Economic Value Added (EVA�)Economic Value Added (EVA�)

By
Shyamlal R Sharma
MBA (Marketing) 2004-06
Sardar Patel University
VV Nagar, Gujarat-388 001
E-mail: shyamsharma_2001@rediffmail.com / rock_0021@yahoo.co.uk

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.
EVA� (Economic Value Added)
EVA� (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, 1998). 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 1998), 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').
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

NameTimeframeUse of EVA
The Coca-Cola Co.Early 1980sFocused business managers on increasing
shareholder value
AT&T Corp.1994Used EVA as the lead indicator of a performance
measurement system that included "people value added" and "customer
value added"
IBM1999Conducted a study with Stern Stewart that indicated that
outsourcing IT often led to short-term increases in EVA
Herman Miller Inc.Late 1990sTied 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.
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Shyamlal R Sharma
MBA (Marketing) 2004-06
Sardar Patel University
VV Nagar, Gujarat-388 001
E-mail: shyamsharma_2001@rediffmail.com / rock_0021@yahoo.co.uk

Source : E-mail December 31, 2005