Focus on operational improvements

Focus on operational improvements and increase the value of the company

The company’s results are created by the management, not by industry conditions.

Most production and logistics managers are familiar with the constant pressure of minimising costs, reducing stocks and bringing down outstandings. Furthermore, most of them are able to deliver results within these areas year after year.

Focus on operational improvements and increase the value of the company

Why are the board and group management so preoccupied with operational improvements?

The answer is simple: Because these improvements are instrumental in increasing the economic value and competitive power of the company for the benefit of the owners and the company’s other stakeholders.

In this and three other articles, we will focus on the significance of operational improvements for a company’s economic value creation, and we will take a closer look at some of the most effective methods for creating operational improvements as well as the effect on economic value added (EVA).

The company’s results are created by the management – not by industry conditions

For the past years, a number of large studies have shown that companies’ ability to create profitability and growth are more closely linked to the way they are managed than to the overall development of the industry. Thus, the day-to-day management and operations of a company are much more important in the delivery of results than the overall development of the industry that the company operates in.

Similar views are established in an analysis of European private equity funds’ portfolios, conducted by Center for Entrepreneurial and Financial Studies, which shows that between 50 % and 66 % of value added during the period of ownership derives from operational initiatives, i.e. internal improvements. Merely 4 - 17 % of value added is generated by market conditions.

In other words, companies’ ability to develop continuous operational improvements is decisive for the longterm delivery of results, competitive power and the possibility of increasing the value of the company.

The article continues below.

Morten Søndergaard
Morten Søndergaard
+45 2338 0080

How to calculate EVA

A company’s ability to create economic value may be expressed by its ability to generate a return on invested capital (ROIC) in the company beyond the weighted average cost of capital (WACC), which the investors (both equity and debt) have in general in relation to their invested capital in the company.

The EVA at a given period of time can be expressed by using the following formula:

Calculate EVA (Economic Value Added)

(ROIC – WACC) expresses the difference in percentage points between the ROIC generated by the company in the period in question and the WACC that investors have in relation to the capital that they have provided for the company.

If (ROIC – WACC) is positive, this means that the company has created economic value for the investors during the period in question (a higher return on their investment than they expected). Thus, the level of ROIC and the future expectations of the development of this key figure are decisive for the assessment of a company’s delivery of results as well as its ability to create value.

Calculation of ROIC (Return On Invested Capital)

The figure illustrates how to calculate ROIC and thereby the company’s ability to deliver operational economic results (upper part) based on the invested capital in the company (lower part). For further information about the process and examples of its use, please contact Morten Søndergaard.

The article continues below.

Identify and optimise the company’s value drivers

As shown in the figure above, ROIC sums up all the underlying operational value drivers, and overall, it is optimised by creating the highest possible net operating profit after tax (NOPAT) by means of the best possible optimised invested capital.

As regards the strategic and businessrelated management and development of the company, it is therefore essential to gain an insight into what in particular drives the development and level of ROIC and EVA – the so-called value drivers. This is important for several reasons, but mainly because it helps management to:

  • Ensure that capital is allocated to those activities that may generate a return which is higher than the WACC and thereby create value.
  • Ensure that, in case of “competition” in relation to the capital in the company, which is often the case, capital is allocated to those business-related and strategic initiatives that can achieve the highest level of EVA.
  • Gain an insight into how to potentially optimise value drivers and thereby strengthen the foundation of the company’s competitive power and additional value added.

Comparison before optimisation

Comparison of Company A and Company B

In the figure above, the views are illustrated by an example showing Company A and Company B that are competitors and in many respects are identical but differ in their NOPAT.

As illustrated by the example in the figure above, Company B has a significantly higher level of EVA (45) compared with Company A (20) in the period in question. Observe the striking effect of the difference in NOPAT in terms of the company’s EVA.

Imagine that the board and the management of Company A are dissatisfied with the current situation and decide to initiate an extensive optimisation project to examine the possibilities of optimising the current stock management as well as the integration of sales and operations planning more effectively.

After the completion of the project, the result is as follows: NOPAT has been increased by 20 % to 120, and the invested capital has been optimised and reduced by 15 % to 850, see the figure below.

Comparison after optimisation

Comparison after operations optimisation at Company A

After having optimised operations, Company A is able to more than double its EVA to a level that is higher than that of Company B, even though Company B has increased its NOPAT by 10 % in the same period. The reason for this is that Company B has had to increase the invested capital correspondingly to raise earnings. Thereby, Company B has created more value in the period in question, however, at the same time has experienced that a major competitor (Company A) has increased its EVA, competitive power and attractiveness considerably, which may have a substantial impact on the future strategic development opportunities.