Describe how value added is calculated. To what extent are value added, cash flow and profit connected to a company’s sales performance? Discuss, using an extended example.
In order to identify how to calculate what value has been added to an organisation it is necessary to understand the factors involved in the calculation and how these can add value to the organisation. The factors that will be discussed are: value added, cash flow and profit and how these are connected to the sales performance of the organisation. The main aim of any organisation is improve its value. The operations of the business should use as few resources as possible so that the business can meet customer requirements effectively and efficiently to minimise loss and maximise profit.
The need to establish a competitive advantage within the market is the main reason for adding value to the organisation. According to Grant (2010: p. 211)
When two or more firms compete within the same market, one firm possesses a competitive advantage over its rival when it earns (or has the potential to earn) a persistently higher rate of profit.
The strategic plan of the organisation will be to identify sources of competitive advantage. Competitive advantage adds value to the organisation; this includes human resources, the product etc. There is a genuine need for the organisation to identify what its competitive advantage is and how it can harness and enhance this. The competitive advantage of the organisation can rest on the value of rare resources which may be available to it. De Wit et al (2010: p. 294) state that
It is not difficult to see that if a firm’s valuable resources are absolutely unique among a set of competing and potentially competing firms, these resources will generate at least a competitive advantage and may have the potential of generating a sustained competitive advantage.
In order to evaluate the role of value added to an organisation, it is necessary to understand how it is calculated. According to Haslam et al (2010: p. 33), there is a framework which establishes:
connections between market conditions, internal operating architecture and financial results. Value added is determined by market conditions and the trajectory upon which the organisation is operating. Market conditions are often variable as between firms within the same economy and sector.
Haslam et al (2010: p. 34) identify Wood’s understanding of value added as differing
fundamentally from sales revenue because it excludes the wealth created by the suppliers of the business. Thus value added is a measure of the net rather than the gross output of a factory, company, industry or even country.
It is necessary to understand the calculations of value added. Cox (1979) describes the process as being a managerial one. Cox (1979) wrote that value added can be described from two separate standpoints – the subtractive and the additive. The subtractive standpoint considers sales less purchases while the additive considers depreciation, the sum of the profits, payroll costs, interest, taxation and dividends. The subtractive standpoint stands for the creation of value added while the additive describes how the created wealth is distributed. Haslam (2010) cites the accounts of Ford as an example of the value added of the organisation and maintains that the value added component of the accounts is the value of the work undertaken by Ford. The use of this calculation as a tool enables an organisation such as Ford to benchmark itself against its competitors. How the calculation is made is up to the organisation but the financial statements require some degree of calculation so that the accounts can be balanced and interpreted.
There are many examples of the subtractive and additive calculations of value added. One such example can be seen in BT Group’s Financial Statement (Appendix 1). In order to determine the value added in the BT Group’s accounts, the subtractive calculation can be used as seen as below. The value added in this case is £2,907 million.
|Year ended 31 March 2011|
|Other operating income|
The organisation’s strategy should include an analysis of the present financial position and the likely position it would be in the future. Before calculations of the value added can be done, there are necessary factors which need to be identified such as competitors, previous key successes and any risk which may affect the organisation in the long term. It is recommended that an accounting analysis be made to expose or obscure any relative strategies to the organisation’s strategy. It is necessary for the organisation to effectively assess the financial statements so that they reflect the business. It would also be appropriate for the statements to be adjusted accordingly when needed. A complete financial analysis is necessary to evaluate the effectiveness of the organisation’s strategy so that the organisation can make sound financial forecasts. The analysis should include an examination of value added, cash flow and the measurements of the organisation’s performance. It is also essential that other factors are taken into consideration such as profit and Economic Value Added (EVA). Haslam et al (2010) noted the importance of other concerns such as shareholder value and how this is created. Haslam et al (2010: p. 40) explain that
Some argue that business analysis and strategic calculation(s) should be geared towards the maintenance of all shareholder interests.
They identify EVA, Market Value Added (MVA) and Total Shareholder Return (TSR) as acceptable ways for an organisation to calculate value added. However, these methods of calculation are geared towards the shareholders and may not give a full picture of the value added for the organisation. For example, EVA is the net profit minus adjusted taxes. According to Haslam et al (2010: p. 40)
The calculation of EVA™ requires that managers deduct from a firm’s net operating profit the ‘true’ charge for the capital it employs.
After this calculation has been done, if the organisation is positive then a shareholder surplus has been created. However, if the result is negative, the shareholder value has been destroyed or damaged. EVA has become one of the main methods used to evaluate shareholder value. Doyle (2000: p. 20) explains that
Creating shareholder value is then essentially about building a sustainable competitive advantage – a reason why customers should consistently prefer to buy from one company rather than others.
Close investigation of the cash flow and profit are other ways of identifying the value added component of an organisation. Cash flow forecasting has become a necessary tool in the assessment of the organisation’s future available cash. It allows the organisation to set aside the necessary investment of capital for the future. However, forecasting is not always accurate and often depends on the economic climate. Discounted Cash Flow (DCF) is the value of the total cash earnings of an organisation which it realises over a period of time. The organisational value is then discounted and geared towards the expected future cash flow of the organisation. The discounted value is dependent on the opportunity of the cost of capital.
An organisation’s profit is carefully cited in its financial reports and statements. As seen in Appendix 1, the profit for the year is £1,631 million. There is a significant difference between this figure and the calculation of value added. However, profit does not always equal the value which is added to an organisation. The profit refers to how much money the organisation made over a certain year. It is necessary for the organisation to define its value added figure. While there are numerous ways to effectively calculate certain figures and percentages, it is essential that the organisation calculate and understand not only the figures which it has in its financial statements, but also those which add value to the organisation.
Appendix 1 – BT Group Financial Statement 2011
|GROUP INCOME STATEMENT|
|Year ended 31 March 2011|
|Other operating income|
|Net finance expense|
|Share of post tax profit of associates and joint ventures|
|Profit on disposal of interest in associate|
|Profit before taxation|
|Profit for the year|
|Equity shareholders of the parent|
|Earnings per share|