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January 4, 2013

GDP for Business

There are a great many books, articles and blogs on business performance measures. We have “dashboards” and “Balanced Scorecards”; we have “earnings per share” and “Economic Value Added”; we have gross profit and net profit (before or after interest and tax); we have KPIs and indices.

 

In fact we have a whole load of possible measures, and we are told that “you can’t manage what you can’t measure”, but that setting inappropriate measures can lead to counteractive behaviours.

 

So what could we use as the key business measure?. My opinion, for what it is worth, is that Value Added is the best overall measure of performance, and the least prone to manipulation or obfuscation.

 

“Value Added” is defined as “the amount by which the value of an article is increased at each stage of its production, exclusive of initial costs” (Oxford English Dictionary). That is to say that “Value Added” is sales income less the cost of bought-in goods and services (excluding employee costs).

 

The “Value Added” that a business generates comprises three elements – profit (retained or paid in dividends); debt servicing; and the payment of wages, salaries and other employee benefits. Thus “Value Added” represents the surplus that the business generates through its ingenuity, skills and marketing in order to pay the providers of its capital – share capital, debt capital and human capital.

 

This is a nice clear measure, requiring no fancy formulae. It is very easy to calculate from a company’s management or financial accounts. However, the problem with Value Added is that it is more difficult to analyse within a business down to product lines, or service centres. Sales should be fairly easy to analyse by product or area, as are direct costs. The problem lies in all those indirect costs – overheads. Some of these overheads may, in fact, be pretty much direct expenses of the particular product or centre – for example all the equipment and property used for a specific product group. However, there will also likely be shared costs – perhaps equipment used for the production of more than one product family, transport, and, of course, corporate costs.

 

Trying to allocate these costs to product families or other profit centre groupings will inevitably, involve complex calculations which don’t help decision making and planning. To keep it simple, perhaps we should use a measure of “Product Family Value Added” or “Profit Centre Value Added” (or “Value Stream Value Added” for those following lean principles) which ignores this type of overhead. Thus “Profit Centre Value Added” is the surplus that the profit centre generates net of directly attributable costs. “Product Family Value Added”, therefore, comprises four elements – profit, debt servicing and employee costs (as above), and also a contribution to corporate (unattributable) overheads. This “Product Family Value Added” can be compared for different product families, profit centres or Value Streams to give a nice clear performance measure.