Understanding the Economics of a Business: Top Down or Bottom Up?
The world's largest, savviest investment firms value a company by looking at the returns it generates above and beyond the cost of capital. Yet many companies still run their businesses based on traditional accounting and operational metrics that don't explicitly consider the cost of capital and assets. Should you follow the lead of sophisticated investors and apply a value-based approach to managing your business? And if so, what's an effective way to do it?
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|You’re doing fine. Why change?
Traditional accounting and operational metrics tell you everything you need to know. The bottom line is your business is growing, and you’re making a healthy profit.
|You don’t know what you don’t know.
Many companies that are growing and profitable could be introducing new products and engaging in business activities that destroy shareholder value. A value-based approach will reveal the truth, so you can focus on activities that generate high returns (and cut back on those that don't).
|The truth hurts.
Value-based analytics may reveal that some of the activities you have been pursuing and actively promoting aren’t actually worth doing. That could be a little embarrassing.
|What have you done lately?
Past performance is fine, but what your boss (and company shareholders) really care about is what you are doing now to create or preserve value. A value-based approach to managing your business can help you generate heroic returns.
|Change starts at the top.
The fastest way to implement a value-based approach – and see tangible results – is to start at the enterprise level, examine the high level drivers of business performance, and then focus value-based analytics in areas with the greatest potential for improvement.
|Bottom up is best.
Implementing value-based analytics at the individual transaction level is the most rigorous approach, delivers results that are the most precise, and creates a new mindset in the company.
Frank Borgsmiller, Principal, Deloitte Consulting LLP
Richard J. Hayes, Principal, Deloitte Consulting LLP
Business leaders often talk about enterprise value. But in our experience very few can actually pinpoint the value contribution of individual business segments, products, and customer groups – making it hard to know where a company should focus its efforts and investments, or if a business unit strategy needs to be refreshed. A big part of the problem is that accounting- and operations-based measures do not always reflect economic reality. For example, reported earnings don’t show returns in excess of the cost of capital, which is the truest measure of value creation.
The ideal way to implement a value-based approach is from the bottom up – establishing processes and systems to quantify the value contribution of individual transactions, and then rolling up the results as needed. This enables you to aggregate the data any way you want -- by region, business unit, product, customer segment, etc. – all with transaction-level precision.
Of course, some companies may not have time for a rigorous, bottom-up approach. They need results – and they need them now. These companies might be better off with a top-down approach that can quickly identify and home in on problem areas with the most potential for immediate improvement. Although the results will likely be less comprehensive and precise than with a bottom-up approach, they could still be a huge leap over what traditional accounting- and operations-based metrics can deliver.
Whether you start at the top or bottom, the destination is the same: using value-based analytics to manage performance at every level of your business. Only then will you truly know which activities are creating or destroying value.
As used in this document, “Deloitte” means Deloitte LLP and its subsidiaries. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.