Value Added - Essay Example

?Financial Strategy: Is Value Added Only A Consequence of Ability to Manage Cost Centres? [ID Is value added only a consequence of ability to manage cost centres? Lehman Bros., AIG, Enron, WorldCom, Madoff's schemes... the detritus of history points to company after company that had high profit ratings, amazing return on investment, auditing statements that pointed to success, and cost management, and nonetheless failed and/or bilked their investors out of millions or billions. A firm's value added is not solely associated with management's ability to manage cost centres: Other factors such as transparency, accounting for systemic risk, reliability, intangible assets and other factors must be considered in the post-meltdown market. “Value added” is only meaningful in the context of some kind of value that a firm's portfolio has that isn't immediately apparent from their stock prices or investment guide. The fact that a company is connected to a larger company, for example, would be relevant to investors. Managing cost centres is normally quantified on the balance sheet anyways, but even when it isn't, it is a tiny part of the value added picture. Lu, Tsai and Yen (2010) point out that intangible assets are immensely important to valuing firms. “In knowledge-based economy, the method for creating firm value transfers from traditional physical assets to intangible knowledge. As intangible assets value is an important part of firm value, valuation of intangible assets becomes a widespread topic of interest in the future of economy” (Lu et al, 2010). Lu, Tsai and Yen point to six particular value-added sources that their data-mining from Taiwanese firms found: “R&D intensity, family, participation in management, pyramids, profitability, and dividend” (Lu et al, 2010). Intangible assets are clearly vital to a company: Indeed, they are the company, the money being the way for those assets to be deployed. What makes a company like Microsoft grow ten-thousand fold is intangible elements like strategy, intuition, etc. The problem with these assets is manifold: 1. These assets are not easily fungible. Bill Gates would not have been worth very much before Microsoft's ascension. 2. These assets are not easily measurable. Creativity, political connections, inherited knowledge from family, secret recipes... until they have been tried and tested in the market, they have no quantifiable value. 3. They are context-specific. A piece of land is worth however much it is objectively. But Bill Gates and Paul Allen were a team. Split them apart and their separate value was probably far, far lower. Aside from the factors that Lu, Tsai and Yen (2010) identify, intangible assets of value include far more. Political connections are immensely valuable: If someone can exert political pressure to protect one from upcoming regulation or other important legislation, that can be worth millions to the shareholders. Families are value-added because they typically have a shared sense of camaraderie and loyalty with less need for monitoring and because they have special knowledge passed down a family line not accessible to those outside of it. Again, the problem is the signal-to-noise ratio: The vast majority of family knowledge is not applicable to business success, but sometimes an individual piece of information in the flotsam and jetsam, like a recipe, actually is. Innovation is particularly important, especially a culture of innovation. Companies like Google, 3M, Microsoft in their heydey and Mac now are known for being innovators, which is partially created by the people they hire but also heavily determined by the organizational practices they implement. Partnerships with other firms would be another value-added investors should be aware of. Strategic partnerships have a proven track record of raising company value. In small-to-medium sized software companies, Kennedy and Keeney's research found that “strategic partnerships were initiated to take advantage of firm synergy, reputation and credibility advantages. Partnerships also served as an important foreign market entry mechanism allowing firms to accelerate sales cycles and reduce risk in overseas markets. Challenges facing firms included partner selection and issues of control” (2009). If an investor were faced with a decision to approve of a move into an overseas market or move his stock somewhere else, he would be behaving imprudently if he didn't know about a strategic partnership. But the strategic partnership would appear nowhere on a balance sheet or at any cost centre. It would be impossible even to guess how much the value-added would be even if one knew the size of the partnering firms: A recent study found an abnormal return after the announcement of strategic alliances, and the result was not related to the relative size of either partner (Neill et al, 2001). In the past, research found a strong correlation between size of the partner and growth in value, but newer research finds that the picture is much more complex than that. In fact, risk management itself is immense value-added that is also hard to quantify. Risk is almost impossible to manage. “There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer deep into the bowels of the financial system.... Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in” (Danielsson, 2009). Endogenuous risk, or risk caused by the change of financial systems such that any model is always a step behind, and the observer factor, where the market system is affected by the very observational techniques used to discover it, makes it so that even simple risk-forecasting has a margin of error of at least +/-30%. No cost centre would include these margins of error, but shareholders need to have some idea of risk. No amount of cost centre management can possibly represent holistic risk management. Note that small adjustments to market share can lead to a big change in stock price. In the fast food industry, for example, even stagnating growth has been enough to send stock prices plummeting (Schlosser, 2003). A cost-centre only analysis would see value added based in proportion to increases or decreases in market size, but there is in fact a multiplier value. On the production side of the equation, there are numerous ways one could imagine two firms with identical cost centre control yet two massively different value addeds for their products. One is market structure. A monopoly with identical cost centre control to a firm in an oligopolistic market will see different value addeds. Another is an externality risk. A product being produced that externalizes onto workers or the environment might lead to overhead that is not included in cost centre analysis. A smart, forward-thinking company would preempt this by raising prices to prepare for lawsuits. A third is cross-promotion with other firms. A naive investor who saw that Coke cut McDonalds a break for syrup might perceive a lower value added and therefore rate of return and withdraw, but the promotion between the two companies might so improve profit ratios as to be noteworthy and compensate. Cost centre analysis does not include this important element. There's another point to make that a “cost centre” is itself a limited approach. Zeinstra argues, “Getting on the road from cost center to profit/cost-recovery center can be rewarding in many ways.. Managing cost-recovery programs is vital to a corporate university's future as a viable operation. It means you can come back to your stakeholders with a balanced view of how you're achieving your mission..[W]hen you're in a healthy cost-recovery mode, a funny thing happens: the stakeholders often will let you do the things you want to do” (2004). Cost centers often don't focus on generating profit but at averting loss. The two are not the same thing. The nature of cost centres themselves can be a problem for value added. IT, for example, is often sequestered as a cost-centre, but it has far more value than that (Bauschab and Piot, 2007). This include senior management coordination, cross-echelon and cross-hierarchy coordination, comprehensive risk management, lean auditing, technology initiatives being repurposed and made into money, etc. Finally, branding itself must be considered. Branding is a value add of immense important that has nothing to do with cost centre management. And branding can be sensitive to both short-term shocks and long-term problems. Jack in the Box as a brand suffered for years after the E. coli outbreak (Schlosser, 2003). If a Nike shoe is seen on a celebrity, it might go up in value despite nothing Nike did. Determining the real value of a product is far more than tallying costs. Consumers look for status, prestige, quality, long-term success, reliability, customer service and trustworthiness. Investors look for safe bets with good growth rates. Cost centres can quantify much of the cost side of the equation, though even there they are important. But cost is only half of the profit picture, and revenue is controlled by so many factors that it is impossible to say that cost centre analysis is the only or even integral element. Works Cited Baschab, J. and Piot, J. 2007, The executive's guide to information technology, John Wiley & Sons. Danielsson, J. 2009, “The myth of the riskometer”, Vox, January 5. Kennedy, K, Keeney, K. 2009, “Strategic partnerships and the internationalisation process of software SMEs”, Service Economics, volume 3 issue 3. Lu, Y, Tsai, C and Yen, DC. 2010, “Discovering Important Factors of Intangible Firm Value by Association Rules”, International Journal of Digital Accounting Research. Volume 10. Neill, JD, Pfeiffer, GM and Young-Ybarra, CE. 2001, “Technology R&D alliances and firm value”, Journal of High Technology Management Research, Vol. 12 Issue 2. Schlosser, E. 2003, Fast Food Nation, Penguin Books, Second Edition. Zeinstra, B. 2004, “Converting From a Training Department to a Profit Center”, Chief Learning Officer, December. Read More