Episode #42: First, Create Value

Developing the right leadership mindset

Realising that value is the fundamental building block of leadership, business, and in fact, all human endeavour, is a critical mind shift for a leader.

If we could actually do this, it would potentially lead us to do very different things when we turn up each day to lead our people.

This episode covers off a few pointed examples of what value looks like (and doesn’t look like) to get your creative juices flowing. 

Hear about the value v price paradox, total cost of ownership, the time value of money, and the key economic concepts of specialisation of labour and comparative advantage.  

It all begins with value, and this is the lens a leader must look through.

FIRST, CREATE VALUE: DEVELOPING THE RIGHT LEADERSHIP MINDSET

Episode #42 Transcript

As part of the hippocratic oath taken by medical practitioners, the concept, 'first do no harm', has been popularised. It says basically before you consider anything else like healing the sick, make sure you at least don't have a negative impact on any person.

Professional leaders should take a similar oath. In our case, to first create value. Realising that value is the fundamental building block of leadership, business, and in fact, all human endeavour should come before all other thoughts.

If we could actually do this, it would potentially lead us to a very different way of doing things when we turn up each day to lead our people.

In this article:

• We'll start off by examining the commonly misunderstood concept of 'value versus price'

• We'll move on to asset management with a focus on total cost of ownership or TCO

• I'll give you a quick fly over the top of the time value of money concept

• We'll finish by looking at the key economic concepts of comparative advantage and division of labour.

I teach a whole module about delivering value in our 7-week online leadership program: Leadership Beyond The Theory, so I’m really just skimming the surface of the topic here. I want to cover off a few examples of what value looks like and doesn't look like to get your creative juices flowing. It all begins with value and this is the lens a leader must look through.

VALUE VS PRICE

Let's start talking about value versus price, and in this article, I'm going to reveal a little about the principles that guide my decision making in life in a lighthearted but instructive way, and I'm going to start with my philosophy of what I call CPW. That's the cost per wear ratio. This is all about how I buy my clothes and I'm going to find a lot of listeners out there saying, Marty, oh my God, you are so right, and now I know how to explain it to my sceptical spouse.

This principle is really simple. What I've learned about myself over the years is that if I buy clothes that are on the cheaper side, I just don't wear them that much. I don't love them, I don't feel good in them and they date quickly. However, if I spend money to buy really high quality clothes then I love them. I wear them to death, they don't date, and even after a couple of years, I'm still getting comments about being the best dressed person in the room.

However, this surprisingly is the most value driven way to buy clothes. The CPW principle says if you actually calculate the cost of each wear, it's surprisingly cost effective to buy more expensive things.

In corporate life, unless I was on a site, I wore a business suit to work every day, so it's a staple clothing item for me. Let's say a cheap suit costs about $500. If I bought a cheap suit, I might wear it 20 times and only in the year I bought it, so my cost per wear or CPW is $25. 20 wears x $25 = $500 cost.

However, a nice suit might cost $2,000, but if I was to spend $2,000 on a suit I will get at least a 100 wears out of it over a couple of years, so my cost per wear, my CPW is $20. 100 wears x $20 a wear = $2,000 cost, so per wear it's actually cheaper to buy the more expensive suit, and I'll love wearing it and it doesn't go out of style and I always look sharp.

Now that value case is pretty clear, but I still have a couple of other rules of thumb that I built around this to keep it in check and protect the risk.

For example:

1. Always buy really high quality clothes.

2. Never ever pay full price for them, so wait until they're on special or discounted because no one knows except the guy who sells it to you if it's this summer's stock or last summer's stock.

3. If I have to choose between two competing forces, I would rather have half as many and spend twice as much.

Now let's convert this into something a little closer to your business. Let's talk about procurement. Many people who purchase things on behalf of the organisation only take a cost based approach, so this quite frequently drives a lower value outcome.

Let's say for example, you're purchasing tyres for heavy vehicles. If the only thing you would look at was price, you'd be in serious danger of making a big mistake. The most critical component of a tyre is durability. How many operating hours do I get out of these tyres?

If it costs me $1,000 to buy a tyre and that tyre lasts for 40,000 operating hours, it might cost me $1,200, so $200 more to buy a tyre that lasts for 60,000 operating hours. So I'm actually better off spending 20% more upfront to get 50% more performance.

The trick is to always be thinking about the overall value, not just the upfront cost.

asset management with a focus on total cost of ownership

In asset management, we talk about the whole of life view of an asset, so there's an upfront cost to purchase an asset and then there's an ongoing cost for maintaining and operating it.

An easy example - if you buy a major appliance like a refrigerator, there are loads of different prices that you can pay based on brand, quality, size, features, efficiency, and so forth. All other things being equal, we tend not to think too much about the running cost. But electricity is becoming much more expensive in many parts of the world and it certainly is in Australia.

For example, you might be able to save a few hundred dollars on the front end with a lower purchase price, but then if you don't understand the relative efficiency and the running costs, you could end up paying multiples of this over the life of the asset, as your electricity bills are higher each month than they would otherwise have been with a more efficient appliance.

Buying a car has changed a lot over the years too. It used to be a question of which dealer would give you the best price, and we were generally talking in the margins, hundreds rather than thousands of dollars. But as cars have become more reliable, they were then offered with post-sale items, not based purely on price. So warranties, service plans and insurances, and these could quite significantly impact on the total cost of ownership.

The concept of free servicing for five years is fantastic if you turn your car over in that time frame, this can save you multiple thousands of dollars.

Let's talk about big assets for a moment. There's an upfront cost to purchase an asset and then an ongoing cost for maintaining and operating it as we said.

Let's just look at a quick example from where I've come from most recently, the energy sector. If we were to build another coal fired power station in Australia, it would cost at least $3 billion upfront investment and would have a projected life of up to 50 years. Just so that you know where I'm coming from, I went on the record very clearly on national television a couple of years ago as the chief executive of CS Energy to say that although coal will still be with us for a long time, there is absolutely no reason in the world why another coal fired power station should be built in Australia.

Basically, as an investor you'd have to be convinced that the $3 billion of capital upfront would be earned, including return on capital, over the life of the plant. This relies on being able to assist both what the operating and maintenance costs are likely to be and also how much revenue can be earned from the market using that asset during its life. The closure of the Northern and Hazelwood power plants in Australia in the last few years are quite instructive. They were older plants where the capital had already been sunk many years before.

However, both the companies that own these plans, Alinta Energy and Engie were faced with big investment decisions. The plant suffers wear and tear over time just like any other mechanical asset. Every few years they need to be overhauled which requires significant investment. Before deciding to make the investment, I would imagine that the management team and board asked the following questions. If we spend 30 million, 50 million, 150 million over the next several years in overhauling and maintaining these units, how certain are we that we can earn a sufficient return on capital by trading the electricity that is produced from those plants in the market?

There are also many other questions about the risk of not being able to get a return on capital that would need to be answered by these boards. In both cases, these plants closed due to the assessment of the owners that we couldn't rely on sufficient ROI over time. This demonstrates clearly that you should only invest if there is a strong expectation of the investment paying off over its life. The tricky bit is that I imagine there would have been a lot of political pressure to keep the plant open.

When these plants shut down, the supply demand balance tightens and prices naturally rise, which is what happened after both the closures, but ultimately the CEOs and boards are bound to make decisions that are in the best interest of the shareholders and the ongoing performance of their businesses and that is the highest value decision.

the Time value of money

It's hard to cover off on value without talking about the time value of money. This is a pretty core concept in business. A dollar in a year's time is not worth as much as that dollar is today, and there are a couple of reasons for this. The first one is because of inflation which in the current climate is virtually negligible, but there's a risk that you might not get that dollar down the track, so this is the, 'bird in the hand is worth two in the bush' principle.

To understand future values, we use a modelling technique that hopefully most of you would be aware of, which is the discounted cash flow concept.

You can think of it like compound interest in reverse. There's a discount factor and you may have heard the expression weighted average cost of capital or WACC, that's applied to the expected future cash flows in order to value a project or a business.

The two most common valuation methods for business are discounted cashflow or DCF as we call it, and earnings multiples, so a business in your industry under a certain earning multiple, might typically sell for three to four times earnings.

The other valuation method is a little tricky to put together, but it basically adds up all of the future expected cash flows in order to value what the business is worth. You end up with a DCF calculation for a finite asset life, and this results in what we call the net present value.

Let's have a look at an example we can all probably relate to. In the last several years, many people have invested in rooftop solar panels for their homes. Most people who did this would have very little knowledge of what net present value actually is, and that would have told them over what time period they could expect their upfront investment to pay off, if at all.

The key question is, how much money would I need to save or earn over the life of these panels to make the upfront investment worthwhile?

The NPV of solar panels will take into account a few things. It will take into account the upfront cost of purchasing installation, it would take into account any government or power company subsidies for that purchase and installation, it would take into account any money earned from feeding tariffs that electricity companies and governments paid to encourage putting more renewable energy into the grid, and it would take into account the expected life and performance of the panels.

I can bet you now that 99% of people who bought solar panels didn't sit around their kitchen table on a Saturday night doing NPV calculations. Most people would have made that decision completely emotionally without any real hard value focus and then found a way to justify it later.

For example, we get to become a little more independent from the big retailers and that's good. We're also doing something great for the planet by reducing carbon emissions and that's good, and also the government's giving us a handout to push us in the right direction, so we're getting something for nothing. What a bargain!

The reality is, that some people unwittingly did very well out of it as they were paid inappropriately high subsidies from government to go solar, so this just transferred money from other taxpayers to those who could afford the solar panels. Sort of socially counterintuitive, I guess, but a majority would not necessarily realise that their solar panels were not a good value investment because they didn't go in with eyes wide open about the investment and the return. The value mindset requires you to think about this in everything you do.

How do you value your time?

For the final example on value, I just want to ask the question, how do you value your time? I want to talk about two critical economic concepts.

One of them is division of labour and the other is comparative advantage, and you may have heard of these. These two principles underpin industrialisation and globalisation. I promised I would give you some insights into my life philosophy and these two principles underpin my favourite eight words in life: Surely I can pay someone to do that.

Division of labour dates back to Plato's days, but was popularised in the 18th century by Adam Smith. He observed that productivity overall would be greatly improved if people concentrated on delivering only that part of the system in which they had expertise, so you chunk the activity down to smaller component parts and let people specialise in what they do best. It drove massive gains in productivity in manufacturing and production, but in those days at significant human cost.

Comparative advantage came just a little later down the track from a guy called David Ricardo who observed that country shouldn't try to make and sell goods that could be made more efficiently and cheaply in other places. This depended on things like technology, labour costs and capability, natural resources, proximity to markets and so forth, and this is why certain parts of the world are known for producing different goods. Manufacturing in China for many years was much cheaper than many OECD countries, not just because of the availability and efficiency of labour, but also the scale and capital efficiency of its plants because they do everything on a massive scale there.

Let's get back to my favourite eight words in life. I worked out years ago that I am absolutely rubbish at the traditional male stuff, the yard work, the building, the amateur carpentry, home maintenance and so forth. Not only that, but I had no interest in learning how to get better at it, so I figured I'd have to get good at doing something different and that was making enough money that I could afford to pay someone to come in and do those things for me.

Why do something that you don't enjoy and do it poorly to boot, when you can hire an expert to do it for you, freeing up your time to do other things like making money to pay said experts.

The, 'surely I can pay someone to do that' principal, has helped me a good stead for many years in my personal life. It's also helped me in great stead as a leader because I know how to value my time and expertise and the time and expertise of those around me. We all get to produce our best because we only do the things that we both enjoy and that we're good at. This creates value and we're generally a lot happier doing so as well.

Just to tie all these threads together, I want you to finish with a commitment to look at everything you do in the organisation through the value lens.

Whether it's the understanding of total cost of ownership, the price value trade-offs, the truly defined value, or the way you and your people choose to spend your time. This is the only way for a leader to view the world. Once you become really good at this, it'll then make it easy to pinpoint the things that don't add value. If organisations just did this one thing, the world would be a hell of a lot different.

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