Sunday, February 28, 2010

Projects delayed are profits denied

Sapan Ghosh is a technology consultant specializing in the reduction of emission levels from power plants and petrochemical units. By helping these chemical plants to conform to the increasingly more stringent standards of ecology and regulations governing environmental safety, he was helping his clients extend the lease of life on their aging Chemical plants. However, one of his European clients Finding the investment required to upgrade the facilities in the plant so prohibitively expensive, decided to relocate the plant to India where the cost of upgrading the technology was commercially viable. A team of financiers approved of the plan to commission the plant in November 2012, while the CEO moved the State government to allocate land at a substantial subsidy and hired the best of Indian experts and engineers to oversee the construction of the project.

The entire project was lead by a Project Director with impeccable record for his technological insights and a no-nonsense approach to managing the project along very professional lines. His reputation had generated so much awe that no one dared to question him or his approach although a similar sized project undertaken by Reliance Petrochemical was concluded in under 70 weeks.

A few weeks down the road, the project schedules began to slip, resulting in cost overruns. Upon the reassurance of the redoubtable Project Director, the extra funds were mobilized and the meetings continued without too many questions. Unwilling to confront the issue directly, the members of the board began to register their concerns in a very oblique and guarded fashion.

Sapan, the CEO and the CFO felt uneasy at having to alert the Project Director about the grave risk to the viability of the project. While the CFO reported the progress to the investors and regulated the flow of funds as required for the timely completion of the project, the project review meetings continued to be conducted with the highest levels of professional regard. In one such meeting, the CFO expressed his helplessness to revise the projections of project outlay all too frequently and highlighted the needed for the Project Director to anticipate events better and give advance indications about slippages in the project schedule and the need for fresh capital infusion.

The Project Director took serious offense and protested to the CEO that the CFO was needlessly interfering in his work. He felt he could not compromise the quality of construction or the safety of the plant to save ‘a few Crores of rupees’ the CFO wanted and advised the CEO to caution the CFO to mind his own business. The CFO, on the contrary, felt it was very much his business to question the propriety of the fundamental assumptions underlying the project plan. He cited three reasons:

  1. Across industries, ranging from new product introductions, timely entry into new markets, commissioning of new residential space or bridges and highways meant for the public, are delayed. He registered his surprise at the lack the political will in the management to question a senior fellow member on the projections he made about the lead time for projects resulting in the associated cost over runs.
  2. Given that the single largest reason for the delay in projects of all kinds worldwide stems from a poor review of the estimates of time and efforts required to complete a project on time, why were the project plans not audited for its integrity ? If every purchase could be justified by the invitation of at lest three tenders, whey did it not apply to project estimates. Why was the board allowing itself to be held to ransom?
  3. Ironically, instead of taking the initiative to conclude the project sooner and vacating the scene, the overseas consultants were being paid an inordinate fee until the project was fully commissioned. While their expertise and money was essential, why was no one concerned about their returning home early.

Right from inception, the CFO had prepared himself for just this showdown to happen. If the risk of annoying the Project Director was very real, so was the opportunity for early commissioning of the plant and the release of attractive dividends to the shareholders.

He convened an extraordinary board meeting to deliberate on the merits of saving Rs 5 crores for every day the project was commissioned sooner. He summarized his calculations (see table) and appealed to the Project Director to supplement his techno-managerial line of reasoning with a sound appreciation for the financial risk and appraise the board of the need to fore go these savings.

Sapan appreciated the line of reasoning of the CFO but was visibly anxious.

Meanwhile some of the Board members found the reasoning offered by CFO worthy of consideration but were unwilling to challenge the statusquo. How many of us in the board would stand up to such an invitation to greatness; and save the Millions we are meant to safeguard for the benefit, not merely for the shareholder but, the society our posterity as a whole?

Quite like justice, every project delayed is a profit denied!


Computation of savings of RS 5 Crores per day

  1. Additional investment required to crash the project schedule
  • Re-estimation of effort estimates and execution lead time for project completion
  • Additional investments in balancing equipment required to speed up the project
  • Creation of buffers to meet contingencies
  • Provision of incentives for early commissioning
  1. Avoidable heads of expenditure overrun
  • Cost of rework
  • Cost of interest on additional quantum borrowed due to overrun of the initial project outlay
  • Provision for penalties applied on delayed commissioning by suppliers and financiers
  1. Potential profit opportunity to from cash flows kicking in earlier than 100 weeks
  • Interest saved due to advancement in repayment schedules
  • Higher savings from the enhanced earnings during tax holiday period
  • Lower premiums paid on risk of project delays, currency and forward cover for the price of oil and Natural gas in the global markets

Tuesday, February 16, 2010

Returns on Human Capital

The term Human Capital originated with Theodore Schultz, a Nobel Prize winning economist in1979, interested in the plight of the world’s underdeveloped countries. He argued correctly that traditional approach to economic concepts and the styles of people management originating in the West, most notably the US, ignored, avoided or questioned the value of people merely because it did not have a way of quantifying their contribution. It is customary for every organization to claim that people are their most invaluable assets. Unfortunately, only a few lend credence and live fully up to such a lofty to such a claim. The great irony today is that, in spite of several publications and research pointing to the value of human capital, in times of poor economic performance, it is the employees who get laid off or outsourced and it is the budgets set aside for knowledge creation and skill building that gets axed. Why?

After the recent worldwide economic set back, the Global Airlines industry is undergoing a very painful process of readjustment arising out of lost traffic, high fuel prices, hyper competition and bargain hunting internet savvy youthful passengers.

While 29 Airlines are reported to have disappeared during 2008, it is projected that only about 20 Airlines will stay profitably afloat by 2020. At a time when several of these Airlines are reporting losses and looking for government subsidy, Singapore Airlines stands out as a citadel of managerial excellence.

They not only did not lay off their staff, they stayed profitable. the only differentiator was in the way they motivated their people during turbulent times to generate a value that was 2.2 times the salary they earned. ( See table across: Value added 5570.8/Wage bill 2545.9)

A few Indian companies also measure the contribution of their human capital. Even if they do not, there are two numbers in the balance sheet that will tell all that the Stakeholders need to know.

  • PAT ( Profit After Tax) and
  • FTE ( Full Time Employees on the rolls of the company)

Each employee at Infosys earned 12,000 US Dollars as Profits After Taxes in 2005 ( We can look at the latest numbers) while many of the others were earning progressively lower going down to as little as US $ 3000. With wage bills assuming 50% of the revenues for IT companies, the question relating to how much of the high wages earned by IT professionals is justified, can easily be answered. Similarly, the board may also question the quantum of value created by the management before according their approval for the wages and bonus payable to them.

How often would Board members pose such troublesome and inconvenient questions? They may do so if they demand such numbers to be provided to them and do the homework necessary before sitting at the board meeting. They may question the levels of productivity, people who may be kept or under utilized, departments that are of ornamental value, investment in services and facilities that do not earn any value and question the excessive layers of management.

The managements will always be under pressure from the employee associations and unions to pay more wages citing reasons of work stoppage or employee attrition. By giving away more to the employees within , the top management has much less left to keep as reserves for replacing obsolete equipment, invest in R& D for future, pay taxes, interest on borrowings and declare as dividends.

Unless the Board of directors and the top management is willing to hold their people accountable for justifying the salary and wages they demand and demonstrate adequacy of returns to enjoy the privileges, they run the risk of killing the golden goose prematurely. If everyone is keen to take out more than what they put in, there will be very little value add. Investors will lose faith, employees will feel insecure and lenders will demand higher premiums on the money they put out making the company uncompetitive in the market place.

The trustees of the board earn their trust when they take the trouble of doing the homework in advance and cautioning the management before bad decisions are taken; to do so later on would be to invite a heavy cost and lost reputation.

As is often said in the army, it is better to sweat in peace than bleed in war.

Management is about making difficult choices in an intelligent way.

If managers do not find it convenient to decide, they may have to live with the decisions the markets take on their behalf.


What every stakeholder must make it their business to know

We have all heard and read about the fable of goose and the golden egg in our early childhood. The farmer that owns the golden goose is pleased initially with the golden eggs he is served daily until one day he gets so greedy as to cut open up the goose and regret thereafter for life. Towards the end of 2008, unfortunately for the retail investors and the employees, the farmers in the developed world, comprising of the Government, bankers, regulators, the board members and a few of the auditing firms, in whom they had reposed their faith, were dealt a lethal blow. The farmers had consumed the assets or misstated the earning capabilities to serve them rotten eggs instead of the golden eggs promised as dividends. Worse yet, while the farmers walked away almost scott free, the goose, namely the employers were given the boot. For a while savings, growth, profits and dividends evaporated for most of the unsuspecting lot of the public.

With the growing number of affluent Indians ascending the list of the wealthiest of citizens in the world, the ‘virus’ of mismanagement is beginning to take its toll in India as well. Wealth may have unfortunately gone into the hands of people much faster than their maturity to make responsible use of them. The Satyam fiasco, shocking as it might have been, resulted in over 200 Independent board members being sent marching home. It is still unclear if we learnt our lessons from this failure.

Stakeholders will comprise not merely of the people who invest financially in these companies. There is simply too much at stake for every bod today.

For the corporations, the competitive market conditions allow very little margin of error that they need to employ the best of experts to be doubly sure of the risk they invite and the returns they pursue. With fewer options available to make up for bad decisions and limited avenues for exit options, the managers are under ever greater pressure to perform.

The average retail investor is much more at the mercy of a collective syndicate of sophisticated and powerful coterie of farmers than earlier that they need to wake up and become vigilant. With the interest rates on Public Provident Fund being barely enough to cover up the rate of inflation, there is little incentive to keep the money locked up there. For the first time, while the equities have appreciated by nearly 70% last year, the debt instruments have remained unattractive. With physical limitations to the amount of gold and real estate one may buy, out of necessity, people have to become more knowledgeable about how the corporations make sound decisions, govern their own conduct and resist the temptation to kill the golden goose for short term gains.

Then there are the job seekers and the schools of engineerings and management that undertake to get them placed suitably as they get off the campus. Parents who take justifiable pride in the earning abilities of their children, also need to ensure that their employers stay long enough to provide the job opportunities for them.

While there may be tall proclamations about the public having digested the bad news and the optimists pointing to the euphoria that is fast there is still no evidence in sight of any categorical reassurance from any quarter that we are determined to stay out of woods in future. It is not the confidence of the public that is weak but the credibility of the farmer that is still largely at stake.

The stakeholders comprising of retail investors, job seekers, suppliers and distributors alike need to pay attention to KYC-Know your Corporate client better. We may be intuitively unaware of the price we pay for our collective ignorance and selective incapacity to surface and deal with the reality of the state of health of the businesses may be in. Regardless of the stringency adopted by the corporates to in report and act on the truth, culturally also we suffer the handicap of not wanting to embarrass the powers that be by blowing the whistle too loudly. We can no longer afford to remain blissfully ignorant of the role and competence with which our trustees, i.e the board members and their duly appointed CEO’s and Managing Directors, address the realities of business and assure us of the golden eggs they are meant to deliver to the stakeholders.

Those amongst us that are keen to grow their personal wealth or their inheritance from their ancestors, owe it to our future generations of family heirs to manage the estate better. Since investment in publicly held companies has become more of a compulsion than choice, we have to make it our business to comprehend the use made of our investments and take time actions.

It is about time.

For the discerning, the boardrooms offer lessons on corporate governance and principles of sound business management. It is a well known fact that well before an organization is declared technically bankrupt or morally defunct, the first ones to come to know should be the board members.

We believe that to be forewarned is to be forearmed.

Unless we have responsible investors, we may have no responsible assets as investments left for us to manage.

As a part of my efforts to educate the retail investors and promote business literacy among the readers, I am pleased to bring out a series on the typical decisions that the top management of enlightened corporations are faced with and how they are going about taking decisions that impact the value of their returns to the shareholders.

This is being serialized by Nanayam, a fortnightly magazine on money and finance in TAMIL from the Ananda Vikatan group from February 1, 2010. Stay informed and stay invested.