Current company transformation and the unprecedented power of financial markets have crystallised the economic debate into two fundamental camps: shareholder value versus socio-economic value. Experienced analysts will tell you that the two are not in conflict. Indeed, strategic thinking today is based on short-term profitability for longer-term wealth creation. The latter is not possible if a company is in conflict with business ethics and social norms.

This and the wisdom: “what you measure is what you get” have led to a plethora of new accounting tools such as the Balanced Scorecard, T.O.C. throughput accounting, EVA, etc. They all attempt in one way or another to bridge the gap not covered by your standard statutory accounts and which do not encourage a change in behaviour to a longer-term growth focus.

Except one: the Value-added statement.

While not statutory, this accounting format has been around for decades and is only now starting to be recognised as much more than a set of numbers offered as a communications tit-bit to workers. It surpasses by a long way, all of the other modern attempts to move companies away from short-term cost accounting to longer-term growth. These other attempts often fail for a number of reasons. Mostly it is because they become little more than a surrogate or smokescreen to entrench, rather than move away from, the short-term cost and profit-driven goals. They ultimately lack authenticity. The true power of the Value-added statement lies in its ability to subtly change behaviour and what’s in the heart. It forges a common fate purpose. It enhances understanding and encourages contributory and flexible behaviour.

Used as the final scoring system, a direct, understandable and palatable link is made between operational measurements and the company’s fate. “It is the golden thread that binds us together”: (Ross Duffy A.E.L.) Standard shareholder accounts can be easily and understandably derived from the value-added statement and explained to the general workforce – right down to illiterate level!

This link not only covers accounting formats such as the income statement, but also formulae such as EBIT, RONA, ROTA, EVA, MVA, TVA, etc. It embraces all operational tools such as the 20-keys, World Class Manufacturing, Theory of Constraints and others. And finally, the company’s strategy can easily be linked into sub-scores to the value-added statement that become operational standards and the focal point of operational meetings.

The power of the statement lies in the power of the value-added business concept itself. Value-added can be seen from three perspectives: (1) transforming or process, (2) measurement and (3) intention. Transforming covers everything from structure to optimum operational efficiencies. Measurement creates the monitoring tool and discipline for optimum wealth creation. Intention covers purpose, mission, vision, values and ultimately behaviour.

But that’s not all (as the TV salesman would say!)

Value-added is the accounting synonym for Wealth creation. It therefore is the obvious, direct link to a sensible long-term strategy. Value-added is the company’s measurable annual contribution to GDP, and therefore a contribution to national prosperity. It is really the only valid and credible measurement of productivity because it embraces all three estates: capital labour and state. The standard measurement of output over input is a profitability measurement encouraging input reduction, rather than an increase in output. This leads to containment rather than growth with all of its implications for national prosperity and unemployment. Because value-added embraces the three main stakeholders it is the only valid common focus that enhances a sense of common destiny. It is the ideal trigger for a common fate gain-sharing and flexible pay programme.

The final and perhaps overriding power of the measurement lies in its ability to shift behaviour visibly. Being the difference between the product or service the company offers, (measured as sales) and what it has used from others (outside supplies), it is arguably a measurement of what the company’s market has found useful. In other words, it is the company’s contribution to the market and society as a whole. Value-added is therefore a measurement of contribution. It is the only measurement in accounting to do so! But as this value-added is shared between the three contributors (labour, capital and state) it is also the measurement of reward. Again it is the only measurement in accounting to do so. What is obvious to all is that value was created by the contribution in the first place. No other measurement proves so convincingly that contribution creates reward (give and you will receive!). This must and does shift behaviour and focus from taking to giving.

The value-added statement itself reflects wealth creation and wealth distribution. This translates into two very powerful and mutually supporting strategic “legs”: maximum wealth creation and sensible distribution. In turn five strategic principles are involved here. Three of them relate to wealth creation and two to distribution. Optimum wealth creation is the result of (1) selling the most you can; (2) getting the best price; and (3) keeping your outside costs as low as possible. Sensible distribution is based on (4) meeting the legitimate expectations of each stakeholder and (5) encouraging continued contribution.

It is clear that each heading offers a host of strategic actions that will do much more for company growth and success than any conventional intervention or transformation exercise. They cover all the principles of sound business – from structure to the smallest action in the workplace. Operational measurements such as waste control, quality, delivery, safety, training, absenteeism, throughput accounting, etc, make up sub-scores that force each activity to be in harmony with the overall strategic thrust.

The value-added statement is by far the best music sheet to get the orchestra to play in total harmony. Not only that: it inspires and encourages each musician to play at his or her best!

But there are some blemishes. These can be easily rectified.

The first is that the format is not statutory. While it is recognised as one of the final accounts and has been used by many companies since the 70’s, it is still viewed as a “nice to show” rather than a disciplined account subject to audit. It is interesting that the Value-added statement actually reveals more than the standard income statement, particularly when compared to previous years. I know of some investment analysts that effectively use this statement in their assessment of company health.

The second is that the statement is often used as a manipulative tool to demonstrate to workers that they are the biggest beneficiaries of wealth created. This affects the credibility of the statement, despite the fact that its design was largely the outcome of British labour pressure for greater company transparency. It may be statistically true that in most companies, labour gets the biggest slice of the cake. But if value-added, as we have shown, reflects both reward and contribution, then failing to argue that labour is also by and large the biggest contributor to wealth creation is a deliberate act of misleading the audience.

The third blemish is the absence of a sensible standardised convention regarding its format. The original format emanating from Britain has flaws that can no longer be ignored. In consulting to companies we have adjusted the format marginally to show the following:

It is clear that the above layout is simple, easily understood, and can be presented in a variety of palatable ways, including visual illustrations and even in video format. The seven-line format could obviously be expanded to show more, but quite frankly it already reveals more than the standard income statement and at lower levels this information is enough to test retention capabilities.

Accountants should have absolute clarity and a regulatory guideline on what each heading should cover. In working with a number of company value-added statements in the past few years we have experienced widely differing interpretations. Our advice is simply to follow a certain logic and then to be consistent. The components of each line can be easily communicated at the first presentation and occasionally reinforced thereafter. The detail of the many variables is beyond the scope of this article, so I will deal with some of the more pertinent ones.

The biggest problem I have with the standard British format is in the overall layout, more particularly the classification of interest under “providers of capital”. This simply does not make sense and with all our clients I have won the support of the accounting function to classify bank or other interest as an “outside cost”.

This adheres to the following logic.

Bank and other guaranteed loans are not part of the “family of contributors”. Since we have moved away from fixed exchange rates, banks as usury lenders can no longer be viewed as “risk takers”. Differentiated interest rates imply that the risk is reflected in a premium above or discount below the benchmark (say prime). As far as risk taking is concerned, most banks are preferred creditors to others. Certainly their relationship with a company is so different from that of a shareholder, particularly major shareholders, that it is intolerable to classify them in one group. Similarly, other interest-earning participants such as bond holders, gilts, and perhaps even preference shares should arguably have their return reflected as an outside cost.

Another, and perhaps the strongest argument, is that no company would view interest paid as anything else but a cost and a burden to a company. Although one is tempted to paint tax with the same brush, government tax is clearly part of distribution because it depends entirely on the size of the cake. This is very different from a guaranteed price for the use of someone’s money.

The treatment of interest paid as an outside cost follows the same logic as the treatment of interest earned. Even in the British format, this is shown as part of income in the top line (sometimes separately.) If interest earned is part of the top three lines then surely interest paid must be as well. Otherwise one would have to show interest earned as a negative under “providers of capital”.

A further argument for viewing interest as an outside cost is that lending institutions also add value in their own right. The largest part of the wealth created by a bank for example lies in the difference between interest earned and interest paid. If interest paid becomes part of the value distribution by a company in debt, then on a national level, we are guilty of double accounting.

Treating interest as a beneficiary of wealth distribution probably comes from the need some years back to reflect wealth distribution primarily as a tussle between labour and capital. This need has died with the collapse of the Berlin wall. But if this still had some validity then we would have to argue for the inclusion of a whole host of labour activities that are currently part of outside costs, to be included under employees. Contractors, sub-contractors, consultants, advisors and others could all be classified as “labour”. This is clearly not logical.

For many companies, interest is not a major issue, but for some who are funded by loan financing like bonds (such as Eskom) it makes a significant difference.

Showing interest as an outside cost and a “reducer” of wealth creation can influence behaviour that can affect working capital. Operational principles like “just in time”, unnecessary stockpiling of materials and finished goods, OTIF, debtor control and general cash flow considerations lose their impact if interest paid is viewed as part of wealth creation itself. After all, it could be argued, the more interest we pay the bigger the cake!

INCOME:

The difference between the terms sales, turnover, income and revenue, is often not understood. As these terms are often loosely used and defined in-house, we suggest following the top line of the income statement and explaining the components of the category in a first and repeated communications.

One client initially attempted to include VAT in turnover and then reflect it as part of tax in wealth distribution. The value-added statement should be ex VAT. If one wants to make a point about total tax paid, then one can always share the knowledge that about 14% of Value-added or wealth created is collected on behalf of the government and paid over to the taxman. Better still, get the actual number and share this with interested parties occasionally.

OUTSIDE COSTS:

Outside costs or outside supplies are simply all of those things you bought from others who are not part of the company “family.” There are many pitfalls in compiling the outside costs figure. Apart from the omission of interest paid some equate the figure simply to variable costs or raw materials. This is an obvious direct link to the standard accounts. There are many “fixed costs” that come from outside suppliers, such as electricity, telephones, stationery, etc.

Not all things bought from outsiders, however, should automatically be included in this category. Car purchases or leases intended as an employee perk, for example, should be classified under the employee share. We know of one company that has put training as an outside cost. The logic being that it’s training is outsourced. Again this is obviously part of the employee share. Being rewarded in kind is still part of the reward.

VALUE-ADDED:

Value added or wealth created is a measurement that clearly stands on its own. There is a danger at certain levels that it is seen to be synonymous with “profit”. Because of its importance to the company as a whole, there should be no misunderstanding around this figure. Use of terms such as “is this adding value?” or “what value did you add today?” should become part of everyday language and operational discussions. Employees at one of our sites often refer to “the pie” in discussing influences on wealth creation. There is a familiarity around the concept that “the bigger the pie, the more there is to share.” This kind of familiarity and constant awareness of the need to enhance wealth creation creates the climate for a spontaneous movement towards flexible pay and gain sharing.

EMPLOYEES:

This measurement should reflect everything that is spent on employees: salaries, wages, benefits, P.A.Y.E, training etc. Pressure has been mounting to split the measurement up into categories of employees, particularly to distinguish between management and general workforce. In most cases we have found that such a split says very little because despite differentiated pay, the largest part of this slice of the cake goes to the workforce in any case. It is wise to avoid additional lines in the standard seven-line format. If additional information is required, it can always be reflected as “sub-scores” on an expanded Value-added scoreboard.

Another temptation is to show employee pay less P.A.Y.E. and to add the P.A.Y.E to the “TAX” heading. This is clearly not correct and I’ll deal with this under tax.

SAVINGS:

Savings are made up of retained income and depreciation. If ever there were a case for an additional line then reflecting these two separately would be it. But we think that the potential of creating confusion is not worth the risk. To accommodate the need for additional information at certain levels, we have shown the break up just left of the main “savings” figure. This can be important where one wants to show the coincidence between the income statement profit figure and the value-added statement. Profits are calculated simply by adding retained income to the dividend paid.

While we have followed the British standard regarding savings, a strong case is often made to show depreciation as an outside cost. It is argued that in spirit, depreciation simply means “paying off” a capital item that was bought from an outsider in the first place. It is also argued that it is not logical to show a lease payment as an outside cost, if repayment of equipment is part of savings. The argument is then pushed to the ridiculous by claiming that rental should also be part of “savings”. Two other supporting arguments for classifying depreciation as an outside cost are that because depreciation in essence is the “cost of wear and tear” of equipment from an outside supplier, it clearly is an outside cost, and removing it from savings will be a fairer reflection of the way savings has strengthened the company. Obviously, removing depreciation from savings avoids confusing changes to wealth distribution as plant is written off. It would also facilitate sensible comparisons between wealth distributions of similar companies because it eliminates the need to consider age of plant etc.

Unfortunately, the case for categorising depreciation as an outside cost is not as clear-cut as the argument to make interest an outside cost. It becomes even more complicated if companies provide for additional depreciation as “replacement cost” in line with inflation accounting and prudent provision for imported equipment. In essence, the logic is that the company owns the equipment, and if depreciation represents a kind of repayment for the initial capital outlay, then it should in spirit be part of savings. A new guideline from the accounting profession is needed. I am aware that the British designers opened this can of worms in the 70’s and they appear to have followed the latter logic.

TAX:

This heading reflects company tax mainly. It should also include other government payments such as local government levies. We favour inclusion of expenditure on genuine social investment programmes that are not primarily intended as “promotional” activities. While VAT is clearly not appropriate here, the argument is less certain for other direct taxes such as customs, excise, import tariffs etc. Where possible, these should rather be reflected either as an as an outside cost, or better still, as a reduction in income, because inevitably these taxes are, like VAT, reclaimed from the buyer.

The argument that P.A.Y.E should be taken out of the employee share and added to this category has little, if any, validity. The principle is that company taxes are a reflection of the company’s relationship with the government, and personal income tax the relationship between the individual and his or her government.

Many who feel oppressed by the tax burden often frown upon classifying government as a “contributor” to wealth creation. This is a value judgement that does not detract from the principle that the primary function of government is to create the conditions for maximum wealth creation. Influencing wealth distribution in society through the tax mechanism is a much lower-order secondary function. Government’s income from company tax is totally reliant on the size of value-added, and therefore one could not conceivably classify government as an outside supplier. In some cases, of course, this could be valid where there is a “user-pays” fee implied in a particular government or para-statal service.

SHAREHOLDERS:

Shareholders, owners or simply “the dividend” category should be clear. Unfortunately it is also often muddied by other obscure considerations. I have had extreme difficulty in persuading some fully owned subsidiaries to put “head office” costs as an outside supply because these costs imply paying for a service or support function from another, albeit the owner.

This category can also be complicated by different categories of shareholders, but this is rare.

Customising the value-added statement down to different units in a business is indeed possible and we have done so effectively in operations such as a retail chain, where value-added statements were produced for individual stores. Separate statements, however, depend entirely on the logic behind practices such as transfer pricing. These have to meet strict criteria to ensure that the value-added statement itself has integrity.

Sensible wealth distribution is an extremely important requirement in supporting growth and optimum wealth creation. It is a pity that not much can be gained from trying to compare distribution patterns between different companies in similar industries. There are too many variables.

But sensible wealth distribution can easily be judged by the two criteria of meeting legitimate expectations and encouraging continued contribution. Expectations are not arbitrarily created by a particular vested interest. To be legitimate they have to be shaped by market forces and a recognisable reality.

Encouraging continued contribution is likewise the outcome of a carefully designed strategy that must be subject to fairness and recognising the contribution of others.

Support by the accounting profession for the wider use of the value-added statement and establishing more sensible guidelines on its format, will go a long way to enhancing transparency and economic awareness. More importantly, it could make a valuable contribution to greater workplace harmony and enhanced national prosperity.