Manufacturing company value is complex because there are many stakeholders—owners/investors, employees, customers, communities, society, government, and the environment. However, the initial hurdle is nearly always profitability and an economic return for owners and investors measured by stock price growth. Stock price growth has two primary elements: the company’s profit growth potential and overall economic conditions. Naturally, management focus is on profit growth since the economy is uncontrollable. What metrics should manufacturer’s use to help drive their stock price?
The obvious answer is financial accounting and financial statements created with financial reporting standards. However, financial reporting standards result in “general” financial statements for investors and creditors who cannot demand more specific information. Even though the media publicizes quarterly earnings as a stock price driver, it is widely known that financial statement information on its own is only marginally usable in its original form for predicting long-term capital market value. Sophisticated financial analysts and investors use this information as a starting and confirmation point for much more in-depth analytics. Accounting standards treat many investments that contribute to long-term value as period expenses, such as research and development and brand advertising, and ignore most intangible assets. Today, balance sheet net assets represent only about 15% of the capital market value.
Many companies adjust for the shortcomings of regulated financial statements using tools such as Earned Value Added (EVA), Economic Profit (EP), Return on Total Capital (ROTC), and similar analytics that have better track records for predicting stock price growth. They adjust R&D, advertising expenses, capital investments, and other non-capitalized investments to treat them as value creating investments over an appropriate time. These analytics reconfigure financial statement categories, incorporate a capital charge, and provide estimates of the impact on the future market value of the company. In short, they modify traditional financial statements to better reflect economic reality and value creation capability. Companies that sell major capital improvements such as digital manufacturing equipment, systems, and software often use these analytics to show the return to companies of making these investments.
Another critical challenge is to create information and metrics throughout the company that ensure all managers and employees are looking for solutions and improvements and making decisions that will drive long-term financial performance. Techniques such as EVA, EP, and ROTC are usually applied at the entity level and do not readily translate deeper in the organization. For example, EVA may show that a company’s R&D spending is lagging compared to a group of similar companies and that investing more in R&D would likely create a positive stock return, but EVA cannot identify the resources and work activities included in a company’s R&D or the causal impact on process, products, and customers R&D supports. The solution is to use an advanced managerial costing approach that creates operational and cost information that improves internal decision support, shows causal relationships clearly, and better reflects the economic reality of decisions.
Advanced managerial costing models include approaches like Resource Consumption Accounting (RCA), “pull” oriented Activity Based Costing (ABC), and other approaches that comprehensively apply the principles of the Institute of Management Accounting’s Conceptual Framework for Managerial Costing. These approaches provide clear, decision-oriented insight into processes, resource quantities, and monetary metrics. They operate free from financial statement standards to create information that reflects the causal relationships of resources and processes on products/services and customers. Information from these models looks like the resources and process in your company. For example, RCA clearly shows capacity information, the fixed and proportional amounts of resources used, and the monetary implications providing clear visibility of incremental and marginal cost. Not limited by accounting rules, RCA models can include any resource’s cost with a causal relationship to product/service or customer cost. Items such as sales commissions, collection cost for receivables, R&D expense, or amortization can be included in product cost or customer cost if they have a strong causal relationship. Additionally, RCA eliminates weak or non-causal allocations of overhead, assigning resources and costs based on strong causal relationships.
Companies need a more economically relevant view of their performance than routine financial statement-oriented accounting systems can provide. This is important for executive management and boards of directors, but also throughout the entire organization to ensure they make all decisions with long-term value creation in mind, not distorting, short-term financial statement metrics.
Larry White, CMA, CFM, CPA, CGFM, [email protected], is Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org) which trains and advocates for improved cost information connecting operations to business performance.