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.
3 Critical Questions for Executives
For today’s senior executives, finding the answers to the following three questions is still critical:
- Are managers creating or destroying wealth with IT investments?
- How are managers creating or destroying wealth with these investments?
- How can managers increase wealth creation of future IT investments?
Even more fundamentally, answers cannot be had without first understanding the following topics:
- How is wealth created?
- What are the financial value drivers of wealth creation?
- What do EVA and value drivers look like for several companies in one industry?
- How do you map IT initiatives to value drivers?
- How do you calculate the economic value of IT initiatives?
How is Wealth Created?
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:
- Economic Profit is a better measure of wealth creation than Accounting Profit
- Net Present Value is the rule that maximizes Shareholder Wealth
EVA profit is measured by deducting the full cost of debt and equity capital from net operating profit after taxes (NOPAT).
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.
Revealing the Sources of Value Inside the Company
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.
The Value Drivers Framework
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.
Calculating the Economic Value of IT Initiatives
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:
Mapping IT Initiatives to Value Drivers
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:
- Why do we have to improve?
- What improvements are necessary or possible? These have to be agreed to by the key stakeholders and become investment objectives.
- What benefits will be realized by each stakeholder if the organizational objectives are achieved? How can each benefit be measured?
- Who owns each of the benefits and will be accountable for its delivery? The benefit owner will be responsible for the value assigned to the benefit in the business case.
- What changes are needed to achieve each benefit? This is the key to realizing benefits through identifying explicit links between each benefits and required changes.
- Who will be responsible for ensuring that each change is made successfully?
- How and when can the changes be made? This requires an assessment of the organization’s and specific stakeholder group’s abilities and capacities to make the changes.
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.”