Topics

How important environment and social issues are nowadays!

 
Why not highlighting the good benefits in these fields of such corporation projects that could turn out to be a great return in terms of image and eventually in terms of money!?

All of this should start from the consideration that Value creation is not intended only to bring immediately value to shareholders but it can take on a meaning that looks at the environmental and social aspects.

That's why a a smart CEO needs to take an interest in the development of a new forms of ROI, called social return on investment (SROI).

 
SROI, initially developed in the late 1990s, takes into account larger impacts of projects by using social and environmental metrics not reflected in conventional financial accounts.

As a matter of fact, this metric is do different from the usual profitability indexes that when such undertakings negatively impact traditional ROI in the short term, the net benefit to society and the environment can lead to a positive SROI, that in my opinion could translate into positive traditional ROI in the medium run.

It goes whitout saying that calculating this value can be difficult, even more if we consider that we need to measure social returns in the most common language of value, finance.

 
Summing up, SROI is used to evaluate the general progress of certain developments, showing both the financial and social impact the organization can have.

SROI Calculation
 

SROI calculation is a severe process that may concern both the past and the future.

In fact we are able to measure it at two moments that lead us to distinguish it in:

- Evaluative, which is carried out retrospectively and based on actual outcomes.

- Forecast, intended to calculate how much social value will be created when organization's activities get their expected outcomes.

The process to get SROI takes many steps that require early comprehensive and agile data management.

The steps we are talking about are the following:

- Identifying the Stakeholders, that are the subjects who is impacted by the activity at issue.

- Defining the Outcomes: spotting and documenting the social, environmental, and economic

outcomes.

- Highlighting Outcomes: gathering data and evidence that prove these outcomes have occurred.

- Evaluating Outcomes: Assigning a monetary value to every outcome.

- Achieving the Real Impact: Calculating the net social impact, that is, quantifying what would have happened anyway and the proportion of outcomes caused by other causes.

- Calculating the SROI Ratio: it's achieved by dividing the total social value (sum of valued outcomes) to the total investment.

SROI Formula is expressed as a ratio, indicating how much social value (in terms of benefits to stakeholders) is created for every unit of input.

 
The basic SROI formula is:

SRO =   Social Value - Deadweight - Attribution

                         INVESTMENT

Let's go through each component of the formula.

Social Value Created: it is the total value generated by the activity of the business/entity, including both tangible and intangible benefits. It can be measured through various outcomes, like improved health, increased employment, or environmental benefits.

In general we have two kind of outputs:

Direct and tangible products from the activity (for example, the increased number of working people thanks to a specific program for instance, lower waste amount,....).

Intangible Outcomes, or the changes to people resulting from the activity (improved quality of life for the individuals, reduced support from the government.....)

Assigning financial value to these benefits can have problems and various approaches have been thought and improved to help quantify the results.

Analytical Hierarchy Process (AHP), for example, is one method that organizes and translate qualitative information into quantitative values.

Deadweight: it is the portion of the outcome that would have happened anyway, even without the intervention. For instance, if a job training program claims to increase employment, but some participants would have found jobs without the program, that portion is considered deadweight.

Attribution: it 's the share attributed to other organization's activities might have contributed to the outcome.

 
In other terms the numerator is adjusted to reflect only the portion that can be attributed directly to the intervention at issue.

Investment: total resources invested to achieve the outcomes; not only money but also time, equipment, etc.

Let's go on with an example

Example of Calculation:

Imagine a massive job training program of to be held by a company intended for long-term jobless people to be hired at the end by the company itself.

Input:

Total Investment: $100,000

Total local community' s improved quality of life (Quantified in monetary terms): $600,000

 
Deadweight (Portion of health improvements that would have occurred without the program): 30%

Attribution (Other factors contributing to the health improvements): 10%

Result


Deadweight Adjustment: $600,000 * 20% = $120,000

Attribution Adjustment: $600,000 * 10% = $60,000

Adjusted Social Value Created = Total local community' s improved quality of life - (Deadweight + Attribution)= $600,000 - ($120,000 + $60,000)= $420,000

The SROI is the following:

SRO = 420,000/100,000 = $ 4.2

So, the SROI ratio is 4.2:1, that is every dollar invested in the program will yield $ 4.2 in social value.

At the end of this training course the people passing all the steps will be hired and the company not only will create a direct benefit fot itself but by addressing to jobless people of the local community shall have benefited the whole "society".

Furthermore it will have a return in terms of image within the area benefited from this initiative that will enjoy a sort of major preference in the purchase of the goods and services offered for long time.
Summing up the project will reveal itself to be a great strategic move

For further in-depth information about this topic you can get in touch on Page Contacts.

The misconception of the indirect cost allocation is one of the most important distortions of the cost management perception that leads to erroneous profitability analysis.

In the predominant cost culture the indirect costs (overheads) are those that cannot measured since there isn't a traditional consumption measurement unit of the resources involved by the cost objects.

When we talk about the cost objects, we refer to products, customers, distribution channels, projects.

As a result, in order to get over this flaw some conventional criteria are adopted to allocate the overheads to the cost objects and you know very well that the most common ones are the working hours and the machine hours.

That is the capital sin par excellence!

Why?

By adopting the volume-based approach we don't recognize the same meaning of resource consumption underlying the work done within an organization, except for those resources whose consumption varies in direct proportion to the output that has to be sold to the business' customers.

In order to  consider and "weigh" in a correct way all the resources used by a business unit, the most appropriate approach is to spot all the activities executed within the BU.

In so doing understanding the resources absorbed is easy.

The following step is to pinpoint the drivers (cost drivers), indirect cost category by indirect cost category, that explain the resource consumption by the activities so that the number of driver units "used" by the same activities  can serve as multiplier (times the driver unit value, that we name in different ways) to calculate the resource consumption attributed to each activity.

Last steps are to reverse the activity costs to the cost objects after spotting the drivers (activity drivers) that explain the activity amount consumed by the cost objects, to calculate the number of driver units "used" by the same cost objects that can serve as multiplier (times the driver unit value, that we name activity rate) to calculate the overheads attributed to each cost object.

In the end this procedure allows to allocate all the resources to the cost objects based on the reasons they are consumed for. It's the application of the causality principle.

These steps are easy and the fear of the time consumption fueling many managers for mapping the activities and making everything else we indicated is unjustified in consideration of the available "fast" softwares based on the Activity-based approach and in comparison to the benefits resulting from its full application.

This article isn't intended to dig deep into the ABC but wants to be a strong push toward the real understanding and a good measurement of the resource consumption, by overtaking all the old prejudices about it.

Moreover, if we take into account the enormous percentage of the overheads incurred on the total business costs nowadays by a firm, regardless of the industry, and the differentiation in the activities being done in some industries, this fear is even more unjustified.

The profitability analysis can but take advantage of ABC method.

Lecturing in budget and its steps doesn't concern this article that focuses instead on what many top managers neglect when setting the financial and nonfinancial objectives to the responsibility center managers of the firm and to the firm as a whole.

The Budget process is long and takes a high level effort to translate the goals of a company into numbers that may reflect ambitions, the real capacity of the firm as a whole and with regards to each single unit, its weaknesses, market conditions and the ""will" of the business unit managers that put into play their expertise in exchange for the acknowlegement of their action by negotiating the resource amount they need.

The last element is the most difficult, that's for sure, and the result of this negotiation can distort the way of the business towards the execution of its strategy the stronger the internal power of the managers involved.

How can you lead this negotiation without damaging the company?

The main factors you shoud take into account are Motivation, Goal Congruency, Controllability, Strategic Consistency as the main features of budgeting.

What are they like?

As to the motivation,  it consists of the push that budget should give to the managers of each business unit to achieve the goals assigned to them.

Of course the view of the top managers and a top-down approach, that means setting directly objectives for all the responsibility centers, can be risky since the targets identified couldn't be agreed by the people accountable for the activities and the resources used in the subunits concerned.

At this point the negotiation stage that all of us, finance people, know become longer and longer.

My suggestion is to adopt a mixed approach, halfway between the bottom-up and the  top-down extremes, involving to a certain degree the managers of the responsibility centers that in doing so feel even more important their role within the entire organization and that at the same time allows the overview of top management able to coordinate all the business units towards the firm's objective achievement.

The second point I want to deal with is the goal congruency between the objectives of the business as a whole and those of the subunits.

An example can highlight this factor even more.

Let's suppose that the top managers of the X Group sets a sale increase of some brand-new products as a target for the coming year.

At the same time a strong cost reduction in the Marketing and Sales department is requested to the its manager.

The amount of resources that should be used by the Mkt & Sales function throughout the launch stage of a product/service is well-known and that's why a severe and indiscriminate cost cutting policy impacting all the business' departments  is counterproductive for the goal of the sale increase achievement.

Here a cross-functional knowledge of the business processes comes in, since it is essential to those responsible for translating the strategy of the firm into consistent operating budget goals for the period concerned.

What about the Controllability factor?

In my opinion it is the most complex issue that requires a distinction between variable costs and fixed costs.

The example is my favourite approach.

Let's guess that a manufacturing cost center manager sees, as usual, a threshold put to its maintenance costs.

Many believe these kinds of costs are directly proportionate to the output expressed through either working hours or machine hours and that's the reason why in our example we suppose that they are allocated to "him" on the basis of the budgeted machine hours in that center.

This limit is beneficial to him since the budgeted  hours are higher in comparison with those of other manufacuring centers that as a result cannot take advantage of a fair of maintenance costs.

Let's guess the manufacturing cycle is more complex and less productive in cost centers with fewer budgeted hours since the machinery is obsolete, for instance, and requires more interventions to check its working.

At the year's end these managers with fewer hours but more complex manufactuting processes see their maintenance costs overtake their budget amount and that is the reason why they won't not "rewarded".

The main reason for this perverse and unfair mechanism is that the real factors impacting the maintenance are hidden and as a resulted not controlled.

The solution is pinpointing the right cost drivers that in this example doesn't concern the machine hours but others to be spot so that maintenance costs can be controlled in the most fair way even by those who have taken advantage of the wrong allocation method used so far.

The advantages are two: a reduced cost of maintenance as a whole and a positive impact on the motivation side of the managers that were been "discriminated" by the old method.

The second aspect of the controllability concerns the fixed costs, involving the Investment/Profit Centers where you can find controllable fixed costs and noncontrollable ones.

The formers (such as some research projects, operating advertising, sales promotion....) can be directed within the budget period (one year) and as a result put under the responsibility of the respective managers; the latters (such as depreciation, insurance,....) cover more periods and usually depend on past decisions that weren't made by the present Investment/Profit Center managers.

When setting a cost target in those cases in view of a correct and fair manager performance evaluation the noncontrollable fixed costs must be taken off the performance basis.

In the end you cannot neglect as a soft skill of the budgeters the Strategic Consistency of the bugdet with the long-term goal of the firm.

The budget objectives for each business unit should reflect the goals of the organization set into a multi-year plan that gets the place where the firm wants to be at the end of the period indicated.

For instance if the top management wishes to differentiate the firm even more from its competitors after a lapse of time, it cannot put some severe evaluation basis for the performance of the managers period by period through the usual financial and nonfinancial indicators since the "leap" forward in terms of efficiency or profitability is achieved usually in the final years of the multi-year plan.

If you don't follow this approach, the mission itself of the business won't be accomplished.

The solutions to this aspect are not so hard to be found and a smart and forward-looking budgeter won't have any difficulty to apply them.

After discussing many times with my peers, CFOs, top managers, partecipating in many virtual meetings, I came to the conclusion the Cost Management concept  in this year, 2023, more than ever in these weeks, hit rock bottom.

The misleading idea that the allocation of the indirect costs to product, customer, distribution channel, etc. according to one or another approach is in the end an useless sum-zero game that doesn't bring value to the business not only has been spreading in these uncertain times across all the decision-making lays of an organization but it has been going with another unavoidable certainty: the present lack of governability of many direct costs.

This issue concerns both the volume of the resources involved and the outlay needed to grab them as the result of the supply chain troubles affecting many materials and commodities following mainly the current geopolitical standing that impacts quantity, timing of the delivery and the prices.

This situation crosses the most part of industries and lead the business' management to shift their attention to the most controllable (in their opinion) and predictable item: Revenue.

I have a different opinion about this aspect but reflecting on this general opinon trend it's natural to me to state this.

Today Activity-Based Management is the most "trendy" and useful cost management technique we know.

It's an approach based on the Activities and focus its "formula" on the ones that create value to the customers according to their perspective and not only to the internal view of the managers.

Following this link activity/value they generate Revenue.

Many consider the Value-Add Activity identification in their own company just as a procedure of difficult and/or time-consuming realization, not to say of the determination of the money spent on them.

Nothing more false.

At this point a recall of their meaning together with some examples is useful to the understanding of this category.

 
Value-Add Activities

This category includes all the activities performed to meet the customer preferences about the attributes the product/service needs to have in order to persuade them to purchase it.
In other terms the resources and the related costs the companies spend on these activities generate revenue.

Of course, what I have just explained is good for  both manufacturing businesses and for service ones.

These attributes vary from industry to industry and reflect the importance the customers give to them and may be several.

I want to make two simplified examples of what I have just written:

1° Example (Manufacturing business)

You are a manufacturing company and you know that your customers of a specific segment are sensitive to the Price and to the Color of the product.
All the manufacturing cycle performed to achieve the base product and its costs  will be traced to the Price attribute, while painting phase costs will be traced to the Colour Range attribute if the customers give value to it as one of the main purchase reasons.

2° Example (Service business)

You are an engineering company and your strength is the skills of your people to customize the projects. Imagine you design train coaches and your customers want some of those ones with comfort equipment.

As a result, the hours worked by your engineers and the linked costs incurred to differentiate in that direction the original project are traced to the Comfort attribute.

 
An important punctualization must be made.

Not only the activities linked to the main functionalities of the product/service give Value Added to the customers.

We must consider also, as an example, the speed of the delivery when important, the after-sales services helping the customers better utilize the goods purchased and those activities on request.

The exhamination and the classification of the value varies from industry to industry.

A price leadership business will pay much attention to the activities identified, and their costs, with the “Price” attribute to which all the operating work performed to "bring to life" the core of the product/service are traced.

A company with a differentiation strategy, on the contrary, will pay much attention to other attributes.

After this explanation, it's fundamental to highlight that after the determination of the activities/attributes that create value and revenue and their evaluation, the Activity-Based Management determines the ratio between Revenue and Costs incurred on each Value Attribute allowing the management to see how much they are spending in the right direction and setting the corrections when needed in their decision making.

A most detailed dissertation on ABM could dig dip into the characteristics and the steps of this approach that is not just a fascinating exercise, but the content of this article was highlight how the features of this method contribute a lot to reduce the uncertainty of these times and fill the gap between the importance tha businesses' managers are giving to the governability of Revenue and the one they attribute to the governability of Costs.

If ABM receives more practical applications, the profitability mechanisms of a firm will become more clear.

In one of my articles (n. 66) I wrote about the "crisis" of NPV when evaluating a whole business but the customer evaluation (CLV) could be even more complicated.

That's as more true as more indebted the firms are.

In fact, when you use NPV you should discount the future cash flows ALSO by taking into account the cost of debt of the business as a component of the whole cost of capital.

As you know the Cost of Capital formula is:

WACC= Re x E/D+E + Rd(1-t) x D/D+E

Where:

WACC = Weighted Cost of Capital

E = Equity

D = Debt

Re = Cost of Equity

Rd = Cost of Debt

t = Corporate tax rate

The cost of debt when you don't consider the accounting method, that provides a formula like Total Financial Interests to Total Financial Liabilities, is done by referring in one way or another to the predominant or expected interest rates for the time involved.

As you know the volatility of interest rates is extreme nowadays and it seems to me that it will endure for long.

In these conditions one of the most important factors in understanding in an accurate way the present and the expected standing of the economy, and as a result the time value, is the financial market expectations.

That's why I can guess to determine the cost of debt through the well-known yield curve by subtracting the interest rate (return) of the government bonds with maturity preceding where you are at a precise point in time from the interest rate (return) where you are at precise point in time.

This is to be done year by year, until you reach the maturity of the bonds with the same duration as the lapse considered as the average life of a customer/customer group.

That's a concept that needs an example to show how it works.

Exhibit 1 - Government Bond Yield Curve

Let's suppose you are evaluating the Customer LifeTime Value of a group of your Business' Customers through the discounted Cash Flow Method tha make uses of given WACC consisting also of the cost of debt.

The average Customer's lifetime is 5 years.

The cost of debt to which discounting the yearly cash flows (together with the cost of equity) must be calculated year by year this way (Blue Line):

Rd at year 1 = 1.5%

Rd at starting point = 0

Cost of debt to be used to discount the net cash flows from year 0 to year 1 = Rd1 - Rd0 = 0.8 - 0 = 0.8%

Rd at year 2 = 0.8%

Rd at staring point = 0

Cost of debt to be used to discount at year 1 the net cash flows from  year 1 to year 2 = Rd1 - Rd0 = 1.5 - 0.8 = 0.7%

In so doing we arrive to the maturity of those bonds with the same duration as the lapse considered as the average life (5 years) of the chosen customer/customer group.

 

This is just a hypothesis but there isn't a rule of the thumb as there was in the recent past, instead.

My suggestion is that one should think of the right method according to the industry and some other factors that I would be happy to share directly with you.