Topics
Contents
In this section I will deal with some issues in a detailed and, at the same time, simple way about the world of controlling, its topics, both strategic and operating ones, both the current approaches and the future trends, that is the way the companies "do it" and are going to do it and, of course, my advice.
74. Not Only ROE and ROI!! - Part 2 (The Risk)
73. Not Only ROE and ROI!!
72. Looking at the Society as a Strategic Move
71. The Misconception of the Indirect Cost Allocation
70. The Soft Skills of the "Budgeters"
69. Praise for the Activity-Based Management - More in Fashion than Ever
68. The Crisis of Net Present Value
67. The Correct Framework of a Cost Center's Manager Performance Evaluation
66. Valuation of a Company? Which Approach Makes Sense Today?
65. OKRs and their Strategic Use in the Finance Dpt
64. Flexibility in Real Investments, its Financial and Strategic Value
63. When Depreciation Does Make Sense for the Operating Decision Making
62. Variable Costing vs Full Costing for the Profit Center Assessment
61. The New Evolution of the Performance Indicators
60. Management Accountant Profession in the Spotlight - The Last Song
59. Digital Assets and Customer Data: How to Evaluate Them as Fixed Assets
58. How to link the Capital-Investment Decisions to the Strategy
57. A full view on the use of the Value Chain Analysis
56. Labor-Intensive Businesses and the Learning Impact on Cost Estimation
55. Strategic Reporting Adherence: Lean, from the processes to the accounting
54. Zero-Based Budgeting and its Strategic Sides
53. How Many Kinds of Overhead Variance Analysis!
52. Project Control and some Risk Assessment Methodologies
51. When the Operating Leverage is used as an excuse
50. A Common Manufacturing Accounting "Misundertanding"
49. Make the Right Price.
48. The Choice of the Kind of Bonus: Advantages and Risks
47. How Well is Your Company Using Its Money?
46. ROI: Some Strategic Sides about it and other financial performance metrics
45. Value Creation or Value "Invention"?
44. The Strategic Cost of Quality
43. The Rule of Thumb doesn’t exist
42. Why is the Healthcare Cost Accounting so peculiar?
41. The strategic sides of Target Costing
40. The great implications of the true Capacity Costs (PART TWO)
39. Which is the Most Profitable Customer?
38. The Game of the Ending Inventory
37. How the "work" of the Support dpts affects the Cost Accounting Settings
36. Only Just In Time?
35. The "Way" to spot the real profitability by product
34. Risk Management: some important metrics
33. Another useful "piece" of variance analysis for the BU
32. Budgeting process: not only a numerical issue
31. The great implications of the true Capacity Costs (PART ONE)
30. How does the Lean Accounting support the decision making?
29. The strategic interpretation of the productivity measurement (PREVIEW)
28. How deep you can dig and some strategic aspects in the variance analysis
27. Strategic distortions in the capital-budgeting project evaluation
26. Some errors in the capital-budgeting analysis
25. How and why to try to understand the real trend of the overheads
24. The cost variance analysis in the project control (INTRODUCTION)
23. The cost management and the customer-driven value model (PREVIEW)
22. What if you compete on timeliness and speed to customers?
21. The Strategic Fixed Overheads
20. The assessment of the State of the Work according to the activities
19. The choice of an appropriate costing system
18. How to deal with the uncertainty in the estimation process
17. The importance of the Product/Service Life Cycle costs
16. Resource Consumption Accounting: a comprehensive management accounting system
15. Strategic Transfer Pricing: Cost-based and Negotiated Price Methods
14. Motivation and other strategic factors in the Transfer Pricing: Market Price
13. Strategic sides of ROI
12. SBU's manager evaluation: - Nonfinancial measures and strategic structure
11. How can you evaluate your business?
10. How do you deal with the indirect costs?
9. A very useful "piece" of variance analysis for the BU
8. Are you getting right about the estimation of the overheads?
7. Constraints? Here is the way to make decisions
6. Are you customer-oriented? Here's how you can know about that
5. Global succes indicator
4. Which kind of standard cost is it convenient to set?
3. Joint products: how the contribution margin is calculated
2. ABC: - Great difference in calculating the financial variances versus the traditional costing systems
1. The cost of the complexity
Not Only ROE and ROI!! - Part 2 (The Risk)
In the previous articles we have disserted about many profitability rates concerning different assets and different kinds of info a manager needs from their calculation.
What if we want to navigate the risk incoporated into the assets analyzed?
When usually does it happen?
The ratio that comes up at once is RORAC and usually it is used in the management of banks, insurance companies and other financial enterprises for risk analysis and investment evaluation.
More precisely it is a rate of return commonly used when various projects and investments are evaluated based on capital at risk and when the projects/investments have with different risk profiles.
This work is easier to do if their individual RORAC values have been calculated.
How do we get to this profitability rate?
Return on risk adjusted capital is an adaptation of the concept of ROCE (Return on capital Employed) used by industrial and commercial businesses and it is obtained by placing in the numerator the expected results of transactions relating to a financial instrument, a project, or a certain operational activity and in the denominator the capital to be used adjusted to take into account the associated risks.
Formula
Return on Risk Adjusted Capital (RORAC) = Net Income (or Expected Return)/Risk-Weighted Assets (RWA)
At this point we have to clear what we mean by Risk-Weighted Assets.
Risk-Weighted Assets are the allocated risk capital, economic capital, or value at risk.
Allocated risk capital is the firm's capital we adjust for a maximum potential loss calculated once we have estimated future earnings distributions or the volatility of earnings.
In other terms, it's the amount of capital that a company needs to ensure that it is "at ease" given its risk profile.
Risk-weighted assets (RWA) are calculated by multiplying a bank's assets by their respective risk weights.
....And what about RAROC (Risk-adjusted return on capital)?
See you soon!!!
73. Not Only ROE and ROI!!
The business' Profitability is monitored and estimated in different ways, both through intermediate results and ratios, both with regard to the whole business and with regard to its pieces (units, projects..).
The range is as large as fascinating and many finance people cannot know all of them.
You have heard of ROE (Return on Equity) and ROI (Return on Investment) and seen the "path" to get them thanks to your basic study courses, but in addition to these you have learned or experienced that other ratios are used to explore how efficient and profitable the use of the business assets is or will be within the different specific organization they belong to and according to the specific goal the analysis is intended for.
At this point we could ask ourselves what RONA, ROIC, ROA, ROCE and others are like and why they are used!
Let's kick off with RONA.
RONA
It is the Acronym for Return on Net Assets.
It measures the efficiency at which a company utilizes its net assets, i.e. fixed assets and net working capital (NWC); in particular its goal is determining whether the allocation of business' net assets is generating earnings or not.
There are three inputs we need to calculate the return on net assets (RONA):
Net Income
Fixed Assets
Net Working Capital (NWC)
RONA = Net Income/Fixed assets + Net Working Capital
It gives us the net profits per dollar of fixed assets and net current assets owned.
It's clear how the higher the RONA the more efficient the company is at generating profits .
In order to understand this profitability metrics better, let's focus on the terms at the denominator:
- Fixed Assets : In this metrics we consider the long-term tangible assets belonging to a company such as property, plant and equipment.
- Net Working Capital: it is the difference between operating current assets and operating current liabilities; cash and cash equivalents, as well as debt and any interest-bearing securities, are not not taking into account.
In order to make numerator and denominator consistent about timing, it would be very advisable to use the average for the period under scrutiny with regards to the fixed assets and net working capital (NWC) calculation.
As to the Net Income the bottom line of the Income Statement can be considered but in my opinion the best suitable metrics for this use is NOPAT (Net Operating Profir After Tax) that is the Net Income minus Financial Interests plus the Fiscal Savings from Financial Interests.
RONA = NOPAT/Fixed assets + Net Working Capital
In so doing you have the maximum "Operating" consistency between numerator and denominator.
One profitability ratio that makes use of NOPAT, just as it could be advisable for the calculation opf RONA, is the ROIC.
ROIC
What is ROIC like?
The Return on Invested Capital (ROIC) measures the percent return earned by a company using the capital contributed by equity and debt providers.
In practice, ROIC is commonly used to determine the efficiency at which capital contributed by shareholders and lenders is allocated, because the generation of a positive value is perceived as a necessary attribute of a quality business.
ROIC stands for “Return on Invested Capital”.
It ultimately determines the long-term sustainability of the business model since it represents the rate of return earned by a company from reinvesting the funds contributed by its capital providers, i.e. equity and debt investors.
The formula to calculate ROIC is NOPAT divided by the average invested capital, i.e. the company’s fixed assets and net working capital (NWC).
ROIC = NOPAT/Average Invested Capital
NOPAT (Net Operating Profir After Tax) is the Net Income minus Financial Interests plus the Fiscal Savings from Financial Interests-
NOPAT is the most suitable numerator because even more than the cash flow metric because the latter captures the core operating profits and is an unlevered measure (i.e. unaffected by the capital structure).
Instead NOPAT is a company’s tax-affected operating profit and thus represents what is available for all equity and debt providers.
Average Invested Capital represents the sources of funding raised to grow the company and run the daily operations.
As we know these sources of funds for the businesses are debt and equity.
Debt Financing is the capital raised by a company in exchange for the interest to be paid periodically throughout the borrowing term and the return on the principal at maturity.
Equity Financing consists of the capital a company gets by issuing ownership stakes allocated to institutional investors (i.e. venture capital and/or growth equity firms) or the secondary markets if the company is publicly traded.
Having said that here is the formula.
Invested Capital = Fixed Assets + Net Working Capital (NWC) + Acquired Intangibles + Goodwill
In any case the simplest way to calculate the denominator is to add the net debt (i.e. subtract cash and cash equivalents from the gross debt amount) and equity values from the balance sheet.
in fact cash and cash equivalents (e.g. marketable securities) are not considered as operating assets and as a result the line item is excluded.
As to the uses that a company makes of ROIC, the main one is comparing the business' ROIC at different points in time and together with that making comparisons to peer companies.
ROA
Let's turn our attention to another much used profitability ratio concerning the business' "ability" to use its assets: Return on Assets (ROA).
It indicates how profitable a company is making use to its total assets.
Its formula is:
ROA = Net Income/Total Assets
ROA factors in a company's debt unlike ROE.
In fact the total assets are the sum of the total liabilities of a company and shareholder equity and this consideration exists since both types of financing are used to fund a company's operation and try to generate profits.
ROE comes out as a percentage using a company's net income and its assets.
The higher ROA the more efficient and productive the business at managing its balance sheet to generate profits.
It tells you what earnings are generated from the business' assets.
ROA target for a company depends on the industry in which they work; that's why it is best to compare it against a previous ROA or a similar company's ROA.
A particular use of ROA is the one financial companies do; at the denominator they put the average value of assets instead of the current value and that's done to gauge financial performance.
ROCE
What is Return on Capital Employed (ROCE) like?
Return on Capital Employed (ROCE) is a ratio that in addition to measuring how efficiently a company is using its assets to generate profits is often used by investors to assess whether a company is good to invest in or not.
ROCE = EBIT/ Capital Employed
Earnings before interest and tax (EBIT) is, as we know, the company’s profit, including all expenses except interest and tax expenses.
My opinion is to use instead the Net Operating Profit After Tax (NOPAT) since it excludes the non-operating income such as Lease, Dividend and Investment Income, Foreign exchange transaction income.
Capital employed is commonly derived from total assets less current liabilities.
About the ROCE meaning, its calculations shows how much operating income (or EBIT) is generated for each monetary unit of capital invested.
The higher the better since it tells us that more profits are generated per dollar of capital employed.
As we said above ROCE is used to understand whether a company can be a good investment or not and as a result the comparison of its ROCE with other companies' ROCE of the same industry is the best way to hit this goal.
Some appropriate considerations should be done when comparing these companies' ROCE, just as you shoul do when taking into account other profitability ratios to be used in conjunction with ROCE in order to decide whether to invest in that company or not.
In the end we have seen four Financial Ratios accounted for to determine whether a company is efficient in using its capital or not, each of them with their own use, individually or together with other indexes.
We have seen also the best ways to compute these ratios for every component of their formula.
Further in-depth analyses about use and computation methods can be dealt with by writing on page Contacts of this website.
72. Looking at the Society as a Strategic Move
How important environment and social issues are nowadays!
Why not highlighting the good benefits in these fields of such corporation projects that could turn out to be a great return in terms of image and eventually in terms of money!?
All of this should start from the consideration that Value creation is not intended only to bring immediately value to shareholders but it can take on a meaning that looks at the environmental and social aspects.
That's why a a smart CEO needs to take an interest in the development of a new forms of ROI, called social return on investment (SROI).
SROI, initially developed in the late 1990s, takes into account larger impacts of projects by using social and environmental metrics not reflected in conventional financial accounts.
As a matter of fact, this metric is do different from the usual profitability indexes that when such undertakings negatively impact traditional ROI in the short term, the net benefit to society and the environment can lead to a positive SROI, that in my opinion could translate into positive traditional ROI in the medium run.
It goes whitout saying that calculating this value can be difficult, even more if we consider that we need to measure social returns in the most common language of value, finance.
Summing up, SROI is used to evaluate the general progress of certain developments, showing both the financial and social impact the organization can have.
SROI Calculation
SROI calculation is a severe process that may concern both the past and the future.
In fact we are able to measure it at two moments that lead us to distinguish it in:
- Evaluative, which is carried out retrospectively and based on actual outcomes.
- Forecast, intended to calculate how much social value will be created when organization's activities get their expected outcomes.
The process to get SROI takes many steps that require early comprehensive and agile data management.
The steps we are talking about are the following:
- Identifying the Stakeholders, that are the subjects who is impacted by the activity at issue.
- Defining the Outcomes: spotting and documenting the social, environmental, and economic
outcomes.
- Highlighting Outcomes: gathering data and evidence that prove these outcomes have occurred.
- Evaluating Outcomes: Assigning a monetary value to every outcome.
- Achieving the Real Impact: Calculating the net social impact, that is, quantifying what would have happened anyway and the proportion of outcomes caused by other causes.
- Calculating the SROI Ratio: it's achieved by dividing the total social value (sum of valued outcomes) to the total investment.
SROI Formula is expressed as a ratio, indicating how much social value (in terms of benefits to stakeholders) is created for every unit of input.
The basic SROI formula is:
SRO = Social Value - Deadweight - Attribution
INVESTMENT
Let's go through each component of the formula.
Social Value Created: it is the total value generated by the activity of the business/entity, including both tangible and intangible benefits. It can be measured through various outcomes, like improved health, increased employment, or environmental benefits.
In general we have two kind of outputs:
Direct and tangible products from the activity (for example, the increased number of working people thanks to a specific program for instance, lower waste amount,....).
Intangible Outcomes, or the changes to people resulting from the activity (improved quality of life for the individuals, reduced support from the government.....)
Assigning financial value to these benefits can have problems and various approaches have been thought and improved to help quantify the results.
Analytical Hierarchy Process (AHP), for example, is one method that organizes and translate qualitative information into quantitative values.
Deadweight: it is the portion of the outcome that would have happened anyway, even without the intervention. For instance, if a job training program claims to increase employment, but some participants would have found jobs without the program, that portion is considered deadweight.
Attribution: it 's the share attributed to other organization's activities might have contributed to the outcome.
In other terms the numerator is adjusted to reflect only the portion that can be attributed directly to the intervention at issue.
Investment: total resources invested to achieve the outcomes; not only money but also time, equipment, etc.
Let's go on with an example
Example of Calculation:
Imagine a massive job training program of to be held by a company intended for long-term jobless people to be hired at the end by the company itself.
Input:
Total Investment: $100,000
Total local community' s improved quality of life (Quantified in monetary terms): $600,000
Deadweight (Portion of health improvements that would have occurred without the program): 30%
Attribution (Other factors contributing to the health improvements): 10%
Result
Deadweight Adjustment: $600,000 * 20% = $120,000
Attribution Adjustment: $600,000 * 10% = $60,000
Adjusted Social Value Created = Total local community' s improved quality of life - (Deadweight + Attribution)= $600,000 - ($120,000 + $60,000)= $420,000
The SROI is the following:
SRO = 420,000/100,000 = $ 4.2
So, the SROI ratio is 4.2:1, that is every dollar invested in the program will yield $ 4.2 in social value.
At the end of this training course the people passing all the steps will be hired and the company not only will create a direct benefit fot itself but by addressing to jobless people of the local community shall have benefited the whole "society".
Furthermore it will have a return in terms of image within the area benefited from this initiative that will enjoy a sort of major preference in the purchase of the goods and services offered for long time.
Summing up the project will reveal itself to be a great strategic move
For further in-depth information about this topic you can get in touch on Page Contacts.
71. The Misconception of the Indirect Cost Allocation
The misconception of the indirect cost allocation is one of the most important distortions of the cost management perception that leads to erroneous profitability analysis.
In the predominant cost culture the indirect costs (overheads) are those that cannot measured since there isn't a traditional consumption measurement unit of the resources involved by the cost objects.
When we talk about the cost objects, we refer to products, customers, distribution channels, projects.
As a result, in order to get over this flaw some conventional criteria are adopted to allocate the overheads to the cost objects and you know very well that the most common ones are the working hours and the machine hours.
That is the capital sin par excellence!
Why?
By adopting the volume-based approach we don't recognize the same meaning of resource consumption underlying the work done within an organization, except for those resources whose consumption varies in direct proportion to the output that has to be sold to the business' customers.
In order to consider and "weigh" in a correct way all the resources used by a business unit, the most appropriate approach is to spot all the activities executed within the BU.
In so doing understanding the resources absorbed is easy.
The following step is to pinpoint the drivers (cost drivers), indirect cost category by indirect cost category, that explain the resource consumption by the activities so that the number of driver units "used" by the same activities can serve as multiplier (times the driver unit value, that we name in different ways) to calculate the resource consumption attributed to each activity.
Last steps are to reverse the activity costs to the cost objects after spotting the drivers (activity drivers) that explain the activity amount consumed by the cost objects, to calculate the number of driver units "used" by the same cost objects that can serve as multiplier (times the driver unit value, that we name activity rate) to calculate the overheads attributed to each cost object.
In the end this procedure allows to allocate all the resources to the cost objects based on the reasons they are consumed for. It's the application of the causality principle.
These steps are easy and the fear of the time consumption fueling many managers for mapping the activities and making everything else we indicated is unjustified in consideration of the available "fast" softwares based on the Activity-based approach and in comparison to the benefits resulting from its full application.
This article isn't intended to dig deep into the ABC but wants to be a strong push toward the real understanding and a good measurement of the resource consumption, by overtaking all the old prejudices about it.
Moreover, if we take into account the enormous percentage of the overheads incurred on the total business costs nowadays by a firm, regardless of the industry, and the differentiation in the activities being done in some industries, this fear is even more unjustified.
The profitability analysis can but take advantage of ABC method.