KEY ADVANTAGES OF AVM METHODOLOGY

(C) Oleg Cheremnykh, 2006. All rights reserved cheremnykho@cnt.ru

Managing an organization essentially involves just two steps:

  1. Establishing the fundamental objective for managing an organization

  2. Establishing a business management system (or simply a “business system”) necessary to achieve the previously established fundamental objective

Naturally, if the fundamental management objective (FMO) is not formally established (i.e. missing) or is simply wrong (in other words, contradicts the objective reality) or if there are more than one fundamental objective (which immediately creates an internal contradiction and conflict), the organization will be inefficient (sometimes grossly inefficient) in terms of utilization of its resources – human, financial, material/tangible and intangible.

Unfortunately that’s exactly what happens with many (if not most) modern organizations – commercial, government and non-profit. Therefore, if one can find a way to remedy this unfortunate situation, it will radically improve the efficiency and productivity of a large number of organizations, creating an enormous amount of financial and other value as the result.

Hence, formulating a much more ‘natural’, objective and common-sense – based FMO and developing a methodology and tools for reaching this objective is a highly attractive investment opportunity.

Let’s see why the ‘traditional’ FMO (and the corresponding methodologies) leave much to be desired and why the Aggregate Value Maximization (AVM) is an FMO far superior to its ‘rivals’.

A list of these rivals, interestingly enough, is very short as in ‘traditional’ business management methodology the FMO is typically expressed as maximization of one of the following fundamental performance indicators (FPI):

  • Net income (net 'accounting' profit)

  • Stock price

  • Free cash flow available to investors

  • Shareholders’ value (financial value)

Situation with government entities and non-profit organizations is much worse as each of them typically performs more than one function (provides more than one product or service) and thus (in ‘traditional’ management methodology) it is simply impossible to specify a single FMO (and a financial FMO is out of the question due to the very nature of such organizations).

Net income is not a good FMO for a very simple reason: a company can be perfectly profitable (in fact, very profitable) and at the same time perfectly bankrupt (if, for example, a large enough amount of profit is tied in accounts receivable).

Besides, net income can be too easily manipulated by ‘creative accounting’ (for this reason GAAP was nicknamed ‘BAAP’ which stands for ‘barely acceptable accounting principles’).

Stock price is not a good FMO either: first, because it makes sense only for public companies and second, because stock price is heavily influenced by market forces which company management is totally unable to influence (let alone control).

Free cash flow available to investors is a much better FMO; however, it has at least two fundamental deficiencies. First, it is based on the accounting principle of a ‘going concern’ (unlimited life span) of a business entity. Unfortunately, in today’s economic environment with a very high (and ever-increasing) rate of mergers and acquisitions most companies can expect a finite, rather than infinite life span (in other words, most of the companies will be acquired by stronger rivals).

Therefore, FMO must take into consideration the very real possibility of an acquisition of the company and give its management the methodology and tools for maximizing the value of such acquisition. Free cash flow does not allow that.

Shareholders’ value (financial value) of the company is the FMO that solves this problem (if the company valuation model is properly constructed). The only problem with this FMO (as with any other financial FMO) is the fact that financial value depends not only on some financial performance indicators (PI), but also on a large number of non-financial PI.

And in many cases it is simply impossible to uncover (‘visualize’) the logical chains that connect non-financial PI with the financial value of a company. In other words, we know that by maximizing a certain non-financial PI we are increasing the financial value of a company, but we can not tell exactly how it happens.

Therefore, financial value as an FBO does not allow to build a comprehensive and well-integrated system of performance indicators necessary for maximizing the efficiency of a business enterprise. Besides, the concept of financial value is simply not applicable to government and non-profit entities which does not allow to develop a management paradigm, methodology and tools which can be uniformly applied to all types of organizations.

Fortunately, this paradigm not only exists, but it is also much more ‘natural’ and comprehensive and makes much more sense than any ‘traditional’ (financial) FMO. It is based on a very simple observation – that in order to survive and prosper, an organization must satisfy the needs of not just its ‘clients’, but all of its key stakeholders – consumers, suppliers, partners, government entities, mass-media, business community, etc.

According to another simple observation, every need of every stakeholder falls into one of the three categories – financial, functional or emotional. And higher is the degree of satisfaction of the corresponding need, the higher is the corresponding value for this particular stakeholder.

Indeed, entrepreneurs start businesses to make money (create financial value); to establish a company or companies producing some goods and/or services (create functional value) and to enjoy the process (create emotional value). In other words, entrepreneurs start businesses to create aggregate value (financial + functional + emotional). When appropriate, emotional value can be subdivided into emotional value proper and spiritual value.

Employees come to work for businesses to make (hopefully, earn) money (create financial value), do something useful to others (create functional value) and to enjoy the process (create emotional value).

Stakeholders enter into relationships with the company to satisfy their financial needs (create financial value); to obtain products and/or services that satisfy their functional need (create functional value) and to enjoy the process (create emotional value).

Moreover, clients and other stakeholders choose vendors of these products and services based on expected amount of aggregate value to be received as the result of the corresponding transaction.

Therefore, in order to stay ahead of the competition (i.e., to survive and prosper), an organization must maximize the amount of aggregate value it creates for its key stakeholders. Therefore, maximization of its aggregate value to all of its key stakeholders is the natural fundamental management objective of any organization.

Interestingly enough, if one closely looks at the actual behavior of organizations (regardless of its formal FMO) and the corresponding set of their actual key performance indicators (KPI), one will easily find that successful organizations do try to maximize their aggregate value to all of its key stakeholders. In other words, although de-jure an organization can have other PI as an FMO (or no FMO whatsoever), de-facto, its FMO is aggregate value maximization (AVM).

The only problem is that (because few, if any, organizations formally acknowledge aggregate value maximization as their FMO), they are using an incomplete set of KPI and the resulting system of KPI is not well-balanced.

As the result, their management systems are not as efficient as they could have been. Therefore, formal acknowledgment (‘declaration’) of aggregate value maximization as the FMO of an organization amounts to ‘legitimizing’ what is already going on (calling a spade a spade and making explicit what is already implicit).

A formal approach to AVM will allow to develop a complete, well-balanced and well-integrated system of KPI, establish a proper corporate culture (a very important component of a highly efficient organization) and provide tools for adequate aggregate value measurement and management.

changed January 7, 2008