1.

1 Understanding Corporate Performance

In this first section we provide a brief introduction of the value added accounting framework, which can be used for business analysis and indexing corporate health, with the ultimate goal of providing a detailed understanding of the financial performance of a firm.

Learning Objective After you have completed this section, you will be able to: y Distinguish between the economists' and accountants' use of the value added calculation

Calculation of value added

Central to the value added accounting framework is the calculation of value added. This calculation, or indeed the concept of value added, is not new: it is a calculation that is familiar to both economists and accountants.

Economists' use of value added

The economist will employ the calculation of value added to produce Gross Domestic Product (GDP) data for the national economy and also use value added as a measure of firm net output. Renshall et al note that: 'The concept [of value added] is by no means new or original. It was first employed by economists in the late-eighteenth century as a means of measuring the net output of firms and data on this basis has been collected in the British census of production since 1907.' Source: Renshall, M. et al. (1979) Added value and External Reporting, Institute of Chartered Accountants in England and Wales, London, p. 1.

Accountants' use of value added

We are less concerned here with the economist's preoccupation to measure national output and firm level productivity. Instead, we are concerned with how accounting numbers from a set of company accounts can be re-presented into a value added accounting framework and why this re-presentation of conventional published financial information makes visible a more detailed understanding of firm level financial performance.

Value added accounting framework

We use this accounting framework of analysis to establish connections between market conditions, internal operating architecture and financial results in relation to capital employed. y Market conditions are often variable between firms within the same economy and sector. The absolute level of value added generated by a business is determined by the gross revenue trajectory of growth that an organisation can sustain, which is itself a complex relationship between: product portfolio; volume growth; and price structures. The internal operating architecture of a firm is best described as a series of ratios that show how sales revenue is netted off to cover internal operating costs. Purchases received from suppliers of external products or services are netted off the gross sales to obtain the value added. The ratio of purchases to sales is also variable between firms. Deducting labour costs from value added derives the cash from operations. Financial performance such as profit earned per unit of sales is the combined result of the variable relation between market conditions and internal operating ratios. Return on capital employed (ROCE) is an important financial performance indicator and it, too, results from the variable relation between market conditions, internal operating ratios and the capitalisation of the balance sheet.

Activity 1.1.1
Let us pause for a moment to consolidate our understanding of the value added accounting framework. y Briefly explain the meaning of the term 'internal operating architecture of a firm'.

You can use your notebook to record your answer before moving on. You may also find it useful to go online to compare your answers with others on your course.

1.2 What is Value Added?

In the previous section we learnt about the importance of the value added accounting framework in providing a detailed understanding of corporate performance. Central to the value added accounting framework is the concept of value added. This section addresses the question 'what is value added?' by reviewing some of the seminal academic work on the subject.

Learning Objective After you have completed this section, you will be able to: y Define the concept of value added

Value added and wealth creation

Bernard Cox in his text appropriately titled Value Added notes in the first few introductory lines of the text: 'What on earth can be the significance of: sales - purchases = value added'. He goes on to observe that the calculation of value added is: 'The wealth the reporting entity has been able to create by its own and its employees' efforts' Source: Cox, B. (1979) Value Added, Heinemann: London, p. 1. This understanding of the importance of value added and what it represents is taken up later by Wood who observes that value added is a measure of wealth created by a business or an activity. It is the measure of wealth created by the business because it deducts from gross output or revenue expenditure on purchases from other businesses leaving a net figure of wealth or income: 'It differs fundamentally from sales revenue because it excludes the wealth created by the suppliers of the businesses. Thus value added is a measure of the net rather than the gross output of a factory, company, industry, or even country'. Source: Wood, E. G. (1978) Value Added: The Key to Prosperity, Basic Books: London, p. 1. Bernard Cox was concerned with the idea that businesses should produce a value added report. Today some companies still produce such a report, for example BMW, but this is an exception because firms generally produce a profit and loss account, cash or funds flow statement, movements in equity and a balance sheet. Cox argued for the use of the value added statement because it would make visible the proportion of business net income or value added that was available for distribution to employees and other stakeholders.

Value added as an objective

There is also another issue arising out of the academic debate on value added. At the operational level, Cox notes: 'Once a manager starts using value added ratios he is on the way to using value added in a more positive way in his day-to-day running of the business.' Source: Cox (1979) op.cit. p. 7. Value added accounting therefore becomes not just a static presentation of financial information but is, like profit, a managerial objective. Gilchrist goes so far as to say: 'To maximise Profit we need to maximise Added Value.' Managing for value added should be an important business objective and one which managers should bear in mind all of the time. Gilchrist notes that:

'The creation of Added Value is an objective which ought constantly to be in the minds of company executives. Whenever decisions are made, the acid test of their effectiveness will be whether they have resulted in an improvement in the Value Added per unit of resource input' Source: Gilchrist, R. R. (1971) Managing for Profit: The Added Value Concept, George Allen: London, p.12. Value added represents firm level net income of wealth creation and it should be an objective of management decision making. We could add to this the idea that value added should be the objective of strategic business decision making and strategic thinking. Common to all of the academic work on value added is the understanding that value added represents the difference in income received from the firm's product market minus what the firm itself pays out as purchases. Gilchrist is particularly concerned with management resource use so that what the firm generates as value added is able to cover internal costs and generate a surplus.

Value added and benchmarking

Value added ratios are a useful way of comparing one business against another to observe differences in performance and so a possibility exists for benchmarking differences. Cox notes that it is possible to compare a company with its industry. The value-added calculation is a useful tool for benchmarking firm against firm or firm(s) against industry averages. Gray and Maunders further emphasise the use of the value added accounting statement to examine the various stakeholder claims on the business. 'There are three major beneficiaries in the terms of distribution or sharing out of value added i.e. employees, government, and providers of capital (lenders and shareholders)'. Source: Gray, S. and Maunders, K. (1980) Value Added Reporting: Uses and Measurement, Association of Certified Accountants: London, p.8

Activity 1.2.1
Before moving on to the next section, have a go at answering the following question to ensure that you have fully understood the concept of value added. y Explain what we mean by the term 'value added'.

You can use your notebook to record your answer before moving on. You may also find it useful to go online to compare your answers with others on your course.

1.3 The Calculation of Value Added

Having defined what value added is in the previous section, this section describes two methods used to calculate value added. It goes on to explore the variable relationship between revenue, purchase costs, value added and its distribution, and profit retention in relation to capital employed.

Learning Objective After you have completed this section, you will be able to: y Describe the two methods for calculating value added; identify the relationship between revenue, costs, value added and its distribution, and profit retention in relation to capital employed

Calculating value added

The calculation of value added is outlined by Bernard Cox in his text Value Added. In this management accounting text Cox describes the various managerial applications of the value added accounting calculation. He illustrates how a set of consolidated annual reports and accounts can be used to calculate value added and observes that: 'Value added can be thought of from two stand-points: the subtractive, which is sales less purchases, and the additive, which is the sum of profits, depreciation, interest, payroll costs, dividends and taxation. The subtractive viewpoint represents the creation of value added, while the additive is the way in which wealth created is distributed' Source: Cox (1979), op. cit. page 34.

Subtractive model
Pigou[1] declares that the pig farmer should not consider the income of his business as being that which arises from selling his pigs but the income left after he has paid for food and supplies and equipment used to farm the pigs. Likewise Cox notes that you must first start by deducting the cost of all purchased input supplies and services in order to derive the income and wealth that is available for running your own business. 1. Pigou, A. C. (1920) The Economics of Welfare, Macmillan: London. Cox illustrates the link between company level value added and national accounting for value added. This is illustrated in Figure 1. First start with the revenue and deduct the cost of supplies. This leaves the value added which is available then to cover wages, profits and capital employed. The value added as a percentage of sales income is therefore a value retention ratio representing the value to the business out of sales revenue or gross output.

Figure 1. The constituents of value added. Source: Haslam, C. et al. (2000) Economics in a Business Context, Chapman and Hall: London, p.35. The calculation of value added described above is a subtractive approach. In this way value added is calculated by deducting all expenses relating to the supply of materials and services from the total sales revenue for a given year. However, there is a practical problem with this particular approach. This can be understood when we consider the conventional presentation of a company's annual report and accounts. We have already argued that the conventional report and accounts do not in general present a valueadded statement and in addition they do not generally disclose total purchase costs from external suppliers. We therefore have to approach the calculation of value added from what Cox describes as the additive method.

Additive model
This calculation starts by adding labour costs, including social costs (pensions and social charges), to depreciation and profit before interest and tax. To illustrate the calculation we have chosen to use information from Sainsbury's accounts (Table 1.3.1). Figures (in millions) 2003 2002 Sales Revenue 18,495 18,206 Minus : Purchase of materials and services 15,515 15,311 Value Added 2,980 2,895 % Share in Value Added ( ) Labour costs including social charges 1,913 (64%) 1,910 (66%) Depreciation 393 (13%) 358 (12%) Operating Profit 684 (23%) 627 (22%) Value Added Cash in sales 5.8% 5.4% Table 1.3.1. Sainsbury's Consolidated Value Added Statement 2002 and 2003. Source: Sainsbury's Consolidated Accounts, various years. Figures in brackets are the share of costs in value added.

We start by adding together labour costs (total employee compensation including social costs), then adding them to the depreciation and operating profit, before tax and net of interest charges, to obtain the value added. Subtracting the value added from the sales income allows us to approximate the value of total purchases coming into the business. In this particular company roughly 84 per cent of total sales revenue is paid out to suppliers of food and clothing that are sold on from the superstores. The amount left over after these payments are made is the value added generated from operations. Value added therefore represents the value of work undertaken by Sainsbury's in its own organisation as a percentage of total market sales. Value added as a percentage of sales revenue represents the value added retention rate out of sales revenue. In Sainsbury's the value left over to cover internal costs is a small fraction of total income. Any reduction of value added retention in sales rubs up against the need to cover internal costs. The most important internal cost in value added is that relating to labour costs. Bernard Cox typically observes that labour costs account for 70 per cent of the distribution of internal value added and in Sainsbury's 6466 per cent. According to Cox: 'payrolls normally account for a large proportion of value added the average is about 70 per cent in UK manufacturing industries' Source: Cox (1979), op. cit. p. 70.

Relationship between market conditions, operating architecture and financial results

The above example serves to illustrate connections: y The first of these relates to the connection between gross revenue and value added retention. As the level of gross revenue declines, so also will the level of value added retained in the business, unless the firm can reduce purchase costs in income at a faster rate than the fall in income. The second relationship is that between value added and internal labour costs. This connection arises because where the level of value retained falls we would also expect firms to make adjustments to their labour costs by reducing employment or wages.

The value added calculation therefore deducts externally determined costs for the purchase of materials and services, and what remains (i.e. the value added) is a financial fund applied to cover internal costs. The value added statement makes visible a series of relationships that are invisible when we look at a conventional set of annual reports and accounts. The relationship between sales and purchases is important for our understanding of the value added retention rate in sales. The relationship between value added and labour costs reveals the importance of labour costs in value added. Variably, the level of purchases made out of sales revenue and the labour costs incurred against value added impact on the residual that is left, which is cash from operations or the gross operating surplus (GOS).

Activity 1.3.1
Let us take a moment to recap on the methods of calculating value added that we have learnt. Have a go at the following question: y Write brief notes on the two methods used to calculate value added.

1.4 Source of Funds or Cash Flow Statement

In the previous section, we learnt that the residual left after purchases and labour costs have been subtracted from the value added is, in economics, technically termed the gross operating surplus (GOS). We now move on to look at how we can reconcile this residual by analysing a company's source of funds statement (also known as the cash flow statement or source and application of funds statement).

Learning Objective After you have completed this section, you will be able to: y Reconcile the gross operating surplus with the source of funds statement; explain how the value added accounting framework can be used to identify cash generative businesses

Reconciliation with the source of funds statement

A set of annual reports and accounts will normally produce a source of funds or cash flow statement, the format of which varies nationally and internationally but normally contains the key financial information set out in Table 1.4.1. Gross operating surplus can be used as a proxy for the cash generated from operations (i.e. net income, which is equivalent to depreciation plus operating profit). It is important to be aware that we are not looking here at total cash generated by the business, because there are also external sources of cash funds: firms will obtain cash funds from finance markets through: new share issues; short- and long-term debt; and the manipulation of their working capital (i.e. debtors, creditors, and stocks held). $ X (Positive or negative) X X (Positive or negative) X (Positive or negative) X (Positive or negative)

Net income/Loss for Year Depreciation + Amortisation Working Capital Adjustments Increase/Decrease in Inventory Increase/Decrease Accounts Receivable Increase/Decrease in Accounts Payable

Cash Flows from Operations

Y (Positive or negative)

Table 1.4.1. Example source of funds or cash flow statement.

Cash flow from internal operations

The cash figure after deducting labour costs in value added is more or less equivalent to the cash flow from internal operations (i.e. net income/loss for the year plus depreciation). It is an important residual because where firms are struggling to generate increased cash from operations (or cash as a percentage of sales falls off) they often resort to either external financing or a reduction in commitments against cash (for example capital expenditure). Firms that struggle to maintain their cash and liquidity are vulnerable to losing their credit rating from Corporate Debt Rating Systems (such as S&P or Moody's) and this will inevitably push up the cost of external borrowing, further depressing profits as interest charges increase.

Operating profit (before interest and tax)

Our next deduction from the value added is that for depreciation, which is a non-cash charge but residually leaves the figure of operating profit or profit before interest and the value for return on sales (profit before interest and tax divided into sales) and earnings after interest and tax on sales are the income measures used to generate shareholder information such as dividend yield and earnings yield. In this way we have reformatted the conventional annual report and accounts in a way that makes visible: y y the percolation of revenue into expense, both external and internal to the business; and, how much is deducted at each stage from revenue to cover purchases, labour costs, depreciation, interest charges, tax and dividends.

Gilchrist notes: 'Those who have studied the basic principles leading to the analysis of company income and output may find it strange that the conventional marginal profit and loss layout does not indicate clearly and objectively the net income of the company. For that matter, neither does the conventional profit and loss layout, with its allowance for opening and closing stock valuations. Surely the single most important piece of information which the top management of a company must know is its net income?' Source: Gilchrist (1971) op.cit, page 50.

High and low cash generative businesses

Thus, the value added accounting framework makes visible the internal operating ratios of firms as well as showing how revenue percolates through the firm. Table 1.4.2 presents typical operating ratios for different industry sectors to demonstrate how these ratios can be used to identify high and low cash generative businesses. Labour's Internally Generated Purchases to Share of Cash as a Sales Ratio % Value Added Percentage of Sales 25 30 30 40 60 55 53.0 42.0 26.80 9.00

Activity High Cash Generative High Cash Generative High Cash Generative Low Cash Generative

Water Utilities
Pharmaceuticals

Telecommunications 33 Grocery Retailing 80

Table 1.4.2. High and Low Cash Generative Businesses. Source: Annual Company Accounts.

Variability between firms in different sectors

The first deduction is that the purchases to sales ratio is variable between firms in different sectors. So, in pharmaceuticals the purchases to sales ratio is around 30 per cent but for grocery retailers like WalMart, Tesco or Aldi the purchase to sales ratio can be as high as 80 per cent. In the case of grocery retailers the retention rate of value added from sales income is low, just as it is for Japanese car producers like Toyota who retain as little as 15 per cent of sales income as value added for internal costs.

Cash generative business

A strong cash generative business (as in the case of water utilities and pharmaceuticals) is one that combines a low purchase to sales ratio with a low labour share of value added : y y a low purchase to sales ratio results in a high retention of value added for distribution within the business; and, a low labour share of value added leaves a high residuum of cash per unit of value added and sales revenue.

A value added accounting framework applied in this way allows us to classify businesses as being strongly or weakly cash generative in relation to sales income. It is generally understood that grocery food retailers have a high purchase to sales ratio because these shops buy in grocery foodstuffs that are stacked high on the shelves. Much of the value added is located within the manufacturing and food processing supply chain. A purchase to sales ratio of over 80 per cent is common in many grocery retailers

and so this leaves just 20 per cent of sales revenue retained within the supermarket retailer as value added. From the value added as much as 50 per cent of the value added could be appropriated to wages and salaries leaving just 10 per cent of sales revenue as cash. In contrast, 1.5

Analysing Business Accounts

In this final section we use company accounts to apply the theory presented in the previous sections. Specifically, we restructure the information contained in a set of annual reports and accounts for two companies operating in the same industry and present value added and internal operating ratio for each company (thus allowing the benchmarking of performance between the two firms).

Learning Objective After you have completed this section, you will be able to: y Use company accounts to calculate value added and internal operating ratios

Introduction
In this section, we present value added and internal operating ratios and compare the performance of two companies: y Molex Inc. An American company that manufactures connector devices that fit into electrical goods and computers. These devices connect up internal circuitry or connect the equipment up to external power supply or networks. It is the case that with many US companies we cannot obtain labour costs from the annual report and accounts. Accordingly, we have obtained labour costs from the company direct. Our comparison company is the UK firm Volex, which (although not related to Molex) also manufactures connector devices.

Calculating value added and the operating ratios

Table 1.5.1 presents a comparison of the internal operating ratios for Molex Inc and Volex plc between 1996 and 2003. These ratios are based on the following calculation methods:

Value Added Calculation. To calculate the value added, we add together labour costs (including all social costs and pensions) and depreciation and operating profit (before interest and tax).

[Labour costs + Depreciation + Operating profit before interest and tax] y Value Added to Sales (%). To calculate the value added as a percentage of sales, we divide value added into sales and multiply by 100 to get a percentage.

[Value added / Sales] x 100 y Purchases to Sales (%). To calculate purchases as a percentage of sales, we subtract from sales income the value added to estimate the external purchase costs. We then divide purchases into sales and multiply by 100 to get a percentage of purchases in sales.

[Sales - Value Added] / Sales x 100 y Labour's Share of Internal Costs (or value added) (%). We divide labour costs into value added and multiple by 100 to obtain labour's share of internal value added costs.

[Labour costs / Value Added] x 100 y Cash-to-Sales (%). We add together depreciation and operating income (before tax and interest charges) and divide this into sales and multiply by 100.

[Depreciation plus operating profit before interest and tax] / Sales x 100 y Return on Sales (%). We divide operating income (before interest and tax) into sales and multiply by 100.

[Operating profit before tax and interest / Sales] x 100 Value Purchases to Added in Sales Sales Molex Volex Year % % 1996 50.4 62.0 1997 48.7 61.6 1998 47.5 60.7 1999 49.1 61.3 Labour's Share of Value Added Molex % 49.6 51.3 52.5 50.9 Cash as % of Sales Volex Molex Volex Molex Volex % % % % % 38.0 49.8 72.3 24.3 10.5 38.4 50.9 71.8 25.4 10.8 39.3 52.3 70.9 27.5 11.4 38.7 47.5 70.6 23.6 11.4

2000 2001 2002 2003

49.6 54.5 55.2 54.5

65.2 66.9 67.0 73.9

50.4 45.5 44.8 45.5

34.8 33.1 33.0 26.1

50.1 53.8 57.7 60.0

70.3 69.5 93.3 103.7

24.3 10.3 21.0 10.1 18.9 2.2 18.3 -1.0

Table 1.5.1. Molex Inc and Volex plc compared. Source: Annual Reports and Accounts, Molex Inc and Volex plc.

Interpreting and benchmarking company performance

Value added as a percentage of sales
The first operating ratio presented in Table 1.5.1 is value added as a percentage of sales. This calculation shows how much of total sales revenue is retained with the business for internal costs. In our case example, Molex retains around 50 per cent of total income as value added within the business and this may be explained by the fact that Molex is more vertically integrated than Volex, undertaking more of the manufacturing value chain in its own operations. It may also be the case that Molex is producing products that are selling at a premium mark-up because patents and monopoly-type conditions apply to certain components sold in its product range.

Purchases as a percentage of sales

Volex by way of contrast is a UK company and tends to buy in up to 70 per cent of total sales revenue as purchases and in the last few years looks as though it has been increasing its outsourcing and becoming less vertically integrated. Alternatively, product margins may be being squeezed. We can already observe that, in terms of value added retention, Molex retains some 50 per cent of sales income as value added compared to Volex plc.

Labour's share of value added

Turning now to how internal costs (value added) is distributed to labour, we observe that for Volex plc a steady 70 per cent of value added is distributed to cover internal labour costs for most of the period. This is not far off the percentage quoted by Bernard Cox. In contrast, Molex distributes a consistent 50 per cent of value added for most of the period to cover labour costs. So not only does Molex retain more value added in sales than Volex it also distributes 20 per cent less value to its employees.

Cash as % of sales
As more value added is retained in Molex and less distributed to labour so Molex generates two and a half times as much cash for every unit of sales than Volex plc.

Volex cash-to-sales is 10 per cent on average over most of the period compared to Molex's ability to generate 25 per cent of cash from every unit of sales income over most of the period.

Percolation of income
We can describe the operating ratios (or architecture) of the business as if revenues percolate down through the business and are siphoned off at each stage. This percolation of income for the two companies can be seen in Table 1.5.2, and in the case of Molex a larger share of revenue has been retained as cash. Data on return on sales for the two companies is presented in Table 1.5.3. Volex Molex 33 50 67 50 70 50 10 25

Value added to Sales % Purchases to Sales % Labour's Share of Value Added % Cash in Sales %

Table 1.5.2. Percolation of Income (Molex and Volex plc). Source: Annual Report and Accounts Molex Inc and Volex plc. Volex ROS Molex 1994 7.0 16.2 1995 7.4 17.2 1996 7.7 16.6 1997 8.3 16.4 1998 9.0 16.2 1999 8.9 12.2 2000 8.1 14.2 2001 8.2 11.8 2002 -0.9 5.9 2003 -3.9 5.9 Table 1.5.3. Return on Sales for the Two Companies. Source: Annual Reports and Accounts, Molex Inc and Volex plc.

The importance of cash flow

We should at this point note the importance of cash flow generation in sales. Cash flow is the life blood of an organisation and is often used to establish a firm's credit rating (e.g. Moody's and Standard and Poor's Corporate Debt Rating Systems). The stronger the cash generation of the business the greater the chance that the firm can cover the tax, interest costs and dividends and retain sufficient cash from operations to manage working capital and fixed capital investment. Firms that generate less cash in sales are

therefore often restricted in terms of their ability to increase dividends as a percentage of sales and, after servicing external costs, are at a disadvantage in terms of their capital replacement rates. If we consider the operating ratios of grocery retail, the very high purchase cost in sales (85 per cent) ensures that the retention of value added in sales is 15 per cent or less. Even if labour's share of internal costs is just 50 per cent, cash generation in sales is at best 8 per cent. These firms generate limited cash from total income and as such find it difficult to expand from their own fund and also external funding is restricted when retail firms have little cash to cover interest and dividends associated with external financing. Expanding the business using external funding is also restricted when the interest charge against cash will further restrict funds available for dividend distribution and reinvestment. Firms with such tight operating ratios and cash generation need to tread carefully and strategic moves are limited and constrained. Contrast this with pharmaceutical companies that buy-in 30 per cent of sales as purchased inputs and retain anywhere up to 60-70 per cent as value added distributing some 40 per cent to their employees. So cash generated in sales is more than 30 per cent. These firms can afford to be generous in terms of their distribution of cash as dividends and also sustain a higher level of debt financing (interest costs) and reinvestment in the business, taking strategic gambles that their grocery retailer cannot.

Activity 1.5.1
Now it's your turn! Have a look at the five year financial summary for Caterpillar Inc in figure 2 and have a go at the question that follows. Figure 2. Caterpillar Inc. Five-year Financial Summary. For each of the years 1999 to 2003, calculate the following for Caterpillar Inc.: y y y y y y Value added (in $ million) Value added as a percentage of total income (sales and revenues) Percentage of purchases in total income (calculated as 100 minus the share of value added in income) Labour's share of (i.e. percentage of costs in) value added Cash in Income (i.e. percentage of cash to sales) Profit in Income (i.e. return on sales percentage)

utilities, like water companies, tend to have a low purchase to sales ratio and also a low labour share of value added, which generates strong cash generative businesses. Similarly, pharmaceutical companies have a low purchase to sales ratio and relatively low labour share of value added and are also highly cash generative.

Activity 1.4.1
Before moving on, have a go at the following questions to consolidate your understanding of how the gross operating surplus can be reconciled with the source of funds statement and the use of the value added accounting framework to identify cash generative businesses. y y Explain how you would estimate cash from operations. Why is cash flow an important index of competitiveness rather than profit?