Managing for Profit

The Added Value Concept

R. R. Gilchrist

• Publisher: Taylor & Francis
• Year: 2018
• Print ISBN: 9781138566361
• eBook ISBN: 9781351343466
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

In this book, first published in 1971, the author develops and tests a productivity system based on Added Value as the measure of company income and output. The theory behind the system is that the behaviour of a company can best be explained in terms of its need to create an income. From this, it follows that its effectiveness depends on the efficiency with which it uses all the resources at its disposal to create this income. If it is accepted that the need is to create an income, then the efforts of the employees, the objectives of individuals, the pricing procedures, and the control systems must be co-ordinated to achieve this end. This title will be of interest to students of management, economics, and business studies.

Chapter 1

The Nature of Company Income

The purpose of industry is the fulfilment of human needs. If industry can find customers for its products, sell these products at a profit, and operate within the limitations set by its social obligations, then it can justly claim that these needs are being satisfied.

No company can long survive without profit. Profit is the ultimate measure of effectiveness. A profitable company is likely to offer not only security of employment, but also promotion prospects, job opportunities, and the intense personal motivation that comes from being associated with success.

Mankind is insatiable in its desire for material possessions, as is industry in its search for markets. It is industry that makes and sells the consumer goods so coveted by the public, and it is the incomes generated within society that provide the means of purchase. If industry is efficient, goods will be freely available, at prices acceptable to the consumer. People will enjoy the high standard of living that is the direct result of high productivity. If industry is inefficient, then goods will be in short supply, prices will be high, and people will be discontented.

In the industrial context, efficiency and productivity are virtually synonymous. Each relates to the output resulting from a given input, and the need for constant productivity improvement is both a challenge and an objective to everyone concerned with the prosperity of industry. Assuming a steady level of employment, the standard of living of a nation is a function of its labour productivity, and the relationship between productivity, incomes, and prices has been so well publicized in recent years that few people are entirely ignorant of it.

We have already said that the purpose of industry is the fulfilment of human needs, but it must be admitted that most people find it difficult to equate abstract definitions with the severely practical aspects of their daily tasks. Theory is all very well, but the duty of management is to achieve results, and one must be very clear about the nature of these results before one can measure progress towards them. Without doubt, the final result must be profit, and a business can only earn a profit if it is able to utilize its resources effectively, harness the skills and abilities of its employees, innovate, exploit new markets, and locate and develop new opportunities. It must know its strengths and weaknesses, where it is going, and how it is going to get there.

A business has many resources, each of which is an integral component of successful operation. For example, a manufacturing company has buildings, machines, tools, handling equipment, raw materials, stocks, and many other items which contribute towards the finished product. The essential basis of every cost reduction programme is that it should reduce the resource content of the finished product so that, for a given selling price, the profit content will increase. Here we have the real fundamental of company operation, namely, that a business has only a certain income available to it. If it allocates too much of this income to labour and the other items of cost, then too little will remain for profit. An unsatisfactory profit implies an unsatisfactory cash flow, and if this is inadequate the company will be unable to replace machines, purchase new equipment, or provide additional working capital for expansion.

As we shall see in later chapters, the true income of a company is obtained by deducting, from the value of sales, the value of all raw materials and other bought-out purchases. This income represents the fund from which all wages, salaries, and profits must be paid, as well as other items of operating expense, such as rent, rates, and depreciation. The name given to this fund is ‘Added Value’.

Added Value* has long been used by national statisticians for measuring the income – and hence the output – of a country, but it is only comparatively recently that companies have become aware of the great potential inherent in the Added Value concept as a tool of management. A result of this has been the recognition that the creation of Added Value is a primary business objective. Companies such as Laporte Industries, Delta Metal, and High Duty Alloys have done much valuable work in the development of Added Value control ratios for performance appraisal-an area of particular relevance to holding companies, where the problem of controlling a number of diverse operating companies poses very real difficulties.

The creation of Added Value is an objective which ought constantly to be in the minds of company executives. Whenever decisions are taken, the acid test of their effectiveness will be whether they have resulted in an improvement in the Added Value per unit of resource input. Eventually, of course, greater effectiveness must result in increased profits, but this may take some time to happen. The reason for this is that profits are volume sensitive, that is, they are affected by changes in output. The lower the output, the higher the fixed costs per unit of output, and the lower the profit. Conversely, the higher the output, the higher the profit.

Every investor is aware of the fact that adverse trading conditions generally cause a decline in profits. Because of this it is not easy to assess the true profit potential of a company simply by looking at the published accounts for a given year. It is much more meaningful to analyse results covering several years, so that trends may be established, and conclusions inferred regarding the progress of the business. In the short term, it is not possible to judge the performance of a company on profits alone. Profits are the effects resulting from wise decisions; it is the causes relating to these decisions which the company analyst must endeavour to understand.

Business prosperity depends on many factors, all interwoven and difficult to disentangle. Some are subjective, consisting of intangibles such as company image, market standing, technical expertise, customer satisfaction and quality of product. Others are more factual, such as cost of production, raw material utilization, labour and capital productivity, and price levels. These are all measurable, and indeed must be measured if a company is to be controlled. There are examples of companies which operate on the intuition of the chief executive, but these are becoming much rarer as industrial life becomes ever more competitive. They are becoming rarer either because companies have found intuition to be unsatisfactory, or else because they have gone bankrupt.

By far the most difficult aspect of business administration is concerned with taking decisions, particularly in the subjective areas where opinions may differ, facts are in short supply, and action is necessary. A good management accounting system should enable senior executives to locate areas of developing inefficiency, whether these relate to people, to machines or to any other element of production cost. It is easy to know when things are going wrong. It is very difficult to know what should be done about it. This is where managerial expertise and flair are vitally necessary, for without these characteristics the best information system ever developed will be sterile and useless.

The universal sales and cost equation relating to a company trading at a profit is:

Value of Sales=Cost of external purchases+Labour Cost+Fixed Costs+Profit

The external purchases represent the value of everything the company has bought. They include raw materials, tools, consumable stores, electricity, gas, coal, fuel oil, acid, and other similar items used to convert goods from one form to another. In other words, if we deduct these variable costs from the value of sales, we obtain the Added Value. We can, therefore, rewrite the equation as follows:

Profit=Added Value−(Labour Cost+Fixed Costs)=Net Income−Operating Expenses

The object of quoting this equation is simply to stress that Added Value is the net income of a company, after it has paid all its external suppliers. Once this is fully appreciated, it will be apparent why company control systems should be designed to focus attention on the relationship of operating costs to Added Value, rather than on the more customary relationship of costs to Sales Value.

To maximize Profit we need to maximize Added Value. This must be the objective, and all a company’s policies should be directed to this end, provided always that it does not achieve the end at the expense of its social obligations.

During the nineteenth century economists became increasingly concerned about the possibility that private monopolies could control trade within a country, and Karl Marx believed that it was inevitable that more and more of a nation’s wealth would be accumulated by fewer and fewer enterprises. Both these attitudes were largely conditioned by fear of the disproportionate power which could be wielded by those in charge of large concentrations of wealth.

In recent years there has been renewed concern regarding the dominance of large public companies. In America, the top 200 companies employ one eighth of the total U.S. labour force, and own just under one quarter of all industrial assets. The largest of them all, General Motors, has an annual sales turnover exceeding the national product of all but a few nations. The power wielded by the President of General Motors, and the effect his decisions can have on the well-being of many hundreds of thousands of employees, is awe-inspiring indeed.

Power is undoubtedly an extraordinarily strong motivating factor. Power and a sense of achievement are complementary. One is reminded of the leading industrialist who said,’ I love my job because of the power I wield. If the company stopped paying me, I think I would be prepared to carry on for nothing.’ That this industrialist was exceptionally honest and hard working no one can deny. Yet society could well ask whether a similar man, with fewer scruples, would hesitate to act in a thoroughly anti-social, and even dishonest way, if this were the means of retaining his power.

The purpose of industry is the fulfilment of human needs. The source of this definition is paragraph 3 of the Marlow Declaration, signed in 1962 by a group of industrialists, trade union leaders, Church and Government representatives. These men considered that it was their duty to try to define the responsibilities of industry, in the hope that their creed would give guidance to others. Few people now remember the Marlow Declaration, which is unfortunate, as it was a sincere and honest attempt to define an industrial philosophy. It stated that industry has five responsibilities, namely to the employee, the shareholder, the consumer, the local community and the nation. These responsibilities were further amplified as follows:

To the employee: Fair wages, security, status, comradeship, scope for self development and self fulfilment. Good and safe working conditions. Pride in skill, and a sense of belonging. Value to others of work done.

To the shareholder: A fair and reasonable return on invested capital.

To the consumer: Good quality at a fair price.

To the local community: To be a good neighbour, taking a constructive interest in local affairs.

To the nation: The proper and productive use and development of resources, both human and material, for which it is responsible.

An enterprise, if it is to remain in business and generate employment, must make profits, and must constantly strive for ways and means of reducing costs. There is always a better way, and the search for this must be unending. Nevertheless, in a world where it is increasingly fashionable to question motives, no company can afford to remain indifferent to its social obligations, or to pursue profit with scant regard for human dignity. The belief that the end justifies the means is no longer acceptable in a free society, and the company that neglects public opinion in its business transactions does so at its peril.

* Also called Value Added. In this book, the term ‘Value Added’ is used in the context of company taxation only.

Chapter 2

Men, Motivation and Money

It is generally assumed that the main reason why people go to work is for the money they earn. This is true in that no one would be prepared of his own free will to work for nothing – unless of course he had a private income, and there was some other factor, such as the enjoyment of power, which was all-important.

While it is almost certainly true that people go to work for the money they can earn, it would be untrue to assume that money is necessarily the most important factor leading to job satisfaction. Too often this is assumed to be the case, and as a result there has developed the widely accepted philosophy that, by offering the opportunity of monetary reward, people will behave exactly as required.

Between 1958 and 1963 the author had the opportunity of talking to several hundred supervisors, in groups of about twenty, in the Wolverhampton, Birmingham and Coventry areas. During these talks the supervisors were asked to fill in a questionnaire, so as to find out what they thought were the matters of greater or lesser importance to workpeople on the shop floor.

Before the forms were completed, it was stressed that the supervisors should put themselves in the place of the shop floor personnel they supervised. The object was to find out what the supervisors thought were the attitudes of those they supervised, and not what the supervisors thought themselves.

The supervisors were given a form which listed eight factors which the shop floor employees were likely to consider as having some relevance to their jobs. To illustrate the thinking behind the questionnaire, the case of two factories, A and B, operating in the same town and in the same street, was first considered. Factory A pays 10 per cent more money per hour than B. If both are short of labour, why do not all the employees at B queue up for jobs at A? If they do not do so, presumably there are a number of other factors concerning their jobs at factory B which are considered important. It was to ascertain the supervisors’ views on this that the survey was conducted.

The list of elements of job satisfaction comprised eight items as follows:

ELEMENTS OF JOB IMPORTANCE

Element

1. Prospects of promotion.
2. Good wages.
3. Good working conditions.
4. Sympathetic and helpful treatment with personal pr...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Contents
• Preface
• 1 The Nature of Company Income
• 2 Men, Motivation and Money
• 3 Incomes and Employment
• 4 Prosperity and Productivity
• 5 The Added Value Concept
• 6 The Productivity of Labour
• 7 The Employee’s Share of Company Income
• 8 The Productivity of Capital
• 9 Costing and Cost Standards
• 10 Budgeting
• 11 Budgetary Control
• 12 Pricing for Profit
• 13 Incentives for Profit
• 14 Prosperity and the Executive
• 15 Company Income and the Value Added Tax
• Further Reading
• Glossary
• Index