CHAPTER INTRODUCTION
In this chapter, we will focus on another critical value driver: operating effectiveness. Managers and consultants often debate about their preference for either the word effectiveness or efficiency in this context. While effectiveness is often interpreted as doing things well or selecting the right things to address, efficiency connotes doing things faster and more cheaply. We will use the term effectiveness to encompass both interpretations. Obviously, managers do not want to become highly efficient in an unimportant process or activity. On the other hand, improving efficiency by reducing cycle time, costs, and errors can be a tremendous source of value.
Many observers look to profitability as a key indicator of operating effectiveness. It is a good start, but we recognize that it is possible for a highly inefficient organization to post high profit margins if it possesses a strong competitive advantage leading to pricing strength. In this case, it can pass along high costs arising from its inefficiencies to its customers. This is rarely a sustainable position over the long term, however, since potential competitors are attracted to these opportunities. Additionally, profitability does not directly account for the asset levels required to support a business. Return on invested capital (ROIC) and return on equity (ROE) are considered better overall measures of management effectiveness, since they reflect both profitability and asset effectiveness measures.
There is significant crossover between operating effectiveness and capital effectiveness. While working capital has some independent critical drivers, accounts receivable and inventories are directly related to the effectiveness of the revenue and supply chain processes, respectively. We will discuss these two processes in this chapter and again in more detail in Chapter 17, Capital Management and Cash Flow: Working Capital.
Operating effectiveness has a significant impact on cost and therefore value. Even a highly profitable company recording 15% operating margins is “high cost” since the company incurs costs and expenses equal to 85% of the company's revenue. This represents a tremendous pool of opportunity for value creation. (See Figure 16.1.)
A primary driver of operating effectiveness and profit margins is the effectiveness of business processes. Figure 16.2 identifies critical business processes, including supply chain management, revenue process management, and new product development (NPD), that will impact key financial factors such as costs, revenue levels, working capital requirements, and cash flow.
Typically, a given process will cross several functional areas. For example, new product development may start in marketing with product managers for conceptual definition, then move to research and development for product design. During product development, procurement and manufacturing will begin purchasing materials and developing the manufacturing process for the product. Marketing and sales will become engaged in the promotion and distribution of the product. The effectiveness of this new product development process will impact costs in each of these functional areas. Mistakes made early in the process, in product conceptualization and design, will often have a significant impact on subsequent steps in the process. Further, the process will contribute to sales growth, pricing strength, and working capital requirements. It is typically far more effective to evaluate the performance of a complete process rather than by income statement classification (e.g. SG&A) or function (e.g. sales).
Another critical driver of operational effectiveness is simply a strong focus on execution and cost management. If the CEO, CFO, and other senior managers do not have a focus on operational effectiveness, the organization will drift to follow their other priorities. Even organizations with a history of operational effectiveness can regress quickly when executive leadership shifts emphasis away from this important driver. Managers must achieve a balance between operating effectiveness and other value drivers in order to be successful over the long run.
The specific industry or market served by a company will also impact operational effectiveness. Mature, highly competitive industries such as the automotive industry must relentlessly pursue cost reductions and operational improvements. Other industries, such as aerospace and medical, place a great deal of emphasis on quality due to the nature of the use of their products. Operational effectiveness may be less important for a technology company with products offering significant performance advantages. However, over time, this advantage is likely to dissipate and operational effectiveness is likely to become more important.
Most businesses must anticipate future demand so that products can be ordered or manufactured or human resources can be hired and trained in order to be available for customers at the time of purchase or service. Ineffective forecasting can increase manufacturing costs, including inventory write‐offs, labor, and expediting costs, and can affect quality, customer satisfaction, and working capital levels. However, because forecasting involves an attempt to predict the future, it will always be an imperfect activity. Therefore, in addition to improving the forecasting process, managers should also strive to increase flexibility and response times, for example by reducing lead times. Forecasting future revenue levels was covered in detail in Chapter 15.
We will review selected measures covering several areas, including overall effectiveness, the business model, asset utilization, revenue patterns, key business processes, quality, and functional and people management. For additional background and explanation on the financial statement ratios that follow, please refer to Chapter 2, Fundamentals of Finance.
The following measures represent top‐level indicators of overall operating effectiveness.
Return on Invested Capital (ROIC). ROIC is one of the best overall measures of operating effectiveness since it reflects both profitability and investment levels. ROIC is computed as:
Asset Turnover. This measure reflects the level of investment in all assets, including working capital; property, plant, and equipment; and intangible assets, relative to sales. It reflects each of the individual asset utilization factors discussed in Chapter 2. This measure and underlying drivers are covered in detail in Chapters 17 and 18.
Profitability: Operating Income as a Percentage of Sales. This is a broad measure of operating performance. In addition to operating effectiveness, it will reflect other factors including pricing strength and the level of investments for future growth. Profitability is computed as follows:
Gross Margin Percentage. Gross margin percentage is simply the gross margin as a percentage of total revenues, computed as:
The gross margin percentage will be impacted by several factors and therefore will require comprehensive analysis. The factors affecting gross margin include operating effectiveness and other factors:
R&D Percentage of Sales. Research and development (R&D) as a percentage of sales is computed as follows:
This ratio determines the level of investment in research and development compared to the current period sales. R&D as a percentage of sales ratio will vary significantly from industry to industry and from high‐growth to low‐growth companies. Objective analysis is required to determine if a high R&D percentage of sales is due to ineffective processes or large investments to drive future revenues.
Selling, General, and Administrative (SG&A) Percentage of Sales. Since this measure compares the level of SG&A spending to sales, it provides a view of spending levels in selling and distributing the firms' products and in supporting the administrative aspects of the business. The measure will reflect the method of distribution, process efficiency, and administrative overhead. SG&A will also often include costs associated with initiating or introducing new products. Recall that SG&A percentage of sales is computed as follows:
Sales per Employee. This measure is often used as a high‐level ratio to measure employee productivity. It is computed as:
The problem with sales per employee is that the measure is very dependent on the business model of a company. If a company outsources a substantial part of manufacturing, for example, the revenue per employee may be much higher than it is for a company that is vertically integrated. This makes it difficult to compare performance to other companies or industries. For example, most retail companies have a high ratio of sales per employee since the retailers typically have purchased, not manufactued, all products that are then sold in their stores by employees. Certain manufacturing companies, in contrast, purchase a relatively small level of raw materials and manufacture or transform these materials with substantial labor into finished products, resulting in a lower ratio of sales per employee. Nevertheless, it is useful to look at trends over time and to benchmark performance and business models.
Value Added per Employee. This measure attempts to address the major criticism of the sales per employee measure. Instead of computing the sales per employee, we estimate the value added per employee. Value added would be computed by subtracting purchased labor and materials from sales. The example in Table 16.1 illustrates the difference between the two employee productivity methods.
TABLE 16.1 Sales and Value Added per Employee
Employee Productivity Measures | |
$ 000's | |
Sales | $ 100,000 |
External (Purchased or Contract) Costs | |
Purchased Product | 15,000 |
Purchased Labor | 12,000 |
Outside Processing | 5,000 |
Other | 7,000 |
Total | 39,000 |
Internal Costs | |
Salaries | 30,000 |
Labor | 10,000 |
Rent | 5,000 |
Other | 2,000 |
Total | 47,000 |
Operating Profit | 14,000 |
Employees | 900 |
Sales per Employee | 111 |
Total Value Added (Sales‐External Costs) | 61,000 |
Value Added per Employee | 68 |
In Chapter 3, we discussed the importance of a company's business model, including the composition of costs between fixed and variable and the level of sales required to achieve a breakeven level of profits. A few measures provide insight into the dynamics of the cost structure and breakeven sales levels.
Fixed Costs per Week. In Table 3.14 we estimated the annual level of fixed costs. It can be helpful to compute the weekly (divide by 52) fixed cost level and track it over time. In doing so, the organization will become sensitive to the level of fixed costs and to any changes in the fixed costs levels on a timely basis. The impact of increasing staffing levels or committing to additional space will be reflected in real time in this measure.
Breakeven Sales Levels per Week or Month. Breakeven sales levels can also be easily estimated and tracked on a weekly or monthly basis. This measure translates any changes to the cost model immediately into required increases in sales to break even. It also tends to subliminally influence the organization to level shipments within a given quarter.
In many businesses, there is a substantial fixed cost in factories, stores, or other assets, including people. The extent to which these assets are utilized in a period is a significant driver of breakeven levels and profitability. Until the facility reaches a breakeven level of utilization, these fixed costs will not be covered. Once production exceeds these levels, there is usually a significant increase in profitability, since a substantial part of the costs are fixed and do not increase with production.
Factory Utilization. Depending on the nature of the business, factory utilization may be measured on the basis of labor hours, material or process throughput, or production output. If a factory has resources in place with a capacity to work a certain number of hours, then you can measure the utilization of these resources based on the amount of time spent working on product as a percentage of total available hours. Similarly, it would be critical to understand the capacity, breakeven level, and utilization of a refinery operation on a continuous basis. Actual production levels would be closely monitored since they would be very significant drivers of the operating performance.
Professional Services – People Utilization. A significant driver of revenue and profitability for a professional services firm would be the level of professional staff hours that can be billed to clients. Typically, the total billable hours for a professional would be estimated by taking total available hours for a year (40 hours per week × 52 weeks = 2,080 hours per year), and then subtracting time for holidays, vacations, company meetings, and the like. Partners and managers in these firms may also be expected to spend a significant time in business development and administrative activities. The utilization rate would be computed as follows:
Space Utilization. For businesses that incur significant occupancy costs, measures are often put in place to monitor the utilization of space. These can range from sales per square foot in a retail setting to headcount per square foot for manufacturing and office space. Headcount per square foot can vary significantly between manufacturing, research, office, and other uses. Standards have been developed that allow companies to compare their density levels to other companies.
Headcount Analysis. People‐related costs are typically a significant percentage of total costs. Tracking headcount levels is essential to cost management. Significant changes to the cost model will result from additions or deletions to headcount. Tracking headcount by department over time can provide significant insight into changes in costs. Some companies include the full‐time equivalent (FTE) of part‐time, temporary, or contract employees in the analysis to provide a comprehensive view and to prevent gaming the measure by using resources that may fall outside the employee definition. In addition, tracking open employment requisitions, new hires, and terminations provides a leading indicator of future cost levels. An example of a headcount analysis is presented in Table 16.2.
TABLE 16.2 Headcount Analysis
Increase | ||||||||||
(Decrease) | ||||||||||
Department | Q416 | Q117 | Q217 | Q317 | Q417 | Q118 | Q218 | Q318 | Q418 | Q417‐Q418 |
Operations | ||||||||||
Manufacturing | 125 | 123 | 126 | 135 | 126 | 127 | 125 | 140 | 132 | 6 |
Quality Control | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 0 |
Inspection | 3 | 3 | 3 | 3 | 3 | 3 | 3 | 3 | 3 | 0 |
Procurement | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 0 |
Other | 9 | 9 | 9 | 9 | 9 | 9 | 9 | 9 | 9 | 0 |
Total | 152 | 150 | 153 | 162 | 153 | 154 | 152 | 167 | 159 | 6 |
R&D | ||||||||||
Hardware Engineering | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 0 |
Software Engineering | 17 | 17 | 17 | 17 | 17 | 19 | 23 | 25 | 30 | 13 |
Other | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 0 |
Total | 34 | 34 | 34 | 34 | 34 | 36 | 40 | 42 | 47 | 13 |
SG&A | ||||||||||
Management | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 0 |
Sales | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 0 |
Finance | 11 | 11 | 12 | 12 | 14 | 14 | 14 | 14 | 14 | 0 |
Human Resources | 4 | 4 | 4 | 4 | 4 | 4 | 4 | 4 | 4 | 0 |
Total | 37 | 37 | 38 | 38 | 40 | 40 | 40 | 40 | 40 | 0 |
Company Total | 223 | 221 | 225 | 234 | 227 | 230 | 232 | 249 | 246 | 19 |
Increase (Decrease) | −2 | 4 | 9 | −7 | 3 | 2 | 17 | −3 | ||
Annual | ||||||||||
Open Requisitions | Number | Cost (000's) | ||||||||
Operations | 3 | $ 150 | ||||||||
R&D | 6 | 750 | ||||||||
Finance | 1 | 95 | ||||||||
Human Resources | 1 | 75 | ||||||||
Total | 11 | $1,070 |
Many companies have revenue patterns that are significantly skewed to the end of the quarter or the end of the fiscal year. Revenue patterns impact such areas as receivables, inventories, costs, and risk. Some firms are successful in leveling production and revenue evenly throughout a quarter; others ship as much as 60% or more in the final two weeks of a 13‐week quarter. This latter pattern is often described as a “hockey stick” based on the shape of the curve of weekly shipments shown in Figure 16.3.
This graph is a presentation of revenue patterns within a quarter. The revenue linearity index can be used to track revenue patterns over time, computed as follows:
Revenue patterns can have a significant impact on cost, quality, and risk. Revenue patterns that are skewed to the end of a quarter result in higher costs, since overtime and other costs to match product with demand are likely to be incurred. Quality may suffer as the flurry at the end of a quarter can lead to errors in building, testing, documenting, and shipping product. “Hockey sticks” increase the risk that a problem or event leads to a significant shortfall in revenue for a given period. Revenue patterns also have a significant impact on working capital levels, specifically accounts receivable and inventory. This aspect is addressed in detail in Chapter 17.
Measuring and improving the accuracy of sales forecasts compared to actual demand levels will provide visibility into a key performance driver and serve to establish accountability for sales projections. Inaccurate forecasts lead to operating inefficiencies and higher levels of working capital. The measurements presented in Chapter 15 for measuring revenue forecast accuracy can be easily adapted to other variables including costs, expenses, and profits.
The revenue process covers all activities around a customer order, from the presales activities to order entry, shipping, invoicing, and collections. This process is covered in detail in Chapter 17. A few additional measures that focus on efficiency of the revenue process are covered next.
Cost per Revenue Transaction. What is the total cost to process a revenue transaction, including order processing, shipping and handling, billing, and collections? This measure can be computed by estimating the cost incurred in each department and dividing by the number of transactions. The cost is typically higher than expected and may lead to further analysis to identify process or technology issues. This measure may also lead to the consideration of minimum order levels necessary to cover the cost of transaction processing.
Invoice Error Rate. Invoicing errors can result in a number of problems. They are costly to correct, requiring the issuance of credit memos or additional invoices. They impact customer satisfaction, since customers must also address invoicing errors in their systems. Invoicing errors will delay collection, resulting in higher levels of accounts receivable. They may also go undetected, likely affecting margins and profitability.
Key elements of R&D performance include innovation, cost and time to develop, and impact of design on downstream process activities, for example manufacturing. Measuring R&D effectiveness presents a number of challenges. New product development (NPD) often involves planning for new projects that contain tasks that haven't been performed before. Another challenge is that some engineering professionals resist performance measures in a creative environment. However, there are many aspects of the process that are repeatable and for which feedback on past projects can be extremely useful in planning and managing future projects. In addition, some aspects may be compared to the performance at other companies, for example the time and cost to develop a printed circuit board with certain characteristics.
Key performance indicators (KPIs) for new product development are also discussed in Chapter 15, Revenue and Gross Margins, and include percentage of revenue from new products and projected revenue in the R&D project pipeline. Additional measures that should be considered to evaluate the effectiveness of the new product development process are actual performance versus target development schedule and cost, and target product cost. To measure the broad effectiveness of new product development, other measures should also be considered, including production yields, engineering change notices/orders (ECNs), and warranty costs for new products.
Actual versus Target Development Costs. This measure compares actual costs incurred to the costs estimated for each project. This can be done at the conclusion of the project, but is more useful if it is also examined periodically during the project. Underspending is not necessarily a good thing if it is the result or cause of delays in the development process. This issue can be addressed by combining the cost evaluation with a measure of project progress. This requires disciplined project planning that details key project phases and checkpoints in addition to cost. This type of discipline could result in the analysis shown in Table 16.3.
TABLE 16.3 Critical New Product Development Status
Costs | Status (% completion)1 | ||||||||
Project Name | Actual | Projected | % | Actual | Projected | % | Annual Revenue Potential | Status | Comment |
Coyote | 0.7 | 0.8 | 88% | 95% | 93% | 102% | $25 | Green | On Track, Intro 3/17 |
Fox | 2.8 | 2.5 | 112% | 60% | 80% | 75% | 30 | Yellow | 2 Critical Milestones Missed |
Rabbit | 1.4 | 1.3 | 108% | 40% | 50% | 80% | 15 | Red | Technical Performance Issues |
Tortoise | 1.8 | 2 | 90% | 100% | 100% | 100% | 60 | Green | 1st Shipments, next week |
Total | 6.7 | 6.6 | 102% | 74% | 81% | 89% | $130 |
(1)Based on project milestones planned and achieved
Actual Product Costs versus Target Costs. Even if the product is developed on time and within the development cost estimate, it is unlikely to be a successful project unless the product can be manufactured at a cost approximating the cost target developed in the project proposal. Adopting this measure will help to ensure that the product managers and development team will be attentive to estimating and achieving target costs.
Production Yields on New Products. It is understandable that a new product may incur some problems in the first few production runs. The learning curve and process efficiencies will typically kick in over time. However, if manufacturing incurs large cost overruns, rework, or excessive production variances on new products, it may be an indication of design problems or a failure to design the product for manufacturability.
Engineering Change Notices/Orders (ECNs) on New Products. After a product is designed and released to manufacturing for production, any subsequent changes to the design or manufacture process are initiated by ECNs. ECNs are very expensive in terms of time, rework, and inventory costs. An excessive level of ECNs on new products may indicate process issues or premature release to manufacturing.
Warranty and Return Levels. The new product development (NPD) process has a significant impact on downstream activities in manufacturing and in quality and customer service levels. These measures are typically tracked for other reasons, but should be included in the NPD dashboard, since these measures will be affected by the development process.
Supply chain management is covered in detail in Chapter 17, since it is a critical driver of inventory. Additional measures related directly to operating effectiveness are discussed here.
Cycle Time. A very effective measure of supply chain and inventory management is the amount of time required to produce a unit of inventory. The shorter the cycle time for a product, the less time the product spends in the factory. Reducing cycle times typically leads to lower manufacturing costs, lower inventory balances, and increased flexibility. Cycle time can be estimated by using the days in inventory for the company in total or by looking at days in inventory for specific products or processes. Specific cycle times can be measured by tracking the flow of material through the factory until completion. This detailed method is likely to identify opportunities to reduce the cycle time by exposing bottlenecks and dead time in the process.
First‐Time Production Yield. During most manufacturing or process activities, there are critical steps where the product must be tested for conformity to specifications, including performance, appearance, and other characteristics. Significant costs will be incurred if there is a large percentage of product that must be scrapped or reworked. Measuring the yield rate of products that pass inspection and reviewing the root causes of failures will provide good visibility into critical production processes.
Number of Vendors. There is a significant cost in dealing with vendors. Each buyer can deal with only a certain number of vendors. Contracts must be negotiated. Vendor performance must be assessed. Many companies have reduced procurement and overhead costs and inventory levels by reducing the number of vendors, subject to good business sense on maintaining alternative suppliers.
Number of Unique Parts. The number of unique parts a company carries in inventory is a significant driver of both costs and inventories. Each part number must be ordered, received, stored, and counted. Each part is susceptible to obsolescence and forecasting errors. Companies with a focus on supply chain management attempt to reduce the number of parts. They often start by identifying low‐volume or redundant parts. This may lead to decisions to prune the product line of old or low‐volume products and drive the development team to use common components where possible.
Vendor Performance Assessment. Companies with an effective supply chain management process will monitor vendor performance and typically evaluate performance formally at least once per year. Underperforming vendors may be counseled or terminated in favor of suppliers that consistently meet or exceed pricing, delivery, and quality expectations.
Quality is an important factor in business performance. It will affect costs and expenses, revenues, receivables, inventories, and customer satisfaction. Corporations have focused significant attention on quality over the past 20 years. A few additional measures not covered in other areas are described next.
Cost of Quality (or Cost of Quality Failures). This measure can be a very effective way to estimate the cost of quality issues across the organization. Typical costs that should be considered for inclusion in this measure include:
These costs can be aggregated and used to track the dollar level of quality failures and the cost of quality failures as a percentage of sales:
Defined broadly, the cost of quality failures can easily exceed 10% for many companies. It will typically identify a significant opportunity to address the root cause of these failures and can lead to improved profitability, inventory, receivables, and customer satisfaction.
Error or Defect Rates. We have covered error rates in a number of areas, including invoicing errors and production failures. Many companies have achieved great success with initiatives to measure error rates, including Six Sigma. This program has an objective of decreasing error or failure rates to an extremely low level. Care must be exercised to select and focus on critical activities and processes so that the level of effort in driving to Six Sigma performance will impact important performance drivers.
Many CEOs are often quoted as saying that people are their company's greatest assets and resources. Progressive companies treat these assets well and measure the effectiveness of people‐related processes. Human capital management (HCM) and related measures are more fully explored in Chapter 10, Measuring and Driving What's Important. In addition to KPIs for human capital management, that chapter introduces a “portfolio analysis” of these important assets. Examples of important HCM measures include:
While it is better to look at process measures in general, some measures of functional performance are useful, particularly where an entire process falls within that function. For example, closing the books of the company is primarily an accounting activity. Functional managers should strive to ensure that their organizations are competitive and incorporate best practices in key activities. Consulting firms developed comprehensive benchmarks and best practices for certain functions for this purpose beginning in the 1990s. Many consulting firms and professional and trade associations also conduct and publish benchmark surveys. Examples of measures that can be used to evaluate performance of functional areas are discussed next.
Finance: Budget Cycle. Preparing the annual operating plan or budget can be a time‐consuming and inefficient process in many organizations. The cost and time involved in preparing the budget go well beyond the finance organization, since nearly every function in the organization is involved in the process. The budget cycle can be measured in terms of days, from initial planning through management or board approval.
Financial Closing Cycle. The “closing cycle” can be a time when accounting folks work excessive hours and are unavailable to support the business. The closing cycle begins some time before the end of the accounting period (e.g. quarter end) and ends with the review of financials with the CEO or audit committee. Many organizations have reduced this cycle significantly while maintaining or improving quality by implementing process and technology improvements. This reduces time spent in this activity and provides the management team with critical business information sooner.
Finance: Percentage of Time Spent on Transaction Processing and Compliance Activities. During the 1990s many finance organizations began to measure the percentage of time spent on transaction and compliance versus value‐adding activities such as decision support and financial analysis. The objective was to become more efficient (but not less effective) in the areas of compliance and processing in order to devote more time to business support.
Human Resources (HR): Costs per Employee. How efficient is the human resources (HR) department? What are the costs incurred in recruiting, providing benefits, employee development, and evaluating performance? How do these costs compare to those of other companies in our industry? To best practices companies?
HR: Average Days to Fill Open Positions. This measure captures the speed in filling vacant positions. This is a good productivity measure as long as it is balanced by a measure of hiring effectiveness.
HR: Successful Hire Rate Percentage. While it is important to fill open positions on a timely basis, it is obviously more important to fill the positions with capable people who will be compatible with the organization. This measure tracks the success rate in hiring new employees, including managers. The percentage of new employees retained for certain periods or achieving a performance rating above a certain level will be a good indication of the effectiveness of the recruiting and hiring process.
Information Technology (IT) Costs as a Percentage of Sales. Information technology (IT) has become both a significant asset and a major cost to most businesses. Measures should be used to monitor both effectiveness and efficiency of this critical function. IT costs as a percentage of sales have risen sharply over the past 10 years. Capturing this spending rate and evaluating benefits is a necessity.
IT: Network Uptime. Nearly all business functions are dependent on the reliability of the IT network. Measuring the percentage of time that the network is up and running is an important indicator of service levels and performance.
IT Help Desk: Request Levels and Response Times. How many requests are received by the help desk for application or desktop support? What are the root causes of these requests? They may be due to inadequate training, software problems, user errors, or equipment problems that indicate needed action. How fast and effective are we in responding to help desk requests?
Over time there may be certain specific issues or challenges that warrant special consideration and visibility. These may be due to a dramatic shift in the market or increased regulatory pressure, for example the costs associated with being a public company.
Costs Associated with Being a Public Company. There has always been a focus on the cost of public versus private ownership of a firm. With the enactment of the Sarbanes‐Oxley Act and subsequent attempts to comply with the new requirements implied in the legislation, the cost of compliance has risen significantly. These costs should be captured and be part of an overall evaluation of whether a company should be taken (or remain) public. The costs of being a public company fall into two categories: obvious and subtle.
In addition to the performance measures covering operating effectiveness, two other tools may used to understand costs and business processes: the natural expense code analysis and business process assessment.
While it is generally better to focus on costs and efficiency from a process perspective, another helpful view is what accountants call the “natural” expense accounts. Instead of looking at expenses based on the typical income statement classifications such as R&D or SG&A, we look at the type of spending, for example salaries, wages, and fringe benefits, across the entire company. A top‐level summary of natural expense codes is presented in Table 16.4. Note that it is essentially a roll‐up of information typically presented in a department or cost center report.
TABLE 16.4 Natural Expense Code Analysis
$M | Illustrative | ||||||||
Cost of Sales | |||||||||
Product | Other | R&D | Selling | Marketing | General | Other | Total | % | |
Salaries and Wages | 175.0 | 10.0 | 15.0 | 10.0 | 6.0 | 15.0 | 2.0 | 233.0 | 32% |
Fringe Benefits | 35.0 | 2.0 | 3.0 | 2.0 | 1.2 | 3.0 | 0.4 | 46.6 | 6% |
Travel | 4.0 | 0.5 | 0.8 | 2.0 | 1.5 | 2.0 | 10.8 | 1% | |
Telecommunications | 4.0 | 0.5 | 1.0 | 2.0 | 1.5 | 3.0 | 12.0 | 2% | |
Rent | 15.0 | 1.0 | 1.0 | 1.4 | 0.5 | 0.7 | 19.6 | 3% | |
Depreciation | 15.0 | 1.0 | 3.0 | 2.0 | 3.0 | 4.0 | 28.0 | 4% | |
Purchased Materials | 275.0 | 4.0 | 2.0 | 1.0 | 282.0 | 39% | |||
Purchased Labor | 55.0 | 3.0 | 4.0 | 1.0 | 63.0 | 9% | |||
Consultants | 3.0 | 2.0 | 1.0 | 6.0 | 12.0 | 2% | |||
Other | 4.0 | 1.0 | 3.0 | 2.0 | 4.0 | 3.0 | 1.0 | 18.0 | 2% |
Total | 585.0 | 23.0 | 34.8 | 22.4 | 19.7 | 36.7 | 3.4 | 725.0 | 100% |
This view provides a great way to examine costs. If we are attempting to control or reduce costs, it is important to understand the largest cost categories. The 80/20 rule typically applies here. A small number of expense categories are likely to account for 80% of the total cost. For example, if people and related costs approximate 40% of the total cost base, then these expenses would likely have to be addressed in order to have an impact on total costs. If purchased materials are significant, then we must look at our procurement practices, vendor pricing, and perhaps alternative sources. Can we attack the cost of health care premiums? Can we negotiate better terms with travel vendors to reduce costs? These opportunities do not come into sharp focus if expense analysis is limited to either income statement classification or process view. The results of the natural expense code analysis can then be graphically presented as in Figure 16.4, sorted in descending order to highlight the most significant costs. This analysis is at a summary level. Each of the categories can be broken down into more detail. For example, fringe benefits can be further broken down into medical costs, retirement contributions, and payroll taxes, including Social Security.
Each significant business process can be reviewed to assess the effectiveness and the efficiency of the process. The following critical business processes are likely to have a significant impact on overall business performance, and therefore should be assessed periodically:
Examples of process assessment tools for the revenue process and supply chain management are reviewed in Chapter 17.
Sample dashboards are shown for overall operating effectiveness (Figure 16.5) and new product development (Figure 16.6). The measures selected by an individual company should be based on their specific circumstances and priorities.
Operating effectiveness is a tremendous source of potential shareholder value. Operating effectiveness has an impact on profitability, sales growth, and asset requirements. There are hundreds of potential measures to choose from to measure different aspects of operating effectiveness. Great care must be exercised in selecting the measures that are most appropriate to a firm at a specific point in time. The performance dashboards must reflect key business priorities. The measures should be evaluated periodically and revised to reflect ever‐changing priorities and conditions. It is also critical to provide balance to ensure that a focus on efficiency is not achieved at the expense of quality, customer satisfaction, or growth.