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Home » MBA Articles » MBA - Customer Relationship Management Articles » Economic Value Added (EVAŽ)

Economic Value Added (EVAŽ)

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Introduction

What is Performance Measurement (PM)?

Historically,
PM systems was developed as a means of monitoring and maintaining
organisational control, which is the process of ensuring that an
organisation pursues
strategies that lead to the achievement of overall goals
and objectives (Nanni, et al 1990). PM plays a vital role in every
organisation as it is often viewed as a forward-looking system of
measurements that assist managers to
predict the company's economic performance and spot the
need for changes in operations. In addition, PM can provide managers,
supervisors and operators with information required for making daily
judgements and decisions. PM is
increasingly used by organisations, as it enables them
to ensure that they are achieving continuous improvements in their
operations in order to sustain a competitive edge, increase market share
and increase profits.


Traditional measures

Traditional
PM has mainly been financial measuring ratios such as ROI (Return on
Investment), RI (Residual Income), and EPS (Earnings per share). These
metrics accounts for the costs
associated with capital and help firms spot areas in
which capital is being invested unprofitably. Although these financial
data have the advantage of being precise and objective, the limitations
are far greater, making them less
applicable in today's competitive market. Organisations,
that have adopted the traditional PM, have experienced great difficulty
in trying to fit the measures with increasing new business environment
and current competitive
realities.

While
the traditional financial metrics are value-based, they are nonetheless
lagging indicators. They offer little help for forward-looking
investments, where future earnings and capital requirements are
largely unknown investments such as new product
introductions and capital or new market entry. This will lead to narrow
short-term decision-making based on bottom-line financial results.

On
the other hand, most of
the criticism of traditional PM stems from their failure
to measure and monitor multiple dimensions of performance, by
concentrating almost exclusively on financial measure (Brignall and
Ballantine, 1996). They solely concentrate
on minimising costs and increasing labour efficiency
while neglecting other operational performance measures such as quality,
responsiveness and flexibility (Skinner, 1974) Therefore focusing on
financials to the exclusion of all
other factors can produce distortions such as low cost
and high margin productions unnecessarily.

However,
despite the criticisms made on traditional financial measure, many
companies still use them to measure
performance. Many organisations, even until the end of
1970s, operate performance under central control, through large
functional department. Thus, allowing managers to use slow-reacting and
tactical management control system such
as 'budgets'. These budgeting measures mainly focus on
short-term value creation as it only attempts to control and improve
existing operations. However budgeting systems are inflexible for
today's dynamic and rapidly changing
environment organisations still continue to use them.
This is because implementing new measures designed to manage strategy
and not control is very difficult.

Moreover,
most companies motivate their worker through
reward system. Rewards can be financial such as cash
payments, bonuses or share options and non-financial such as promotion.
Traditionally, employees are rewarded with bonuses at the end of the
year once a specific target has been
achieved. However, this reward system causes
short-termism as employees are seen to narrow down their focus by just
targeting the 'rewarded' goal. They may not take other factors, such as
quality and service into consideration.
Hence leading businesses to run without long-term
vision.

EVAŽ (Economic Value Added)

EVAŽ
(Economic Value Added) was developed by a New York
Consulting firm, Stern Steward & Co in 1982 to promote
value-maximizing behaviour in corporate managers (O'Hanlon. J &
Peasnell. K, 199. It is a single, value-based measure that was
intended to evaluate business strategies, capital projects and to
maximize long-term shareholders wealth. Value that has been created or
destroyed by the firm during the period can be measured by comparing
profits with the cost of capital used to produce them. Therefore,
managers can decide to withdraw value-destructive activities and invest
in projects that are critical to shareholder's wealth. This will lead to
an increase in the market value of the company. However, activities
that do not increase shareholders value might be critical to customer's
satisfaction or social responsibility. For example, acquiring expensive
technology to ensure that the environment is not polluted might not be
of high value from a shareholder's perspective. Focusing solely on
shareholder's wealth might jeopardize a firm reputation and
profitability in the long run.

EVA
sets managerial performance target and links it to reward systems. The
single goal of maximizing shareholder value helps to overcome the
traditional measure problem, where different measures are used for
different purposes with inconsistent standards and goal.
Rewards will be given to managers who are able to turn investor's money
and capital into profits efficiently. Researches have found that
managers are more likely to respond
to EVA incentives when making financial, operational and
investing decision (Biddle, Gary, Managerial finance 199, allowing
them to be motivated to behave like owners. However this behaviour might
lead to some managers pursuing
their own goal and shareholder value at the expense of
customer satisfaction.

Unlike
simple traditional budgeting, EVA focuses on ends and not means as it
does not state how manager can increase company's value as
long as the shareholders wealth are maximised. This
allowed managers to have discretion and free range creativity, avoiding
any potential dysfunctional short-term behaviour. Rewards such as
bonuses from the attainment of EVA target
level are usually paid fully at the end of 3 years. This
is because workers' performance is monitored and will only be rewarded
when this target is maintained consistently. Hence, leading to long-term
shareholders' wealth.

Cola-Cola
is one of the many companies that adopted EVA for measuring its
performance. Its aim, which was to create shareholders wealth, was
announced in its annual report. Coca-Cola CEO Roberto Goizueta
accredited
EVA for turning Coca-Cola into the number one Market
Value Added Company. Coca-Cola's stock price increased from $3 to over
$60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola's
investor received $8.63 wealth for
every dollar they invested.

Most
companies refer to stock price increase as an outcome of implementing
EVA. However, empirical studies have found that traditional accounting
measure have provided a similar, or even
better result in increasing stock performance (Dodd J
and Johns J 'EVA reconsidered&apos.

EVA
is a financial measure based on accounting data and is therefore
historical in nature. It has the same limitations as other
traditional accounting measures and cannot adequately
replace all measures within the company especially the non-financial
ones. Due to the historical nature of EVA, manager can benefit in terms
of rewards or be punished by the
past history of the organisation (Otley, David
Performance management 1999). Dodd J and Johns J see the balanced
scorecard as one approach to overcome the potential problem of using a
single financial measure such as EVA.


How Companies Have Used EVA




























Name

Timeframe

Use of EVA

The Coca-Cola Co.

Early 1980s

Focused business managers on increasing shareholder value

AT&T Corp.

1994

Used EVA as the lead indicator of a performance measurement system that included "people value
added" and "customer value added"

IBM

1999

Conducted a study with Stern Stewart that indicated that outsourcing IT often led to short-term
increases in EVA

Herman Miller Inc.

Late 1990s

Tied EVA measure to senior managers' bonus and compensation system



4 Ms of EVA

As a mnemonic device, Stern Stewart describes four main applications of EVA with four words beginning
with the letter M.

Measurement


EVA
is the most accurate measure of corporate performance over any given
period. Fortune magazine
has called it "today's hottest financial idea," and
Peter Drucker rightly observed in the Harvard Business Review that EVA
is a measure of "total factor productivity" whose growing popularity
reflects the new
demands of the information age.

Management System

While
simply measuring EVA can give companies a better focus on how they are
performing, its true
value comes in using it as the foundation for a
comprehensive financial management system that encompasses all the
policies, procedures, methods and measures that guide operations and
strategy.
The EVA system covers the full range of managerial
decisions, including strategic planning, allocating capital, pricing
acquisitions or divestitures, setting annual goals-even day-to-day
operating decisions.
In all cases, the goal of increasing EVA is paramount.

Motivation



To
instill both the sense of urgency and the long-term perspective of an
owner, Stern Stewart designs
cash bonus plans that cause managers to think like and
act like owners because they are paid like owners. Indeed, basing
incentive compensation on improvements in EVA is the source of the
greatest
power in the EVA system. Under an EVA bonus plan, the
only way managers can make more money for themselves is by creating even
greater value for shareholders. This makes it possible to have bonus
plans with no upside limits. In fact, under EVA the
greater the bonus for managers, the happier shareholders will be.

Mindset


When implemented in its totality, the EVA financial
management and incentive compensation system transforms a corporate
culture. By putting all financial and operating functions on the same
basis, the
EVA system effectively provides a common language for
employees across all corporate functions. EVA facilitates communication
and cooperation among divisions and departments, it links strategic
planning
with the operating divisions, and it eliminates much of
the mistrust that typically exists between operations and finance. The
EVA framework is, in effect, a system of internal corporate governance
that automatically guides all managers and employees and
propels them to work for the best interests of the owners. The EVA
system also facilitates decentralized decision making because it holds
managers responsible for-and rewards them for-delivering
value.

The EVA Concept of Profitability


EVA is based on the concept that a successful firm
should earn at least its cost of capital. Firms that earn higher returns
than financing costs benefit shareholders and account for increased
shareholder
value. In its simplest form, EVA can be expressed as the
following equation:

EVA = Net Operating Profit After Tax (NOPAT) - Cost of Capital


NOPAT is calculated as net operating income after
depreciation, adjusted for items that move the profit measure closer to
an economic measure of profitability. Adjustments include such items as:
additions
for interest expense after-taxes (including any implied
interest expense on operating leases); increases in net capitalized
R&D expenses; increases in the LIFO reserve; and goodwill
amortization. Adjustments
made to operating earnings for these items reflect the
investments made by the firm or capital employed to achieve those
profits. Stern Stewart has identified as many as 164 items for potential

adjustment, but often only a few adjustments are
necessary to provide a good measure of EVA.[1]

Measurement of EVA


Measurement of EVA can be made using either an operating
or financing approach. Under the operating approach, NOPAT is derived
by deducting cash operating expenses and depreciation from sales.
Interest expense is excluded because it is considered as
a financing charge. Adjustments, which are referred to as equity
equivalent adjustments, are designed to reflect economic reality and
move income
and capital to a more economically-based value. These
adjustments are considered with cash taxes deducted to arrive at NOPAT.
EVA is then measured by deducting the company's cost of capital from
the NOPAT value. The amount of capital to be used in the
EVA calculations is the same under either the operating or financing
approach, but is calculated differently.


The operating approach starts with assets and builds up
to invested capital, including adjustments for economically derived
equity equivalent values. The financing approach, on the other hand,
starts with
debt and adds all equity and equity equivalents to
arrive at invested capital. Finally, the weighted average cost of
capital, based on the relative values of debt and equity and their
respective cost
rates, is used to arrive at the cost of capital which is
multiplied by the capital employed and deducted from the NOPAT value.
The resulting amount is the current period's EVA.

EVA Calculation and Adjustments

As
stated above, EVA is measured as NOPAT less a firm's cost of capital.
NOPAT is obtained by adding interest expense after tax back to net
income after-taxes, because interest is considered a capital
charge for EVA. Interest expense will be included as
part of capital charges in the after-tax cost of debt calculation.


Other items that may require adjustment depend on
company-specific activities. For example, when operating leases rather
than financing leases are employed, interest expense is not recorded on
the
income statement, nor is a liability for future lease
payments recognized on the balance sheet. Thus, while interest is
implicit in the yearly lease payments, an attempt is not made to
distinguish it as a
financing activity under GAAP.

Under
EVA, however, the interest portion of the payment is estimated and the
after-tax amount from it
is added back into NOPAT because the interest amount is
considered a capital charge rather than an operating expense. The
corresponding present value of future lease payments represents equity
equivalents for purposes of capital employed by the
firm, and an adjustment for capital is also required.

R&D
expense items call for careful evaluation and adjustment. While GAAP
generally requires most R&D
expenditures to be expensed immediately, EVA capitalizes
successful R&D efforts and amortizes the amount over the period
benefiting the successful R&D effort.


Other adjustments recommended by Stern Stewart include
the amortization of goodwill. The annual amortization is added back for
earnings measurement, while the accumulated amount of amortization is
added back to equity equivalents. Goodwill amortization
is handled in this manner because by "unamortizing" goodwill, the rate
of return reflects the true cash-on-yield. In addition, the decision to
include the accumulated goodwill in capital improves the
real cost of acquiring another firm's assets regardless of the manner
in which the acquisition is accounted.


While the above adjustments are common in EVA
calculations, according to Stern Stewart, those items to be considered
for adjustment should be based on the following criteria:

  • Materiality: Adjustments should make a material difference in EVA.
  • Manageability: Adjustments should impact future decisions.
  • Definitiveness: Adjustments should be definitive and objectively determined.
  • Simplicity: Adjustments should not be too complex.

If an item meets all four of the criteria, it should
be considered for adjustment. For example, the impact on EVA is usually
minimal for firms having small amounts of operating leases. Under these
conditions, it
would be reasonable to ignore this item in the
calculation of EVA. Furthermore, adjustments for items such as deferred
taxes and various types of reserves (i.e. warranty expense, etc.) would
be typical in
the calculation of EVA, although the materiality for
these items should be considered. Unusual gains or losses should also be
examined and eliminated if appropriate. This last item is particularly
important as
it relates to EVA-based compensation plans.

Strategies for increasing EVA

  • Increase the return on existing projects (improve operating performance)
  • Invest in new projects that have a return greater than the cost of capital
  • Use less capital to achieve the same return
  • Reduce the cost of capital
  • Liquidate capital or curtail further investment in sub-standard operations where inadequate returns are being earned

Advantages of EVA

EVA
is more than just performance measurement system and it is also
marketed as a motivational,
compensation-based management system that facilitates
economic activity and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their competitors
when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

  • EVA eliminates economic distortions of GAAP to focus decisions on real economic results
  • EVA provides for better assessment of decisions
    that affect balance sheet and income statement or tradeoffs between each
    through the use of the capital charge against NOPAT
  • EVA decouples bonus plans from budgetary targets
  • EVA covers all aspects of the business cycle
  • EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional benefits:

  • Goal congruence of managerial and shareholder
    goals achieved by tying compensation of managers and other employees to
    EVA measures (Dierks & Patel, 1997)
  • Better goal congruence than ROI (Brewer, Chandra, & Hock, 1999)
  • Annual performance measured tied to executive compensation
  • Provision of correct incentives for capital allocations (Booth, 1997)
  • Long-term performance that is not compromised in favor of short-term results (Booth, 1997)
  • Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE (Chen & Dodd, 1997)

Limitations of EVA

EVA
also has its critics. The biggest limitation is that the only major
publicly-available sample evidence
on the evidence of EVA adoption on firm performance is
an in-house study conducted by Stern Stewart and except that there are
only a number of single-firm or industry field studies.


Brewer, Chandra & Hock (1999) cite the following limitations to EVA:

  • EVA does not control for size differences across plants or divisions
  • EVA is based on financial accounting methods that can be manipulated by managers
  • EVA may focus on immediate results which diminishes innovation
  • EVA provides information that is obvious but offers no solutions in much the same way as historical financial statement do

Also, Chandra (2001) identifies the following two limitations of EVA:

  • Given the emphasis of EVA on improving
    business-unit performance, it does not encourage collaborative
    relationship between business unit managers
  • EVA although a better measure than EPS, PAT and RONW is still not a perfect measure

Brewer et al (1999) recommend using other performance
measures along with EVA and suggest the balanced scorecard system.
Other researchers have noted that EVA does not correlate as strongly
with stock returns as its proponents claim. Chen &
Dodd (1997) found that, while EVA provides significant information
value, other accounting profit measures also provide significant
information and
should not be discarded in favor of EVA alone. Biddle,
Brown & Wallace (1997) found only marginal information content
beyond earnings and suggest a greater association of earnings with
returns and
firm values than EVA, residual income, or cash flow from
operations.

Finally, a key criticism of EVA is
that it is simply a retreaded model of residual income and that the
large number of "equity adjustments" incorporated in the
Stern Stewart system may not be necessary (Barfield, 1998; Chen &
Dodd, 1997; O'Hanlon & Peasnell, 1998; Young, 1997). The similarity
between
EVA and residual income is supported by Chen and Dodd
(1997) who note that most of the EVA and residual income variables are
highly correlated and are almost identical in terms of association to
stock return.


Bibliography

Berry J. (2003). Economic Value Added. Computerworld.
McLaren J. (2003). A Sterner Test. Financial Management.
Taub S. (2003). MVPs of MVA. CFO.

King J. (2002). Metrics for the Book. Computerworld.
Paulo S. (2002) Is EVA Fiction? An Academic Comment. Corporate Finance.
"EVAŽ Clients Outperform the Market and Their Peers" (2002). EVAluation.

"How to Structure Incentive Plans that Work" (2002). EVAluation.
Aggarwal R. (2001). Using Economic Profit to assess performance: A metric for Modern firms. Business Horizons.

Ray R. (2001). EVA: Theory, Evidence, A Missing Link. Review of Business.
"EVAluating M&As – How to avoid overpaying" (2001). EVAluation.
Shand D. (2000). Economic Value Added. Computerworld.

Kudla R. J. (2000). Making EVA Work. Corporate Finance.
Prober L. M. (2000). EVA: A Better Financial Reporting Tool. CPA Journal.
"Case study: NIIT, Paying for value" (2000). Business India Intelligence.
 






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