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Finance and Accounting 3

Posted by Stephen E. Roulac, Phd on Feb 10, 2020 4:56:40 PM

Stephen E. Roulac, Phd

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Misapplication of Economic Value Added Concept
Many companies have embraced the notion that the economic-value-added concept is superior to the traditional performance assessment measures based on traditional accounting.

Economic value added, known by the acronym EVA, is a financial measurement metric that considers the relationship between the enterprise’s profitability and the cost of the capital employed to achieve that profitability. The idea behind EVA is that managers should be evaluated in terms of how effectively, productively and profitably they employ capital in the business. To evaluate profit alone without considering the cost of the capital employed to achieve that profit can be very misleading. But if the relevant content and timing factors are not appropriately considered, EVA calculations can be as distorting and misleading as traditional profitability measures.
In one instance, a comparison of an EVA calculation of a real estate development venture to an EVA calculation of a consumer finance activity was severely flawed because the differing contexts and time horizons of the two businesses were not sufficiently considered in the EVA analyses.

Relying on a misapplication of EVA performance assessment can be a mistake.

Confusing Volume with Profit
Many companies have the attitude that if they achieve enough volume, profits will take care of themselves.

At the end of the day profit is the primary financial metric of concern to a business. If your business is fixated on what will maximize profit, you have a far better prospect of achieving your desired profit objectives than if your business if fixated upon volume. Although a larger volume business will generate more profits than a smaller business with the same profit margin, if you do not confirm that the business is profitable, volume alone will not get you there.

Emphasizing volume rather than profits can be a mistake.

Disregarding Importance of Economic Environment
A company’s ability to be successful is very much a function of the economic environment in which it operates.

If a company is operating in a very difficult, challenging economic environment its chances of achieving outstanding business performance are fundamentally constrained by the condition of the economy. As long as the economy is difficult, the company’s chances of achieving outstanding results, from a business as usual approach, are going to be limited. In certain circumstances, the company may want to consider redirecting its business to those products or service offers that may be more positively received in that economy, allocating resources to markets in other economies that are not constrained by the difficult home economy, and/or advocating public policies to improve the economy.

To consider business as usual, irrespective of the condition of the economy, is a mistake.

Refusing to Spend Money to Make Money
Some companies, when faced with financial pressures, cut spending.

The thinking behind cutting spending, when faced with financial pressures, is the imperative to reduce out-going expenses and husband financial reserves. As important as cost containment can be, there is a maxim in business that you have to spend money to make money. Indeed, a major motivation for company spending is to invest in tools of production to reduce costs of production rather than to expand output. Companies unwilling to make such expenditures may be unable to reduce costs.

To decline to spend money to make money can be a mistake.

Forgetting to Confirm That You Are Actually Using All That You Are Paying For
In business it can be all too easy for there to be a disconnect between what is paid for and what is actually used.

Just because a business pays for something doesn’t mean that it is actually used. It can be all too easy for a payment arrangement to become institutionalized, to become part of ongoing regular procedures, and a standard feature of the budget. But it may be that what is being paid for is no longer utilized. Maybe what is being paid for served the needs of an activity or division or individual that is no longer involved in the company. Just because you are paying for something does not necessarily mean you are using it.

Paying for something that you don’t actually use is a mistake.

Too Much Legacy Expense
Legacy expenses are those expenses that derive from prior activities and prior investments, rather than present business and investments for the future.

Legacy expenses reflect decisions made in the past and obligations undertaken in the past. Companies that have disproportionate legacy expenses, relative to the present and future, are at a significant competitive disadvantage to those that are not similarly burdened. If disproportionate resources are spent paying for the past, relative to the present and the future, the capability of the company to be effective is compromised.

Too much legacy expense is a mistake.

Expending too Many Resources on Problems
It has been said that business is all about solving problems.

Superior executives are superior because of their ability to solve problems. But problem-solving is not the only thing that business is about. Business also involves identifying and exploiting opportunities. Peter Drucker once observed that companies should survive problems and concentrate on opportunities. If you spend too many resources on problems, you may not have sufficient resources remaining to pursue opportunities.

Spending too many resources on problems can be a mistake.

Miscomprehending Direct Costs
Many in business miscomprehend the difference between direct costs and full costs.

Direct costs are the incremental costs involved in delivering a product or delivering a service. Direct costs are the costs involved in adding additional units of production or service delivery, as contrasted to full cost, which includes not only the incremental direct costs, but also other costs including investment return, overhead expenses not directly related to that transaction, and the capital invested in that particular venture. In some instances, full costs are much higher than direct costs, sometimes many multiples higher. Decisions made without comprehension of full costs can lead to bad decisions.

If you do not understand the difference between direct costs and full costs, you may be
making a mistake.

Decision Based on Weak Cost Information
Many companies operate with weak cost information.

If your cost information is weak, your decisions may be weak. If you do not know what your costs are for different volumes of business, different product lines, different times of the year, and different circumstances and conditions, you may make decisions that are very different than the decisions you would make, if you had that knowledge. Strong cost information is crucial to effective business decisions.

Making decisions on the basis of weak cost information is a mistake.

Confused by Sunk Costs
Economic theory holds that sunk costs can be irrelevant to decision making.

Sunk costs are those costs that are already spent and therefore cannot be recovered. The idea behind the irrelevancy of sunk costs for decision making is that one should consider only incremental costs and benefits from this point forward. Decision making should be based on a forward-looking rather than backward-looking perspective.

To concentrate on that which has already been spent and cannot be recovered, is a mistake.

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