Summary by Rosalyn Mansour
Master of Accountancy Program
University of South Florida, Summer 2002
Economic-Value-Added (EVA), or the firm’s economic income, is a way to evaluate a firm’s financial performance and is equal to its net income minus a charge for the cost of capital used to generate the net income. If EVA is positive, then economic value has been created for stockholders and vise-versa and it is believed that EVA eliminates the disparity between stockholders’ and management’s goals. It is simpler to determine EVA at the aggregated higher levels within an organization, but in order to use EVA at lower levels within an organization, ABC is needed to trace the capital costs to the various objects using capital.
EVA is a concept that originates as far back as the 1800s; however, it didn’t become popular until the 1980’s. Its increase in popularity was a result of:
1. An increase in leveraged buyouts and corporate takeovers.
2. Capital markets were deregulated and there was more emphasis on institutional investors for obtaining capital.
In both cases, there was a need to make sure investors remained content. EVA provided a measurement for management to determine how resource allocations affected investors.
According to Stern Stewart and Co, the consulting firm that introduced EVA during the 1980’s, the conservative nature of GAAP distorts this measure of how resource allocations affect investors. Therefore, GAAP net income must be adjusted. For example, costs such as R&D, which benefit multiple periods and then are expensed in the current period only, are capitalized for EVA purposes and expensed over the useful life of the expected asset. According to the author, "Stern Stewart has identified 164 potential adjustments" although in practice only "5 to 10 adjustments" are usually made (p. 4). Another major adjustment, which is always made to GAAP net income, is an adjustment to deduct the organization’s cost of capital, whether it is comprised of debt or equity.
Debt cost of capital is a weighted average cost of its debt and equity. The cost of debt is its after-tax interest rate. The cost of equity, according to the capital asset pricing model, equals the risk-free rate plus a premium for the risk related to the firm’s stock. The risk free rate is an estimate based on the rate of return for a long-term government bond. The premium is equal to the Return for the Market as a % * Stock’s beta coefficient.
To determine EVA:
1. Determine the % weight that debt and equity each contributes to the firm’s cost of capital.
2. Multiply the percentages in step 1 by the book value of the firm’s assets.
3. Subtract the value calculated in step 2 from the adjusted net income as previously described.
A formula for EVA:
E = (P-C) x (1-t) – F
E = EVA; P=Sales price; C=Unit cost of consumable resource
F = Cost of Capital
t = tax rate
At breakeven (E=0) formula can be restated to: P = C + (F ((1-t))
Arguments for using the EVA measurement include:
It is consistent with discounted cash flow methods of making investment decisions.
It enables management to evaluate the efficiency and effectiveness of capital utilization throughout the organization and to increase economic income by:
Increasing revenue while maintaining the same amount of investment.
Reducing investment while maintaining the same revenues.
Choosing assets that have return greater than the cost of capital.
Empirical evidence shows that increases in EVA are closely linked to increases in share prices.
Activity Based Costing
How does ABC differ from traditional cost accounting systems? It assumes that production activities incur costs, including overhead costs. To control overhead, the activities that produce it must be controlled. Also, product costs should be based, not on resources supplied to production, but instead on the resources actually used in production.
How is ABC Costing used? ABC is used for pricing, investment, product mix, outsourcing, and other decision making activities because it is a long-term measurement of the cost of a product, regardless of volume of production, and also allows the measure of the cost of individual production activities. It is used to reduce or eliminate non-value-added activities. Information obtained from ABC can also be used to benchmark against competitors’ practices.
Deficiencies of ABC? With overhead, there are primary overhead costs and secondary overhead costs. Such secondary overhead costs, such as data processing, are very difficult to trace to specific products. Another problem with ABC is that it ignores the cost of capital. ABC encourages management to focus on decreasing costs and not increasing shareholder wealth.
How and why should the cost of capital be considered with ABC? In order to increase shareholder wealth, revenues must be greater than the cost of capital. An organization must trace the assets to the support and production activities using them and then compute the opportunity cost of the monies invested. According to the author, "a cost driver is then used to trace the capital cost from support and production activities to objects of interest (p. 6)." For EVA purposes, the cost of capital and the cost of consumable resources (such as direct materials) should be maintained separately even if it is determined that they have the same cost drivers.
Incorporating The Cost of Capital Into ABC
The author provides production data for a medium sized company that has two secondary support activities and 3 primary activities. The author’s detailed example shows how EVA may be implemented at the activity and product level of a company’s operations.
Because ABC makes it possible to clearly see how various activities use both consumable and capital resources, management is better able to strategize ways to increase overall shareholder wealth.
Bacidore, J. M., J. A. Boquist, T. T. Milbourn and A. V. Thakor. 1997. The search for the best financial performance measure. Financial Analysts Journal (May/June): 11-20. (Summary).
Clinton, B. D. and S. Chen. 1998. Do new performance measures measure up? Management Accounting (October): 38, 40-43. (Summary).
Dierks, P. A. and A. Patel. 1997. What is EVA, and how can it help your company? Management Accounting (November): 52-58. (Summary).
Ittner, C. D. and D. F. Larcker. 1998. Innovations in performance measurement: Trends and research implications. Journal of Management Accounting Research (10): 205-238. (Summary).
Jalbert, T. and S. P. Landry. 2003. Which performance measurement is best for your company? Management Accounting Quarterly (Spring): 32-41. (Discussion of EVA, tracking stock and balanced scorecard). (Summary).
Wallace, J. S. 1998. EVA® Financial systems: Management perspectives. Advances in Management Accounting (6): 1-15. (Summary).