The Potential Destructive Effects of Financial Measures

How is value created from a manufacturing business? This does not seem like a challenging question. Businesses make a profit, have positive cash flow, the stock price goes up, or the business can be sold for more money. Simple, right? Make the financial statements look good, and value is created. This is the natural order of things in business and finance. Or is it?

The real issue is the nature of the value created. Is it long-term sustainable value or short-term capital market value? The nature of the value is the result of the performance management approach. The spectrum ranges from “builders” who treat a business like a living entity and build the business for the long term to “gamers” who only care about ensuring their tenure looks as good as possible by whatever scorecard determines their compensation (and they often leave when they have achieved a reasonable win). A significant element for both types of managers is the nature of the financial performance scorecard used.

 

Consider some popular financial performance measures derived from financial accounting information. Earnings before interest, taxes, depreciation and amortization (EBITDA) focus all attention on earnings growth and costs. The games associated with a focus on EBITDA are incurring expenses in the early years of a manager’s tenure to show earnings growth, not pursuing improvement opportunities that involve expenses such as Lean and Six Sigma, over-production of inventory to ensure no sales are missed (and not recognizing the risk of impairment).

Return on investment/assets/net assets focuses attention on the company’s capital assets; but when this measure is gamed, it results in a lack of investment and capital renewal for the long term, particularly if traditional accounting depreciation measures are used. Measures based on cash flow also often constrain capital investment. A variety of financial “per unit” measures of manufacturing effectiveness are flawed if idle capacity and fixed costs are not properly tracked and analyzed. There may also be considerable non-manufacturing costs, such as specific customer-driven costs, sales and marketing cost, distribution or warranty costs that are not considered when looking at per-unit manufacturing costs.

The common solution for the flaws in all these measures is to use a variety of performance measures to provide some balance. However, the danger, even for builders, is that financial accounting information is defined by a set of man-made rules and definitions. Gamers can exploit some aspects of these rules by manipulating operations, expenses and investments to achieve the rewarded financial outcome. Builders can be misled by the limitations of the accounting information collected to comply with financial reporting requirements. For example, costing systems that still use only direct labor hours to distribute overhead can distort product profitability and result in bad decisions about which products to focus on, outsource or discontinue.

Accountants are primarily trained and educated to follow accounting rules and create compliant financial information. This enables gamers and can result in bad advice to builders. The only antidote to financial measures is to ensure that the decision support information managers use is grounded in reality, not just finance and accounting rules. This means: When advice based on accounting information conflicts with advice from operational information that is grounded in the reality of resources and processes, it must be carefully evaluated and often set aside. In today’s complex and highly competitive world, manufacturing organizations need dedicated costing systems that focus on reflecting operational resources and processes. Advanced costing systems that create financial information to reflect operational models and focus on the principle of causality support builders and are far less enabling to gamers.

>>Larry White, CMA, CFM, CPA, CGFM, lwhite@rcainstitute.org, is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information, connecting operations to business performance.