TVI - The true measure for profitability

Recently we were hanging up a small cupboard in the kitchen. We carefully calculated where between the walls the cupboard should be – right in the middle, and how much below the ceiling it should be. The cupboard is hanging, but not in the middle and lower than we expected. What we should’ve done is simply hold the cupboard where it should be and draw circles on the wall, with a pencil through the screwholes.

If you listen to what most commentators say about the current financial crisis, there is an interesting parallel to hanging up the kitchen cupboard. The value and risk of the packages of subprime mortgages turned out to be unknown. No real assessment had taken place in buying and selling these packages, just very complex financial modeling. It seems banks have forgotten their true source of profit, being interest margins and fees, instead of buying, chopping up and selling packages of financial instruments.

In fact, most of the corporate scandals, spectacular business failures and the dotcom bubble have been caused by the same phenomenon: organizations forgetting about their core business and true value drivers. Retailers, Telecoms and Media businesses saw their supermarkets as cash machines to finance acquisitions.

In pursuit of maximizing profit and shareholder value, some organizations have lost touch with the reality. And let’s face it, how many organizations ask themselves why they make a profit, and if their sources of profit are sustainable. Some organizations see the world of business as a zero-sum game. Their value creation is someone else’s value destruction. That is not sustainable. Other organizations aim to add value to their stakeholders, and see profits as their reward, that can be invested in even higher added value, a virtuous circle. This is a more sustainable view. 

How do we measure if an organization’s profit is sustainable? I think we need a new measure. I’d like to introduce the “True Value Index” (TVI).

TVI = Profit – X / Profit
X = Unfair procurement savings (X1) + Intransparant margin (X2) + Income from
non-primary sources (X3) + Unnecessary cost (X4)

X1 - Procurement savings
There is nothing wrong with strong negotiations between the organization and its suppliers, as long as it doesn’t lead to squeezing the supplier below a fair margin. Even if the procurement cost leads to lower consumer prices, there is a negative effect on the value chain. It creates weak links and suboptimal results. Leaving a supplier a fair margin and invite suppliers to closely integrate into administrative and logistical processes and systems could easily lead to higher – and more sustainable -- cost savings. Organizations should assess which part of their procurement savings are unhealthy. This constitutes X1.

X2 – Intransparent margins
There are two sources of profit. A part of the profit is based on true added value, and a fair premium. The second source of profit is based on market intransparencies, customers not knowing the same product or service can be obtained elsewhere at a better price. Intransparencies can be caused by a lack of information, market access or illegal practices such as price-kartels. Due to globalization and increased power of buyers, markets move more towards a model of “pure competition” where buyers nor sellers have the power to alter the market price of products and services. Organizations should assess to which extent their profits are based on a fair premium, and which part is based on intransparency, being factor X2.

X3 – Income from non-primary sources
Organizations have income from different sources. For the true value index we should count only the income from the organization’s core businesses. Of course treasury should contribute to the organization’s income, but this should be the core business (in fact, if the return of treasury is higher than the return on the core business, the organization is in the wrong business or has serious business model issues). Also, revenue coming from non-core activities should be evaluated. Either it is deemed vital, which means it should become a core activity, and be managed as such, or it should be discounted from true value. Treasury income and revenue from non-core activities form X3.

X4 – Unnecessary cost
Creating the TVI should not lead to the thought that only direct costs are healthy. If this were the case, there would be no brand marketing – just lead generation, or no investments in IT infrastructure – just tactical implementation, and no innovation – just milking the cash cows. That would be very unhealthy. In fact, it seems in many businesses the indirect costs are growing. However, once in a while organizations do build up excessive overhead, some ‘fat around the waist’, that needs to be removed. Sometimes organizations sponsor activities that cannot be linked to business results or social relevance– if only PR. The assessment of these cost lead to X4.

As you can see, TVI is not a mathematical formula, it consists of various assessments. In putting together a profitability management program, TVI might be an important instrument. The discussion around the various assumptions and evaluations may be as important as the actual result. And if the TVI index is lower than, let’s say, 2/3, you could say you’re in trouble, or about to hit it. 

Could the TVI be a predictive indicator for business failure?

frank

P.S. I would like to thank professor Wim Scheper of Deloitte for the wonderful discussion a few weeks ago that led to this line of thinking.