Antoine Melo's blog
Tuesday, November 30, 2004
Operational Risk and the Basel II Accords
Peter Vinella - PVA International Inc - 29 November 2004
In the first article of the series, we made several important steps towards understanding operational risk in practical terms.
First, we linked together three important concepts: operational performance, cost, and risk. Quite simply, in order to achieve
a desired level of operational performance, there is a natural trade off between cost and operational risk - once you have
reached your minimum cost for a given level of performance, operational risk will increase with further cost-cutting.i
Second, we were able to directly state operational risk in terms of operational performance and performance targets as
opposed to the more common Basel II definition which stresses operational losses.
Now, we didn't actually show that these two definitions are equivalent, we just implied that they are equivalent and
postponed the proof until a future article.ii We also carefully avoided the sticky problem of formally defining the terms,
"operational performance" and "performance targets". We simply stated that operational risk is the probability that our
operations will fail to meet one or more performance targets and left it at that.iii In this article and the next, we are going to
take them both head on.
Of course, we will be very careful to link our work to Basel II to make sure that in the end, we are still compliant with the
Accords. But as you will see, our approach has many practical advantages, not the least of which is a theory of operational
risk that is intuitive and easy to understand.
More Questions Than Answers
Unless you have been under a rock for the past couple of years, I'm sure that you have heard the terms, "Key Performance
Indicators" (KPI), "Key Risk Indicators" (KRI), and "Operational Risk Factors". You have probably used them yourself. But do
you really know what they are?
Sure, they are used to describe possible sources and measures of operational risk - quite interchangeably I might add. And
everybody seems to talk about them like old friends who need no introduction, but just what are they? How do you identify
them? How are they used to describe operational risk? How do they fit into Basel II?
It was thinking about these very questions three years ago that got me and my co-author started on the road to developing a
comprehensive theory of operational risk in the first place.iv Even though Basel II requires the use of operational risk factors,
nobody, including the regulators could tell us if KPI were KRI or if they were different. Or what they should measure or how?
Or how often they should be measured? Did they span the enterprise or were they business specific? Did they span multiple
companies? Ad infinitum...v
Other than the fact that you had to use them somehow, nobody knew too much about them and so our journey began. Over
the next three of years, we did succeed in answering most of these questions and while it wasn't necessarily easy, along the
way, we did develop a simple analogy to help describe KPI and KRI and their very critical role in the successful management
of operational risk.
It's Time for a Ride
Modern automobiles are quite complicated machines. Dozens of microprocessors adjust nearly every aspect of a car's
operation, from the fuel/air mixture to the tightness of the suspension in a turn - all in realtime no less. Fortunately, while
driving, most of us only have to worry about two gauges on the dashboard: the speedometer and the petrol gauge. With just
these two indicators, we can safely drive to our destinations as fast as possible without getting a ticket or waiting for hours
on the side of the road for petrol - provided, of course, that we actually pay attention while driving to avoid accidents,
maintain our course, avoid traffic, etc.
If you think about it a bit, that's pretty impressive. Ignoring driving skills, a driver only has to worry about his speed and the
amount of gas while driving and nothing else regarding the performance of his car. But what does this have to do with KPI
and KRI?
To answer this, let's assume that on a specific trip we would like to get to our destination as quickly as possible - not an
unreasonable goal. In order to do that, we need to drive at the highest speed permitted, which is, of course, measured by our
speedometer. In other words, for us to achieve our goal, we need to attain a certain level of operational performance: in this
case, speed. Hence, it is not too hard to infer that speed is a key performance indicator while the speedometer is how speed
is measured.vi
This begs the question that if speed is a KPI, is the amount of gas also a KPI? Well yes and no. As we drive along, the car
consumes gas. Although the rate of gas consumption may be an indicator of engine performance, in terms of our specific
goal - getting to our destination as quickly as possible - the amount of gas is only a factor when it's gone, i.e. when our
speed drops to zero because we have run out of gas or have to pull over for a fill up. In other words, the amount of gas is
not a direct indicator of our ability to achieve our goal, rather, it simply indicates that our speed may drop in the future, i.e. it
is a risk that we may not achieve our required level of performance and, hence, miss our goal.
Although equally important, speed and the amount of gas are fundamentally different indicators and we really can't call the
amount of gas a KPI since it is a measure of performance risk, not performance. As clever academics, we will coin the term
"key risk indicator" for the amount of gas as well as all those factors that describe the risk of a future drop in performance.
It's All in the Definition
The car analogy also brings up another interesting aspect KPI and KRI: they are not absolute, but are based on our choice of
operational goals. The importance of speed and the amount of gas in our example was due to the specific goal of our trip -
to get to our destination as quickly as possible. If we were to choose a different goal, say, riding in style and comfort, speed
and amount of gas wouldn't be too helpful and we would need performance and risk measures that better reflect style and
comfort such as the smoothness of the ride for example.
Therefore, in order to identify meaningful KPI and KRI for any operation, we must first define our operational goals (i.e.
performance target) - we need to know what we want to achieve in order to measure how well we are achieving it. This may
sound pretty trivial, but it has big ramifications.
Since KPI and KRI are specific to our operational goals, it is unlikely that they all will span multiple business lines or
companies unless all of us happen to share the same goals. While some goals are fairly universal - maximize profits, reduce
error rates, improve customer satisfaction, etc. - many will be specific to a particular line of business: lying on the efficient
frontier may be a great goal for an investment portfolio, but it doesn't mean a whole lot to AP/AR department.
Secondly, goals, as well as their priority, change over time; hence KPI and KRI must also change if we are to accurately reflect
the performance. On top of this, while goals may change quickly, the operation itself doesn't. As a result of both of these
drift factors, it is quite possible that our operations, as measured by outdated or misaligned metrics, may appear to be
working great when we are actually losing money left and right due to unseen operational failures and inefficiencies.
Additionally, reaching our performance targets may be misleading. For instance, if my daily Repo daylight overdraft target is
$100K, just because I only lose $90K doesn't mean I have great operations. It could just mean that I have very low
expectations.
Another Big Problem - Transparency
The car analogy also points to another problem with KPI and KRI. In the example, as drivers, we only had to be concerned
with speed and the amount of gas. However, we were really relying on the car's numerous microprocessors to measure a
large number of hidden KPI and KRI and optimize the overall performance of the car. If fact, there may actually have been
hundreds of important KPI and KRI that we are simply unaware of due to a lack of operational transparency. As long as the
microprocessors worked correctly, we were fine. However, while this lack of operational transparency may be a benefit in
driving a car, in a financial operation, you could end up in jail.vii
Thank Goodness for Basel II
While the Accords leave much to be desired in terms of concrete, practical definitions, the definitions of loss event categories
and business lines do help make the problem of defining industry-wide KPI and KRI much easier.viii To be consistent with
the Accords, we label the most important KPI and KRI - defined in terms of our specific goals - as "Operational Risk Factors"
(ORF), which can be used for scenario analysis and regulatory reporting, both Basel II requirements.
Ideally, we use the 80/20 rule to select the 20% of the KPI and KRI that explain 80% of our operational risk - for instance, in
the car example, we only needed one KPI and one KRI to explain most of the risk. At worse, we can simply use those
indicators we have on hand until we have better operational transparency and a bigger, more accurate collection of KPI and
KRI.ix
Once we have selected the most predictive KPI and KRI, we can map them to the Basel II loss event categories and business
lines to construct ORF which are consistent with general industry definitions. These can be used for regulatory reporting
purposes as well as benchmarking against external data, both Basel II requirements.x
While the Accords do very little in helping us measure operational risk in terms of our specific operational goals and do very
little in terms of achieving operational transparency, they do give us a way to at least standardize the definition and reporting
of KPI and KRI across lines of business and companies. However, in practice, good operational risk management requires KPI
and KRI that are tied directly to specific and idiosyncratic goals of our unique operations.
Where did We Get To and Where Do We Go from Here?
In this article, we established a general definition of KPI and KRI in terms of performance and particular operational goals of a
business line or the enterprise. We also saw that the KPI and KRI are very dependent on the specific choice of operational
goals and except for the mom and apple pie indicators, they don't easily span businesses nor are they constant in time. We
also saw that due to a lack of operational transparency, we may only find a small fraction of the important indicators without
some significant detective work.
We also saw that we could use the Accords to help define a smaller, more intuitive set of KPI and KRI - the ORF - that can be
used for regulatory reporting and external benchmarking. In the next article, we will take on the somewhat Herculean task of
establishing a practical way of identifying all the critical KPI and KRI in any operation, one that will ultimately provide full
operational transparency.
Fortunately, we won't have to this on our own. In fact, we will be able to borrow quite a bit from other disciplines that will
make this a whole lot easier. And we will step briefly into academia with a look at the "Efficient Operations Hypothesis" which
will cleverly tie all the KPI and KRI to the overall corporate objectives. Now that's something to look forward to.
****
iv This a reference to Jeanette Jin as well as a shameless plug of our upcoming book, "Corporate Governance and Operational
Risk Management: A Practical Guide, currently slated for release through John Wiley & Sons in Q2 2005.
v Unfortunately, this lack of formal definitions and rigor, especially on the part of the regulators, is one of the main reasons
that it is so damn hard to implement an operational risk management practice. Definitions seem intuitive and obviously on
the surface, but when you try to implement the concepts, there is far too ambiguity and room for interpretation - just one of
my pet peeves
vi What metric is measured and how it is measured are often confused with regards to KPI and KRI. We deal with this more in
a future article
vii This balance between too much information and too little with be discussed at length in a future article
viii See the Accords for the complete list of loss event types and business lines
ix There are a variety of statistical techniques that are outside the scope of these articles, such as "Spectral Analysis", that
can be used to identify the number factors as well as help identify the factors themselves . However, we will touch upon this
issue on a less theoretical level in future articles
x This can be done via a simple linear regression. This will covered in more detail in the next article
¶ 7:42 AM 0 Comments
In the first article of the series, we made several important steps towards understanding operational risk in practical terms.
First, we linked together three important concepts: operational performance, cost, and risk. Quite simply, in order to achieve
a desired level of operational performance, there is a natural trade off between cost and operational risk - once you have
reached your minimum cost for a given level of performance, operational risk will increase with further cost-cutting.i
Second, we were able to directly state operational risk in terms of operational performance and performance targets as
opposed to the more common Basel II definition which stresses operational losses.
Now, we didn't actually show that these two definitions are equivalent, we just implied that they are equivalent and
postponed the proof until a future article.ii We also carefully avoided the sticky problem of formally defining the terms,
"operational performance" and "performance targets". We simply stated that operational risk is the probability that our
operations will fail to meet one or more performance targets and left it at that.iii In this article and the next, we are going to
take them both head on.
Of course, we will be very careful to link our work to Basel II to make sure that in the end, we are still compliant with the
Accords. But as you will see, our approach has many practical advantages, not the least of which is a theory of operational
risk that is intuitive and easy to understand.
More Questions Than Answers
Unless you have been under a rock for the past couple of years, I'm sure that you have heard the terms, "Key Performance
Indicators" (KPI), "Key Risk Indicators" (KRI), and "Operational Risk Factors". You have probably used them yourself. But do
you really know what they are?
Sure, they are used to describe possible sources and measures of operational risk - quite interchangeably I might add. And
everybody seems to talk about them like old friends who need no introduction, but just what are they? How do you identify
them? How are they used to describe operational risk? How do they fit into Basel II?
It was thinking about these very questions three years ago that got me and my co-author started on the road to developing a
comprehensive theory of operational risk in the first place.iv Even though Basel II requires the use of operational risk factors,
nobody, including the regulators could tell us if KPI were KRI or if they were different. Or what they should measure or how?
Or how often they should be measured? Did they span the enterprise or were they business specific? Did they span multiple
companies? Ad infinitum...v
Other than the fact that you had to use them somehow, nobody knew too much about them and so our journey began. Over
the next three of years, we did succeed in answering most of these questions and while it wasn't necessarily easy, along the
way, we did develop a simple analogy to help describe KPI and KRI and their very critical role in the successful management
of operational risk.
It's Time for a Ride
Modern automobiles are quite complicated machines. Dozens of microprocessors adjust nearly every aspect of a car's
operation, from the fuel/air mixture to the tightness of the suspension in a turn - all in realtime no less. Fortunately, while
driving, most of us only have to worry about two gauges on the dashboard: the speedometer and the petrol gauge. With just
these two indicators, we can safely drive to our destinations as fast as possible without getting a ticket or waiting for hours
on the side of the road for petrol - provided, of course, that we actually pay attention while driving to avoid accidents,
maintain our course, avoid traffic, etc.
If you think about it a bit, that's pretty impressive. Ignoring driving skills, a driver only has to worry about his speed and the
amount of gas while driving and nothing else regarding the performance of his car. But what does this have to do with KPI
and KRI?
To answer this, let's assume that on a specific trip we would like to get to our destination as quickly as possible - not an
unreasonable goal. In order to do that, we need to drive at the highest speed permitted, which is, of course, measured by our
speedometer. In other words, for us to achieve our goal, we need to attain a certain level of operational performance: in this
case, speed. Hence, it is not too hard to infer that speed is a key performance indicator while the speedometer is how speed
is measured.vi
This begs the question that if speed is a KPI, is the amount of gas also a KPI? Well yes and no. As we drive along, the car
consumes gas. Although the rate of gas consumption may be an indicator of engine performance, in terms of our specific
goal - getting to our destination as quickly as possible - the amount of gas is only a factor when it's gone, i.e. when our
speed drops to zero because we have run out of gas or have to pull over for a fill up. In other words, the amount of gas is
not a direct indicator of our ability to achieve our goal, rather, it simply indicates that our speed may drop in the future, i.e. it
is a risk that we may not achieve our required level of performance and, hence, miss our goal.
Although equally important, speed and the amount of gas are fundamentally different indicators and we really can't call the
amount of gas a KPI since it is a measure of performance risk, not performance. As clever academics, we will coin the term
"key risk indicator" for the amount of gas as well as all those factors that describe the risk of a future drop in performance.
It's All in the Definition
The car analogy also brings up another interesting aspect KPI and KRI: they are not absolute, but are based on our choice of
operational goals. The importance of speed and the amount of gas in our example was due to the specific goal of our trip -
to get to our destination as quickly as possible. If we were to choose a different goal, say, riding in style and comfort, speed
and amount of gas wouldn't be too helpful and we would need performance and risk measures that better reflect style and
comfort such as the smoothness of the ride for example.
Therefore, in order to identify meaningful KPI and KRI for any operation, we must first define our operational goals (i.e.
performance target) - we need to know what we want to achieve in order to measure how well we are achieving it. This may
sound pretty trivial, but it has big ramifications.
Since KPI and KRI are specific to our operational goals, it is unlikely that they all will span multiple business lines or
companies unless all of us happen to share the same goals. While some goals are fairly universal - maximize profits, reduce
error rates, improve customer satisfaction, etc. - many will be specific to a particular line of business: lying on the efficient
frontier may be a great goal for an investment portfolio, but it doesn't mean a whole lot to AP/AR department.
Secondly, goals, as well as their priority, change over time; hence KPI and KRI must also change if we are to accurately reflect
the performance. On top of this, while goals may change quickly, the operation itself doesn't. As a result of both of these
drift factors, it is quite possible that our operations, as measured by outdated or misaligned metrics, may appear to be
working great when we are actually losing money left and right due to unseen operational failures and inefficiencies.
Additionally, reaching our performance targets may be misleading. For instance, if my daily Repo daylight overdraft target is
$100K, just because I only lose $90K doesn't mean I have great operations. It could just mean that I have very low
expectations.
Another Big Problem - Transparency
The car analogy also points to another problem with KPI and KRI. In the example, as drivers, we only had to be concerned
with speed and the amount of gas. However, we were really relying on the car's numerous microprocessors to measure a
large number of hidden KPI and KRI and optimize the overall performance of the car. If fact, there may actually have been
hundreds of important KPI and KRI that we are simply unaware of due to a lack of operational transparency. As long as the
microprocessors worked correctly, we were fine. However, while this lack of operational transparency may be a benefit in
driving a car, in a financial operation, you could end up in jail.vii
Thank Goodness for Basel II
While the Accords leave much to be desired in terms of concrete, practical definitions, the definitions of loss event categories
and business lines do help make the problem of defining industry-wide KPI and KRI much easier.viii To be consistent with
the Accords, we label the most important KPI and KRI - defined in terms of our specific goals - as "Operational Risk Factors"
(ORF), which can be used for scenario analysis and regulatory reporting, both Basel II requirements.
Ideally, we use the 80/20 rule to select the 20% of the KPI and KRI that explain 80% of our operational risk - for instance, in
the car example, we only needed one KPI and one KRI to explain most of the risk. At worse, we can simply use those
indicators we have on hand until we have better operational transparency and a bigger, more accurate collection of KPI and
KRI.ix
Once we have selected the most predictive KPI and KRI, we can map them to the Basel II loss event categories and business
lines to construct ORF which are consistent with general industry definitions. These can be used for regulatory reporting
purposes as well as benchmarking against external data, both Basel II requirements.x
While the Accords do very little in helping us measure operational risk in terms of our specific operational goals and do very
little in terms of achieving operational transparency, they do give us a way to at least standardize the definition and reporting
of KPI and KRI across lines of business and companies. However, in practice, good operational risk management requires KPI
and KRI that are tied directly to specific and idiosyncratic goals of our unique operations.
Where did We Get To and Where Do We Go from Here?
In this article, we established a general definition of KPI and KRI in terms of performance and particular operational goals of a
business line or the enterprise. We also saw that the KPI and KRI are very dependent on the specific choice of operational
goals and except for the mom and apple pie indicators, they don't easily span businesses nor are they constant in time. We
also saw that due to a lack of operational transparency, we may only find a small fraction of the important indicators without
some significant detective work.
We also saw that we could use the Accords to help define a smaller, more intuitive set of KPI and KRI - the ORF - that can be
used for regulatory reporting and external benchmarking. In the next article, we will take on the somewhat Herculean task of
establishing a practical way of identifying all the critical KPI and KRI in any operation, one that will ultimately provide full
operational transparency.
Fortunately, we won't have to this on our own. In fact, we will be able to borrow quite a bit from other disciplines that will
make this a whole lot easier. And we will step briefly into academia with a look at the "Efficient Operations Hypothesis" which
will cleverly tie all the KPI and KRI to the overall corporate objectives. Now that's something to look forward to.
****
iv This a reference to Jeanette Jin as well as a shameless plug of our upcoming book, "Corporate Governance and Operational
Risk Management: A Practical Guide, currently slated for release through John Wiley & Sons in Q2 2005.
v Unfortunately, this lack of formal definitions and rigor, especially on the part of the regulators, is one of the main reasons
that it is so damn hard to implement an operational risk management practice. Definitions seem intuitive and obviously on
the surface, but when you try to implement the concepts, there is far too ambiguity and room for interpretation - just one of
my pet peeves
vi What metric is measured and how it is measured are often confused with regards to KPI and KRI. We deal with this more in
a future article
vii This balance between too much information and too little with be discussed at length in a future article
viii See the Accords for the complete list of loss event types and business lines
ix There are a variety of statistical techniques that are outside the scope of these articles, such as "Spectral Analysis", that
can be used to identify the number factors as well as help identify the factors themselves . However, we will touch upon this
issue on a less theoretical level in future articles
x This can be done via a simple linear regression. This will covered in more detail in the next article
¶ 7:42 AM 0 Comments
Thursday, November 25, 2004
Ratio Worksheet
Self-Assessment
Ask yourself the following questions to determine how much you know about
each of the following financial concepts:
1. Does my company have enough working capital?
2. Do I know how much working capital is "enough" for my business's size and
industry?
3. How profitable is my business?
4. Will our income cover payroll and other liabilities/debts?
5. Are we carrying too much debt?
6. Do I know how much debt is "too much" for my business's size and
industry?
7. Are we leveraging our assets properly?
8. Are we carrying the proper level of inventory, and do we turn it over
efficiently?
Are you able to answer all of these questions accurately? When you have
finished this workshop, you will be armed with the tools and information you
need to do so.
A. Income Ratios
Ask yourself the following questions:
1. Do you know how effective your assets are in attaining revenue?
2. Do you have the proper level of operating assets for your company's sales
level?
3. Do you have too little or too much working capital on hand?
4. How much revenue does our core business operations produce?
The Income Ratios will help you obtain the answers to these questions and
more.
1. Asset Turnover
Calculate your Asset Turnover by using the following equation:
Total Revenue
Average Assets for Period
2. Sales to Tangible Net Worth
Calculate your Sales to Tangible Net Worth Ratio by using the following
equation:
Total Sales
Tangible Net Worth
3. Operating Income to Net Sales Ratio
Calculate your Operating Income to Net Sales Ratio by using the following
equation:
Operating Income
Net Sales
B. Profitability Ratios
Take the following mini-quiz:
1. How much profit did your company make during the last fiscal year?
2. Was the wealth of the owners increased during the year as a result of
business operations?
3. Does your average markup on goods normally cover your expenses, and
therefore result in a profit?
4. Does the company generate enough cash that you can avoid loans or other
external debt?
These questions will all be addressed by computing the Profitability Ratios.
1. Gross Profit Margin (GPM)
Calculate your Gross Profit Margin by using the following equation:
Net Sales - Cost of Goods Sold
Total Revenue
2. Net Profit Margin (NPM)
Calculate your Net Profit Margin by using the following equation:
Earnings After Taxes
Total Revenue
3. Return on Assets (ROA)
Calculate your Return on Assets by using the following equation:
Net Income
Average Assets for Period
4. Return on Equity (ROE)
Calculate your Return on Equity by using the following equation:
Net Income
Average Shareholder Equity for Period
5. Net Operating Profit Rate of Return
Calculate your Net Operating Profit Rate of Return by using the following
equation:
Earnings Before Interest and Taxes
Average Shareholder Equity for Period
6. Management Rate of Return
Calculate your Management Rate of Return Ratio by using the following
equation:
Operating Income
Fixed Assets + Net Working Capital
7. Earning Power
Calculate your Earning Power by using the following equation:
Earnings Before Interest and Taxes
Total Assets
C. Liquidity Ratios
Ask yourself the following questions:
1. If your business needed to come up with cash quickly to settle on its
debts, could it? If so, how quickly?
2. Does your company actually generate enough capital to cover those debts
in a one-year period?
3. Do you have too much or too little cash tied up in inventory?
4. Do you know what the proper level of inventory is for your business?
5. How efficient are your collection practices?
6. Are you getting paid in a timely manner by your customers?
The following ratios will provide clarity on all of these liquidity-related
issues.
1. Current Ratio
Calculate your Current Ratio by using the following equation:
Total Current Assets
Total Current Liabilities
2. Quick Test Ratio (a.k.a. The "Acid Test")
Calculate your Quick Ratio by using the following equation:
Current Assets - Inventory
Total Current Liabilities
3. Absolute Liquidity Ratio
Calculate your Absolute Liquidity Ratio by using the following equation:
Cash + Marketable Securities
Current Liabilities
4. Basic Defense Interval
Calculate your Basic Defense Interval by using the following equation:
Cash + Receivables + Marketable Securities
(Operating Expenses + Interest + Income Taxes)/365 days
5. Receivables Turnover
Calculate your Receivables Turnover by using the following equation:
Total Credit Sales
Average Receivables Balance
6. Average Collection Period (ACP)
Calculate your Average Collection Period by using the following equation:
365 days
Receivables Turnover*
7. Inventory Turnover
Calculate your Inventory Turnover by using the following equation:
Cost of Goods Sold
Average Value of Inventory
D. Working Capital Ratios
Before delving into the Working Capital Ratios, consider the following
questions.
1. Does your company need to borrow money to meet short-term obligations?
2. Is the amount of debt (both short- and long-term) you carry greater than
the funds company owners have invested in the firm?
3. Does the company carry an appropriate level of investments?
1. Working Capital
Calculate your Working Capital by using the following equation:
Current Assets - Current Liabilities
2. Working Capital Turnover
Calculate your Working Capital Turnover by using the following equation:
Net Sales
Average Working Capital
3. Debt to Net Worth
Calculate your Debt to Net Worth by using the following equation:
Total Liabilities
Tangible Net Worth
E. Bankruptcy Ratios
Ask yourself these bankruptcy "red flag" questions before reviewing the
related ratios.
1. Is your business currently experiencing or trending toward an operating
loss?
2. Has your investment in the business allowed you to achieve ongoing
profits?
3. Has your ability to generate revenue increased over time, decreased or
remained stable?
4. Is your company over-invested in depreciating assets?
1. Working Capital to Total Assets
Calculate your Working Capital to Total Assets by using the following
equation:
Net Working Capital
Total Assets
2. Retained Earnings to Total Assets
Calculate your Retained Earnings to Total Assets by using the following
equation:
Retained Earnings
Total Assets
3. EBIT to Total Assets
Calculate your EBIT to Total Assets by using the following equation:
Earnings Before Interest and Taxes
Total Assets
4. Sales to Total Assets
Calculate your Sales to Total Assets Ratio by using the following equation:
Total Sales
Total Assets
5. Equity to Debt
Calculate your Equity to Debt Ratio by using the following equation:
Market Value of Stock
Total Debt
6. Cash Flow to Debt
Calculate your Cash Flow to Debt Ratio by using the following equation:
Net Income + Depreciation
Total Debt
F. Long-Term Analysis
Self-Assessment:
Ask yourself these questions regarding the long-term financial outlook of
your company.
1. Does your company have adequate working capital to cover both short- and
long-term debts?
2. Does your firm's net worth outweigh its debts?
3. In short, are your creditors protected from risk of non-payment of debt?
1. Current Assets to Total Debt
Calculate your Current Assets to Total Debt Ratio by using the following
equation:
Current Assets
Total Debt
2. Stockholders' Equity Ratio
Calculate your Stockholders' Equity Ratio by using the following equation:
Stockholders' Equity
Total Assets
3. Debt to Net Worth Ratio
Calculate your Debt to Net Worth Ratio by using the following equation:
Total Debt
Tangible Net Worth
G. Coverage Ratios
1. Times Interest Earned (TIE)
Calculate your Times Interest Earned by using the following equation:
Earnings Before Interest and Taxes
Interest Payable on Debt
2. Total Coverage Ratio (a.k.a. "Debt Service Ratio")
Calculate your Total Coverage Ratio by using the following equation:
Total Operating Income
Total Debt Service
H. Leverage Ratios
Ask yourself:
1. What percentage of your company's total funds are provided by creditors?
2. What percentage is provided by owners?
3. Do you generate enough cash in-house to cover liabilities?
4. Do you have an appropriate level of debt - and do you know what that
level should be?
1. Equity Ratio
Calculate your Equity Ratio by using the following equation:
Common Shareholders' Equity
Total Capital Employed
2. Debt to Equity Ratio
Calculate your Debt to Equity Ratio by using the following
equation:Long-Term Debt
Shareholders' Equity
3. Debt Ratio
Calculate your Debt Ratio by using the following equation:
Total Debt
Total Assets
¶ 6:11 AM 0 Comments
Ask yourself the following questions to determine how much you know about
each of the following financial concepts:
1. Does my company have enough working capital?
2. Do I know how much working capital is "enough" for my business's size and
industry?
3. How profitable is my business?
4. Will our income cover payroll and other liabilities/debts?
5. Are we carrying too much debt?
6. Do I know how much debt is "too much" for my business's size and
industry?
7. Are we leveraging our assets properly?
8. Are we carrying the proper level of inventory, and do we turn it over
efficiently?
Are you able to answer all of these questions accurately? When you have
finished this workshop, you will be armed with the tools and information you
need to do so.
A. Income Ratios
Ask yourself the following questions:
1. Do you know how effective your assets are in attaining revenue?
2. Do you have the proper level of operating assets for your company's sales
level?
3. Do you have too little or too much working capital on hand?
4. How much revenue does our core business operations produce?
The Income Ratios will help you obtain the answers to these questions and
more.
1. Asset Turnover
Calculate your Asset Turnover by using the following equation:
Total Revenue
Average Assets for Period
2. Sales to Tangible Net Worth
Calculate your Sales to Tangible Net Worth Ratio by using the following
equation:
Total Sales
Tangible Net Worth
3. Operating Income to Net Sales Ratio
Calculate your Operating Income to Net Sales Ratio by using the following
equation:
Operating Income
Net Sales
B. Profitability Ratios
Take the following mini-quiz:
1. How much profit did your company make during the last fiscal year?
2. Was the wealth of the owners increased during the year as a result of
business operations?
3. Does your average markup on goods normally cover your expenses, and
therefore result in a profit?
4. Does the company generate enough cash that you can avoid loans or other
external debt?
These questions will all be addressed by computing the Profitability Ratios.
1. Gross Profit Margin (GPM)
Calculate your Gross Profit Margin by using the following equation:
Net Sales - Cost of Goods Sold
Total Revenue
2. Net Profit Margin (NPM)
Calculate your Net Profit Margin by using the following equation:
Earnings After Taxes
Total Revenue
3. Return on Assets (ROA)
Calculate your Return on Assets by using the following equation:
Net Income
Average Assets for Period
4. Return on Equity (ROE)
Calculate your Return on Equity by using the following equation:
Net Income
Average Shareholder Equity for Period
5. Net Operating Profit Rate of Return
Calculate your Net Operating Profit Rate of Return by using the following
equation:
Earnings Before Interest and Taxes
Average Shareholder Equity for Period
6. Management Rate of Return
Calculate your Management Rate of Return Ratio by using the following
equation:
Operating Income
Fixed Assets + Net Working Capital
7. Earning Power
Calculate your Earning Power by using the following equation:
Earnings Before Interest and Taxes
Total Assets
C. Liquidity Ratios
Ask yourself the following questions:
1. If your business needed to come up with cash quickly to settle on its
debts, could it? If so, how quickly?
2. Does your company actually generate enough capital to cover those debts
in a one-year period?
3. Do you have too much or too little cash tied up in inventory?
4. Do you know what the proper level of inventory is for your business?
5. How efficient are your collection practices?
6. Are you getting paid in a timely manner by your customers?
The following ratios will provide clarity on all of these liquidity-related
issues.
1. Current Ratio
Calculate your Current Ratio by using the following equation:
Total Current Assets
Total Current Liabilities
2. Quick Test Ratio (a.k.a. The "Acid Test")
Calculate your Quick Ratio by using the following equation:
Current Assets - Inventory
Total Current Liabilities
3. Absolute Liquidity Ratio
Calculate your Absolute Liquidity Ratio by using the following equation:
Cash + Marketable Securities
Current Liabilities
4. Basic Defense Interval
Calculate your Basic Defense Interval by using the following equation:
Cash + Receivables + Marketable Securities
(Operating Expenses + Interest + Income Taxes)/365 days
5. Receivables Turnover
Calculate your Receivables Turnover by using the following equation:
Total Credit Sales
Average Receivables Balance
6. Average Collection Period (ACP)
Calculate your Average Collection Period by using the following equation:
365 days
Receivables Turnover*
7. Inventory Turnover
Calculate your Inventory Turnover by using the following equation:
Cost of Goods Sold
Average Value of Inventory
D. Working Capital Ratios
Before delving into the Working Capital Ratios, consider the following
questions.
1. Does your company need to borrow money to meet short-term obligations?
2. Is the amount of debt (both short- and long-term) you carry greater than
the funds company owners have invested in the firm?
3. Does the company carry an appropriate level of investments?
1. Working Capital
Calculate your Working Capital by using the following equation:
Current Assets - Current Liabilities
2. Working Capital Turnover
Calculate your Working Capital Turnover by using the following equation:
Net Sales
Average Working Capital
3. Debt to Net Worth
Calculate your Debt to Net Worth by using the following equation:
Total Liabilities
Tangible Net Worth
E. Bankruptcy Ratios
Ask yourself these bankruptcy "red flag" questions before reviewing the
related ratios.
1. Is your business currently experiencing or trending toward an operating
loss?
2. Has your investment in the business allowed you to achieve ongoing
profits?
3. Has your ability to generate revenue increased over time, decreased or
remained stable?
4. Is your company over-invested in depreciating assets?
1. Working Capital to Total Assets
Calculate your Working Capital to Total Assets by using the following
equation:
Net Working Capital
Total Assets
2. Retained Earnings to Total Assets
Calculate your Retained Earnings to Total Assets by using the following
equation:
Retained Earnings
Total Assets
3. EBIT to Total Assets
Calculate your EBIT to Total Assets by using the following equation:
Earnings Before Interest and Taxes
Total Assets
4. Sales to Total Assets
Calculate your Sales to Total Assets Ratio by using the following equation:
Total Sales
Total Assets
5. Equity to Debt
Calculate your Equity to Debt Ratio by using the following equation:
Market Value of Stock
Total Debt
6. Cash Flow to Debt
Calculate your Cash Flow to Debt Ratio by using the following equation:
Net Income + Depreciation
Total Debt
F. Long-Term Analysis
Self-Assessment:
Ask yourself these questions regarding the long-term financial outlook of
your company.
1. Does your company have adequate working capital to cover both short- and
long-term debts?
2. Does your firm's net worth outweigh its debts?
3. In short, are your creditors protected from risk of non-payment of debt?
1. Current Assets to Total Debt
Calculate your Current Assets to Total Debt Ratio by using the following
equation:
Current Assets
Total Debt
2. Stockholders' Equity Ratio
Calculate your Stockholders' Equity Ratio by using the following equation:
Stockholders' Equity
Total Assets
3. Debt to Net Worth Ratio
Calculate your Debt to Net Worth Ratio by using the following equation:
Total Debt
Tangible Net Worth
G. Coverage Ratios
1. Times Interest Earned (TIE)
Calculate your Times Interest Earned by using the following equation:
Earnings Before Interest and Taxes
Interest Payable on Debt
2. Total Coverage Ratio (a.k.a. "Debt Service Ratio")
Calculate your Total Coverage Ratio by using the following equation:
Total Operating Income
Total Debt Service
H. Leverage Ratios
Ask yourself:
1. What percentage of your company's total funds are provided by creditors?
2. What percentage is provided by owners?
3. Do you generate enough cash in-house to cover liabilities?
4. Do you have an appropriate level of debt - and do you know what that
level should be?
1. Equity Ratio
Calculate your Equity Ratio by using the following equation:
Common Shareholders' Equity
Total Capital Employed
2. Debt to Equity Ratio
Calculate your Debt to Equity Ratio by using the following
equation:Long-Term Debt
Shareholders' Equity
3. Debt Ratio
Calculate your Debt Ratio by using the following equation:
Total Debt
Total Assets
¶ 6:11 AM 0 Comments
Balancing Scorecards With Reality: How to make Balanced
Scorecards work for your organization
BY SUSAN H. CRAMM
To be at the top of your game in IT, you have to measure results. Most
large organizations have implemented some type of Balanced Scorecard
initiative, although many are unhappy with the impact of their efforts.
Before you jump onto the bandwagon, take a deep breath, pull the research
(www.bnet.com has a good list of reference material), and think hard about
what you want to achieve.
The Balanced Scorecard is useful because it is grounded in reality. We
can't have it all; trade-offs are inevitable among financial contribution,
customer focus, operational excellence and organization maturityÂthe four
dimensions of the Balanced Scorecard. Since the CIO job is by definition the
management of contending opposites (for example, improving service while
reducing expenses, delivering quickly while building a reusable
infrastructure, and creating alignment while delivering value and reducing
technology footprint), scorecard techniques make sense for IT.
It's important to distinguish between the Balanced Scorecard and the role
of operational measurements. A ton of measurements are required to ensure
that day-to-day operations are under control. Many of these measurements are
the domain of the functional managers; the CIO will see them only when
something goes awry.
In contrast, the primary goal of Balanced Scorecard metrics is to help
drive and monitor the implementation of strategy. This happens because
attention gets focused on achieving the critical outcomes, aligning efforts
and resources, and communicating results and implications for the future.
If you don't have a business-aligned IT strategy that helps you allocate
scarce resources and create value, then you don't have the clarity of
purpose necessary to use a Balanced Scorecard. A good IT strategy can be
communicated to the front line of your organization in a way that directs
actions, forces trade-offs and establishes behavioral guidelines. In
addition, since strategy and scorecards require business commitment, you
must ensure that your strategy and scorecard definition processes are
participative.
Whereas operational dashboards are comprehensive and relatively static,
Balanced Scorecard metrics are more narrowly focused and shift with changes
in strategy. Effective scorecard metrics measure outcomes (versus activities
or milestones). In my experience, the number of metrics at the enterprise
level should definitely be less than 10, while at the individual level the
number can be narrowed to two or three. Whereas enterprise metrics are
useful in guiding the leadership cadre's actions, individual metrics are
essential to focusing frontline contributors on their roles.
To create strategically relevant IT metrics, define your strategic goals
within each of these five categories: financial performance, project
performance, operational performance, talent management and user
satisfaction. Then consider how to measure success within each of the four
Balanced Scorecard dimensions. For example: If a strategic goal under
financial performance calls for supporting an increase in acquisitions, then
a financial contribution metric might be keeping IT integration costs within
a certain range; the customer focus metric could be integrating acquisitions
within a certain time frame; the operational excellence metric might be to
leverage the new scale by reducing the per-seat costs; the organization
maturity metric could be the development of a common acquisition integration
process that is repeatable and reliable.
Once you have completed this process, you will have far too many metrics.
Your next challenge will be to identify metrics that are correlated, in that
they support more than one of the Balanced Scorecard dimensions and
strategic goals. For example, "percentage of calls resolved on first call"
supports both the customer focus and operational excellence metrics, while
reducing project cycle time is a measurement that will contribute to all
four dimensions. Rather than starting from scratch, build a list of
potential IT metrics by leveraging your research, professional associations
and contacts.
When you are comfortable using the Balanced Scorecard at the enterprise or
business unit level, then it's time to align the IT organization by
cascading the metrics down to the front line of employees in order to drive
performance improvements. Do so by defining job-specific outcomes,
integrating these into the performance management processes, and evolving
your metrics and monitoring systems so that data aggregation and drill-down
capabilities exist.
The old adage that "You get what you inspect, not what you expect" applies
to Balanced Scorecards. It's a great tool for enterprises and IT groups
alike, but only if the principles of strategic relevance, commitment, focus
and organizational alignment are respected.
Reader Q&A
Q: How many different balanced scorecards are there? I'm familiar with
Robert Kaplan and David Norton's work and their Balanced Scorecard
Collaborative. Which approach do you recommend?
A: Kaplan and Norton are the rightful parents of the Balanced Scorecard and
their framework serves as the foundation for all the derivative works in
this area. As researchers and consultants have applied the concept, they
have adapted the Balanced Scorecard to fit particular applications and
extended it to tie into other concepts, but the fundamental concepts are
unchanged.
For example, in its overview on scorecards, the Balanced Scorecard
Institute, which is government-focused, goes beyond Kaplan and Norton's
definition of scorecards by tying them to performance measurement systems
and quality methods such as TQM.
Q: In my view, the Balanced Scorecard has to be adopted corporatewide
rather than in individual organizational units. The Balanced Scorecard
provides metrics beyond financial results. If other organizational units are
focused solely on financial results, then the unit measuring by the Balanced
Scorecard will be out of step, and it may even be at a disadvantage.
A: I agree that for maximum performance impact, Balanced Scorecard
initiatives need to be sponsored at the enterprise level and cascaded down
through the organization. Enterprise adoption is not, however, a
precondition for successful implementation. The Balanced Scorecard is a
structured way of implementing common sense. Organizational performance is
measured on multiple dimensionsÂwhether or not the organization reports only
in the financial dimension.
For example, consider a CIO at a very financially focused and disciplined
retail organization. Even though the only numbers she needs to report are
financial, she understands that her performance is also dependent on
improving service levels, building human capital and delivering value to the
business while improving efficiency. The Balanced Scorecard helps her focus
and lead her organization. The fact that the powers that be in her company
don't ask for her strategy map and metrics should not deter her from
applying common sense in a disciplined manner.
¶ 4:56 AM 0 Comments
To be at the top of your game in IT, you have to measure results. Most
large organizations have implemented some type of Balanced Scorecard
initiative, although many are unhappy with the impact of their efforts.
Before you jump onto the bandwagon, take a deep breath, pull the research
(www.bnet.com has a good list of reference material), and think hard about
what you want to achieve.
The Balanced Scorecard is useful because it is grounded in reality. We
can't have it all; trade-offs are inevitable among financial contribution,
customer focus, operational excellence and organization maturityÂthe four
dimensions of the Balanced Scorecard. Since the CIO job is by definition the
management of contending opposites (for example, improving service while
reducing expenses, delivering quickly while building a reusable
infrastructure, and creating alignment while delivering value and reducing
technology footprint), scorecard techniques make sense for IT.
It's important to distinguish between the Balanced Scorecard and the role
of operational measurements. A ton of measurements are required to ensure
that day-to-day operations are under control. Many of these measurements are
the domain of the functional managers; the CIO will see them only when
something goes awry.
In contrast, the primary goal of Balanced Scorecard metrics is to help
drive and monitor the implementation of strategy. This happens because
attention gets focused on achieving the critical outcomes, aligning efforts
and resources, and communicating results and implications for the future.
If you don't have a business-aligned IT strategy that helps you allocate
scarce resources and create value, then you don't have the clarity of
purpose necessary to use a Balanced Scorecard. A good IT strategy can be
communicated to the front line of your organization in a way that directs
actions, forces trade-offs and establishes behavioral guidelines. In
addition, since strategy and scorecards require business commitment, you
must ensure that your strategy and scorecard definition processes are
participative.
Whereas operational dashboards are comprehensive and relatively static,
Balanced Scorecard metrics are more narrowly focused and shift with changes
in strategy. Effective scorecard metrics measure outcomes (versus activities
or milestones). In my experience, the number of metrics at the enterprise
level should definitely be less than 10, while at the individual level the
number can be narrowed to two or three. Whereas enterprise metrics are
useful in guiding the leadership cadre's actions, individual metrics are
essential to focusing frontline contributors on their roles.
To create strategically relevant IT metrics, define your strategic goals
within each of these five categories: financial performance, project
performance, operational performance, talent management and user
satisfaction. Then consider how to measure success within each of the four
Balanced Scorecard dimensions. For example: If a strategic goal under
financial performance calls for supporting an increase in acquisitions, then
a financial contribution metric might be keeping IT integration costs within
a certain range; the customer focus metric could be integrating acquisitions
within a certain time frame; the operational excellence metric might be to
leverage the new scale by reducing the per-seat costs; the organization
maturity metric could be the development of a common acquisition integration
process that is repeatable and reliable.
Once you have completed this process, you will have far too many metrics.
Your next challenge will be to identify metrics that are correlated, in that
they support more than one of the Balanced Scorecard dimensions and
strategic goals. For example, "percentage of calls resolved on first call"
supports both the customer focus and operational excellence metrics, while
reducing project cycle time is a measurement that will contribute to all
four dimensions. Rather than starting from scratch, build a list of
potential IT metrics by leveraging your research, professional associations
and contacts.
When you are comfortable using the Balanced Scorecard at the enterprise or
business unit level, then it's time to align the IT organization by
cascading the metrics down to the front line of employees in order to drive
performance improvements. Do so by defining job-specific outcomes,
integrating these into the performance management processes, and evolving
your metrics and monitoring systems so that data aggregation and drill-down
capabilities exist.
The old adage that "You get what you inspect, not what you expect" applies
to Balanced Scorecards. It's a great tool for enterprises and IT groups
alike, but only if the principles of strategic relevance, commitment, focus
and organizational alignment are respected.
Reader Q&A
Q: How many different balanced scorecards are there? I'm familiar with
Robert Kaplan and David Norton's work and their Balanced Scorecard
Collaborative. Which approach do you recommend?
A: Kaplan and Norton are the rightful parents of the Balanced Scorecard and
their framework serves as the foundation for all the derivative works in
this area. As researchers and consultants have applied the concept, they
have adapted the Balanced Scorecard to fit particular applications and
extended it to tie into other concepts, but the fundamental concepts are
unchanged.
For example, in its overview on scorecards, the Balanced Scorecard
Institute, which is government-focused, goes beyond Kaplan and Norton's
definition of scorecards by tying them to performance measurement systems
and quality methods such as TQM.
Q: In my view, the Balanced Scorecard has to be adopted corporatewide
rather than in individual organizational units. The Balanced Scorecard
provides metrics beyond financial results. If other organizational units are
focused solely on financial results, then the unit measuring by the Balanced
Scorecard will be out of step, and it may even be at a disadvantage.
A: I agree that for maximum performance impact, Balanced Scorecard
initiatives need to be sponsored at the enterprise level and cascaded down
through the organization. Enterprise adoption is not, however, a
precondition for successful implementation. The Balanced Scorecard is a
structured way of implementing common sense. Organizational performance is
measured on multiple dimensionsÂwhether or not the organization reports only
in the financial dimension.
For example, consider a CIO at a very financially focused and disciplined
retail organization. Even though the only numbers she needs to report are
financial, she understands that her performance is also dependent on
improving service levels, building human capital and delivering value to the
business while improving efficiency. The Balanced Scorecard helps her focus
and lead her organization. The fact that the powers that be in her company
don't ask for her strategy map and metrics should not deter her from
applying common sense in a disciplined manner.
¶ 4:56 AM 0 Comments
Wednesday, November 24, 2004
Will high-tech CFOs adapt to slower growth?
Financial officers in the high-tech sector should learn to balance six roles
to help guide companies into a more mature market.
Bertil E. Chappuis, Kevin A. Frick, and Paul J. Roche
The McKinsey Quarterly, Web exclusive, October 2004
The technology industry has changed dramatically in the past five years, and
so have the demands on its CFOs. While some thrived as strategists during
the boom times, others steered clear of mergers and limited themselves to
the role of controller. Now, in a time of slower growth, high-tech CFOs must
broaden their responsibilities by paying more attention to the factors that
drive value in mature companies, such as measuring and improving
productivity. This approach to growth isn't as sexy as mergers and
acquisitions, but it is required at this point in the sector's evolution. In
other words, technology CFOs must become more like their peers in other
industries.
The missions of CFOs
Over the past year we studied the role of CFOs in high-tech companies to see
what makes executives effective in that position. Through our research and
discussions with 38 CFOs, we identified a financial officer's six missions.
These roles may be familiar to CFOs in other kinds of companies but not
necessarily to those in thetechnology business. No CFO we spoke with
excelled at all six. Chief financial officers who did excel at this whole
range of duties would become the most important advocates of productivity
and value within their companies (see sidebar, "Balancing roles").
Act as the keeper of the business model
The chief financial officer must understand the company's blueprint for
making money better than anyone else. Armed with that knowledge and with a
thorough grasp of industry trends and economics, the CFO is in a unique
position to know what will affect the company's stock price. As technology
markets mature, an informed CFO should initiate discussions with other top
executives about how the business model ought to evolve. The CFO at one
software company, for example, helped its senior-management team to see that
its core source of Fortune 500 accounts would soon be exhausted. This
realization led the team to target smaller companies. The CFO then began a
dialogue about whether to augment the company's direct-sales efforts by
using its channel partnersto exploit the indirect channelÂan approach better
suited to the economics of a fragmented customer base.
Furthermore, new initiatives can sometimes hurt individual business units
even while benefiting the company as a whole. CFOs, who are not tied to any
one unit, can objectively judge the overall interests of the company and
therefore help arbitrate in such cases. At one computer manufacturer, for
instance, the CFO showed senior managers how they could reach their revenue
targets by expanding a services business, even though it delivered lower
gross margins that had to be compensated for in other areas of the company.
The CFO played a critical role in determining the pace at which it should
expand the business and the level of investment that would be needed to do
so.
Prioritize initiatives
Management teams often suffer from an overload of initiatives, and the chief
financial officer can use information from the capital markets as a
pragmatic and independent way of prioritizing among them. By analyzing the
reactions of the markets to any given change and identifying the levels of
growth, profitability, asset turnover, and capital costs that will excite
investors, a good financial officer can help managers identify their most
promising initiatives.
The CFO at one software company, for example, compared the relative impact
of growth and higher margins on the company's share price. He found that the
latter had a bigger effect, so he introduced a company-wide initiative to
increase productivity. To win the support of the chief executive and the
head of the largest business unit, he linked operating-profit targets to
investor expectations and the performance of comparable companiesÂboth
critical priorities for the CEO. Once the manager of the top business unit
became interested, others followed, and they launched a review of the
company's processes. Operating margins had been in the low to mid single
digits but rose to the upper teens within nine months. The company's share
price more than doubled over the same period.
Ensure accountability and fact-based decision making
Although companies in all industries struggle to obtain consistent and
reliable data to help them meet their strategic and operational goals, the
problem may be more severe in the technology sector. Most high-tech
companies have grown rapidly, and the internal information systems they set
up as recently as five to seven years ago may no longer provide relevant
data. They have also been through more mergers and acquisitions than most
companies, and though you might expect tech-savvy management teams to have
experience successfully integrating IT systems, few of them have actually
undertaken such a project. As a result, M&A often leaves in place a number
of accounting and other measurement systems.
When such information is inadequate, a CFO's first priority should be to set
up systems that deliver it, on time, to the people who need it. This might
seem to be a basic step, but many technology enterprises resemble the
software company that had more than 80 separate databases to track customer
information. As systems improve, the finance team can analyze the data and
help business managers to do so as well, thereby delivering what one CFO
called "insight, not information."
enlarge exhibit
Many companies rely on key performance indicators to shed light on their
financial and operational performance and to provide insight into the
long-term health of the business. Although these metrics have been around
for years, they seemed unimportant when technology companies were still
growing quickly and focusing on the "next big thing." In those days,
improving a business unit's performance by an extra 5 percent may not have
seemed worth the effort. Today, however, share prices are more likely to be
influenced by growth in margins than by market share (exhibit). Big ideas
still matter, but execution is paramount.
Our research suggests that high-tech CFOs must do a better job of
implementing forward-looking metrics for market share trends, customer
satisfaction, and employee turnover (which affects labor productivity). They
should also tie these metrics to performance reviews. Many technology
companies don't complete the loop by enforcing accountability for success or
failure; some don't even recognize the need to do so.
Convert operating income to cash flow efficiently
One of the CFO's primary responsibilities is to use the operating income of
the company in the most effective way possible by reducing its tax burden,
minimizing its cost of capital, and keeping asset turnover high. High-tech
CFOs often pride themselves on how well they manage these classic financial
responsibilities, but we find that they generally underperform compared with
theirpeers in other industriesÂoften because they haven't adjusted to the
new realities. Many academics and leaders from other industries would argue,
for instance, that given the increasing maturity and predictability of some
parts of the sector, a high-tech company's capital structure should have
higher debt levels to reduce the cost of capital. Yet a lot of the CFOs we
spoke with refused to entertain that notion, citing the outdated rationales
of volatility and convention.
Understand investors and tailor communications to them
Much as product developers and marketers segment a customer base, the CFO
should work with the investor relations team to segment the universe of
potential investors. The company can then identify those groups whose
interests closely match its value proposition and develop plans to attract
others as well. This kind of communications effort is especially important
for tech companies, many of which are shifting their business models and
offering investors a new, longer-term perspective. One chief financial
officer revamped the investor relations program of his company to appeal to
20 prospects; 18 of them eventually made its list of the top 20
shareholders.
To reach these investors, a CFO must analyze their needs. One imaging
company had historically focused 90 percent of its investor relations
announcements on a business unit with high growth potential. When the
company examined its investor base, however, it found that most of the
shareholders were more interested in the largest business unit, which
generated a substantial cash flow but little buzz. The CFO retooled
communications around the cash-generating part of the company, a move
applauded by investors and analysts alike for increasing its transparency.
One way a corporation can refine its focus is to choose which metrics to
report. A certain CFO wanted investors to think of his company not as an
Internet business, as they had before, but as a media enterprise. Therefore,
he began publicizing metrics, such as revenue per subscriber, more typical
of media-related stocks. His move was in line with the decision many
companies have made to report only key business metrics instead of offering
guidance on future earnings. As one CFO put it, "My role is not to predict
future earnings per share but to tell the market what they need to know in
order to fairly value us."
Represent the shareholders
New corporate-governance regulations in the United States and Europe require
CFOs to attest personally to the accuracy of any financial statement. Most
are therefore keenly aware of their role as "chief integrity officer": the
manager who ensures that shareholders are served properly. CFOs generally
believe that recent governance problems resulted not from too few rules but
rather from poor enforcement. They should thus go beyond basic compliance
and serve as role models for good practices throughout the organization. One
CFO, for instance, told us how she spends time reviewing accounts with her
receivables teamÂa job that, while tedious, emphasizes "the need to pay
attention to details."
Becoming a better CFO
High-tech CFOs must shift the financial focus of their companies from
short-term growth to long-term value. They can take several steps to make
this transition as smooth as possible.
First, they can concentrate on building a strong finance team. One CFO told
us that he wants to spend his time talking strategy with business-unit
managers but can't, because he doesn't have people he can rely on to manage
the new regulatory obligations. If CFOs are to expand their role, many will
have to bring in qualified talent, either from the business units or from
outside the company. In investor relations, for example, some CFOs are
bringing in marketing stars who can apply segmenting, targeting, and
positioning know-how to the investor base. A software CFO is conducting an
external search to recruit qualified controllers who can manage the finances
of newly reorganized business units.
Second, it is important for the CFO to have the support of the CEO and other
top managers, especially at critical moments. For the aforementioned CFO who
launched a productivity-improvement effort at a software company, the moment
of truth came during the budget process. All of the operating managers were
lobbying the CEO for target relief but he didn't budge, and his support gave
the CFO a new level of credibility.
Thanks to the push for corporate-governance reform, CFOs have also developed
more direct relationships with their boards of directors, particularly the
audit committee. One goal is to reassure investors that the board is
receiving information that has not been filtered through the chief
executive, although the chief financial officer reports to the CEO. This
connection between the directors and the CFO fosters dialogue that helps the
CFO learn where investor support can be found.
Third, CFOs can use process initiatives to gain traction with executives and
to establish themselves as value managers, thereby embracing their
traditional control function and establishing a stronger influence on
operations. Moving beyond the narrow specialty of CFOs in this way can help
them build credibility within the organization. Although they could
concentrate on managing value in the finance function, they can expand their
influence most effectively by selecting an area with company-wide
implications. CFOs who began as controllers should choose a more strategic
activity, such as guiding senior managers through the decomposition of the
stock price. Those who have previous experience in strategy may want to
select something more operational, such as setting up a fact-based
performance system.
Productivity is a popular platform for extending the role of the CFO, who
usually analyzes movements in the company's share price to determine what
raises value. This understanding, in turn, informs the focus of the
productivity-improvement program: operating expenses, performance,
profit-and-loss targets, or a range of other metrics. Once targets are set,
the CFO has a platform for talking with business-unit managers. By
pinpointing where costs are incurred, these conversations can shape the way
the business operates.
PricingÂanother area where CFOs are extending their reachÂis traditionally
the domain of sales and marketing. Now CFOs are beginning to use their
financial expertise to calculate the impact of pricing decisions. At one
tech company, this new understanding led the CFO to revamp the pricing
methodology.
Moreover, though renewed scrutiny of accounting controls may weigh down a
company's reporting systems, it can also give CFOs a way to reevaluate
financial processes. At one software company, the CFO combined the control
function with new initiatives supporting business goals. Recognizing that
the company's numerous order-entry systems threatened the credibility and
timing of its financial reporting, he led an effort to consolidate them into
a single system and then launched a project to redesign the quote-to-cash
process.
The technology sector is maturing, but many CFOs haven't adapted to the new
environment. They need to focus on rebalancing debt ratios, on courting
investors who seek long-term value, and on improving productivity. A strong
platform and the support of the CEO and the board can help a CFO become an
effective advocate for performance and shareholder value
¶ 10:17 AM 0 Comments
to help guide companies into a more mature market.
Bertil E. Chappuis, Kevin A. Frick, and Paul J. Roche
The McKinsey Quarterly, Web exclusive, October 2004
The technology industry has changed dramatically in the past five years, and
so have the demands on its CFOs. While some thrived as strategists during
the boom times, others steered clear of mergers and limited themselves to
the role of controller. Now, in a time of slower growth, high-tech CFOs must
broaden their responsibilities by paying more attention to the factors that
drive value in mature companies, such as measuring and improving
productivity. This approach to growth isn't as sexy as mergers and
acquisitions, but it is required at this point in the sector's evolution. In
other words, technology CFOs must become more like their peers in other
industries.
The missions of CFOs
Over the past year we studied the role of CFOs in high-tech companies to see
what makes executives effective in that position. Through our research and
discussions with 38 CFOs, we identified a financial officer's six missions.
These roles may be familiar to CFOs in other kinds of companies but not
necessarily to those in thetechnology business. No CFO we spoke with
excelled at all six. Chief financial officers who did excel at this whole
range of duties would become the most important advocates of productivity
and value within their companies (see sidebar, "Balancing roles").
Act as the keeper of the business model
The chief financial officer must understand the company's blueprint for
making money better than anyone else. Armed with that knowledge and with a
thorough grasp of industry trends and economics, the CFO is in a unique
position to know what will affect the company's stock price. As technology
markets mature, an informed CFO should initiate discussions with other top
executives about how the business model ought to evolve. The CFO at one
software company, for example, helped its senior-management team to see that
its core source of Fortune 500 accounts would soon be exhausted. This
realization led the team to target smaller companies. The CFO then began a
dialogue about whether to augment the company's direct-sales efforts by
using its channel partnersto exploit the indirect channelÂan approach better
suited to the economics of a fragmented customer base.
Furthermore, new initiatives can sometimes hurt individual business units
even while benefiting the company as a whole. CFOs, who are not tied to any
one unit, can objectively judge the overall interests of the company and
therefore help arbitrate in such cases. At one computer manufacturer, for
instance, the CFO showed senior managers how they could reach their revenue
targets by expanding a services business, even though it delivered lower
gross margins that had to be compensated for in other areas of the company.
The CFO played a critical role in determining the pace at which it should
expand the business and the level of investment that would be needed to do
so.
Prioritize initiatives
Management teams often suffer from an overload of initiatives, and the chief
financial officer can use information from the capital markets as a
pragmatic and independent way of prioritizing among them. By analyzing the
reactions of the markets to any given change and identifying the levels of
growth, profitability, asset turnover, and capital costs that will excite
investors, a good financial officer can help managers identify their most
promising initiatives.
The CFO at one software company, for example, compared the relative impact
of growth and higher margins on the company's share price. He found that the
latter had a bigger effect, so he introduced a company-wide initiative to
increase productivity. To win the support of the chief executive and the
head of the largest business unit, he linked operating-profit targets to
investor expectations and the performance of comparable companiesÂboth
critical priorities for the CEO. Once the manager of the top business unit
became interested, others followed, and they launched a review of the
company's processes. Operating margins had been in the low to mid single
digits but rose to the upper teens within nine months. The company's share
price more than doubled over the same period.
Ensure accountability and fact-based decision making
Although companies in all industries struggle to obtain consistent and
reliable data to help them meet their strategic and operational goals, the
problem may be more severe in the technology sector. Most high-tech
companies have grown rapidly, and the internal information systems they set
up as recently as five to seven years ago may no longer provide relevant
data. They have also been through more mergers and acquisitions than most
companies, and though you might expect tech-savvy management teams to have
experience successfully integrating IT systems, few of them have actually
undertaken such a project. As a result, M&A often leaves in place a number
of accounting and other measurement systems.
When such information is inadequate, a CFO's first priority should be to set
up systems that deliver it, on time, to the people who need it. This might
seem to be a basic step, but many technology enterprises resemble the
software company that had more than 80 separate databases to track customer
information. As systems improve, the finance team can analyze the data and
help business managers to do so as well, thereby delivering what one CFO
called "insight, not information."
enlarge exhibit
Many companies rely on key performance indicators to shed light on their
financial and operational performance and to provide insight into the
long-term health of the business. Although these metrics have been around
for years, they seemed unimportant when technology companies were still
growing quickly and focusing on the "next big thing." In those days,
improving a business unit's performance by an extra 5 percent may not have
seemed worth the effort. Today, however, share prices are more likely to be
influenced by growth in margins than by market share (exhibit). Big ideas
still matter, but execution is paramount.
Our research suggests that high-tech CFOs must do a better job of
implementing forward-looking metrics for market share trends, customer
satisfaction, and employee turnover (which affects labor productivity). They
should also tie these metrics to performance reviews. Many technology
companies don't complete the loop by enforcing accountability for success or
failure; some don't even recognize the need to do so.
Convert operating income to cash flow efficiently
One of the CFO's primary responsibilities is to use the operating income of
the company in the most effective way possible by reducing its tax burden,
minimizing its cost of capital, and keeping asset turnover high. High-tech
CFOs often pride themselves on how well they manage these classic financial
responsibilities, but we find that they generally underperform compared with
theirpeers in other industriesÂoften because they haven't adjusted to the
new realities. Many academics and leaders from other industries would argue,
for instance, that given the increasing maturity and predictability of some
parts of the sector, a high-tech company's capital structure should have
higher debt levels to reduce the cost of capital. Yet a lot of the CFOs we
spoke with refused to entertain that notion, citing the outdated rationales
of volatility and convention.
Understand investors and tailor communications to them
Much as product developers and marketers segment a customer base, the CFO
should work with the investor relations team to segment the universe of
potential investors. The company can then identify those groups whose
interests closely match its value proposition and develop plans to attract
others as well. This kind of communications effort is especially important
for tech companies, many of which are shifting their business models and
offering investors a new, longer-term perspective. One chief financial
officer revamped the investor relations program of his company to appeal to
20 prospects; 18 of them eventually made its list of the top 20
shareholders.
To reach these investors, a CFO must analyze their needs. One imaging
company had historically focused 90 percent of its investor relations
announcements on a business unit with high growth potential. When the
company examined its investor base, however, it found that most of the
shareholders were more interested in the largest business unit, which
generated a substantial cash flow but little buzz. The CFO retooled
communications around the cash-generating part of the company, a move
applauded by investors and analysts alike for increasing its transparency.
One way a corporation can refine its focus is to choose which metrics to
report. A certain CFO wanted investors to think of his company not as an
Internet business, as they had before, but as a media enterprise. Therefore,
he began publicizing metrics, such as revenue per subscriber, more typical
of media-related stocks. His move was in line with the decision many
companies have made to report only key business metrics instead of offering
guidance on future earnings. As one CFO put it, "My role is not to predict
future earnings per share but to tell the market what they need to know in
order to fairly value us."
Represent the shareholders
New corporate-governance regulations in the United States and Europe require
CFOs to attest personally to the accuracy of any financial statement. Most
are therefore keenly aware of their role as "chief integrity officer": the
manager who ensures that shareholders are served properly. CFOs generally
believe that recent governance problems resulted not from too few rules but
rather from poor enforcement. They should thus go beyond basic compliance
and serve as role models for good practices throughout the organization. One
CFO, for instance, told us how she spends time reviewing accounts with her
receivables teamÂa job that, while tedious, emphasizes "the need to pay
attention to details."
Becoming a better CFO
High-tech CFOs must shift the financial focus of their companies from
short-term growth to long-term value. They can take several steps to make
this transition as smooth as possible.
First, they can concentrate on building a strong finance team. One CFO told
us that he wants to spend his time talking strategy with business-unit
managers but can't, because he doesn't have people he can rely on to manage
the new regulatory obligations. If CFOs are to expand their role, many will
have to bring in qualified talent, either from the business units or from
outside the company. In investor relations, for example, some CFOs are
bringing in marketing stars who can apply segmenting, targeting, and
positioning know-how to the investor base. A software CFO is conducting an
external search to recruit qualified controllers who can manage the finances
of newly reorganized business units.
Second, it is important for the CFO to have the support of the CEO and other
top managers, especially at critical moments. For the aforementioned CFO who
launched a productivity-improvement effort at a software company, the moment
of truth came during the budget process. All of the operating managers were
lobbying the CEO for target relief but he didn't budge, and his support gave
the CFO a new level of credibility.
Thanks to the push for corporate-governance reform, CFOs have also developed
more direct relationships with their boards of directors, particularly the
audit committee. One goal is to reassure investors that the board is
receiving information that has not been filtered through the chief
executive, although the chief financial officer reports to the CEO. This
connection between the directors and the CFO fosters dialogue that helps the
CFO learn where investor support can be found.
Third, CFOs can use process initiatives to gain traction with executives and
to establish themselves as value managers, thereby embracing their
traditional control function and establishing a stronger influence on
operations. Moving beyond the narrow specialty of CFOs in this way can help
them build credibility within the organization. Although they could
concentrate on managing value in the finance function, they can expand their
influence most effectively by selecting an area with company-wide
implications. CFOs who began as controllers should choose a more strategic
activity, such as guiding senior managers through the decomposition of the
stock price. Those who have previous experience in strategy may want to
select something more operational, such as setting up a fact-based
performance system.
Productivity is a popular platform for extending the role of the CFO, who
usually analyzes movements in the company's share price to determine what
raises value. This understanding, in turn, informs the focus of the
productivity-improvement program: operating expenses, performance,
profit-and-loss targets, or a range of other metrics. Once targets are set,
the CFO has a platform for talking with business-unit managers. By
pinpointing where costs are incurred, these conversations can shape the way
the business operates.
PricingÂanother area where CFOs are extending their reachÂis traditionally
the domain of sales and marketing. Now CFOs are beginning to use their
financial expertise to calculate the impact of pricing decisions. At one
tech company, this new understanding led the CFO to revamp the pricing
methodology.
Moreover, though renewed scrutiny of accounting controls may weigh down a
company's reporting systems, it can also give CFOs a way to reevaluate
financial processes. At one software company, the CFO combined the control
function with new initiatives supporting business goals. Recognizing that
the company's numerous order-entry systems threatened the credibility and
timing of its financial reporting, he led an effort to consolidate them into
a single system and then launched a project to redesign the quote-to-cash
process.
The technology sector is maturing, but many CFOs haven't adapted to the new
environment. They need to focus on rebalancing debt ratios, on courting
investors who seek long-term value, and on improving productivity. A strong
platform and the support of the CEO and the board can help a CFO become an
effective advocate for performance and shareholder value
¶ 10:17 AM 0 Comments
5 Ways to Cut Costs in 2005
by Tad Leahy
Cost-cutting initiatives remain firmly at the top of most CFOs' agenda. In a
May 2004 survey of finance executives at more than 150 large companies
conducted by New York City-based consulting firm Booz Allen Hamilton, 85
percent of respondents said cost reduction is their highest priority. Nearly
60 percent reported that they are focusing on opportunities to reduce the
cost of providing overhead services by trimming nonessential spending,
restructuring costs and standardizing service levels. And only 3 percent
said they have reduced overhead costs as much as possible.
Ongoing studies by The Hackett Group confirm that cost containment remains
most companies' primary objective. "Sixty-one percent of 300 executives who
responded to a recent poll said cost cutting was their number one
companywide priority," says Richard Roth, Hackett's Atlanta-based chief
research officer. "There's still a strong feeling among senior executives
that 'if our company does grow, let's make sure our costs don't grow along
with it.' "
While the draconian cost-cutting campaigns many organizations implemented
during the downturn may already have harvested much of the low-hanging
fruit, savvy CFOs can still find opportunities to ferret out efficiencies.
Here's a look at five approaches finance executives may want to consider as
they plan their cost-cutting strategies for 2005.
1. Look for the easy savings first. Where should CFOs begin their next round
of cost cutting? Chris Bogan, CEO of Best Practices LLC, a research and
consulting firm in Chapel Hill, N.C., says they should look for areas in
which they can drive efficiencies while minimizing disruption.
"Best-practice companies start by putting a freeze on entertainment and
travel expenditures," he says. For example, "the company could institute a
policy whereby employees can only travel with the president's authorization.
"Other top-line cost-cutting areas include consulting and marketing," Bogan
adds. After squeezing costs in those areas, CFOs should turn their attention
to discretionary spending. "That includes things like training, continuing
education and developmental capital [expenditures]," he says. Cost-control
initiatives in these areas "typically cause minor internal inconveniences,
but they can reduce overall costs by 1 percent to 2 percent or so," he
notes.
2. Grab compliance costs by the horns. Sarbanes-Oxley compliance activities
offer a huge target for CFOs bent on cost control. But compliance costs are
a wild card, a variable that companies have trouble quantifying. Most
organizations realize that their compliance expenditures are escalating, but
few have developed effective strategies for monitoring these costs.
In July, Financial Executives International (FEI) surveyed 224 public
companies with average revenues of $2.5 billion in order to gauge their
Section 404 compliance costs. Respondents' estimated average was $3.14
million. That's 62 percent more than the $1.93 million estimate obtained in
a similar FEI survey in January. Participants in the July survey expected to
pay their auditors $823,200 in fees for attestation of their internal
controls, up from $590,100 in the earlier study.
And, of course, many large organizations are shelling out much more than
average. According to Dan DiFilippo, U.S. leader of governance, risk and
compliance at PricewaterhouseCoopers in New York City, The Hongkong and
Shanghai Banking Corp. Ltd. reports spending about $300 million annually on
Sarbanes-Oxley compliance activities, and the CEO of insurance provider
American Inter-national Group Inc. has reported that his company is spending
approximately $400 million per year.
"Those are two examples of companies that have at least quantified the
compliance cost bucket," says DiFilippo. "Compliance is the one cost area
that has probably been examined the least.
"Companies with a solid understanding of their compliance costs tend to tie
them to their overall performance results," DiFilippo adds. "Once you factor
those costs into your bottom line performance stats, it gets attention --
and people start taking them seriously."
Organizations can get started on compliance cost-cutting measures even if
they don't fully have a handle on those expenses. For example, DiFilippo
points out that many companies underuse their enterprise resource planning
(ERP) system's control features. On average, only about 40 percent of those
features are turned on because many companies implemented their ERP systems
back in the days before regulatory compliance became such a big issue. "It's
certainly not a big spending item to check and see if your ERP system is
running at 100 percent when it comes to its control features," he says.
Manually pulling together data from multiple sources is a huge compliance
money drain, but "the implementation of Web services and XBRL [extensible
business reporting language] can help keep the manual intervention to a
minimum, improving cost efficiencies while reducing the likelihood for
errors," DiFilippo says. "Those are existing technologies at many companies
that are simply not being used for compliance cost control." He adds that
"manual processes are still the most common way of fulfilling compliance
requirements."
While CFOs may be looking to prune back their organization's educational
offerings, they shouldn't skimp on compliance training. Investing in
communication and training programs to educate employees about compliance
goals and procedures can help reduce errors, which in turn reduces costs,
DiFilippo notes. "Even a modest investment in training and education yields
significant savings and control efficiencies on the back end," he says.
Ultimately, compliance cost savings come from melding compliance activities
into the company's everyday business processes, so that they become an
integral part of the company's operations. "That way, there is no separate
compliance view of the world -- just one view, which incorporates the
compliance aspect," says DiFilippo.
3. Cut IT costs by standardizing technology. Budgets bloated with IT
expenditures and purchases still plague many companies. As CFOs search for
ways to corral those costs, they would do well to develop a consistent
methodology for selecting and evaluating potential IT investments and
understanding how new systems will integrate with their current IT
infrastructure.
Mastering IT complexity has become a critical success factor in managing
overhead, according to the Booz Allen Hamilton survey. Nearly 90 percent of
respondents who described themselves as behind the competition in providing
cost-efficient internal services cited "managing a patchwork of different
systems" as their main IT challenge.
Research from Hackett also points to lack of standardization as a major
source of IT cost overruns. "We see a lot of companies that deviate from
their standard IT architecture and equipment all too often, which tends to
drive up IT costs," reports Roth. "For instance, if the company's enterprise
standard is Oracle, and one of its divisions decides to use SAP, those kinds
of deviations complicate IT processes and waste time and money.
"The same often holds true for how much IT customization a company does,"
Roth adds. "The urge to customize -- vs. sticking with the
out-of-the-package version -- usually drives up costs."
Roth notes that world-class IT organizations focus on standardization and
simplification across the board, relying on 50 percent fewer ERP systems
than median companies and 29 percent fewer applications per 1,000 end users.
"The top companies are more likely to use data standards across all systems
and are significantly more likely to have implemented a high level of
standards enforcement across hardware, networking and software
applications," he says.
Labor expenses historically have been the biggest cost segment of IT.
World-class organizations accomplish significantly more with fewer IT
workers than median companies do, according to Roth. "The best companies are
running their operations with 36 percent less staff than average companies
-- 28 IT staff per 1,000 end users for world-class [organizations] vs. 44
for median companies," he says. In addition, "these top companies allocate
their internal IT staff very differently, dedicating a significantly larger
percentage of their staff to application management and less staff to
addressing technology infrastructure issues."
What's more, world-class companies are more effective in their IT efforts,
delivering 91 percent of all projects to specification, on time and on
budget, while median companies meet these criteria only 68 percent of the
time, according to Roth.
4. Reap workforce efficiencies by leveraging outsourcing, shared services
and offshoring. Companies have notched some major cost-cutting successes in
recent years by turning over noncore functions to third-party providers.
That's especially true in the IT realm. "World-class companies spend 60
percent more than their median peers outsourcing technology infrastructure
activities," Roth says. "Overall, they commit 23 percent more annually to
outsourcing."
But Scott Brennan, a Charlotte, N.C.-based partner in Accenture's finance
and performance management practice, sees room for improvement in
businesses' outsourcing practices. "Companies fail to eliminate the
employees whose jobs have now disappeared because of the outsourcing," he
says. "And while it takes some backbone to fire those people, not doing so
is cost-inefficient. That includes the operational management personnel who
were managing those people, as well as any other operational management
areas supporting the people who were fired."
Many organizations have achieved cost efficiencies by consolidating
back-office functions in shared-services centers. But companies have failed
to cast their shared-services net wide enough, Brennan says. "Not many firms
have brought the total back office together under one shared services
umbrella that includes purchasing, finance, HR, legal and other
administrative functions," he notes. "Companies capable of overcoming [that
problem] can realize 15 percent more in cost efficiencies than they're
currently getting."
Moving business processes, and sometimes whole departments, overseas is an
increasingly popular decision for companies looking to trim costs. Omar
Aguilar, principal with Deloitte Consulting LLP in Philadelphia, believes
that organizations which leverage a mix of offshoring, domestic outsourcing
and shared services rake in the biggest gains. "By combining all three, you
can reap significantly more cost-cutting benefits," he says. "Companies with
the most competitive cost structures apply a measure of all of these
initiatives. They're redefining their service delivery strategy.
"Outsourcing the offshore functions produces greater cost benefits than when
a company tries to establish its own offshore operations," Aguilar points
out, "because the outsourcer typically has greater expertise within the
region under consideration."
5. Reduce supply chain costs by consolidating vendors and driving inventory
improvements. Supply chain improvements should be high on every CFO's to-do
list, according to Bogan. "When it comes to process improvement, the first
and easiest area to focus on is the supply chain, by reducing the number of
vendors you work with and negotiating for better rates based on doing higher
volume business with [the ones you keep]," he says.
Inventory is the single most important target for cost-reduction initiatives
within the supply chain management function, according to John Rittenhouse,
national practice leader for operations risk management in the San Francisco
offices of KPMG LLP.
"Supply chain management revolves around inventory, including the amount of
it, where it's held and its quality," Rittenhouse says. "One way to reduce
[inventory] costs is to have the manufacturer keep more of the inventory and
to avoid owning the raw goods until the time of sale. Doing so helps improve
the management of C-class inventory; that is, products which typically don't
turn over very fast and have the highest likelihood of becoming obsolete."
Outsourcing supply chain management processes is a viable option, and one
that some companies have used in order to minimize capital expenditures when
embarking on a new business. "For example, Wal-Mart outsourced its food
division to a third party initially so it could get a better idea of how
successful that new business was likely to be," Rittenhouse says. "Then they
brought the operation in-house after they became convinced of its profit
potential."
Supply chain management software can help companies gain greater visibility
into key inventory processes. "It can provide a better view of where
inventory is located, so people can react faster to that information and
ensure the product is in the right place at the right time," says
Rittenhouse. Supply chain management systems "can also provide alerts
outside the supply area to the CFO and CEO if there are any issues those
executives need to address," he says.
Radio frequency identification (RFID) technology promises to become a huge
boon for inventory management, Rittenhouse adds. Eventually companies will
be able to place a tiny microchip on each product. The device will broadcast
data that will enable supply managers to pinpoint the item's location,
greatly improving inventory processes.
In addition to exploring these five key opportunities, finance executives
may want to revisit the cost-cutting strategies they implemented in the
downturn. For some companies, that may mean taking another hard look at the
size of their workforce.
"If you reach the point where you're forced to cut your people, you can do
that by degree, by putting a freeze on hiring and letting people retire, or
cutting back on the number of hours people work," says Bogan. "Another lever
you can pull is the health care, equipment and supplies those people had
been using. Paying someone a salary of $100,000 is in effect like paying
them about $140,000 after factoring in all the benefits and company support
they consume. You can also consider consolidating some jobs."
Anita Tilley, managing director with BearingPoint Inc. in Nashville, Tenn.,
cautions that layoffs can backfire in organizations with inefficient
business processes. "Research shows that companies that only cut heads but
remain mired in the same poor processes and strategies just end up hiring
new people to fill the spaces left by those fired, which ends up costing
them more money because they have to train the new people," she says.
Proactive CFOs will continue to scour their company for cost-cutting
opportunities. But they should also bear in mind that the most effective
measures aren't those that focus on individual processes or departments --
they are enterprisewide initiatives that become embedded in virtually every
corner of the organization. Initiatives like Six Sigma, lean manufacturing
and activity-based costing are proven methodologies not only for reducing
costs in the short term, but also for developing a cost-conscious culture
over the long haul.
The Power of Alignment
Companies' overhead cost reduction efforts often flounder because of
misalignments in their internal service delivery model, according to a
survey of CFOs at more than 150 large companies conducted by New York
City-based management and technology consulting firm Booz Allen Hamilton.
Internal service providers and the business units they serve are frequently
in conflict, leading to frustration and inefficiency.
Four of the top five reasons why cost reduction measures meet with
resistance from business units are "lack of communication," cited by 38
percent of respondents; "services not tailored to business needs" (36
percent); "didn't involve the business unit in decisions" (33 percent); and
"work offloaded to the business unit" (31 percent).
The study notes a strong correlation between business units' receptivity to
cost control measures and the presence of key business alignment mechanisms,
including the following:
* Service level agreements
* Chargebacks
* Physical consolidation of operations
* Performance-based compensation linked to key performance indicators
* Benchmarking of performance against outside companies and providers
* Access to external providers if business units are dissatisfied with
internal services
However, relatively few companies have adopted these measures, the study
notes. Fewer than 60 percent of the organizations surveyed have implemented
any of the most common alignment mechanisms: service level agreements,
chargebacks or physical consolidation of their operations.
Originally printed in the October 2004 issue of Business Finance
¶ 9:19 AM 0 Comments
Cost-cutting initiatives remain firmly at the top of most CFOs' agenda. In a
May 2004 survey of finance executives at more than 150 large companies
conducted by New York City-based consulting firm Booz Allen Hamilton, 85
percent of respondents said cost reduction is their highest priority. Nearly
60 percent reported that they are focusing on opportunities to reduce the
cost of providing overhead services by trimming nonessential spending,
restructuring costs and standardizing service levels. And only 3 percent
said they have reduced overhead costs as much as possible.
Ongoing studies by The Hackett Group confirm that cost containment remains
most companies' primary objective. "Sixty-one percent of 300 executives who
responded to a recent poll said cost cutting was their number one
companywide priority," says Richard Roth, Hackett's Atlanta-based chief
research officer. "There's still a strong feeling among senior executives
that 'if our company does grow, let's make sure our costs don't grow along
with it.' "
While the draconian cost-cutting campaigns many organizations implemented
during the downturn may already have harvested much of the low-hanging
fruit, savvy CFOs can still find opportunities to ferret out efficiencies.
Here's a look at five approaches finance executives may want to consider as
they plan their cost-cutting strategies for 2005.
1. Look for the easy savings first. Where should CFOs begin their next round
of cost cutting? Chris Bogan, CEO of Best Practices LLC, a research and
consulting firm in Chapel Hill, N.C., says they should look for areas in
which they can drive efficiencies while minimizing disruption.
"Best-practice companies start by putting a freeze on entertainment and
travel expenditures," he says. For example, "the company could institute a
policy whereby employees can only travel with the president's authorization.
"Other top-line cost-cutting areas include consulting and marketing," Bogan
adds. After squeezing costs in those areas, CFOs should turn their attention
to discretionary spending. "That includes things like training, continuing
education and developmental capital [expenditures]," he says. Cost-control
initiatives in these areas "typically cause minor internal inconveniences,
but they can reduce overall costs by 1 percent to 2 percent or so," he
notes.
2. Grab compliance costs by the horns. Sarbanes-Oxley compliance activities
offer a huge target for CFOs bent on cost control. But compliance costs are
a wild card, a variable that companies have trouble quantifying. Most
organizations realize that their compliance expenditures are escalating, but
few have developed effective strategies for monitoring these costs.
In July, Financial Executives International (FEI) surveyed 224 public
companies with average revenues of $2.5 billion in order to gauge their
Section 404 compliance costs. Respondents' estimated average was $3.14
million. That's 62 percent more than the $1.93 million estimate obtained in
a similar FEI survey in January. Participants in the July survey expected to
pay their auditors $823,200 in fees for attestation of their internal
controls, up from $590,100 in the earlier study.
And, of course, many large organizations are shelling out much more than
average. According to Dan DiFilippo, U.S. leader of governance, risk and
compliance at PricewaterhouseCoopers in New York City, The Hongkong and
Shanghai Banking Corp. Ltd. reports spending about $300 million annually on
Sarbanes-Oxley compliance activities, and the CEO of insurance provider
American Inter-national Group Inc. has reported that his company is spending
approximately $400 million per year.
"Those are two examples of companies that have at least quantified the
compliance cost bucket," says DiFilippo. "Compliance is the one cost area
that has probably been examined the least.
"Companies with a solid understanding of their compliance costs tend to tie
them to their overall performance results," DiFilippo adds. "Once you factor
those costs into your bottom line performance stats, it gets attention --
and people start taking them seriously."
Organizations can get started on compliance cost-cutting measures even if
they don't fully have a handle on those expenses. For example, DiFilippo
points out that many companies underuse their enterprise resource planning
(ERP) system's control features. On average, only about 40 percent of those
features are turned on because many companies implemented their ERP systems
back in the days before regulatory compliance became such a big issue. "It's
certainly not a big spending item to check and see if your ERP system is
running at 100 percent when it comes to its control features," he says.
Manually pulling together data from multiple sources is a huge compliance
money drain, but "the implementation of Web services and XBRL [extensible
business reporting language] can help keep the manual intervention to a
minimum, improving cost efficiencies while reducing the likelihood for
errors," DiFilippo says. "Those are existing technologies at many companies
that are simply not being used for compliance cost control." He adds that
"manual processes are still the most common way of fulfilling compliance
requirements."
While CFOs may be looking to prune back their organization's educational
offerings, they shouldn't skimp on compliance training. Investing in
communication and training programs to educate employees about compliance
goals and procedures can help reduce errors, which in turn reduces costs,
DiFilippo notes. "Even a modest investment in training and education yields
significant savings and control efficiencies on the back end," he says.
Ultimately, compliance cost savings come from melding compliance activities
into the company's everyday business processes, so that they become an
integral part of the company's operations. "That way, there is no separate
compliance view of the world -- just one view, which incorporates the
compliance aspect," says DiFilippo.
3. Cut IT costs by standardizing technology. Budgets bloated with IT
expenditures and purchases still plague many companies. As CFOs search for
ways to corral those costs, they would do well to develop a consistent
methodology for selecting and evaluating potential IT investments and
understanding how new systems will integrate with their current IT
infrastructure.
Mastering IT complexity has become a critical success factor in managing
overhead, according to the Booz Allen Hamilton survey. Nearly 90 percent of
respondents who described themselves as behind the competition in providing
cost-efficient internal services cited "managing a patchwork of different
systems" as their main IT challenge.
Research from Hackett also points to lack of standardization as a major
source of IT cost overruns. "We see a lot of companies that deviate from
their standard IT architecture and equipment all too often, which tends to
drive up IT costs," reports Roth. "For instance, if the company's enterprise
standard is Oracle, and one of its divisions decides to use SAP, those kinds
of deviations complicate IT processes and waste time and money.
"The same often holds true for how much IT customization a company does,"
Roth adds. "The urge to customize -- vs. sticking with the
out-of-the-package version -- usually drives up costs."
Roth notes that world-class IT organizations focus on standardization and
simplification across the board, relying on 50 percent fewer ERP systems
than median companies and 29 percent fewer applications per 1,000 end users.
"The top companies are more likely to use data standards across all systems
and are significantly more likely to have implemented a high level of
standards enforcement across hardware, networking and software
applications," he says.
Labor expenses historically have been the biggest cost segment of IT.
World-class organizations accomplish significantly more with fewer IT
workers than median companies do, according to Roth. "The best companies are
running their operations with 36 percent less staff than average companies
-- 28 IT staff per 1,000 end users for world-class [organizations] vs. 44
for median companies," he says. In addition, "these top companies allocate
their internal IT staff very differently, dedicating a significantly larger
percentage of their staff to application management and less staff to
addressing technology infrastructure issues."
What's more, world-class companies are more effective in their IT efforts,
delivering 91 percent of all projects to specification, on time and on
budget, while median companies meet these criteria only 68 percent of the
time, according to Roth.
4. Reap workforce efficiencies by leveraging outsourcing, shared services
and offshoring. Companies have notched some major cost-cutting successes in
recent years by turning over noncore functions to third-party providers.
That's especially true in the IT realm. "World-class companies spend 60
percent more than their median peers outsourcing technology infrastructure
activities," Roth says. "Overall, they commit 23 percent more annually to
outsourcing."
But Scott Brennan, a Charlotte, N.C.-based partner in Accenture's finance
and performance management practice, sees room for improvement in
businesses' outsourcing practices. "Companies fail to eliminate the
employees whose jobs have now disappeared because of the outsourcing," he
says. "And while it takes some backbone to fire those people, not doing so
is cost-inefficient. That includes the operational management personnel who
were managing those people, as well as any other operational management
areas supporting the people who were fired."
Many organizations have achieved cost efficiencies by consolidating
back-office functions in shared-services centers. But companies have failed
to cast their shared-services net wide enough, Brennan says. "Not many firms
have brought the total back office together under one shared services
umbrella that includes purchasing, finance, HR, legal and other
administrative functions," he notes. "Companies capable of overcoming [that
problem] can realize 15 percent more in cost efficiencies than they're
currently getting."
Moving business processes, and sometimes whole departments, overseas is an
increasingly popular decision for companies looking to trim costs. Omar
Aguilar, principal with Deloitte Consulting LLP in Philadelphia, believes
that organizations which leverage a mix of offshoring, domestic outsourcing
and shared services rake in the biggest gains. "By combining all three, you
can reap significantly more cost-cutting benefits," he says. "Companies with
the most competitive cost structures apply a measure of all of these
initiatives. They're redefining their service delivery strategy.
"Outsourcing the offshore functions produces greater cost benefits than when
a company tries to establish its own offshore operations," Aguilar points
out, "because the outsourcer typically has greater expertise within the
region under consideration."
5. Reduce supply chain costs by consolidating vendors and driving inventory
improvements. Supply chain improvements should be high on every CFO's to-do
list, according to Bogan. "When it comes to process improvement, the first
and easiest area to focus on is the supply chain, by reducing the number of
vendors you work with and negotiating for better rates based on doing higher
volume business with [the ones you keep]," he says.
Inventory is the single most important target for cost-reduction initiatives
within the supply chain management function, according to John Rittenhouse,
national practice leader for operations risk management in the San Francisco
offices of KPMG LLP.
"Supply chain management revolves around inventory, including the amount of
it, where it's held and its quality," Rittenhouse says. "One way to reduce
[inventory] costs is to have the manufacturer keep more of the inventory and
to avoid owning the raw goods until the time of sale. Doing so helps improve
the management of C-class inventory; that is, products which typically don't
turn over very fast and have the highest likelihood of becoming obsolete."
Outsourcing supply chain management processes is a viable option, and one
that some companies have used in order to minimize capital expenditures when
embarking on a new business. "For example, Wal-Mart outsourced its food
division to a third party initially so it could get a better idea of how
successful that new business was likely to be," Rittenhouse says. "Then they
brought the operation in-house after they became convinced of its profit
potential."
Supply chain management software can help companies gain greater visibility
into key inventory processes. "It can provide a better view of where
inventory is located, so people can react faster to that information and
ensure the product is in the right place at the right time," says
Rittenhouse. Supply chain management systems "can also provide alerts
outside the supply area to the CFO and CEO if there are any issues those
executives need to address," he says.
Radio frequency identification (RFID) technology promises to become a huge
boon for inventory management, Rittenhouse adds. Eventually companies will
be able to place a tiny microchip on each product. The device will broadcast
data that will enable supply managers to pinpoint the item's location,
greatly improving inventory processes.
In addition to exploring these five key opportunities, finance executives
may want to revisit the cost-cutting strategies they implemented in the
downturn. For some companies, that may mean taking another hard look at the
size of their workforce.
"If you reach the point where you're forced to cut your people, you can do
that by degree, by putting a freeze on hiring and letting people retire, or
cutting back on the number of hours people work," says Bogan. "Another lever
you can pull is the health care, equipment and supplies those people had
been using. Paying someone a salary of $100,000 is in effect like paying
them about $140,000 after factoring in all the benefits and company support
they consume. You can also consider consolidating some jobs."
Anita Tilley, managing director with BearingPoint Inc. in Nashville, Tenn.,
cautions that layoffs can backfire in organizations with inefficient
business processes. "Research shows that companies that only cut heads but
remain mired in the same poor processes and strategies just end up hiring
new people to fill the spaces left by those fired, which ends up costing
them more money because they have to train the new people," she says.
Proactive CFOs will continue to scour their company for cost-cutting
opportunities. But they should also bear in mind that the most effective
measures aren't those that focus on individual processes or departments --
they are enterprisewide initiatives that become embedded in virtually every
corner of the organization. Initiatives like Six Sigma, lean manufacturing
and activity-based costing are proven methodologies not only for reducing
costs in the short term, but also for developing a cost-conscious culture
over the long haul.
The Power of Alignment
Companies' overhead cost reduction efforts often flounder because of
misalignments in their internal service delivery model, according to a
survey of CFOs at more than 150 large companies conducted by New York
City-based management and technology consulting firm Booz Allen Hamilton.
Internal service providers and the business units they serve are frequently
in conflict, leading to frustration and inefficiency.
Four of the top five reasons why cost reduction measures meet with
resistance from business units are "lack of communication," cited by 38
percent of respondents; "services not tailored to business needs" (36
percent); "didn't involve the business unit in decisions" (33 percent); and
"work offloaded to the business unit" (31 percent).
The study notes a strong correlation between business units' receptivity to
cost control measures and the presence of key business alignment mechanisms,
including the following:
* Service level agreements
* Chargebacks
* Physical consolidation of operations
* Performance-based compensation linked to key performance indicators
* Benchmarking of performance against outside companies and providers
* Access to external providers if business units are dissatisfied with
internal services
However, relatively few companies have adopted these measures, the study
notes. Fewer than 60 percent of the organizations surveyed have implemented
any of the most common alignment mechanisms: service level agreements,
chargebacks or physical consolidation of their operations.
Originally printed in the October 2004 issue of Business Finance
¶ 9:19 AM 0 Comments
Why You Need to Know About ITIL
By Kevin Behr , Gene Kim
IP Services and Tripwire
Introduction
For the past several year, Gene Kim and Kevin Behr have been hosting a
unique series of events that they call the Practitioner's Roundtable. Kim
and Behr invite IT security and operations executives from leading
organizations, and discuss their common business issues and challenges.
Today, they have hosted over 15 of these events, and have interacted with
over 150 executives from companies such as America Online, Magellan Health,
Warner Bros., Goldman Sachs, OnCommand, Verisign, and PaineWebber.
Indeed, these companies' common problems seemed independent of their
industry or region. IT Operations executives were being tasked with
increasing service levels, while simultaneously decreasing costs (in many
cases, their cost reduction model was having their budget cut by 20%). IT
Security executives, with budgets that are orders of magnitude smaller than
their business units or operations peers, continue to grapple with
integration into everyday business processes. In other words, even if they
had the budget staff, they often are not invited to the right meetings early
enough in the lifecycle, so activities center on urgent firefighting,
instead of improving processes.
Kim and Behr's surprising conclusion? Organizations that invest most in
creating IT Operations and Security processes had the highest service levels
(as measured by Mean Time to Repair and Mean Time Between Failures), the
best security (as measured by the earliest integration of security into the
Ops lifecycle), and also the most efficient cost structures (as measured by
having "server to system administrator" ratios greater than 100:1).
The results appear very similar to other arenas where best practices
emerge. Organizations in firefighting mode rarely have time to automate
their tedious and error-prone tasks, while ³best in class² organizations
have freed up enough resources to continually invest in automation and
continuous improvement.
Why ITIL Can Help
Many executives express frustration as they attempt to reign in the chaos
and expense associated with their IT investments but find little in the way
of substantive guidance. The IT Infrastructure Library (ITIL) has emerged as
the worlds most widely accepted approach to the management and delivery of
IT Services.
If you haven¹t heard of ITIL, don¹t be surprised. ITIL currently has over
42,000 certified consultants, primarily in Europe and Canada, with only a
small fraction of those certified professionals residing or practicing in
the U.S.
The Information Technology Infrastructure Library (ITIL) represents a
drastically different approach to IT by framing all activity under two broad
umbrellas named Service Management and Service Delivery respectively. By
focusing on the critical business processes and disciplines needed to
deliver services around IT, the ITIL provides a maturity path for IT that is
not based on technology. This accessibility allows senior executives to both
sponsor and shepherd IT quality improvement efforts. The ITIL has become the
most widely accepted approach to IT service management.
ITIL provides a comprehensive, consistent volume of best practices drawn
from the collective experience and wisdom of thousands of IT practitioners
around the world. By defining IT quality as the level of alignment between
the actual services delivered and the actual needs of the business the
library serves as a common point of engagement for IT and the other business
units.
What ITIL Covers
To codify and organize the guidance contained in the ITIL the British
Standards Institution published the BS15000 as a code of IT Practice for IT
Service Management. The BS15000 organizes all of the guidance from the ITIL
in to five distinct categories. The areas include: Service Design and
Management Processes, Supplier Processes, Resolution Processes, Control
Processes, and Release Processes.
Service Design and Management - The goal of this process is to provide the
best possible service levels to meet the business needs of the organization.
This process area includes the monitoring and management of IT
infrastructure as it relates to Security management, Availability and
Contingency Management, Capacity Management, Financial Management and
Service Level Management and Reporting.
Supplier Processes - This area focuses on the processes necessary to
support effective customer relations as well as the management of third
party vendors from a performance and contractual standpoint.
Resolution Processes- The focus of Resolution Processes is centered on the
organizations ability to manage incidents and problems. This process group
provides for the controlled, consistent management of IT customers and
issues.
Control Processes - These processes are designed to control the amount of
unique configurations and assets required to efficiently deliver IT
services, as well as the prevention of service interruption. By better
understanding the type and location of infrastructure, IT can create
effective plans for ongoing maintenance without overlooking any critical
item. Configuration management is the process of identifying all of the
components that make up working infrastructure and putting these components
under management. When implemented this process allows IT to maintain
infrastructure in its intended state and when necessary, recreate it from
scratch.
Release Processes - Release Process related activities include the
planning, design, build, configuration of hardware and software releases to
create an accepted library of build components. This process is directly
linked to the configuration and change management processes and depends
largely on the integrity they can assure the business. Release processes are
traditionally the last process area that organizations invest in. Yet it is
the process area that delivers the highest return on investment, because it
encompasses the entire pre-production infrastructure, where the cost of
defect repair is least expensive.
ITIL Success Stories
Now that you have been exposed to what the ITIL and BS15000 are the next
logical question is "has anyone successfully adopted this framework"? The
answer is a resounding yes. Over the last ten years organizations ranging
both in size and industry have succesfuly integrated the best practices
guidance and taken their results to the public. Some of the most familiar
names include Proctor and Gamble, that credits its ITIL adoption with saving
the company well over one hundred million (U.S.) dollars each year. Other
organizations such as Shell have leveraged the ITIL and saved both large
amounts of man-hours and well hard currency. Other noteworthy ITIL adopters
include Guinness, IBM, British Airways, and The Internal Revenue Service.
It has become clear that focusing on the development of a process driven IT
organization can yield significant efficiency related savings. What is also
interesting is that effectiveness of services delivered has also ranked
highly as one of the many positive outcomes of best practice adoption.
Moving into the realm of IT Service Management requires the attention and
focus of the IT organization as well as many important stakeholders from
other business units.
Easy Steps To Get Value With ITIL
How do you get started with ITIL? After all, ITIL covers over volumes upon
volumes of manuals that sometimes read like a dictionary. A better approach
would be to look at several key process areas in your organization, assess
where you are versus best practices, and use that to generate smaller
projects to bootstrap controls and processes that need attention.
We include a short questionnaire in several key areas below that have high
leverage, and have a high probability of quick improvements with high
visibility of return. Take the short questionnaire below, and see whether
any of these issues uncover any issues, that commonly cause widespread
service disruption and firefighting behaviors.
Control processes
 Do your system administrators spend too much time fire-fighting?
 Do you have a well documented change management process that
provides visibility and control points for changes?
 Are the largest percentage of problems caused by changes made
internally as opposed to externally?
 Can you quickly discover unauthorized or undocumented changes?
 Can you lock down production servers so no change is allowed?
 Can you map systems changes to a change request or an authorized
work order?
 Do you schedule all system changes to fixed maintenance windows
to mitigate the risk of changes?
 Do you have an end-of-shift audit process, to ensure that the Ops
manager is handing over the data center in the same that as he/she received
it?
Release processes
 Can you enforce a standard configuration build across all of your
devices?
 Do you know precisely how many different configurations you have
in your environment?
 Can you reliably rebuild servers that are in production (i.e.,
"we can do bare-metal builds")?
 Do you perform change audits for all of your production systems?
 Are production and development systems clearly separated?
 How do ensure that the staging environment matches the
pre-production environment before deploying into production?
 Can you capture the known good state or "golden build" as part of
the release management process?
 Do have confidence that the deployed systems match the golden
build?
 Do you have a library of automated build systems for all critical
devices (i.e., repeatable, automated processes that can provision all
critical systems)?
Resolution Processes
 Is change regardless of source the root cause of most of your
remediation efforts?
 Is the longest part of your repair cycle spent diagnosing what's
wrong?
 Can you quickly detect what changed on systems during problem
resolution?
 Can you perform precision rollbacks when undesired change is
detected?
 During remediation, can you see all authorized work orders
pertaining to a target system?
 During remediation, can you see all previous work tickets in
order to learn what has caused failures on your system in the past?
 Do you track the change success rate?
 Do you have a process that maps all changes to a valid business
purpose or authorized work order?
 Have you identified a set of change owner for all critical
systems?
 Do you have a list of repeat offenders who circumvent change
management policies?
From Denial, Acceptance, and Problem Solving
If you are like most IT operation organizations, you may have uncovered
some issues with this short questionnaire. Don¹t worry, because these are
common problems that ITIL was designed to solve.
Have an ITIL Question? Ask the Experts on the ITVM Blog!
Additional Information:
Gene Kim is the chief technology officer and co-founder of Tripwire, Inc. He
is currently working with Kevin Behr on IT integrity models to explain why
IT is in so much pain, and show how basic capabilities such as repeatable
builds and quick remediation are the key to running IT securely.
¶ 9:04 AM 0 Comments
IP Services and Tripwire
Introduction
For the past several year, Gene Kim and Kevin Behr have been hosting a
unique series of events that they call the Practitioner's Roundtable. Kim
and Behr invite IT security and operations executives from leading
organizations, and discuss their common business issues and challenges.
Today, they have hosted over 15 of these events, and have interacted with
over 150 executives from companies such as America Online, Magellan Health,
Warner Bros., Goldman Sachs, OnCommand, Verisign, and PaineWebber.
Indeed, these companies' common problems seemed independent of their
industry or region. IT Operations executives were being tasked with
increasing service levels, while simultaneously decreasing costs (in many
cases, their cost reduction model was having their budget cut by 20%). IT
Security executives, with budgets that are orders of magnitude smaller than
their business units or operations peers, continue to grapple with
integration into everyday business processes. In other words, even if they
had the budget staff, they often are not invited to the right meetings early
enough in the lifecycle, so activities center on urgent firefighting,
instead of improving processes.
Kim and Behr's surprising conclusion? Organizations that invest most in
creating IT Operations and Security processes had the highest service levels
(as measured by Mean Time to Repair and Mean Time Between Failures), the
best security (as measured by the earliest integration of security into the
Ops lifecycle), and also the most efficient cost structures (as measured by
having "server to system administrator" ratios greater than 100:1).
The results appear very similar to other arenas where best practices
emerge. Organizations in firefighting mode rarely have time to automate
their tedious and error-prone tasks, while ³best in class² organizations
have freed up enough resources to continually invest in automation and
continuous improvement.
Why ITIL Can Help
Many executives express frustration as they attempt to reign in the chaos
and expense associated with their IT investments but find little in the way
of substantive guidance. The IT Infrastructure Library (ITIL) has emerged as
the worlds most widely accepted approach to the management and delivery of
IT Services.
If you haven¹t heard of ITIL, don¹t be surprised. ITIL currently has over
42,000 certified consultants, primarily in Europe and Canada, with only a
small fraction of those certified professionals residing or practicing in
the U.S.
The Information Technology Infrastructure Library (ITIL) represents a
drastically different approach to IT by framing all activity under two broad
umbrellas named Service Management and Service Delivery respectively. By
focusing on the critical business processes and disciplines needed to
deliver services around IT, the ITIL provides a maturity path for IT that is
not based on technology. This accessibility allows senior executives to both
sponsor and shepherd IT quality improvement efforts. The ITIL has become the
most widely accepted approach to IT service management.
ITIL provides a comprehensive, consistent volume of best practices drawn
from the collective experience and wisdom of thousands of IT practitioners
around the world. By defining IT quality as the level of alignment between
the actual services delivered and the actual needs of the business the
library serves as a common point of engagement for IT and the other business
units.
What ITIL Covers
To codify and organize the guidance contained in the ITIL the British
Standards Institution published the BS15000 as a code of IT Practice for IT
Service Management. The BS15000 organizes all of the guidance from the ITIL
in to five distinct categories. The areas include: Service Design and
Management Processes, Supplier Processes, Resolution Processes, Control
Processes, and Release Processes.
Service Design and Management - The goal of this process is to provide the
best possible service levels to meet the business needs of the organization.
This process area includes the monitoring and management of IT
infrastructure as it relates to Security management, Availability and
Contingency Management, Capacity Management, Financial Management and
Service Level Management and Reporting.
Supplier Processes - This area focuses on the processes necessary to
support effective customer relations as well as the management of third
party vendors from a performance and contractual standpoint.
Resolution Processes- The focus of Resolution Processes is centered on the
organizations ability to manage incidents and problems. This process group
provides for the controlled, consistent management of IT customers and
issues.
Control Processes - These processes are designed to control the amount of
unique configurations and assets required to efficiently deliver IT
services, as well as the prevention of service interruption. By better
understanding the type and location of infrastructure, IT can create
effective plans for ongoing maintenance without overlooking any critical
item. Configuration management is the process of identifying all of the
components that make up working infrastructure and putting these components
under management. When implemented this process allows IT to maintain
infrastructure in its intended state and when necessary, recreate it from
scratch.
Release Processes - Release Process related activities include the
planning, design, build, configuration of hardware and software releases to
create an accepted library of build components. This process is directly
linked to the configuration and change management processes and depends
largely on the integrity they can assure the business. Release processes are
traditionally the last process area that organizations invest in. Yet it is
the process area that delivers the highest return on investment, because it
encompasses the entire pre-production infrastructure, where the cost of
defect repair is least expensive.
ITIL Success Stories
Now that you have been exposed to what the ITIL and BS15000 are the next
logical question is "has anyone successfully adopted this framework"? The
answer is a resounding yes. Over the last ten years organizations ranging
both in size and industry have succesfuly integrated the best practices
guidance and taken their results to the public. Some of the most familiar
names include Proctor and Gamble, that credits its ITIL adoption with saving
the company well over one hundred million (U.S.) dollars each year. Other
organizations such as Shell have leveraged the ITIL and saved both large
amounts of man-hours and well hard currency. Other noteworthy ITIL adopters
include Guinness, IBM, British Airways, and The Internal Revenue Service.
It has become clear that focusing on the development of a process driven IT
organization can yield significant efficiency related savings. What is also
interesting is that effectiveness of services delivered has also ranked
highly as one of the many positive outcomes of best practice adoption.
Moving into the realm of IT Service Management requires the attention and
focus of the IT organization as well as many important stakeholders from
other business units.
Easy Steps To Get Value With ITIL
How do you get started with ITIL? After all, ITIL covers over volumes upon
volumes of manuals that sometimes read like a dictionary. A better approach
would be to look at several key process areas in your organization, assess
where you are versus best practices, and use that to generate smaller
projects to bootstrap controls and processes that need attention.
We include a short questionnaire in several key areas below that have high
leverage, and have a high probability of quick improvements with high
visibility of return. Take the short questionnaire below, and see whether
any of these issues uncover any issues, that commonly cause widespread
service disruption and firefighting behaviors.
Control processes
 Do your system administrators spend too much time fire-fighting?
 Do you have a well documented change management process that
provides visibility and control points for changes?
 Are the largest percentage of problems caused by changes made
internally as opposed to externally?
 Can you quickly discover unauthorized or undocumented changes?
 Can you lock down production servers so no change is allowed?
 Can you map systems changes to a change request or an authorized
work order?
 Do you schedule all system changes to fixed maintenance windows
to mitigate the risk of changes?
 Do you have an end-of-shift audit process, to ensure that the Ops
manager is handing over the data center in the same that as he/she received
it?
Release processes
 Can you enforce a standard configuration build across all of your
devices?
 Do you know precisely how many different configurations you have
in your environment?
 Can you reliably rebuild servers that are in production (i.e.,
"we can do bare-metal builds")?
 Do you perform change audits for all of your production systems?
 Are production and development systems clearly separated?
 How do ensure that the staging environment matches the
pre-production environment before deploying into production?
 Can you capture the known good state or "golden build" as part of
the release management process?
 Do have confidence that the deployed systems match the golden
build?
 Do you have a library of automated build systems for all critical
devices (i.e., repeatable, automated processes that can provision all
critical systems)?
Resolution Processes
 Is change regardless of source the root cause of most of your
remediation efforts?
 Is the longest part of your repair cycle spent diagnosing what's
wrong?
 Can you quickly detect what changed on systems during problem
resolution?
 Can you perform precision rollbacks when undesired change is
detected?
 During remediation, can you see all authorized work orders
pertaining to a target system?
 During remediation, can you see all previous work tickets in
order to learn what has caused failures on your system in the past?
 Do you track the change success rate?
 Do you have a process that maps all changes to a valid business
purpose or authorized work order?
 Have you identified a set of change owner for all critical
systems?
 Do you have a list of repeat offenders who circumvent change
management policies?
From Denial, Acceptance, and Problem Solving
If you are like most IT operation organizations, you may have uncovered
some issues with this short questionnaire. Don¹t worry, because these are
common problems that ITIL was designed to solve.
Have an ITIL Question? Ask the Experts on the ITVM Blog!
Additional Information:
Gene Kim is the chief technology officer and co-founder of Tripwire, Inc. He
is currently working with Kevin Behr on IT integrity models to explain why
IT is in so much pain, and show how basic capabilities such as repeatable
builds and quick remediation are the key to running IT securely.
¶ 9:04 AM 0 Comments
IT and Business Alignment: Finding the Mark
July 23, 2004
Charles Steinmetz was once called out of retirement by General Electric to
help it locate a problem in an intricate system of complex machines. Having
spent some time tinkering with and testing various parts of the system, he
finally placed a chalk-marked 'X' on a small component in one machine. GE's
engineers promptly examined the component, and were amazed to find the
defect in the precise location of Steinmetz's mark.
Some time later, GE received an invoice from the wily engineer - for
$10,000. Incredulous, they protested the bill and challenged him to itemize
it. Steinmetz did so: "Making one chalk mark: $1," he wrote. "Knowing where
to place it: $9,999."
This knowledge that Steinmetz exhibited is not unlike the deftness of a good
CIO that knows where to place the mark in regards to IT strategy and
business alignment. Just like the intricate system of the GE machines, many
corporations have intricate business strategies, adding a complexity to
achieving business alignment.
According to Computer Economics, Inc., over 65% of companies polled report
their business alignment to be either somewhat effective or not effective at
all. This isn¹t surprising if multiple business strategies make alignment
extremely challenging. For such a situation, optimizing IT¹s core strengths
in a strategically flexible manner can reduce the feeling of
ineffectiveness.
This requires a diligent CIO that understands where the company is headed.
If, for example, the corporation¹s primary business strategy is to be the
market leader in their field by reducing production costs, then the CIO is
strongly motivated to run a lean IT shop, establishing IT as a low cost,
optimized work force to all lines of business.
At the same time, imagine this same corporation also has a business strategy
of achieving full financial transparency through their corporate governance
initiatives. The savvy CIO implements activity-based costing and correlates
this information with lines-of-business throughout the enterprise. Strategic
IT value initiatives are identified and measured to manage the causes of IT
costs instead of the cost itself.
In the background to being a market leader and supporting corporate
governance, this same corporation has a robust business strategy to expand
into untouched global markets. The CIO must maximize IT¹s assets, accurately
assess new investments and coordinate an infrastructure that is agile and
robust while achieving IT operational excellence.
Surrounding this entire scenario are other IT projects jockeying for
position, claiming urgency and creating competition between senior managers
supporting various projects. The discipline required of the CIO to identify
the projects that truly align with business strategy becomes imperative.
IT Portfolio Management
The pressure for IT to find the mark of alignment in regards to business
strategy becomes impossible without the aid of tools that support this
process. If we are to take Steinmetz¹ example in precisely identifying the
defect within the intricate system of business alignment, it may rest with a
lack of business process within IT.
In the financial world, portfolio management is a method of maintaining a
healthy diversification for maximum return, the premise being that a
portfolio of investments minimizes risk, unlike a individual investment. By
absorbing this method from the financial world, a CIO is positioned for
success. Defined processes are in place for reviewing IT projects and how
they coordinate with business strategies. From an IT perspective, portfolio
management is the process of creating and managing a portfolio of projects
as they best relate to and support the overall business strategies of the
enterprise.
This requires business intelligence to rate projects from the following
perspectives:
Maximizing the value of IT investments
Aligning IT projects with corporate business objectives
Scheduling resources more efficiently
Consolidating IT resources
Conveying the cost and value of IT in terms easily understood.
Placing the mark in regards to IT strategy and business alignment stems
from the deftness of the CIO and the business intelligence and communication
supported across all lines of business. Learning to visualize projects from
multiple perspectives enables stronger prioritization and evaluation when it
comes to identifying projects to invest in. Ultimately, identifying
alignment despite the complexity of strategies leads to delivering
meaningful value within the enterprise. And value, as Steinmetz pointed out,
is everything.
Ruby Gates
Editor
¶ 8:40 AM 0 Comments
Charles Steinmetz was once called out of retirement by General Electric to
help it locate a problem in an intricate system of complex machines. Having
spent some time tinkering with and testing various parts of the system, he
finally placed a chalk-marked 'X' on a small component in one machine. GE's
engineers promptly examined the component, and were amazed to find the
defect in the precise location of Steinmetz's mark.
Some time later, GE received an invoice from the wily engineer - for
$10,000. Incredulous, they protested the bill and challenged him to itemize
it. Steinmetz did so: "Making one chalk mark: $1," he wrote. "Knowing where
to place it: $9,999."
This knowledge that Steinmetz exhibited is not unlike the deftness of a good
CIO that knows where to place the mark in regards to IT strategy and
business alignment. Just like the intricate system of the GE machines, many
corporations have intricate business strategies, adding a complexity to
achieving business alignment.
According to Computer Economics, Inc., over 65% of companies polled report
their business alignment to be either somewhat effective or not effective at
all. This isn¹t surprising if multiple business strategies make alignment
extremely challenging. For such a situation, optimizing IT¹s core strengths
in a strategically flexible manner can reduce the feeling of
ineffectiveness.
This requires a diligent CIO that understands where the company is headed.
If, for example, the corporation¹s primary business strategy is to be the
market leader in their field by reducing production costs, then the CIO is
strongly motivated to run a lean IT shop, establishing IT as a low cost,
optimized work force to all lines of business.
At the same time, imagine this same corporation also has a business strategy
of achieving full financial transparency through their corporate governance
initiatives. The savvy CIO implements activity-based costing and correlates
this information with lines-of-business throughout the enterprise. Strategic
IT value initiatives are identified and measured to manage the causes of IT
costs instead of the cost itself.
In the background to being a market leader and supporting corporate
governance, this same corporation has a robust business strategy to expand
into untouched global markets. The CIO must maximize IT¹s assets, accurately
assess new investments and coordinate an infrastructure that is agile and
robust while achieving IT operational excellence.
Surrounding this entire scenario are other IT projects jockeying for
position, claiming urgency and creating competition between senior managers
supporting various projects. The discipline required of the CIO to identify
the projects that truly align with business strategy becomes imperative.
IT Portfolio Management
The pressure for IT to find the mark of alignment in regards to business
strategy becomes impossible without the aid of tools that support this
process. If we are to take Steinmetz¹ example in precisely identifying the
defect within the intricate system of business alignment, it may rest with a
lack of business process within IT.
In the financial world, portfolio management is a method of maintaining a
healthy diversification for maximum return, the premise being that a
portfolio of investments minimizes risk, unlike a individual investment. By
absorbing this method from the financial world, a CIO is positioned for
success. Defined processes are in place for reviewing IT projects and how
they coordinate with business strategies. From an IT perspective, portfolio
management is the process of creating and managing a portfolio of projects
as they best relate to and support the overall business strategies of the
enterprise.
This requires business intelligence to rate projects from the following
perspectives:
Maximizing the value of IT investments
Aligning IT projects with corporate business objectives
Scheduling resources more efficiently
Consolidating IT resources
Conveying the cost and value of IT in terms easily understood.
Placing the mark in regards to IT strategy and business alignment stems
from the deftness of the CIO and the business intelligence and communication
supported across all lines of business. Learning to visualize projects from
multiple perspectives enables stronger prioritization and evaluation when it
comes to identifying projects to invest in. Ultimately, identifying
alignment despite the complexity of strategies leads to delivering
meaningful value within the enterprise. And value, as Steinmetz pointed out,
is everything.
Ruby Gates
Editor
¶ 8:40 AM 0 Comments
High-Performing IT Organizations: What You Need to Change to
Become One
By Gene Kim & Julia Allen
www.itpi.org
IT is being challenged on many fronts, from cost containment, business
alignment, compliance, competitive pressures in managing outsourced IT
services, and security. Many experienced IT practitioners confronted by this
potentially staggering array of challenges will point out that the solution
to virtually all these issues is more repeatable IT processes and effective
controls. However, merely understanding this does not necessarily equate to
an effective plan to solve the problems, and may create more questions than
answers. To simplify the problem, Dr. Eliyahu Goldratt, creator of the
"Theory of Constraints", articulates three simple questions that must have
credible answers: what do I need to change, what should I change to, and how
do I cause the change?
Finding answers to those three questions has been an area of passion for
Gene since 1999. He has been researching high-performing IT operations and
security organizations, attempting to understand what makes them so
different than typical IT organizations, as well as studying how
organizations have accomplished the transformations that take them from
being merely average to best in class. Along this journey, Gene started
working with other organizations that are also interested in these issues,
such as SANS, the IT Process Institute (ITPI), the Institute of Internal
Auditors (IIA), and most recently, the Software Engineering Institute (SEI)
with Julia Allen. In particular, the collaboration between the ITPI and SEI
has yielded some extremely promising results, both in characterizing
high-and low-performing IT organizations, the key differences in their
belief systems, and the necessary components to achieve an organizational
transformation from low- to high-performer.
In this article, we will discuss two areas of research that we believe are
foundational for answering the question of what IT organizations typically
need to change and what they need to change it to. We will present a working
definition of what characterizes a high-performing IT organization, and then
discuss the key differences in the belief systems between them and more
typical IT organizations in three areas of pain: patch management,
proliferation of IT management scorecards, and managing outsourced IT
services.
Lastly, to help answer the question of how to cause the change, we will
describe the publicly available Visible Ops methodology, which captures how
IT organizations have transformed into high-performers in a way that is can
be accomplished in four steps, each which is a finite project and returns
more value back than was invested. We will also describe the ITPI Community
of Practice Listserv, and the upcoming VEESC benchmarking study. We conclude
the article with a call to action and an active solicitation for feedback in
participation in creating this community of practice for high-performing IT
organizations.
Key Characteristics of High-Performing IT Organizations
Since 1999, after studying the IT processes of hundreds of organizations,
it started becoming clear to Gene that a handful of them stood out as
somehow different from the others in some notable way. He started keeping a
list of these organizations, at that time informally called ³Gene¹s list of
people with amazing kung fu.² In 2000, Gene started working with Kevin Behr,
CTO of one of these unusual organizations, and they started a more
systematic analysis of what was common to these organizations, called the
³best in class IT operations and security organizations.² In 2003, Julia
Allen from the SEI actively joined this effort, which resulted in a
remarkable event in October 2003 at Carnegie Mellon University called the
Best In Class Security and Operations Roundtable (BIC-SORT).
Among the stated goals were to ³begin to build an executive-level community
of practice for IT (information technology) operations and security, with a
common sense of purpose and a desire to influence other relevant and
connected communities of practice; and to better capture and articulate the
relevant bodies of knowledge that enable and accelerate IT operational and
security process improvement.² Since then, we have been actively processing
and synthesizing the data we collected.
Based on our analysis, we have created the following working definition of
high-performing IT organizations: They are effective and efficient and they
succeed in applying resources to accomplish their stated business objectives
with little to no wasted effort. These organizations have evolved a system
of process improvement as a natural consequence of their business demands.
They regularly implement formal, repeatable and secure operational
processes.
Results of informal benchmarking indicate that in these best-in-class IT
organizations, IT operations and security work together to create higher
service levels (e.g., as measured by mean time to repair, mean time between
failure); higher percentage of planned, scheduled work relative to unplanned
work; unusually efficient cost structures (e.g., as measured by server to
system administrator ratios); productive working relationships with
management and peers; and smoother audits. Furthermore, they have more
timely identification and resolution of security incidents, the earliest
integration of information security requirements in the service delivery
lifecycle, and the ability to quickly return to a reliable and trusted
operational state. And perhaps most admirably, these organizations devote
increasingly more time and resources to strategic issues, having mastered
tactical concerns.
The high-performing organizations desire to detect production variances
early so they can fix problems in a planned manner and where the repair
costs are lowest and have the least impact. They value repeatable and
verifiable processes and use controls to improve efficiency and
effectiveness. And because these organizations use controls to improve their
own operation, life is much easier for auditors who evaluate operational
risk based on the presence of effective and verifiable preventive,
detective, and corrective controls. In other words, the controls aren¹t
there just because auditors asked for them, but because they are used to
improve daily operations! As a result, high-performing organizations require
considerably less effort to meet management and audit expectations.
To achieve these characteristics, several key performance metrics are
essential to this level of performance: they have the highest change success
rate (typically over 98%), highest effective rate of change (sometimes
making over 1000+ successful changes per week), highest level of mastery of
production infrastructure (achieved by low configuration counts and low
configuration variance), and highest ratio of staff dedicated to
pre-production activities (achieved by release management processes,
pre-production testing, etc.).
Surprisingly, we found that all of the high-performing IT organizations had
independently developed virtually the exact same processes to achieve these
results. They shared similarities in three key process areas, which we will
describe in the parlance of ITIL (IT Infrastructure Library): they had a
³culture of causality² that ensured all production problems ruled out change
as early as possible in the repair cycle (resolution processes), they had a
³culture of change management² embedded in the way all work is done (control
processes), and they moved as many production changes through a
pre-production process that orchestrated changes with the production
environment (release processes).
The high-performing organizations all implemented virtually the same
procedures in these three ITIL process areas, which form the minimal
closed-loop that generates metrics that allow continual process improvement.
These procedures and processes are described in the Visible Ops methodology
in detail, published by the ITPI.
Belief System Differences Between High- And Low- Performing IT Organizations
Given the fact that high-performing IT organizations exist, what prevents
low-performing organizations from becoming high-performers, given the
promise of a better way? Understanding why this was so became one of the
main areas of activity after the BIC-SORT event. Julia Allen, Kevin Behr,
and Gene Kim from the ITPI and SEI have been synthesizing the captured list
of key areas of pain and promise from the participating organizations during
BIC-SORT. Our goal was to create a taxonomy of pains, find any cause-effect
relationships and root causes and understand what belief systems that
preserved the status quo for the low-performers.
In the BIC-SORT, we captured almost one hundred specific areas of pain, such
as the challenges of keeping up with security patches, the massive efforts
required to do effective audits of business peers, and so forth. Of these,
we chose to analyze three of the most acute of the listed pains: keeping up
with patching, dealing with the proliferation of management scorecards, and
management of outsourced IT services.
To analyze these problems, we used a technique pioneered by Dr. Eliyahu
Goldratt called the Theory of Constraints Thinking Tools
(http://www.thedecalogue.com/Tools/crt.htm), specifically problem clouds and
current reality trees (for more information. The goal was to understand the
causal factors and beliefs that led to the high- and low-performing
behaviors, and then finally, to find any commonalities among the three pain
areas. What we found was illuminating.
Volume of Security Patches
An area of pain articulated by many of the participants at the BIC-SORT was
the volume of urgent patches needing to be applied to infrastructure,
resulting from the constant stream of new security vulnerabilities, and the
need to find an effective solution to managing patches.
In the low-performers, this activity was characterized as ad hoc, chaotic,
and urgent. Announcement of the availability of a patch to address a
critical security vulnerability would lead to widespread chaos and
disruption, often resulting in massive amounts of unplanned work at the
expense of planned work. Worse, even successfully deploying the patch would
often cause unintended consequences, such as servers becoming non-functional
or even non-booting.
In contrast, the high-performers addressed patching as a predictable and
planned activity, treating them as just another change. Announcement of
critical patches would result in merely adding the patch to the release
engineering candidate queue, where it could be evaluated, tested and
integrated into an already scheduled deployment. The absence of urgency and
a well-defined process for integrating changes leads to a much higher change
success rate. Interestingly, virtually all of the high-performers apply
patches much less frequently than the low-performers, perhaps by one or two
orders of magnitude!
Proliferation of IT Management Scorecards
BIC-SORT attendees also listed the proliferation of IT management
³scorecards² and other management and assessment instruments as another area
of pain. We also threw into this category all the various industry
compliance requirements, ranging from Sarbanes-Oxley Section 404,
Gramm-Leach-Bliley, HIPAA, and so forth.
In the low-performers, this activity was characterized by having to look to
external sources and authorities for the desired behaviors and measurements.
The absence of a strong internal IT management framework and belief system
might lead to adopting a ³scorecard du jour,² or worse, multiple external
scorecards simultaneously that conflict with each other. This would lead to
more work for the organization, and excess retrofitting to deal with the
necessary process and organizational gymnastics. Worse, executive turnover
might result in switching scorecards, which repeats the entire chaos cycle.
In contrast, the high-performers have their own clearly defined performance
goals and desired characteristics. If the need to conform to an external
scorecard or regulatory requirement materializes, they assign a small team
to demonstrate traceability to it. Consequently, they have a lower cost of
developing, sustaining and documenting controls, a better posture of audit
and compliance, and have little need to look externally for authorities to
tell them how they need to operate.
Managing Outsourced IT Services
The last area of pain we analyzed was the challenge of managing outsourced
IT services. Any challenges with IT are inherently made more complex when
these services are provided by an outside provider instead of an employee:
corrective actions may have contractual implications, the scope of
corrections may be constrained by the service level agreement, and so forth.
In the low-performers, there is often a real desire to transfer the IT risk
and responsibilities to someone else, especially if management perceives an
absence of internal skills to meet the business objectives. However, when
outsource IT functions, such functions rapidly become out of sight and out
of mind, until the organization finds that it is unable to control and
attest to the controls of the service provider. The organization then
discovers that it may have inadvertently exacerbated the challenges by
outsourcing, but unfortunately, ³re-insourcing² the services may no longer
be an option.
In contrast, the high-performers manage outsourced IT services just like any
other business unit or project. They understand the unique positive and
negative challenges of fulfilling IT projects or services by an external
party. As a result, they tend to develop more bullet-proof service level
agreements to proactively get better service and create avenues for future
corrections from the service provider.
Common Root Causes For Preservation Of the Status Quo
After analyzing the three areas of pain, we started looking for common
patterns and root causes that led to the preservation of the status quo in
the low-performers, despite the clear promise of achieving the
characteristics of the high-performers. We found five areas of root cause.
1. The absence of explicit articulation of current state and
desired state hides or obscures the amount of pain.
Often, management will conclude that the current state, along with all the
companion pains, is tolerable. These organizations may articulate a litany
of pains and frustrations, but in the absence of being able to quantify the
pain, may decide without that it probably does not hurt enough yet to
warrant any corrective action. This may be because of a sincere belief that
the pain is not high enough yet, or it may be the following:
2. A culturally embedded belief that control is not possible.
Often, management may not know that there is an alternative, believing that
the control is not possible due to its nature (i.e., ³IT operational and
security issues are like the weather: there is nothing we can do about it,
and that bad things happen to us, just like rain or hurricanes²), control is
not possible due to business needs (i.e., ³my business environment is too
dynamic to accommodate bureaucratic processes or controls²), or maybe even
deliberate abdication of responsibility.
3. Rewards/reinforcements for personal heroics vs. repeatable,
predictable discipline
Often, there may be a culture or a hidden reward system that encourages
heroics and a ³cowboy culture.² For instance, one person may work throughout
the night for an entire weekend fighting a fire and get rewarded as the hero
who saved the day. What is overlooked is that if one person can save the
entire boat, one person can probably sink it, too. In these organizations,
implementing effective processes and controls may be resisted or actively
ejected, almost as an immune system would resist an unknown and foreign
object.
4. Continued argument that IT operations and security are different
than other business investments or projects
Often, there may be a view that IT is different than other business
functions or projects, thus leading to need to determine the ³business
alignment of IT.² Worse, IT may be operating as a silo, but here may be a
separate security silo inside it! There is a common belief that ongoing
security can exist outside the scope of IT operations. While security
requirements certainly exist outside of the IT context, security controls
must be embedded into IT processes so that they are jointly owned by both
the IT and security organizations. When the two organizations do not have
defined roles where they are collectively solving common business
objectives, blame-games and finger-pointing for failures can cause a
downward spiral.
5. A desire for a technical solution, which is easier to justify
and implement than people and process improvements
Often, because of their backgrounds, IT management values automation and
technology over repeatable processes and controls. In the absence of
properly functioning processes and controls, the massive deployment of
security technology solutions invariably results in the staggering
capability to automatically perform devastating, irreversible IT operational
changes in mere seconds, resulting in potentially monumental episodes of
unplanned work and chaos for the entire organization. Combined with the
previous root cause, this factor creates the kindling for an extremely fast
and accelerated downward spiral.
The entirety of these findings are available in a report published by the
SEI as follows: Allen, Julia; Behr, Kevin; Kim, Gene et al. Best in Class
Security and Operations Round Table Report (CMU/SEI-2004-SR-002).
Pittsburgh, PA: Software Engineering Institute, Carnegie Mellon University,
March 2004. Copies of the report are available upon request.
Tools To Find The Way To High-Performing IT: Visible Ops, an Executive Level
Community Of Practice, and the VEESC Benchmarking Project To help
organizations achieve the process transformation to achieve high-performing
IT characteristics, the ITPI has created three publicly available tools: the
Visible Ops methodology, the ITPI Community of Practice Listserv, and the
upcoming VEESC benchmarking study.
1. Visible Ops describes four prescriptive and self-fueling steps
to take an organization from any starting point to a continually improving,
controlled process. In early May, the Visible Ops Handbook will be
published, which is a handbook designed to jumpstart implementation of
controls and process improvement in IT organizations needing to increase
service levels, decrease costs, and increase security and auditability.
Furthermore, BetterManagement presentations on Visible Ops and creating best
in class change management processes are available at :
? So We've Got Change Management: Why Are We Still Firefighting?
? Building Effective Change Management Processes for Sarbanes-Oxley:
Step By Step
? Twenty Service Level Management Metrics to Enable Corporate
Governance: Questions IT Operations Should Be Able To Answer
2. The ITPI Community of Practice Listserv is a mailing list that
includes some of the best practitioners from the domain of IT operations,
security, audit and governance. The purpose of this list is to discuss their
perceived issues of pains and promise, with the hope of building an
executive-level community of practice for IT operations and security, with a
common sense of purpose and desire to influence other relevant and connected
communities of practice. Among the topics discussed are issues of
governance, audit, risk management, IT operations, security, project
management, and process management (including benchmarking).
3. The VEESC (Value of Effective and Efficient Security Controls)
benchmarking and survey of practice study attempts to quantify the business
value of controls, and test which of five controls have the highest
correlation with high performing IT organizations. Many practitioners view
them as simply another level of bureaucracy, whether it is called ITIL,
COBIT, Six Sigma or so forth. The purpose of this benchmark is to determine
empirically whether IT controls affect the value, effectiveness, efficiency,
and security of information-technology operations. We hypothesize that
implementation of IT controls improves IT efficiency, IT effectiveness, IT
security, and indirectly, business value.
Based on prior research and extensive pilot testing with high-performing
organizations, we will develop a survey to test our hypotheses. We will then
distribute the survey to a sample of Fortune 1000 companies. The results
will be analyzed using structural-equation-modeling techniques to determine
which controls are the most important in improving IT efficiency,
effectiveness, and security. This will be the topic of an upcoming article.
Summary and Call To Action
In this article, we explored three critical questions in the context of
solving the most common IT challenges: what do I need to change, what should
I change to, and how do I cause the change?
By studying high-performing IT organizations, the areas that most often
need changing in lower performing organizations are those with cultures that
sustain a belief that control is not possible, that the absence of controls
have tolerable costs, that success of the individual can outweigh the needs
for success of the organization, and that somehow IT security and operations
are independent of each other. By overcoming these incorrect beliefs, and by
implementing repeatable processes in the ITIL process areas of release,
controls and resolution as outlined in the Visible Ops methodology,
organizations can not only achieve a belief transformation, but a
performance transformation as well.
So, here is our call to action: Do you agree or disagree with our
definitions of high- and low-performing IT organizations? Do you have more
characteristics that should be added to our list of best-in-class
attributes? If so, please let us know by emailing Gene Kim and Julie Allen.
Also, if you are interested in any of this work, please join the ICOPL
mailing list.
Gene Kim is the CTO and co-founder of Tripwire, Inc. In 1992, he co-authored
Tripwire while at Purdue University with Dr. Gene Spafford. He is currently
actively working on a series of projects to capture how "best in class"
organizations have Security, Operations, Audit, Management, and Governance
working together to solve common objectives.
Julia Allen is a senior member of the technical staff within the Networked
Systems Survivability Program at the Software Engineering Institute (SEI),
Carnegie Mellon University (CMU). Allen is engaged in the development and
transition of security improvement practices for network-based systems and
executive programs in information security and survivability.
¶ 8:13 AM 0 Comments
www.itpi.org
IT is being challenged on many fronts, from cost containment, business
alignment, compliance, competitive pressures in managing outsourced IT
services, and security. Many experienced IT practitioners confronted by this
potentially staggering array of challenges will point out that the solution
to virtually all these issues is more repeatable IT processes and effective
controls. However, merely understanding this does not necessarily equate to
an effective plan to solve the problems, and may create more questions than
answers. To simplify the problem, Dr. Eliyahu Goldratt, creator of the
"Theory of Constraints", articulates three simple questions that must have
credible answers: what do I need to change, what should I change to, and how
do I cause the change?
Finding answers to those three questions has been an area of passion for
Gene since 1999. He has been researching high-performing IT operations and
security organizations, attempting to understand what makes them so
different than typical IT organizations, as well as studying how
organizations have accomplished the transformations that take them from
being merely average to best in class. Along this journey, Gene started
working with other organizations that are also interested in these issues,
such as SANS, the IT Process Institute (ITPI), the Institute of Internal
Auditors (IIA), and most recently, the Software Engineering Institute (SEI)
with Julia Allen. In particular, the collaboration between the ITPI and SEI
has yielded some extremely promising results, both in characterizing
high-and low-performing IT organizations, the key differences in their
belief systems, and the necessary components to achieve an organizational
transformation from low- to high-performer.
In this article, we will discuss two areas of research that we believe are
foundational for answering the question of what IT organizations typically
need to change and what they need to change it to. We will present a working
definition of what characterizes a high-performing IT organization, and then
discuss the key differences in the belief systems between them and more
typical IT organizations in three areas of pain: patch management,
proliferation of IT management scorecards, and managing outsourced IT
services.
Lastly, to help answer the question of how to cause the change, we will
describe the publicly available Visible Ops methodology, which captures how
IT organizations have transformed into high-performers in a way that is can
be accomplished in four steps, each which is a finite project and returns
more value back than was invested. We will also describe the ITPI Community
of Practice Listserv, and the upcoming VEESC benchmarking study. We conclude
the article with a call to action and an active solicitation for feedback in
participation in creating this community of practice for high-performing IT
organizations.
Key Characteristics of High-Performing IT Organizations
Since 1999, after studying the IT processes of hundreds of organizations,
it started becoming clear to Gene that a handful of them stood out as
somehow different from the others in some notable way. He started keeping a
list of these organizations, at that time informally called ³Gene¹s list of
people with amazing kung fu.² In 2000, Gene started working with Kevin Behr,
CTO of one of these unusual organizations, and they started a more
systematic analysis of what was common to these organizations, called the
³best in class IT operations and security organizations.² In 2003, Julia
Allen from the SEI actively joined this effort, which resulted in a
remarkable event in October 2003 at Carnegie Mellon University called the
Best In Class Security and Operations Roundtable (BIC-SORT).
Among the stated goals were to ³begin to build an executive-level community
of practice for IT (information technology) operations and security, with a
common sense of purpose and a desire to influence other relevant and
connected communities of practice; and to better capture and articulate the
relevant bodies of knowledge that enable and accelerate IT operational and
security process improvement.² Since then, we have been actively processing
and synthesizing the data we collected.
Based on our analysis, we have created the following working definition of
high-performing IT organizations: They are effective and efficient and they
succeed in applying resources to accomplish their stated business objectives
with little to no wasted effort. These organizations have evolved a system
of process improvement as a natural consequence of their business demands.
They regularly implement formal, repeatable and secure operational
processes.
Results of informal benchmarking indicate that in these best-in-class IT
organizations, IT operations and security work together to create higher
service levels (e.g., as measured by mean time to repair, mean time between
failure); higher percentage of planned, scheduled work relative to unplanned
work; unusually efficient cost structures (e.g., as measured by server to
system administrator ratios); productive working relationships with
management and peers; and smoother audits. Furthermore, they have more
timely identification and resolution of security incidents, the earliest
integration of information security requirements in the service delivery
lifecycle, and the ability to quickly return to a reliable and trusted
operational state. And perhaps most admirably, these organizations devote
increasingly more time and resources to strategic issues, having mastered
tactical concerns.
The high-performing organizations desire to detect production variances
early so they can fix problems in a planned manner and where the repair
costs are lowest and have the least impact. They value repeatable and
verifiable processes and use controls to improve efficiency and
effectiveness. And because these organizations use controls to improve their
own operation, life is much easier for auditors who evaluate operational
risk based on the presence of effective and verifiable preventive,
detective, and corrective controls. In other words, the controls aren¹t
there just because auditors asked for them, but because they are used to
improve daily operations! As a result, high-performing organizations require
considerably less effort to meet management and audit expectations.
To achieve these characteristics, several key performance metrics are
essential to this level of performance: they have the highest change success
rate (typically over 98%), highest effective rate of change (sometimes
making over 1000+ successful changes per week), highest level of mastery of
production infrastructure (achieved by low configuration counts and low
configuration variance), and highest ratio of staff dedicated to
pre-production activities (achieved by release management processes,
pre-production testing, etc.).
Surprisingly, we found that all of the high-performing IT organizations had
independently developed virtually the exact same processes to achieve these
results. They shared similarities in three key process areas, which we will
describe in the parlance of ITIL (IT Infrastructure Library): they had a
³culture of causality² that ensured all production problems ruled out change
as early as possible in the repair cycle (resolution processes), they had a
³culture of change management² embedded in the way all work is done (control
processes), and they moved as many production changes through a
pre-production process that orchestrated changes with the production
environment (release processes).
The high-performing organizations all implemented virtually the same
procedures in these three ITIL process areas, which form the minimal
closed-loop that generates metrics that allow continual process improvement.
These procedures and processes are described in the Visible Ops methodology
in detail, published by the ITPI.
Belief System Differences Between High- And Low- Performing IT Organizations
Given the fact that high-performing IT organizations exist, what prevents
low-performing organizations from becoming high-performers, given the
promise of a better way? Understanding why this was so became one of the
main areas of activity after the BIC-SORT event. Julia Allen, Kevin Behr,
and Gene Kim from the ITPI and SEI have been synthesizing the captured list
of key areas of pain and promise from the participating organizations during
BIC-SORT. Our goal was to create a taxonomy of pains, find any cause-effect
relationships and root causes and understand what belief systems that
preserved the status quo for the low-performers.
In the BIC-SORT, we captured almost one hundred specific areas of pain, such
as the challenges of keeping up with security patches, the massive efforts
required to do effective audits of business peers, and so forth. Of these,
we chose to analyze three of the most acute of the listed pains: keeping up
with patching, dealing with the proliferation of management scorecards, and
management of outsourced IT services.
To analyze these problems, we used a technique pioneered by Dr. Eliyahu
Goldratt called the Theory of Constraints Thinking Tools
(http://www.thedecalogue.com/Tools/crt.htm), specifically problem clouds and
current reality trees (for more information. The goal was to understand the
causal factors and beliefs that led to the high- and low-performing
behaviors, and then finally, to find any commonalities among the three pain
areas. What we found was illuminating.
Volume of Security Patches
An area of pain articulated by many of the participants at the BIC-SORT was
the volume of urgent patches needing to be applied to infrastructure,
resulting from the constant stream of new security vulnerabilities, and the
need to find an effective solution to managing patches.
In the low-performers, this activity was characterized as ad hoc, chaotic,
and urgent. Announcement of the availability of a patch to address a
critical security vulnerability would lead to widespread chaos and
disruption, often resulting in massive amounts of unplanned work at the
expense of planned work. Worse, even successfully deploying the patch would
often cause unintended consequences, such as servers becoming non-functional
or even non-booting.
In contrast, the high-performers addressed patching as a predictable and
planned activity, treating them as just another change. Announcement of
critical patches would result in merely adding the patch to the release
engineering candidate queue, where it could be evaluated, tested and
integrated into an already scheduled deployment. The absence of urgency and
a well-defined process for integrating changes leads to a much higher change
success rate. Interestingly, virtually all of the high-performers apply
patches much less frequently than the low-performers, perhaps by one or two
orders of magnitude!
Proliferation of IT Management Scorecards
BIC-SORT attendees also listed the proliferation of IT management
³scorecards² and other management and assessment instruments as another area
of pain. We also threw into this category all the various industry
compliance requirements, ranging from Sarbanes-Oxley Section 404,
Gramm-Leach-Bliley, HIPAA, and so forth.
In the low-performers, this activity was characterized by having to look to
external sources and authorities for the desired behaviors and measurements.
The absence of a strong internal IT management framework and belief system
might lead to adopting a ³scorecard du jour,² or worse, multiple external
scorecards simultaneously that conflict with each other. This would lead to
more work for the organization, and excess retrofitting to deal with the
necessary process and organizational gymnastics. Worse, executive turnover
might result in switching scorecards, which repeats the entire chaos cycle.
In contrast, the high-performers have their own clearly defined performance
goals and desired characteristics. If the need to conform to an external
scorecard or regulatory requirement materializes, they assign a small team
to demonstrate traceability to it. Consequently, they have a lower cost of
developing, sustaining and documenting controls, a better posture of audit
and compliance, and have little need to look externally for authorities to
tell them how they need to operate.
Managing Outsourced IT Services
The last area of pain we analyzed was the challenge of managing outsourced
IT services. Any challenges with IT are inherently made more complex when
these services are provided by an outside provider instead of an employee:
corrective actions may have contractual implications, the scope of
corrections may be constrained by the service level agreement, and so forth.
In the low-performers, there is often a real desire to transfer the IT risk
and responsibilities to someone else, especially if management perceives an
absence of internal skills to meet the business objectives. However, when
outsource IT functions, such functions rapidly become out of sight and out
of mind, until the organization finds that it is unable to control and
attest to the controls of the service provider. The organization then
discovers that it may have inadvertently exacerbated the challenges by
outsourcing, but unfortunately, ³re-insourcing² the services may no longer
be an option.
In contrast, the high-performers manage outsourced IT services just like any
other business unit or project. They understand the unique positive and
negative challenges of fulfilling IT projects or services by an external
party. As a result, they tend to develop more bullet-proof service level
agreements to proactively get better service and create avenues for future
corrections from the service provider.
Common Root Causes For Preservation Of the Status Quo
After analyzing the three areas of pain, we started looking for common
patterns and root causes that led to the preservation of the status quo in
the low-performers, despite the clear promise of achieving the
characteristics of the high-performers. We found five areas of root cause.
1. The absence of explicit articulation of current state and
desired state hides or obscures the amount of pain.
Often, management will conclude that the current state, along with all the
companion pains, is tolerable. These organizations may articulate a litany
of pains and frustrations, but in the absence of being able to quantify the
pain, may decide without that it probably does not hurt enough yet to
warrant any corrective action. This may be because of a sincere belief that
the pain is not high enough yet, or it may be the following:
2. A culturally embedded belief that control is not possible.
Often, management may not know that there is an alternative, believing that
the control is not possible due to its nature (i.e., ³IT operational and
security issues are like the weather: there is nothing we can do about it,
and that bad things happen to us, just like rain or hurricanes²), control is
not possible due to business needs (i.e., ³my business environment is too
dynamic to accommodate bureaucratic processes or controls²), or maybe even
deliberate abdication of responsibility.
3. Rewards/reinforcements for personal heroics vs. repeatable,
predictable discipline
Often, there may be a culture or a hidden reward system that encourages
heroics and a ³cowboy culture.² For instance, one person may work throughout
the night for an entire weekend fighting a fire and get rewarded as the hero
who saved the day. What is overlooked is that if one person can save the
entire boat, one person can probably sink it, too. In these organizations,
implementing effective processes and controls may be resisted or actively
ejected, almost as an immune system would resist an unknown and foreign
object.
4. Continued argument that IT operations and security are different
than other business investments or projects
Often, there may be a view that IT is different than other business
functions or projects, thus leading to need to determine the ³business
alignment of IT.² Worse, IT may be operating as a silo, but here may be a
separate security silo inside it! There is a common belief that ongoing
security can exist outside the scope of IT operations. While security
requirements certainly exist outside of the IT context, security controls
must be embedded into IT processes so that they are jointly owned by both
the IT and security organizations. When the two organizations do not have
defined roles where they are collectively solving common business
objectives, blame-games and finger-pointing for failures can cause a
downward spiral.
5. A desire for a technical solution, which is easier to justify
and implement than people and process improvements
Often, because of their backgrounds, IT management values automation and
technology over repeatable processes and controls. In the absence of
properly functioning processes and controls, the massive deployment of
security technology solutions invariably results in the staggering
capability to automatically perform devastating, irreversible IT operational
changes in mere seconds, resulting in potentially monumental episodes of
unplanned work and chaos for the entire organization. Combined with the
previous root cause, this factor creates the kindling for an extremely fast
and accelerated downward spiral.
The entirety of these findings are available in a report published by the
SEI as follows: Allen, Julia; Behr, Kevin; Kim, Gene et al. Best in Class
Security and Operations Round Table Report (CMU/SEI-2004-SR-002).
Pittsburgh, PA: Software Engineering Institute, Carnegie Mellon University,
March 2004. Copies of the report are available upon request.
Tools To Find The Way To High-Performing IT: Visible Ops, an Executive Level
Community Of Practice, and the VEESC Benchmarking Project To help
organizations achieve the process transformation to achieve high-performing
IT characteristics, the ITPI has created three publicly available tools: the
Visible Ops methodology, the ITPI Community of Practice Listserv, and the
upcoming VEESC benchmarking study.
1. Visible Ops describes four prescriptive and self-fueling steps
to take an organization from any starting point to a continually improving,
controlled process. In early May, the Visible Ops Handbook will be
published, which is a handbook designed to jumpstart implementation of
controls and process improvement in IT organizations needing to increase
service levels, decrease costs, and increase security and auditability.
Furthermore, BetterManagement presentations on Visible Ops and creating best
in class change management processes are available at :
? So We've Got Change Management: Why Are We Still Firefighting?
? Building Effective Change Management Processes for Sarbanes-Oxley:
Step By Step
? Twenty Service Level Management Metrics to Enable Corporate
Governance: Questions IT Operations Should Be Able To Answer
2. The ITPI Community of Practice Listserv is a mailing list that
includes some of the best practitioners from the domain of IT operations,
security, audit and governance. The purpose of this list is to discuss their
perceived issues of pains and promise, with the hope of building an
executive-level community of practice for IT operations and security, with a
common sense of purpose and desire to influence other relevant and connected
communities of practice. Among the topics discussed are issues of
governance, audit, risk management, IT operations, security, project
management, and process management (including benchmarking).
3. The VEESC (Value of Effective and Efficient Security Controls)
benchmarking and survey of practice study attempts to quantify the business
value of controls, and test which of five controls have the highest
correlation with high performing IT organizations. Many practitioners view
them as simply another level of bureaucracy, whether it is called ITIL,
COBIT, Six Sigma or so forth. The purpose of this benchmark is to determine
empirically whether IT controls affect the value, effectiveness, efficiency,
and security of information-technology operations. We hypothesize that
implementation of IT controls improves IT efficiency, IT effectiveness, IT
security, and indirectly, business value.
Based on prior research and extensive pilot testing with high-performing
organizations, we will develop a survey to test our hypotheses. We will then
distribute the survey to a sample of Fortune 1000 companies. The results
will be analyzed using structural-equation-modeling techniques to determine
which controls are the most important in improving IT efficiency,
effectiveness, and security. This will be the topic of an upcoming article.
Summary and Call To Action
In this article, we explored three critical questions in the context of
solving the most common IT challenges: what do I need to change, what should
I change to, and how do I cause the change?
By studying high-performing IT organizations, the areas that most often
need changing in lower performing organizations are those with cultures that
sustain a belief that control is not possible, that the absence of controls
have tolerable costs, that success of the individual can outweigh the needs
for success of the organization, and that somehow IT security and operations
are independent of each other. By overcoming these incorrect beliefs, and by
implementing repeatable processes in the ITIL process areas of release,
controls and resolution as outlined in the Visible Ops methodology,
organizations can not only achieve a belief transformation, but a
performance transformation as well.
So, here is our call to action: Do you agree or disagree with our
definitions of high- and low-performing IT organizations? Do you have more
characteristics that should be added to our list of best-in-class
attributes? If so, please let us know by emailing Gene Kim and Julie Allen.
Also, if you are interested in any of this work, please join the ICOPL
mailing list.
Gene Kim is the CTO and co-founder of Tripwire, Inc. In 1992, he co-authored
Tripwire while at Purdue University with Dr. Gene Spafford. He is currently
actively working on a series of projects to capture how "best in class"
organizations have Security, Operations, Audit, Management, and Governance
working together to solve common objectives.
Julia Allen is a senior member of the technical staff within the Networked
Systems Survivability Program at the Software Engineering Institute (SEI),
Carnegie Mellon University (CMU). Allen is engaged in the development and
transition of security improvement practices for network-based systems and
executive programs in information security and survivability.
¶ 8:13 AM 0 Comments
Minimize IT Risk with a Business Focused Capacity Plan
By Richard Seery
SAS
For many years Capacity Planning has been looked upon as a mainstream
technical discipline. Focusing on planning for such entities as Disk storage
space, server memory, network bandwidth, I/O rates, and so on. Whilst
planning the future capacity of these entities is an absolute necessity for
the infrastructure growth of an IT organization, many times there is too
little emphasis on how the capacity plan connects to corporate and customer
utilization of the IT infrastructure.
This chasm between IT and the business creates a huge risk for the IT
Director.The IT Director cannot align IT¹s capacity to facilitate the growth
of business. This inevitably will lead to poor service delivery,
overspending of the IT budget and ultimately the decision of the board of
directors to outsource the IT organization.
This presentation and paper discusses the role of capacity planning in the
modern IT organization. It will present how Capacity Planning fits with
other ITIL based disciplines such as Service Level Management, IT Financial
Management and Availability Management. Plus, it will focus on how a
business focused Capacity Plan can reduce the risk of poor service delivery
and overspending.
Introduction
Capacity planning is again fast becoming a necessary IT discipline. With
the current financial and commercial climate, the need to reduce costs by
consolidation and accurately forecasting future capacity requirements are
high in the minds of every CIO and senior IT manager. This places a
tremendous strain on the operational management of running an IT
organisation all the way from managing the Helpdesk through to managing IT
budgets on a day-to-day basis.
Capacity planning though of course is an important facet of Computer
Capacity Management. In this paper we will look at the whole Capacity
Management function.
Capacity Management is still viewed by other IT management as an
old-fashioned, mainframe centric discipline. The view is that Capacity
Management is not worth the effort and that it would be better to pay for
upgrades as required.
The problem with this view is that procurement of IT hardware is justified
on an individual capital return, rather than an overall corporate
requirement, therefore little planning or alignment of business goals to IT
growth is performed. Managing the capacity of large networks is more complex
than managing the mainframe, and for all thriving organisations, financial
investment in IT is growing. Therefore it makes even more sense to plan for
growth.
A corporate Capacity Management process ensures that the entire
organisations capacity requirements are catered for.
Goals and Objectives
Capacity Managements responsibility is to ensure that the evolving demands
of business can be met with the IT infrastructures capacity to facilitate
those needs. There are a number processes that take place in order to
perform effective Capacity Management:
 Understanding the current demands being made on IT by the business
 Monitoring of performance, throughput and responses of IT services
and components
 Undertaking or initiating performance tuning efforts
 Influencing the IT resource demands in conjunction with IT
financial management
 Forecasting for future capacity requirements
 Compilation and publication of Capacity Plan
In essence, the goal of Capacity Management is to ensure that cost
justifiable IT Capacity always exists and that it is matched to the current
and future identified needs of the business.
The Capacity Management process should be the focal point for all IT
performance and capacity decisions. Operational depts., such as Network
support may carry out the majority of the relevant day-to-day duties, but
overall responsibility lies with the Capacity management process.However,
the driving force for Capacity Management should be the business
requirements.
If Capacity Management is to be a success it must have a two-way
relationship with the business strategy and planning processes within an
organisation.
Capacity Management needs to understand the long-term business strategy
whilst at the same time providing information on the latest ideas, trends
and technologies.
The IT Infrastructure Library (ITIL)
A Business Focused Capacity Planning process cannot be achieved entirely on
its own. Other areas of the IT organisation will need to play a significant
role. At this point, let us look at the other areas of an IT organisation
through the IT Infrastructure Library (ITIL). ITIL is a consistent and
comprehensive documentation of best practice for IT Service Management. Used
by many hundreds of organisations around the world, a whole ITIL philosophy
has grown up around the guidance contained within the ITIL books.
ITIL consists of a series of books giving guidance on the provision of
quality IT services, and on the accommodation and environmental facilities
needed to support IT. ITIL has been developed in recognition of
organisations' growing dependency on IT and embodies best practices for IT
Service Management. ITIL provides the foundation for quality IT Service
Management. The widespread adoption of the ITIL guidance has encouraged
organisations worldwide, both commercial and non-proprietary, to develop
supporting products as part of a shared 'ITIL philosophy'.
The reason for including ITIL into this paper is to position Capacity
Management, as a ÂBest Practice¹ and how it fits with other IT Service
Management areas. This will be covered in the next section.
Capacity Management and other ITIL Areas
ITIL¹s IT Service Management philosophy breaks down into 2 areas:
 Service Support
 Service Delivery
Service Delivery is concerned primarily with the following disciplines:
 Service Level Management
 Capacity Management
 Availability Management
 Financial Management for IT Services
 Service Continuity
Service Support is concerned with the operational disciplines of IT:
 Incident Management
 Problem Management
 Change Management
 Release Management
 Configuration Management
Capacity Management is closely aligned to business requirements, as such it
is a vital element of the planning process and therefore has close ties with
all aspects of Service Delivery. However, Capacity Management also has close
ties to Service Support disciplines.
Each of the ITIL Service Management disciplines and their interfaces with
Capacity Management follows:
Incident Management
Capacity Management should keep the Incident Management function informed
of any potential performance or capacity problems, either on a manual or
automatic basis. At the same time the Incident Management function should be
notifying the Capacity Management function of any incidents related to
capacity and performance.
Problem Management
Capacity problems should be documented and made available through the
Problem Management function. Capacity Management should also provide a
proactive role to the Problem Management function through the analysis of
performance and capacity information to identify any significant trends.
Change Management
If there is a ÂChange advisory council¹ in place within the IT
organization, Capacity Management should be represented there. This
representation should assess the impact of any changes upon the capacity
needs.
Release Management
Capacity management helps determine the distribution strategy, particularly
where the network is used for distribution. Network bandwidth and
host/target capacity plus others will need to be considered as part of the
distribution strategy.
Configuration Management
Without the knowledge of individual IT Component information, such as
configuration of the vast number of servers or network bandwidth capability,
Capacity Management will not function correctly. The Configuration
Management function has the responsibility of maintaining the Configuration
Management DataBase (CMDB), which retains the basic configuration features
of each IT resource.
Service Level Management
Capacity Management supports Service Level management to ensure that
performance and capacity targets can be achieved. Capacity Management also
provides technical information to a Service Improvement Program.
Financial Management for IT Services
A cost summary should be provided as a key component of the Capacity Plan.
Procurement recommendations included in the Capacity Plan should be compared
with budget forecasts and actual forecasts before purchase.
IT Service Continuity
Capacity management determines the capacity required for all recovery
options used. The Capacity Plan should incorporate IT Service continuity
requirements.
Availability Management
Unacceptable slow performance is effectively the same as Âunavailability¹.
Therefore capacity and Availability Management share common goals and
complement each other.
A Business Approach to Capacity Management
Before attempting to address the implementation of an effective Capacity
Management function, let¹s look at the influences, the activities and
outputs of Capacity Management.
The Influences
A number of sources of information have relevance. A subset would be:
 External suppliers of new technology
 Business strategy and plans (commercial and financial)
 Contents of Service Level Agreements (SLA¹s)
 Change Management process
 IT Operations (scheduling, etc.)
The Activities
Capacity Management takes on 3 levels of activities:
 Business Capacity Management
 Service Capacity Management
 Resource Capacity Management
Business Capacity Management
The main role of this activity is to ensure that the future business
requirements are catered for, planned and implemented in a timely manner.
These can be achieved by analysing existing information on current resource
utilization that is used by the various IT Services. Once this is known, the
future business requirements will need to be applied against current
resource utilization through various forecasting, trending and the modeling
tasks.
Service Capacity Management
The main focus of this activity is to manage the performance of the
production IT services that customers purchase and use. The service targets
that are defined in the SLA¹s and Service Level Requirements (SLR¹s) provide
the basis for this activity. The main tasks are to ensure that the
performance of all the services are monitored, measured, analysed and
reported on. And of course, the performance of the services need to meet the
business requirements.
Resource Capacity Management
This activity is almost always seen as the traditional mainframe based
Capacity Planning role. The main focus of this activity is the management of
individual resources of the IT infrastructure. All IT components have finite
resources available to it (i.e. a Server has limited memory and storage
space). These resources need to monitored and measured. Action must be taken
to manage the available resources to ensure that the IT services meet the
business requirements. This could essentially result in a Âresource-tuning
task¹.
In summary, Business Capacity Management activities address the current and
future business requirements. Service Capacity Management activities are
focused on the delivery of the existing services that support the business.
Resource Capacity Management traditionally is concerned with the management
of underpinning technology.
The Outputs
The outputs from the Capacity Management activities are either shared
within the Capacity Management function (i.e. a shared Capacity Management
database), used in conjunction with other IT Service Management activities
(i.e. shared information between the IT Financial Management function) or by
other parts of the organization (i.e. the Production Capacity Plan
Document).
Capacity Management tasks can be either reactive or proactive. The main
focus should be on proactive tasks, which can include such tasks as:
 Pre-empting performance problems
 Trending and forecasting future resource requirements
 Modeling predicted changes
 Ensuring system upgrades are planned, budgeted and implemented
before any SLA targets are breached.
Of course, there will be situations when the Capacity Management function
will need to react. For example, Helpdesk reported capacity problems, where
the Capacity resource expert will need to rectify the performance problem.
The structure of the Capacity Management Function
Once the Capacity Management activities and their respective tasks have
been identified, a structure of how they should work together needs to be
established. The ITIL approach here is to Âlayer¹ the respective Capacity
Management activities and then Âoverlaying¹ the tasks, all with the aim of
producing a formal Capacity Plan that is relevant to the business and IT
collectively.
Capacity Managements¹ Iterative tasks include:
 Monitoring of each resource and service
 Analysis of the Âmonitored¹ data
 Tuning of resources that have been monitored and/or analysed
 Storage of Capacity utilization data in the Capacity Planning
Database
 The implementation of any changes necessary that results out of
monitoring, analysis and tuning tasks
 Collection and storage of any relevant data/information into the
Capacity Management Database
The prime objective of the Demand Management tasks is to influence the
demand of computing resources and the uses of those resources. The Capacity
management function will need to understand which services are utilizing
resources, to what depth the usage is, and when the services use the
resources. Then a decision can be made whether it is possible to influence
the demand of the resources.
Demand Management can be performed by any one of the activities but must be
conducted in a manner that would not adversely impact business customers.
Therefore, a pre-requisite of performing any Demand Management task, is a
thorough knowledge of the business requirements and the demands on IT
services.
Modelling tasks provide the Capacity Management function with the ability to
predict the behaviour of IT Services under a given volume and variety of
work. All Capacity Management activities will benefit the effect from
Modelling tasks.
In order to estimate the computing capacity required in supporting a
proposed new application or application change, an Application Sizing
sub-project should be undertaken. The sub-project should be started at
project initiation time and completed when the application is Âsigned-off¹
in the operational environment.
The Âcornerstone¹ of a successful Capacity Management function is a well
maintained Capacity Planning Database. The database itself will be the
repository that holds all relevant information necessary for all the
Capacity Management activities. The Database itself will retain many
different types of data, including business, service, technical, financial
and utilization based. It will be used as the foundation of all reporting
and analytical tasks.
The major output of the Capacity Management function is to produce a
Capacity Plan that documents the current levels of resource utilisation and
service performance. Once the revision of business strategy, plans and
forecasts has been considered, the Plan should also contain forecasts of the
future IT infrastructure that needs to support the business requirements.
There should be consideration of resources required, costs associated with
any forecasted acquisitions, alternative scenarios (resource, infrastructure
and financial), associated benefits and any impacts. The plan should be
unambiguous and state clearly if any proposals are being based on any
assumptions.
Benefits
Once a Business focused Capacity Management function has been established,
with its structures, activities and tasks defined, the following benefits
become apparent to the IT department, the business customer and the business
itself:
 Increased efficiency
 Cost savings
 Reduced risk
Cost savings and increased efficiency come in many flavours. The main
exponents are deferred expenditure, capacity savings and a more accurate
buying strategy.
If a Capacity Planning exercise can defer the acquisition of new hardware to
a later date, then the money that is in the budget can be spent elsewhere.
In today¹s economic climate of reduced IT budgets, the ability to identify
hardware consolidation, service consolidation and consolidating server
capacity reinforces the need for a Business focused Capacity Management
function.
Reduced risk is most probably the most beneficial outcome of a business
focused Capacity Management approach. It will reduce the risk of performance
problems and failures. The reduced risk to existing business applications
can be realised through the better management of the IT resources and
services. More accurate application sizing will assist in the introduction
of new business applications.
Confident and more accurate forecasting will instill a sense of confidence
in both IT and business management, thus increasing the credibility of the
IT organisation in the eyes of the business.
Other visible benefits include a positive impact on other IT Service
Management functions, including the reduction of trouble tickets raised to
the Incident Management function, plus the reduction in the number of Change
Management requests being made through a more effective Capacity Planning
process.
Conclusions
Capacity Planning is a well-known, ³tried and tested² discipline in the IBM
Mainframe centric world. Capacity Management is a fundamental IT/IS function
that should be considered a key role in the Service Delivery and Service
Support functions.
With the Businesses greater dependence on IT, a closer alignment of Business
and IT strategy is required. All IT functions have a role to play in this
scenario. Capacity Management plays a key role in aligning the business
plans to IT/IS plans, contributing to the bottom-line Âincreased
performance¹ and Âcost savings¹ of both the IT department and wider
organization.
Additional Information:
 Best Practice for Service Delivery, IT Infrastructure Library -
OGC.
 Capacity Planning for Business Intelligence Applications:
Approach & methodologies  International Business Machines (Red Books)
¶ 8:12 AM 0 Comments
SAS
For many years Capacity Planning has been looked upon as a mainstream
technical discipline. Focusing on planning for such entities as Disk storage
space, server memory, network bandwidth, I/O rates, and so on. Whilst
planning the future capacity of these entities is an absolute necessity for
the infrastructure growth of an IT organization, many times there is too
little emphasis on how the capacity plan connects to corporate and customer
utilization of the IT infrastructure.
This chasm between IT and the business creates a huge risk for the IT
Director.The IT Director cannot align IT¹s capacity to facilitate the growth
of business. This inevitably will lead to poor service delivery,
overspending of the IT budget and ultimately the decision of the board of
directors to outsource the IT organization.
This presentation and paper discusses the role of capacity planning in the
modern IT organization. It will present how Capacity Planning fits with
other ITIL based disciplines such as Service Level Management, IT Financial
Management and Availability Management. Plus, it will focus on how a
business focused Capacity Plan can reduce the risk of poor service delivery
and overspending.
Introduction
Capacity planning is again fast becoming a necessary IT discipline. With
the current financial and commercial climate, the need to reduce costs by
consolidation and accurately forecasting future capacity requirements are
high in the minds of every CIO and senior IT manager. This places a
tremendous strain on the operational management of running an IT
organisation all the way from managing the Helpdesk through to managing IT
budgets on a day-to-day basis.
Capacity planning though of course is an important facet of Computer
Capacity Management. In this paper we will look at the whole Capacity
Management function.
Capacity Management is still viewed by other IT management as an
old-fashioned, mainframe centric discipline. The view is that Capacity
Management is not worth the effort and that it would be better to pay for
upgrades as required.
The problem with this view is that procurement of IT hardware is justified
on an individual capital return, rather than an overall corporate
requirement, therefore little planning or alignment of business goals to IT
growth is performed. Managing the capacity of large networks is more complex
than managing the mainframe, and for all thriving organisations, financial
investment in IT is growing. Therefore it makes even more sense to plan for
growth.
A corporate Capacity Management process ensures that the entire
organisations capacity requirements are catered for.
Goals and Objectives
Capacity Managements responsibility is to ensure that the evolving demands
of business can be met with the IT infrastructures capacity to facilitate
those needs. There are a number processes that take place in order to
perform effective Capacity Management:
 Understanding the current demands being made on IT by the business
 Monitoring of performance, throughput and responses of IT services
and components
 Undertaking or initiating performance tuning efforts
 Influencing the IT resource demands in conjunction with IT
financial management
 Forecasting for future capacity requirements
 Compilation and publication of Capacity Plan
In essence, the goal of Capacity Management is to ensure that cost
justifiable IT Capacity always exists and that it is matched to the current
and future identified needs of the business.
The Capacity Management process should be the focal point for all IT
performance and capacity decisions. Operational depts., such as Network
support may carry out the majority of the relevant day-to-day duties, but
overall responsibility lies with the Capacity management process.However,
the driving force for Capacity Management should be the business
requirements.
If Capacity Management is to be a success it must have a two-way
relationship with the business strategy and planning processes within an
organisation.
Capacity Management needs to understand the long-term business strategy
whilst at the same time providing information on the latest ideas, trends
and technologies.
The IT Infrastructure Library (ITIL)
A Business Focused Capacity Planning process cannot be achieved entirely on
its own. Other areas of the IT organisation will need to play a significant
role. At this point, let us look at the other areas of an IT organisation
through the IT Infrastructure Library (ITIL). ITIL is a consistent and
comprehensive documentation of best practice for IT Service Management. Used
by many hundreds of organisations around the world, a whole ITIL philosophy
has grown up around the guidance contained within the ITIL books.
ITIL consists of a series of books giving guidance on the provision of
quality IT services, and on the accommodation and environmental facilities
needed to support IT. ITIL has been developed in recognition of
organisations' growing dependency on IT and embodies best practices for IT
Service Management. ITIL provides the foundation for quality IT Service
Management. The widespread adoption of the ITIL guidance has encouraged
organisations worldwide, both commercial and non-proprietary, to develop
supporting products as part of a shared 'ITIL philosophy'.
The reason for including ITIL into this paper is to position Capacity
Management, as a ÂBest Practice¹ and how it fits with other IT Service
Management areas. This will be covered in the next section.
Capacity Management and other ITIL Areas
ITIL¹s IT Service Management philosophy breaks down into 2 areas:
 Service Support
 Service Delivery
Service Delivery is concerned primarily with the following disciplines:
 Service Level Management
 Capacity Management
 Availability Management
 Financial Management for IT Services
 Service Continuity
Service Support is concerned with the operational disciplines of IT:
 Incident Management
 Problem Management
 Change Management
 Release Management
 Configuration Management
Capacity Management is closely aligned to business requirements, as such it
is a vital element of the planning process and therefore has close ties with
all aspects of Service Delivery. However, Capacity Management also has close
ties to Service Support disciplines.
Each of the ITIL Service Management disciplines and their interfaces with
Capacity Management follows:
Incident Management
Capacity Management should keep the Incident Management function informed
of any potential performance or capacity problems, either on a manual or
automatic basis. At the same time the Incident Management function should be
notifying the Capacity Management function of any incidents related to
capacity and performance.
Problem Management
Capacity problems should be documented and made available through the
Problem Management function. Capacity Management should also provide a
proactive role to the Problem Management function through the analysis of
performance and capacity information to identify any significant trends.
Change Management
If there is a ÂChange advisory council¹ in place within the IT
organization, Capacity Management should be represented there. This
representation should assess the impact of any changes upon the capacity
needs.
Release Management
Capacity management helps determine the distribution strategy, particularly
where the network is used for distribution. Network bandwidth and
host/target capacity plus others will need to be considered as part of the
distribution strategy.
Configuration Management
Without the knowledge of individual IT Component information, such as
configuration of the vast number of servers or network bandwidth capability,
Capacity Management will not function correctly. The Configuration
Management function has the responsibility of maintaining the Configuration
Management DataBase (CMDB), which retains the basic configuration features
of each IT resource.
Service Level Management
Capacity Management supports Service Level management to ensure that
performance and capacity targets can be achieved. Capacity Management also
provides technical information to a Service Improvement Program.
Financial Management for IT Services
A cost summary should be provided as a key component of the Capacity Plan.
Procurement recommendations included in the Capacity Plan should be compared
with budget forecasts and actual forecasts before purchase.
IT Service Continuity
Capacity management determines the capacity required for all recovery
options used. The Capacity Plan should incorporate IT Service continuity
requirements.
Availability Management
Unacceptable slow performance is effectively the same as Âunavailability¹.
Therefore capacity and Availability Management share common goals and
complement each other.
A Business Approach to Capacity Management
Before attempting to address the implementation of an effective Capacity
Management function, let¹s look at the influences, the activities and
outputs of Capacity Management.
The Influences
A number of sources of information have relevance. A subset would be:
 External suppliers of new technology
 Business strategy and plans (commercial and financial)
 Contents of Service Level Agreements (SLA¹s)
 Change Management process
 IT Operations (scheduling, etc.)
The Activities
Capacity Management takes on 3 levels of activities:
 Business Capacity Management
 Service Capacity Management
 Resource Capacity Management
Business Capacity Management
The main role of this activity is to ensure that the future business
requirements are catered for, planned and implemented in a timely manner.
These can be achieved by analysing existing information on current resource
utilization that is used by the various IT Services. Once this is known, the
future business requirements will need to be applied against current
resource utilization through various forecasting, trending and the modeling
tasks.
Service Capacity Management
The main focus of this activity is to manage the performance of the
production IT services that customers purchase and use. The service targets
that are defined in the SLA¹s and Service Level Requirements (SLR¹s) provide
the basis for this activity. The main tasks are to ensure that the
performance of all the services are monitored, measured, analysed and
reported on. And of course, the performance of the services need to meet the
business requirements.
Resource Capacity Management
This activity is almost always seen as the traditional mainframe based
Capacity Planning role. The main focus of this activity is the management of
individual resources of the IT infrastructure. All IT components have finite
resources available to it (i.e. a Server has limited memory and storage
space). These resources need to monitored and measured. Action must be taken
to manage the available resources to ensure that the IT services meet the
business requirements. This could essentially result in a Âresource-tuning
task¹.
In summary, Business Capacity Management activities address the current and
future business requirements. Service Capacity Management activities are
focused on the delivery of the existing services that support the business.
Resource Capacity Management traditionally is concerned with the management
of underpinning technology.
The Outputs
The outputs from the Capacity Management activities are either shared
within the Capacity Management function (i.e. a shared Capacity Management
database), used in conjunction with other IT Service Management activities
(i.e. shared information between the IT Financial Management function) or by
other parts of the organization (i.e. the Production Capacity Plan
Document).
Capacity Management tasks can be either reactive or proactive. The main
focus should be on proactive tasks, which can include such tasks as:
 Pre-empting performance problems
 Trending and forecasting future resource requirements
 Modeling predicted changes
 Ensuring system upgrades are planned, budgeted and implemented
before any SLA targets are breached.
Of course, there will be situations when the Capacity Management function
will need to react. For example, Helpdesk reported capacity problems, where
the Capacity resource expert will need to rectify the performance problem.
The structure of the Capacity Management Function
Once the Capacity Management activities and their respective tasks have
been identified, a structure of how they should work together needs to be
established. The ITIL approach here is to Âlayer¹ the respective Capacity
Management activities and then Âoverlaying¹ the tasks, all with the aim of
producing a formal Capacity Plan that is relevant to the business and IT
collectively.
Capacity Managements¹ Iterative tasks include:
 Monitoring of each resource and service
 Analysis of the Âmonitored¹ data
 Tuning of resources that have been monitored and/or analysed
 Storage of Capacity utilization data in the Capacity Planning
Database
 The implementation of any changes necessary that results out of
monitoring, analysis and tuning tasks
 Collection and storage of any relevant data/information into the
Capacity Management Database
The prime objective of the Demand Management tasks is to influence the
demand of computing resources and the uses of those resources. The Capacity
management function will need to understand which services are utilizing
resources, to what depth the usage is, and when the services use the
resources. Then a decision can be made whether it is possible to influence
the demand of the resources.
Demand Management can be performed by any one of the activities but must be
conducted in a manner that would not adversely impact business customers.
Therefore, a pre-requisite of performing any Demand Management task, is a
thorough knowledge of the business requirements and the demands on IT
services.
Modelling tasks provide the Capacity Management function with the ability to
predict the behaviour of IT Services under a given volume and variety of
work. All Capacity Management activities will benefit the effect from
Modelling tasks.
In order to estimate the computing capacity required in supporting a
proposed new application or application change, an Application Sizing
sub-project should be undertaken. The sub-project should be started at
project initiation time and completed when the application is Âsigned-off¹
in the operational environment.
The Âcornerstone¹ of a successful Capacity Management function is a well
maintained Capacity Planning Database. The database itself will be the
repository that holds all relevant information necessary for all the
Capacity Management activities. The Database itself will retain many
different types of data, including business, service, technical, financial
and utilization based. It will be used as the foundation of all reporting
and analytical tasks.
The major output of the Capacity Management function is to produce a
Capacity Plan that documents the current levels of resource utilisation and
service performance. Once the revision of business strategy, plans and
forecasts has been considered, the Plan should also contain forecasts of the
future IT infrastructure that needs to support the business requirements.
There should be consideration of resources required, costs associated with
any forecasted acquisitions, alternative scenarios (resource, infrastructure
and financial), associated benefits and any impacts. The plan should be
unambiguous and state clearly if any proposals are being based on any
assumptions.
Benefits
Once a Business focused Capacity Management function has been established,
with its structures, activities and tasks defined, the following benefits
become apparent to the IT department, the business customer and the business
itself:
 Increased efficiency
 Cost savings
 Reduced risk
Cost savings and increased efficiency come in many flavours. The main
exponents are deferred expenditure, capacity savings and a more accurate
buying strategy.
If a Capacity Planning exercise can defer the acquisition of new hardware to
a later date, then the money that is in the budget can be spent elsewhere.
In today¹s economic climate of reduced IT budgets, the ability to identify
hardware consolidation, service consolidation and consolidating server
capacity reinforces the need for a Business focused Capacity Management
function.
Reduced risk is most probably the most beneficial outcome of a business
focused Capacity Management approach. It will reduce the risk of performance
problems and failures. The reduced risk to existing business applications
can be realised through the better management of the IT resources and
services. More accurate application sizing will assist in the introduction
of new business applications.
Confident and more accurate forecasting will instill a sense of confidence
in both IT and business management, thus increasing the credibility of the
IT organisation in the eyes of the business.
Other visible benefits include a positive impact on other IT Service
Management functions, including the reduction of trouble tickets raised to
the Incident Management function, plus the reduction in the number of Change
Management requests being made through a more effective Capacity Planning
process.
Conclusions
Capacity Planning is a well-known, ³tried and tested² discipline in the IBM
Mainframe centric world. Capacity Management is a fundamental IT/IS function
that should be considered a key role in the Service Delivery and Service
Support functions.
With the Businesses greater dependence on IT, a closer alignment of Business
and IT strategy is required. All IT functions have a role to play in this
scenario. Capacity Management plays a key role in aligning the business
plans to IT/IS plans, contributing to the bottom-line Âincreased
performance¹ and Âcost savings¹ of both the IT department and wider
organization.
Additional Information:
 Best Practice for Service Delivery, IT Infrastructure Library -
OGC.
 Capacity Planning for Business Intelligence Applications:
Approach & methodologies  International Business Machines (Red Books)
¶ 8:12 AM 0 Comments
Four High-performance Opportunities for CIOs
By Tor Mesøy and Jonas Arlebäck
Accenture
Information technology is becoming an ever larger part of the economy.
Driving this trend is the increasing importance of managing information
technology to ensure high performance across business cycles.
A global Accenture study shows that the companies delivering the highest
total return to shareholders throughout a five-year period before, during
and after the major recession in the early 1990s, were the ones managing to
retain profitable revenue growth rather than focusing purely on cost
cutting.1 Other Accenture research focusing on IT governance disclosed that
companies with high profit margin growth allocate a significantly larger
portion of their IT budget to innovation rather than IT operations, compared
to companies with lower profit margin growth. 3
Thinking about these research results from the CIO¹s perspective brings to
light the critical role CIOs will play during the next few years as
companies work to capture shareholder return. But it is not easy for CIOs to
drive the necessary dialogue about balancing information technology and
business value. An Accenture survey of CIOs and CEOs found that most CIOs
said their CEOs still do not actively invite them to meetings on the
strategic planning of the business, but rather expect the CIOs to make
³quick fixes.² 3
CIOs must break through this barrier and become a welcomed and integral part
of strategic business planningÂand that means moving away from the
traditional role of a technologist. The good news is that Accenture¹s
continuing research into the characteristics of high-performance businesses
indicates that they use information technology as a tool to innovate,
creating more effective business models while simultaneously increasing
productivity. Specifically, Accenture believes there are four things CIOs
must do to ensure information technology contributes to helping their
companies achieve high performanceÂand in the process achieve high personal
performance.
1. Focus the Information Technology Debate on Creating Business Value
Within the context of achieving high performance, CIOs have an opportunity
to frame the information technology discussion with their fellow executives
around the role information technology can play in high priority areas, such
as creating growth, lowering risks and reducing cycle times.
CIOs have the responsibility to drive a shared vision for information
technology that is co-owned by business and IT leadership and that provides
the platform for value creation. Rolls-Royce, for example, used to make
money selling spare parts to customers of its gas turbines. Increasingly it
will make money from maintaining high availability and reliability of its
products in service. Its business vision is selling ³power by the hour.²
This incorporates a vision of information and transaction systems that
enables the vital supply chain, service management and engine health
monitoring capabilities.
In this context it is important that the CIO brings the business value
discussion to the level of shareholder value. It is not enough to use
conventional methods for the return on investment of IT, which should be
reserved for checkpoints for project approvals.
2. Create Powerful Propositions for IT-enabled Change
CIOs must constantly look for opportunities to create greater value through
partnering, such as with other companies in their companies¹ supply chain.
Consider two examples:
 Using IT capabilities to facilitate business collaboration, as
when AstraZeneca researchers seamlessly collaborate on drug discoveries with
external research contractors through virtual channels, and
 Collaborating to develop propositions for IT-enabled change, as
when Northern Europe¹s largest yellow pages company, Eniro, collaborating
closely with Microsoft, developed a product development tool with the
potential to reduce Eniro¹s product development lead time dramatically.
CIOs must focus on risk reduction, investment sharing and establishment of
de facto standards, by leveraging the distinctive capabilities of third
parties. Companies in Investor sphere, Scandinavia¹s largest equity holding
organization, co-funded the development of a joint supplier relationship
solution, IBX, based on SAP software, where the interface with the suppliers
became the de facto Scandinavian standard for virtual supplier interaction.
A well-developed deal structure based on parameters directly linked to
business value creation is one of the most important factors to achieve high
performance from partnering. Outsourcing the entire IT function, or major
parts of it, does not off-load the strategic burden from the CIOÂrather the
contrary. The CIO must have a contract as well as a continuous dialogue with
the outsourcing party, clearly stating what business value the outsourcing
party is expected to contribute.
For example, BC Hydro and Accenture formed Accenture Business Services of
British Columbia Limited Partnership to provide a wide variety of
back-office functionsÂincluding customer service, procurement and office
management servicesÂto BC Hydro and other North American utilities. The
pioneering new entity will enable these companies to focus sole attention on
managing their core utility businesses, delivering greater value to
shareholders and customers at a considerably reduced cost. While information
technology office functions made up the main contract components, BC Hydro
also achieved substantial direct business performance enhancements by
bundling IT-intensive business functions, such as call centers and finance
and accounting.
3. Optimize the Information Technology Investment Agenda
Accenture research2 shows companies with high profit margin growth dedicate
significantly greater funds to new information technology and still spend
less than their peers on information technology. The research also showed
that among more than 100 European companies, those leading in productivity
commonly align their IT organizations and governance with business units
that may be diverse and quite autonomous. To achieve this kind of high
performance, CIOs need to lead the way in creating and then implementing an
IT roadmap that will ensure information technology funds are invested the
right way.
This requires CIOs to keep watch so that investments are not siphoned to
less important areas due to political pressure, ego, confusion or
misunderstandings about the link between information technology and business
value. In addition, CIOs must use training, change management and program
management to mobilize all levels of the IT department to help realize the
roadmap, with particular attention paid to active collaboration with their
peers on the business side. In addition, CIOs need to stay alert to external
shifts that might invalidate a business caseÂand be ready to make
adjustments.
4. Transform Information Technology to Deliver Improved Capability and
Business Results
New trends, tools, capabilities and architectures create an ever-fresh
supply of new opportunities for improving the performance of information
technology. It is the CIO¹s responsibility to evaluate these opportunities
and recommend the ones that will result in a significant, positive impact.
Smaller scale transformation needs to take place continuously, as when the
IT department of a large telecom provider evaluated a new, innovative
Accenture tool for end-to-end testing of IT applications and estimated the
return on investment in three years to be 400 percent. The proposal was
implemented and the pay-back from the tool is exceeding even those
estimates.
A CIO succeeding in these four areas will significantly contribute to a
balanced management of the company and position the CIO¹s participation in
important business decisions as essential to achieving high performance.
Additional Information:
This article is part of the Cultivating IT to Meet Business Demand: The IT
Value Management Learning Series
Tor Mesøy is a partner in Accenture Strategy & Business Architecture and
leads the company¹s Strategic IT Effectiveness group in the Nordic region.
His primary role is to work with senior executives across a wide range of
industries to achieve strategic value for their companies form information
technology.
Jonas Arlebäck is a senior manager in the Strategic IT Effectiveness group.
His areas of expertise include advising companies on how to establish and
execute strategy to exploit new market opportunitiesÂespecially as they
pertain to innovative uses of information technology.
- ³When Good Management Shows: Creating Value in an Uncertain Economy² by
the Accenture Institute for High Performance Business.
- "Business Value Creation through IT,² Accenture 2003.
- ³The Innovator¹s Advantage: Using Innovation and Technology to Improve
Business Performance² by Accenture Policy & Corporate Affairs.
¶ 7:51 AM 0 Comments
Accenture
Information technology is becoming an ever larger part of the economy.
Driving this trend is the increasing importance of managing information
technology to ensure high performance across business cycles.
A global Accenture study shows that the companies delivering the highest
total return to shareholders throughout a five-year period before, during
and after the major recession in the early 1990s, were the ones managing to
retain profitable revenue growth rather than focusing purely on cost
cutting.1 Other Accenture research focusing on IT governance disclosed that
companies with high profit margin growth allocate a significantly larger
portion of their IT budget to innovation rather than IT operations, compared
to companies with lower profit margin growth. 3
Thinking about these research results from the CIO¹s perspective brings to
light the critical role CIOs will play during the next few years as
companies work to capture shareholder return. But it is not easy for CIOs to
drive the necessary dialogue about balancing information technology and
business value. An Accenture survey of CIOs and CEOs found that most CIOs
said their CEOs still do not actively invite them to meetings on the
strategic planning of the business, but rather expect the CIOs to make
³quick fixes.² 3
CIOs must break through this barrier and become a welcomed and integral part
of strategic business planningÂand that means moving away from the
traditional role of a technologist. The good news is that Accenture¹s
continuing research into the characteristics of high-performance businesses
indicates that they use information technology as a tool to innovate,
creating more effective business models while simultaneously increasing
productivity. Specifically, Accenture believes there are four things CIOs
must do to ensure information technology contributes to helping their
companies achieve high performanceÂand in the process achieve high personal
performance.
1. Focus the Information Technology Debate on Creating Business Value
Within the context of achieving high performance, CIOs have an opportunity
to frame the information technology discussion with their fellow executives
around the role information technology can play in high priority areas, such
as creating growth, lowering risks and reducing cycle times.
CIOs have the responsibility to drive a shared vision for information
technology that is co-owned by business and IT leadership and that provides
the platform for value creation. Rolls-Royce, for example, used to make
money selling spare parts to customers of its gas turbines. Increasingly it
will make money from maintaining high availability and reliability of its
products in service. Its business vision is selling ³power by the hour.²
This incorporates a vision of information and transaction systems that
enables the vital supply chain, service management and engine health
monitoring capabilities.
In this context it is important that the CIO brings the business value
discussion to the level of shareholder value. It is not enough to use
conventional methods for the return on investment of IT, which should be
reserved for checkpoints for project approvals.
2. Create Powerful Propositions for IT-enabled Change
CIOs must constantly look for opportunities to create greater value through
partnering, such as with other companies in their companies¹ supply chain.
Consider two examples:
 Using IT capabilities to facilitate business collaboration, as
when AstraZeneca researchers seamlessly collaborate on drug discoveries with
external research contractors through virtual channels, and
 Collaborating to develop propositions for IT-enabled change, as
when Northern Europe¹s largest yellow pages company, Eniro, collaborating
closely with Microsoft, developed a product development tool with the
potential to reduce Eniro¹s product development lead time dramatically.
CIOs must focus on risk reduction, investment sharing and establishment of
de facto standards, by leveraging the distinctive capabilities of third
parties. Companies in Investor sphere, Scandinavia¹s largest equity holding
organization, co-funded the development of a joint supplier relationship
solution, IBX, based on SAP software, where the interface with the suppliers
became the de facto Scandinavian standard for virtual supplier interaction.
A well-developed deal structure based on parameters directly linked to
business value creation is one of the most important factors to achieve high
performance from partnering. Outsourcing the entire IT function, or major
parts of it, does not off-load the strategic burden from the CIOÂrather the
contrary. The CIO must have a contract as well as a continuous dialogue with
the outsourcing party, clearly stating what business value the outsourcing
party is expected to contribute.
For example, BC Hydro and Accenture formed Accenture Business Services of
British Columbia Limited Partnership to provide a wide variety of
back-office functionsÂincluding customer service, procurement and office
management servicesÂto BC Hydro and other North American utilities. The
pioneering new entity will enable these companies to focus sole attention on
managing their core utility businesses, delivering greater value to
shareholders and customers at a considerably reduced cost. While information
technology office functions made up the main contract components, BC Hydro
also achieved substantial direct business performance enhancements by
bundling IT-intensive business functions, such as call centers and finance
and accounting.
3. Optimize the Information Technology Investment Agenda
Accenture research2 shows companies with high profit margin growth dedicate
significantly greater funds to new information technology and still spend
less than their peers on information technology. The research also showed
that among more than 100 European companies, those leading in productivity
commonly align their IT organizations and governance with business units
that may be diverse and quite autonomous. To achieve this kind of high
performance, CIOs need to lead the way in creating and then implementing an
IT roadmap that will ensure information technology funds are invested the
right way.
This requires CIOs to keep watch so that investments are not siphoned to
less important areas due to political pressure, ego, confusion or
misunderstandings about the link between information technology and business
value. In addition, CIOs must use training, change management and program
management to mobilize all levels of the IT department to help realize the
roadmap, with particular attention paid to active collaboration with their
peers on the business side. In addition, CIOs need to stay alert to external
shifts that might invalidate a business caseÂand be ready to make
adjustments.
4. Transform Information Technology to Deliver Improved Capability and
Business Results
New trends, tools, capabilities and architectures create an ever-fresh
supply of new opportunities for improving the performance of information
technology. It is the CIO¹s responsibility to evaluate these opportunities
and recommend the ones that will result in a significant, positive impact.
Smaller scale transformation needs to take place continuously, as when the
IT department of a large telecom provider evaluated a new, innovative
Accenture tool for end-to-end testing of IT applications and estimated the
return on investment in three years to be 400 percent. The proposal was
implemented and the pay-back from the tool is exceeding even those
estimates.
A CIO succeeding in these four areas will significantly contribute to a
balanced management of the company and position the CIO¹s participation in
important business decisions as essential to achieving high performance.
Additional Information:
This article is part of the Cultivating IT to Meet Business Demand: The IT
Value Management Learning Series
Tor Mesøy is a partner in Accenture Strategy & Business Architecture and
leads the company¹s Strategic IT Effectiveness group in the Nordic region.
His primary role is to work with senior executives across a wide range of
industries to achieve strategic value for their companies form information
technology.
Jonas Arlebäck is a senior manager in the Strategic IT Effectiveness group.
His areas of expertise include advising companies on how to establish and
execute strategy to exploit new market opportunitiesÂespecially as they
pertain to innovative uses of information technology.
- ³When Good Management Shows: Creating Value in an Uncertain Economy² by
the Accenture Institute for High Performance Business.
- "Business Value Creation through IT,² Accenture 2003.
- ³The Innovator¹s Advantage: Using Innovation and Technology to Improve
Business Performance² by Accenture Policy & Corporate Affairs.
¶ 7:51 AM 0 Comments
Tuesday, November 23, 2004
How Important is Data Quality in Your Company?
PwC's 2004 Data Quality Survey finds that data management strategies are
still not a top priority among senior executives despite compliance and
regulatory drivers that demand data integrity.
PricewaterhouseCoopers
11-November-2004
Have board members in major companies been exhibiting a higher or a lower
level of engagement in data management issues? Does the majority of senior
management place sufficient importance on data management? And how important
are privacy, security and compliance with external regulations?
Surprising revelations from the survey include:
* Board level engagement in data management issues has actually declined
in the past three years, in spite of significant changes to global business
operating environments triggered by events such as major corporate scandals
and new regulatory compliance requirements.
* Only two in five respondents are certain that their data management
strategy has board approval ÂÂ although 67 percent of all organisations
surveyed claim to have a company-wide data management strategy in place, up
from 63 percent in 2001.
* Only 59 percent of all respondents think that the senior management of
their company place sufficient importance on data management.
* 63 percent of respondents consider privacy, security and compliance
with external regulations as the most important business driver, further
raising the questions as to why there has not been a more substantial
increase in board-approved data strategies.
* Most organisations ÂÂ about 2/3 of respondents with a data strategyÂÂ
still view data quality management as an IT issue. Of these respondents,
most claimed that responsibility for driving that strategy belonged to IT.
The remaining respondents assigned responsibility for data management to
senior management within their organisation, such as the CFO, CEO managing
director or corporate board.
"The decline in board engagement with data management issues is at odds with
companies increasing dependence on data," said George Marinos, Partner,
PricewaterhouseCoopers. "With corporations establishing objectives of
improving their level of transparency, and the clean linkage between data
quality and reporting accuracy, it is surprising that having a data quality
strategy is not top of mind for board level executives."
Confidence in Third Party Data Has Eroded
Over half of the respondents in this 2004 survey indicated that sharing of
data to third parties is likely to increase over the next three years. Yet
while respondents also indicated they are at least "somewhat" dependent on
third party data, only 18 percent of respondents whose organisations share
data with third parties are very confident in the quality of that data. In
addition, only 24% of companies claiming to use third party data are
actually measuring the quality of that data. And fifty percent of
respondents are at best only 'fairly confident' in others' data while 24%
express little to no confidence.
"With today's collaborative e-commerce economy, it's surprising that
companies are not more formally engaged in validating the integrity of third
party data," said Henry Kenyon, Partner, PricewaterhouseCoopers.
He continues, "With an expected increase in the need to share data
externally among companies, regulatory bodies and stakeholders, senior
management must resolve to create and execute a strategic and actionable
data quality program to validate not only data they receive from third
parties, but the data they share with third parties."
A Critical Gap Between Intention and Execution
From the respondents that stated they did not have a formalised data
management strategy, 81 percent agreed that their company should view data
management more strategically and believed this could be accomplished within
the next three years. Alternately, for those companies that did not feel
confident that they would have a formalised strategy, the primary barriers
included lack of:
* Budget;
* Board support;
* Appreciation of the benefits;
* Knowledge about how to best manage the data; and
* Belief that there is a problem.
"We are beginning to see organisations taking a more strategic approach to
data management, and we're telling them that it can be viewed as a
competitive advantage," says Willie Jordaan, Partner,
PricewaterhouseCoopers.
"A comprehensive data management programme can help companies reduce the
costs associated with risk and compliance, as well as improve the company's
overall business performance," continues Jordaan. "The commitment to data
quality needs to be driven from the top, with a clear line of accountability
threaded throughout the company. Data quality is not simply an IT issue, but
it an imperative for the entire organisation."
Best Practice Organisations Realise a Positive Payoff
Respondents able to cite data management initiatives that produced a
positive return on investment represent companies who do pay attention to
data quality issues:
* 90 percent of these "best practice organisations" responded that
senior management does pay sufficient attention to data management.
* 60 percent of these companies measure the quality of their data
compared to only 45% of overall respondents.
* Confidence for best practice organisations is also increased, with 45%
feeling "very confident" compared to 34% overall.
Click here to read the full Global Data Management Survey ÂÂ "Data Quality
Management:
http://www.pwc.com/extweb/onlineforms.nsf/weblookup/GXENGSECUsecurityprivacy
docrequest?opendocument&sandpfile=05-0187-A-Global-Data-Mgmt-Survey.pdf
¶ 11:01 AM 0 Comments
still not a top priority among senior executives despite compliance and
regulatory drivers that demand data integrity.
PricewaterhouseCoopers
11-November-2004
Have board members in major companies been exhibiting a higher or a lower
level of engagement in data management issues? Does the majority of senior
management place sufficient importance on data management? And how important
are privacy, security and compliance with external regulations?
Surprising revelations from the survey include:
* Board level engagement in data management issues has actually declined
in the past three years, in spite of significant changes to global business
operating environments triggered by events such as major corporate scandals
and new regulatory compliance requirements.
* Only two in five respondents are certain that their data management
strategy has board approval ÂÂ although 67 percent of all organisations
surveyed claim to have a company-wide data management strategy in place, up
from 63 percent in 2001.
* Only 59 percent of all respondents think that the senior management of
their company place sufficient importance on data management.
* 63 percent of respondents consider privacy, security and compliance
with external regulations as the most important business driver, further
raising the questions as to why there has not been a more substantial
increase in board-approved data strategies.
* Most organisations ÂÂ about 2/3 of respondents with a data strategyÂÂ
still view data quality management as an IT issue. Of these respondents,
most claimed that responsibility for driving that strategy belonged to IT.
The remaining respondents assigned responsibility for data management to
senior management within their organisation, such as the CFO, CEO managing
director or corporate board.
"The decline in board engagement with data management issues is at odds with
companies increasing dependence on data," said George Marinos, Partner,
PricewaterhouseCoopers. "With corporations establishing objectives of
improving their level of transparency, and the clean linkage between data
quality and reporting accuracy, it is surprising that having a data quality
strategy is not top of mind for board level executives."
Confidence in Third Party Data Has Eroded
Over half of the respondents in this 2004 survey indicated that sharing of
data to third parties is likely to increase over the next three years. Yet
while respondents also indicated they are at least "somewhat" dependent on
third party data, only 18 percent of respondents whose organisations share
data with third parties are very confident in the quality of that data. In
addition, only 24% of companies claiming to use third party data are
actually measuring the quality of that data. And fifty percent of
respondents are at best only 'fairly confident' in others' data while 24%
express little to no confidence.
"With today's collaborative e-commerce economy, it's surprising that
companies are not more formally engaged in validating the integrity of third
party data," said Henry Kenyon, Partner, PricewaterhouseCoopers.
He continues, "With an expected increase in the need to share data
externally among companies, regulatory bodies and stakeholders, senior
management must resolve to create and execute a strategic and actionable
data quality program to validate not only data they receive from third
parties, but the data they share with third parties."
A Critical Gap Between Intention and Execution
From the respondents that stated they did not have a formalised data
management strategy, 81 percent agreed that their company should view data
management more strategically and believed this could be accomplished within
the next three years. Alternately, for those companies that did not feel
confident that they would have a formalised strategy, the primary barriers
included lack of:
* Budget;
* Board support;
* Appreciation of the benefits;
* Knowledge about how to best manage the data; and
* Belief that there is a problem.
"We are beginning to see organisations taking a more strategic approach to
data management, and we're telling them that it can be viewed as a
competitive advantage," says Willie Jordaan, Partner,
PricewaterhouseCoopers.
"A comprehensive data management programme can help companies reduce the
costs associated with risk and compliance, as well as improve the company's
overall business performance," continues Jordaan. "The commitment to data
quality needs to be driven from the top, with a clear line of accountability
threaded throughout the company. Data quality is not simply an IT issue, but
it an imperative for the entire organisation."
Best Practice Organisations Realise a Positive Payoff
Respondents able to cite data management initiatives that produced a
positive return on investment represent companies who do pay attention to
data quality issues:
* 90 percent of these "best practice organisations" responded that
senior management does pay sufficient attention to data management.
* 60 percent of these companies measure the quality of their data
compared to only 45% of overall respondents.
* Confidence for best practice organisations is also increased, with 45%
feeling "very confident" compared to 34% overall.
Click here to read the full Global Data Management Survey ÂÂ "Data Quality
Management:
http://www.pwc.com/extweb/onlineforms.nsf/weblookup/GXENGSECUsecurityprivacy
docrequest?opendocument&sandpfile=05-0187-A-Global-Data-Mgmt-Survey.pdf
¶ 11:01 AM 0 Comments
Human Capital Management: How CFOs Manage Investments In Their
Company's Biggest Asset
by Eric Krell
IF YOU CAN'T MEASURE IT, YOU CAN'T MANAGE IT. Until recently, that corporate
finance axiom was rarely uttered in human resources departments. Today,
however, it's increasingly familiar to HR executives, many of whom face
growing pressure to manage the enterprise's largest asset with much greater
financial rigor.
The finance and human resources functions typically view human capital
management from different -- and often opposing -- perspectives. HR takes
responsibility for investments that support recruiting; retention; and, to a
certain degree, employee performance management. Finance scrutinizes overall
costs.
"Finance tends to have a better handle on the true cost of human capital,
while human resources tends to [focus on] related costs, such as the levels
of compensation and benefits," explains Jim Kochanski, senior vice president
of Sibson Consulting, the New York City-based human capital consulting
pision of The Segal Co. "HR also influences some of the dynamics of human
capital, such as turnover and rates of hiring."
At the same time, many finance executives and managers question whether HR
can manage human capital in a financially disciplined manner. "Most human
resources professionals lack the financial acumen to ensure that the company
is receiving the best benefit for its investment in human capital," says
Bert Hensley, chairman and CEO of Morgan Samuels Co., a Beverly Hills,
Calif.-based management consulting firm that specializes in executive
recruitment.
Finance must take part of the blame for that shortcoming because it has
failed to provide HR with an adequate level of guidance and support. In
Business Finance's annual executive career and compensation surveys, finance
executives consistently rank "managing and developing people" in the middle
of their pack of priorities.
In private conversations, however, many CFOs bemoan the fact that the more
immediate demands of their job -- growing the business, boosting revenue and
cutting costs, for example -- prevent them from giving workforce issues the
attention they feel is warranted.
"Human resources and finance are finding out that we really need to merge
our understanding of employees to develop a deeper understanding of the
costs, benefits and risks associated with our people," says David Davis,
director of finance and corporate controller for SAS Institute Inc. in Cary,
N.C. "I know we can do a better job by blending our skills and strengths."
Kochanski agrees. "You need both parts of the picture to really manage human
capital like an asset," he observes.
Hensley believes finance executives can help their organization's HR
department by emphasizing overarching corporate goals and insisting that
human capital management means much more than hiring people to fill
positions. "CFOs should focus the organization on the company's strategy,"
he says, "and then emphasize the importance of analyzing the skill sets
necessary to execute that strategy and finding the best talent to meet those
needs."
Finance executives may need to offer their HR colleagues an introduction to
basic financial principles and terminology (see Teaching Scorecard 101). But
they can do much more than that. They can partner with HR executives to help
them increase returns from pension, benefit and compensation investments;
manage the impact of new regulations; and address a looming labor crunch.
Driving HR Improvements
Corporate finance departments' "measure to manage" mantra has helped most
areas of the organization -- including, belatedly, HR -- to understand the
importance of tracking the costs and benefits that their processes, projects
and investments generate. CFOs' efforts in these areas have leaned heavily
on sophisticated information systems that enable companies to conduct
concise and timely analyses. Human capital management software, for example,
can show inpidual employees how their activities relate to high-level
corporate objectives and, in cases where incentive compensation is applied,
how their performance directly influences the size of their paycheck.
Michael Bileca, CFO and COO of Towncare Dental Partnership Inc., a dental
care and service provider in Miami, views human capital management as a
natural extension of his role. When his organization restructured its
doctors' compensation plan two years ago, switching from a revenue-sharing
model to a profit-sharing model, it invested substantial time, money and
effort in new performance management and training processes and technology,
including a workforce management application from Kronos.
"We needed to help develop our doctors' abilities to take on management
responsibilities, which means cultivating entrepreneurial skills and a
greater willingness to take business risks," Bileca explains. "Companies can
build great skill sets, but they can still be the wrong skill sets. To avoid
that pitfall, you need to place the training in a much larger enterprise
context."
Towncare Dental uses the new system's balanced scorecard functionality to
keep its doctors and their staff focused on business objectives and
continually informed of their performance. The organization ties training,
performance management, operational processes and enterprise strategy into
its scorecard.
David Klementz is another finance executive with a deep commitment to HR
improvements. He's senior vice president and CFO of Progress Rail Services
Corp., an Albertville, Ala.-based company that supplies rail and track-work
components to the railroad industry. During the past two years, Klementz has
invested much of his time in overhauling his $800 million organization's
incentive compensation plan and extending it to all of Progress Rail
Services' employees.
A central component of the initiative is a matrix Klementz designed that
tracks how the corporation's top five goals trickle down to the facility
level of the enterprise, where Progress Rail Services uses metrics such as
productivity and injury rates to gauge its workers' performance.
Klementz does not see human capital management as a departure from his core
priorities. "I view this as clarifying the links among our forecast,
business plan, and the systems and rewards we have in place," he explains.
Beyond Benchmarked Compensation
Initiatives like Towncare Dental's and Progress Rail Services' illustrate
the strengths that finance can bring to human capital issues. "CFOs are
expected to provide a return analysis on just about every capital investment
that a company makes, whether it is a piece of machinery, a new factory or
new office equipment," notes Peter LeBlanc, senior vice president in the
Raleigh, N.C., offices of Sibson Consulting. "That ROI analysis has never
been applied to compensation."
A company may attach a much higher value to a given job than other
organizations in its industry do, yet the majority of companies base their
nonexecutive compensation programs on industry benchmarks. "Almost every job
in the enterprise is being paid relative to the marketplace," LeBlanc says.
Instead, he insists, "there should be jobs that are paid higher vis-Ã -vis
their benchmark and lower vis-Ã -vis their benchmark."
Companies that are beginning to embrace this approach, such as Circuit City
and Standard Register, separate jobs into three or four buckets based on
their impact (low, moderate or high) on a handful of high-level corporate
objectives such as revenue growth. Some of these organizations also rate
their employees -- A player, B player or C player, for example -- based on
their job performance. This dual-rating system can provide valuable insights
into human capital deployment. For example, it can help companies ensure
that they are optimizing deployment of their HR assets by assigning A
players to high-impact positions.
Not surprisingly, LeBlanc says that he finds CFOs more receptive to this
innovative approach to compensation than HR executives, few of whom give
deep strategic thought to salary and benefits packages below the executive
level. Yet "most of the money spent on compensation is spent below the
executive level," he points out. "From the CFO perspective, there is an
opportunity."
Klementz agrees. Companies should look beyond industry compensation
benchmarks, he believes, if doing so helps them attract the skills they need
to meet high-level objectives. Progress Rail Services now pays as much as
110 percent of the industry benchmark for some positions.
Before adopting that strategy, the company conducted a compensation planning
exercise that was helpful in large part, Klementz says, because Progress
Rail Services' senior management team actively participated and had a voice
in how compensation levels would be stratified.
Vigilance in Pensions and Recruiting
CFOs and HR executives alike have been breathing a little easier in the past
couple of years thanks to some good news in another critical area of
employee rewards: retirement benefits. Pension plan funding levels have
regained some of the ground they lost in a dramatic three-year dive that
began in 1999. A recent Watson Wyatt Worldwide study of defined-benefit
pension plans at more than 600 of the 1,000 largest U.S. companies found
that the average plan's "funded status" -- the ratio of plan assets to the
estimated cost of its accrued pension obligations -- increased from 82
percent in 2002 to 88 percent in 2003. Pension plan liabilities increased by
nearly $125 billion (about 11 percent) in that period; however, assets rose
by $172.4 billion, or about 18 percent.
"After three years of low interest rates and weak investment performance,
last year's increase in funded status is a welcome change," notes Kevin
Wagner, a consulting actuary in Watson Wyatt's Southfield, Mich., offices.
"Many employers and participants should be heartened that their pension
plans remain well-positioned to pay retirement benefits."
At the same time, few finance executives feel sufficiently reassured to
relax their vigilance over this complex and critical area. As the equity
markets' reaction to a more restrictive federal monetary policy unfolds,
CFOs will continue to monitor their organization's pension plan assets and
liabilities closely.
The financial acumen that companies have applied to compensation strategies
and pension plans less frequently supports other areas of human capital
management. However, the recruiting process also offers opportunities for
efficiency improvements. For example, Morgan Samuels helps it clients
streamline their hiring processes by improving metrics such as the amount of
time they take to fill a position and the number of candidates they
interview for a given job.
Davis notes that the growing financial complexity of internal recruiting
calls for greater involvement of finance in HR. As SAS's global presence has
grown, he says, the financial aspects of its internal recruiting processes
have become increasingly intricate. They now include fair value analyses,
which help ensure that pisions losing managers are appropriately
compensated; currency ramifications associated with country-to-country
personnel transfers; transfer pricing calculations; and tax evaluations.
HR's Compliance Dimension
Finance executives who remain chary of involvement in human capital
management might want to reconsider that attitude in light of the HR-related
issues raised by Sarbanes-Oxley compliance initiatives.
"CFOs are quickly realizing that there are several business processes
residing in the HR department that have a direct and material impact on
their financial statements," notes a paper published by Pleasanton,
Calif.-based risk consulting and internal audit firm Protiviti Inc. titled
"The Impact of Sarbanes-Oxley on Human Capital Management." For example,
employees' fringe benefits are a potential compliance risk, according to the
report, and these rewards should be tracked carefully. Companies should also
conduct periodic reviews to ensure that their calculations of tax
liabilities and accruals for pensions, vacations and bonuses are correct.
Payroll and benefits account for 35 percent to 40 percent of companies'
operating costs on average, according to PricewaterhouseCoopers, so errors
by external payroll and benefits administrators can have a material impact
on an organization's balance sheet. Not surprisingly, many Sarbanes-Oxley
Section 404 initiatives have identified outsourced payroll and benefits
administration as significant risks.
Many organizations are asking their outsourcing partners to provide audits
that conform to the American Institute of Certified Public Accountants'
Statement on Auditing Standards (SAS) No. 70, Type II, which requires that a
public accounting firm attest to the quality of the provider's internal
controls environment. But some outsourcing providers are balking at the cost
and scope of these audits. As a result, many businesses face difficult
sourcing decisions with complex cost and compliance ramifications.
What's more, companies' HR and training functions will play a key role in
determining the effectiveness and cost-efficiency of Sarbanes-Oxley
compliance efforts over the long haul. If ongoing compliance monitoring is
to succeed, inpidual process owners throughout a company -- most of whom
have scant finance and accounting experience -- must be trained to
anticipate changes which may affect the internal controls that support their
process.
Building Bench Strength
A broader partnership between finance and HR can also help companies
strengthen their executive pipeline -- an aspect of human resources planning
that too many organizations neglect. CFOs are particularly at risk of being
stung by weak succession planning. "People who tend to gravitate toward a
financial career don't necessarily have in their own skill set the expertise
of developing leadership talent," says Guy Beaudin, Toronto-based managing
director of management consulting firm RHR International.
Although few, if any, human capital consultants predict a return to the
tight labor market of the late 1990s and the inflated compensation packages
that accompanied it, most believe a demographically fueled labor crunch will
occur as large numbers of baby boomers enter retirement between 2010 and
2015. And that will have serious repercussions for executive teams. In RHR
International's most recent executive bench study, half of the 115 companies
that participated said that they expect to lose 50 percent or more of their
senior management team by 2010.
Developing leadership talent internally is much easier and more
cost-effective than integrating executives hired from another organization,
Beaudin points out. Yet most of the surveyed companies that formally
identify high-potential talent report that they have been doing so for three
years or less.
Beaudin sees a bright spot in this area of widespread neglect.
"Organizations that take this seriously and develop formal bench-development
programs will be able to develop a competitive advantage that will certainly
emerge by 2010 -- and probably sooner than that," he says.
Given the fact that CFOs historically have neglected HR issues, proactive
finance executives may be able to exploit a range of opportunities in human
capital management. CFOs who help their organization's HR executives master
the language of finance and strengthen the financial management of human
capital will better position their company to handle the regulatory and
competitive challenges that lie ahead.
But the chance to pull ahead of competitors on the strength of human capital
management sophistication may disappear before long. Terms like Balanced
Scorecard, metrics, alignment and portfolio of talent are already slipping
into the HR vernacular.
And some organizations -- Towncare Dental, for example --have a head start.
"It may sound like a cliché," Bileca says, "but in the service business,
people are our greatest asset. We need to invest in our workforce in a way
that will help us achieve the results we want to achieve. It's really a
matter of pinpointing how well our investment in human capital is
performing."
Teaching Scorecard 101
It's not easy to learn a new language. Finance executives should keep that
in mind when teaching their HR colleagues the basic vocabulary of finance --
return on investment, return on assets and alignment, for example.
HR professionals will likely need help with scorecard concepts and
terminology, too. James Hatch offers a useful scorecard primer in his paper
"The HR Scorecard: The New Way To Measure Your Human Capital." Hatch is a
New York City-based principal, HR services, with PricewaterhouseCoopers and
managing partner with the Saratoga Institute, a human capital benchmarking
and survey organization that's a wholly owned subsidiary of PwC. Here are
the principles he recommends:
* Remember that absolute numbers are less meaningful than relative
numbers. "Data must always be placed within the appropriate context," Hatch
notes. "Factors such as number of employees, revenue, operating expenses and
geographic location can be useful in establishing such context. Many metrics
are of limited value if there is no basis for comparison."
* Ensure that the data you use to calculate the metrics is clean,
transparent and easy to collect. Companies new to scorecards often spend too
much time collecting and validating data, and not enough time analyzing the
information and elucidating its meaning. Hatch also emphasizes the
importance of clearly documenting the numbers and calculations behind the
metrics.
* Dovetail your scorecard metrics with measures and tools that your
organization is already using. Companies should consider including data from
their ongoing performance management programs and employee surveys in their
scorecard, at least in its early design stages.
* Focus on outcomes. Executives and line managers tend to focus more on
results than on activities. Metrics should reflect that focus by helping HR
people answer questions such as: Are we hiring the right people? Are we
developing them in a way that supports corporate objectives? Are the right
people staying?
* Assign a champion. "Find someone to own this process," Hatch advises,
"and make sure every relevant member is made aware of that person's
responsibility -- and of theirs."
* Treat your scorecard as a program, not a project. Organizations using
scorecards for the first time tend to stop using them once they have settled
on measures and begun to track performance.
Originally printed in the October 2004 issue of Business Finance
¶ 11:01 AM 0 Comments
IF YOU CAN'T MEASURE IT, YOU CAN'T MANAGE IT. Until recently, that corporate
finance axiom was rarely uttered in human resources departments. Today,
however, it's increasingly familiar to HR executives, many of whom face
growing pressure to manage the enterprise's largest asset with much greater
financial rigor.
The finance and human resources functions typically view human capital
management from different -- and often opposing -- perspectives. HR takes
responsibility for investments that support recruiting; retention; and, to a
certain degree, employee performance management. Finance scrutinizes overall
costs.
"Finance tends to have a better handle on the true cost of human capital,
while human resources tends to [focus on] related costs, such as the levels
of compensation and benefits," explains Jim Kochanski, senior vice president
of Sibson Consulting, the New York City-based human capital consulting
pision of The Segal Co. "HR also influences some of the dynamics of human
capital, such as turnover and rates of hiring."
At the same time, many finance executives and managers question whether HR
can manage human capital in a financially disciplined manner. "Most human
resources professionals lack the financial acumen to ensure that the company
is receiving the best benefit for its investment in human capital," says
Bert Hensley, chairman and CEO of Morgan Samuels Co., a Beverly Hills,
Calif.-based management consulting firm that specializes in executive
recruitment.
Finance must take part of the blame for that shortcoming because it has
failed to provide HR with an adequate level of guidance and support. In
Business Finance's annual executive career and compensation surveys, finance
executives consistently rank "managing and developing people" in the middle
of their pack of priorities.
In private conversations, however, many CFOs bemoan the fact that the more
immediate demands of their job -- growing the business, boosting revenue and
cutting costs, for example -- prevent them from giving workforce issues the
attention they feel is warranted.
"Human resources and finance are finding out that we really need to merge
our understanding of employees to develop a deeper understanding of the
costs, benefits and risks associated with our people," says David Davis,
director of finance and corporate controller for SAS Institute Inc. in Cary,
N.C. "I know we can do a better job by blending our skills and strengths."
Kochanski agrees. "You need both parts of the picture to really manage human
capital like an asset," he observes.
Hensley believes finance executives can help their organization's HR
department by emphasizing overarching corporate goals and insisting that
human capital management means much more than hiring people to fill
positions. "CFOs should focus the organization on the company's strategy,"
he says, "and then emphasize the importance of analyzing the skill sets
necessary to execute that strategy and finding the best talent to meet those
needs."
Finance executives may need to offer their HR colleagues an introduction to
basic financial principles and terminology (see Teaching Scorecard 101). But
they can do much more than that. They can partner with HR executives to help
them increase returns from pension, benefit and compensation investments;
manage the impact of new regulations; and address a looming labor crunch.
Driving HR Improvements
Corporate finance departments' "measure to manage" mantra has helped most
areas of the organization -- including, belatedly, HR -- to understand the
importance of tracking the costs and benefits that their processes, projects
and investments generate. CFOs' efforts in these areas have leaned heavily
on sophisticated information systems that enable companies to conduct
concise and timely analyses. Human capital management software, for example,
can show inpidual employees how their activities relate to high-level
corporate objectives and, in cases where incentive compensation is applied,
how their performance directly influences the size of their paycheck.
Michael Bileca, CFO and COO of Towncare Dental Partnership Inc., a dental
care and service provider in Miami, views human capital management as a
natural extension of his role. When his organization restructured its
doctors' compensation plan two years ago, switching from a revenue-sharing
model to a profit-sharing model, it invested substantial time, money and
effort in new performance management and training processes and technology,
including a workforce management application from Kronos.
"We needed to help develop our doctors' abilities to take on management
responsibilities, which means cultivating entrepreneurial skills and a
greater willingness to take business risks," Bileca explains. "Companies can
build great skill sets, but they can still be the wrong skill sets. To avoid
that pitfall, you need to place the training in a much larger enterprise
context."
Towncare Dental uses the new system's balanced scorecard functionality to
keep its doctors and their staff focused on business objectives and
continually informed of their performance. The organization ties training,
performance management, operational processes and enterprise strategy into
its scorecard.
David Klementz is another finance executive with a deep commitment to HR
improvements. He's senior vice president and CFO of Progress Rail Services
Corp., an Albertville, Ala.-based company that supplies rail and track-work
components to the railroad industry. During the past two years, Klementz has
invested much of his time in overhauling his $800 million organization's
incentive compensation plan and extending it to all of Progress Rail
Services' employees.
A central component of the initiative is a matrix Klementz designed that
tracks how the corporation's top five goals trickle down to the facility
level of the enterprise, where Progress Rail Services uses metrics such as
productivity and injury rates to gauge its workers' performance.
Klementz does not see human capital management as a departure from his core
priorities. "I view this as clarifying the links among our forecast,
business plan, and the systems and rewards we have in place," he explains.
Beyond Benchmarked Compensation
Initiatives like Towncare Dental's and Progress Rail Services' illustrate
the strengths that finance can bring to human capital issues. "CFOs are
expected to provide a return analysis on just about every capital investment
that a company makes, whether it is a piece of machinery, a new factory or
new office equipment," notes Peter LeBlanc, senior vice president in the
Raleigh, N.C., offices of Sibson Consulting. "That ROI analysis has never
been applied to compensation."
A company may attach a much higher value to a given job than other
organizations in its industry do, yet the majority of companies base their
nonexecutive compensation programs on industry benchmarks. "Almost every job
in the enterprise is being paid relative to the marketplace," LeBlanc says.
Instead, he insists, "there should be jobs that are paid higher vis-Ã -vis
their benchmark and lower vis-Ã -vis their benchmark."
Companies that are beginning to embrace this approach, such as Circuit City
and Standard Register, separate jobs into three or four buckets based on
their impact (low, moderate or high) on a handful of high-level corporate
objectives such as revenue growth. Some of these organizations also rate
their employees -- A player, B player or C player, for example -- based on
their job performance. This dual-rating system can provide valuable insights
into human capital deployment. For example, it can help companies ensure
that they are optimizing deployment of their HR assets by assigning A
players to high-impact positions.
Not surprisingly, LeBlanc says that he finds CFOs more receptive to this
innovative approach to compensation than HR executives, few of whom give
deep strategic thought to salary and benefits packages below the executive
level. Yet "most of the money spent on compensation is spent below the
executive level," he points out. "From the CFO perspective, there is an
opportunity."
Klementz agrees. Companies should look beyond industry compensation
benchmarks, he believes, if doing so helps them attract the skills they need
to meet high-level objectives. Progress Rail Services now pays as much as
110 percent of the industry benchmark for some positions.
Before adopting that strategy, the company conducted a compensation planning
exercise that was helpful in large part, Klementz says, because Progress
Rail Services' senior management team actively participated and had a voice
in how compensation levels would be stratified.
Vigilance in Pensions and Recruiting
CFOs and HR executives alike have been breathing a little easier in the past
couple of years thanks to some good news in another critical area of
employee rewards: retirement benefits. Pension plan funding levels have
regained some of the ground they lost in a dramatic three-year dive that
began in 1999. A recent Watson Wyatt Worldwide study of defined-benefit
pension plans at more than 600 of the 1,000 largest U.S. companies found
that the average plan's "funded status" -- the ratio of plan assets to the
estimated cost of its accrued pension obligations -- increased from 82
percent in 2002 to 88 percent in 2003. Pension plan liabilities increased by
nearly $125 billion (about 11 percent) in that period; however, assets rose
by $172.4 billion, or about 18 percent.
"After three years of low interest rates and weak investment performance,
last year's increase in funded status is a welcome change," notes Kevin
Wagner, a consulting actuary in Watson Wyatt's Southfield, Mich., offices.
"Many employers and participants should be heartened that their pension
plans remain well-positioned to pay retirement benefits."
At the same time, few finance executives feel sufficiently reassured to
relax their vigilance over this complex and critical area. As the equity
markets' reaction to a more restrictive federal monetary policy unfolds,
CFOs will continue to monitor their organization's pension plan assets and
liabilities closely.
The financial acumen that companies have applied to compensation strategies
and pension plans less frequently supports other areas of human capital
management. However, the recruiting process also offers opportunities for
efficiency improvements. For example, Morgan Samuels helps it clients
streamline their hiring processes by improving metrics such as the amount of
time they take to fill a position and the number of candidates they
interview for a given job.
Davis notes that the growing financial complexity of internal recruiting
calls for greater involvement of finance in HR. As SAS's global presence has
grown, he says, the financial aspects of its internal recruiting processes
have become increasingly intricate. They now include fair value analyses,
which help ensure that pisions losing managers are appropriately
compensated; currency ramifications associated with country-to-country
personnel transfers; transfer pricing calculations; and tax evaluations.
HR's Compliance Dimension
Finance executives who remain chary of involvement in human capital
management might want to reconsider that attitude in light of the HR-related
issues raised by Sarbanes-Oxley compliance initiatives.
"CFOs are quickly realizing that there are several business processes
residing in the HR department that have a direct and material impact on
their financial statements," notes a paper published by Pleasanton,
Calif.-based risk consulting and internal audit firm Protiviti Inc. titled
"The Impact of Sarbanes-Oxley on Human Capital Management." For example,
employees' fringe benefits are a potential compliance risk, according to the
report, and these rewards should be tracked carefully. Companies should also
conduct periodic reviews to ensure that their calculations of tax
liabilities and accruals for pensions, vacations and bonuses are correct.
Payroll and benefits account for 35 percent to 40 percent of companies'
operating costs on average, according to PricewaterhouseCoopers, so errors
by external payroll and benefits administrators can have a material impact
on an organization's balance sheet. Not surprisingly, many Sarbanes-Oxley
Section 404 initiatives have identified outsourced payroll and benefits
administration as significant risks.
Many organizations are asking their outsourcing partners to provide audits
that conform to the American Institute of Certified Public Accountants'
Statement on Auditing Standards (SAS) No. 70, Type II, which requires that a
public accounting firm attest to the quality of the provider's internal
controls environment. But some outsourcing providers are balking at the cost
and scope of these audits. As a result, many businesses face difficult
sourcing decisions with complex cost and compliance ramifications.
What's more, companies' HR and training functions will play a key role in
determining the effectiveness and cost-efficiency of Sarbanes-Oxley
compliance efforts over the long haul. If ongoing compliance monitoring is
to succeed, inpidual process owners throughout a company -- most of whom
have scant finance and accounting experience -- must be trained to
anticipate changes which may affect the internal controls that support their
process.
Building Bench Strength
A broader partnership between finance and HR can also help companies
strengthen their executive pipeline -- an aspect of human resources planning
that too many organizations neglect. CFOs are particularly at risk of being
stung by weak succession planning. "People who tend to gravitate toward a
financial career don't necessarily have in their own skill set the expertise
of developing leadership talent," says Guy Beaudin, Toronto-based managing
director of management consulting firm RHR International.
Although few, if any, human capital consultants predict a return to the
tight labor market of the late 1990s and the inflated compensation packages
that accompanied it, most believe a demographically fueled labor crunch will
occur as large numbers of baby boomers enter retirement between 2010 and
2015. And that will have serious repercussions for executive teams. In RHR
International's most recent executive bench study, half of the 115 companies
that participated said that they expect to lose 50 percent or more of their
senior management team by 2010.
Developing leadership talent internally is much easier and more
cost-effective than integrating executives hired from another organization,
Beaudin points out. Yet most of the surveyed companies that formally
identify high-potential talent report that they have been doing so for three
years or less.
Beaudin sees a bright spot in this area of widespread neglect.
"Organizations that take this seriously and develop formal bench-development
programs will be able to develop a competitive advantage that will certainly
emerge by 2010 -- and probably sooner than that," he says.
Given the fact that CFOs historically have neglected HR issues, proactive
finance executives may be able to exploit a range of opportunities in human
capital management. CFOs who help their organization's HR executives master
the language of finance and strengthen the financial management of human
capital will better position their company to handle the regulatory and
competitive challenges that lie ahead.
But the chance to pull ahead of competitors on the strength of human capital
management sophistication may disappear before long. Terms like Balanced
Scorecard, metrics, alignment and portfolio of talent are already slipping
into the HR vernacular.
And some organizations -- Towncare Dental, for example --have a head start.
"It may sound like a cliché," Bileca says, "but in the service business,
people are our greatest asset. We need to invest in our workforce in a way
that will help us achieve the results we want to achieve. It's really a
matter of pinpointing how well our investment in human capital is
performing."
Teaching Scorecard 101
It's not easy to learn a new language. Finance executives should keep that
in mind when teaching their HR colleagues the basic vocabulary of finance --
return on investment, return on assets and alignment, for example.
HR professionals will likely need help with scorecard concepts and
terminology, too. James Hatch offers a useful scorecard primer in his paper
"The HR Scorecard: The New Way To Measure Your Human Capital." Hatch is a
New York City-based principal, HR services, with PricewaterhouseCoopers and
managing partner with the Saratoga Institute, a human capital benchmarking
and survey organization that's a wholly owned subsidiary of PwC. Here are
the principles he recommends:
* Remember that absolute numbers are less meaningful than relative
numbers. "Data must always be placed within the appropriate context," Hatch
notes. "Factors such as number of employees, revenue, operating expenses and
geographic location can be useful in establishing such context. Many metrics
are of limited value if there is no basis for comparison."
* Ensure that the data you use to calculate the metrics is clean,
transparent and easy to collect. Companies new to scorecards often spend too
much time collecting and validating data, and not enough time analyzing the
information and elucidating its meaning. Hatch also emphasizes the
importance of clearly documenting the numbers and calculations behind the
metrics.
* Dovetail your scorecard metrics with measures and tools that your
organization is already using. Companies should consider including data from
their ongoing performance management programs and employee surveys in their
scorecard, at least in its early design stages.
* Focus on outcomes. Executives and line managers tend to focus more on
results than on activities. Metrics should reflect that focus by helping HR
people answer questions such as: Are we hiring the right people? Are we
developing them in a way that supports corporate objectives? Are the right
people staying?
* Assign a champion. "Find someone to own this process," Hatch advises,
"and make sure every relevant member is made aware of that person's
responsibility -- and of theirs."
* Treat your scorecard as a program, not a project. Organizations using
scorecards for the first time tend to stop using them once they have settled
on measures and begun to track performance.
Originally printed in the October 2004 issue of Business Finance
¶ 11:01 AM 0 Comments
5 Ways to Cut Costs in 2005
by Tad Leahy
Cost-cutting initiatives remain firmly at the top of most CFOs' agenda. In a
May 2004 survey of finance executives at more than 150 large companies
conducted by New York City-based consulting firm Booz Allen Hamilton, 85
percent of respondents said cost reduction is their highest priority. Nearly
60 percent reported that they are focusing on opportunities to reduce the
cost of providing overhead services by trimming nonessential spending,
restructuring costs and standardizing service levels. And only 3 percent
said they have reduced overhead costs as much as possible.
Ongoing studies by The Hackett Group confirm that cost containment remains
most companies' primary objective. "Sixty-one percent of 300 executives who
responded to a recent poll said cost cutting was their number one
companywide priority," says Richard Roth, Hackett's Atlanta-based chief
research officer. "There's still a strong feeling among senior executives
that 'if our company does grow, let's make sure our costs don't grow along
with it.' "
While the draconian cost-cutting campaigns many organizations implemented
during the downturn may already have harvested much of the low-hanging
fruit, savvy CFOs can still find opportunities to ferret out efficiencies.
Here's a look at five approaches finance executives may want to consider as
they plan their cost-cutting strategies for 2005.
1. Look for the easy savings first. Where should CFOs begin their next round
of cost cutting? Chris Bogan, CEO of Best Practices LLC, a research and
consulting firm in Chapel Hill, N.C., says they should look for areas in
which they can drive efficiencies while minimizing disruption.
"Best-practice companies start by putting a freeze on entertainment and
travel expenditures," he says. For example, "the company could institute a
policy whereby employees can only travel with the president's authorization.
"Other top-line cost-cutting areas include consulting and marketing," Bogan
adds. After squeezing costs in those areas, CFOs should turn their attention
to discretionary spending. "That includes things like training, continuing
education and developmental capital [expenditures]," he says. Cost-control
initiatives in these areas "typically cause minor internal inconveniences,
but they can reduce overall costs by 1 percent to 2 percent or so," he
notes.
2. Grab compliance costs by the horns. Sarbanes-Oxley compliance activities
offer a huge target for CFOs bent on cost control. But compliance costs are
a wild card, a variable that companies have trouble quantifying. Most
organizations realize that their compliance expenditures are escalating, but
few have developed effective strategies for monitoring these costs.
In July, Financial Executives International (FEI) surveyed 224 public
companies with average revenues of $2.5 billion in order to gauge their
Section 404 compliance costs. Respondents' estimated average was $3.14
million. That's 62 percent more than the $1.93 million estimate obtained in
a similar FEI survey in January. Participants in the July survey expected to
pay their auditors $823,200 in fees for attestation of their internal
controls, up from $590,100 in the earlier study.
And, of course, many large organizations are shelling out much more than
average. According to Dan DiFilippo, U.S. leader of governance, risk and
compliance at PricewaterhouseCoopers in New York City, The Hongkong and
Shanghai Banking Corp. Ltd. reports spending about $300 million annually on
Sarbanes-Oxley compliance activities, and the CEO of insurance provider
American Inter-national Group Inc. has reported that his company is spending
approximately $400 million per year.
"Those are two examples of companies that have at least quantified the
compliance cost bucket," says DiFilippo. "Compliance is the one cost area
that has probably been examined the least.
"Companies with a solid understanding of their compliance costs tend to tie
them to their overall performance results," DiFilippo adds. "Once you factor
those costs into your bottom line performance stats, it gets attention --
and people start taking them seriously."
Organizations can get started on compliance cost-cutting measures even if
they don't fully have a handle on those expenses. For example, DiFilippo
points out that many companies underuse their enterprise resource planning
(ERP) system's control features. On average, only about 40 percent of those
features are turned on because many companies implemented their ERP systems
back in the days before regulatory compliance became such a big issue. "It's
certainly not a big spending item to check and see if your ERP system is
running at 100 percent when it comes to its control features," he says.
Manually pulling together data from multiple sources is a huge compliance
money drain, but "the implementation of Web services and XBRL [extensible
business reporting language] can help keep the manual intervention to a
minimum, improving cost efficiencies while reducing the likelihood for
errors," DiFilippo says. "Those are existing technologies at many companies
that are simply not being used for compliance cost control." He adds that
"manual processes are still the most common way of fulfilling compliance
requirements."
While CFOs may be looking to prune back their organization's educational
offerings, they shouldn't skimp on compliance training. Investing in
communication and training programs to educate employees about compliance
goals and procedures can help reduce errors, which in turn reduces costs,
DiFilippo notes. "Even a modest investment in training and education yields
significant savings and control efficiencies on the back end," he says.
Ultimately, compliance cost savings come from melding compliance activities
into the company's everyday business processes, so that they become an
integral part of the company's operations. "That way, there is no separate
compliance view of the world -- just one view, which incorporates the
compliance aspect," says DiFilippo.
3. Cut IT costs by standardizing technology. Budgets bloated with IT
expenditures and purchases still plague many companies. As CFOs search for
ways to corral those costs, they would do well to develop a consistent
methodology for selecting and evaluating potential IT investments and
understanding how new systems will integrate with their current IT
infrastructure.
Mastering IT complexity has become a critical success factor in managing
overhead, according to the Booz Allen Hamilton survey. Nearly 90 percent of
respondents who described themselves as behind the competition in providing
cost-efficient internal services cited "managing a patchwork of different
systems" as their main IT challenge.
Research from Hackett also points to lack of standardization as a major
source of IT cost overruns. "We see a lot of companies that deviate from
their standard IT architecture and equipment all too often, which tends to
drive up IT costs," reports Roth. "For instance, if the company's enterprise
standard is Oracle, and one of its divisions decides to use SAP, those kinds
of deviations complicate IT processes and waste time and money.
"The same often holds true for how much IT customization a company does,"
Roth adds. "The urge to customize -- vs. sticking with the
out-of-the-package version -- usually drives up costs."
Roth notes that world-class IT organizations focus on standardization and
simplification across the board, relying on 50 percent fewer ERP systems
than median companies and 29 percent fewer applications per 1,000 end users.
"The top companies are more likely to use data standards across all systems
and are significantly more likely to have implemented a high level of
standards enforcement across hardware, networking and software
applications," he says.
Labor expenses historically have been the biggest cost segment of IT.
World-class organizations accomplish significantly more with fewer IT
workers than median companies do, according to Roth. "The best companies are
running their operations with 36 percent less staff than average companies
-- 28 IT staff per 1,000 end users for world-class [organizations] vs. 44
for median companies," he says. In addition, "these top companies allocate
their internal IT staff very differently, dedicating a significantly larger
percentage of their staff to application management and less staff to
addressing technology infrastructure issues."
What's more, world-class companies are more effective in their IT efforts,
delivering 91 percent of all projects to specification, on time and on
budget, while median companies meet these criteria only 68 percent of the
time, according to Roth.
4. Reap workforce efficiencies by leveraging outsourcing, shared services
and offshoring. Companies have notched some major cost-cutting successes in
recent years by turning over noncore functions to third-party providers.
That's especially true in the IT realm. "World-class companies spend 60
percent more than their median peers outsourcing technology infrastructure
activities," Roth says. "Overall, they commit 23 percent more annually to
outsourcing."
But Scott Brennan, a Charlotte, N.C.-based partner in Accenture's finance
and performance management practice, sees room for improvement in
businesses' outsourcing practices. "Companies fail to eliminate the
employees whose jobs have now disappeared because of the outsourcing," he
says. "And while it takes some backbone to fire those people, not doing so
is cost-inefficient. That includes the operational management personnel who
were managing those people, as well as any other operational management
areas supporting the people who were fired."
Many organizations have achieved cost efficiencies by consolidating
back-office functions in shared-services centers. But companies have failed
to cast their shared-services net wide enough, Brennan says. "Not many firms
have brought the total back office together under one shared services
umbrella that includes purchasing, finance, HR, legal and other
administrative functions," he notes. "Companies capable of overcoming [that
problem] can realize 15 percent more in cost efficiencies than they're
currently getting."
Moving business processes, and sometimes whole departments, overseas is an
increasingly popular decision for companies looking to trim costs. Omar
Aguilar, principal with Deloitte Consulting LLP in Philadelphia, believes
that organizations which leverage a mix of offshoring, domestic outsourcing
and shared services rake in the biggest gains. "By combining all three, you
can reap significantly more cost-cutting benefits," he says. "Companies with
the most competitive cost structures apply a measure of all of these
initiatives. They're redefining their service delivery strategy.
"Outsourcing the offshore functions produces greater cost benefits than when
a company tries to establish its own offshore operations," Aguilar points
out, "because the outsourcer typically has greater expertise within the
region under consideration."
5. Reduce supply chain costs by consolidating vendors and driving inventory
improvements. Supply chain improvements should be high on every CFO's to-do
list, according to Bogan. "When it comes to process improvement, the first
and easiest area to focus on is the supply chain, by reducing the number of
vendors you work with and negotiating for better rates based on doing higher
volume business with [the ones you keep]," he says.
Inventory is the single most important target for cost-reduction initiatives
within the supply chain management function, according to John Rittenhouse,
national practice leader for operations risk management in the San Francisco
offices of KPMG LLP.
"Supply chain management revolves around inventory, including the amount of
it, where it's held and its quality," Rittenhouse says. "One way to reduce
[inventory] costs is to have the manufacturer keep more of the inventory and
to avoid owning the raw goods until the time of sale. Doing so helps improve
the management of C-class inventory; that is, products which typically don't
turn over very fast and have the highest likelihood of becoming obsolete."
Outsourcing supply chain management processes is a viable option, and one
that some companies have used in order to minimize capital expenditures when
embarking on a new business. "For example, Wal-Mart outsourced its food
division to a third party initially so it could get a better idea of how
successful that new business was likely to be," Rittenhouse says. "Then they
brought the operation in-house after they became convinced of its profit
potential."
Supply chain management software can help companies gain greater visibility
into key inventory processes. "It can provide a better view of where
inventory is located, so people can react faster to that information and
ensure the product is in the right place at the right time," says
Rittenhouse. Supply chain management systems "can also provide alerts
outside the supply area to the CFO and CEO if there are any issues those
executives need to address," he says.
Radio frequency identification (RFID) technology promises to become a huge
boon for inventory management, Rittenhouse adds. Eventually companies will
be able to place a tiny microchip on each product. The device will broadcast
data that will enable supply managers to pinpoint the item's location,
greatly improving inventory processes.
In addition to exploring these five key opportunities, finance executives
may want to revisit the cost-cutting strategies they implemented in the
downturn. For some companies, that may mean taking another hard look at the
size of their workforce.
"If you reach the point where you're forced to cut your people, you can do
that by degree, by putting a freeze on hiring and letting people retire, or
cutting back on the number of hours people work," says Bogan. "Another lever
you can pull is the health care, equipment and supplies those people had
been using. Paying someone a salary of $100,000 is in effect like paying
them about $140,000 after factoring in all the benefits and company support
they consume. You can also consider consolidating some jobs."
Anita Tilley, managing director with BearingPoint Inc. in Nashville, Tenn.,
cautions that layoffs can backfire in organizations with inefficient
business processes. "Research shows that companies that only cut heads but
remain mired in the same poor processes and strategies just end up hiring
new people to fill the spaces left by those fired, which ends up costing
them more money because they have to train the new people," she says.
Proactive CFOs will continue to scour their company for cost-cutting
opportunities. But they should also bear in mind that the most effective
measures aren't those that focus on individual processes or departments --
they are enterprisewide initiatives that become embedded in virtually every
corner of the organization. Initiatives like Six Sigma, lean manufacturing
and activity-based costing are proven methodologies not only for reducing
costs in the short term, but also for developing a cost-conscious culture
over the long haul.
The Power of Alignment
Companies' overhead cost reduction efforts often flounder because of
misalignments in their internal service delivery model, according to a
survey of CFOs at more than 150 large companies conducted by New York
City-based management and technology consulting firm Booz Allen Hamilton.
Internal service providers and the business units they serve are frequently
in conflict, leading to frustration and inefficiency.
Four of the top five reasons why cost reduction measures meet with
resistance from business units are "lack of communication," cited by 38
percent of respondents; "services not tailored to business needs" (36
percent); "didn't involve the business unit in decisions" (33 percent); and
"work offloaded to the business unit" (31 percent).
The study notes a strong correlation between business units' receptivity to
cost control measures and the presence of key business alignment mechanisms,
including the following:
* Service level agreements
* Chargebacks
* Physical consolidation of operations
* Performance-based compensation linked to key performance indicators
* Benchmarking of performance against outside companies and providers
* Access to external providers if business units are dissatisfied with
internal services
However, relatively few companies have adopted these measures, the study
notes. Fewer than 60 percent of the organizations surveyed have implemented
any of the most common alignment mechanisms: service level agreements,
chargebacks or physical consolidation of their operations.
Originally printed in the October 2004 issue of Business Finance
¶ 10:51 AM 0 Comments
Cost-cutting initiatives remain firmly at the top of most CFOs' agenda. In a
May 2004 survey of finance executives at more than 150 large companies
conducted by New York City-based consulting firm Booz Allen Hamilton, 85
percent of respondents said cost reduction is their highest priority. Nearly
60 percent reported that they are focusing on opportunities to reduce the
cost of providing overhead services by trimming nonessential spending,
restructuring costs and standardizing service levels. And only 3 percent
said they have reduced overhead costs as much as possible.
Ongoing studies by The Hackett Group confirm that cost containment remains
most companies' primary objective. "Sixty-one percent of 300 executives who
responded to a recent poll said cost cutting was their number one
companywide priority," says Richard Roth, Hackett's Atlanta-based chief
research officer. "There's still a strong feeling among senior executives
that 'if our company does grow, let's make sure our costs don't grow along
with it.' "
While the draconian cost-cutting campaigns many organizations implemented
during the downturn may already have harvested much of the low-hanging
fruit, savvy CFOs can still find opportunities to ferret out efficiencies.
Here's a look at five approaches finance executives may want to consider as
they plan their cost-cutting strategies for 2005.
1. Look for the easy savings first. Where should CFOs begin their next round
of cost cutting? Chris Bogan, CEO of Best Practices LLC, a research and
consulting firm in Chapel Hill, N.C., says they should look for areas in
which they can drive efficiencies while minimizing disruption.
"Best-practice companies start by putting a freeze on entertainment and
travel expenditures," he says. For example, "the company could institute a
policy whereby employees can only travel with the president's authorization.
"Other top-line cost-cutting areas include consulting and marketing," Bogan
adds. After squeezing costs in those areas, CFOs should turn their attention
to discretionary spending. "That includes things like training, continuing
education and developmental capital [expenditures]," he says. Cost-control
initiatives in these areas "typically cause minor internal inconveniences,
but they can reduce overall costs by 1 percent to 2 percent or so," he
notes.
2. Grab compliance costs by the horns. Sarbanes-Oxley compliance activities
offer a huge target for CFOs bent on cost control. But compliance costs are
a wild card, a variable that companies have trouble quantifying. Most
organizations realize that their compliance expenditures are escalating, but
few have developed effective strategies for monitoring these costs.
In July, Financial Executives International (FEI) surveyed 224 public
companies with average revenues of $2.5 billion in order to gauge their
Section 404 compliance costs. Respondents' estimated average was $3.14
million. That's 62 percent more than the $1.93 million estimate obtained in
a similar FEI survey in January. Participants in the July survey expected to
pay their auditors $823,200 in fees for attestation of their internal
controls, up from $590,100 in the earlier study.
And, of course, many large organizations are shelling out much more than
average. According to Dan DiFilippo, U.S. leader of governance, risk and
compliance at PricewaterhouseCoopers in New York City, The Hongkong and
Shanghai Banking Corp. Ltd. reports spending about $300 million annually on
Sarbanes-Oxley compliance activities, and the CEO of insurance provider
American Inter-national Group Inc. has reported that his company is spending
approximately $400 million per year.
"Those are two examples of companies that have at least quantified the
compliance cost bucket," says DiFilippo. "Compliance is the one cost area
that has probably been examined the least.
"Companies with a solid understanding of their compliance costs tend to tie
them to their overall performance results," DiFilippo adds. "Once you factor
those costs into your bottom line performance stats, it gets attention --
and people start taking them seriously."
Organizations can get started on compliance cost-cutting measures even if
they don't fully have a handle on those expenses. For example, DiFilippo
points out that many companies underuse their enterprise resource planning
(ERP) system's control features. On average, only about 40 percent of those
features are turned on because many companies implemented their ERP systems
back in the days before regulatory compliance became such a big issue. "It's
certainly not a big spending item to check and see if your ERP system is
running at 100 percent when it comes to its control features," he says.
Manually pulling together data from multiple sources is a huge compliance
money drain, but "the implementation of Web services and XBRL [extensible
business reporting language] can help keep the manual intervention to a
minimum, improving cost efficiencies while reducing the likelihood for
errors," DiFilippo says. "Those are existing technologies at many companies
that are simply not being used for compliance cost control." He adds that
"manual processes are still the most common way of fulfilling compliance
requirements."
While CFOs may be looking to prune back their organization's educational
offerings, they shouldn't skimp on compliance training. Investing in
communication and training programs to educate employees about compliance
goals and procedures can help reduce errors, which in turn reduces costs,
DiFilippo notes. "Even a modest investment in training and education yields
significant savings and control efficiencies on the back end," he says.
Ultimately, compliance cost savings come from melding compliance activities
into the company's everyday business processes, so that they become an
integral part of the company's operations. "That way, there is no separate
compliance view of the world -- just one view, which incorporates the
compliance aspect," says DiFilippo.
3. Cut IT costs by standardizing technology. Budgets bloated with IT
expenditures and purchases still plague many companies. As CFOs search for
ways to corral those costs, they would do well to develop a consistent
methodology for selecting and evaluating potential IT investments and
understanding how new systems will integrate with their current IT
infrastructure.
Mastering IT complexity has become a critical success factor in managing
overhead, according to the Booz Allen Hamilton survey. Nearly 90 percent of
respondents who described themselves as behind the competition in providing
cost-efficient internal services cited "managing a patchwork of different
systems" as their main IT challenge.
Research from Hackett also points to lack of standardization as a major
source of IT cost overruns. "We see a lot of companies that deviate from
their standard IT architecture and equipment all too often, which tends to
drive up IT costs," reports Roth. "For instance, if the company's enterprise
standard is Oracle, and one of its divisions decides to use SAP, those kinds
of deviations complicate IT processes and waste time and money.
"The same often holds true for how much IT customization a company does,"
Roth adds. "The urge to customize -- vs. sticking with the
out-of-the-package version -- usually drives up costs."
Roth notes that world-class IT organizations focus on standardization and
simplification across the board, relying on 50 percent fewer ERP systems
than median companies and 29 percent fewer applications per 1,000 end users.
"The top companies are more likely to use data standards across all systems
and are significantly more likely to have implemented a high level of
standards enforcement across hardware, networking and software
applications," he says.
Labor expenses historically have been the biggest cost segment of IT.
World-class organizations accomplish significantly more with fewer IT
workers than median companies do, according to Roth. "The best companies are
running their operations with 36 percent less staff than average companies
-- 28 IT staff per 1,000 end users for world-class [organizations] vs. 44
for median companies," he says. In addition, "these top companies allocate
their internal IT staff very differently, dedicating a significantly larger
percentage of their staff to application management and less staff to
addressing technology infrastructure issues."
What's more, world-class companies are more effective in their IT efforts,
delivering 91 percent of all projects to specification, on time and on
budget, while median companies meet these criteria only 68 percent of the
time, according to Roth.
4. Reap workforce efficiencies by leveraging outsourcing, shared services
and offshoring. Companies have notched some major cost-cutting successes in
recent years by turning over noncore functions to third-party providers.
That's especially true in the IT realm. "World-class companies spend 60
percent more than their median peers outsourcing technology infrastructure
activities," Roth says. "Overall, they commit 23 percent more annually to
outsourcing."
But Scott Brennan, a Charlotte, N.C.-based partner in Accenture's finance
and performance management practice, sees room for improvement in
businesses' outsourcing practices. "Companies fail to eliminate the
employees whose jobs have now disappeared because of the outsourcing," he
says. "And while it takes some backbone to fire those people, not doing so
is cost-inefficient. That includes the operational management personnel who
were managing those people, as well as any other operational management
areas supporting the people who were fired."
Many organizations have achieved cost efficiencies by consolidating
back-office functions in shared-services centers. But companies have failed
to cast their shared-services net wide enough, Brennan says. "Not many firms
have brought the total back office together under one shared services
umbrella that includes purchasing, finance, HR, legal and other
administrative functions," he notes. "Companies capable of overcoming [that
problem] can realize 15 percent more in cost efficiencies than they're
currently getting."
Moving business processes, and sometimes whole departments, overseas is an
increasingly popular decision for companies looking to trim costs. Omar
Aguilar, principal with Deloitte Consulting LLP in Philadelphia, believes
that organizations which leverage a mix of offshoring, domestic outsourcing
and shared services rake in the biggest gains. "By combining all three, you
can reap significantly more cost-cutting benefits," he says. "Companies with
the most competitive cost structures apply a measure of all of these
initiatives. They're redefining their service delivery strategy.
"Outsourcing the offshore functions produces greater cost benefits than when
a company tries to establish its own offshore operations," Aguilar points
out, "because the outsourcer typically has greater expertise within the
region under consideration."
5. Reduce supply chain costs by consolidating vendors and driving inventory
improvements. Supply chain improvements should be high on every CFO's to-do
list, according to Bogan. "When it comes to process improvement, the first
and easiest area to focus on is the supply chain, by reducing the number of
vendors you work with and negotiating for better rates based on doing higher
volume business with [the ones you keep]," he says.
Inventory is the single most important target for cost-reduction initiatives
within the supply chain management function, according to John Rittenhouse,
national practice leader for operations risk management in the San Francisco
offices of KPMG LLP.
"Supply chain management revolves around inventory, including the amount of
it, where it's held and its quality," Rittenhouse says. "One way to reduce
[inventory] costs is to have the manufacturer keep more of the inventory and
to avoid owning the raw goods until the time of sale. Doing so helps improve
the management of C-class inventory; that is, products which typically don't
turn over very fast and have the highest likelihood of becoming obsolete."
Outsourcing supply chain management processes is a viable option, and one
that some companies have used in order to minimize capital expenditures when
embarking on a new business. "For example, Wal-Mart outsourced its food
division to a third party initially so it could get a better idea of how
successful that new business was likely to be," Rittenhouse says. "Then they
brought the operation in-house after they became convinced of its profit
potential."
Supply chain management software can help companies gain greater visibility
into key inventory processes. "It can provide a better view of where
inventory is located, so people can react faster to that information and
ensure the product is in the right place at the right time," says
Rittenhouse. Supply chain management systems "can also provide alerts
outside the supply area to the CFO and CEO if there are any issues those
executives need to address," he says.
Radio frequency identification (RFID) technology promises to become a huge
boon for inventory management, Rittenhouse adds. Eventually companies will
be able to place a tiny microchip on each product. The device will broadcast
data that will enable supply managers to pinpoint the item's location,
greatly improving inventory processes.
In addition to exploring these five key opportunities, finance executives
may want to revisit the cost-cutting strategies they implemented in the
downturn. For some companies, that may mean taking another hard look at the
size of their workforce.
"If you reach the point where you're forced to cut your people, you can do
that by degree, by putting a freeze on hiring and letting people retire, or
cutting back on the number of hours people work," says Bogan. "Another lever
you can pull is the health care, equipment and supplies those people had
been using. Paying someone a salary of $100,000 is in effect like paying
them about $140,000 after factoring in all the benefits and company support
they consume. You can also consider consolidating some jobs."
Anita Tilley, managing director with BearingPoint Inc. in Nashville, Tenn.,
cautions that layoffs can backfire in organizations with inefficient
business processes. "Research shows that companies that only cut heads but
remain mired in the same poor processes and strategies just end up hiring
new people to fill the spaces left by those fired, which ends up costing
them more money because they have to train the new people," she says.
Proactive CFOs will continue to scour their company for cost-cutting
opportunities. But they should also bear in mind that the most effective
measures aren't those that focus on individual processes or departments --
they are enterprisewide initiatives that become embedded in virtually every
corner of the organization. Initiatives like Six Sigma, lean manufacturing
and activity-based costing are proven methodologies not only for reducing
costs in the short term, but also for developing a cost-conscious culture
over the long haul.
The Power of Alignment
Companies' overhead cost reduction efforts often flounder because of
misalignments in their internal service delivery model, according to a
survey of CFOs at more than 150 large companies conducted by New York
City-based management and technology consulting firm Booz Allen Hamilton.
Internal service providers and the business units they serve are frequently
in conflict, leading to frustration and inefficiency.
Four of the top five reasons why cost reduction measures meet with
resistance from business units are "lack of communication," cited by 38
percent of respondents; "services not tailored to business needs" (36
percent); "didn't involve the business unit in decisions" (33 percent); and
"work offloaded to the business unit" (31 percent).
The study notes a strong correlation between business units' receptivity to
cost control measures and the presence of key business alignment mechanisms,
including the following:
* Service level agreements
* Chargebacks
* Physical consolidation of operations
* Performance-based compensation linked to key performance indicators
* Benchmarking of performance against outside companies and providers
* Access to external providers if business units are dissatisfied with
internal services
However, relatively few companies have adopted these measures, the study
notes. Fewer than 60 percent of the organizations surveyed have implemented
any of the most common alignment mechanisms: service level agreements,
chargebacks or physical consolidation of their operations.
Originally printed in the October 2004 issue of Business Finance
¶ 10:51 AM 0 Comments
With the Rise of ERM, Should CFOs Give Up Handling Risk?
By Duncan Wood / Treasury & Risk Management
11-November-2004
When the board of Pepco Holdings Inc. emerged from a planning retreat
earlier this year, it had decided to revamp the Washington D.C.Âbased
electric utility's management structure. The aim was to use enterprise risk
management to put a sharp focus on strategic planning.
At the time, Andrew Williams was the company's CFO, a post he had held since
the start of 2001. But when the Pepco board determined that it was time to
get a grip on risk, it also decided it needed a chief risk officer (CRO)Âa
new position for Pepco that would manage risks that could derail the
utility's long-term strategic initiativesÂand Williams would be moved into
the job. "We've identified all of the different risks associated with each
of our strategic planning initiatives and created a strategic risk dashboard
which is color-coded so the board can see where we're most likely to
encounter an adverse event," Williams explains.
Even though, as CFO, Williams already supervised Pepco's more traditional
risk management, the risk revolution at Pepco not only rerouted Williams'
career, it pushed the role of CFO back into the more tactical domain of
treasury operations, day-to-day cash management, equity and debt financing,
shareholder services and financial reporting. While the finance organization
may be more important to Pepco on a day-to-day basis, the board's actions
clearly signalled that it would be the CRO and the risk organization that is
the lens through which the company sees its future.
Should CFOs worryÂor salivate at the possibilities? Proponents of enterprise
risk management have been predicting for years that the discipline would
revolutionize the way that companies respond to threats and opportunities.
Outside of the financial sector, the discipline has been slow to take
rootÂbut now amid a heightened awareness within the business community about
the need for a holistic perspective on risk, ERM's more likely adoption is
portending a shake-up of the corporate org chart that is often as radical as
the changes ERM promotes in risk management practices. Until recently, there
was no question that the province of risk resided in the CFO's office. But
with an ERM view of business, there is a much broader role for the owner of
the risk functionÂone that at some companies has prompted the creation of a
CRO who reports directly to the CEO or board. "Finance executives have an
important role in helping companies understand and manage risk, but they
should not be viewed as the sole fiduciary of a company's risk," says Miles
Everson, a partner at PricewaterhouseCoopers LLP and principal author of the
framework document on ERM that was published by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). "What is important is to
step back and look at the various responsibilities that need to be carried
out to both manage risk and ensure that the risk management process has
proper oversight. Essentially everyone on the executive team has a role."
That's certainly the message of the COSO enterprise risk management
framework, released in late September. A three-year project that
incorporates and builds on the group's widely influential internal controls
guidelines released more than a decade ago, the new framework includes eight
general guidelines on areas such as objective setting, event identification
and risk assessment to help a company establish an ERM strategy or improve
on an existing one. "There was no commonly understood base of knowledge of
what ERM was, not unlike internal controls prior to the release of that
framework," says John Flaherty, COSO chairman and former vice president and
general auditor of PepsiCo Inc. "The terms meant different things to
different people."
The COSO report also emphasizes the role of financial executives in ERM
activities, given that they control much of the flow of key financial data
and technology necessary for accurate and timely risk management
assessments, especially at larger companies. But the group failed to provide
specific guidance on whether a CRO is necessary or whether the CFO should be
the place where the buck stops on risk.
The issue has come to the forefront with recent revelations about accounting
policies and financial reporting at Fannie Mae, the home mortgage financing
group. Among the criticisms was the fact that Fannie Mae's CFO Timothy
Howard also oversaw corporate risk management. "The concentration of these
responsibilities in a single person does not provide the independence
necessary for an effective chief risk officer function," said Armando
Falcon, Jr., director of Fannie Mae's regulator, the Office of Federal
Housing Enterprise Oversight, in recent congressional testimony. Among the
recent reforms Fannie's board agreed to was the appointment of an
independent chief risk officer. Even so Tom Dowling, the CRO at advertising
giant Interpublic Group of Cos., says it's too early to conclude how
enterprise-wide risk structures will evolve at companies or whether the COSO
framework will become a de facto ERM standard. And even though Interpublic
believes it is the only advertising company to have appointed a CRO, Dowling
is convinced that his company is headed in the right direction. "We want to
build a model that helps the company understand all of its risks," Dowling
says. "ERM is about achieving a granular understanding of the risks and
opportunities arising from your business."
Interpublic's search for an answer began in 2002, when it uncovered
intercompany billing problems within its largest unit and launched an
in-house review. (Subsequently, the SEC launched an investigation of
financial controls and accounting practices at the company.) Interpublic's
internal review produced two key recommendations: The company should tighten
up its financial controls, and it should try to capture all of its potential
risks and opportunities by centralizing risk management. At the same time,
passage of the Sarbanes-Oxley Act was pushing Interpublic and every other
public company in the U.S. in a similar direction, resulting in what Dowling
calls "an intense focus on internal controls and risk management."
Interpublic created the CRO's post to give its drive an organizational
leaderÂa point person on risk, so to speakÂand Dowling, then senior vice
president for financial administration, moved across the hall to take up the
responsibility, just as Pepco's Williams did earlier this year. But while
Sarbanes-Oxley may have been a force behind the creation of the CRO position
at Interpublic, it also has been the key driver behind the expanding power
base of the CFO that anointed the CEO and CFO as the two executives
responsible for certifying the accuracy of a company's internal controls.
"It's really only the CEO and CFO who are risking jail time, and that binds
them together in a major way," says Laurence Stybel, vice president of
Boston-based Board Options Inc., a career services firm for board-level
executives. For this reason, many predict that CFOs will be wary, if not
downright ornery, about handing over the reins on risk, and the CEO is
unlikely to force the one person in the organization that shares his or her
regulatory role to do so.
AT HEART, IT'S FINANCIAL
CFOs also still own the most significant risk faced by a business
enterpriseÂfinancial risks, which many would argue compose the heart of
every risk for a profit-making organization. "Part of the risk management
process is making sure there is a strong balance sheet and understanding the
inherent volatility in reported earnings. Nobody would know that better than
the CFO," says Frank Sabatini, a partner in the insurance and actuarial
advisory services department at Ernst & Young LLP. According to Sabatini,
it's often "CFOs [who] are driving the evolution of ERM within their
respective companies." At trucking company Yellow Roadway Corp., the CFO was
the prime mover in changes that saw internal audit folded into an expanded
risk management mandate, notes Dan Churay, the company's CRO and general
counsel. "He wanted to ensure that there was some distanceÂthat internal
audit would have the independence to act as a real check and balance on
internal controlsÂso it became part of the risk function."
Now, while internal financial controls are owned by the finance department,
and the CFO is responsible for sign-off under Sarbanes-Oxley, it is a risk
management responsibility to test the controls and, more generally, to get
the company geared up for the new regulations, says Churay. The other
responsibilities that fall under Churay's umbrella are "all those functions
which were 60% or more to do with risk management," he says. In practice,
that means the legal department, liability claims (a fairly active
department because of the company's vast fleet of vehicles), workers comp,
general insurance and corporate audit. Over and above that, Yellow Roadway's
risk management group has a responsibility at the corporate level to monitor
how the company's different pools of risk influence each other and also to
look out for risks that wouldn't traditionally be captured by any of the
pre-existing departments.
It's this kind of underlying philosophy that should determine how companies
reform their organizational hierarchy, says Robert Vettoretti, a director in
advisory services with PwC in New York. "You have to align your corporate
structure with your risk management aims. If risk management is seen as a
purely defensive function, that might argue for the formation of a new
committee. But if you want risk to play a broader role, that really requires
the creation of a dedicated groupÂwhich could be located within treasury or
strategic planningÂto facilitate risk measurement."
SURROGATE CRO
The broader role that Vettoretti has in mind is one in which ERM is seen as
a way of aggregating a company's traditionally dispersed buckets of risk
information and harnessing it to get a firmer grip on strategic planning or
performance measurement. AMEC plc, the UK's largest construction company,
has adopted this facilitative approach to risk management as well. Here
again, risk used to be the responsibility of the company's CFO, but the risk
management reporting lines now terminate at the commercial director, says
Kate Boothroyd, AMEC's head of risk management and internal audit. Now, it's
Boothroyd and the commercial director who present a profile of AMEC's risks
to the board twice a year.
Boothroyd insists that she isn't a CRO: "We discussed that kind of role here
and decided that it wasn't needed." But she is the managerial focal point
for the reporting of risk at the executive level and bears the
responsibility of reporting to the board. "I think 'risk manager' is a
misnomer," she says. "I don't manage the risksÂit's up to the businesses to
manage the risks. What we're here to do is to provide assurance that risks
are being monitored and managed."
If that sounds like a limited mandate in some ways, in others it is
incredibly ambitious: The array of risks which Boothroyd is responsible for
monitoring include "worrying about having the right staff and making sure
they're safe, risks to do with the treasury function and tax, especially
when we work in all sorts of regions around the worldÂrisks related to
mergers and acquisitions, strategy, internal and external communication,
financing risks, investor relations and ethics."
Moreover, unlike most nonfinancial companies, AMEC makes an attempt to
introduce some comparability into its risk management assessments, and ties
that in to its decision-making process. All new projects are scored in terms
of the probability and impact of the risk involved. As the level of risk
escalates, so does the decision-making responsibility, culminating in a
board-level risk review committee.
PwC's Vettoretti says that defining the scope and structure of the risk
function is "a challenge" for nonfinancial companies. "If you opt for a CRO,
how do you define the role and how does it relate to the existing
organizational structure? You need to decide how it differs from the office
of environment, health and safety, how it differs from the general counsel's
office. Different companies will have different answers."
That may be true, but the new approaches to risk are dramatically distinct
from what went on before, and they have certain things in common. At the
root of all these risk overhauls is the fundamental belief that companies
stand to benefit by aggregating the management and oversight of risk at the
corporate level. Responsibilities that used to reside elsewhere now reside
with an evolving risk function. It may be taking longer than some had
predicted, but ERM is changing the way that companies work and may transform
CFOs into CROsÂif not in name, then certainly in how they operate.
¶ 10:48 AM 0 Comments
11-November-2004
When the board of Pepco Holdings Inc. emerged from a planning retreat
earlier this year, it had decided to revamp the Washington D.C.Âbased
electric utility's management structure. The aim was to use enterprise risk
management to put a sharp focus on strategic planning.
At the time, Andrew Williams was the company's CFO, a post he had held since
the start of 2001. But when the Pepco board determined that it was time to
get a grip on risk, it also decided it needed a chief risk officer (CRO)Âa
new position for Pepco that would manage risks that could derail the
utility's long-term strategic initiativesÂand Williams would be moved into
the job. "We've identified all of the different risks associated with each
of our strategic planning initiatives and created a strategic risk dashboard
which is color-coded so the board can see where we're most likely to
encounter an adverse event," Williams explains.
Even though, as CFO, Williams already supervised Pepco's more traditional
risk management, the risk revolution at Pepco not only rerouted Williams'
career, it pushed the role of CFO back into the more tactical domain of
treasury operations, day-to-day cash management, equity and debt financing,
shareholder services and financial reporting. While the finance organization
may be more important to Pepco on a day-to-day basis, the board's actions
clearly signalled that it would be the CRO and the risk organization that is
the lens through which the company sees its future.
Should CFOs worryÂor salivate at the possibilities? Proponents of enterprise
risk management have been predicting for years that the discipline would
revolutionize the way that companies respond to threats and opportunities.
Outside of the financial sector, the discipline has been slow to take
rootÂbut now amid a heightened awareness within the business community about
the need for a holistic perspective on risk, ERM's more likely adoption is
portending a shake-up of the corporate org chart that is often as radical as
the changes ERM promotes in risk management practices. Until recently, there
was no question that the province of risk resided in the CFO's office. But
with an ERM view of business, there is a much broader role for the owner of
the risk functionÂone that at some companies has prompted the creation of a
CRO who reports directly to the CEO or board. "Finance executives have an
important role in helping companies understand and manage risk, but they
should not be viewed as the sole fiduciary of a company's risk," says Miles
Everson, a partner at PricewaterhouseCoopers LLP and principal author of the
framework document on ERM that was published by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). "What is important is to
step back and look at the various responsibilities that need to be carried
out to both manage risk and ensure that the risk management process has
proper oversight. Essentially everyone on the executive team has a role."
That's certainly the message of the COSO enterprise risk management
framework, released in late September. A three-year project that
incorporates and builds on the group's widely influential internal controls
guidelines released more than a decade ago, the new framework includes eight
general guidelines on areas such as objective setting, event identification
and risk assessment to help a company establish an ERM strategy or improve
on an existing one. "There was no commonly understood base of knowledge of
what ERM was, not unlike internal controls prior to the release of that
framework," says John Flaherty, COSO chairman and former vice president and
general auditor of PepsiCo Inc. "The terms meant different things to
different people."
The COSO report also emphasizes the role of financial executives in ERM
activities, given that they control much of the flow of key financial data
and technology necessary for accurate and timely risk management
assessments, especially at larger companies. But the group failed to provide
specific guidance on whether a CRO is necessary or whether the CFO should be
the place where the buck stops on risk.
The issue has come to the forefront with recent revelations about accounting
policies and financial reporting at Fannie Mae, the home mortgage financing
group. Among the criticisms was the fact that Fannie Mae's CFO Timothy
Howard also oversaw corporate risk management. "The concentration of these
responsibilities in a single person does not provide the independence
necessary for an effective chief risk officer function," said Armando
Falcon, Jr., director of Fannie Mae's regulator, the Office of Federal
Housing Enterprise Oversight, in recent congressional testimony. Among the
recent reforms Fannie's board agreed to was the appointment of an
independent chief risk officer. Even so Tom Dowling, the CRO at advertising
giant Interpublic Group of Cos., says it's too early to conclude how
enterprise-wide risk structures will evolve at companies or whether the COSO
framework will become a de facto ERM standard. And even though Interpublic
believes it is the only advertising company to have appointed a CRO, Dowling
is convinced that his company is headed in the right direction. "We want to
build a model that helps the company understand all of its risks," Dowling
says. "ERM is about achieving a granular understanding of the risks and
opportunities arising from your business."
Interpublic's search for an answer began in 2002, when it uncovered
intercompany billing problems within its largest unit and launched an
in-house review. (Subsequently, the SEC launched an investigation of
financial controls and accounting practices at the company.) Interpublic's
internal review produced two key recommendations: The company should tighten
up its financial controls, and it should try to capture all of its potential
risks and opportunities by centralizing risk management. At the same time,
passage of the Sarbanes-Oxley Act was pushing Interpublic and every other
public company in the U.S. in a similar direction, resulting in what Dowling
calls "an intense focus on internal controls and risk management."
Interpublic created the CRO's post to give its drive an organizational
leaderÂa point person on risk, so to speakÂand Dowling, then senior vice
president for financial administration, moved across the hall to take up the
responsibility, just as Pepco's Williams did earlier this year. But while
Sarbanes-Oxley may have been a force behind the creation of the CRO position
at Interpublic, it also has been the key driver behind the expanding power
base of the CFO that anointed the CEO and CFO as the two executives
responsible for certifying the accuracy of a company's internal controls.
"It's really only the CEO and CFO who are risking jail time, and that binds
them together in a major way," says Laurence Stybel, vice president of
Boston-based Board Options Inc., a career services firm for board-level
executives. For this reason, many predict that CFOs will be wary, if not
downright ornery, about handing over the reins on risk, and the CEO is
unlikely to force the one person in the organization that shares his or her
regulatory role to do so.
AT HEART, IT'S FINANCIAL
CFOs also still own the most significant risk faced by a business
enterpriseÂfinancial risks, which many would argue compose the heart of
every risk for a profit-making organization. "Part of the risk management
process is making sure there is a strong balance sheet and understanding the
inherent volatility in reported earnings. Nobody would know that better than
the CFO," says Frank Sabatini, a partner in the insurance and actuarial
advisory services department at Ernst & Young LLP. According to Sabatini,
it's often "CFOs [who] are driving the evolution of ERM within their
respective companies." At trucking company Yellow Roadway Corp., the CFO was
the prime mover in changes that saw internal audit folded into an expanded
risk management mandate, notes Dan Churay, the company's CRO and general
counsel. "He wanted to ensure that there was some distanceÂthat internal
audit would have the independence to act as a real check and balance on
internal controlsÂso it became part of the risk function."
Now, while internal financial controls are owned by the finance department,
and the CFO is responsible for sign-off under Sarbanes-Oxley, it is a risk
management responsibility to test the controls and, more generally, to get
the company geared up for the new regulations, says Churay. The other
responsibilities that fall under Churay's umbrella are "all those functions
which were 60% or more to do with risk management," he says. In practice,
that means the legal department, liability claims (a fairly active
department because of the company's vast fleet of vehicles), workers comp,
general insurance and corporate audit. Over and above that, Yellow Roadway's
risk management group has a responsibility at the corporate level to monitor
how the company's different pools of risk influence each other and also to
look out for risks that wouldn't traditionally be captured by any of the
pre-existing departments.
It's this kind of underlying philosophy that should determine how companies
reform their organizational hierarchy, says Robert Vettoretti, a director in
advisory services with PwC in New York. "You have to align your corporate
structure with your risk management aims. If risk management is seen as a
purely defensive function, that might argue for the formation of a new
committee. But if you want risk to play a broader role, that really requires
the creation of a dedicated groupÂwhich could be located within treasury or
strategic planningÂto facilitate risk measurement."
SURROGATE CRO
The broader role that Vettoretti has in mind is one in which ERM is seen as
a way of aggregating a company's traditionally dispersed buckets of risk
information and harnessing it to get a firmer grip on strategic planning or
performance measurement. AMEC plc, the UK's largest construction company,
has adopted this facilitative approach to risk management as well. Here
again, risk used to be the responsibility of the company's CFO, but the risk
management reporting lines now terminate at the commercial director, says
Kate Boothroyd, AMEC's head of risk management and internal audit. Now, it's
Boothroyd and the commercial director who present a profile of AMEC's risks
to the board twice a year.
Boothroyd insists that she isn't a CRO: "We discussed that kind of role here
and decided that it wasn't needed." But she is the managerial focal point
for the reporting of risk at the executive level and bears the
responsibility of reporting to the board. "I think 'risk manager' is a
misnomer," she says. "I don't manage the risksÂit's up to the businesses to
manage the risks. What we're here to do is to provide assurance that risks
are being monitored and managed."
If that sounds like a limited mandate in some ways, in others it is
incredibly ambitious: The array of risks which Boothroyd is responsible for
monitoring include "worrying about having the right staff and making sure
they're safe, risks to do with the treasury function and tax, especially
when we work in all sorts of regions around the worldÂrisks related to
mergers and acquisitions, strategy, internal and external communication,
financing risks, investor relations and ethics."
Moreover, unlike most nonfinancial companies, AMEC makes an attempt to
introduce some comparability into its risk management assessments, and ties
that in to its decision-making process. All new projects are scored in terms
of the probability and impact of the risk involved. As the level of risk
escalates, so does the decision-making responsibility, culminating in a
board-level risk review committee.
PwC's Vettoretti says that defining the scope and structure of the risk
function is "a challenge" for nonfinancial companies. "If you opt for a CRO,
how do you define the role and how does it relate to the existing
organizational structure? You need to decide how it differs from the office
of environment, health and safety, how it differs from the general counsel's
office. Different companies will have different answers."
That may be true, but the new approaches to risk are dramatically distinct
from what went on before, and they have certain things in common. At the
root of all these risk overhauls is the fundamental belief that companies
stand to benefit by aggregating the management and oversight of risk at the
corporate level. Responsibilities that used to reside elsewhere now reside
with an evolving risk function. It may be taking longer than some had
predicted, but ERM is changing the way that companies work and may transform
CFOs into CROsÂif not in name, then certainly in how they operate.
¶ 10:48 AM 0 Comments
IFRS Pocket Guide 2004
This PwC publication provides a summary of the recognition and measurement
requirements of IFRSs published up to and including March 2004 (the 'stable
platform').
Global Corporate Reporting Group
PricewaterhouseCoopers
6-October-2004
This pocket-sized PwC publication provides a summary of the recognition and
measurement requirements of IFRSs published up to and including March 2004
(the 'stable platform'). It includes sections on:
* accounting framework
* financial statements
* currencies
* assets
* liabilities
* equity
* income
* expense
* industry-specific topics
* business combinations and
* interim financial statements
This publication does not address most disclosure requirements. More
detailed information and guidance on these matters can be found in other
publications from PricewaterhouseCoopers.
Download the below .pdf file (167 kb) to read this publication in its
entirety:
http://www.cfodirect.com/CFOTrial.nsf/cab835c5a980fd1c8525690a000d0bad/a5be2
f8c654e4a8185256f260007d04c/$FILE/IFRS%20Pocket%20Guide%202004.pdf
¶ 10:44 AM 0 Comments
requirements of IFRSs published up to and including March 2004 (the 'stable
platform').
Global Corporate Reporting Group
PricewaterhouseCoopers
6-October-2004
This pocket-sized PwC publication provides a summary of the recognition and
measurement requirements of IFRSs published up to and including March 2004
(the 'stable platform'). It includes sections on:
* accounting framework
* financial statements
* currencies
* assets
* liabilities
* equity
* income
* expense
* industry-specific topics
* business combinations and
* interim financial statements
This publication does not address most disclosure requirements. More
detailed information and guidance on these matters can be found in other
publications from PricewaterhouseCoopers.
Download the below .pdf file (167 kb) to read this publication in its
entirety:
http://www.cfodirect.com/CFOTrial.nsf/cab835c5a980fd1c8525690a000d0bad/a5be2
f8c654e4a8185256f260007d04c/$FILE/IFRS%20Pocket%20Guide%202004.pdf
¶ 10:44 AM 0 Comments
Similarities and Differences - A comparison of IFRS and US GAAP
Global Corporate Reporting Group
This PwC publication provides an overview of the key similarities and
differences between IFRS and US GAAP. It is an update of the February 2004
edition and takes into account all pronouncements issued under IFRS and US
GAAP up to June 30, 2004.
PricewaterhouseCoopers
20-October-2004
This PwC publication is for those who wish to gain a broad understanding of
the key similarities and differences between IFRS and US GAAP. It is an
update of the February 2004 edition and takes into account all
pronouncements issued under IFRS and US GAAP up to June 30, 2004.
PwC has focused on the differences most commonly found in practice, although
there are many differences of detail which exist between IFRS and US GAAP.
Please ensure that you consult all the relevant standards when dealing with
a specific accounting issue.
Download the below .pdf file (252 kb) to read this report in its entirety:
http://www.cfodirect.com/CFOPrivate.nsf/887a417a292d9d4d8525690a000d04cc/169
6a0567ac91fee85256f33006080de/$FILE/Sims%20and%20Diffs%20IFRS-US%20GAAP1004.
pdf
¶ 10:44 AM 0 Comments
This PwC publication provides an overview of the key similarities and
differences between IFRS and US GAAP. It is an update of the February 2004
edition and takes into account all pronouncements issued under IFRS and US
GAAP up to June 30, 2004.
PricewaterhouseCoopers
20-October-2004
This PwC publication is for those who wish to gain a broad understanding of
the key similarities and differences between IFRS and US GAAP. It is an
update of the February 2004 edition and takes into account all
pronouncements issued under IFRS and US GAAP up to June 30, 2004.
PwC has focused on the differences most commonly found in practice, although
there are many differences of detail which exist between IFRS and US GAAP.
Please ensure that you consult all the relevant standards when dealing with
a specific accounting issue.
Download the below .pdf file (252 kb) to read this report in its entirety:
http://www.cfodirect.com/CFOPrivate.nsf/887a417a292d9d4d8525690a000d04cc/169
6a0567ac91fee85256f33006080de/$FILE/Sims%20and%20Diffs%20IFRS-US%20GAAP1004.
¶ 10:44 AM 0 Comments
Tools for Detecting the Next Enron; Index Analyzes Companies'
Openness Toward Shareholders
AVRUM D. LANK
The Milwaukee Journal Sentinel
15-November-2004
Tools for detecting the next Enron
Index analyzes companies' openness toward shareholders
Some of the brightest stars of investing emit false light.
Finding and avoiding such fakers has become of increasing concern in the
wake of the corporate scandals of the early 21st century. Missing the next
Enron Corp. has become as important as hitting the next Microsoft Corp.
Recently, a new tool has emerged to help in the quest to separate the real
from the unreal in the investment world: analysis of how open corporate
directors and managers are to shareholders.
In deciding where to invest, institutional money managers have begun to
consider such things as whether the CEO also serves as chairman of the
board, how many directors are independent of the company, and how easy it is
for investors to communicate with the board.
Institutional Shareholder Services Inc. of Rockville, Md., has begun to
calculate an index that measures 61 indicators of corporate openness. The
so-called Corporate Governance Quotient, or CGQ, is available for sale to
institutional investors, the firms that manage pension funds and mutual
funds.
Institutional Shareholder Services long has been known for the advice it
provides companies on how to vote on proxy matters. The CGQ is a new product
that was still being tested internally in 2001, said Patrick McGurn, ISS
senior vice president. That was when a wave of corporate malfeasance started
to wash over the nation, resulting in the passage of the Sarbanes-Oxley Act
of 2002.
But according to a presentation made by McGurn last week at the annual
Directors' Summit at the University of Wisconsin-Madison, if the CGQ had
been publicly available for sale in 2001, the Enrons of the world would have
stood out as potential problems.
On a scale of 100, Enron would have rated a below average 42 in June 2001,
even while it was posting apparently stellar earnings, he said. Other
companies later found to have been painting a false public picture would
have rated even lower -- Adelphia Communications Corp., 16; WorldCom Inc.,
11; Global Crossing Ltd., 6; and Tyco International Ltd., 5.5.
"Clearly the notion that there weren't warning flags out there is plain
wrong," McGurn said in an interview.
Paying attention to corporate openness is a positive indicator for
investors, said Jon C. Bruss, managing director and CEO of Fortress Partners
Capital Management Ltd., Hartland. Although his company does not buy the CGQ
or any other similar index, it does look for the same kind of indicators of
corporate responsiveness to shareholders when evaluating an investment.
For example, it often considers the anti-takeover provisions in corporate
charters and bylaws. If a company has a lot of such things, they can be seen
as working to protect the board and management instead of the shareholders
in the event an outsider wants to buy the company.
To Jay Van Cleave, a vice president at Loomis Sayles & Co. in Milwaukee, a
company that is trying to insulate the board and management is one to be
avoided.
"We won't invest in companies that develop these kinds of things," he said.
"Often they are having trouble and then they try to put up the barriers to
openness."
Frederic E. Mohs understands the questions of corporate openness from a
different direction -- the attorney and former regent of the University of
Wisconsin System serves as a director of Madison Gas & Electric Co., and as
such attended the Directors' Summit.
While Mohs agrees that measures of corporate openness should be considered
when looking for investments, he sees them only as a place to start
evaluating a company, not an end in and of themselves.
He compared trying to get a good score on the CGQ to fulfilling the
requirements to be certified under the international standards organization
used by corporations to show they meet certain levels of quality.
"Companies that are paying attention to the governance are probably paying
attention to a lot of other things, too," he said.
ISO and CGQ "may not produce much on the bottom line," he said. "But the
exercise in getting there and the focus and the attention is probably worth
the energy."
That is the correct way to use the information measured by the CGQ, McGurn
said. It is not about finding companies that will do better than the market,
but it can help to eliminate ones with a good chance of doing worse.
"People have learned that corporate governance is a four letter word, it is
r-i-s-k," he said.
"This is not about a silver bullet, this is about finding the brain
aneurysm," McGurn continued. "It is about figuring out the company that is
going to have the sudden and potentially fatal problem before it occurs."
*****
More information on the GCQ, including the elements it measures, is
available at www.issproxy.com/corporate/analytics/ uscgqcriteria.jsp
¶ 10:42 AM 0 Comments
The Milwaukee Journal Sentinel
15-November-2004
Tools for detecting the next Enron
Index analyzes companies' openness toward shareholders
Some of the brightest stars of investing emit false light.
Finding and avoiding such fakers has become of increasing concern in the
wake of the corporate scandals of the early 21st century. Missing the next
Enron Corp. has become as important as hitting the next Microsoft Corp.
Recently, a new tool has emerged to help in the quest to separate the real
from the unreal in the investment world: analysis of how open corporate
directors and managers are to shareholders.
In deciding where to invest, institutional money managers have begun to
consider such things as whether the CEO also serves as chairman of the
board, how many directors are independent of the company, and how easy it is
for investors to communicate with the board.
Institutional Shareholder Services Inc. of Rockville, Md., has begun to
calculate an index that measures 61 indicators of corporate openness. The
so-called Corporate Governance Quotient, or CGQ, is available for sale to
institutional investors, the firms that manage pension funds and mutual
funds.
Institutional Shareholder Services long has been known for the advice it
provides companies on how to vote on proxy matters. The CGQ is a new product
that was still being tested internally in 2001, said Patrick McGurn, ISS
senior vice president. That was when a wave of corporate malfeasance started
to wash over the nation, resulting in the passage of the Sarbanes-Oxley Act
of 2002.
But according to a presentation made by McGurn last week at the annual
Directors' Summit at the University of Wisconsin-Madison, if the CGQ had
been publicly available for sale in 2001, the Enrons of the world would have
stood out as potential problems.
On a scale of 100, Enron would have rated a below average 42 in June 2001,
even while it was posting apparently stellar earnings, he said. Other
companies later found to have been painting a false public picture would
have rated even lower -- Adelphia Communications Corp., 16; WorldCom Inc.,
11; Global Crossing Ltd., 6; and Tyco International Ltd., 5.5.
"Clearly the notion that there weren't warning flags out there is plain
wrong," McGurn said in an interview.
Paying attention to corporate openness is a positive indicator for
investors, said Jon C. Bruss, managing director and CEO of Fortress Partners
Capital Management Ltd., Hartland. Although his company does not buy the CGQ
or any other similar index, it does look for the same kind of indicators of
corporate responsiveness to shareholders when evaluating an investment.
For example, it often considers the anti-takeover provisions in corporate
charters and bylaws. If a company has a lot of such things, they can be seen
as working to protect the board and management instead of the shareholders
in the event an outsider wants to buy the company.
To Jay Van Cleave, a vice president at Loomis Sayles & Co. in Milwaukee, a
company that is trying to insulate the board and management is one to be
avoided.
"We won't invest in companies that develop these kinds of things," he said.
"Often they are having trouble and then they try to put up the barriers to
openness."
Frederic E. Mohs understands the questions of corporate openness from a
different direction -- the attorney and former regent of the University of
Wisconsin System serves as a director of Madison Gas & Electric Co., and as
such attended the Directors' Summit.
While Mohs agrees that measures of corporate openness should be considered
when looking for investments, he sees them only as a place to start
evaluating a company, not an end in and of themselves.
He compared trying to get a good score on the CGQ to fulfilling the
requirements to be certified under the international standards organization
used by corporations to show they meet certain levels of quality.
"Companies that are paying attention to the governance are probably paying
attention to a lot of other things, too," he said.
ISO and CGQ "may not produce much on the bottom line," he said. "But the
exercise in getting there and the focus and the attention is probably worth
the energy."
That is the correct way to use the information measured by the CGQ, McGurn
said. It is not about finding companies that will do better than the market,
but it can help to eliminate ones with a good chance of doing worse.
"People have learned that corporate governance is a four letter word, it is
r-i-s-k," he said.
"This is not about a silver bullet, this is about finding the brain
aneurysm," McGurn continued. "It is about figuring out the company that is
going to have the sudden and potentially fatal problem before it occurs."
*****
More information on the GCQ, including the elements it measures, is
available at www.issproxy.com/corporate/analytics/ uscgqcriteria.jsp
¶ 10:42 AM 0 Comments
2004 IT Directions Survey: CFOs agree on the value of Information
Technology but disagree on how to measure and manage it
Scott Leibs
CFO IT Magazine
17-November-2004
"It's one thing for a CFO to demand a solid approach to ROI, and another for
a CIO to deliver it. We have to solve this problem, but there's been little
progress."
"At some point, it all comes back to ROI Â in theory. But ROI is just one
tool for setting priorities."
"Every year there's talk of giving the business units control of IT
spending, and each time the decision is, 'Not this year!' "
The preceding thoughts came from a CFO, a CIO, and a college professor, but
can you guess who said which? The first comment comes not from a frustrated
CFO, but from Mark Cotteleer, an assistant professor at Marquette
University's business school and a senior consultant for the Cutter
Consortium, an IT research firm. Cotteleer recently served as guest editor
of an issue of the Cutter IT Journal that examined the perpetually vexing
question of ROI analysis as it pertains (if it does) to IT investments.
The second comment comes from Michael Zellner, CFO of Wind River Systems
Inc., an Alameda, California, software company. While CFOs are often
portrayed as absolutists in the quest for rock-solid ROI analysis, Zellner's
pragmatic approach is in line with many of his peers'.
The final quote is attributable to Al Etterman, senior vice president of
corporate infrastructure at Openwave Systems Inc., which makes software for
the telecom industry. Etterman is in some ways a CFO's worst nightmare
("When you do ROI, the numbers are always suspect, and can you even put
business improvements in financial terms?"), but in other ways his best
friend ("When I started my job here, there was a big capital budget waiting
for me, and I gave it all back. The CFO's jaw dropped.").
All of this serves as a lengthy preamble to our third annual IT Directions
survey. These comments capture many of the challenges and disagreements that
are threaded throughout this year's results. In polling nearly 250 senior
finance executives at U.S. companies, CFO IT uncovered a number of sharp
divisions, disappointments, and even a certain disillusionment. But there
was also a surprising consensus on the ultimate potential of IT, and on the
working relationship between finance and IT.
Battle of the Metrics
CFOs remain optimistic  improbably optimistic, some might say  about the
role that IT can play in their companies. Despite a surfeit of talk about IT
becoming a commodity or a utility, fully three-fourths of respondents said
they consider IT to be strategic, and of those, about 60 percent will spend
more on IT next year as a result.
But they despair of spending it wisely. Despite assuming greater involvement
in setting IT strategy  a trend in effect for several years  CFOs remain
unconvinced that IT investments are paying off, or that they know how to
properly assess IT projects before giving the green light. Fewer than half
believe the IT expenditures they've made in the past year have achieved the
return they had hoped for, and for every CFO who has resolved the ROI debate
by adopting a formal approach for some or all IT projects, another continues
to search for better ways to analyze the return on spending.
"At the end of the day," says Etterman, "these are judgment calls, not
empirical decisions. We focus more on business metrics than financial
metrics." As one example, he cites a recent project to improve his company's
maintenance and service renewal rates. "We got a 30 percent improvement," he
says, "and there was an IT component to it, but it also entailed changes to
our processes. So I can't say exactly how much of the benefit can be traced
to the IT portion of the effort."
Many CFOs still seem interested in trying. In September, 80 finance
executives gave up a perfect San Francisco Sunday afternoon to attend a
three-hour ROI boot camp taught by Ian Campbell, president and CEO of
Nucleus Research, an IT advisory firm that specializes in ROI analysis.
Campbell offers a more-intensive version of this training at Babson College
in Wellesley, Massachusetts, where, he says, finance and IT staffers often
show up "having been given a mandate from the CFO to put a process in place;
some structured approach."
But wasn't that what finance was supposed to bring to the table from the
start, its structured approach to investment analysis? What does it mean
when CFOs and their reports have to get training in what was supposed to be
their "value add" in IT strategy? "The calculations are easy," says
Campbell, "but what people need help with is learning how to extract the
right data; how to ask the right questions of the right people." A
structured approach, he says, guarantees consistency, even if accuracy
remains elusive.
The Governance Approach
Many companies have decided that having the right people ask the right
questions is the single best way to keep IT spending on track. Unable or
unwilling to impose a formula on IT project plans, they impose some form of
governance instead (or in addition to, with the balance of power between
numbers and human judgment varying from one company to another and even one
project to another). IT investment decisions are made by one or more teams,
with members drawn from the executive suite and/or lines of business.
As part of that, some companies have adjusted reporting relationships so
that the CIO reports to the CFO. Survey respondents were split on the wisdom
of that: 43 percent believed such an arrangement makes sense, while 56
percent said IT should not report to finance but that the two functions
should work together to sort through major IT expenditures.
When Etterman returned the IT capital budget to his CFO, he was effectively
insisting on a certain approach to IT governance. Having come from Cisco
Systems, where business units control their respective portions of the IT
budget, he wanted to instill a similar sense of responsibility on the part
of the people who were requesting the projects. While the business units at
Openwave do not, strictly speaking, own the IT budget (at least not yet),
Etterman and his staff won't move on a project that doesn't have a business
sponsor. In a sense, a substantial portion of the IT budget is a sort of
trust fund that can be tapped only when responsible parties step forth with
solid plans.
"We had a project called OneView," says Etterman, "that was a $6 million CRM
project. But key executives couldn't articulate why we should do it, so we
canceled it." Similarly, before Etterman arrived, the company had purchased
a $750,000 professional-services automation application, but it was an IT
initiative that had no business sponsor. "When the second year rolled around
and we had to pay another $100,000 in maintenance," says Etterman, "I let it
be known that if it didn't find a champion, we'd kill it. It didn't, so we
did." A sponsor came forward later, and the IT staff was able to meet his
needs with a lower-cost technology.
The Nature of the Company
Most companies have one, and often several, teams of senior executives who
assess the case for a given IT project and ultimately say yea or nay. As
Zellner of Wind River Systems says, an ROI analysis is often part of that
effort, but rarely the deciding factor. "The applicability of ROI depends,
to some degree, on the nature of your company," he says. "We think of
ourselves as being very good at customer service as opposed to some other
emphasis, like being a commodity provider that might stress operational
efficiency. So if a project looks like it will enhance our mission, we tend
to like it," even if a firm payback within a specified time frame appears
impossible to calculate.
Although nearly 40 percent of survey respondents said they continue to
debate the ROI issue and look for better approaches, very few will admit
publicly that their companies should do things differently. Marquette's
Cotteleer says that, too often, companies go through a "justification
exercise" in lieu of making a truly smart decision because they lack the
discipline needed to link IT projects to the underlying business processes
they support. "There's no commonly accepted paradigm," he says, "no GAAP for
IT spending. But it's a variant of capital spending, albeit with more
uncertainty. It can be cracked."
Curiously, while more than half of the respondents said that their IT
investments either had not produced the ROI they expected (27 percent) or
that they were unsure (30 percent), nearly 80 percent said that IT
investments had resulted in productivity gains, although a strong majority
of those said the results were hard to quantify. "So many projects entail a
human element that is very hard to measure," says George McGrath, CIO at
Norcal Waste. "You may know that a new system saves keystrokes or some other
form of labor and allows you to get more out of people, but you may not
necessarily reduce head count or otherwise be able to measure the labor
savings in an exact way."
As one example, McGrath cites a Web-based electronic billing system that his
company installed. "Everyone we spoke to said that a 7 percent adoption rate
was standard," he says. "But we found that in some areas, fewer than 1
percent of customers were willing to pay their bills online, while in other
areas it was 19 percent or higher. If we had done an ROI analysis [for this
project] and stuck to it, we never would have done the project. But
sometimes you simply decide to do it based on judgment."
Even if continuing interest in ROI seems to be outstripping progress by a
good margin, CFOs are nearly unanimous in believing that a strong working
relationship between finance and IT is essential to achieving business
alignment. And many see the demands posed by Sarbanes-Oxley as being at
least partly responsible for fostering stronger ties between the two groups,
a possible silver lining to a regulatory burden that has weighed very
heavily on CFOs (see "Hard Times," CFO, November).
And frustration over the lack of solid ROI numbers and the questionable
payback on IT investments doesn't seem to affect spending: 29 percent of
respondents said they'll increase IT budgets by 6 percent or more next year,
compared with only 16 percent who planned a similar increase last year. Only
16 percent anticipate decreased spending; from 2003 to 2004, 30 percent made
cuts.
All of which suggests that IT remains far from mature, its potential
balanced by its demands. Whether the closer working relationship between
CFOs and CIOs ever results in that "GAAP for IT" that Cotteleer spoke of
remains to be seen, but even if a hard-and-fast formula remains elusive, a
cross-disciplinary approach to management seems more essential than ever.
See the CFO.com survey results:
http://www.cfo.com/printable/chart.cfm/3373788
¶ 10:39 AM 0 Comments
CFO IT Magazine
17-November-2004
"It's one thing for a CFO to demand a solid approach to ROI, and another for
a CIO to deliver it. We have to solve this problem, but there's been little
progress."
"At some point, it all comes back to ROI Â in theory. But ROI is just one
tool for setting priorities."
"Every year there's talk of giving the business units control of IT
spending, and each time the decision is, 'Not this year!' "
The preceding thoughts came from a CFO, a CIO, and a college professor, but
can you guess who said which? The first comment comes not from a frustrated
CFO, but from Mark Cotteleer, an assistant professor at Marquette
University's business school and a senior consultant for the Cutter
Consortium, an IT research firm. Cotteleer recently served as guest editor
of an issue of the Cutter IT Journal that examined the perpetually vexing
question of ROI analysis as it pertains (if it does) to IT investments.
The second comment comes from Michael Zellner, CFO of Wind River Systems
Inc., an Alameda, California, software company. While CFOs are often
portrayed as absolutists in the quest for rock-solid ROI analysis, Zellner's
pragmatic approach is in line with many of his peers'.
The final quote is attributable to Al Etterman, senior vice president of
corporate infrastructure at Openwave Systems Inc., which makes software for
the telecom industry. Etterman is in some ways a CFO's worst nightmare
("When you do ROI, the numbers are always suspect, and can you even put
business improvements in financial terms?"), but in other ways his best
friend ("When I started my job here, there was a big capital budget waiting
for me, and I gave it all back. The CFO's jaw dropped.").
All of this serves as a lengthy preamble to our third annual IT Directions
survey. These comments capture many of the challenges and disagreements that
are threaded throughout this year's results. In polling nearly 250 senior
finance executives at U.S. companies, CFO IT uncovered a number of sharp
divisions, disappointments, and even a certain disillusionment. But there
was also a surprising consensus on the ultimate potential of IT, and on the
working relationship between finance and IT.
Battle of the Metrics
CFOs remain optimistic  improbably optimistic, some might say  about the
role that IT can play in their companies. Despite a surfeit of talk about IT
becoming a commodity or a utility, fully three-fourths of respondents said
they consider IT to be strategic, and of those, about 60 percent will spend
more on IT next year as a result.
But they despair of spending it wisely. Despite assuming greater involvement
in setting IT strategy  a trend in effect for several years  CFOs remain
unconvinced that IT investments are paying off, or that they know how to
properly assess IT projects before giving the green light. Fewer than half
believe the IT expenditures they've made in the past year have achieved the
return they had hoped for, and for every CFO who has resolved the ROI debate
by adopting a formal approach for some or all IT projects, another continues
to search for better ways to analyze the return on spending.
"At the end of the day," says Etterman, "these are judgment calls, not
empirical decisions. We focus more on business metrics than financial
metrics." As one example, he cites a recent project to improve his company's
maintenance and service renewal rates. "We got a 30 percent improvement," he
says, "and there was an IT component to it, but it also entailed changes to
our processes. So I can't say exactly how much of the benefit can be traced
to the IT portion of the effort."
Many CFOs still seem interested in trying. In September, 80 finance
executives gave up a perfect San Francisco Sunday afternoon to attend a
three-hour ROI boot camp taught by Ian Campbell, president and CEO of
Nucleus Research, an IT advisory firm that specializes in ROI analysis.
Campbell offers a more-intensive version of this training at Babson College
in Wellesley, Massachusetts, where, he says, finance and IT staffers often
show up "having been given a mandate from the CFO to put a process in place;
some structured approach."
But wasn't that what finance was supposed to bring to the table from the
start, its structured approach to investment analysis? What does it mean
when CFOs and their reports have to get training in what was supposed to be
their "value add" in IT strategy? "The calculations are easy," says
Campbell, "but what people need help with is learning how to extract the
right data; how to ask the right questions of the right people." A
structured approach, he says, guarantees consistency, even if accuracy
remains elusive.
The Governance Approach
Many companies have decided that having the right people ask the right
questions is the single best way to keep IT spending on track. Unable or
unwilling to impose a formula on IT project plans, they impose some form of
governance instead (or in addition to, with the balance of power between
numbers and human judgment varying from one company to another and even one
project to another). IT investment decisions are made by one or more teams,
with members drawn from the executive suite and/or lines of business.
As part of that, some companies have adjusted reporting relationships so
that the CIO reports to the CFO. Survey respondents were split on the wisdom
of that: 43 percent believed such an arrangement makes sense, while 56
percent said IT should not report to finance but that the two functions
should work together to sort through major IT expenditures.
When Etterman returned the IT capital budget to his CFO, he was effectively
insisting on a certain approach to IT governance. Having come from Cisco
Systems, where business units control their respective portions of the IT
budget, he wanted to instill a similar sense of responsibility on the part
of the people who were requesting the projects. While the business units at
Openwave do not, strictly speaking, own the IT budget (at least not yet),
Etterman and his staff won't move on a project that doesn't have a business
sponsor. In a sense, a substantial portion of the IT budget is a sort of
trust fund that can be tapped only when responsible parties step forth with
solid plans.
"We had a project called OneView," says Etterman, "that was a $6 million CRM
project. But key executives couldn't articulate why we should do it, so we
canceled it." Similarly, before Etterman arrived, the company had purchased
a $750,000 professional-services automation application, but it was an IT
initiative that had no business sponsor. "When the second year rolled around
and we had to pay another $100,000 in maintenance," says Etterman, "I let it
be known that if it didn't find a champion, we'd kill it. It didn't, so we
did." A sponsor came forward later, and the IT staff was able to meet his
needs with a lower-cost technology.
The Nature of the Company
Most companies have one, and often several, teams of senior executives who
assess the case for a given IT project and ultimately say yea or nay. As
Zellner of Wind River Systems says, an ROI analysis is often part of that
effort, but rarely the deciding factor. "The applicability of ROI depends,
to some degree, on the nature of your company," he says. "We think of
ourselves as being very good at customer service as opposed to some other
emphasis, like being a commodity provider that might stress operational
efficiency. So if a project looks like it will enhance our mission, we tend
to like it," even if a firm payback within a specified time frame appears
impossible to calculate.
Although nearly 40 percent of survey respondents said they continue to
debate the ROI issue and look for better approaches, very few will admit
publicly that their companies should do things differently. Marquette's
Cotteleer says that, too often, companies go through a "justification
exercise" in lieu of making a truly smart decision because they lack the
discipline needed to link IT projects to the underlying business processes
they support. "There's no commonly accepted paradigm," he says, "no GAAP for
IT spending. But it's a variant of capital spending, albeit with more
uncertainty. It can be cracked."
Curiously, while more than half of the respondents said that their IT
investments either had not produced the ROI they expected (27 percent) or
that they were unsure (30 percent), nearly 80 percent said that IT
investments had resulted in productivity gains, although a strong majority
of those said the results were hard to quantify. "So many projects entail a
human element that is very hard to measure," says George McGrath, CIO at
Norcal Waste. "You may know that a new system saves keystrokes or some other
form of labor and allows you to get more out of people, but you may not
necessarily reduce head count or otherwise be able to measure the labor
savings in an exact way."
As one example, McGrath cites a Web-based electronic billing system that his
company installed. "Everyone we spoke to said that a 7 percent adoption rate
was standard," he says. "But we found that in some areas, fewer than 1
percent of customers were willing to pay their bills online, while in other
areas it was 19 percent or higher. If we had done an ROI analysis [for this
project] and stuck to it, we never would have done the project. But
sometimes you simply decide to do it based on judgment."
Even if continuing interest in ROI seems to be outstripping progress by a
good margin, CFOs are nearly unanimous in believing that a strong working
relationship between finance and IT is essential to achieving business
alignment. And many see the demands posed by Sarbanes-Oxley as being at
least partly responsible for fostering stronger ties between the two groups,
a possible silver lining to a regulatory burden that has weighed very
heavily on CFOs (see "Hard Times," CFO, November).
And frustration over the lack of solid ROI numbers and the questionable
payback on IT investments doesn't seem to affect spending: 29 percent of
respondents said they'll increase IT budgets by 6 percent or more next year,
compared with only 16 percent who planned a similar increase last year. Only
16 percent anticipate decreased spending; from 2003 to 2004, 30 percent made
cuts.
All of which suggests that IT remains far from mature, its potential
balanced by its demands. Whether the closer working relationship between
CFOs and CIOs ever results in that "GAAP for IT" that Cotteleer spoke of
remains to be seen, but even if a hard-and-fast formula remains elusive, a
cross-disciplinary approach to management seems more essential than ever.
See the CFO.com survey results:
http://www.cfo.com/printable/chart.cfm/3373788
¶ 10:39 AM 0 Comments
Thursday, November 11, 2004
7-Step Decision-Making Model
What Do You Plan To Do With Your Life?
Decisions, decisions, decisions! Choosing a career path or course of action essentially boils down to a career decision-making process. The effectiveness of your career decision-making relies heavily on the information available to you at the decision-making point. Information is power. The more information you have the easier it is to make a decision. Oftentimes an inability to choose one career path over another is an indication that you do not have sufficient information. The trick is to figure out what information you are lacking and then gather and analyze that information.
Whether choosing a career path or deciding what to do about a job offer, the following 7-step Career Decision-Making Model will help give you structure while processing and identifying the necessary information.
Step One: Identify the Decision to be Made
Before you begin gathering information, it is important that you have a clear understanding of what it is you are trying to decide. Some decisions you might be facing could include:
1. What will I choose for a major?
2. Should I have a thematic minor?
3. What do I want to do after graduation?
* Should I go to grad school?
* Should I get a job? What kind of job do I want?
* Should I travel and see the world?
* Should I move back in with Mom and/or Dad?
* Should I be a ski bum?
* Other?
Step Two: Know Yourself (Self-Assessment)
Before you begin exploring careers and trying to identify jobs and careers which will prove satisfying, you must first develop a true understanding of you--your skills, interests, values, and personality characteristics. Questions you may want to ask yourself are:
Skills:
1. What can I do best?
2. What are my strengths and weaknesses?
3. What are my most prominent skills and abilities?
4. What skills do I want to use on the job?
5. What skills do I need to acquire?
Interests:
1. What am I interested in doing?
2. What activities have I enjoyed the most?
3. What kinds of people would I like to work with?
4. What kind of job settings would I enjoy?
Values:
1. What satisfactions do I seek in a career?
2. In what ways must I be challenged and rewarded on the job?
3. In what type of work environments would I be happy?
Personality:
1. What personal qualities do I possess that will help me on the job?
2. How will my personal style influence my career choice?
3. How will I get along with my supervisor? co-workers?
Step Three: Begin Identifying Options (Career Exploration)
To continue gathering information and researching careers, you will need to start identifying your options. Questions you might ask yourself at this point are:
1. At this point in time, What are my options?
2. Do I have a strong interest in other types of jobs or careers?
3. What other types of jobs or careers should I be considering?
Step Four: Gather Information and Data
If you have completed the first three steps you should have a list of careers and jobs which your plan to explore and research in more depth. You will now:
1. Examine the information and resources you already have
2. Identify what additional information and resources you will need
3. Seek out and utilize new information
Step Five: Evaluate Options that will Solve the Problem
If you have completed your career research, you are now ready to evaluate each of the options you have identified:
1. Identify the pros and cons of each alternative.
2. Identify the values and needs that are satisfied by each.
3. Identify the risks involved with each alternative.
4. Project the probable future consequences of selecting each.
Step Six: Select One of the Options
Based on the information you have gathered and analyzed, you should now be able to choose one of the options
1. Do you have enough information to choose one option over another? If not you might need to do more research
Step Seven: Design a Course of Action to Implement the Decision
Having chosen one of the options, you can now begin developing and implementing a plan of action. Ask yourself:
1. What information or resources are needed to complete each step?
2. What are the obstacles to implementing my decision and how can I overcome them?
3. Identify steps to implement the decision.
4. Identify when to begin and end each step.
5. Identify the information or resources needed to complete each step.
[AM-SVTBCX]
Tuesday, November 09, 2004
Format du compte de résultat et du tableau de flux en normes internationales
LA LETTRE VERNIMMEN.NET / NOV04
Dans la mesure où l'IASB n'a pas prévu de modèle développé du compte de résultat (1), le Conseil National de la Comptabilité (CNC) a eu l'excellente idée de réunir autour de lui des organisations professionnelles et des utilisateurs des comptes pour proposer un format. Les entreprises qui publieront leurs comptes en normes IAS - IFRS pourront, si elles le souhaitent, retenir le format de ces tableaux.
Gageons et espérons qu'elles seront nombreuses à le faire car le travail ffectué par le CNC est de grande qualité et contribue à améliorer nettement l'information financière pour les utilisateurs.
Les principales améliorations apportées au compte de résultat sont les suivantes :
• création du solde de résultat d'exploitation (ou opérationnel) courant.
L'IASB a supprimé les notions de résultat exceptionnel ou extraordinaire pour n'isoler dans le compte de résultat que le résultat des entités arrêtées ou en cours de cession. Cette rubrique s'imposait donc pour permettre à l'utilisateur des comptes de distinguer les composantes récurrentes et non récurrentes du résultat. L'écart entre le résultat d'exploitation courant et le résultat d'exploitation est constitué des autres produits et charges d'exploitation. Ils devront être détaillés en annexe aux comptes en montant et en nature permettant ainsi à l'utilisateur de vérifier qu'il s'agit bien d'éléments non récurrents.
• ventilation du résultat financier entre le coût de l'endettement financier et bancaire net des disponibilités et des valeurs mobilières de placement et les autres produits et charges financières (dividendes reçus, dépréciation, variations de valeurs, …)
L'analyste pourra ainsi facilement, en divisant le coût de l'endettement par l'endettement net au bilan, vérifier que l'endettement net à la clôture de l'exercice est bien représentatif de l'endettement moyen de l'année (si le taux d'intérêt ainsi calculé est proche d'un taux de marché plausible ou non dans le cas inverse). Il pourra alors en tirer des conclusions pertinentes en matière de liquidité, de risque financier et d'évaluation de l'entreprise.
• ventilation du résultat des couverture de change et de taux dans la même rubrique que l'opération sous-jacente objet de la couverture : en exploitation pour la couverture d'un chiffre d'affaires ou de charges d'exploitation, en financier pour la couverture de l'endettement financier net.
Ce n'est qu'un traitement de bon sens. Félicitons-nous qu'il soit retenu.
• Disparition de facto du poste transfert de charges (2), non que les opérations sous-jacentes disparaissaient pour autant. Elles seront simplement enregistrées par diminution / augmentation des charges concernées ou par diminution / augmentation des charges et du poste d'actifs concernés. C'est une simplification bienvenue.
Le CNC réaffirme que les entrepreneurs choisissent entre compte de résultat par nature et compte de résultat par fonction "la présentation qui paraît la mieux adaptée à leurs activités". Aussi propose-t-il deux modèles de comptes de résultat :
Modèle de compte de résultat par fonction
COMPTE DE RESULTAT / N N-1 N-2
Chiffre d’affaires
Autres produits de l’activité
Coût des ventes
Frais de Recherche & Développement
Frais commerciaux
Frais généraux
Autres produits et charges d’exploitation
Résultat opérationnel courant (optionnel)
Autres produits et charges opérationnels (note 1)
RESULTAT OPERATIONNEL
Produits de trésorerie et d’équivalents de trésorerie
Coût de l’endettement financier brut
Coût de l’endettement financier net (note 2)
Autres produits et charges financiers (note 3)
Charge d’impôt
Quote-part du résultat net des sociétés mises en équivalence
Résultat net avant résultat des activités arrêtées ou en cours de cession
Résultat net d’impôt des activités arrêtées ou en cours de cession
Résultat net
. part du groupe
. intérêts minoritaires
Modèle de compte de résultat par nature
COMPTE DE RESULTAT / N N-1 N-2
Chiffre d’affaires
Autres produits de l’activité
Achats consommés
Charges de personnel
Charges externes
Impôts et taxes
Dotation aux amortissements
Dotation aux provisions
Variation des stocks de produits en cours et de produits finis
Autres produits et charges d’exploitation
Résultat opérationnel courant (optionnel)
Autres produits et charges opérationnels (note 1)
Résultat opérationnel
Produits de trésorerie et d’équivalents de trésorerie
Coût de l’endettement financier brut
Coût de l’endettement financier net (note 2)
Autres produits et charges financiers (note 3)
Charge d’impôt
Quote-part du résultat net des sociétés mises en équivalence
Résultat net avant résultat des activités arrêtées ou en cours de cession
Résultat net d’impôt des activités arrêtées ou en cours de cession
Résultat net
. part du groupe
. intérêts minoritaires
Source : CNC
Notes annexes
Note 1
Les « Autres produits et charges opérationnels » comprennent un nombre limité de produits ou de charges tels que :
Certaines plus et moins-values de cession d’actifs non courants corporels ou incorporels
Certaines dépréciations d’actifs non courants corporels ou incorporels
Certaines charges de restructuration
Une provision relative à un litige majeur pour l’entreprise
Pour tout élément présenté dans cette rubrique : préciser nature et montant.
Note 2
Le « Coût de l’endettement financier net » comprend :
. Produits de trésorerie et d’équivalents de trésorerie
- Produits d’intérêt générés par la trésorerie et les équivalents de trésorerie
- Résultat de cession d’équivalents de trésorerie
- Résultat des couvertures de taux et de change sur trésorerie et équivalents de trésorerie
. Coût de l’endettement financier brut
- Charges d’intérêt sur opérations de financement
- Résultat des couvertures de taux et de change sur endettement financier brut
- Gains et pertes liés à l’extinction des dettes
Note 3
Les « Autres produits et charges financiers » comprennent :
. Produits financiers
- Dividendes
- Profit sur cession de titres non consolidés
- Produits d’intérêts et produits de cession des autres actifs financiers (hors trésorerie et équivalents de trésorerie)
- Profit sur dérivés de trading (change, taux)
- Produits financiers d’actualisation
- Variation positive de juste valeur des actifs et passifs financiers évalués en juste valeur
- Résultats des couvertures de taux et de change sur opérations ci-dessus
- Autres produits financiers
. Charges financières
- Dépréciation de titres non consolidés
- Perte sur cession de titres non consolidés
- Dépréciation et pertes sur cession des autres actifs financiers (hors trésorerie et équivalents de trésorerie)
- Perte sur dérivés de trading (change, taux)
- Charges financières d’actualisation
- Variation négative de juste valeur des actifs et passifs financiers évalués en juste valeur
- Résultat des couvertures de taux et de change sur opérations ci-dessus
- Autres charges financières
Le CNC a le courage de dire que "les analystes français ou anglo-saxons expriment généralement une forte préférence pour la présentation par nature", contrairement à un mythe qui voudrait que la présentation par fonction soit celle requise par les marchés, sous prétexte probablement que c'est celle qui domine aux Etats-Unis.
Concernant le tableau de flux de trésorerie, le CNC propose des améliorations par rapport à celui présenté par l'IASB (voir page suivante).
Elles se situent principalement au niveau des flux de trésorerie générés par l'activité où la capacité d'autofinancement pourra être calculée avant frais financiers nets et impôts, autrement dit on retrouverait l'excédent de trésorerie d'exploitation (3) ; où le coût de l'endettement net pourrait être exclu et reporté au niveau des flux de financement.
On regrettera que le CNC n'ait pas eu la possibilité de préconiser le bouclage du tableau de flux sur la variation de l'endettement bancaire et financier net, qu'il définit précisément par ailleurs, plutôt que sur la trésorerie telle que l'IAS le préconise.
Cela donne un tableau de flux dont le bas est finalement peu lisible (mélange des flux de capitaux propres et d'endettement) et peu significatif : la trésorerie nette résultant d'un arbitrage entre le court terme et le moyen / long terme au niveau de la gestion de l'endettement net et non d'un choix stratégique entre dettes et capitaux propres.
Toutefois, l'utilisateur pourra facilement faire la correction lui-même, puisque le CNC préconise d'établir en annexe un tableau de variation de l'endettement net.
TABLEAU DES FLUX DE TRESORERIE NETTE / N-2 N-1 N
Résultat net consolidé (y compris intérêts minoritaires)
+/- Dotations nettes aux amortissements et provisions (à l’exclusion de celles liées à l’actif circulant)
-/+ Gains et pertes latents liés aux variations de juste valeur
+/ - Charges et produits calculés liés aux stock-options et assimilés
-/+ Autres produits et charges calculés
-/+ Plus et moins-values de cession
-/+ Profits et pertes de dilution
+/- Quote-part de résultat liée aux sociétés mises en équivalence
- Dividendes (titres non consolidés)
Capacité d’autofinancement après coût de l’endettement financier net et impôt
+ Coût de l’endettement financier net
+/- Charge d’impôt (y compris impôts différés)
Capacité d’autofinancement avant coût de l’endettement financier net et impôt (A)
- Impôts versés (B)
+/- Variation du B.F.R. lié à l'activité (y compris dette liée aux avantages au personnel) (C)
= FLUX NET DE TRESORERIE GENERE PAR L'ACTIVITE (D) = (A + B + C)
- Décaissements liés aux acquisitions d'immobilisations corporelles et incorporelles
+ Encaissements liés aux cessions d'immobilisations corporelles et incorporelles
- Décaissements liés aux acquisitions d'immobilisations financières (titres non consolidés)
+ Encaissements liés aux cessions d'immobilisations financières (titres non consolidés)
+/- Incidence des variations de périmètre
+ Dividendes reçus (sociétés mises en équivalence, titres non consolidés) * cf. traitement alternatif 6.2
+/- Variation des prêts et avances consentis
+ Subventions d’investissement reçues
+/- Autres flux liés aux opérations d'investissement
= FLUX NET DE TRESORERIE LIE AUX OPERATIONS D’INVESTISSEMENT (E)
+ Sommes reçues des actionnaires lors d’augmentations de capital
. Versées par les actionnaires de la société mère
. Versées par les minoritaires des sociétés intégrées
+ Sommes reçues lors de l’exercice des stock-options
-/+ Rachats et reventes d’actions propres
- Dividendes mis en paiement au cours de l'exercice
. Dividendes versés aux actionnaires de la société mère
. Dividendes versés aux minoritaires de sociétés intégrées
+ Encaissements liés aux nouveaux emprunts
- Remboursements d'emprunts (y compris contrats de location financement)
- Intérêts financiers nets versés (y compris contrats de location financement)
+/- Autres flux liés aux opérations de financement
= FLUX NET DE TRESORERIE LIE AUX OPERATIONS DE FINANCEMENT (F)
+/- Incidence des variations des cours des devises (G)
= VARIATION DE LA TRESORERIE NETTE ( D + E + F + G )
Modèle de tableau des flux de trésorerie nette
Source : CNC
(1) Le projet commun à l'IASB et au FASB dans ce domaine a été reporté sine die. Voir la Lettre Vernimmen.net n° 24 de février 2004.
(2) Pour plus de détails, voir le chapitre 10 du Vernimmen.
(3) Pour plus de détails, voir le chapitre 2 du Vernimmen.
¶ 1:53 PM 0 Comments
Dans la mesure où l'IASB n'a pas prévu de modèle développé du compte de résultat (1), le Conseil National de la Comptabilité (CNC) a eu l'excellente idée de réunir autour de lui des organisations professionnelles et des utilisateurs des comptes pour proposer un format. Les entreprises qui publieront leurs comptes en normes IAS - IFRS pourront, si elles le souhaitent, retenir le format de ces tableaux.
Gageons et espérons qu'elles seront nombreuses à le faire car le travail ffectué par le CNC est de grande qualité et contribue à améliorer nettement l'information financière pour les utilisateurs.
Les principales améliorations apportées au compte de résultat sont les suivantes :
• création du solde de résultat d'exploitation (ou opérationnel) courant.
L'IASB a supprimé les notions de résultat exceptionnel ou extraordinaire pour n'isoler dans le compte de résultat que le résultat des entités arrêtées ou en cours de cession. Cette rubrique s'imposait donc pour permettre à l'utilisateur des comptes de distinguer les composantes récurrentes et non récurrentes du résultat. L'écart entre le résultat d'exploitation courant et le résultat d'exploitation est constitué des autres produits et charges d'exploitation. Ils devront être détaillés en annexe aux comptes en montant et en nature permettant ainsi à l'utilisateur de vérifier qu'il s'agit bien d'éléments non récurrents.
• ventilation du résultat financier entre le coût de l'endettement financier et bancaire net des disponibilités et des valeurs mobilières de placement et les autres produits et charges financières (dividendes reçus, dépréciation, variations de valeurs, …)
L'analyste pourra ainsi facilement, en divisant le coût de l'endettement par l'endettement net au bilan, vérifier que l'endettement net à la clôture de l'exercice est bien représentatif de l'endettement moyen de l'année (si le taux d'intérêt ainsi calculé est proche d'un taux de marché plausible ou non dans le cas inverse). Il pourra alors en tirer des conclusions pertinentes en matière de liquidité, de risque financier et d'évaluation de l'entreprise.
• ventilation du résultat des couverture de change et de taux dans la même rubrique que l'opération sous-jacente objet de la couverture : en exploitation pour la couverture d'un chiffre d'affaires ou de charges d'exploitation, en financier pour la couverture de l'endettement financier net.
Ce n'est qu'un traitement de bon sens. Félicitons-nous qu'il soit retenu.
• Disparition de facto du poste transfert de charges (2), non que les opérations sous-jacentes disparaissaient pour autant. Elles seront simplement enregistrées par diminution / augmentation des charges concernées ou par diminution / augmentation des charges et du poste d'actifs concernés. C'est une simplification bienvenue.
Le CNC réaffirme que les entrepreneurs choisissent entre compte de résultat par nature et compte de résultat par fonction "la présentation qui paraît la mieux adaptée à leurs activités". Aussi propose-t-il deux modèles de comptes de résultat :
Modèle de compte de résultat par fonction
COMPTE DE RESULTAT / N N-1 N-2
Chiffre d’affaires
Autres produits de l’activité
Coût des ventes
Frais de Recherche & Développement
Frais commerciaux
Frais généraux
Autres produits et charges d’exploitation
Résultat opérationnel courant (optionnel)
Autres produits et charges opérationnels (note 1)
RESULTAT OPERATIONNEL
Produits de trésorerie et d’équivalents de trésorerie
Coût de l’endettement financier brut
Coût de l’endettement financier net (note 2)
Autres produits et charges financiers (note 3)
Charge d’impôt
Quote-part du résultat net des sociétés mises en équivalence
Résultat net avant résultat des activités arrêtées ou en cours de cession
Résultat net d’impôt des activités arrêtées ou en cours de cession
Résultat net
. part du groupe
. intérêts minoritaires
Modèle de compte de résultat par nature
COMPTE DE RESULTAT / N N-1 N-2
Chiffre d’affaires
Autres produits de l’activité
Achats consommés
Charges de personnel
Charges externes
Impôts et taxes
Dotation aux amortissements
Dotation aux provisions
Variation des stocks de produits en cours et de produits finis
Autres produits et charges d’exploitation
Résultat opérationnel courant (optionnel)
Autres produits et charges opérationnels (note 1)
Résultat opérationnel
Produits de trésorerie et d’équivalents de trésorerie
Coût de l’endettement financier brut
Coût de l’endettement financier net (note 2)
Autres produits et charges financiers (note 3)
Charge d’impôt
Quote-part du résultat net des sociétés mises en équivalence
Résultat net avant résultat des activités arrêtées ou en cours de cession
Résultat net d’impôt des activités arrêtées ou en cours de cession
Résultat net
. part du groupe
. intérêts minoritaires
Source : CNC
Notes annexes
Note 1
Les « Autres produits et charges opérationnels » comprennent un nombre limité de produits ou de charges tels que :
Certaines plus et moins-values de cession d’actifs non courants corporels ou incorporels
Certaines dépréciations d’actifs non courants corporels ou incorporels
Certaines charges de restructuration
Une provision relative à un litige majeur pour l’entreprise
Pour tout élément présenté dans cette rubrique : préciser nature et montant.
Note 2
Le « Coût de l’endettement financier net » comprend :
. Produits de trésorerie et d’équivalents de trésorerie
- Produits d’intérêt générés par la trésorerie et les équivalents de trésorerie
- Résultat de cession d’équivalents de trésorerie
- Résultat des couvertures de taux et de change sur trésorerie et équivalents de trésorerie
. Coût de l’endettement financier brut
- Charges d’intérêt sur opérations de financement
- Résultat des couvertures de taux et de change sur endettement financier brut
- Gains et pertes liés à l’extinction des dettes
Note 3
Les « Autres produits et charges financiers » comprennent :
. Produits financiers
- Dividendes
- Profit sur cession de titres non consolidés
- Produits d’intérêts et produits de cession des autres actifs financiers (hors trésorerie et équivalents de trésorerie)
- Profit sur dérivés de trading (change, taux)
- Produits financiers d’actualisation
- Variation positive de juste valeur des actifs et passifs financiers évalués en juste valeur
- Résultats des couvertures de taux et de change sur opérations ci-dessus
- Autres produits financiers
. Charges financières
- Dépréciation de titres non consolidés
- Perte sur cession de titres non consolidés
- Dépréciation et pertes sur cession des autres actifs financiers (hors trésorerie et équivalents de trésorerie)
- Perte sur dérivés de trading (change, taux)
- Charges financières d’actualisation
- Variation négative de juste valeur des actifs et passifs financiers évalués en juste valeur
- Résultat des couvertures de taux et de change sur opérations ci-dessus
- Autres charges financières
Le CNC a le courage de dire que "les analystes français ou anglo-saxons expriment généralement une forte préférence pour la présentation par nature", contrairement à un mythe qui voudrait que la présentation par fonction soit celle requise par les marchés, sous prétexte probablement que c'est celle qui domine aux Etats-Unis.
Concernant le tableau de flux de trésorerie, le CNC propose des améliorations par rapport à celui présenté par l'IASB (voir page suivante).
Elles se situent principalement au niveau des flux de trésorerie générés par l'activité où la capacité d'autofinancement pourra être calculée avant frais financiers nets et impôts, autrement dit on retrouverait l'excédent de trésorerie d'exploitation (3) ; où le coût de l'endettement net pourrait être exclu et reporté au niveau des flux de financement.
On regrettera que le CNC n'ait pas eu la possibilité de préconiser le bouclage du tableau de flux sur la variation de l'endettement bancaire et financier net, qu'il définit précisément par ailleurs, plutôt que sur la trésorerie telle que l'IAS le préconise.
Cela donne un tableau de flux dont le bas est finalement peu lisible (mélange des flux de capitaux propres et d'endettement) et peu significatif : la trésorerie nette résultant d'un arbitrage entre le court terme et le moyen / long terme au niveau de la gestion de l'endettement net et non d'un choix stratégique entre dettes et capitaux propres.
Toutefois, l'utilisateur pourra facilement faire la correction lui-même, puisque le CNC préconise d'établir en annexe un tableau de variation de l'endettement net.
TABLEAU DES FLUX DE TRESORERIE NETTE / N-2 N-1 N
Résultat net consolidé (y compris intérêts minoritaires)
+/- Dotations nettes aux amortissements et provisions (à l’exclusion de celles liées à l’actif circulant)
-/+ Gains et pertes latents liés aux variations de juste valeur
+/ - Charges et produits calculés liés aux stock-options et assimilés
-/+ Autres produits et charges calculés
-/+ Plus et moins-values de cession
-/+ Profits et pertes de dilution
+/- Quote-part de résultat liée aux sociétés mises en équivalence
- Dividendes (titres non consolidés)
Capacité d’autofinancement après coût de l’endettement financier net et impôt
+ Coût de l’endettement financier net
+/- Charge d’impôt (y compris impôts différés)
Capacité d’autofinancement avant coût de l’endettement financier net et impôt (A)
- Impôts versés (B)
+/- Variation du B.F.R. lié à l'activité (y compris dette liée aux avantages au personnel) (C)
= FLUX NET DE TRESORERIE GENERE PAR L'ACTIVITE (D) = (A + B + C)
- Décaissements liés aux acquisitions d'immobilisations corporelles et incorporelles
+ Encaissements liés aux cessions d'immobilisations corporelles et incorporelles
- Décaissements liés aux acquisitions d'immobilisations financières (titres non consolidés)
+ Encaissements liés aux cessions d'immobilisations financières (titres non consolidés)
+/- Incidence des variations de périmètre
+ Dividendes reçus (sociétés mises en équivalence, titres non consolidés) * cf. traitement alternatif 6.2
+/- Variation des prêts et avances consentis
+ Subventions d’investissement reçues
+/- Autres flux liés aux opérations d'investissement
= FLUX NET DE TRESORERIE LIE AUX OPERATIONS D’INVESTISSEMENT (E)
+ Sommes reçues des actionnaires lors d’augmentations de capital
. Versées par les actionnaires de la société mère
. Versées par les minoritaires des sociétés intégrées
+ Sommes reçues lors de l’exercice des stock-options
-/+ Rachats et reventes d’actions propres
- Dividendes mis en paiement au cours de l'exercice
. Dividendes versés aux actionnaires de la société mère
. Dividendes versés aux minoritaires de sociétés intégrées
+ Encaissements liés aux nouveaux emprunts
- Remboursements d'emprunts (y compris contrats de location financement)
- Intérêts financiers nets versés (y compris contrats de location financement)
+/- Autres flux liés aux opérations de financement
= FLUX NET DE TRESORERIE LIE AUX OPERATIONS DE FINANCEMENT (F)
+/- Incidence des variations des cours des devises (G)
= VARIATION DE LA TRESORERIE NETTE ( D + E + F + G )
Modèle de tableau des flux de trésorerie nette
Source : CNC
(1) Le projet commun à l'IASB et au FASB dans ce domaine a été reporté sine die. Voir la Lettre Vernimmen.net n° 24 de février 2004.
(2) Pour plus de détails, voir le chapitre 10 du Vernimmen.
(3) Pour plus de détails, voir le chapitre 2 du Vernimmen.
¶ 1:53 PM 0 Comments
Monday, November 08, 2004
Valuation ratio
The Valuation Ratios Report helps you decide whether a stock is inexpensive or costly relative to alternative investment opportunities. Each company's ratios are presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Valuation Ratios Company Industry Sector S&P 500
P/E Ratio (TTM) 39.55* 34.27 34.88 37.65
P/E High - Last 5 Yrs. 34.48 35.19 41.95 42.70
P/E Low - Last 5 Yrs. 17.54 16.64 16.17 14.50
Beta 0.97 0.95 0.89 1.00
Price to Sales (TTM) 4.93* 3.48 4.29 5.76
Price to Book (MRQ) 6.60 5.50 6.88 8.67
Price to Tangible Book (MRQ) 6.60 5.73 9.64 12.34
Price to Cash Flow (TTM) 24.61 21.93 23.35 28.13
Price to Free Cash Flow (TTM) 133.00 31.16 54.59 49.89
% Owned Institutions 69.77 56.48 52.58 63.94
The Price-to-Earnings (P/E) ratio is the single most widely used measure of a stock's value. That's because the key to stock ownership is the shareholder's stake in a portion of the company's profit stream. The P/E ratio is calculated by dividing the current Price by the sum of the Diluted Earnings Per Share from continuing operations before Extraordinary Items and Accounting Changes over the last four quarters. The P/E ratio is given for the Trailing Twelve Months (TTM). The P/E High and Low for the last 5 years is included for context.
Beta measures stock price volatility relative to the overall stock market. We use the S&P 500 as a proxy for the market and we automatically define its Beta as being 1.00. A higher beta indicates that a stock is relatively volatile while a lower beta indicates more stability. A stock with a Beta of 0.90 would, on average, be expected to rise or fall only 90% as much as the market. So if the market dropped 1.0%, such a stock might rise or fall 0.9% On the other hand, a stock with a Beta of 1.10 would, on average, rise or fall 10% more than the market. So a 1.0% market move, up or down, should spur a 1.1% move for the stock.
Price to Sales is generally used to evaluate companies that don't have earnings and don't pay dividends. For these companies, you may consider that high multiples of sales and high growth rates suggest optimistic future earnings expectations on the part of investors. Also, Sales trends tend to be less volatile than Earnings trends, because earnings can vary widely from one year to the next due to temporary issues such as reserves or gains and losses on asset divestitures. So the Price-to-Sales ratio can be useful in situations where the P/E ratio is distorted by unusual swings in earnings over the Trailing Twelve Months (TTM).
Price to Book is a theoretical comparison of the value of the company's stock to the value of the assets it owns free and clear of debt. Classical financial theory suggests that book value is a proxy for the proceeds that would be realized if the company was to be liquidated by selling all of its assets and paying all of its debt. For some companies, that may, indeed, be valid. But nowadays, you need to take it with a grain of salt. Assets are valued on the books at the actual prices the company paid to acquire them, minus cumulative depreciation/amortization charges. The idea behind these costs is to gradually reduce the value of the assets to zero over a period of use in which they presumably approach obsolescence. But note: the write-offs are based on specific accounting formulas that may or may not resemble real world progress toward obsolescence. Also, it's not clear that book value is effective in measuring the value of service-oriented companies that are less dependent on traditional brick-and-mortar factories and machinery. The Price to Book ratio is given for the Most Recent Quarter (MRQ).
Price to Tangible Book is similar to Price to Book, except that we have subtracted the value of intangibles such as goodwill from book value. It is tempting to assume that intangible assets are less valuable than tangible assets. We suggest that you avoid jumping to such a conclusion. Consider a fast food chain such as McDonald's (MCD). Its tangible book value would include the collective amounts it spent to construct and equip company-owned properties. But what about the value of the agreements it holds with its huge and powerful network of franchisees, the true engine of MCD's growth? What about the value of the brand name? These are not the sorts of assets that are included in a calculation of tangible book value. But if you were going to attempt to purchase the entire company, you would understand that you would have to pay a price that truly reflects the considerable value of these intangibles. Indeed, some of the most valuable intangibles a company owns may not show up, in any sense, on its books. The sort of intangible assets we described for MCD may never be associated with any number, absent some accounting event, such as the acquisition of the company. The difference between the price paid for MCD and the book value of MCD's assets would appear on the buyer's books as their intangible asset. Given these issues, we suggest that Price to Book and Price to Tangible Book are best used in comparison to the Industry.
The Price to Cash Flow ratio is the current Price divided by Cash Flow Per Share for the Trailing Twelve Months (TTM). When measuring a company's operating performance, Cash Flow is an alternative to Net Income, which is calculated by subtracting all expenses from revenues.
Net Income sounds simple, but in truth, measuring expenses can raise interesting questions. Suppose a manufacturing firm spends $100 million to build a factory that will help it create salable products for a period of ten years. Looking strictly at cash outlays, we would recognize factory construction expenses of $100 million in Year 1, and zero in each of years 2-10. This would suggest one unusually poor year for profits, followed by nine very good ones. Accountants recognize that this isn't realistic. The preferred practice is to match revenues as closely as possible to the expenses incurred to generate the Revenues. In our example, we assume that the $100 million factory generates 10 years worth of Revenues. So we recognize one-tenth of the $100 million outlay in each of those 10 years. This one-tenth charge is known as depreciation. (Amortization is a similar annual charge for a different sort of one-time expenditure that is matched against more than one year's worth of sales.)
How should an investor assess all of this? The revenue/expense matching practice of the accountants is a reasonable way to measure a company's economic success or failure. So you should pay heed to the traditional Net Income (or Earnings) and Earnings Per share figures as reported by the companies. But this number does not tell you how much cash the company generates year in and year out. If you want to know how much the company can afford to pay in dividends or use for other investments, you would look to a figure known as Cash Flow, which is calculated by adding non-cash depreciation and amortization charges back to Net Income.
But Cash Flow alone doesn't necessarily give you the full story. Even if you'd rather study cash flows than economic performance, you still need to account for the $100 million our hypothetical company spent to build the factory. Free Cash Flow looks at the cash the company's operations actually generated in a given year, and subtracts important non-operating cash outlays; capital spending and dividend payments. Accordingly, Free Cash Flow is the purest measure of a company's capacity to generate cash.
When analyzing stocks, you need to examine Cash Flow and Free Cash Flow. Cash Flow is a less pure number, but it is less susceptible to wide year-to-year swings as capital programs periodically build up and wind down. Examining the Price to Cash Flow and Price to Free Cash Flow ratios presented here, we confirm our impression that MCD is more richly valued than the Restaurant group, but that the industry as a whole may be undervalued.
% Owned Institutions, the final line on the table, is an especially important one to check. This item, which shows the percent of shares owned by institutions, helps you gauge the level of demand for the stock on the part of this influential investor group. Institutions are an important segment of the investment community because of their expertise and size. You can also go to the Institutional Ownership table on the Reuters Performance Report to see whether these investors have been buying or selling the stock.
Dividend Ratios
The Dividends table shows you key information about the company's cash payments to shareholders. The Dividend Yield is calculated by dividing the annual dividend per share by the price of the stock. Obviously, this information is of considerable importance to those who are looking for income. But even if income is not a significant goal for you, it is still possible to gain some interesting insights from the Dividend table.
Dividends Company Industry Sector S&P 500
Dividend Yield 0.46 0.53 1.57 1.52
Dividend Yield - 5 Year Avg. 0.60 0.51 1.37 1.89
Dividend 5 Year Growth Rate 10.41 9.59 7.29 10.19
Payout Ratio (TTM) 87.43 54.77 26.99 32.32
Each company's dividend information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Dividend Yield vs. Dividend 5 Year Growth Rate: If income is an important part of your investment goal, you will need to focus on the tradeoff between high current yield and high rates of dividend growth. Ideally, you would like to maximize both, but realistically, you will find that the stocks with the highest yield tend to have less attractive prospects for dividend growth. Even so, you will still want to come as close as you can to the best-case ideal.
If you want to maximize yield, you are probably focusing on Utility (Electric, Natural Gas, or Water) or Real Estate stocks. Recognize that dividend growth in these sectors is typically less buoyant than is the case elsewhere. But in choosing among Utility/Real Estate stocks of comparable yield and risk, you would still want to select those that offer the best growth prospects relative to these categories. Analyze this issue by comparing Company yield to the Average Yield for the Industry and Sector. Do likewise for 5-year Average Yield and 5-Year Growth Rate.
Income investors outside the Utility and Real Estate areas are typically willing to sacrifice some current yield in exchange for the greater potential dividend growth. Assuming yields on these stocks will typically be lower than what you would expect within the utility sector, it would still be reasonable for you to seek stocks whose yields are higher than their respective Industry and Sector averages. An income seeker should not accept a yield lower than that of the S&P 500 unless the stock's dividend growth rate is dramatically higher.
Whether you stress dividend yield or dividend growth, you should be sensitive to the level of the company's Payout Ratio, the percent of Net Income that is paid to shareholders as Dividends. All else being equal, lower Payout Ratios are better. That's because such companies have greater income cushions that would allow them to avoid cutting dividends in bad times. Different businesses have different cash needs and different levels of normal earnings volatility. Hence it's best to evaluate Payout Ratios by comparing a company to the average for its Industry.
Net Income is prone to temporary developments such as gains or losses from the sale of assets or write-offs of various kinds that could cause the Payout Ratio to fluctuate widely from one year to the next. If a company Payout Ratio differs from the industry average in a dramatic way, that might be serve as a hint that the current level of earnings is unusually high or low. Confirm this by comparing the stock's Yield to the industry average. A noteworthy difference in Payout Ratio, accompanied by a modest difference in Yield, suggests that the Payout Ratio is being computed based on an atypical level of net income. There are two reasons why you can use this assumption.
Companies in the same industry share a generally common set of cash flow and capitol needs characteristics, so it's reasonable to assume that Payout Ratios will be generally similar.
As we'll discuss below, Yield provides an important window into Wall Street sentiment. Hence a generally normal Yield relative to the industry usually suggests that Wall Street sentiment toward the stock more or less matches sentiment toward the industry.
Let's look at how Yield can function as a barometer of investor sentiment about a stock. Suppose the shares of ABC Company normally yield about 1.0% and the average yield for the other stocks in the same industry typically runs near 1.1%. One day, you look at ABC and find that it yields 2.5%, while the average yield for the industry is 1.2%.
True or False? ABC is a very attractive investment right now because it presents an unusual opportunity to earn a greater level of income than you could normally expect from this stock.
It's very tempting to say "true." And indeed, it might really be true for a particular stock. But until you've carefully investigated the facts, you should start by assuming that ABC's soaring yield is a negative signal. In the real world, all things are possible, so perhaps ABC is a true needle in a haystack. But more likely than not, the yield has jumped - relative to the industry - because of a drop in the stock price without a comparable drop in the dividend. Investors probably know about the high yield; this sort of information is extremely easy to uncover in a wide variety of sources. But they choose to ignore it because they perceive company developments that could cause the Directors to cut the payout.
All investors, even those who seek capital growth, can benefit from using Yield relative to the industry as a barometer of investor sentiment.
Growth Rate Ratios
You can get a utility stock with a dividend yield in the 4-6% range. You can buy a risk-free U.S. Treasury bond yielding in the neighborhood of 4-5%. Or you can buy non-utility stocks, many of which sport yields in the range of zero-1.5%. Why would anyone ever choose the latter?
Earnings Per Share (EPS) growth is, of course, the prime focus of any investor's stock analysis efforts. Most of the other things you look at are designed, in one way or another, to help you assess the company's ability to generate future earnings growth.
Growth Rates(%) Company Industry Sector S&P 500
Sales (MRQ) vs Qtr. 1 Yr. Ago 9.08* 7.92 19.47 12.28
Sales (TTM) vs TTM 1 Yr. Ago 8.88* 8.30 26.89 14.72
Sales - 5 Yr. Growth Rate 9.85 13.15 22.43 16.65
EPS (MRQ) vs Qtr. 1 Yr. Ago -13.79* 5.39 25.44 8.51
EPS (TTM) vs TTM 1 Yr. Ago -3.92* 3.84 23.49 11.18
EPS - 5 Yr. Growth Rate 12.66 14.13 21.84 20.63
Capital Spending - 5 Yr. Growth Rate 14.20 15.81 28.30 15.81
The answer is Growth. Growth is, perhaps, the single most important consideration for the typical equity investor. Indeed, it's the reason why shares of healthy firms usually sell at prices that are far above their here-and-now liquidation values. Investors don't generally buy companies with the idea of realizing cash from liquidation; they buy companies based on their appeal as businesses capable of growing in the years ahead. Accordingly, the Reuters Growth Rates Comparison table is a very important one for you to consider.
Each company's Growth information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Also consider Sales growth. Over short periods of time, it is possible for stocks to perform very well despite sales that are growing slowly, or even falling. Typically, this occurs when earnings growth comes from cost-cutting programs, or when a company divests a poorly performing subsidiary. But such scenarios can last only so long. Sooner or later, costs become as lean as they can be, or a company will have sold or shuttered all of its weak operations. At that point, a sustained increase in sales will be needed if one is to expect a sustained increase in earnings and cash flow.
For Sales and EPS, we present year-to-year growth rates for three different periods. By year-to-year, we mean that we are comparing a particular period of time to a comparable period a year earlier. In other words, if we were examining the second quarter of 1999, we would be comparing it to the second quarter of 1998. Alternatively, a comparison between the second quarter of 1999 and the first quarter of 1999 would be referred to as a "consecutive-quarter" comparison. Whenever you encounter any information about a company's growth, assume you are seeing a year-to-year comparison unless you are specifically told otherwise.
The year-to-year convention is followed in the financial community in order to prevent the distortion of growth data by seasonal issues. For example, retailers typically show very dynamic growth from the third quarter to the fourth quarter, but that's usually because business is ramping up from the slow summer-autumn season to the holiday period, when many retailers usually generate most of the year's sales. The only way to measure whether or not a retailer is really growing at that key period is to compare the most recent holiday period to the year-ago holiday season.
The year-to-year comparison for the most recent quarter (MRQ) represents the most up-to-date growth information available to the financial community and is always an important determinant of near-term stock price performance. Start your inquiry with an assumption that strong MRQ growth rates will be accompanied by strong stock price performance and vice versa. That won't always happen. But when you spot an exception, make sure you examine the News reports to find out why this is happening. Often, you'll find important information in the latest Earnings Flash announcement.
The Trailing-Twelve-Month (TTM) period adds context to the MRQ data because it helps you determine the extent to which the MRQ data represents a sustainable trend.
The 5 Year Growth Rates cover a period of time that is long enough to further mitigate periodic quarterly aberrations in growth.
The last line of this table shows Capital Spending 5 Year Growth Rate. There's a great deal of variation from one business to another in terms of capital intensity and the rate at which physical assets need to be modernized. Comparisons against the sector and the S&P 500 should be used mainly to provide a sense of the sort of spending needs that are faced by the industry you are examining.
When examining company-to-industry Capital Spending comparisons, remember that it is normal for a business to spend at least some money for capital projects year in and year out. But at times, capital spending can mushroom to especially high levels as a major project ramps up, and then slide to a lesser pace as the newly-completed project allows the company to trim down to basic maintenance levels.
If you see that a company's capital spending growth was significantly higher than that of its industry, that could suggest that the company's needs should moderate, relative to its peers, in the next few years. That would give the company more flexibility regarding use of its cash flow (dividends, share buybacks, acquisitions, etc.). If you see that growth in spending trailed the industry average, that might suggest pent-up capital needs (and increased spending) in the years ahead.
Finally, you should compare the Capital Spending 5 Year Growth Rate with the Sales 5 Year Growth Rate. This can be important since there's usually a relationship between the value of a company's assets and the amount of sales that those assets can generate. A rate of Sales growth that exceeds the rate of Capital Spending growth might indicate that a company is finding new ways to generate more Revenues from existing plant. But it could also mean that capacity is getting tight and that capital spending increases are around the corner.
Financial Condition Ratios
Financial strength is an important indicator of the amount of business risk the company is taking. When business conditions turn bad, financially stronger companies have more staying power. Not only are they less likely to face insolvency, they are also less likely to find a need to make the sort of drastic cutbacks that might restrain their ability to grow even after better times resume. Use the Reuters Financial Strength Ratio Comparison to help you assess the financial condition of any company in which you are interested.
Financial Strength Company Industry Sector S&P 500
Quick Ratio (MRQ) 0.39 0.45 0.94 0.97
Current Ratio (MRQ) 0.58 0.71 1.48 1.47
LT Debt to Equity (MRQ) 0.71 0.63 0.89 0.67
Total Debt to Equity (MRQ) 0.79 0.69 1.03 0.97
Interest Coverage (TTM) 6.94 7.17 5.59 9.06
Each company's Financial Strength information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
The Quick Ratio and Current Ratio at the top of the table are the most stringent tests of financial strength. They measure the level of liquidity that is or could become available to the company in short period of time. These ratios are base on the Most Recent Quarter (MRQ).
The Quick Ratio compares a company's cash and short-term investments (that is, investments that could be converted to cash very quickly) to the financial liabilities the company is expected to incur within a year's time. A ratio of .80 would mean that cash and cash equivalents now available would cover eighty percent of expected year-ahead liabilities. The shortfall below 100% might seem alarming at first glance. But remember, the Quick Ratio is a very stringent test that compares a year's worth of obligations with cash that, for all practical purposes, is already in the bank.
The Current Ratio compares year-ahead liabilities to cash on hand now plus other inflows the company is likely to realize over that same twelve-month period. These additional expected inflows include such items as Accounts Receivable (payments the company expects to receive within a year from customers who already purchased goods or services) and Inventories (goods the company expects to sell within a year). The Current Ratio is often above 1.00 (100%).
The LT Debt to Equity Ratio looks at the company's capital base. If the ratio is at 1.00, that means the company's long-term (LT) debt and equity are equal. Put another way, fifty percent of the company's capital consists of equity (contributed by shareholder-owners) and the other fifty percent was contributed by long-term creditors.
The Total Debt to Equity ratio takes into account both long-term and short-term debt. Traditionally, one would analyze a company's leverage on the basis of its long-term debt, which includes debt that is due more than one year hence. Long-Term Debt is assumed to be a permanent part of the company's capital structure. Short-term debt is traditionally regarded as not being part of the capital structure. With trade debt, for example, a manufacturer might borrow money to finance the purchase of raw material, which is converted into finished products and sold to customers. Once the company receives the proceeds of these sales, it immediately repays the money it borrowed in order to finance its raw material purchases. Such debt is not usually regarded as part of the company's capital base.
But nowadays, borrowing arrangements have become much more flexible. Many companies use short-term debt as if it was part of the capital structure. This occurs when companies continually refinance the debt as soon as it comes due. This might be done if a company expects interest rates to fall. Continually refinancing short-term debts at lower and lower interest rates is preferable to locking the company into a long-term obligation at an interest rate that will be well above rates that are likely to prevail in the marketplace next year.
This strategy can be risky. If the company's interest rate forecast proves wrong, its cost structure will suffer. It may wind up refinancing its short-term debt at a rate that is well above the rate it might have paid had it borrowed long-term in the first place. Either way, we suggest looking at total debt/equity as an additional measure of financial leverage as well. When doing so, consider two issues:
The more debt in a company's capital structure, the greater the financial leverage risk. If business turns weak, there are some costs a company can easily reduce to protect its profits and preserve liquidity. But interest on debt is generally not among these variable costs. Interest must be paid even when revenues are falling. Hefty levels of debt and heavy interest expense burdens could led to insolvency if revenues or operating profits remain weak for a prolonged period.
The larger the Total Debt to Equity Ratio is relative to the LT Debt to Equity Ratio, the more risk the company faces from the prospect of rising interest rates. But remember, some short-term debt is based on a corporate forecast of lower interest rates, while other types of short-term debt represents trade borrowing, such as the above raw materials financing example. You can't always tell for certain what sort of short-term debt your company has. But you can make some reasonable assumptions by using the Reuters Report to compare your company's debt ratios with those of its industry peers. A company that uses short-term debt much more aggressively than others in its industry is probably doing so because it expects lower interest rates.
It is generally assumed that higher debt ratios signify greater levels of risk. But don't jump too quickly to conclusions. Companies in industries characterized by stable cash flows can safely carry more debt than can companies whose cash flows follow volatile trends. Before you reach your final conclusion, you will need to compare the company's ratios with those of its industry peers. Look, too, at the final part of the Financial Strength Ratio Comparisons Report, which shows Interest Coverage. Companies with high levels of interest coverage are better able to carry more debt.
Since debt increases risk, why should any company ever carry any debt? Wouldn't it be reasonable to simply restrict consideration to debt-free companies?
There are two reasons why you should not narrow your horizons this way. First, as discussed above, some forms of debt, such as trade debt, are necessary to the day-to-day operation of a business. This is especially so in the financial sector, where much depends on the process of borrowing money and re-lending it at higher rates. Second, permanent debt, prudently used, can enhance corporate returns. You can measure this effect by examining the Management Effectiveness table.
Profit Margin Ratios
Profitability Ratios tell you how much of each Revenue dollar is left over, after subtracting costs, as profit to the company. We present several different ways of looking at profit, each of which shows you something important about the company's performance. All of the Profitability Ratios are calculated for the Trailing Twelve Month (TTM) time period and over a 5 Year Average.
Each company's Profit Margin information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Profitability Ratios (%) Company Industry Sector S&P 500
Gross Margin (TTM) 36.16 36.81 43.07 48.94
Gross Margin - 5 Yr. Avg. 37.80 36.85 42.17 48.68
EBITD Margin (TTM) 30.49 23.11 19.81 22.48
EBITD - 5 Yr. Avg. 33.18 24.45 20.73 22.07
Operating Margin (TTM) 23.20 16.76 9.26 17.69
Operating Margin - 5 Yr. Avg. 25.91 18.06 10.94 17.85
Pre-Tax Margin (TTM) 19.59 14.14 10.32 14.77
Pre-Tax Margin - 5 Yr. Avg. 21.92 15.20 9.71 16.01
Net Profit Margin (TTM) 12.48* 8.95 5.86 10.72
Net Profit Margin - 5 Yr. Avg. 14.60 11.25 5.54 10.29
Effective Tax Rate (TTM) 32.27 33.45 37.30 34.19
Effective Tax Rate - 5 Yr. Avg. 33.32 33.80 36.83 35.70
The Gross Margin tells you how much of each Revenue dollar is left over after subtracting costs directly incurred to generate those sales. In company financial statements, such costs are referred to as "Cost of Goods Sold," or "Cost of Revenues." For a manufacturer, the cost of raw materials and the wages/benefits of employees who make the products would be examples of direct costs.
The Operating Margin shows us how much of each sales dollar is left over after subtracting direct costs of generating the sales and indirect costs, such as corporate overhead. Neither the Gross Margin nor the Operating Margin is more important than the other. They are equally vital, and each tells us something different about the company.
EBITD (Earnings Before Interest, Taxes and Depreciation) Margin is similar to Operating Margin except that it adds back non-cash depreciation costs that are subtracted from revenues to compute net income. To understand the nature of these depreciation charges, assume a manufacturing firm spends $100 million to build a factory that it can use to produce products for ten years. If, in computing profit, we deduct all expenditures in a strict dollar-for-dollar manner, we would subtract factory construction expenses of $100 million in Year 1, and zero for each of years 2-10. This would suggest one very bad year for profits, followed by nine exceptionally good ones. Recognizing that this is not a realistic picture of business performance, we choose instead to match revenues as closely as possible to expenses incurred to generate the sales. If a $100 million factory generates 10 years worth of sales, we would subtract one-tenth of the $100 million outlay in each of those ten years. This one-tenth charge is known as depreciation.
As you can see, depreciation is not something to be dismissed lightly simply because it is a non-cash outlay. It's a legitimate factor in measuring a company's economic performance. Hence you should give serious attention to Gross and Operating Margins, which do reflect the depreciation charges. But if you want to measure a company's financial flexibility, as opposed to economic success, it would be reasonable for you to ignore depreciation and examine the EBITD margin.
The Operating Margin showed us the impact of such normal corporate expenditures as overhead. All companies have overhead and differences in Operating Margin reflect the extent to which overhead acts as a drain on sales dollars. Pretax Margin goes beyond overhead and reflects non-operating costs that are not regularly related to the running of the business or the maintenance of the corporate entity. Examples would be interest on debt, gains and losses from asset sales, and income from corporate investments that are unrelated to its business.
Net Profit Margin tells us what percent of each sales dollar has been brought to the bottom line after subtracting all costs of any kind.
All else being equal, high margins are better than low margins. For the most part, this principle will apply when you compare company margins to Industry margins. But be careful about comparing company margins to S&P 500 margins, and to a lesser extent, Sector margins). When you do that, all else is often not equal.
Turnover must also be considered. For example, the average net margin for furniture manufacturers is approximately 8%, while retail grocery chains command average net margins that are a bit shy of 2.5%. If investors were to look only at margins, nobody would want to own shares of a grocery chain. But grocers typically buy large quantities of inventory, sell the products very quickly, and repeat the process by frequently reordering goods. Newly manufactured furniture sells much more slowly. In other words, a new sofa will fetch a bigger margin than will a can of soup. But the sofa will tie up far more of the seller's capital during the manufacturing period and for the time when it is held by the seller as finished goods inventory than will the can of soup. So which business is more profitable?
Fortunately for investors, there is another set of ratios that can reduce both considerations to a single number. We refer here to Returns on Capital, which can be studied in the Reuters Management Effectiveness Report.
Before leaving the Profitability Ratios, we must consider one more data item. The Effective Tax Rate, shown at the bottom of this table, can provide important signals about earnings quality. Watch out for unusually low tax rates. They may be caused by issues that aren't likely to persist over time, such as carryforwards from prior year's losses that will eventually be exhausted. In such a case, when the tax rate moves toward a more normal level, EPS may decline even if business fundamentals are improving.
Management Effectiveness
The ratios shown in Management Effectiveness Comparison Report are widely regarded as the ultimate measure of corporate performance. By combining the concepts of margin and turnover, they let you make direct comparisons between vastly different businesses. For example, you cannot properly compare a grocery chain to a furniture manufacturer in terms of margin or turnover. But you can make such a comparison based on the ratios presented here. All of the Management Effectiveness Ratios are calculated for the Trailing Twelve Month (TTM) time period and over a 5 Year Average.
Management Effectiveness (%) Company Industry Sector S&P 500
Return On Assets (TTM) 8.30* 7.03 5.18 8.45
Return On Assets - 5 Yr. Avg. 9.47 8.76 5.08 8.29
Return On Investment (TTM) 9.45* 8.09 7.50 13.51
Return On Investment - 5 Yr. Avg. 10.91 10.23 8.03 13.07
Return On Equity (TTM) 17.34* 16.44 15.13 23.05
Return On Equity - 5 Yr. Avg. 19.52 17.20 15.28 21.49
Each company's Management Effectiveness information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Reuters presents three different ratios in this section. All three ratios use Net Profit as the measure of return. The differences are in how we measure the amount of capital employed in the business.
Return on Equity is calculated by dividing Net Profits by Equity. It shows how much return management has earned on the capital that is actually owned by the shareholders; the owners of the business.
Our starting point is the total of all assets employed in the business. From that, we subtract those assets that are devoted to current working capital (money that is owed to vendors, or money owed to short-term trade creditors to help the company bridge the period between purchase of inventory and receipt of proceeds from sale of finished goods). We also subtract long-term liabilities. What's left over is referred to as Shareholder's Equity.
Let's say a group pools together $100 million to form a business. They hire a management team to run it. The business generates a Net Profit of $10 million. Return on Equity is 10% ($10 million of Profit divided by $100 million of Equity).
Return on Investment is calculated by dividing Net Profits by Investment. Investment is defined as long-term debt and other long-term liabilities, plus equity. This shows how much return management has earned on all long-term capital; that which is owned by the shareholders and that which is contributed by long-term creditors.
The capital markets exist for the purpose of matching investors who wish to supply capital with those who have the skills and vision to run businesses but are in need of more capital than they can invest on their own. There are two approaches a businessperson can follow when raising capital. One is to seek others who wish to be co-owners (shareholders). These co-owners share fully when the company prospers, and see their investment deteriorate when the company falters. There is another type of capital supplier who is willing to miss out on the full benefits of the company's prosperity in exchange for the privilege of realizing a more stable return, in good years and lean years. Such individuals make long-term loans to the company.
This time the group pools together $100 million to form the same sort of business as in the example above, but they decide to supplement their own funds by borrowing an additional $50 million on a long-term basis. The company earns a Net Profit of $15 million. Return on Investment is 10% ($15 million of Profit divided by $150 million of capital, consisting of $100 million supplied by owners and $50 million supplied by long-term lenders). Return on Equity, however, is now 15% ($15 million of Profit divided by $100 million of Equity). This is an example of the way in which a business owner can increase the return on his/her capital through the skillful use of borrowed money.
Return on Assets is calculated by dividing Net Profits by Assets. This shows how much return management has earned on all assets available to it, from all sources. In examining all capital resources available to a business manager, we can, as a practical matter, go beyond owner's capital and long-term liabilities. A talented manager is also able to make use of assets, known as current liabilities, that are available only for a year or less. Examples include short-term debt or trade accounts payable. In other words, if a bill is due in sixty days, and the company already has the money in its possession, it may use those funds in the business until the last possible moment.
Now the group pools together $100 million to form the same sort of business as in the example above, and supplements their own funds by borrowing an additional $50 million on a long-term basis. Also, the company, in the course of its day-to-day operations, usually has about $20 million of funds that it needs to pay to vendors within sixty days. By the time that money is paid, the company will have accumulated another $20 million, more or less in accounts payable that will be paid sixty days further into the future. On a full-year basis, the company has, on average, $20 million of this short-term money available to it. The business generates a Net Profit of $17 million. Return on Assets is 10% ($17 million of Profit divided by $170 million of equity, long term, and short term capital). Return on Investment is now 11.3% ($17 million of Profit divided by $150 million of equity and long-term capital). Return on Equity has jumped to 17% ($17 million of profit divided by $100 million of equity).
These examples demonstrate that Return on Equity (owner's capital) reflects a combination of business performance and skillful financial management. In all three examples, business performance alone gave us returns on capital equal to 10%. But we saw that the Return on Equity was increased to 15% through effective use of long-term liabilities. Skillful use of short-term capital generated a still-higher 17% return. All of these ratios, in one way or another, seek to measure how much profit management has been able to earn from the capital it is using. The most basic benchmark against which you can evaluate a return on capital is the U.S. Treasury bond rate, which tells us how much can be earned if all capital were to be invested in these securities. It's regarded as a risk-free investment since there's no uncertainty at all as to the dollar amount of income that will be received as well as the timing of all receipts (interest income and repayment of principal). If a business is consistently unable to earn as much from its capital as could be obtained from a risk free U.S. government bonds, shareholders would be well within their rights to believe they'd do better if they liquidated the firm, divided up the proceeds, and invested in treasuries. Any excess return earned by running a business, instead of owning Treasuries, is known as a "risk premium."
When evaluating risk premiums, it's best to avoid doing so in a rigid manner. Unlike a treasury portfolio, the world of business is subject to ups and downs. Anyone who invests in stocks must understand and be prepared to accept this. Hence at times, corporate returns will trail risk-free rates. Shareholders are compensated for accepting periodic bad years by the fact that they can earn much higher returns if they stay in stocks for the long term. Because returns fluctuate, use the Trailing Twelve Month (TTM) data you see here to give you a sense of whether the present is a strong or sluggish period for the company, its industry, its sector and the S&P 500. But to assess how effectively management utilizes the capital available to it, use the 5-Year Average Returns.
Efficiency Ratios
The Efficiency Comparisons Table can put some of the data you see in other Comparisons tables into proper perspective. Also, certain ratios can serve as important signals of deteriorating or improving business fundamentals that may not yet be reflected in reported earnings. All of the Efficiency ratios are calculated for the Trailing Twelve Month (TTM) time period. Each company's Efficiency information is presented in comparison to its Industry, Sector, and the S&P 500.
Efficiency Company Industry Sector S&P 500
Revenue/Employee (TTM) 46,522* 65,265 331,939 391,610
Net Income/Employee (TTM) 5,806* 5,927 51,075 59,543
Receivable Turnover (TTM) 23.63* 31.28 15.56 9.99
Inventory Turnover (TTM) 112.94 35.13 14.01 9.02
Asset Turnover (TTM) 0.67* 1.03 1.17 1.10
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
The Revenue/Employee and Income/Employee ratios provide a sense of how labor intensive the company's operations are. A lower level of Revenue and Net Income per Employee suggests a greater degree of labor intensity.
Asset Turnover is defined as revenues for the Trailing Twelve Month (TTM) period divided by average Assets for that interval. Average assets is calculated by adding the assets for the 5 most recent quarters and dividing by 5. Asset Turnover tells you how quickly the company is converting its physical asset base into sales. A lower ratio suggests a high degree of capital intensity.
Normally, there's nothing inherently good or bad about labor intensity versus capital intensity. The situation can vary based on developments in the overall economic environment. For example, if you expect labor costs to escalate rapidly, you may decide to focus on sectors and industries that are less labor intensive than the S&P 500. Conversely, expectations regarding interest rates can, for better or worse, affect your willingness to invest in firms that are more capital intensive than the S&P 500.
The Asset Turnover ratio is also important because it provides a backdrop for the interpretation of margins. The higher a company's Asset Turnover ratio, the better able it is to thrive while maintaining low profit margins. Alternatively, high margins can be combined with a low Asset Turnover ratio. Net Profit Margin and Asset Turnover can be combined into a single concept, Return on Assets, which can be found on the Management Effectiveness Table. You can use Return on Assets to compare companies with different margin/turnover characteristics.
The Receivable Turnover and Inventory Turnover ratios can be very important indicators of the underlying health or deterioration of a business.
Receivable Turnover is calculated as Trailing Twelve Month Revenues divided by average accounts receivable. Average receivables is calculated by adding the receivables for the 5 most recent quarters and dividing by 5.
Inventory Turnover is defined as Trailing Twelve Month cost of revenues divided by average inventory. To calculate average inventory, total inventory for the 5 most recent quarters is added and divided by 5.
The most important comparisons here are between company and industry. Below par Receivables Turnover ratios suggest that the company may be finding it difficult to collect money owed by customers who took delivery of products. Low Inventory Turnover ratios suggest that the sales may be slowing, causing a growing stockpile of unsold goods. If that's taking place, the company will eventually have to cut production to allow stockpiles to diminish and/or slash prices to move slow-selling products.
Although low Receivable and Inventory Ratios always require investigation, they don't always signal danger. For example, a company may deliberately build inventories to support the launch of a new product or in anticipation of a peak selling period.
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Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Valuation Ratios Company Industry Sector S&P 500
P/E Ratio (TTM) 39.55* 34.27 34.88 37.65
P/E High - Last 5 Yrs. 34.48 35.19 41.95 42.70
P/E Low - Last 5 Yrs. 17.54 16.64 16.17 14.50
Beta 0.97 0.95 0.89 1.00
Price to Sales (TTM) 4.93* 3.48 4.29 5.76
Price to Book (MRQ) 6.60 5.50 6.88 8.67
Price to Tangible Book (MRQ) 6.60 5.73 9.64 12.34
Price to Cash Flow (TTM) 24.61 21.93 23.35 28.13
Price to Free Cash Flow (TTM) 133.00 31.16 54.59 49.89
% Owned Institutions 69.77 56.48 52.58 63.94
The Price-to-Earnings (P/E) ratio is the single most widely used measure of a stock's value. That's because the key to stock ownership is the shareholder's stake in a portion of the company's profit stream. The P/E ratio is calculated by dividing the current Price by the sum of the Diluted Earnings Per Share from continuing operations before Extraordinary Items and Accounting Changes over the last four quarters. The P/E ratio is given for the Trailing Twelve Months (TTM). The P/E High and Low for the last 5 years is included for context.
Beta measures stock price volatility relative to the overall stock market. We use the S&P 500 as a proxy for the market and we automatically define its Beta as being 1.00. A higher beta indicates that a stock is relatively volatile while a lower beta indicates more stability. A stock with a Beta of 0.90 would, on average, be expected to rise or fall only 90% as much as the market. So if the market dropped 1.0%, such a stock might rise or fall 0.9% On the other hand, a stock with a Beta of 1.10 would, on average, rise or fall 10% more than the market. So a 1.0% market move, up or down, should spur a 1.1% move for the stock.
Price to Sales is generally used to evaluate companies that don't have earnings and don't pay dividends. For these companies, you may consider that high multiples of sales and high growth rates suggest optimistic future earnings expectations on the part of investors. Also, Sales trends tend to be less volatile than Earnings trends, because earnings can vary widely from one year to the next due to temporary issues such as reserves or gains and losses on asset divestitures. So the Price-to-Sales ratio can be useful in situations where the P/E ratio is distorted by unusual swings in earnings over the Trailing Twelve Months (TTM).
Price to Book is a theoretical comparison of the value of the company's stock to the value of the assets it owns free and clear of debt. Classical financial theory suggests that book value is a proxy for the proceeds that would be realized if the company was to be liquidated by selling all of its assets and paying all of its debt. For some companies, that may, indeed, be valid. But nowadays, you need to take it with a grain of salt. Assets are valued on the books at the actual prices the company paid to acquire them, minus cumulative depreciation/amortization charges. The idea behind these costs is to gradually reduce the value of the assets to zero over a period of use in which they presumably approach obsolescence. But note: the write-offs are based on specific accounting formulas that may or may not resemble real world progress toward obsolescence. Also, it's not clear that book value is effective in measuring the value of service-oriented companies that are less dependent on traditional brick-and-mortar factories and machinery. The Price to Book ratio is given for the Most Recent Quarter (MRQ).
Price to Tangible Book is similar to Price to Book, except that we have subtracted the value of intangibles such as goodwill from book value. It is tempting to assume that intangible assets are less valuable than tangible assets. We suggest that you avoid jumping to such a conclusion. Consider a fast food chain such as McDonald's (MCD). Its tangible book value would include the collective amounts it spent to construct and equip company-owned properties. But what about the value of the agreements it holds with its huge and powerful network of franchisees, the true engine of MCD's growth? What about the value of the brand name? These are not the sorts of assets that are included in a calculation of tangible book value. But if you were going to attempt to purchase the entire company, you would understand that you would have to pay a price that truly reflects the considerable value of these intangibles. Indeed, some of the most valuable intangibles a company owns may not show up, in any sense, on its books. The sort of intangible assets we described for MCD may never be associated with any number, absent some accounting event, such as the acquisition of the company. The difference between the price paid for MCD and the book value of MCD's assets would appear on the buyer's books as their intangible asset. Given these issues, we suggest that Price to Book and Price to Tangible Book are best used in comparison to the Industry.
The Price to Cash Flow ratio is the current Price divided by Cash Flow Per Share for the Trailing Twelve Months (TTM). When measuring a company's operating performance, Cash Flow is an alternative to Net Income, which is calculated by subtracting all expenses from revenues.
Net Income sounds simple, but in truth, measuring expenses can raise interesting questions. Suppose a manufacturing firm spends $100 million to build a factory that will help it create salable products for a period of ten years. Looking strictly at cash outlays, we would recognize factory construction expenses of $100 million in Year 1, and zero in each of years 2-10. This would suggest one unusually poor year for profits, followed by nine very good ones. Accountants recognize that this isn't realistic. The preferred practice is to match revenues as closely as possible to the expenses incurred to generate the Revenues. In our example, we assume that the $100 million factory generates 10 years worth of Revenues. So we recognize one-tenth of the $100 million outlay in each of those 10 years. This one-tenth charge is known as depreciation. (Amortization is a similar annual charge for a different sort of one-time expenditure that is matched against more than one year's worth of sales.)
How should an investor assess all of this? The revenue/expense matching practice of the accountants is a reasonable way to measure a company's economic success or failure. So you should pay heed to the traditional Net Income (or Earnings) and Earnings Per share figures as reported by the companies. But this number does not tell you how much cash the company generates year in and year out. If you want to know how much the company can afford to pay in dividends or use for other investments, you would look to a figure known as Cash Flow, which is calculated by adding non-cash depreciation and amortization charges back to Net Income.
But Cash Flow alone doesn't necessarily give you the full story. Even if you'd rather study cash flows than economic performance, you still need to account for the $100 million our hypothetical company spent to build the factory. Free Cash Flow looks at the cash the company's operations actually generated in a given year, and subtracts important non-operating cash outlays; capital spending and dividend payments. Accordingly, Free Cash Flow is the purest measure of a company's capacity to generate cash.
When analyzing stocks, you need to examine Cash Flow and Free Cash Flow. Cash Flow is a less pure number, but it is less susceptible to wide year-to-year swings as capital programs periodically build up and wind down. Examining the Price to Cash Flow and Price to Free Cash Flow ratios presented here, we confirm our impression that MCD is more richly valued than the Restaurant group, but that the industry as a whole may be undervalued.
% Owned Institutions, the final line on the table, is an especially important one to check. This item, which shows the percent of shares owned by institutions, helps you gauge the level of demand for the stock on the part of this influential investor group. Institutions are an important segment of the investment community because of their expertise and size. You can also go to the Institutional Ownership table on the Reuters Performance Report to see whether these investors have been buying or selling the stock.
Dividend Ratios
The Dividends table shows you key information about the company's cash payments to shareholders. The Dividend Yield is calculated by dividing the annual dividend per share by the price of the stock. Obviously, this information is of considerable importance to those who are looking for income. But even if income is not a significant goal for you, it is still possible to gain some interesting insights from the Dividend table.
Dividends Company Industry Sector S&P 500
Dividend Yield 0.46 0.53 1.57 1.52
Dividend Yield - 5 Year Avg. 0.60 0.51 1.37 1.89
Dividend 5 Year Growth Rate 10.41 9.59 7.29 10.19
Payout Ratio (TTM) 87.43 54.77 26.99 32.32
Each company's dividend information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Dividend Yield vs. Dividend 5 Year Growth Rate: If income is an important part of your investment goal, you will need to focus on the tradeoff between high current yield and high rates of dividend growth. Ideally, you would like to maximize both, but realistically, you will find that the stocks with the highest yield tend to have less attractive prospects for dividend growth. Even so, you will still want to come as close as you can to the best-case ideal.
If you want to maximize yield, you are probably focusing on Utility (Electric, Natural Gas, or Water) or Real Estate stocks. Recognize that dividend growth in these sectors is typically less buoyant than is the case elsewhere. But in choosing among Utility/Real Estate stocks of comparable yield and risk, you would still want to select those that offer the best growth prospects relative to these categories. Analyze this issue by comparing Company yield to the Average Yield for the Industry and Sector. Do likewise for 5-year Average Yield and 5-Year Growth Rate.
Income investors outside the Utility and Real Estate areas are typically willing to sacrifice some current yield in exchange for the greater potential dividend growth. Assuming yields on these stocks will typically be lower than what you would expect within the utility sector, it would still be reasonable for you to seek stocks whose yields are higher than their respective Industry and Sector averages. An income seeker should not accept a yield lower than that of the S&P 500 unless the stock's dividend growth rate is dramatically higher.
Whether you stress dividend yield or dividend growth, you should be sensitive to the level of the company's Payout Ratio, the percent of Net Income that is paid to shareholders as Dividends. All else being equal, lower Payout Ratios are better. That's because such companies have greater income cushions that would allow them to avoid cutting dividends in bad times. Different businesses have different cash needs and different levels of normal earnings volatility. Hence it's best to evaluate Payout Ratios by comparing a company to the average for its Industry.
Net Income is prone to temporary developments such as gains or losses from the sale of assets or write-offs of various kinds that could cause the Payout Ratio to fluctuate widely from one year to the next. If a company Payout Ratio differs from the industry average in a dramatic way, that might be serve as a hint that the current level of earnings is unusually high or low. Confirm this by comparing the stock's Yield to the industry average. A noteworthy difference in Payout Ratio, accompanied by a modest difference in Yield, suggests that the Payout Ratio is being computed based on an atypical level of net income. There are two reasons why you can use this assumption.
Companies in the same industry share a generally common set of cash flow and capitol needs characteristics, so it's reasonable to assume that Payout Ratios will be generally similar.
As we'll discuss below, Yield provides an important window into Wall Street sentiment. Hence a generally normal Yield relative to the industry usually suggests that Wall Street sentiment toward the stock more or less matches sentiment toward the industry.
Let's look at how Yield can function as a barometer of investor sentiment about a stock. Suppose the shares of ABC Company normally yield about 1.0% and the average yield for the other stocks in the same industry typically runs near 1.1%. One day, you look at ABC and find that it yields 2.5%, while the average yield for the industry is 1.2%.
True or False? ABC is a very attractive investment right now because it presents an unusual opportunity to earn a greater level of income than you could normally expect from this stock.
It's very tempting to say "true." And indeed, it might really be true for a particular stock. But until you've carefully investigated the facts, you should start by assuming that ABC's soaring yield is a negative signal. In the real world, all things are possible, so perhaps ABC is a true needle in a haystack. But more likely than not, the yield has jumped - relative to the industry - because of a drop in the stock price without a comparable drop in the dividend. Investors probably know about the high yield; this sort of information is extremely easy to uncover in a wide variety of sources. But they choose to ignore it because they perceive company developments that could cause the Directors to cut the payout.
All investors, even those who seek capital growth, can benefit from using Yield relative to the industry as a barometer of investor sentiment.
Growth Rate Ratios
You can get a utility stock with a dividend yield in the 4-6% range. You can buy a risk-free U.S. Treasury bond yielding in the neighborhood of 4-5%. Or you can buy non-utility stocks, many of which sport yields in the range of zero-1.5%. Why would anyone ever choose the latter?
Earnings Per Share (EPS) growth is, of course, the prime focus of any investor's stock analysis efforts. Most of the other things you look at are designed, in one way or another, to help you assess the company's ability to generate future earnings growth.
Growth Rates(%) Company Industry Sector S&P 500
Sales (MRQ) vs Qtr. 1 Yr. Ago 9.08* 7.92 19.47 12.28
Sales (TTM) vs TTM 1 Yr. Ago 8.88* 8.30 26.89 14.72
Sales - 5 Yr. Growth Rate 9.85 13.15 22.43 16.65
EPS (MRQ) vs Qtr. 1 Yr. Ago -13.79* 5.39 25.44 8.51
EPS (TTM) vs TTM 1 Yr. Ago -3.92* 3.84 23.49 11.18
EPS - 5 Yr. Growth Rate 12.66 14.13 21.84 20.63
Capital Spending - 5 Yr. Growth Rate 14.20 15.81 28.30 15.81
The answer is Growth. Growth is, perhaps, the single most important consideration for the typical equity investor. Indeed, it's the reason why shares of healthy firms usually sell at prices that are far above their here-and-now liquidation values. Investors don't generally buy companies with the idea of realizing cash from liquidation; they buy companies based on their appeal as businesses capable of growing in the years ahead. Accordingly, the Reuters Growth Rates Comparison table is a very important one for you to consider.
Each company's Growth information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Also consider Sales growth. Over short periods of time, it is possible for stocks to perform very well despite sales that are growing slowly, or even falling. Typically, this occurs when earnings growth comes from cost-cutting programs, or when a company divests a poorly performing subsidiary. But such scenarios can last only so long. Sooner or later, costs become as lean as they can be, or a company will have sold or shuttered all of its weak operations. At that point, a sustained increase in sales will be needed if one is to expect a sustained increase in earnings and cash flow.
For Sales and EPS, we present year-to-year growth rates for three different periods. By year-to-year, we mean that we are comparing a particular period of time to a comparable period a year earlier. In other words, if we were examining the second quarter of 1999, we would be comparing it to the second quarter of 1998. Alternatively, a comparison between the second quarter of 1999 and the first quarter of 1999 would be referred to as a "consecutive-quarter" comparison. Whenever you encounter any information about a company's growth, assume you are seeing a year-to-year comparison unless you are specifically told otherwise.
The year-to-year convention is followed in the financial community in order to prevent the distortion of growth data by seasonal issues. For example, retailers typically show very dynamic growth from the third quarter to the fourth quarter, but that's usually because business is ramping up from the slow summer-autumn season to the holiday period, when many retailers usually generate most of the year's sales. The only way to measure whether or not a retailer is really growing at that key period is to compare the most recent holiday period to the year-ago holiday season.
The year-to-year comparison for the most recent quarter (MRQ) represents the most up-to-date growth information available to the financial community and is always an important determinant of near-term stock price performance. Start your inquiry with an assumption that strong MRQ growth rates will be accompanied by strong stock price performance and vice versa. That won't always happen. But when you spot an exception, make sure you examine the News reports to find out why this is happening. Often, you'll find important information in the latest Earnings Flash announcement.
The Trailing-Twelve-Month (TTM) period adds context to the MRQ data because it helps you determine the extent to which the MRQ data represents a sustainable trend.
The 5 Year Growth Rates cover a period of time that is long enough to further mitigate periodic quarterly aberrations in growth.
The last line of this table shows Capital Spending 5 Year Growth Rate. There's a great deal of variation from one business to another in terms of capital intensity and the rate at which physical assets need to be modernized. Comparisons against the sector and the S&P 500 should be used mainly to provide a sense of the sort of spending needs that are faced by the industry you are examining.
When examining company-to-industry Capital Spending comparisons, remember that it is normal for a business to spend at least some money for capital projects year in and year out. But at times, capital spending can mushroom to especially high levels as a major project ramps up, and then slide to a lesser pace as the newly-completed project allows the company to trim down to basic maintenance levels.
If you see that a company's capital spending growth was significantly higher than that of its industry, that could suggest that the company's needs should moderate, relative to its peers, in the next few years. That would give the company more flexibility regarding use of its cash flow (dividends, share buybacks, acquisitions, etc.). If you see that growth in spending trailed the industry average, that might suggest pent-up capital needs (and increased spending) in the years ahead.
Finally, you should compare the Capital Spending 5 Year Growth Rate with the Sales 5 Year Growth Rate. This can be important since there's usually a relationship between the value of a company's assets and the amount of sales that those assets can generate. A rate of Sales growth that exceeds the rate of Capital Spending growth might indicate that a company is finding new ways to generate more Revenues from existing plant. But it could also mean that capacity is getting tight and that capital spending increases are around the corner.
Financial Condition Ratios
Financial strength is an important indicator of the amount of business risk the company is taking. When business conditions turn bad, financially stronger companies have more staying power. Not only are they less likely to face insolvency, they are also less likely to find a need to make the sort of drastic cutbacks that might restrain their ability to grow even after better times resume. Use the Reuters Financial Strength Ratio Comparison to help you assess the financial condition of any company in which you are interested.
Financial Strength Company Industry Sector S&P 500
Quick Ratio (MRQ) 0.39 0.45 0.94 0.97
Current Ratio (MRQ) 0.58 0.71 1.48 1.47
LT Debt to Equity (MRQ) 0.71 0.63 0.89 0.67
Total Debt to Equity (MRQ) 0.79 0.69 1.03 0.97
Interest Coverage (TTM) 6.94 7.17 5.59 9.06
Each company's Financial Strength information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
The Quick Ratio and Current Ratio at the top of the table are the most stringent tests of financial strength. They measure the level of liquidity that is or could become available to the company in short period of time. These ratios are base on the Most Recent Quarter (MRQ).
The Quick Ratio compares a company's cash and short-term investments (that is, investments that could be converted to cash very quickly) to the financial liabilities the company is expected to incur within a year's time. A ratio of .80 would mean that cash and cash equivalents now available would cover eighty percent of expected year-ahead liabilities. The shortfall below 100% might seem alarming at first glance. But remember, the Quick Ratio is a very stringent test that compares a year's worth of obligations with cash that, for all practical purposes, is already in the bank.
The Current Ratio compares year-ahead liabilities to cash on hand now plus other inflows the company is likely to realize over that same twelve-month period. These additional expected inflows include such items as Accounts Receivable (payments the company expects to receive within a year from customers who already purchased goods or services) and Inventories (goods the company expects to sell within a year). The Current Ratio is often above 1.00 (100%).
The LT Debt to Equity Ratio looks at the company's capital base. If the ratio is at 1.00, that means the company's long-term (LT) debt and equity are equal. Put another way, fifty percent of the company's capital consists of equity (contributed by shareholder-owners) and the other fifty percent was contributed by long-term creditors.
The Total Debt to Equity ratio takes into account both long-term and short-term debt. Traditionally, one would analyze a company's leverage on the basis of its long-term debt, which includes debt that is due more than one year hence. Long-Term Debt is assumed to be a permanent part of the company's capital structure. Short-term debt is traditionally regarded as not being part of the capital structure. With trade debt, for example, a manufacturer might borrow money to finance the purchase of raw material, which is converted into finished products and sold to customers. Once the company receives the proceeds of these sales, it immediately repays the money it borrowed in order to finance its raw material purchases. Such debt is not usually regarded as part of the company's capital base.
But nowadays, borrowing arrangements have become much more flexible. Many companies use short-term debt as if it was part of the capital structure. This occurs when companies continually refinance the debt as soon as it comes due. This might be done if a company expects interest rates to fall. Continually refinancing short-term debts at lower and lower interest rates is preferable to locking the company into a long-term obligation at an interest rate that will be well above rates that are likely to prevail in the marketplace next year.
This strategy can be risky. If the company's interest rate forecast proves wrong, its cost structure will suffer. It may wind up refinancing its short-term debt at a rate that is well above the rate it might have paid had it borrowed long-term in the first place. Either way, we suggest looking at total debt/equity as an additional measure of financial leverage as well. When doing so, consider two issues:
The more debt in a company's capital structure, the greater the financial leverage risk. If business turns weak, there are some costs a company can easily reduce to protect its profits and preserve liquidity. But interest on debt is generally not among these variable costs. Interest must be paid even when revenues are falling. Hefty levels of debt and heavy interest expense burdens could led to insolvency if revenues or operating profits remain weak for a prolonged period.
The larger the Total Debt to Equity Ratio is relative to the LT Debt to Equity Ratio, the more risk the company faces from the prospect of rising interest rates. But remember, some short-term debt is based on a corporate forecast of lower interest rates, while other types of short-term debt represents trade borrowing, such as the above raw materials financing example. You can't always tell for certain what sort of short-term debt your company has. But you can make some reasonable assumptions by using the Reuters Report to compare your company's debt ratios with those of its industry peers. A company that uses short-term debt much more aggressively than others in its industry is probably doing so because it expects lower interest rates.
It is generally assumed that higher debt ratios signify greater levels of risk. But don't jump too quickly to conclusions. Companies in industries characterized by stable cash flows can safely carry more debt than can companies whose cash flows follow volatile trends. Before you reach your final conclusion, you will need to compare the company's ratios with those of its industry peers. Look, too, at the final part of the Financial Strength Ratio Comparisons Report, which shows Interest Coverage. Companies with high levels of interest coverage are better able to carry more debt.
Since debt increases risk, why should any company ever carry any debt? Wouldn't it be reasonable to simply restrict consideration to debt-free companies?
There are two reasons why you should not narrow your horizons this way. First, as discussed above, some forms of debt, such as trade debt, are necessary to the day-to-day operation of a business. This is especially so in the financial sector, where much depends on the process of borrowing money and re-lending it at higher rates. Second, permanent debt, prudently used, can enhance corporate returns. You can measure this effect by examining the Management Effectiveness table.
Profit Margin Ratios
Profitability Ratios tell you how much of each Revenue dollar is left over, after subtracting costs, as profit to the company. We present several different ways of looking at profit, each of which shows you something important about the company's performance. All of the Profitability Ratios are calculated for the Trailing Twelve Month (TTM) time period and over a 5 Year Average.
Each company's Profit Margin information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Profitability Ratios (%) Company Industry Sector S&P 500
Gross Margin (TTM) 36.16 36.81 43.07 48.94
Gross Margin - 5 Yr. Avg. 37.80 36.85 42.17 48.68
EBITD Margin (TTM) 30.49 23.11 19.81 22.48
EBITD - 5 Yr. Avg. 33.18 24.45 20.73 22.07
Operating Margin (TTM) 23.20 16.76 9.26 17.69
Operating Margin - 5 Yr. Avg. 25.91 18.06 10.94 17.85
Pre-Tax Margin (TTM) 19.59 14.14 10.32 14.77
Pre-Tax Margin - 5 Yr. Avg. 21.92 15.20 9.71 16.01
Net Profit Margin (TTM) 12.48* 8.95 5.86 10.72
Net Profit Margin - 5 Yr. Avg. 14.60 11.25 5.54 10.29
Effective Tax Rate (TTM) 32.27 33.45 37.30 34.19
Effective Tax Rate - 5 Yr. Avg. 33.32 33.80 36.83 35.70
The Gross Margin tells you how much of each Revenue dollar is left over after subtracting costs directly incurred to generate those sales. In company financial statements, such costs are referred to as "Cost of Goods Sold," or "Cost of Revenues." For a manufacturer, the cost of raw materials and the wages/benefits of employees who make the products would be examples of direct costs.
The Operating Margin shows us how much of each sales dollar is left over after subtracting direct costs of generating the sales and indirect costs, such as corporate overhead. Neither the Gross Margin nor the Operating Margin is more important than the other. They are equally vital, and each tells us something different about the company.
EBITD (Earnings Before Interest, Taxes and Depreciation) Margin is similar to Operating Margin except that it adds back non-cash depreciation costs that are subtracted from revenues to compute net income. To understand the nature of these depreciation charges, assume a manufacturing firm spends $100 million to build a factory that it can use to produce products for ten years. If, in computing profit, we deduct all expenditures in a strict dollar-for-dollar manner, we would subtract factory construction expenses of $100 million in Year 1, and zero for each of years 2-10. This would suggest one very bad year for profits, followed by nine exceptionally good ones. Recognizing that this is not a realistic picture of business performance, we choose instead to match revenues as closely as possible to expenses incurred to generate the sales. If a $100 million factory generates 10 years worth of sales, we would subtract one-tenth of the $100 million outlay in each of those ten years. This one-tenth charge is known as depreciation.
As you can see, depreciation is not something to be dismissed lightly simply because it is a non-cash outlay. It's a legitimate factor in measuring a company's economic performance. Hence you should give serious attention to Gross and Operating Margins, which do reflect the depreciation charges. But if you want to measure a company's financial flexibility, as opposed to economic success, it would be reasonable for you to ignore depreciation and examine the EBITD margin.
The Operating Margin showed us the impact of such normal corporate expenditures as overhead. All companies have overhead and differences in Operating Margin reflect the extent to which overhead acts as a drain on sales dollars. Pretax Margin goes beyond overhead and reflects non-operating costs that are not regularly related to the running of the business or the maintenance of the corporate entity. Examples would be interest on debt, gains and losses from asset sales, and income from corporate investments that are unrelated to its business.
Net Profit Margin tells us what percent of each sales dollar has been brought to the bottom line after subtracting all costs of any kind.
All else being equal, high margins are better than low margins. For the most part, this principle will apply when you compare company margins to Industry margins. But be careful about comparing company margins to S&P 500 margins, and to a lesser extent, Sector margins). When you do that, all else is often not equal.
Turnover must also be considered. For example, the average net margin for furniture manufacturers is approximately 8%, while retail grocery chains command average net margins that are a bit shy of 2.5%. If investors were to look only at margins, nobody would want to own shares of a grocery chain. But grocers typically buy large quantities of inventory, sell the products very quickly, and repeat the process by frequently reordering goods. Newly manufactured furniture sells much more slowly. In other words, a new sofa will fetch a bigger margin than will a can of soup. But the sofa will tie up far more of the seller's capital during the manufacturing period and for the time when it is held by the seller as finished goods inventory than will the can of soup. So which business is more profitable?
Fortunately for investors, there is another set of ratios that can reduce both considerations to a single number. We refer here to Returns on Capital, which can be studied in the Reuters Management Effectiveness Report.
Before leaving the Profitability Ratios, we must consider one more data item. The Effective Tax Rate, shown at the bottom of this table, can provide important signals about earnings quality. Watch out for unusually low tax rates. They may be caused by issues that aren't likely to persist over time, such as carryforwards from prior year's losses that will eventually be exhausted. In such a case, when the tax rate moves toward a more normal level, EPS may decline even if business fundamentals are improving.
Management Effectiveness
The ratios shown in Management Effectiveness Comparison Report are widely regarded as the ultimate measure of corporate performance. By combining the concepts of margin and turnover, they let you make direct comparisons between vastly different businesses. For example, you cannot properly compare a grocery chain to a furniture manufacturer in terms of margin or turnover. But you can make such a comparison based on the ratios presented here. All of the Management Effectiveness Ratios are calculated for the Trailing Twelve Month (TTM) time period and over a 5 Year Average.
Management Effectiveness (%) Company Industry Sector S&P 500
Return On Assets (TTM) 8.30* 7.03 5.18 8.45
Return On Assets - 5 Yr. Avg. 9.47 8.76 5.08 8.29
Return On Investment (TTM) 9.45* 8.09 7.50 13.51
Return On Investment - 5 Yr. Avg. 10.91 10.23 8.03 13.07
Return On Equity (TTM) 17.34* 16.44 15.13 23.05
Return On Equity - 5 Yr. Avg. 19.52 17.20 15.28 21.49
Each company's Management Effectiveness information is presented in comparison to its Industry, Sector, and the S&P 500.
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
Reuters presents three different ratios in this section. All three ratios use Net Profit as the measure of return. The differences are in how we measure the amount of capital employed in the business.
Return on Equity is calculated by dividing Net Profits by Equity. It shows how much return management has earned on the capital that is actually owned by the shareholders; the owners of the business.
Our starting point is the total of all assets employed in the business. From that, we subtract those assets that are devoted to current working capital (money that is owed to vendors, or money owed to short-term trade creditors to help the company bridge the period between purchase of inventory and receipt of proceeds from sale of finished goods). We also subtract long-term liabilities. What's left over is referred to as Shareholder's Equity.
Let's say a group pools together $100 million to form a business. They hire a management team to run it. The business generates a Net Profit of $10 million. Return on Equity is 10% ($10 million of Profit divided by $100 million of Equity).
Return on Investment is calculated by dividing Net Profits by Investment. Investment is defined as long-term debt and other long-term liabilities, plus equity. This shows how much return management has earned on all long-term capital; that which is owned by the shareholders and that which is contributed by long-term creditors.
The capital markets exist for the purpose of matching investors who wish to supply capital with those who have the skills and vision to run businesses but are in need of more capital than they can invest on their own. There are two approaches a businessperson can follow when raising capital. One is to seek others who wish to be co-owners (shareholders). These co-owners share fully when the company prospers, and see their investment deteriorate when the company falters. There is another type of capital supplier who is willing to miss out on the full benefits of the company's prosperity in exchange for the privilege of realizing a more stable return, in good years and lean years. Such individuals make long-term loans to the company.
This time the group pools together $100 million to form the same sort of business as in the example above, but they decide to supplement their own funds by borrowing an additional $50 million on a long-term basis. The company earns a Net Profit of $15 million. Return on Investment is 10% ($15 million of Profit divided by $150 million of capital, consisting of $100 million supplied by owners and $50 million supplied by long-term lenders). Return on Equity, however, is now 15% ($15 million of Profit divided by $100 million of Equity). This is an example of the way in which a business owner can increase the return on his/her capital through the skillful use of borrowed money.
Return on Assets is calculated by dividing Net Profits by Assets. This shows how much return management has earned on all assets available to it, from all sources. In examining all capital resources available to a business manager, we can, as a practical matter, go beyond owner's capital and long-term liabilities. A talented manager is also able to make use of assets, known as current liabilities, that are available only for a year or less. Examples include short-term debt or trade accounts payable. In other words, if a bill is due in sixty days, and the company already has the money in its possession, it may use those funds in the business until the last possible moment.
Now the group pools together $100 million to form the same sort of business as in the example above, and supplements their own funds by borrowing an additional $50 million on a long-term basis. Also, the company, in the course of its day-to-day operations, usually has about $20 million of funds that it needs to pay to vendors within sixty days. By the time that money is paid, the company will have accumulated another $20 million, more or less in accounts payable that will be paid sixty days further into the future. On a full-year basis, the company has, on average, $20 million of this short-term money available to it. The business generates a Net Profit of $17 million. Return on Assets is 10% ($17 million of Profit divided by $170 million of equity, long term, and short term capital). Return on Investment is now 11.3% ($17 million of Profit divided by $150 million of equity and long-term capital). Return on Equity has jumped to 17% ($17 million of profit divided by $100 million of equity).
These examples demonstrate that Return on Equity (owner's capital) reflects a combination of business performance and skillful financial management. In all three examples, business performance alone gave us returns on capital equal to 10%. But we saw that the Return on Equity was increased to 15% through effective use of long-term liabilities. Skillful use of short-term capital generated a still-higher 17% return. All of these ratios, in one way or another, seek to measure how much profit management has been able to earn from the capital it is using. The most basic benchmark against which you can evaluate a return on capital is the U.S. Treasury bond rate, which tells us how much can be earned if all capital were to be invested in these securities. It's regarded as a risk-free investment since there's no uncertainty at all as to the dollar amount of income that will be received as well as the timing of all receipts (interest income and repayment of principal). If a business is consistently unable to earn as much from its capital as could be obtained from a risk free U.S. government bonds, shareholders would be well within their rights to believe they'd do better if they liquidated the firm, divided up the proceeds, and invested in treasuries. Any excess return earned by running a business, instead of owning Treasuries, is known as a "risk premium."
When evaluating risk premiums, it's best to avoid doing so in a rigid manner. Unlike a treasury portfolio, the world of business is subject to ups and downs. Anyone who invests in stocks must understand and be prepared to accept this. Hence at times, corporate returns will trail risk-free rates. Shareholders are compensated for accepting periodic bad years by the fact that they can earn much higher returns if they stay in stocks for the long term. Because returns fluctuate, use the Trailing Twelve Month (TTM) data you see here to give you a sense of whether the present is a strong or sluggish period for the company, its industry, its sector and the S&P 500. But to assess how effectively management utilizes the capital available to it, use the 5-Year Average Returns.
Efficiency Ratios
The Efficiency Comparisons Table can put some of the data you see in other Comparisons tables into proper perspective. Also, certain ratios can serve as important signals of deteriorating or improving business fundamentals that may not yet be reflected in reported earnings. All of the Efficiency ratios are calculated for the Trailing Twelve Month (TTM) time period. Each company's Efficiency information is presented in comparison to its Industry, Sector, and the S&P 500.
Efficiency Company Industry Sector S&P 500
Revenue/Employee (TTM) 46,522* 65,265 331,939 391,610
Net Income/Employee (TTM) 5,806* 5,927 51,075 59,543
Receivable Turnover (TTM) 23.63* 31.28 15.56 9.99
Inventory Turnover (TTM) 112.94 35.13 14.01 9.02
Asset Turnover (TTM) 0.67* 1.03 1.17 1.10
Industry: The company universe is grouped into more than 100 distinctive industries. These industries have been developed to contain those companies that operate along similar lines of business.
Sector: Industries are grouped into 12 distinct sectors. These sectors represent different segments of the US economy.
S&P 500: The S&P 500 is used to represent the market as a whole.
The Revenue/Employee and Income/Employee ratios provide a sense of how labor intensive the company's operations are. A lower level of Revenue and Net Income per Employee suggests a greater degree of labor intensity.
Asset Turnover is defined as revenues for the Trailing Twelve Month (TTM) period divided by average Assets for that interval. Average assets is calculated by adding the assets for the 5 most recent quarters and dividing by 5. Asset Turnover tells you how quickly the company is converting its physical asset base into sales. A lower ratio suggests a high degree of capital intensity.
Normally, there's nothing inherently good or bad about labor intensity versus capital intensity. The situation can vary based on developments in the overall economic environment. For example, if you expect labor costs to escalate rapidly, you may decide to focus on sectors and industries that are less labor intensive than the S&P 500. Conversely, expectations regarding interest rates can, for better or worse, affect your willingness to invest in firms that are more capital intensive than the S&P 500.
The Asset Turnover ratio is also important because it provides a backdrop for the interpretation of margins. The higher a company's Asset Turnover ratio, the better able it is to thrive while maintaining low profit margins. Alternatively, high margins can be combined with a low Asset Turnover ratio. Net Profit Margin and Asset Turnover can be combined into a single concept, Return on Assets, which can be found on the Management Effectiveness Table. You can use Return on Assets to compare companies with different margin/turnover characteristics.
The Receivable Turnover and Inventory Turnover ratios can be very important indicators of the underlying health or deterioration of a business.
Receivable Turnover is calculated as Trailing Twelve Month Revenues divided by average accounts receivable. Average receivables is calculated by adding the receivables for the 5 most recent quarters and dividing by 5.
Inventory Turnover is defined as Trailing Twelve Month cost of revenues divided by average inventory. To calculate average inventory, total inventory for the 5 most recent quarters is added and divided by 5.
The most important comparisons here are between company and industry. Below par Receivables Turnover ratios suggest that the company may be finding it difficult to collect money owed by customers who took delivery of products. Low Inventory Turnover ratios suggest that the sales may be slowing, causing a growing stockpile of unsold goods. If that's taking place, the company will eventually have to cut production to allow stockpiles to diminish and/or slash prices to move slow-selling products.
Although low Receivable and Inventory Ratios always require investigation, they don't always signal danger. For example, a company may deliberately build inventories to support the launch of a new product or in anticipation of a peak selling period.
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