Value Added explained

It has been said that to sustain sound performance Britain needs to continue making a transition to being an open, globally integrated ‘knowledge economy’ in manufacturing and services. Value Added measures the wealth a company creates not just for itself but also for its stakeholders and society as a whole.

Value Added has been used as a performance indicator for a number of decades and as a trainee accountant in the 1960s I read an article in the Financial Times entitled ‘How to measure output’, by Ronald Gilcrist of Urwick Orr and Partners. Gilcrist defined Value Added as “the value of sales less the cost of all materials, heat light and power and all other bought out items”. It constitutes the fund from which a company applies to:

• Pay employees.

• Pay providers of capital.

• Pay government taxation.

• Maintain and expand assets. During the period 2000-2009, the then Department of Trade and Industry, followed by the Department for Innovation, Universities and Skills, published the Value Added Scoreboard. The Scoreboard provided measures of wealth for some 800 UK companies and the top 700 EU companies by Value Added. Value Added simply analyses how efficiently companies use their staff and assets to create wealth. The Scoreboard states that:

• Productivity is the rate of output per unit of input and is particularly useful for assessing the effective use of labour, materials and equipment. Productivity is often defined as value added per employee when labour is the major input but value added as a percentage of labour and equipment costs for more capital incentive business may be a more appropriate measure for companies.

• The two productivity measures used in the Scoreboard are P1, Value Added per employee and P2, Value Added as a percentage of labour and depreciation costs (for allowing both labour and capital inputs). P1 is referred to as the Wealth Creation Efficiency, P2 as percentage ratio.

Mini case study

A recent extract from the Accounts of Whitby Engineering showed: £ m Revenue 8.50 Cost of sales 6.20 * Earnings before interest and tax 2.30 Number of employees 150 * Cost of sales comprise: wages, salaries and employee benefits £2.05m; depreciation £0.55m; and Bought out items £3.60m. Value added: revenue less cost of bought out items: £8.50 – £3.60 = £4.90m Alternatively: EBIT + employee costs + depreciation: £2.30m + £2.05m + £0.55m = £4.90m From these figures the following can be determined:

• Value Added per employee.

• Value Added per £ of employee costs.

• Value Added as a percentage of employee costs and depreciation. For Whitby Engineering the measures are:

• Value Added per employee. Value Added/No of employees £4.90m/150 = £32,667.

• Value Added per £ of employee costs. £4.90m/£2.05m = 2.39 (number of times).

• Value Added as a percentage of employee costs and depreciation. Value Added/employee costs and depreciation % £4.90m/£2.05m + £0.55m % = 188.5% or 1.89 per £ of input costs.

These performance indicators (ratios) measure employee productivity and wealth creation and can form a benchmark for the company for a year-on-year comparison internally or for an industry sector as a whole. The 2009 P1 and P2 measures for BT and Tesco Plc were £105,000 and 143% (1.43) and £19,000 and 149.5% (1.49).

Recent research at Lancaster University by Dr Anthony Hesketh has added a further dimension to P2.

A model has been developed for measuring and improving human capital management that centres on a measure ROIT – Return on Invested Talent.

This comprises:

EBIT + Employee Costs + Depreciation and Amortisation less a Capital Charge/Employee Costs + Depreciation and Amortisation. The capital charge is based on (Working Capital + Non Current Assets) * WACC.

It is interesting to note in an article in the ICAEW Finance and Management Faculty publication (issue 220, April 2014), Dr Hesketh gives examples of ROIT for Telecommunications Sector of 1.45 and Food Retailers 1.41.

I highly recommend this most interesting article to readers.

• Dr Philip E Dunn is a freelance author and technical editor for Kaplan and Osborne Books