI: 10.2139/ssrn.310139 Top of Form Read More