Management Accounting Research 14 (2003) 235254

Value Based Management practicessome evidence from the eld

Teemu Malmi , Seppo Ikheimo
Department of Accounting and Finance, Helsinki School of Economics, P.O. Box 1210, FIN 00101 Helsinki, Finland Received 31 July 2001; accepted 10 June 2003

Abstract Value Based Management (VBM), and especially Economic Value Added (EVATM ),1 has attracted considerable interest among organisations in recent years. These concepts can be applied to capital budgeting, valuation, management control, and incentive compensation. Despite the growing number of applications, we have only limited independent research-based evidence on how these concepts are actually applied. However, this can be considered not only an essential step in research investigating the benets of VBM [cf. Ittner, C.D., Larcker, D.F.,1998. Innovations in performance measurement: trends and research implications. Manage. Acc. Res. 10, 205238], but also on its limitations. With the aid of six Finnish-based organisations from ve different industries, we illustrate the diversity of actual use of VBM. Our results indicate that for some organisations VBM is merely rhetoric, while for others it seems to have an impact on both decision making and control system, taking various forms from one rm to another. In some organisations, application of VBM is restricted only to the highest levels of hierarchy, whereas in others it covers the whole organisation. However, in none of the studied organisations is VBM applied in as comprehensive a manner as suggested in the normative literature. This multitude of different ways in which VBM is actually used in practice raises some problems regarding the study of VBM and its benets. In particular, the adoption of EVATM , as measured with EVATM based bonuses [see e.g. Wallace, J.S., 1997. Adopting residual income-based compensation plans: do you get what you pay for? J. Acc. Econ. 24, 275300; Kleiman, R., 1999. Some evidence on EVA companies. J. Appl. Corp. Finance 12, 8091], is seriously challenged. 2003 Elsevier Ltd. All rights reserved.
Keywords: Value Based Management; Economic Value Added (EVATM ); Field study; Management control practice; Decision-making practice

1. Introduction Value Based Management (VBM) and especially Economic Value Added (EVATM ) has attracted considerable interest among organisations in recent years. Ittner and Larcker (1998) discuss innovations in
1

EVATM is a trademark of Stern, Stewart and Co. Corresponding author. Tel.: +358-9-43138471; fax: +358-9-43138678. E-mail addresses: malmi@hkkk. (T. Malmi), ikaheimo@hkkk. (S. Ikheimo).

1044-5005/$ see front matter 2003 Elsevier Ltd. All rights reserved. doi:10.1016/S1044-5005(03)00047-7

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performance measurement in their recent article, selecting economic value measures as one of the three main themes that should be focused on by researchers. They nd the long-term benets of economic value measures to be the most pressing research topic under this theme. Within this theme, the relatively scarce academic research examining the use of VBM has mainly compared the success of rms having adopted VBM to those that have not (Wallace, 1997; Kleiman, 1999). Wallace (1997) found that those companies using EVATM or other residual income-based measures as the basis for incentive compensation had higher levels of residual income than the control rms. Kleiman (1999) focused on EVATM adopters (most of which had compensation tied to EVATM ) and found their stock market performance to be signicantly better than that of their industry competitors. These research settings implicitly assume that VBM or EVATM is applied similarly in each organisation and that the use of EVATM as a basis for compensation is a strong indication of true EVATM adoption. In the other areas of management accounting, evidence shows the divergent use of management accounting methods, such as ABC and Balanced Scorecard (Gosselin, 1997; Kaplan and Norton, 2001; Malmi, 2001). Thus, one may expect that companies could vary with respect to their VBM use as well. Such variation has even been acknowledged in the normative VBM literature (Martin and Petty, 2000, pp. 228229), though the precise nature of these differences remains unexplored. Nevertheless, differences in use might have important implications for study of the long-term benets of VBM or EVATM , since the performance implications may depend upon the nature of the use. The aim of this study is to nd out how the concept of VBM is applied in practice. We will rst examine the normative literature on VBM, attempting to identify core elements of VBM. We will then examine organisations that have publicly announced their adoption of VBM. Differences between the normative literature and the actual practices could thus provide us with insights into how to study the benets of VBM. The paper is organised as follows. Section 2 describes normative literature on VBM. Our research method is discussed in Section 3, and Section 4 presents the analysis of empirical material as well as the results. The results and further research are discussed in the nal section.

2. Value based management literature It is not quite clear what we should understand by the term VBM. In the following, we rst discuss the framework presented by Ittner and Larcker (2001). We then examine the main arguments as presented in the normative literature, and conclude by presenting the framework to be used in our empirical inquiry. Ittner and Larcker (2001), building on normative VBM literature, suggest that VBM consists of six basic steps: 1. Choosing specic internal objectives that lead to shareholder value enhancement; 2. Selecting strategies and organisational designs consistent with the achievement of the chosen objectives; 3. Identifying the specic performance variables, or value drivers, that actually create value in the business given the organisations strategies and organisational design; 4. Developing action plans, selecting performance measures, and setting targets based on the priorities identied in the value driver analysis; 5. Evaluating the success of action plans and conducting organisational and managerial performance evaluation;

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6. Assessing the ongoing validity of the organisations internal objectives, strategies, plans, and control systems in light of current results, and modifying them as required. Ittner and Larckers description represents a fairly good example of the normative VBM approach. In addition to the six steps outlined above, Ittner and Larcker (2001) suggest that VBM integrates various practices, including Balanced Scorecard and strategic management accounting systems. We consider such a broad view of VBM to be rather problematic, as it provides researchers or managers with little help in distinguishing between the various alternative approaches to building management accounting and control systems (cf. Otley, 1999). For example, Balanced Scorecards, or strategic management accounting, though sometimes applied together with VBM, can also be used for purposes other than shareholder value enhancement, e.g. in the public sector. Therefore, these should not be included under the concept of VBM. Let us next turn to the normative literature on VBM to examine the type of prescriptions that have been presented regarding the above six steps. The literature contains prescriptions on the design of a management control system, including objectives, performance evaluation, target setting and rewards. Moreover, a number of examples have been presented to illustrate how the adoption of VBM should impact on decision making, both at strategic and operational levels. This impact on decision making is partly assumed to be a consequence of adopting a certain management control system design, and partly as a consequence of using VBM related tools for assessing, e.g. strategic investments (see e.g. Martin and Petty, 2000). 2.1. Objectives, performance evaluation and target settingsteps 1, 3 and 4 (Ittner and Larcker, 2001) The goal of the company is to deliver value to investors (Knight, 1997, p. 4). This value creation process is best measured within the company using an economic prot metric, given the amount of total capital used to generate those prots (Martin and Petty, 2000, p. 81). The most commonly used metrics include the Economic Value Added (EVATM ) framework introduced by Stern Stewart & Co., and the Cash Value Added (CVA) model by Boston Consulting Group and Holt Value Associates (Martin and Petty, 2000, p. 111). These metrics and their value drivers should solely be used to evaluate performance from the top-tobottom of an organisation (Black et al., 1998, p. 90). By accounting correctly for the economics of the business and by subtracting the cost of all resources required to produce revenues, including the cost of capital, EVATM accurately captures the combined productivity of all factors of production in a single measure (Ehrbar, 1998). Traditional performance metrics such as earnings per share (EPS), book value (BV), return on equity (ROE), return on assets (ROA) and return on invested capital (ROIC) . . . do a poor job of capturing the three fundamental determinants of value creation: the amount, timing, and risk of the future cash ows of a company (Morin and Jarrell, 2001, p. 309), and the use of these accounting gures should be abandoned when VBM is adopted (Ehrbar, 1998, p. 67). In EVATM companies, target setting is based on calculations, rather than negotiations. Target setting is calculated from the current level of EVATM , taking into consideration any changes in the circumstances (Martin and Petty, 2000). Although zero-EVATM is the minimum acceptable level of EVATM , the inheritance effect remains in the target setting (Otley, 1999). At the lower levels of organisations, targets should be based on measures that can be affected by employees. Hence, the focus should be on the value drivers that simulate market value creation (Morin and Jarrell, 2001).

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2.2. Rewards In the VBM literature, it is assumed that target setting cannot be effective without linking it to compensation. Although the VBM framework introduced by Ittner and Larcker does not explicitly mention rewards, compensation has been one of the major themes in the normative literature. Moreover, researchers (Wallace, 1997; Kleiman, 1999) have used compensation tied to EVATM or other residual income metrics as a sign of true VBM adoption. Compensation strategy is an essential link between strategy formulation and implementation. A successful compensation strategy decomposes the business strategy into a series of value drivers and appropriate time horizons, and creates performance incentives to link employee actions with changes in the value drivers (Morin and Jarrell, 2001, p. 349). The fundamental premise underlying VBM systems is simple: what a rm measures and rewards gets done (Martin and Petty, 2000, p. 160). Stern Stewart & Co. recommends that bonuses be paid based upon changes in EVA rather than the level of EVA for the period (Martin and Petty, 2000, p. 171). This leads to constantly increasing requirements on the performance. The bonuses should be paid without any upper limit because more EVATM produces more wealth (Steward III, 2002). To avoid short-term focus, banking is advocated. In banked compensation plans only a portion of the compensation earned in 1 year is paid out in that year. The rest accrues in a bank and is paid out depending on the performance of later years (Morin and Jarrell, 2001, p. 356). Equity-based compensation, such as stock options, could be used to further align shareholder and manager interests (Martin and Petty, 2000, pp. 172173), but they should be targeted to higher level management, since for others [s]tock ownership is simply too abstract and too remote to have a strong inuence on behavior (Ehrbar, 1998, p. 99). Normal stock option plans are unnecessarily expensive since they pay for all increases in share price, as well as that caused by general changes in the market. Therefore, options should be granted with an exercise price that rises each year in line with the cost of equity capital. The number of options an executive gets each year is determined by the size of his or her EVATM bonus. In effect, the manager uses a portion of the cash bonus to buy the options (Ehrbar, 1998, p. 100). 2.3. Decision making These changes in the management control systems caused by adoption of VBM should lead to improved decision making within the company. Or decision making could change due to VBM adoption irrespective of the design of the control system, as suggested in normative literature (e.g. Morin and Jarrell, 2001). These decisions are made at different levels in an organisation. Matters of strategy, such as the question of which market your company should actually be in, are dealt with by the chairman, CEO and CFO; at the next level down, in strategic business units, decisions about capital expenditure and investment in (for instance) product development or new distribution networks are taken; while at operating unit level its a question of detailed planning and budgeting (Black et al., 1998, p. 90). 2.4. Selecting strategies and strategic decisionsstep 2 Morin and Jarrell (2001) argue that [t]he specic objective of the strategic analysis module of the VBM framework is to formulate appropriate value-creating strategies across all the business units of

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the company (pp. 219220). The VBM literature does not explicitly say anything about strategies per se. What VBM does, however, it offers tools to link strategy alternatives to shareholder value (e.g., on business strategy, Rappaport, 1999; McTaggert et al., 1994; Day and Fahey, 1990; and on corporate strategy, Trigeorgis, 1996; Porter, 1998; Oster, 1999; see Morin and Jarrell, 2001, pp. 219278). Strategic level decisions, like capital investments, acquisitions and divestments, industries in which to remain and where to invest, are solely outcomes of VBM metrics without any strategy decision making beyond VBM. These tools will be used, and strategising will be located, within the business units. Headquarters will become very lean with the dismantling of large strategic planning departments (Mouritsen, 1998). 2.5. Action planning and operational decisionsstep 4 It is argued that VBM will have little effect on corporate strategy, business strategy and operating-level decisions, as the same metrics and arithmetic are valid at all levels. Hence, at the operational level, VBM should lead to big changes in working-capital management and capital appropriations, since managers will automatically take into account the balance-sheet impact of their decisions (Ehrbar, 1998). 2.6. Summary The normative literature does not add much to the last two steps in the VBM framework presented by Ittner and Larcker. The prescriptions provided in the VBM literature relate both to the design of a control system, the types of decisions that are assumed to follow, as well as the heuristics to be used in the decision-making process. Hence, the literature suggests that VBM means the use of certain control principles, which are assumed to have an impact on decision making. On the other hand, the VBM
Table 1 Summary of normative VBM solutions for management control and decision making Dimension of VBM use Management control Objectives and strategies VBM solutions Maximisation shareholder wealth. EVATM metrics (or its value drivers) as a single goal throughout the organisation A value-creating strategy is the only possible solution, though silent about the type of strategy per se. Business units are responsible for strategic planning Performance measured using economic prot metrics and their value drivers from top-to-bottom. Other measures abandoned Improvement in the current level EVATM . Zero-EVATM minimum acceptable level. Target setting linked to value drivers Bonuses paid are based upon changes in EVATM . Bonuses have no caps. Banking to avoid myopia. Stock options only to top management with increasing target level in line with the cost of capital Based on EVATM calculations, no room for decision making beyond; acquisitions, strategic capital investments and divestments are made accordingly. Strategising within the business units Both balance sheet and income statements are considered, leading to improved capital investments and more efcient working-capital management

Performance measurement Target setting Compensation

Inuence on decision making Strategic decisions

Operational decisions

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literature also suggests that certain heuristics should be used in making decisions at all levels of an organisation. Therefore, to study the actual use of VBM in practice, it is not enough to study only the elements of the management control system. The actual decision-making process should be included in the analysis as well. Table 1 (rst column) shows the dimensions of VBM use, which will be next examined to identify similarities and differences in practice. The second column contains the VBM solutions for the topic, which will be compared to actual observed practices.

3. Research method Finnish companies provide an interesting setting due to their strong interest in VBM (PA Consulting Group, 1999). A survey by PA Consulting indicated that almost all (98%) CEOs of major companies in Finland accept the basic tenants of VBM, with as many as 17% actually applying the concepts in practice.2 To evaluate the application of VBM in Finnish companies, we conducted an interview-based eld study. The companies were selected on the following basis. First, we dened large, mostly multinational Finnish-based companies from different industries that have publicly announced their intention to apply VBM. We started our selection by identifying those rms having a competitor that did not rely on VBM in order to make effective comparisons. Accordingly, ve companies were eventually selected for inclusion in the study: Tamro (medical retailer), Pohjola (nancial services/insurance company), Huhtamki Van Leer (diversied/packaging), Cultor (agricultural/food processing) and TietoEnator (information technology). As Pohjola refused to participate in this study due to re-structuring of its operations, we opted to include Sampo in our study, after having discussed with its CFO about their intentions to apply VBM. We choose, as a reference case in the nancial sector, a large domestic insurance co-operative (Tapiola). As Sampo did not yet have any experience in using VBM, these two companies were subsequently excluded from our VBM analysis. Moreover, Oriola (medical retailer) which was not using VBM was included as a reference case for Tamro. It became evident, however, that such reference cases were of little use, and were thus excluded from this study. Nevertheless, as we proceeded with our interviews, it became apparent that we would need to nd more organisations claiming to apply VBM. Therefore, two further companies were included in our study: Raisio (Agricultural/Food Processing) and Sanitec (Porcelain/Bathrooms; a member of the diversied Metra Group). Thus, six companies were ultimately used to illustrate the diverse use of VBM among Finnish organisations. The companies are designated AF in order to retain anonymity. A brief description of each company is included in Appendix A. The companies are listed according to their level of VBM adoption, with Company A having the strongest commitment to VBM, and Company F the weakest commitment. The organisations are all fairly large with divisional structure. In some cases, VBM is adopted proceeding from the group level, while in others it is applied to one of the divisions. Some of our case companies
2 The survey included all listed companies in Finland, as well as those with a turnover of over FIM 1 billion (during the year 1999 FIM 1 varied between US$ 0.16 and US$ 0.2). A similar study was also conducted in the US and several other European countries. In these countries, the senior executives also believe that the key objective of senior management is to manage for shareholder value (in the US, 88%, in the UK, 96%, in the Benelux countries, 76%), whereas managing shareholder value was put into practice in a much smaller number of companies (in the US, 13%, in the UK, 5%, in the Benelux countries, 8%). These gures show that similar processes are also underway in other modern industrialised countries.

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have used VBM technology for several years; one has even abandoned it, while others have only recently implemented VBM. Data for analysis are gathered through interviews and written documents. In each company we interviewed the CFO. In addition, the persons responsible for corporate development, the CEO and business-unit managers were interviewed in some organisations. Altogether, 15 persons were interviewed. Interviews were semi-structured and lasted from 60 to 90 min. All interviews were tape-recorded. Written documents included annual reports, mission statements, internal memoranda/guidelines concerning such matters as the method of calculating EVATM and power point presentations used for internal training on VBM. We would like to emphasise that the evidence from this type of eld study provides only limited exposure to each organisation and should thus be considered preliminary. In many organisations, we could have actually interviewed more persons. For example, had top management argued for major changes due to VBM adoption, it would have been prudent to have also interviewed lower levels of organisations. However, since the messages focused primarily on more minor implications, we have little reason to doubt what these managers said. Moreover, since Finland is a small country, we also have, in addition to interviews, access to a number of other contacts within these organisations. These include in-house training, master thesis supervision, colleagues researching these organisations and friends in managerial positions. Hence, there are number of routes available to check the validity of given arguments.

4. Results 4.1. VBM and management control 4.1.1. Objectives and strategies A stated long-term goal for each company was to increase shareholder wealth. This is not surprising given the results of a PA Consulting Group survey (1999), which reported that almost all CEOs of major companies accept the basic tenants of VBM. Those companies that had adopted EVATM also indicated this in their annual report by either underlining the importance of shareholders or directly stating that the EVATM was adopted as a managerial control system to promote shareholder interest.3 VBM was adopted to foster two different strategic orientations. Two of the studied organisations emphasised growth as an essential means to ensure long-term shareholder wealth. Top management of these companies had found that the ROI as a divisional performance measure lowered the interest of successful divisions to invest. As a development manager of a divisional adopter (Company B) explains: EVA was adopted because it is good for business and aims for growth. ROI could have prevented acquisitions. EVA shows the acquisitions that create value. A similar comment was provided by the corporate CFO of a divisionalised organisation (Company F) regarding all types of investments: Growth easily stopped on high ROCE as division heads did not want to ruin it. This (VBM) helped growth, stimulated growth and investments. In four other organisations adopting VBM, the focus and motive for adopting EVATM , was on the efcient use of assets. In terms of capital investments and working-capital management, VBM was expected to direct more attention to the more efcient use of capital. Increased
In the recent study by Huolman et al. (1999), shareholder value was found to be emphasised in 59% of the company annual reports issued by the top 50 companies in 1999. The comparable gure was 37% in 1995 and 15% in 1990. This emphasis on shareholders is natural in our case companies, since they were selected based on their annual reports.
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foreign competition was regarded as forcing some of the interviewed organisations to improve their efciency. Our ndings indicate that shareholder value is emphasised in all our VBM companies. Given the results of the PA Consulting survey, this is not surprising. It also seems that VBM in practice is used to support two fairly different strategic orientations at the group level, while strategising is not delegated to the division level or to any other lower level of the organisation. 4.1.2. Performance measurement The success of a strategy can be measured in various ways. In three of the adopting companies, EVATM was calculated at a group and divisional level, but not at the level of business units. In these companies, the adoption of VBM had no impact on measurements at the business unit or lower levels. One explanation for not calculating EVATM at the business-unit level was, according to the CFO of Company D, that the most important driver of EVA is operating prot. In one divisional level adopter, Company C, EVATM was calculated only for the division as a whole, though it was claimed that, lower levels are measured on the drivers of EVA. This divisional level EVATM adopter had implemented EVATM and Balanced Scorecard, and planned to use both nancial and non-nancial indicators to follow up the success of this strategy. The interviewed CFO regarded the use of EVATM at lower levels of the organisation as problematic, but also saw that the VBM is of little worth unless linked to operations through a Balanced Scorecard. Shareholders do not have any relevance unless value creation and destruction is linked to BSC. WACC is not very interesting. Somebody has to take care of it, but it is denitely not an issue that the front line should spend time with. That is the duty of group nance. . . . Middle-management has to adopt what matters. Two adopters also dened EVATM for business units. Hence, it appears that the adoption of VBM has, in some organisations, had an impact on measurement at almost all levels; whereas, in other organisations metrics only at the highest levels of hierarchy have been altered. In addition to EVATM , return on investment, net sales, net prot, cash ow and gearing were among the indicators followed by VBM adopters. In other words, the adoption of EVATM does not seem to lead to a single measure of success or the abandonment of other measures. There were differences, however, among the adopters in the use of non-nancial measures regarding group control over divisions. In some organisations, the measurement for divisions is purely based on nancial measures; whereas, in others, assessment includes non-nancial measures as well. Although there appears to be a single objective of shareholder value creation in VBM companies, it is in practice adopted differently at different organisational levels and measured in various ways. Therefore, VBM does not seem to solve the problem of using different nancial measures. Neither does it lead to one common language throughout the organisation, nor to decentralisation or empowerment of local business unit managers, as has been suggested by EVATM proponents (Stern, 1994). 4.1.3. Target setting Similar to measurement, target setting also takes various forms among VBM adopters. Traditionally, many organisations set targets as part of the budgeting process. One of the interviewed divisional level adopters (Company C) stated that they moved to rolling budgeting concurrently with the adoption of VBM. Before adopting VBM, they had budgeted earnings and balance sheet, and target ROCE, on a yearly basis. Performance was compared with the budgets. Now, the company derives targets from long-range plans. Targets are set for cash ows, accounts receivables and accounts payables, inventory levels as well as other leading indicators, presented in the form of BSC, in addition to an earnings statement and balance

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sheet. EVATM is calculated only for the company as a whole; targets for business units are set as described above. Budgets and targets for measures are updated every 4 months, and performance is evaluated against these targets. Hence, together with VBM, rolling budgeting and BSC, both how and how often the targets are dened have changed in this company. In one group-level adopter (Company A), no major changes occurred in yearly budgeting. The managing director derives targets for units based on group EVATM targets. The units make budgets using a bottom-up method, with the target of deriving the maximum EVATM . If budgets do not meet expected targets, budgets are re-formulated within the units. Once budgets have been prepared and agreed upon, the units are evaluated against the budgets and budgeted EVATM . This is not a calculated EVATM based on the current level EVATM , rather the level is set during the budgeting process, resulting in either a positive or negative EVATM change. Hence, in this company, EVATM appears to represent a major variable to which targets are tied. The frequency of target setting has remained on a yearly basis. Another group-level adopter (Company D) sets targets for divisions based on EVATM , other nancial metrics and some non-nancial metrics. At the business-unit level, operating prot is considered to be a prime driver of EVATM . Therefore, targets at the business-unit level are tied to operating prot, as well as to other nancial and non-nancial measures. In this company, target setting is done on a yearly basis, but remains separate from the budgeting process. In fact, the company does not budget at the corporate level. Hence, the target setting in this company is accomplished on a yearly basis, independent of the budgeting cycle. Targets are set for both nancial and non-nancial metrics, instead of relying on only EVATM , though EVATM is used only for setting targets at the divisional level. In yet another group-level adopter (Company F), the CFO commented, targets were exible according to this [earlier success of division], and we should have been better in budgeting. This suggests that EVATM adoption in this organisation has had little effect on the objectivity of target setting. Targets for divisions and units were set in terms of ROCE. As they explained it: There is a common target of a certain ROCE %, and we have relied on divisions seeking to achieve that. They tried to focus on EVATM , but as the nancial success of the company was not strong at that time, operating net earnings was used as a surrogate. Moreover, they admitted that when business is not going well, absolute gures such as earnings before interest tend to draw attention. Hence, the introduction of VBM did not lead to any actual changes in how targets were set or how performance was measured in practice. In sum, the implications of VBM for target setting have taken various forms. In some of the adopting organisations, targets are set mainly on an EVATM basis; in others, based on EVATM in combination with other nancial measures; yet in others, based on both nancial and non-nancial measures (when considering those organisational levels in which EVATM is claimed to be in use). It is interesting that there are companies claiming to use VBM, though target setting is actually based on other metrics. Moreover, in some organisations, target setting appears to be tied to the yearly budgeting process; whereas, in others it either occurs more often than once a year, or is independent of the budgeting process. Nevertheless, targets were negotiated in all the organisations examined in this study. Therefore, EVATM has not led in practice to a more objective target setting than that provided by any other nancial measure. Indeed, an inheritance effect seems to remain very inuential in the target setting process (see Mouritsen, 1998). 4.1.4. Incentives and reward structures In all the studied organisations, short-term compensation plans were in use, and short-term bonuses were based solely on nancial gures, such as turnover, total gross margin, ROCE, EPS, EBIT or EVATM . For the top management, the group-level protability gure was a key component. At the divisional level,

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divisional level protability was emphasised, though part of the compensation was typically based on group-level achievements as well. The emphasis on nancial gures was the case even at the divisional level, although Balanced Scorecard had already been adopted. Only in one divisional level organisation were there far reaching plans to adopt Balanced Scorecard as the basis for compensations, though none had actually adopted non-nancial measures for this purpose. In addition to nancial targets, there were special personal projects or development targets, which could bring additional rewards if they were found to be successfully managed. Only in three studied organisations, two at the group and one at the divisional level, were bonuses actually tied to EVATM . In all three organisations, EVATM was not specied as the only basis for rewards. As the Development Manager of a divisional adopter explained it: EVA contributes 40% of the bonus, 20% of that is based on achieving group targets, 20% on unit targets. In addition, 20% is based on unit EBIT, with qualitative personal targets forming the rest. In all three organisations, the target levels were set during the budgeting process. Maximum bonuses were restricted. The maximum varied between 2 and 7 months of salary, and did not conform with the unlimited maximum suggested by Stern and Stewart. In addition, the proportional size of this variable component decreased at the lower level of organisations, and only a small proportion of the bonuses was paid based on EVATM , varying between 20 and 40% of the total bonuses. Financial bonuses are paid annually in all case companies. In one divisional adopter (Company C), where rolling budgeting had already been introduced, bonuses were to be paid in 4-month periods in the future, based on nancial and non-nancial performance during the previous 12 months. Such a procedure is assumed to improve both the accuracy of the target level and the motivation of the management, resulting in a control system more sensitive to environmental and internal changes. No bonus bank system was adopted in any of our case companies. Neither was such a banking system planned for the future. Instead of bonus plans, BSC-based bonuses were carefully considered to avoid short-termism in those bonuses paid solely on the basis of nancial performance. All the interviewed companies have implemented stock option plans, and several plans had already been issued by all except one of the companies. The interviews revealed that stock option plans have been issued due to requirements set by investors and analysts as well as the interest in options expressed by management. At the same time, they admitted that stock options have not motivated management or employees to work harder. Especially in the case of out-of-money stock options, the motivating factor was reported to be even negative. Four of our study companies have issued stock options only to top management. The dilution of these companies varied between 4 and 6%. For the two study companies that issued options to employees, dilution was 18.7 and 22.6%. In all except one stock option plan, the strike price was xed, and in one plan it was increasing very moderately. In addition, most of these plans had a xed vesting period. None of the interviews revealed any problems related to the dilution effect. In sum, the reward structures of VBM companies were divergent and did not solely emphasise EVATM type measures. These measures were used for rewards only to personnel at higher organisational levels. In addition, other nancial measures played an important role in the reward structure. Furthermore, there were strict upper limits in the rewards, and no banking system was present in our case companies. Therefore, the adoption of VBM did not appear to simulate the pay-off of shareholders in our case companies, and thus did not necessarily lead to any improved alignment of shareholders and managers. Stock option plans have been used in our VBM companies as suggested in the normative literature, though the strike price does not conform with suggested practice, and some companies have issued options to all employees. In addition, our interviewees hold the view that stock option plans do little to motivate managers to work harder.

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4.2. VBM and decision making Although the management control implications were rather different from those proposed by the consultancy literature, we attempted to study behavioural changes as a consequence of VBM adoption. 4.2.1. VBM and strategic decisionscapital investments, acquisitions and divestments Shareholder value was frequently emphasised in the strategic capital investments, acquisitions and divestments of the case companies. As one former CFO, currently working as the Vice President of Corporate Development at Company B operating in a mature business, explains: One of the main questions is what to do to increase share price. . . . We bought X Ltd from the Netherlands, and it has been one clear initiative to increase share price. . . . We are forced to consider the impact of acquisitions on value. We assess, with the help of investment banks, how markets would regard a planned acquisition. Similarly, another corporate CFO (Company D) responded to our question of whether they have bought companies with negative expected EVATM : we have calculated that it is not sensible to bid more (for an acquisition target), and lost the battle (over those companies). Hence, for the strategic evaluation of various businesses, shareholder value (SHV) and VBM seem to offer a useful measure for some organisations in estimating both the current and future protability of each business. Although VBM could be useful in making strategic decisions, the introduction of VBM does not necessarily lead to changes. The CFO of Company F told that: we should have divested some businesses, but we never could make it. He explained that the owners, who had also other stakes as producers and customers in the company, were interested in looking after their own total interest. In such a case, VBM tools indicated actions that the owners did not perceive to be of value to them. One of the major strategies of the studied organisations was to focus on a core business. It is difcult to judge whether VBM has had a signicant role in forming such a strategy. We assume this to be more a general trend in business than an outcome of VBM. Nevertheless, VBM may facilitate such transformations. One example of such use is found in a formerly multidivisional organisation using EVATM . The corporate controller of Company A described the process of focusing on core business: We saw from the EVA of division Y that margins were getting tight. Investments did not bring what they were expected to bring. Similar developments occurred in another major division. If you want to be a top player in global terms, the resources required are huge. In our current core business, we were number one in narrow niche markets, and today we are that even more clearly. An interesting feature in the re-structuring of some of these companies was that cash cow businesses were not necessary sold. Instead, the survival of these businesses was guaranteed to ensure cash for growth businesses. The major selection was among growth businesses, where to invest and where to divest. For example, in one divisionalised organisation (Company F) claiming to use VBM, two divisions became explicitly cash cow businesses. In these divisions, emphasis was placed on capital investments increasing efciency and thus . . . neither growth investments nor acquisitions were allowed, though they made prot for others. Their duty was to generate cash ow. One may, however, question whether this type of reliance on internal funding of growth businesses is in line with shareholders interests. Is there room for strategic decision making in VBM companies beyond the VBM? In several of our VBM companies, it appears that there exist investments that would not appear protable by any measure. This is true even in organisations that seem to use VBM fairly comprehensively. Acquisitions that look unprotable were made to maintain market share. Investments required by customers were made to

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maintain quality standards of customers business. Therefore, VBM seems to direct investments towards more protable purposes, but it does not overrule strategic judgement. 4.2.2. VBM and operational decisions At the operational level, shareholder value seems to emphasise the efciency of capital employed. As the corporate CFO of a divisionalised organisation (Company A) explained, the company beneted from adopting VBM: It focused attention on the impact of the balance sheet on protability. Especially in division X, there were marketing oriented product managers who were willing to create a nice new brand, and to invest in it handsomely. They saw only increased sales. For such a problem, the EVA shed light on the whole organisation. It appears that in this organisation, EVATM was effective in reducing what was referred to as CAPEX (capital expenditure) hunger. Similar comments were also expressed in other companies adopting VBM. At least one of the main arguments used by Company A for subsequently abandoning EVATM was to promote growth. As sales were decreasing in one large division, and company was loosing market share, managers argued that EVATM focused too much on assets, whereas they should instead be focusing on sales and markets. For evaluating operational capital investments, various standard methods were found to be used, such as payback, NPV, IRR and DCF. Most organisations use more than one of these methods to evaluate their investment opportunities, including payback. Hence, at least for investment decisions, adoption of VBM/EVATM does not lead to the use of one single measure. In addition to capital investments, we found some evidence that the adoption of VBM/EVATM has led to a more careful consideration of working capital. A statement by the corporate CFO of a divisionalised organisation (Company D) illustrates this: They (sales persons) remember to think about how to get the money back home from the customers even while making a deal. In one of the adopting organisations (Company C), the introduction of VBM was said to have led to a re-calculation of customer protability. More accurate assessment of storing costs, including the cost of capital, and terms of payment were seen to dene the economic protability of customers. They created an ABC model to provide more accurate product and customer costs. Similar economic prot assessments had already been done for its suppliers. In a sense their method captures single period EVATM for the customer, but not the long-term potential of that customer. To sum, it appears that in four of the six adopters, VBM has had an impact on strategic evaluations and decisions (Appendix A). These four organisations include both group and division level adopters. VBM has changed the ways in which acquisitions and divestments of units and divisions are analysed, and how investment funds are allocated among divisions. However, the adoption of VBM/EVATM does not necessarily imply that strategic judgement has disappeared when making strategic investment decisions. With regard to the making of operational decisions, it appears that VBM companies have lower hunger for capital investments and become more concerned with the cost of working capital. 4.2.3. Summary Our empirical evidence suggests that the use of VBM does not lead to management control mechanisms, in their purest form, as suggested by the normative literature. Table 2 summarises our ndings. Our evidence shows the weaknesses of distinguishing VBM companies from other companies solely on the basis of either annual reports or information indicating VBM use in forming compensation plans. On the other hand, our ndings suggest that VBM adoption has had an inuence on decision making both at the

T. Malmi, S. Ikheimo / Management Accounting Research 14 (2003) 235254 Table 2 Summary of VBM practices in management control and decision making Dimension of VBM use Management control Objectives and strategy Performance measurement Target setting Compensation Inuence on decision making Strategic decisions Operational decisions VBM practice

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Maximisation of shareholder wealth. Both growth and efciency strategies. Mainly used at the group level EVATM metrics or its value drivers used at different organisational levels. Such measures are not the only ones throughout the organisation. Old measures are retained Mainly negotiated, frequently other measures are used. Zero-EVATM does not have any major relevance Bonuses paid based upon several nancial metrics. EVATM has a minor role. No banking is present. Stock options mainly for the top management at a xed price Still room for strategic judgement beyond VBM. Impact on acquisitions, strategic capital investments and divestments Increased emphasise on balance sheet. Leads to lower hunger for capital investments and more concern about the cost of working capital

strategic and operational levels in at least some organisations. Therefore, it is reasonable to argue that VBM adoption may contribute to some changes in company performance. 5. Discussion 5.1. Types of VBM adoption The VBM use proles for six adopters are illustrated in Appendix A together with some background information. This study shows that VBM has been applied in different ways in different organisations. In Company F, EVATM had no real inuence on strategy, capital investment/divestment decisions, performance measurement, target setting or compensation. Although they claimed to have changed WACC in their investment analysis, no examples of it altering the course of action could be presented. Although at times they used EVATM as a performance measure, they also retained all previously used nancial measures. The focus was not on EVATM , but on those measures that were already familiar, and usually more forgivable. The bonuses were EBIT-based with a 2-month salary cap. Application of VBM at Company E appears fairly similar to that of Company F, even though Company E claimed that the allocation of investment funds between divisions had changed. The change was basically achieved by changing the capital charge in evaluating the protability of divisions and proposed projects. In both organisations, the claimed changes occurred at the group level, with no changes occurring at lower levels of the organisational hierarchy. Our interpretation is that in these two organisations, the adoption of VBM has been more or less rhetorical, or represents an expression of good will in their annual report. In the remaining four organisations, the adoption of VBM has had an impact on both control and decision making. In Company D, the EVATM was adopted at the upper levels of hierarchy. The adoption of EVATM introduced no change in performance measurement or target setting at lower levels. Although incentives are partially tied to EVATM , it has only been done at the divisional level. Moreover, divisional incentive schemes include a number of other elements in addition to EVATM . The justication for not applying EVATM at the business-unit level was that the prime driver of EVATM at that level is unit prot.

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Given that unit protability is a prime driver of EVATM , we may still question the impact EVATM has had on business-unit operations, as the rules of performance measurement and target setting were not altered in any way during adoption. Hence, it seems that Company D represents a case of EVATM adoption where the highest levels of the organisation are inuenced, while only limited impact is seen on the organisation as a whole. Three of the analysed companies A, B and C, can be regarded as fairly comprehensive users of VBM. There were some signs of its use in the decision making within all three organisations. In Companies A and B, EVATM was dened at the business-unit level and was included in strategic considerations, as well as in operational decision making, reducing capital investment hunger and improving working-capital management. In addition, VBM comprises an important component of the performance measurement for reward structures. Company C calculated EVATM only for the division as a whole. At lower levels of the organisation, performance measurement and target setting was based on drivers of EVATM . In that organisation, the adoption of VBM was tied to a major reform of management systems, including changes in budgeting, ABC implementation and the adoption of BSC. In Company C, the change in the control system occurred at all levels of organisation. The EVATM may also effect lower levels of organisation, but this depends on how well the value drivers are identied, and whether the incentives are tied to appropriate drivers, either nancial or non-nancial in nature. Although no incentives were directly tied to EVATM , Company C is regarded here as a comprehensive user due to the change in control system at lower levels of the organisation, emphasising the drivers of EVATM . To sum, adoption of EVATM does not seem to be manifested similarly in all organisations. It could be adopted either at a higher level of organisation or at all levels. It appears that it is implemented as an additional part of the control system, to complement the existing system instead of replacing it. Even the adoption of EVATM as a basis for rewards appears to have limited implications since it seems, in practice, to play only a minor role in the reward structures, quite different from proposals by EVATM proponents. Hence, the adoption may take various forms, with organisational depth being one key element to focus on, in addition to the content of use. In this study, three basic VBM adoption types were found: rhetorical use, group-level use and organisation-wide use. Group-level use and organisation-wide use refer to similar content of use, the difference being in the organisational depth of use. Further classication could be based on comprehensiveness of use. None of the studied organisations used solely economic prot metrics for performance evaluation, target setting and/or compensation. Many suggestions on compensation schemes found in the literature were totally ignored in these organisations. Hence, further studies should demonstrate whether there are organisations that comprehensively follow the advice in the VBM literature. If not, the obvious question would be why this would be so. 5.2. On explaining the variety of VBM practices Given our research aim and the material we collected from the eld, we are not in a position to objectively explain why these practices are so different. We will, however, provide some preliminary thoughts on this issue to aid further research on the topic. If motives for adoption are different, we may assume different applications as well. In our case organisations, the major outside pressures to adopt VBM varied. Intensied international competition was mentioned as one main reason by three of the studied companies (C, E and F). All three had previously operated in protected markets, where liberalisation was an ongoing process. Two of these companies were rhetorical

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users of VBM, and one company used VBM at only the group level. Increased pressure from the nancial markets was provided as another reason for VBM adoption in two of our case companies (B and D). In these companies, nancial analysts created pressures on company management to adopt shareholder value based control systems. Company D adopted VBM at the group level, while Company B adopted it at the division level as well. In Company A, we could not detect any contextual reason for VBM adoption based on the interviews. Hence, although contextual reasons for adopting VBM varied, based on this study, we are not able to detect any systematic impact of these reasons on determining the type of adoption. Further studies should attempt to study the impact of various institutional changes on the type of adoption implemented. All studied organisations claimed they wanted to encourage certain behaviour by adopting VBM. In two organisations, the resulting actions remained rather limited, however. This may be explained by the motives for adoption being other than those stated. It may be that some organisations want to signal shareholder sympathy, or state of the art of management, without changing much of the actual decision making and control practices (see e.g. Abrahamson, 1991; DiMaggio and Powell, 1983). Even if the motive is to inuence the organisation rather than signalling, there may be different motives for adoption depending on factors, such as the job responsibilities of VBM proponents. A person working in a divisional strategic planning department with responsibility for acquisitions may have a different approach to VBM than a group controller concerned with divisions not looking for healthy growth. Hence, various internal motives for adopting VBM may well explain some of the observed differences in practice, and further studies could focus on the impact that various motives for adoption could have on actual practices. The question of differences in practices is even more interesting if the motives were similar. It may be that some organisations actually tried to change decision making and control practices, but failed for some reason. The reasons for failures in management accounting implementation have been a topic of much debate in recent years (see e.g. Argyris, 1990; Cobb et al., 1995; Kasurinen, 2002; Malmi, 1997; Markus and Pfeffer, 1983; Scapens and Roberts, 1993). One explanation in the VBM context may be found in organisational power and politics. In the case of Company A, VBM was strongly supported by a strong CEO. In contrast, in case D, the idea arose from the CFO, and most other managers were not very appreciative of VBM. Hence, the power of the VBM champion may determine how it is adopted. It also appears that the organisational depth of VBM application was closely related to divisional autonomy. In three group-level adopters, the divisions were fairly autonomous, and hence the group management did not interfere in how divisions manage their business units. Moreover, strong divisions were reluctant to change the rules of the game, as traditional measures were often more forgiving. This suggests a paradox in VBM adoption: VBM is thought to be good for steering fairly independent units, but since these units are independent, it may be difcult to gain acceptance for its implementation. It was also interesting that both organisations in which VBM appeared to have no real impact on company operations came from formerly regulated markets. One of the rhetorical users had owners that were also providers of raw materials to that company. In such an environment, it is not necessarily clear what are the prime interests of the various shareholders. A history of regulated markets or vested interests of various shareholders may suggest that corporate cultures in those organisations are not necessarily favourable to practices that may give preference to one stakeholder group over the others. Further research could provide a more comprehensive understanding of why VBMs fail, or identify whether there are contingent factors that might explain differences in such practices. Finally, we may ask why none of the studied organisations adopted VBM as comprehensively as suggested in the literature. Burns and Scapens (2000) have argued that management accounting systems are slow to change. It may be that when new practices are adopted, the old ones are maintained as well.

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In the organisations studied here, old performance measures were maintained and VBM ideas were only partially applied in compensation schemes. Usually, old measures and compensation practices are fairly well understood. This reluctance to throw out traditional measures and compensation practices used for years could reect healthy risk aversion. Further research may focus on risk management perspective in adopting certain features of VBM. 5.3. On the study of performance implications of VBM One could assume that the benets, and problems, of using VBM are not identical for different types of uses. Hence, to study whether companies that have adopted VBM outperform organisations that have not is bound to be problematic unless differences in applications can be accounted for. In such studies, high performance has been shown to be related to the use of EVATM or other residual income-based measures as the basis for incentive compensation (Wallace, 1997). Our observations suggest that this interpretation may be somewhat more complex than originally envisioned. In one organisation, the compensation was tied to EVATM , but only at high levels of hierarchy. At lower levels, no changes in management control practices were instituted due to the adoption of VBM. It is questionable whether such changes would truly have an impact on organisational behaviour, and thus protability. On the other hand, we observed an organisation where incentives were not tied to EVATM , but to its value drivers. Our interpretation was that in this case the value drivers were thoroughly analysed and understood. Hence, in order to have an impact on organisational behaviour and prots, EVATM itself need not necessarily provide a basis for incentives as long as its value drivers do. A further observation complicating the study of VBM use as a basis for compensation, as well as the resulting benets from adopting VBM, was that in most organisations, EVATM or related measures formed only a small proportion of the total bonus base. Although incentives may be tied to EVATM , this may have no practical relevance unless the proportion is sufciently large. Therefore, our study suggests that the use of VBM/EVATM as a base for compensation does not necessarily mean that VBM is applied prudently, or that it has any inuence on the nancial performance of a rm. 5.4. On the concept of VBM Companies seem to assume that it is possible to select certain specic features of a management philosophy/tool, while leaving other features aside. Such behaviour is not only limited to VBM/EVATM studied here.4 Furthermore given the rhetorical use found in this study, we could argue that VBM seems to be more of an institutional requirement than a functional entity. For research, this poses an interesting and important problem in dening concepts. For example, when would it be justied to say that a company is applying VBM or EVATM , and when would it not, despite claims by the company that such practices have been implemented? It makes little sense to study the benets or failures of certain management technologies if organisations do not even apply their core ideas. Should we assume benets, a priori, for rhetorical use, group level use or organisation-wide use? Should we assume benets from organisation-wide use if all previously existing systems and measures still remain intact, or if rewards are only partially tied to EVATM ? These types of questions seem to have received little attention in current management accounting research.
4 See e.g. Gosselin (1997) for some of the diversity in ABC use, and Ax and Bjornenak (2000) and Malmi (2001) for diversity in BSC use.

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Ittner and Larcker (2001), building on normative literature, dened VBM to consist of six basic steps (see above). Their framework, like all management frameworks, includes elements similar to those in many other management frameworks, as well as elements that distinguish it from other management approaches. Compared to the generic performance management framework presented by Otley (1999), three out of the six steps seem to differentiate VBM from other management techniques. The rst step suggests that internal objectives should aim for shareholder value enhancement, and the third step invokes identifying value drivers. The fourth step urges the rm to develop action plans, select performance measures and set targets based on value driver analysis. However, as suggested in the normative literature, rewards form an essential element of VBM. Rewards are also included in the performance management framework by Otley (1999) and have been used in the earlier research to differentiate EVATM adopters from non-adopters. Therefore, rewards should be explicitly included in the concept of VBM. Moreover, the six steps do not sufciently account for decision making. Decision making should, at all levels, follow a certain logic in the organisations using VBM. The key elements of VBM, differentiating it from other management approaches, would then be to: 1. 2. 3. 4. aim to create shareholder value; identify the value drivers; connect performance measurement, target setting and rewards to value creation or value drivers; connect decision making and action planning, both strategic and operational, to value creation or value drivers.

As suggested by this study, we should hardly expect all these features to appear in organisations claiming to use VBM. A minimum requirement could be that the organisation aims for shareholder value creation and that either (1) decisions are taken at some levels of an organisation using EVATM or VBM or (2) the management control system (performance measurement, target setting and rewards) is based on economic prot metrics or value drivers. Such minimum requirements for the denition would allow VBM to serve as a solution to different types of problems in practice. It would not, however, offer much help to researchers wishing to study the performance implications of VBM. The performance implications are likely to vary depending on the depth, as well as the comprehensiveness of its use. Therefore, further research could focus on the types of VBM uses. Instead of comparing all types of VBM/EVATM adopters to non-adopters, researchers could compare one type of use to another and the benets and problems of various uses. Finally, our ndings are not particularly good news for those management accounting researchers wishing to use publicly available databases (cf. Ittner and Larcker, 2001). Such databases do not contain information about differences in use. Hence, the study of VBM use and its benets is bound to be a laborious exercise, fraught with problems concerning the comparability of research results. Acknowledgements The authors wish to thank two anonymous reviewers and the editor for helpful comments. The authors appreciate the comments offered by the session participants of the 23rd EAA Annual Congress in Munich (March 2000) and the participants of the Helsinki School of Economics research workshop in 2001. Financial support by Jenny and Antti Wihuri Foundation and HSE Foundation are greatly appreciated.

Appendix A. Illustration of Value Based Management in six organisations

Case Level of adoption Year(s) of adoption Decision making: Strategic decisions A Group 1993 to >1998 Focusing on core business; emphasis however on strategic judgement Indirect effect through performance measurement, reduce CAPEX hunger SVA. efciency Business unit level B Division 1998 Acquisitions C Division 1999 Strategy formulation, scenarios D Group 19931994 Acquisitions E Group 1999 Allocation of investment funds F Group 19931994 Change in WACC

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Operational decisions

No change in investment analysis methods

Customer and supplier economic protability

Terms of payment, operational investments

Change in WACC

Change in WACC

Management control: Objectives and strategies Organisation level where the adoption of VBM has changed measurements, targets and rewards Performance measurement

SVA. growth Business unit level

SVA. efciency Business unit level

SVA. efciency Divisional level

SVA. efciency Divisional level

SVA. growth Divisional level

EVA + other nancials

EVA + other nancials

EVA + drivers of EVA + non-nancials

EVA + other nancials and non-nancials Target setting and incentives independent from budgeting (no budgeting at group level), done yearly EVA and other nancials

Target setting

Targets in budgeting process yearly

Targets in budgeting process yearly

Rolling targets three times a year alongside rolling budgeting

EVA + three other nancials, all equally important Targets in budgeting process yearly

ROCE main target + other nancials

Incentives and rewards tied to:

EVA and other nancials

EVA and other nancials + personal targets

Financials (drivers of EVA) and personal targets, in future also to non-nancials, as BSC is ready

EBIT, EPS considered

EVA targets were set in times when business conditions were favorable. Targets in budgeting process yearly ROCE + other nancials

Note: SVA = Shareholder Value Added.

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