Topics
70. The Soft Skills of the "Budgeters"
Lecturing in budget and its steps doesn't concern this article that focuses instead on what many top managers neglect when setting the financial and nonfinancial objectives to the responsibility center managers of the firm and to the firm as a whole.
The Budget process is long and takes a high level effort to translate the goals of a company into numbers that may reflect ambitions, the real capacity of the firm as a whole and with regards to each single unit, its weaknesses, market conditions and the ""will" of the business unit managers that put into play their expertise in exchange for the acknowlegement of their action by negotiating the resource amount they need.
The last element is the most difficult, that's for sure, and the result of this negotiation can distort the way of the business towards the execution of its strategy the stronger the internal power of the managers involved.
How can you lead this negotiation without damaging the company?
The main factors you shoud take into account are Motivation, Goal Congruency, Controllability, Strategic Consistency as the main features of budgeting.
What are they like?
As to the motivation, it consists of the push that budget should give to the managers of each business unit to achieve the goals assigned to them.
Of course the view of the top managers and a top-down approach, that means setting directly objectives for all the responsibility centers, can be risky since the targets identified couldn't be agreed by the people accountable for the activities and the resources used in the subunits concerned.
At this point the negotiation stage that all of us, finance people, know become longer and longer.
My suggestion is to adopt a mixed approach, halfway between the bottom-up and the top-down extremes, involving to a certain degree the managers of the responsibility centers that in doing so feel even more important their role within the entire organization and that at the same time allows the overview of top management able to coordinate all the business units towards the firm's objective achievement.
The second point I want to deal with is the goal congruency between the objectives of the business as a whole and those of the subunits.
An example can highlight this factor even more.
Let's suppose that the top managers of the X Group sets a sale increase of some brand-new products as a target for the coming year.
At the same time a strong cost reduction in the Marketing and Sales department is requested to the its manager.
The amount of resources that should be used by the Mkt & Sales function throughout the launch stage of a product/service is well-known and that's why a severe and indiscriminate cost cutting policy impacting all the business' departments is counterproductive for the goal of the sale increase achievement.
Here a cross-functional knowledge of the business processes comes in, since it is essential to those responsible for translating the strategy of the firm into consistent operating budget goals for the period concerned.
What about the Controllability factor?
In my opinion it is the most complex issue that requires a distinction between variable costs and fixed costs.
The example is my favourite approach.
Let's guess that a manufacturing cost center manager sees, as usual, a threshold put to its maintenance costs.
Many believe these kinds of costs are directly proportionate to the output expressed through either working hours or machine hours and that's the reason why in our example we suppose that they are allocated to "him" on the basis of the budgeted machine hours in that center.
This limit is beneficial to him since the budgeted hours are higher in comparison with those of other manufacuring centers that as a result cannot take advantage of a fair of maintenance costs.
Let's guess the manufacturing cycle is more complex and less productive in cost centers with fewer budgeted hours since the machinery is obsolete, for instance, and requires more interventions to check its working.
At the year's end these managers with fewer hours but more complex manufactuting processes see their maintenance costs overtake their budget amount and that is the reason why they won't not "rewarded".
The main reason for this perverse and unfair mechanism is that the real factors impacting the maintenance are hidden and as a resulted not controlled.
The solution is pinpointing the right cost drivers that in this example doesn't concern the machine hours but others to be spot so that maintenance costs can be controlled in the most fair way even by those who have taken advantage of the wrong allocation method used so far.
The advantages are two: a reduced cost of maintenance as a whole and a positive impact on the motivation side of the managers that were been "discriminated" by the old method.
The second aspect of the controllability concerns the fixed costs, involving the Investment/Profit Centers where you can find controllable fixed costs and noncontrollable ones.
The formers (such as some research projects, operating advertising, sales promotion....) can be directed within the budget period (one year) and as a result put under the responsibility of the respective managers; the latters (such as depreciation, insurance,....) cover more periods and usually depend on past decisions that weren't made by the present Investment/Profit Center managers.
When setting a cost target in those cases in view of a correct and fair manager performance evaluation the noncontrollable fixed costs must be taken off the performance basis.
In the end you cannot neglect as a soft skill of the budgeters the Strategic Consistency of the bugdet with the long-term goal of the firm.
The budget objectives for each business unit should reflect the goals of the organization set into a multi-year plan that gets the place where the firm wants to be at the end of the period indicated.
For instance if the top management wishes to differentiate the firm even more from its competitors after a lapse of time, it cannot put some severe evaluation basis for the performance of the managers period by period through the usual financial and nonfinancial indicators since the "leap" forward in terms of efficiency or profitability is achieved usually in the final years of the multi-year plan.
If you don't follow this approach, the mission itself of the business won't be accomplished.
The solutions to this aspect are not so hard to be found and a smart and forward-looking budgeter won't have any difficulty to apply them.
69. Praise for the Activity-Based Management - More in Fashion than Ever
After discussing many times with my peers, CFOs, top managers, partecipating in many virtual meetings, I came to the conclusion the Cost Management concept in this year, 2023, more than ever in these weeks, hit rock bottom.
The misleading idea that the allocation of the indirect costs to product, customer, distribution channel, etc. according to one or another approach is in the end an useless sum-zero game that doesn't bring value to the business not only has been spreading in these uncertain times across all the decision-making lays of an organization but it has been going with another unavoidable certainty: the present lack of governability of many direct costs.
This issue concerns both the volume of the resources involved and the outlay needed to grab them as the result of the supply chain troubles affecting many materials and commodities following mainly the current geopolitical standing that impacts quantity, timing of the delivery and the prices.
This situation crosses the most part of industries and lead the business' management to shift their attention to the most controllable (in their opinion) and predictable item: Revenue.
I have a different opinion about this aspect but reflecting on this general opinon trend it's natural to me to state this.
Today Activity-Based Management is the most "trendy" and useful cost management technique we know.
It's an approach based on the Activities and focus its "formula" on the ones that create value to the customers according to their perspective and not only to the internal view of the managers.
Following this link activity/value they generate Revenue.
Many consider the Value-Add Activity identification in their own company just as a procedure of difficult and/or time-consuming realization, not to say of the determination of the money spent on them.
Nothing more false.
At this point a recall of their meaning together with some examples is useful to the understanding of this category.
Value-Add Activities
This category includes all the activities performed to meet the customer preferences about the attributes the product/service needs to have in order to persuade them to purchase it.
In other terms the resources and the related costs the companies spend on these activities generate revenue.
Of course, what I have just explained is good for both manufacturing businesses and for service ones.
These attributes vary from industry to industry and reflect the importance the customers give to them and may be several.
I want to make two simplified examples of what I have just written:
1° Example (Manufacturing business)
You are a manufacturing company and you know that your customers of a specific segment are sensitive to the Price and to the Color of the product.
All the manufacturing cycle performed to achieve the base product and its costs will be traced to the Price attribute, while painting phase costs will be traced to the Colour Range attribute if the customers give value to it as one of the main purchase reasons.
2° Example (Service business)
You are an engineering company and your strength is the skills of your people to customize the projects. Imagine you design train coaches and your customers want some of those ones with comfort equipment.
As a result, the hours worked by your engineers and the linked costs incurred to differentiate in that direction the original project are traced to the Comfort attribute.
An important punctualization must be made.
Not only the activities linked to the main functionalities of the product/service give Value Added to the customers.
We must consider also, as an example, the speed of the delivery when important, the after-sales services helping the customers better utilize the goods purchased and those activities on request.
The exhamination and the classification of the value varies from industry to industry.
A price leadership business will pay much attention to the activities identified, and their costs, with the “Price” attribute to which all the operating work performed to "bring to life" the core of the product/service are traced.
A company with a differentiation strategy, on the contrary, will pay much attention to other attributes.
After this explanation, it's fundamental to highlight that after the determination of the activities/attributes that create value and revenue and their evaluation, the Activity-Based Management determines the ratio between Revenue and Costs incurred on each Value Attribute allowing the management to see how much they are spending in the right direction and setting the corrections when needed in their decision making.
A most detailed dissertation on ABM could dig dip into the characteristics and the steps of this approach that is not just a fascinating exercise, but the content of this article was highlight how the features of this method contribute a lot to reduce the uncertainty of these times and fill the gap between the importance tha businesses' managers are giving to the governability of Revenue and the one they attribute to the governability of Costs.
If ABM receives more practical applications, the profitability mechanisms of a firm will become more clear.
68. The Crisis of Net Present Value
In one of my articles (n. 66) I wrote about the "crisis" of NPV when evaluating a whole business but the customer evaluation (CLV) could be even more complicated.
That's as more true as more indebted the firms are.
In fact, when you use NPV you should discount the future cash flows ALSO by taking into account the cost of debt of the business as a component of the whole cost of capital.
As you know the Cost of Capital formula is:
WACC= Re x E/D+E + Rd(1-t) x D/D+E
Where:
WACC = Weighted Cost of Capital
E = Equity
D = Debt
Re = Cost of Equity
Rd = Cost of Debt
t = Corporate tax rate
The cost of debt when you don't consider the accounting method, that provides a formula like Total Financial Interests to Total Financial Liabilities, is done by referring in one way or another to the predominant or expected interest rates for the time involved.
As you know the volatility of interest rates is extreme nowadays and it seems to me that it will endure for long.
In these conditions one of the most important factors in understanding in an accurate way the present and the expected standing of the economy, and as a result the time value, is the financial market expectations.
That's why I can guess to determine the cost of debt through the well-known yield curve by subtracting the interest rate (return) of the government bonds with maturity preceding where you are at a precise point in time from the interest rate (return) where you are at precise point in time.
This is to be done year by year, until you reach the maturity of the bonds with the same duration as the lapse considered as the average life of a customer/customer group.
That's a concept that needs an example to show how it works.
Exhibit 1 - Government Bond Yield Curve
Let's suppose you are evaluating the Customer LifeTime Value of a group of your Business' Customers through the discounted Cash Flow Method tha make uses of given WACC consisting also of the cost of debt.
The average Customer's lifetime is 5 years.
The cost of debt to which discounting the yearly cash flows (together with the cost of equity) must be calculated year by year this way (Blue Line):
Rd at year 1 = 1.5%
Rd at starting point = 0
Cost of debt to be used to discount the net cash flows from year 0 to year 1 = Rd1 - Rd0 = 0.8 - 0 = 0.8%
Rd at year 2 = 0.8%
Rd at staring point = 0
Cost of debt to be used to discount at year 1 the net cash flows from year 1 to year 2 = Rd1 - Rd0 = 1.5 - 0.8 = 0.7%
In so doing we arrive to the maturity of those bonds with the same duration as the lapse considered as the average life (5 years) of the chosen customer/customer group.
This is just a hypothesis but there isn't a rule of the thumb as there was in the recent past, instead.
My suggestion is that one should think of the right method according to the industry and some other factors that I would be happy to share directly with you.
67. The Correct Framework of a Cost Center's Manager Performance Evaluation
Throughout my experience i have just encountered just a few controllers aware of the appropriatness of the features of the cost center system in place that justified the kind of strategic evaluation of their managers' performance.
What was on place was unarguable and immutable.
Moreover the approach to measure and evaluate a Strategic Business Unit can be requested to change over the time due to some behaviours of the managers that try to elude their responsibility for the costs incurred or to be incurred in their cost center.
That's the reason why a smart controller should be monitoring the kind of costs into a BU over the time and set up the corrective actions either by requiring a change in the measurement and evaluation method or by making BU's managers "get back on track".
But let's make step by step.
Many companies have their measurement and evaluation system of the performance of the cost center looking at the short term and as result to take into great consideration the financial aspect.
At his point the basics of the cost analysis come into play.
We divide costs according to their sensitivity to the business's output variation into variable and fixed ones.
This sensitivity translates into a higher degree of controllability of the variable costs compared to the fixed ones and this, as we have seen in different articles on this webage, produces different impacts on the choices of the top management during the business's life.
One of these effectcs concerns the settings of the cost center's manager performance evaluation that shift their focus following the predominance of the variable costs over the fixed ones or viceversa.
Let's suppose that a cost center sees a higher share of fixed costs and the strategy of the business is to compete based on the Cost Leadership.
This strategy in practical terms should mean limiting the investments and the most attention is on the planning stage that is the beginning of the reference period when the forecast amount to spend on those costs is restricted.
The performance evaluation at the end of the period is less important since the variation of the fixed costs, within some ranges, is not linked to the variation of the firm's output.
Following the same principle, when the business'strategy turns to innovation/differentiation of products-services to the customers and the cost structure is again mainly "fixed", the manager's performance evaluation based on financial aspects at the end of period is even less important since the budgeted amount of cost is higher the the previous case.
Both in the former and in the latter case the strong suggestion is to accompany the evaluation system in place with nonfinancial performance indicators even the focus of all that is the short term.
What about the opposite case?
When the variable costs are predominant into a cost center the focus of the performance evaluation goes to the end of the reference period just because most part of their ongoing amount is to be traced back to the decisions and skills of the concerned managers.
All the kinds of the variance analysis take as a result more value in assessing the managers.
Be aware not to charge the responsibilty of some external causes to the accountabilty sphere of the managers because this could be see as unfair and bring about lack of motivation.
In the lines above I mentioned the attention a controller should pay also to the behaviour of the managers of the cost centers just with regards to the financial performance evaluation purposes.
Many managers choose to address spending decisions that consist mainly of fixed costs in order to subtract them from the basis of their evaluation.
This phenomenon is called Cost Shifting.
Another case to be considered is the Budget Slack that happens mainly when costs are mainly variable.
Many managers when negotiating the money to be spent on the activities of their cost center aim at setting a target as high as possible so that their goals could be hit more easily and this is even more true when the strategy of the business consists of the Cost Leadership!!
The most appropriate framework of a cost center's manager performance evaluation is to be taken into great account not only for rewarding them in a fairly and motivating way but even for the health of the whole company in view of the cascade issues potentially arising in a hyperconnected reality like a company.
Further details about this topic are to be considered and that's why I invite you to check the website publications out regularly!!!
66. Valuation of a Company? Which Approach Makes Sense Today?
When talking about business valuation many go along with one of the method s without considering the appropriatness with the business case and with the time they live in.
Yes, you have understood well the time they tima they are living in.
This issue affects even the techniques a manager m akes use of to determine the value of a business regardless of the size oif the unit, of the reason he will make the valuation on and of the listing or not of the company on the stock exchange.
This large involvment derives from the very large uncertainty of some factors that are the basis of the methods involved.
Before to explain my concept a bit of introduction of the techniques is needed.
Managers, investors and analysts rely on two major methods.
Discounted Cash Flow and Multiples of some performance measure, such as earnings or sales.
The former is considered to be a valuation, internal to a company, that relies on the discount of the predicted cash flows by a rate that factors in the structure of capital (equity and debt).
The predicted cash flows are expression of an expected growth, generally by averaging different scenarios of projected cash flows and profits.
The latters, Valuation multiples are the quickest way to value a company, useful first of all in comparing similar companies (comparable company analysis) by considering also the mood of the market (Share Price and Market Capitalization) where the company operates.
They want to capture the expected growth in a single number, multiplying the ratio between two appropriate numbers by some financial metrics to achieve an enterprise or equity value.
Please notive the both of them can be used for listed and unlisted companies even if their use for the unlisted ones is more difficult since the calculations of some inputs involved need to find the respective values of the listed companies more similar to the business whose valuation is going to be done and in order to average them.
Generally they are used in Merger and Acquistion cases but in the other valuation opportunities for comparable analysis, too.
Without goung deep into the technical dissertation, I will make some examples ot the Multiples used in order to have more clear the reasons on which "nowadays" I prefer them to the DFC method.
VALUATION MULTIPLES
We have 2 kinds:
- Equity multiples.
- Enterprise value multiples.
EQUITY MULTIPLES
Price-to-Earnings (P/E) Multiple
Without a doubt the most common equity multiple used to valuate stocks is the P/E multiple.
It is equal to Share Price To Earnings per Share (EPS).
A company with a high P/E is considered to be overvalued. Likewise, a company with a low P/E is undervalued.
You can see the easiness of valuation when comparing shares of different companies, as a matter of fact they are readily available on many financials information tools, but they don't take into account the different capital structures of the companies involved mainly because they use denominators relevant only to equity holders, EPS.
Most forward-looking equity multiple is the PEG ratio similar to the P/E ratio since this metric also takes the company's expected earnings growth rate into account.
However even PEG presents the same negative aspect just seen.
This drawback is overtaken by using a particular Equity Multiple, Price/Sales, but in this sense the following EV multiples are more complete since also the numerators comes in to consideri the debt holders.
Enterprise Value Multiples
There are many Enterprise Value (EV) multiples but all of them have EV in its numerator.
EV shows very simply how much money you need to buy a company.
EV of a company is calculated by taking the company's market capitalization (Market Cap = Current Share Price * Total Number of Shares Outstanding), adding total debt (including long-term and short-term debt), and subtracting all cash and cash equivalents.
In my opinion, that suffices to be a better tool since it is more transparent by giving a more complete picture of a company's valuation.
However, let's give dome examples to focus on the features of EV multiples.
Examples of this kind of multiples?
EV/EBITDA Multiple
EV/EBIT Multiple
EV/Sales Multiple
- The first is used generally by investors to compare companies in the same industry before making an investment decision and it gives a good "idea" of the firm's cash flows.
Of course, being a comparison tool it will be "good" or "bad" enterprise multiple will depend on the industry.
- The second is preferred by some analysts for its ability to give a more complete picture ot the actual worth but in my opinion it is rather linked to the book value of the fixed assets hence a bit backward-looking.
It is advisable using it for less capital-intensive companies that have in their Income Statements small Deprectiation and Amortization.
Both EV/EBITDA Multiple and EV/EBIT Multiple are useful for understanding if companies might be undervalued or overvalued.
- The third is the most forward-looking tool because it takes into account the value potential of a company per Dollar Sales that can be higher or lower than that of many companies of the same cindustry even if the profits are lower or even negative.
As you can see EV multiples have denominators relevant to all stakeholders, not only shareholders, since the numerator Enterprise Value in itself (Market Cap = Current Share Price * Total Number of Shares Outstanding) concerns both stock and debt holders.
Moreover they are less impactesed by accounting differences, since the denominator is taken higher up on the income statement.
As to EV multiple uses other than M&A, such as transnational comparisons, all of three are useful because it ignores the distorting effects of individual countries' taxation policies.
Multiple valuation, finally, captures the mood of the market, a variable mostly ignored with the DCF method.
Once we have seen all of these feature my preference goes towards since the Enterprice Valuation Multiples compared to DCF mainly since today the uncertainty of the factors considered by the latter method is greater and more pivotal in consideration of the fact it's not tempered by an external and complete analysis like that of the market.
I will be more clear.
The cost of debt, part o the discount rate in DCF method, is linked to the future interest rates, around which the Central Banks are making a severe crackdown for cutting inflation by aiming at causing a recession.
You will see, as a result, how both the interest rates and not only the future Cash Flows are hard to forecast in their timing and extent.
Not to say about the current geopolitical situation (year 2023) that brings about more unpredictability.
That's the reason where the mood (expressing more complete knowledge and more reliable predictive analisys) of the market (Share Price and Market Capitalization) incorporated into the multiples is more reliable than an intrinsic valution as the DCF is.
The changing structure of capital (M&A, spinning off) is another factor to be considered in the future just because of this uncertainty and that's the further reason I now judge EV multiples most good at valuating a company.
If you put into their denominators the company's expected EBIT/EBITDA, that expresses an expected growth rate, my preference becomes even greater.