Financial Planning & Analysis and Performance Management

16OPERATING EXPENSES AND EFFECTIVENESS

CHAPTER INTRODUCTION

In this chapter, we will focus on another critical value driver: operating effectiveness. Managers and consultants often debate about their preference for either the word effectiveness or efficiency in this context. While effectiveness is often interpreted as doing things well or selecting the right things to address, efficiency connotes doing things faster and more cheaply. We will use the term effectiveness to encompass both interpretations. Obviously, managers do not want to become highly efficient in an unimportant process or activity. On the other hand, improving efficiency by reducing cycle time, costs, and errors can be a tremendous source of value.

Many observers look to profitability as a key indicator of operating effectiveness. It is a good start, but we recognize that it is possible for a highly inefficient organization to post high profit margins if it possesses a strong competitive advantage leading to pricing strength. In this case, it can pass along high costs arising from its inefficiencies to its customers. This is rarely a sustainable position over the long term, however, since potential competitors are attracted to these opportunities. Additionally, profitability does not directly account for the asset levels required to support a business. Return on invested capital (ROIC) and return on equity (ROE) are considered better overall measures of management effectiveness, since they reflect both profitability ...