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Home > Performance Management Best Practice > Value Creation—Perspectives and Implications

Performance Management Best Practice

Value Creation—Perspectives and Implications

by John C. Groth

Executive Summary

  • Cultural perspectives and respect for differences are important in a global economy. “Value” is viewed in different ways in different economies and cultures.

  • The forms of capital include human, tangible, and financial. Human capital divides into physical and mind capital. We are living in the era of mind capital.

  • A holistic view of an economy and an operating company allows one to recognize the origin of value in a competitive environment.

  • Analysts and decision-makers benefit from thinking in terms of the opportunity costs of capital and the implications of employing capital.

  • The economic returns of capital are very distinct from returns on capital.

  • Invested capital, flowing capital, idle capital, and opportunities related to these variables are core to decisions that seek to create value.

  • Idle human capital in an organization becomes lost capital with each passing minute.

  • Lost capital represents an unfavorable, and even potentially disastrous, event for a company and for society.

  • Value creation is consistent with the wise use of resources. Thus it provides an important perspective for executives who live in a world that is giving increased attention to the use of resources in the context of social responsibility, sustainability, and environmental concerns.

Introduction

This article focuses on the creation of value by a company or organization. We assume a competitive environment in the sense that the end user of a product or service has the right to buy or not to buy, to use or not to use a product or service. Although the discussion and examples focus on value creation in terms of economic measures—for example, an increase in share price—we recognize that other important measures of value exist. Quality of life is one such indicator—and even this measure varies with culture and circumstance. Such cultural differences and perspectives are important and should command our respect. At the end of the article, we will assert that at the local level competitive environments do allow individuals to make choices, determine what is of value, and subsequently influence the use of resources and the rewards or punishments for the use or misuse of those resources.

Forms of Capital

Capital has three forms: tangible, financial, and human. Human capital has two forms: physical capital, and mind capital. We live in an era of mind capital—with mind capital offering profound opportunities.

Employing capital wisely leads to the creation of value. The unwise use of capital destroys value. The creation of value accrues to the firm or organization and to society. The destruction of value takes from the organization and from society.

A Holistic View of an Economy

In a working economy, the production process uses resources—tangible, human, and financial—to fulfill human needs. Figure 1 illustrates the discussion.

Need fulfillment occurs at the point of value, where individuals choose to exchange money or some other form of exchange/store of value in expectation of fulfilling a need. A person buys a product or service not to be nice, but to satisfy needs, wants, and desires. In a competitive environment the customer chooses to select or reject the offered product or service. The ability to choose the best alternative in a competitive market is essential to wise resource use and the potential creation of value, taking into account the long-term implications of short-term choices.

Fulfilling human needs when a customer buys a product is essential to potential value creation. The production cycle converts inputs of capital into a product or service. Selection of the product brings need fulfillment to the customer, fulfillment that is possible because we converted capital of one form into another form, or made available a product (for example food) otherwise not easily accessible to the customer.

The Company’s Perspective

For the company, the fundamental processes of the value cycle are: convert capital of one form into capital of another form (i.e. convert inputs of production into finished goods); sell the product; collect on sale; pay all costs, including the cost of capital and taxes; have a positive economic return net of capital costs; reinvest in the cycle and repeat the process.

Investment in working assets, and often capital assets and land, supports the operation of the cycle. Working assets often include those shown in Figure 1—for example, raw materials inventories. Capital assets such as plant, equipment, and land often support the operating cycle. Capital assets are tangible or physical assets with an expected useful life that extends beyond the current operating period.

Various financing arrangements fund the working and capital assets that support the value cycle.

Reinvestment of the recovered capital, and possibly of net margins, and allowing it to circulate through the cycle again occur if the expected returns of repeating the cycle appear attractive compared to the opportunity cost of capital. The opportunity cost of capital represents the expected returns on the next best alternative with the same risk.

In valuation we refer to cash or economic returns, not accounting returns. Second, investments/disinvestments represent capital opportunities; for example, if I reduce my investment in finished goods inventory, the amount of capital I release or disinvest opens an opportunity for investment elsewhere.

When the cycle works, resources are used to deliver need fulfillment. In a competitive environment in which the customer chooses to buy from us, we earn the return—we do not extract or exploit the return. Value creation occurs if this return exceeds all costs, including the cost of capital. Value creation signals an approval of our use of resources.

In a competitive environment, if the person selects your product or service rather than an alternative, currently you enjoy a competitive advantage. Without a sale, your capital stops circulating, becomes idle, declines in value during this idle period, and may even become lost capital. We will address these issues shortly.

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Further reading

Articles:

  • Byers, Steven S., John C. Groth, Malcolm R. Richards, and Marilyn K. Wiley. “Capital investment analysis for managers.” Management Decision 35:3 (1997): 250–257.
  • Byers, Steven S., John C. Groth, and Marilyn K. Wiley. “Managing operating assets to create value.” Management Decision 35:2 (1997): 133–142.
  • Groth, John C., and Clair J. Nixon. “Financial information, risk, and share value.” Management Decision 30:7 (1992) 30–37.
  • Groth, John C., Steven S. Byers, and James D. Bogert. “Value management: Capital, economic returns and the creation of value.” Management Decision 34:6 (1996): 21–30.

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