-051-shreyance shah-eva

8/7/2019 -051-Shreyance Shah-EVA

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ACKNOWLEDGEMENTS

-Expression is the Dress Of Thought.

But, at times even the best of words cannot convey your deepest

thoughts. However, this is an attempt to convey to all those people who

have generously lent me their help and support as to how much I

appreciate and value it

I would like to express my heartfelt gratitude to the people whose

contributions have helped me tremendously not only in the successful

completion of my project but also, made the experience extrem

informative and fruitful.

I am indeed thankful to:

Ms. Amrita Vijaykumar

Ms. Rajeshwari Ramachandran

Prof. Kalim Khan

Mr. Gaurav Shah

Mr. Tushar Patel

Who at various capacities have helped me in shaping this report

I am also grateful to Mrs. Sonal Ved, my project guide, K.J.Somaiya

Institute of Management Studies & Research, for spending her valuable

time and providing me all the necessary guidance for my project.


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DECLARATION

The project report in the Area of Specialization Finance is submitted in March 2005 to

K. J. Somaiya Institute of Management Studies & Research, Mumbai in p

fulfillment of the requirement for the award of the degree of Master of Management

Studies (M.M.S) affiliated to the University of Mumbai.

Submitted to

Prof P. V. Narasimham

By

Name: Shreyance Shah

Roll No: 51


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CERTIFICATE

This is to certify that project entitled Economic Value Added (EVA) - An in depth

study is submitted in March 2005 to K. J. Somaiya Institute of Management Studies &

Research by Shreyance Shah, Roll No 51 in partial fulfillment on the requirements of the

awards of the degree of Master of Management Studies (M.M.S) affiliated to the

University of Mumbai for the batch of 2003 - 05

Prof Sonal Ved Prof. P. V. Narasimham

(Project Guide) (Director General)


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Synopsis

Objective of the Report

To understand the concept of EVA and its application in organizations

To understand the implementation and pitfalls in EVA

To understand application of EVA in Corporate portfolio management & other aspect of

portfolio management

To understand the implementation process in Indian organization.

Chapter Scheme

Chapter one Introduction to Value Based Management

This chapter deals with the introduction of the concept of Value based management. EVA is a

subset of this concept. This chapter outlines the need for value based management in the

contemporary and dynamic corporate world.

Chapter Two- EVA

This chapter outlines the meaning of EVA. It also specifies the background in which the concept

was evolved. It also shows with an illustration the methodology to calculate EVA. It also

clarifies certain important concepts relating to the calculation of EVA. Difference between EVA

and other traditional measures have also been dealt with in brief. The chapter also lists down the

rationale for companies adopting or using EVA as a performance management and control tool.

Chapter Three- Pitfalls and Limitations of EVA

The chapter deals with commonly made errors in the process of calculating EVA. Various

pitfalls(mistakes) have been highlighted. Some limitation of the concept have also been

discussed.


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Chapter Four- Implementation of EVA

Model for the implementation of EVA in a corporate setup has been highlighted. Sterns 4M, the

steps specified by Stern Stewart & co., the pioneers in the concepts have been mentioned.

Common mistakes the companies should avoid in implementing EVA have also been highlighted.

Chapter Five- EVA & Corporate Portfolio Strategy

This chapter forms the heart of the research. It shows as to how corporates should manage their

portfolio of customers, brands, SKU through EVA. It gives guidelines for companies to look out

for creating value and enhancing value drivers. It also specifies the procedure for EVA

forecasting. Valuation of companys true economic value through EVA and illustration thereof

have been also provided. It also enumerates the steps to be taken to effectively and efficiently

manage ones portfolio.

Chapter Six- EVA & Portfolio Management

This chapter specifies the main drivers of value of a firm. It shows with illustrations that how the

value of a company is comprised of current operations value (COV) plus Future Growth value

(FGV). It also specifies the method of valuing ones portfolio. The performance \ valuation matrix

helps us to identify the superstars from the laggards and help in further investment or divestment.

Chapter Seven Case study - EVA @ Godrej Industries Ltd.

A brief profile about Godrej industries have been given. This case study highlights the

association of Godrej Industries with the concept of EVA, the process of implementation. The

implementation is analyzed based on the research methodology and parameters mentioned later in

the project.


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Limitations of the report:

The research is restricted to ex-post analysis. Due to strategic nature of the subject companies

are unwilling to part with information due to which ex-ante analysis was not possible.

For certain parameters primary data available was insufficient hence secondary data was used

to supplement it. In some places the author has used the author has used his ingenuity.

The objective of the research is to instill a framework, create awareness about the concepts of

EVA, which is still at a nascent stage in India. Thus in the process to creating awareness the

research may have become a bit theoretical. The author has taken due care to keep the

research subject as contemporary as possible.

Working on the project was a great value addition accompanied by fun. The author is thankful to

all the people associated with him, without whose support and guidance this study would not

have been possible.

Shreyance Shah.


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Research Methodology

Research Design

As the objective indicates, this research is tries to understand in detail how an organization

implements EVA. Further EVA implementation is acontemporary topic that has not been well

researched. This research looks at a sample and describes the process in the organization. Thus a

research design is required that facilities the in-depth exploration of how these organizations have

implemented the EVA process. Hence the case study method has been used in this research.

The case study method is a preferred strategy when how and why questions are being posed.

A technical definition of a case study approach is as follows (Yin, 1987):

A case study is an empirical enquiry that:

Investigates into contemporary phenomenon within real-life context; when

The boundaries between phenomenon and context are not clearly evident; and in which

Multiple source of evidence is used

The case study refers to the collection and presentation of detailed information about a particular

participant or small group, frequently including the accounts of subjects themselves. A form of

qualitative descriptive research, the case study looks intensely at an individual or small

participant pool, drawing conclusions only about that participant or group and only in that

specific context.

The study is exploratory in nature. The focus is not on identifying a generalizable truth or look at

cause effect relationships but on exploration and description which can be accomplished via the

case study method


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Sources of data

Documentation

Announcements & written report of events

Presentations

Formal studies & evaluation of organization under study

Archival Records

Newspapers, business magazines

Company Website

Reliability and validity

According to positivists, the validity of qualitative studies is determined in terms of reliability.

i.e. the reliable (repeatable, generalizable) methods and finding are valid ones. Primarily

secondary sources have been used to validate the data. Further primary data has been obtained

from people who have been a part of the EVA implementation process in the organization. Thus

credible sources add to the validity of the study.

Data Analysis

To facilitate the within case analysis a theoretical framework has been used.

Framework for within case analysis

EVA entails a change in the culture of the organization (Bryne). Implementing EVA in an

organization requires a commitment from the top management, conducting training programs,

modifying systems and structure in the organization. All these imply a process of facilitating and

managing change. Hence a change management framework has been used to analyze the case


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studies considered for the study. This framework is based on a paper that was written by the

researcher. Change in this framework consists of three phases viz leading change, mobilizing

commitment and sustaining momentum.

Leading change

In this stage the organization senses the need for the change (Nadler, 1998); it articulates a vision

around this change (Ulrich, 1997); identifies owners for the change process (Hammer & Slaton,

1998).

Mobilizing commitment

In this stage the organization needs to impart training at all the levels in the organization to equip

people to manage this change . Modifications need to be made to the systems and structures in

the organization to accommodate this change.(Ulrich,1997)

Sustaining momentum

In this final stage the organization may use metrics to track the status of a process and guide

improvement efforts, they also disseminate them through the organization to reinforce peoples

awareness of the process and to focus them on its performance and also conduct organizational

audit (Ulrich, 1997)


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Table of Contents

Synopsis _____________________________________________________________4

Objective of the Report ................................................................................................. 4

Chapter one Introduction to Value Based Management ........................................4

Chapter Two- EVA ........................................................................................................ 4

Chapter Three- Pitfalls and Limitations of EVA ....................................................... 4

Chapter Four- Implementation of EVA ...................................................................... 5

Chapter Five- EVA & Corporate Portfolio Strategy .................................................5

Chapter Six- EVA & Portfolio Management ............................................................. 5

Chapter Seven Case study - EVA @ Godrej Industries Ltd. .................................5Research Methodology _________________________________________________7

___________________________________________________________________12

Chapter 1 Introduction to Value Based Management _______________________13

1.1 Introduction ............................................................................................................ 13

1.2 What is value based management ....................................................................... 14

1.3 The need for Value Based Management .............................................................. 14

Chapter 2 Economic Value Added (EVA) _________________________________17

___________________________________________________________________17

2.1.Introduction ............................................................................................................ 17

2.2.The background of EVA ....................................................................................... 17

2.3. The concept ............................................................................................................ 18

2.4.Calculating EVA ................................................................................................... 19

2.5.Clarifying some concepts ....................................................................................... 20

2.6 .EVA vs. traditional accounting measures ...........................................................22

2.7. EVA and MVA ...................................................................................................... 23

2.8. Why do organizations use EVA ........................................................................... 25

Chapter 3 Pitfalls & Limitations of EVA __________________________________32

3.1 EVA is based on accounting return ...................................................................... 32

3.2 The problem of unevenly divided EVA ...............................................................32

3.3 Distortions caused by inflation, asset structure etc. ............................................34


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3.4 How are different industries affected with these problems? .............................35

3.5 How can you cope with these distortions of EVA ............................................... 35

3.6 The importance of these distortions to companies .............................................. 36

3.7 Limitation ............................................................................................................... 36

Chapter 4 :Implementing EVA in organizations. ____________________________38

4.1.Stern Stewarts 4Ms ............................................................................................... 38

4.2 .EVA and Balanced score Card ............................................................................ 42

4.3.Value drivers .......................................................................................................... 43

4.4 EVA implementation: case study ......................................................................... 44

4.5 The common mistakes in implementing/using EVA ...........................................46

Chapter 5 EVA & Corporate Portfolio Strategy _____________________________49

5.1 Introduction ............................................................................................................ 49

5.2 Measuring Value Creation .................................................................................... 50

5.3 Economic Value Added (EVA) ............................................................................. 52

EVA = Net Operating Profit After Tax Capital Employed x Cost of Capital _____52

5.4 Managing the Value Proposition .......................................................................... 54

5.5 Managing For Both The Short And Long Term ................................................. 56

5.6 The problem of Excess capacity ............................................................................59

5.7 Summary ................................................................................................................. 61

6.1 Introduction ............................................................................................................ 626.2 What does it mean to manage for value ? ............................................................ 62

6.3 Measuring Performance In Your Portfolio ......................................................... 65

6.4 Measuring Value In Your Portfolio ..................................................................... 68

6.5 EVA Forecasting .................................................................................................... 69

6.6 Implications For Terminal Values ....................................................................... 70

6.7 Mapping Performance & Value In Your Portfolio .............................................72

6.8 The Performance / Value Matrix ..........................................................................72

6.9 Value-Based Strategies & Tactics .........................................................................74

6.10 Conclusion ............................................................................................................ 76

Chapter 7 Case study - EVA @ Godrej Industries Ltd. _______________________76

7.1 About Godrej LTD. ............................................................................................... 76

Chronology of events in implementing EVA ............................................................. 77

7.2 Decision To Introduce Eva .................................................................................... 78


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7.3 Implementing EVA @ Godrej .............................................................................. 80

Chapter 8 Bibliography ________________________________________________82


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Chapter 1 Introduction to Value Based Management

Alice never could quite make out, in thinking it over afterwards, how it was that they began: all

she remembers is, that they were running hand in hand and the Queen kept crying `Faster!

Faster!'

But Alice felt she could not go faster, thought she had not breath left to say so. However fast they

went, they never seemed to pass anything. `I wonder if all the things move along with us?'

thought poor puzzled Alice.

`Are we nearly there?' Alice managed to pant out at last.

`Nearly there!' the Queen repeated. `Why, we passed it ten minutes ago! Faster!

Alice looked round her in great surprise. `Why, I do believe we've been under this tree the whole

time! Everything's just as it was!'

The Queen said `Now, HERE, you see, it takes all the running YOU can do, to keep in the same

place.

If you want to get somewhere else, you must run at least twice as

fast as that!'

- Adapted from Through the looking glass by Lewis Caroll.

1.1 Introduction

The plight of todays manager, strikes an instant chord with that of Alice. Every

organization is on the run to outperform its competitor and clinch the crown. However

like Alice they find this finish elusive and find themselves not far from their competitors.

Like Alice, each one wants to get somewhere else and hence you fin

experimenting with a host of concepts like ABC costing, Total Quality Management,

Balanced Score Card, Human Resource Accounting and Economic Value Added, in the

hope that this would result in customer delight, increased top line and bottom line and

thereby creating share holder value.


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Thus when this research was conceived, the objective was to detail what these concepts are, how

organizations implement them and benefit from it. However during the course of the literature

review, it was found that:

Concepts like BSC, TQM, ABC costing have been researched and documented in the Indian

and Global context.

EVA is a concept that is winning fame across the globe. It has caught the attention of the

corporate world and academicians alike; while in the west EVA is old, India has recently but

steadily woken up to EVA. At the same time there is immense scope for research in EVA, in

the Indian Context.

So the question is what makes EVA so popular ? Well, EVA belongs to a school of thought called

Value Based Management. Thus before we understand EVA, its important to understand Value

Based Management.

1.2 What is value based management

VBM is a relatively recent innovation in financial practice. Many regard this as one of the most

important developments in corporate management. VBM represents a synthesis of various

disciplines like finance, strategy, accounting, and organizational behavior.

The VBM or Value Based Management system constitutes a management system designed to

create value for shareholders. A company creates value when the obtained returns are higher than

the cost of capital used to produce these returns It is important for the success of the VBM, to

evaluate and remunerate employees with base in the value created for shareholders (Kratur,et al)

1.3 The need for Value Based Management

The idea that the primary responsibility of corporate management is to increase shareholder value

has gained widespread acceptance worldwide. With the globalization of capital markets,

intensification of competition, and massive privatization initiatives, shareholder value is gaining


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the attention of executives all over the world, including India. The interest in value creation has

been stimulated by several developments:

Institutional investors, who traditionally were passive investors, have begun exer

influence on corporate managements to create value for shareholders.

Many leading companies who have accorded value creation a central place in their corporate

planning serve as role model for others.

The market for corporate control has made value destroyers more vulnerable to raiders.

The business press is emphasizing shareholder value creation in performance rating exercises.

Greater attention is being paid to linking top management compensation to shareholder

returns.

According to Peterson & Peterson (1996), a company should consider the following factors when

choosing a performance measure:

1. The chosen measure should not be influenced by accounting methods,

2. The measures should take into consideration results expected in the future,

3. The measures should take into consideration the risks,

4. The measures should contemplate factors that are not under the control of employees.

VBM consists of the following three principal methods :

The free cash flow method proposed by McKinsey and LEK/Alcar group.

The Economic Value Added/ Market Value Added (EVA/MVA) method pioneered by Stern

Stewart and Company.

The cash flow return on investment/ cash value added (CFROI/CVA) method developed by

BCG and Holt Value Associates. (Chandra,2002)

While the different methods to VBM have their own fan clubs, the EVA method seems to

have received more attention and gained more popularity. This was perhaps triggered by

a leading article in Fortune in 1993 that called EVA todays hottest financial idea.


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According to Michael Jensen, the Fortune story put EVA on the map as the leading

management tool. Since then references to EVA have appeared in Fortune, Wall Street

Journal, and the London times and a number of special-interest magazines. Peter Drucker

referred to EVA as a measure of Total factor productivity and Robert Boldt, the

investment officer at CalPERS, a leading pension fund believes that only EVA gives a

real picture of value creation.

In the subsequent chapters the concept of EVA and how it has been implemented in three Indian

organizations have been detailed.


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Chapter 2 Economic Value Added (EVA)

EVA is based on something we have known for a long time: what we call profits, themoney left to service equity, is usually not profit at all. Until a business returns a profit

that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxesas if it had a genuine profit. The enterprise still returns less to the economy than it

devours in resources. Until then it does not create wealth; it destroys it.-Peter Drucker

2.1.Introduction

The acronym EVA stands for Economic Value Added, a trademark of the New York

based consulting firm, Stern Stewart & Co. EVA is not just a measure of performance;

rather it claims to be a framework for a complete financial management and incentive

compensation system that can guide every decision a company makes, from the

boardroom to the shop floor; that can transform a corporate culture; that can improve the

working lives of everyone in an organization by making them more successful; and that

can help them produce greater wealth for shareholders, customers and themselves.

EVA really caught fire in the 1990s. Big corporations, including Coca-Cola, GE and AT&T,

employ EVA internally to measure wealth creation performance.

2.2.The background of EVA

EVA is not a new discovery. An accounting performance measure called residual income

is defined to be operating profit subtracted with capital charge. EVA is thus one variation

of residual income with adjustments to how one calculates income and capital. According

to Wallace (1997,p.l) one of the earliest to mention the residual income concept was

Alfred Marshall in 1890. Marshall defined economic profit as total net gains less the

interest on invested capital at the current rate. According to Dodd & Chen (1996, p.27)


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the idea of residual income appeared first in accounting theory literature early in this

century by e.g. Church in 1917 and by Scovell in 1924 and appeared in management

accounting literature in the 1960s.

2.3. The concept

EVA estimates a particular type of economic profit, which has been a part of mainstream

economic thinking for more than a century. (Chakrabarati,2000)

For running a business, any organization needs four factors of production viz. capital, labour, rent and

management. Each of these factors have a cost associated with it. Capital in simple term refers to the

fund or money required to finance the business. Broadly an organization can raise this finance in two

ways i.e. either invest its own capital or borrow capital from outside the firm. The financial parlance

for own money is called the money of the shareholders or the equity fund and the money borrowed

from outside is called the debt fund.

Now both debt fund and equity fund entail a cost called the cost of capital. The cost of capital

embodies the fundamental percept, dating all the way back to Adam Smith, that a business has to

produce a minimum, competitive return on all the capital invested in it. The cost of debt is the interest

payment made to the moneylenders. Just as lenders demand their interest payments, shareholders

insist on getting at least a minimum acceptable rate of return on the money they have at risk. This cost

of capital is what economists call an opportunity cost. It is the return that investors could expect to get

by putting their money in a portfolio of other stocks and bonds of comparable risk, and that they

forego by owning the securities of the company in question.

Thus the EVA concept states that in order to assess whether a company earns genuine, it is not

only necessary that the company earns sufficient profit to cover the firms operating costs, but

they should also cover the cost of capital, that is, the cost of borrowed money in the business as

well as the owners fund deployed in the business. Only then, the owner of the business can claim

to have earned a profit. (Chakrabarati,2000)


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Viewed another way, EVA is profit the way shareholders measure it. If shareholders

expect a minimum return of say, 12% on their investment, they dont begin to make

profits until profits rise above that.

2.4.Calculating EVA

EVA is computed as:

Where

EVA = Economic Value Added

NOPAT = Net Operating Profit After Tax

c* = Cost of capital

CAPITAL = economic book value of the capital employed in the firm

r = return on capital = NOPAT/CAPITAL

PAT = Profit After Tax

INT = Interest expense of the firm

t = marginal tax rate of the firm

ke = cost of equity

EQUITY = equity employed in the firm.

Exhibit 2 : Measuring EVA

NOPAT -

EVA =

Capital (r-c*)

[PAT + INT (1-T)] - c* x capital

PAT - Ke EQUITY

c* x capital 1

2

3

4


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2.5.Clarifying some concepts

NOPAT NOPAT represents the total pool of profits available to provide a return to

lenders and shareholders. It is computed as

Weighted Average Cost of Capital (WACC) As mentioned earlier a company may

raise funds through different sources. While computing cost of capital, the goal is to

compute the relative importance of each source of fund in the firms capital structure. In

other words, weights will show the extent to which each component contributes to the

value of the firms capital structure. This is called as the WACC. The formula to

compute WACC is

To illustrate the calculation of EVA let us take a hypothetical profit and loss account of

Company XYZ (Chandra,2002)

Exhibit 3: Balance sheet and P&L statement of XYZ company

Balance sheet as on 31.03.03 P&L Statement for the year

ending 31.03.03

Liabilities

Equity 100

Debt 100

Assets

Fixed assets

140

Net sales

Cost of goods sold 258

Sales/Income Less Operating expenses (including tax but excluding interest)

Percentage of debt in total capital *Cost of debt after tax

+

Percentage of Equity * Cost of Equity.


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200

Net current

60

Assets

20

0

PBIT

Interest

PBT

Tax

PAT

Company XYZs cost of equity is 18 per cent.

The interest rate on debt is 12 per cent and the marginal tax rate is 30 percent. Now

before tax is computed, the company does a deduction to the extent of interest paid on

debt. Thus even though the company claims to pay 12% on debt, its post tax cost of debt

is 8.4 percent

Post tax cost of debt is calculated as:

Pre-tax cost of debt (1-tax rate)

i.e. 12(1-0.30) = 8.4%

XYZ applies both debt and equity. Hence we need to compute the Weighted Average

cost of Capital (WACC) to find out the companys cost of capital.

The formula to compute WACC is

Percentage of debt in total capital *Cost of debt after tax

+

Percentage of Equity * Cost of Equity.

Since XYZ applies debt and equity in equal proportion,

0.5 *18.00.5 * 8.4


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WACC =

XYZs NOPAT (Net Operating Profit After Tax) is calculated as

(Profit before interest and Tax) (1-tax rate)

i.e. 42(1-0.3) = Rs.29.4 million

Based on the above information, XYZs EVA many be computed in four different yet equivalent

ways:

Formula Value EVA

NOPAT c* x Capital 29.4 (0.132) * 200 Rs.3 millionCapital (r-c*) 200 (0.147 0.132) Rs.3 million[PAT + INT (1-t] c* Capital [21 + 12(0.7)] 0.132 * 200 Rs.3 millionPAT Ke EQUITY 21 0.18*100 Rs.3 million

2.6 .EVA vs. traditional accounting measures

Traditional performance measures are based on accounting data. Their advantages include the

fact that information is available in financial reports and they can be easily calculated and

construed (Peterson & Peterson, 1996). The main traditional performance measures are ROI

(return on investment), ROA (return on assets), ROE (return on equity), RONA (return on net

assets), EPS (earnings per share), P/E (price/earnings ratio) (Ricemen et al, 1996)

Martin & Petty (2000) point the following problems with these metrics:

1. The accounting profits and the cash flow are not equal, and it is the cash flow that is

important for the creation of value for shareholders;

2. Accounting figures do not reflect the risk of operations, neither do they consider the cost of

opportunity of equity and the value of money over time;

3. Accounting practices vary from one company to the next.

+

Cost of equityCost of debt

= 13.2%


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The companies are discovering that the traditional measures are not aligned with their cultures

and their strategies. The search for better methods of evaluation is conducting companies to the

adoption of measures of added value, that besides supplying a more consistent evaluation, align

the objectives of the shareholders and of the executives (Flannery et al., 1997).

2.7. EVA and MVA

MVA is the difference between the market value of an enterprise and the capital contributed by

shareholders and lenders. The ultimate objective of every corporation should be to produce as

much MVA as possible. MVA is the definitive measure of wealth creation. It beats out all other

measures because it is the difference between cash in and cash out - between what investors put

into a company as capital and what they could get out by selling at todays market price. As such,

MVA is the cumulative amount by which a company has enhanced or diminished - shareholder

wealth. It is the best external measure of management performance because it captures the

markets assessment of the effectiveness with which a companys managers have used the scarce

resources under their control. MVA also reflects how well management has positioned the

company for the long term because market values incorporate the present value of expected long-

run payoffs. In the jargon of modern financial theory, MVA is nothing more or less than the net

present value, or NPV, of a company. (Ehrbar, 1999)

EVA and MVA are considered as better measures of a companys performance because

both focus on capital efficiency, instead of mere absolute numbers. MVA tells us how

much wealth has been created or destroyed by a company relative to its original

investment. Therefore the company with the highest market capitalization need not be

the biggest wealth creator. This point was highlighted in the fourth BT-Stern Stewart

study on Indias biggest wealth creators:

Company MV MV Rank MVA MVA Rank

Reliance industries 59,113 1 11577 4


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ONGC 56365 2 1167 28

Hindustan Lever 39330 3 35462 1

Indian oil Corporation 38149 4 -3453 499

Wipro 35710 5 33030 2

Infosys Technologies 29985 6 27503 3

SAIL 17721 7 -1335 493ITC 16714 8 11501 5

HPCL 13233 9 1595 15

Ranbaxy Labs. 11816 10 9711 6

Market value and market value added in Rs.crore

(Source : Indias biggest wealth creators, Business today, April 2003)

Exhibit: Enterprise value Vs MVA

While the goal of every company should be to create as much MVA as possible, MVA itself is

not much use as a guide to day-to-day decision-making or long-term planning.

For one thing, changes in the overall level of the stock market can overwhelm the contribution of

management actions in the short run. Second, MVA can be calculated only if a company is

publicly traded and has a market price. Third, even for public companies, MVA can be calculated

only at the consolidated level; there is no MVA for a division, business unit, subsidiary, or

product line. Thus, MVA provides no help in assessing the performance of the many pieces that

make up the corporate whole, and there is no clear way to manage directly for increases in MVA.

As a result, managers have to focus on some internal measure of performance that is closely

linked to the external MVA verdict and EVA is linked to NPV and EVA

As noted, the value of a firm is equal to invested capital plus MVA. Since MVA is the same as

the NPV of the firm, it also is the present value of the amount by which expected future profits

exceed or fall short of the cost of capital (the discount rate used in NPV calculations). That, by

definition, is the same thing as the present value of future EVA. If investors expect a company to

earn its cost of capital - and nothing more or less - it will have a value equal to invested capital,

and MVA will be zero. MVA will be positive if investors expect the company to earn more than

its cost of capital - to produce positive EVA and negative if they expect EVA to be negative.

Thus Algebraically, MVA = the present value of future EVA


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2.8. Why do organizations use EVA

Single metric to assess the performance of an organization

There are several aspects to running a business. These include strategic planning, annual

budgeting, investor relations, human resources, setting financial goals developing long-term

strategic plans and short-term profit plans, making capital investment and disinvestments

decisions, measuring operating performance, communicating with investors. Conventionally,

companies do not do these things in a uniform, systematic and cohesive fashion. For each of

these different metrics were used as shown below :

(Adapted from The Real key to Creating wealth, Ehrbar,1999)

This hodgepodge of rules, and measures often are contradictory and foster confusion and conflict

within an organization, and focus on performance variables that bear no or little relation to the

value of the business.

The EVA based management system are built on the premise that EVA provides a single, unified

and accurate measure of value and performance. It eliminates conflict among various parameters

by incorporating all business issues into integrated criteria. It can start with strategy and move all

the way down to daily operating decisions in the context of impact on EVA. Hence it allows all

financial decisions to be planned, directed, monitored, controlled, evaluated, communicated and

EVA:Integrated

measure

Investor

relations Strategic

planning

Capital

investment

Individual

departments

Incentive based

compensation

Acquisitions

Individual business lines

Corporate

financial goals

Investorrelations

EPS

Marketshare,

EarningsgrowthCapital

investmentDiscounted cashflow

Individualdepartments

Budgeted cost

Incentive basedcompensation

Arbitrarilydetermined targets

Aspects ofmanaging

a business

Conventional

Management

Divergentapproach

Strategicplanning

Acquisitions

Contributions toearning growth

Corporatefinancial goals

EPS & Net worth Individual

business linesReturn on assets

Exhibit: Conventional management


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compensated in terms of a single measure and would provide a common language for employees

across all operating and staff functions. EVA unites all employees in the pursuit of the single goal

of value creation. Managers will certainly still have to consider margins, turnover ratio, unit

costs, cycle time and host of other variables, but the focus is always in the context of their impact

on EVA. Communication channels are strengthened, decision-making speeded up, teamwork

bolstered and parochial behavior declines when everyone is pulling the same ore. (Ehrbar,1999)

This can be represented as follows:

(Adapted from The Real key to Creating wealth, Ehrbar,1999)

True measure of profit

EVA is the fact that it adjusts for the weaknesses in the traditional accounting-based measures.

Conventional accounting practices can be creatively manipulated to generate reports that please

investors. The GAAP based conventional accounting practice is said to be conservative in its

approach. Accountants typically charge off all outlays on intangibles like research

development, employee training and market development. This may deter companies from

investing in these tangibles to realize short-term gains. EVA accounts for these by providing

adjustments over a period of time and thereby eliminating these distortions (Ellen Wong, 1995)

Exhibit: Management under EVA


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Tied to shareholder wealth and a progressive measure.

EVA as a corporate performance measure is tied most directly both theoretically and empirically,

to the creation of shareholder wealth. In this context, studies have been conducted by Stern

Stewart that show a correlation between increasing EVA and increasing stock prices. Further

unlike accounting measures, EVA is not a single period measure; rather EVA planning is a cycle

of around 3-5 years. Thus decisions are guided by short term and long-term gains.

EVA proposes that that the value of a company depends on the extent to which investors expect

future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in

EVA will bring an increase in the market value of a company. This approach has proved effective

in virtually all types of organizations, from emerging growth companies to turnarounds. This is

because the level of EVA isn't what really matters. Current performance already is reflected in

share prices. It is the continuous improvement in EVA that brings continuous increases in

shareholder wealth.

A number of studies attest to the efficacy of EVA as a measure of company performance. Tulley

(1999) summarizes a study that reveals superior stock market performance of companies that have

adopted EVA compared to competitors using other valuation methods. The study, conducted by Stern

Stewart, comprised of 67 publicly owned US EVA clients were compared to 10 firms with similar

Standard Industrial Classification Index (SIC) codes over a five year period. The findings suggest that

EVA adopting companies consistently outperformed their competitors in terms of total returns to

shareholders.

Research by Lehn and Makhija (1997) on 452 firms for the period 1985-94 compared ROA,ROE,

ROS (return on sales), RET (stock performance), EVA and MVA. Among their findings were that

stock returns and EVA had a correlation coefficient of .59. Other accounting measures ROE, ROA,

ROS had coefficients of .46, .46 and .39 respectively, indicating a stronger correlation between EVA

and stock return than the accounting measures.


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Simple to communicate

EVA has the advantage of being conceptually simple and easy to explain to non-financial

managers, since it starts with familiar operating profits and simply deducts a charge for the

capital invested in the company as a whole, in a business unit, or even in a single plant, office or

assembly line. By assessing a charge for using capital, EVA makes managers care about

managing assets as well as income, and helps them properly assess the tradeoffs between the two.

By using EVA drivers (explained in detail later), every employee can understand the contribution

he can make towards creating shareholder wealth.

Further it also helps companies in communicating their goals and achievement to investors, and

that investors can use to identify companies with superior performance prospect

The rewards systems are anchored in EVA.

EVA bonus schemes have two major characteristics of interest from the perspective of creating

value Firstly, congruence is a primary concern of the approach that is, managers objectives are

aligned with shareholders value maximization thanks to a number of economic adjustments of

accounting indicators and to the explicit reference to an external standard of value creation.

Secondly, the approach may be cascaded down towards lower levels of management ensuring a

high degree of controllability that is, managers are accountable with respect to performance

measures defined on their area of responsibility. Consequently, EVA bonus schemes may be

considered as an important management innovation to bypass the traditional congruence-

controllability dilemma. (Larmande and Ponssard, 2003)

Financial Management

A value oriented financial management concept is a better tool as it focuses on profitability and

growth. To put it another way, if ROE is used to manage, then all those units, which increase


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their ROE, are rewarded. There are generally two options for doing this: Increasing profit when

keeping capital employed constant, or reducing capital employed for a given profit. With EVA it

doesn't work this way. Capital costs are the decisive factor. Value is only created if a business

division can either increase its ROE without changing the capital employed to exceed the capital

costs, or if more capital is invested and ROE remains consistently above the capital costs. The

second option is known as profitable growth. Unlike a pure ROE system, the EVA concept

focuses on this second route.. The EVA system helps to highlight and assess the various

alternatives management has to create value.

Gives better direction towards Capital Management

EVA takes all capital sources into account when calculating the return required and therefore

determines the value added, i.e. the shareholder value, as the ultimate objective of the company.

And the theory behind it: companies need equity to grow. The better they can manage the capital

available, the easier it is to obtain new capital for further growth. Its objective is to increase the

organizations knowledge of the company and the understanding of the financial implications of

its processes, which will improve decision-making that, in turn, will increase the value of the

company.

Strategizing

The EVA system is the tool with which you can evaluate and manage a business portfolio on a

value-oriented basis. In different terms, a strategy sets the framework and EVA helps to

demonstrate the extent to which business segments within that framework are contributing to the

overall value of the company. It enables to assess different investment and divestment strategies.

Planning


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The planning process is based on a multi-level and multi-faceted top-down bottom-up dialogue

approach. This means that parameters and targets are set top-down and then, in next steps, these

are validated bottom-up. At the end of the process, a budget and medium term plan emerges with

targets for the Bank as a whole, as well as the divisions and profit centers.

Harmonizes Varied Goals

Most companies use a numbing array of measures to express financial goals and objectives.

Strategic plans often are based on growth in revenues or market share. Companies may evaluate

individual products or lines of business on the basis of gross margins or cash flow. Business units

may be evaluated in terms of return on assets or against a budgeted profit level. Finance

departments usually analyze capital investments in terms of net present value, but weigh

prospective acquisitions against the likely contribution to earnings growth. The result of the

inconsistent standards, goals, and terminology usually is in cohesive planning, operating strategy,

and decision-making. EVA provides a common language for employees across all operating and

staff functions and allows all management decisions to be modeled, monitored, communicated

and compensated in a single and consistent way - always in terms of the value added to

shareholder investment.

Coordination & Control

EVA approach helps divide the whole company into profit centers and determines the value

added for each individual profit center, taking the capital employed into account. EVA derives

internal targets for each profit center from an external capital market oriented viewpoint and

measures the actual value added of a company and all its profit centers.

Wider Scope


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Takes into cost investments in employee training, Research & Development capitalizing the R&D

and writing it off over a period that approximates its expected economic life.

Benefits in Customer Relationship Management

CRM projects typically have large costs early without any cost savings or recognizable revenue

enhancements for a while after the project is completed. EVA enables the Management to have a

basis for comparing these different net cost savings and for evaluating costs incurred now against

benefits achieved later.

Positive Effect on Stock Market Valuation

As companies have become more and more capital market oriented. EVA enables to link internal

management and controlling needs with the external capital market requirements.

Its advantage over other calculations is that it relates directly to stock valuation. The present

value of all future EVA likely to be generated by a company plus the value of its invested capital

is equal to its intrinsic value. In some cases, the intrinsic value and stock price (for publicly held

companies) are linked. If a company is privately held, an internal valuation must be calculated to

determine if EVA is indicating positive or negative results.


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Chapter 3 Pitfalls & Limitations of EVA

Although EVA is a value based measure, and it gives in valuations exactly same answer as

discounted cash flow, the periodic EVA values still have some accounting distortions That is

because EVA is after all an accounting-based concept, suffering from the same problems

of accounting rate of returns (ROI etc.). In other words the historical asset values that distort

ROI do distort also EVA values

The equivalence with EVA and the cash flow based investment and valuation tools NPV and

DCF is due to the fact that in valuations the problematic historical asset values (book value)

are irrelevant (cancel out) and only the cash flows are left to give the end result

3.1 EVA is based on accounting return

As the following formula:

EVA = (ROIC - WACC) * CAPITAL EMPLOYED

reveals, EVA is based on the accounting rate of return. Unfortunately accounting rate of return

have at least two severe pitfalls:

Wrong periodizing (EVA is divided unevenly between different years)

With normal depreciation schedules EVA (and ROI) tend to be small at the beginning of a

project and big at the end of the project. Therefore companies with a lot of new investments

have lower EVA than their true profitability would imply and companies with a lot of old

investments have bigger EVA than their true profitability would imply

3.2 The problem of unevenly divided EVA

The accounting rate of return (e.g. ROI) is far from perfect in estimating the true rate of

return of a company


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If one examines a single project then ROI is a poor estimator or the true rate of return, since

at the beginning of the project when the capital base is big, the ROI is small and then at the

end when the capital base is small then the ROI is big. Following figure illustrates this

problem. It shows the ROI of a 8-year project producing constant operating income and a true

total return of 11% (estimated with IRR).


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As in the above illustration ROI cannot describe the return of a single project since at the

beginning of the project, when capital base is still big, the return is low and when the capital

base gets smaller and smaller ROI shoots to the skies.

Of course no firm is made of one single project and thus projects started at different times

even out this problem a great deal.

However, a firm have seldom totally even investment schedule. So it is seldom the case that a

firm invests every year the same amount of money in fixed assets and that it would then have

assets of all ages smoothly.

Normally the assets have emphasis either on new investments (companies growing heavily)

or on old investments (consider a old unit e.g. an old paper mill that has already depreciated

almost all of its initial fixed investment)

Thus the accounting return is often either understating or overstating the true return of the

enterprise

3.3 Distortions caused by inflation, asset structure etc.

It has been proved many times in financial literature that ROI (or any other accounting return)

is also on average a poor estimator of the true underlying rate of return (Harcourt (1965),

Salomon and Laya (1967), Livingston and Salomon (1970), Kay (1976), Van Breda (1981),

Fischer and McGowan (1983), Fisher (1984), Kay and Mayer (1986), Rappaport (1989), De

Villiers (1989, 1997). That is because Historical asset-values can not describe accurately the

current value of assets tied into business (inflation, different depreciation schedules etc.)

ROI itself does not take into account the time value of money therefore e.g. the decision to

activate R&D costs or to subtract them at once in the income statement effects ROI (ROI is

bigger in the long run if R&D cost are subtracted at once and not activated on the balance

sheet)


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The extent of this distortion in accounting rate of return (and thus in EVA) depends on the

asset structure (the relative proportions of current assets, depreciable assets, undepreciable

assets) and on the length of the investment period, depreciation policy etc.

3.4 How are different industries affected with these problems?

Industries with very cyclical investments (not smooth over the years) and/or industries with

very long investment horizon suffer most from these pitfalls of EVA. These kinds of

industries are e.g.: Telecom. forestry products, pharmaceuticals, semiconductors

Industries with a lot of current (instead of fixed) assets and with short investment period

should not be so worried about these pitfalls. Because current assets represent a large amount

of total assets, then also the value of assets is close to current value of capital tied into

business Short investment period does not give time for distortions, This kind of branches are

e.g.: Personal computers, banking, food and beverages, retailing and publishing, consulting,

engineering, constructing

3.5 How can you cope with these distortions of EVA

There are at least two good ways to try to fix these distortions (These methods (1 and 2) are

totally different and can not be used at the same time/in similar cases as alternatives)

Method 1:

Modify your depreciation schedule so that the periodizing problem vanishes: When depreciations

are flat or emphasized at the beginning of investment period EVA emphasizes at the end of the

period. If depreciations are low at the beginning (compensating high capital cost) then this

problem of unevenly distributed EVA will vanish)

Method 2:


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Estimate the current value of assets and use this as a basis of calculations (instead of book

value of assets)

Another possibility is that you just assess these distortions and thereafter measure your

performance with EVA just as before (when you know the direction of the problem and have

some - although vague - estimation about the effects on your EVA youll probably do quite

well even though you do not correct the problem)

Consideration (not trying to fix this but considering these effects in interpreting information)

3.6 The importance of these distortions to companies

These presented pitfalls of EVA can often be ignored since they are in many cases small and

furthermore it is justified to state that:

It is usually always good when EVA increases and always bad when EVA decreases, thus the

change of EVA is often more important than the absolute level

However it is vital for every CFO to realize that EVA has its weaknesses and thus it is not the

ultimate truth and it does not always tell you the amount of wealth created or destroyed

Understanding the pitfalls helps companies to understand both the concept of EVA and

concept of profitability better

3.7 Limitation

EVA is a widely used Value based performance measure. However studies how shown that EVA may

still not be the best measure of shareholder value. EVA suffers from drawbacks that today question its

efficacy.

Weissenrieder (1997) says EVA must make several adjustments in accounting. He strongly

questions. The possibility of obtaining this in practice, and even if it is possible to make all

164 corrections/adjustments it will still not function well enough. Companies that implement


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EVA are recommended to make about 5-15 corrections/adjustments. This is the strongest

reason for why he claims that EVA cannot be used for Value Based Management.

Further Stern Stewart recommends the four tests that need to be administered before any

adjustment is made. Not many corrections/adjustment can pass all of these tests, which is thereason for why only a few corrections/adjustments are made in reality.

EVA is a concept based on a company's Profit & Loss statements and balance sheets so it is

based on accounting, not cash flow on what determines value, i.e. the relationship between

investments, the cash flow they generate, the economic life of those and their capital cost. So

why does he choose a method that is based on accounting and not cash flow?

Also it has been found that it is difficult to measure how the human resource function

contributes to EVA. Research in the area of developing financial and non-financial

metrics that help identify the contribution of HR to EVA can be carried out.


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Chapter 4 :Implementing EVA in organizations.

One of the widely recognized model for implementing EVA in organization is the 4M

framework proposed by Stern Stewart. Stern Stewart claims that these 4 from the pillars

for a successful value based management system in organizations.

(Adapted fromwww.eva.com)

Exhibit: Stern Stewarts 4-M EVA framework

4.1.Stern Stewarts 4Ms

1. Measurement (M1)

The initial step in the EVA implementation process is developing the EVA measure. Key

adjustments to GAAP accounting translate financial statements from an accounting framework

into an economic framework. Although the recommended adjustments vary from industry to

industry and even company to company, the overall goal of the EVA measure remains the same

to better capture the economic performance of the measured unit.

Stern Stewarts rationale for these adjustments is

a) To better represent the underlying economics of the transactions;

M1MEASUREM

ENT

M1MEASUREM

ENT

M2MANAGEME

NT

M2MANAGEME

NT

M3MOTIVATIO

N

M3MOTIVATIO

N

M4MINDSET

M4MINDSET
http://www.eva.com/http://www.eva.com/http://www.eva.com/


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b) To reduce incentives for dysfunctional or sub optimal decision making; and

c) To improve comparability externally (across firms) and internally (e.g., across divisions) by

putting the accounting on a similar basis. Not all rationales apply to each adjustment. (Biddle et

al, 1999)

Stern Stewart has identified around 165 such adjustments. However it recommends its clients to

make around 10 to 15 adjustments based on each clients specific situations. The following are

some of the common adjustments made to arrive at EVA: (Biddle et al, 1999)

Common Areas where

GAAP based

Accounting is Adjusted

GAAP Treatment Nature of Adjustments

Marketing and R&D costs Expense Record as asset and amortize

Deferred taxes Record as asset

and/or liability

Reverse recording of asset

and/or liability to reflect cash

basis reporting

Purchased goodwill Record as asset;

Amortize over up to 40 years

Reverse amortization to

reflect original asset amount

Operating leases Expense Record asset and amortize;

Bad debts and warranty

costs

Estimate accrual Reverse accruals to reflect

cash basis reporting

LIFO inventory costing LIFO permitted Convert to FIFO

Construction in progress Record as asset Remove from assets

Discontinued operations Include in assets

and earnings

Remove from assets and

earnings

(Source: Evidence on EVA, Biddle et al,99)

Exhibit: Examples of typical Stern Stewart Adjustments for Alleged Accounting Distortions


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tools to help improve the analysis of business issues, consistency of decision-m

documentation, and approval processes throughout the corporation.

3. Motivation (M3)

To instill both the sense of urgency and the long-term perspective of an owner, the company has

to design 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. The aspect of incentives being a crucial one, and of

interest to HR, this aspect has been dealt separately in the subsequent chapter.

4. Mindset (M4)

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.

In order to facilitate transition employees into a mindset of value creation, a significant effort has

to be made on training and communications. Training of key staff on EVA concepts and

corporate finance topics creates a foundation for better understanding. The cont

communication of the EVA philosophy and its successful application then builds on this

foundation and maintains the momentum of these ideas.


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4.2 .EVA and Balanced score Card

Often queries have been raised as to whether EVA and Balanced Score card are in conflict.

However, Robert Kaplan, one of the founders of this concept, has attested that companies can

benefit immensely from the synergies derived from EVA and BSC. There is scope to enhance the

value of both by using the EVA calculation to drive the definition of categories of measures used

in the Balanced Score Cards financial perspective. While EVA is efficient in tracking the

relative value generating performance of an organization and its components, Balanced Score

Card is a powerful complementary tool to guide the management of strategic and operational

plans intended to trigger the sought value generating improvements. (Lawrie, 2001)

A study was carried out by Ellen Wong (1995, University of Waterloo) on the effectiveness of

EVA based on 27 Canadian organizations. His literature indicated that the following factors were

considered essential for EVA implementation

1 Level in senior management support;

2 Use of EVA champions;

3 Extent of compensation integration;

4 Extent of training on EVA;

5 Use of external consultants3.

6 Frequency of considering EVA in business decisions;

7 Number of preliminary analysis considered before EVA that is an analysis of the

culture of the organization, an external analysis of the performance of other organizations

that have implemented EVA, internal analysis of the companys accounting system,

performance and reward management system.

8 Length of time for EVA implementation;

9 Adequacy of the accounting system in supporting EVA;


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All these showed a positive correlation with the success of EVA in the organization.

Three strategy professors at INSEAD provided a comprehensive view of the practice of value-

based management. The authors' companion article, "It's Not Just About the Numbers," in the

July/August 2001 issue of Harvard Business Review draws on the fieldwork and survey data to

argue that successful VBM implementation requires a cultural transformation in large companies.

The summarized findings of the study are as follows:

The top reasons for adopting VBM was to understand what creates and destroys value, to ensure

that the employees appreciate that capital has a cost, and make them act like owners

An explicit commitment to value increases the odds that a VBM program will have a high impact

on a companys relative share price.

Successful VBM companies train all managers

The more widespread the compensation, the greater the chance of success

Successful VBM companies are more likely to integrate the entire resource-allocation into a

single process driven by VBM

4.3.Value drivers

Often concerns are raised that EVA may not be of much practical use to lower level

managers. In response to this, companies are turning to drivers of EVA that can be more

accurately measured at the level of a particular unit than EVA itself and that more closely

corresponds to the responsibilities of unit managers.

Value drivers are proactive measures on which companies can act to anticipate results, with the

objective of creating value for shareholders (RAPPAPORT, 2001; YOUNG & OBYRNE, 2001).

There are two types of drivers: financial and non-financial. Financial drivers consist of historical

data that appraises performance after the event has occurred. For this reason, they are considered

lagging indicators (YOUNG & OBYRNE, 2001).


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Black et al. (2001) identified seven financial drivers: growth of sales, investment in working

capital, investment in fixed capital, operating profit margin, income tax rate, cost of capital and

period of competitive advantage

Companies need indicators with the capacity to forecast the creation of value, which indicate the

value that is being created or destroyed before the events occur. These indicators, known as

leading indicators, are non-financial.

According to Ittner et al. (1997), the exclusive use of financial measures to appraise performance

is not sufficient to motivate managers to act in accordance with the interest of the owners.

Young & OByrne (2001) with a basis on the work by Ittner et al. (1997), present the following

non-financial indicators:

Customer satisfaction, quality of the product or service, safety of employee, productivity, market

share, satisfaction of employee, training of employee and innovation.

The disadvantage of non-financial indicators is that they are difficult to measure and vary from

industry to industry. With the objective of maximizing the creation of value on the long term,

companies need to use financial and non-financial indicators, and the choice of indicators must be

related to the companys strategy. (Krauter, et al)

4.4 EVA implementation: case study

At Briggs & Stratton, training for salaried staff and shop floor workers in the Milwaukee area

began in 1994 and went on for three years; 3000 employees passed through the classes that was

conducted by the corporate training classes. Employees had already been exposed to information

about EVA in a detailed question answer fashion in the company newsletter. Training program

encompassed an overview of the situation that called for EVA, the restructuring program the

company underwent, an explanation on Brigg & Stratton Roadmap to Value creation, strategies

for increasing EVA. (Stern et al, 2001)


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When the Pillsbury Company tried to bake the principles of Economic Value Added, into its

operating philosophy, it brought out large schematic maps of a hypothetical factory. Employees

could trace the flow in and out of the company, from revenues to net operating profit after taxes

to weighted average cost of capital. And rather than reply on standard lectures, they trained 250

senior managers to coach their own departments through an interactive learning session that

encourages employees to figure out for themselves the working of EVA. (CFO,2000)

At Varity, EVA permeates at every level from the boardroom to shop floor. The bonus of the CEO

too depends on whether Varity, meets its EVA targets. Varitys EVA was negative $150 million in

1992. In other words, their cost of capital exceeded net operating profits by &150 million. They set a

five-year target to reach positive EVA in annual increments, using a pre tax cost of capital of 20

percent. By 1995, just three years later, they were approaching 80 percent of their targets. Now EVA

has been passed into their vision statement that clearly articulates Varitys priority to shareholder

value.

The EVA advantage also applies to other contemporary business trends, such as outsourcing .

Advances in communication technologies are making it easier for organizations to coordinate and

cooperate. That makes it more worthwhile to create virtual corporations that are highly

specialized in their value-adding activities. Take Cisco. Commonly regarded as the premier

manufacturing company in the new economy, Cisco, ironically, owns only two of the 36 plants

it uses. The rest are farmed out to contract manufacturers like Solectron and Jabil Circuits. Those

vendors can do the work better than Cisco by concentrating on that end of the business and by

reacting to the reams of real-time information that Cisco provides them. However much Cisco

benefits from the arrangementand it do, in spadesoutsourcing its manufacturing takes a toll

on its P&L statement. Besides invoicing Cisco for the cost of materials and other normal

operating expenses, the contract manufacturers must also charge Cisco for the cost of financing

the manufacturing capital they employ on Ciscos behalf. The vendors in effect pass an asset


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rental charge through Ciscos cost of goods sold. Compared to in-house operation, Ciscos

outsourcing reduces the profit registered on its income statement in exchange for reducing the

capital tied up in its assets on balance sheet Outsourcing sends Ciscos accounting earnings lower

while making its true economic profits higher. By combining the income statement expenses and

balance sheet capital costs into one overall score, EVA enables managers to measure and respond

to the true economic value added by outsourcing and specialization.

4.5 The common mistakes in implementing/using EVA

There are a few common mistakes that are often made in implementing or using EVA. Most of

them are bound up with either misunderstanding and thus misusing the concept at upper levels

(peculiar definition of EVA) or not training all the employees to use EVA and thus not using the

full capacity of the concept

The common mistakes include:

A. Defining capital costs intentionally wrong (usually too high for some reason)

B. Using EVA only in the upper management level

C. Investing too little in training of employees

A. Defining capital costs correctly

EVA akin ROI: Some companies have understood EVA controlling in the same way

as ROI-controlling; if an unit produces a good return then also capital costs are set to a high

level. This kind of procedure is against the whole EVA approach

Other kind of manipulating of capital costs: Some companies have simplified

the reporting by building the tax-costs into capital cost rate (so there is no taxes in reporting

but capital cost percentage is a little bit higher than normally. This is not recommendable for

two reasons:


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Nowadays all the employees are usually so well educated that they can easily understand and

accept EVA if it is properly told to them the capacity of ordinary employees is usually

underestimated and therefore this kind of things are not even tried to explain to all employees


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Chapter 5 EVA & Corporate Portfolio Strategy

5.1 Introduction

Many companies feel pressed to discern exactly where they are creating value and where

they are destroying value within their business portfolios. Yet 80% of companies cannot

measure returns on assets below the business unit level. In practice, meaningful measures

of customer, product and SKU profitability remain a distant dream. Strategies fail in the

decisions, not the vision. It is the deployment and execution of strategies that require

countless economic, value-based decisions to be made at all levels within the company

integrations, dispositions, closures, outsourcing, licensing, customer & SKU

rationalization, and changes to pricing, promotions and value propositions. We have

found all too often that strategies and their execution are premised on flawed measures

and metrics, driving uneconomic decisions and value destruction or sub-optimization.

Figure 1, introduces our value based strategy framework. It draws on Six Sigma and

economic principles to drive value-based strategic change through operations and the

corporate portfolio.


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We apply sound economic analysis and progressive accounting practices to unearth the sources

of value creation and value destruction within a corporate portfolio. We also show how to decide

what to do about it. We define the key elements of a granular value-based profitability measure,

describe what levers can be used to increase contributions to value, show how to categorize

business and activities along a spectrum of contribution to value, and how to optimize the value

of a portfolio of SKUs, customers, and products.

5.2 Measuring Value Creation

Gross Margin or Standard Profit are commonly used measures for low level profitability analysis.

At best, costs may include all variable costs plus fixed costs unitized over the production

quantity, creating severe drawbacks for discerning the sources of value creation and value

destruction.

Standard Measures Are Flawed

Standard Profit ignores the cost of capital the opportunity costs of capital employed in capacity,

inventory, receivables, etc. And excess (unsold) throughput often reduces perceived unit costs,

increasing Standard Profit. Excess throughput costs are capitalized into inventory. Because

inventory has no income statement cost (and sometimes a false absorption benefit) Standard

Profit increases with production, even if there is no demand for the goods that are

produced. Standard Cost also tends to convert period costs into unit costs the fixed production

costs and the costs of capacity. This leads to a situation where Standard Profit per unit can be

maximized by producing as many units as possible, independent of demand. Figure 2 illustrates

the chronic problem that results from using the ever-popular potpourri of performance metrics

top line growth, market share, gross margin, operating income and Standard Cost as an implicit

proxy for value creation. This company chased these metrics into bankruptcy with a declining


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return on capital and negative economic profits. Top line growth and Standard Cost reduction can

mask rampant value destruction if the costs of capital and capacity are not adequately accounted

for and covered. This company was growing capacity and inventory at a time when markets were

already flooded with products. Plant managers are often directed to minimize unit costs,

irrespective of actual demand, and will thus produce to, and expand capacity. Gross margins and

Standard Profits will increase with production and capital investment, but inventory levels,

utilization and ultimately returns on capital and EVA suffer. This company, within a short period

of time, found themselves with warehouses full of excess inventory and plant capacity they didnt

need.

In our experience this case is all too common. Rampant over-capacity plagues many sectors,

undermining margins. In some cases, excess inventory reaches a point where product quality,

material flow, and order fulfillment suffer. Excess product is often heavily disc

wholesaled, or scrapped. One chocolate company allowed trade loading to tarnish its brand

because of consumer association with stale product. In another case, a company actually rented

storage trailers and filled them with excess inventory.


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5.3 Economic Value Added (EVA)

Economic Value Added (EVA) is the most prominent version of economic profit or residual

income and is defined as follows:

EVA simultaneously captures revenue, cost and the cost of capital in one measure. It charges the

full cost of your balance sheet to a new economic profit statement. It is the single measure to

manage the complex tradeoffs between profit and capital, risk and return, short and long term.

But to measure value creation and destruction at low, granular levels within the corporate

portfolio (customer, SKU, product, brand) several measurement issues must be addressed.

1. A Cost for Capital

A true economic profit measure must include a charge for the capital invested in the business.

Although a capital charge is a necessary component for creating a value based profitability

measure, there are issues with how to measure the actual level of capital employed at these low

levels. Capital has two main components, they are net working capital and the fixed assets put in

place to provide a platform for doing business. On the surface, measuring the components of

capital would seem to be a simple procedure: Simply measure the point-in-time levels of working

capital plus fixed assets, and attribute these to products and customers. But there are difficulties.

a) Actual versus Optimal Inventory

Actual inventory levels are not likely to be optimal. As demonstrated above, traditional

performance measurement and incentive systems, which neglect the cost of capital, focus on plant

efficiency. Thus, the observed level of inventory does not reflect the level needed to run the

business smoothly, thus distorting a forward-looking analysis of economic profitability. When

EVA = Net Operating Profit After Tax Capital


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measuring performance ex poston a firm level, actual levels of inventory, accounts receivable

and accounts payable must be considered because managers should be held accountable for tying

up working capital. However, looking back at our previous example, it can be inappropriate to

assign the costs of the excess inventory sitting in trailers ex ante. These inflated levels of

inventory do not represent the true capital investment needed to sell the product. Therefore, to

assess economic profitability on a forward-looking basis, it may be most appropriate to

approximate normalized inventory requirements.

b) Customer versus Product Working Capital

Net working capital is especially susceptible to distortion by inaccurately assigning capital costs

to either products or customers. While it may be easy to attribute accounts receivable to a

customer, it is more difficult to justify that charge when looking at product profitability because

the charge is the result of the customer being served. When a product is sold to a large customer,

the profitability of that product is influenced by the profitability of that customer. Retail suppliers

are subject to this problem. Many of their products appear unprofitable because they serve a very

few large customers and numerous small shops. Large customers have the power to force a

supplier into longer terms, higher inventory requirements and lower margins. When the product is

sold to the small shops it appears profitable, but when the same product is sold to large customers

it looks unprofitable.

c) Fixed Assets

Measuring fixed capital has some of the same pitfalls as working capital. Fixed asset values are

not as volatile, but book values do not represent the true opportunity cost of capital employed.

Book values can be overstated for plant and property in sectors with chronic overcapacity or high

closure costs, and can be understated for equipment that can remain in service long beyond stated

lives. Net realizable value (NRV) is a more accurate measure for the opportunity cost of fixed


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assets. NRV should be an approximate expected salvage or liquidation value, net of all exit or

closure costs (e.g. severance and tax). NRV is a forward-looking measure for the opportunity cost

of capital and should be used especially when liquidation can be considered a viable long- or

short-term alternative. However, closing facilities with little or no NRV provides no economic

benefit beyond potential secondary effects from a reduction in capacity. In economic terms, this

capacity is now essentially free.

2. Throughput Accounting

We propose full cost accounting, including the cost of all capital, but with an assumed 100%

capacity utilization. Instead of unitizing fixed costs (including the cost of capital) over actual or

budgeted volumes, throughput accounting unitizes them by capacity. When utilization is less than

100%, a portion of overhead remains an unallocated, period cost. Thus, volume variance does not

impose any burden on either customer or product profitability. Traditional Standard Costing

makes volume variance a unit cost rather than a period cost. Under this system, increased excess

capacity increases Standard Cost and reduces perceived product profitability. If this measure is

used to make decisions and unprofitable customers or products are dropped, all remaining

customers or products are forced to absorb an even higher fixed-cost burden, making the products

appear even less profitable. This Death Spiral accounting is even more severe when the cost of

capital is also included, making the cost of volume variance that much more significant. But,

using throughput accounting, profitability is independent of utilization and portfolio mix and

capacity decisions can be made more correctly and independently. Additionally, comparisons of

customer and product profitability can be made across plants where utilization rates vary.

5.4 Managing the Value Proposition

Measuring and analyzing the sources of value creation and value destruction within your

corporate portfolio is only the beginning. Ultimately, improvements must be made to mitigate


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sources of value destruction while leveraging sources of value creation. Changes in pricing,

terms, promotions, selection, availability, process control and quality, packaging and other

aspects of the total value proposition will each need to be reviewed in light of the new insights.

Much ado is often made of loss leader strategies, intentionally losing money somewhere in

order to more than make up for it elsewhere. For example, retailers drop their prices on select

visible items (e.g. milk, diapers) to establish an image of value pricing in the minds of

shoppers. Weve all heard how Polaroid must sell cameras at a loss in order to make it up in film.

However, these strategies, their performance and their value need to be carefully quantified and

monitored. Once a star, Polaroid is now a bankrupt company. The loss leader strategy creates

challenges for your action plan. While it might appear that dropping a loss leader would

improve profitability, it can reduce sales of profitable products and overall profitability. For

example, after lobbying for a price increase and working capital improvements, one client was

still losing $2 million per year on a product to a large retailer but retained the customer because

of $4 million per year of related, and profitable, sales.

1. Pricing

Pricing is a primary lever in the value proposition. But generally price and volume vary inversely.

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