We are all familiar with the many IT mega trends of today: Cloud, Social, Mobile, Big Data, the Internet of Things, etc. The common theme is clear; the role of Information Technology (IT) in the turbulent, digital economy has become absolutely critical in helping organizations respond and adapt to these mega trends.
No matter how dramatic the shifts in digital economy are, an essential requirement that has not diminished or changed is the crucial importance of creating shareholder value.
In today’s connected, global economy, boards and managers increasingly recognize that their primary responsibility is to maximize the total wealth-creating potential of the enterprises under their direction.
For today’s senior executives, finding the answers to the following three questions is still critical:
Even more fundamentally, answers cannot be had without first understanding the following topics:
The fundamental economic principle for creating shareholder value, or shareholder wealth, is for businesses to earn a profit that is greater than the cost of capital. This measure of profit, first described by the British economist Alfred Marshall 250 years ago, is called Economic Profit (EP) or Economic Value Added (EVA©). EP, sometimes called Residual Income, has been known to accountants for decades. EVA is also a standard part of MBA curriculum in most business schools. EP or EVA is a measure of shareholder value that has been adopted by thousands of companies globally.
The EVA framework uses a practical application of well-established corporate finance tenets. The two most important are:
EVA profit is measured by deducting the full cost of debt and equity capital from net operating profit after taxes (NOPAT).
EVA = Net Operating Profit after Tax - A Capital Charge EVA = NOPAT - Cost of Capital x Total Capital
Creating wealth requires that managers grow sales and manage costs. However, they must also effectively manage the capital provided by investors and lenders in order to create wealth.
Calculating company EVA shows whether shareholder value is being created. In order to de-construct the sources of economic value within the company, the economic value contribution of business units, customers and products need to be calculated as shown in the diagram below. Finally, the value contribution of IT services is revealed by tracing these services to the value drivers that impact products and customers.
Unpacking the definition of EVA, the Financial Value Drivers are revealed as:
Measuring IT’s impact on shareholder value is aided by a visual map showing the value drivers that create it.
Using Discounted Cash Flow
The economic value of the firm is simply the sum of the economic value of all the business units and initiatives undertaken by the firm. The best single measure of economic value is the present discounted value of cash flows; or Net Present Value (NPV). The process for calculating the NPV of an IT initiative is diagramed below:
Although there are many methods for mapping IT programs and initiatives to the financial Value Drivers of a company, the two most effective are Activity-Based Management and the Cranfield Business Dependency Network.
Activity-based management (ABM)
ABM is a method of identifying and evaluating activities that a business performs using activity-based costing to carry out a value chain analysis or a re-engineering initiative to improve strategic and operational decisions in an organization. Activity-based costing establishes relationships between overhead costs and activities so that overhead costs can be more precisely traced to products, services, or customer segments. Activity-based management focuses on managing activities to reduce costs and improve process productivity. Acorn Systems, an activity based costing software company, has combined ABC and EVA to calculate the Economic Value Contribution of customers. (1)
Benefits Dependency Network (BDN)
The Cranfield University in England has developed a Benefits Management program for delivering value from investments in business projects and change programs. The Benefits Dependency Network (BDN) is part of a convincing and robust business case. The business case must be aligned to the business drivers of an organization. The means of collecting the information may come in a highly structured process involving many workshops, discovery sessions, and interviews; or management might be able to quickly identify the business benefits or might even have them already documented. The goal is to ensure that the proposed investment is tied to real drivers for the organization. The BDN becomes the communication tool to ensure that management understands, and more importantly, agrees with the relationship between the proposed changes, the benefits, and their objectives and drivers.
The use of the BDN will help to facilitate the necessary discussion to answer the following questions, identified by Cranfield research as critical to the successful development of an effective business case:
Aligning IT initiatives with business goals and objectives is critical. The number one goal of any for profit organization is to improve shareholder value. Consequently, it is essential that technology executives demonstrate to their fellow executives and shareholders how the value of IT is measurable and traceable to shareholder value.
(1)Houston, TX, May 17, 2004-Stern Stewart, pioneer of its proprietary EVA® framework and Acorn Systems, the leader in profit and cost analytics, have partnered to deliver Customer Value Analytics (CVA), a solution that enables companies to measure and identify opportunities to increase the Economic Profit of their customers.
“Acorn Systems’ Consumption-Driven Costing is the most advanced and scalable profitability analytics package in the market today,” said G. Bennet Stewart III, Senior Partner, Stern Stewart. “With CVA companies can now accurately measure the economic profit of individual customers and customer segments and identify actions they can take to grow their most profitable customer base and to increase the profitability of underperforming customers.”