Economic Value Added (EVA)





Economic Value Added (EVA)

EVA is the most successful performance metric used by their corporations as per a commercial perspective. Despite its popularity attributed to successful marketing by Stern Stewart & Co, by financial theory has proven it. It is also consistent with various valuation principles, which is important to investors’ analyses. Today it is one of the most sought after financial tools. It is simple to understand why. Administrators have increased the value of their companies by simply following the rules of EVA. Similarly, equity investors who have used EVA and have identified which companies are using them have gained wealth. Therefore, the decision by major corporations such as AT&T to switch to EVA as a measure of performance is justified.

EVA is simply a metric used to determine a corporation’s profitability relative to its capital cost. Capital cost refers to money used in purchase of products necessary for the operation’s success. In short, EVA refers to after-tax-profits minus the sum of annual capital costs. As it turns out, most companies do not know how much their capital costs and thus they end up covering their costs and adding value to a firm. Despite EVA’s popularity today, it isn’t the newest idea in corporate finance. The oldest idea in business is earning more revenues than the cost of capital.

In 1988, John Snow, CEO of CSX Corp, introduced EVA to his company. CSX deals with freighting goods using its enormous fleet of containers and railcars. On that particular year, the metric pointed at negative $70 million in its Intermodal business.. The CEO therefore ordered the division to get the EVA up to breakeven point by 1993 or face sale. Since then, Intermodal’s freight volumes have been up while the capital costs have declined. Other major corporations have also embraced the metric with profound success. Briggs & Stratton for instance, has achieved profitability by enforcing EVA on its five divisions. The principle has also enabled Coca-Cola to achieve improved cash flow in its operations (Tully & Hadjian 38).

Job order costing is a method of allocating costs of manufacturing to individual products. When the manufacturing processes are different from each other, job-order costing is applied. Due to the significant differences in the manufacture of products, the job order costing system will develop a job cost record for every commodity. That record will show the materials used, labor utilized as well as manufacturing overhead spent in each activity. This way, the cost of capital can be determined as per EVA methodology. An instance of a company that utilized this was Briggs & Stratton.

Before its implementation of EVA, Briggs & Stratton lacked a profit centre in the consumer engine business. The company also lacked knowledge of each division’s EVA thus; it suffered high capital costs without knowledge. With implementation, each division knows its EVA regardless of the product made; whether a lawn mower or pump. That knowledge has enabled the company to save a lot of money by outsourcing production of some expensive components. For instance, the company has phased out production of the largest engines for pumps and generators to Mitsubishi. Thus, capital that was previously tied to expensive processes has now been freed up for more profitable ventures by reduction of variable costs.

Cost Volume Profit analysis (CVP analysis) is a powerful tool. This is because it enables managers to understand the relationships between cost, volume and profit in their enterprise. CVP is takes place by focusing on various interactions. For instance; prices of products and per unit variable cost. Other interactions are; the level of activity, total fixed costs and the mix of sold products. Use of CVP analysis is important in making of various decisions by managers such as what products to manufacture, pricing to apply and which strategies to implement in marketing. CVP concepts play a critical role in EVA.

CVP concepts such as change in variable, fixed and sales costs enable managers to determine costs of capital. Since application of EVA by CSX Corp, its Intermodal division has been able to track such costs efficiently. The number of containers and trailers used has dropped from 18,000 to 14,000. However, its freight volume has since increased by 25%. Initially, they used to delay at terminals. With EVA, managers at CSX were able to identify them as idle capital. They therefore developed means to take the containers to the rails in five days. CSX has also been able to reduce its fleet of locomotives from 150 to 100, representing a $70 million decrease in capital costs. By ensuring higher load capacities in its routes, the trains used reduced.

Segment reporting is the provision of separate accounts of a public corporation’s different divisions. Its purpose is to provide shareholders proper knowledge of the company’s performance in each segment it carries out business. Managers use it to determine profitability and incomes for each division. This is very useful in EVA metrics. Initially, AT&T Corporation only provided balance sheets for its six largest divisions. Most of the smaller business segments such as toll-free number services were lumped together as a group. Therefore, managers were oblivious of which segment benefited AT&T and which made losses. On adoption of EVA however, things have taken a turn. Robert Allen, CEO of AT&T encouraged managers to sub-divide their profit centers into several semi-independent entities. As a result, the balance sheet contains all capital costs. Smaller divisions are now required to beat capital costs and contribute to the company’s earnings.

Activity based costing (ABC) is useful in implementation of EVA. It enables managers to assign overhead costs in manufacture based on machine hours and returns on investment. The Coca-Cola Company has implemented EVA very successfully by carrying out activity based costing. The company consists of several divisions. However, its most profitable is the soft-drinks business. Under the leadership of Robert Goizueta, the company has focused manufacturing on soft drinks and is slowly moving away from instant tea and other businesses. This is because soft drinks earn 24.9% on capital while the other segments average around 7% returns on investment. With this, the company has averaged a 27% increase in EVA over 5 years

EVA has also influenced capital budgeting decisions. Divisional spending is now under control. Useful investments are now been made. An instance of such impact is the Quaker corporation, which manufactures breakfast cereals and other snacks. Previously, the company operated slowly, only to accelerate beyond capacity as the end of a quarter approached. This filled 15 warehouses with finished goods. The reason for this practice is managers trying to load retailers with goods, therefore improving quarterly results (and their bonuses). Such practices increased costs of operation in several ways. First, more warehouses had to be occupied and laborers had to work overtime. However, EVA has brought such practices to light. Warehouses reduced to ten and inventories to $6 million.

From the above it is clear that EVA is an important tool in performance and wealth metrics in corporations. For instance, it has enabled identification of non-performing divisions. Therefore, improving profitability of various corporations has improved. In that way, it has also improved transparency in operations of public companies via segment reporting. EVA has influenced decision making in corporations. Investment centers now use differential analysis in evaluation of business opportunities in order to come up with a solution holding the least capital cost.


Works Cited

Tully, Shawn & Hadjian, Ani. ‘The Real Key to Creating Wealth.’ Fortune. 20th September 1993: Page 38. Print

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