Remember
Microeconomics 101? Maybe not. At any rate, the class would
typically start with the professor striding slowly to the front of
the room and announcing that "accounting profits are not economic
profits." He would peer over his spectacles to see if any wide-eyed
freshman had even a glimmer of the profundity of this statement,
then he would sigh. No one gets it at first.
Unfortunately, it's a tenet that often confuses many business and
information technology managers as well.
Basic accounting practices define a profit as revenue minus
costs. If you spent $10 million on a new plant and earned $10.5
million from the sales of the products it produced, you would claim
an accounting profit of $500,000. But that same investment might
have generated $11 million or more if it had been invested
elsewhere. Suddenly, that $500,000 accounting profit doesn't look so
compelling, especially to investors.
According to economic theory, capital eventually moves to the
investment opportunities with the best returns because investors
want to maximize their profits. An economic profit means that a
business generates returns similar to an investment in the stock
market. Getting decision-makers to think about economic profits as
they evaluate new business opportunities is the purpose of using
economic value added (EVA).
Michael Contrada, executive vice president at Balanced Scorecard
Collaborative Inc. in Lincoln, Mass., explains that "revenue minus
costs doesn't tell you much about the cost of resources, such as
equity and debt."
EVA says that assets used by a line of business have opportunity
costs. Investments in one arena (such as distribution) detract from
another (such as manufacturing) that may hold an opportunity for
bigger returns.
For example, London-based Diageo PLC, which owns United
Distillers & Vintners Ltd., used EVA to gauge which of its
liquor brands generated the best returns. The analysis determined
that because of the time required for storage and care, aged Scotch
didn't generate as much profit as vodka, which could be sold within
weeks of being distilled. As a result of the EVA analysis,
management at United Distillers began to emphasize vodka production
and sales.
A Better Way
The use of EVA has grown steadily as business managers have
become increasingly disgruntled with standard accounting practices
that often fail to generate information helpful to decision-making.
Therefore, more companies have turned to performance measurement
tools such as EVA to bolster their understanding of and ability to
achieve profitability.
In the mid-1990s, EVA became a popular supplement to the balance
sheet. Companies such as Hewlett-Packard Co. began using EVA to show
investors just how profitable they really were. Fortune magazine
even ranks companies by their EVA contributions to show which
companies contribute most to overall economic growth.
Consulting firm Stern Stewart & Co. in New York is most often
associated with EVA. While it didn't invent microeconomics, the firm
has developed proprietary methods and metrics for constructing
accurate assessments of EVA.
Al Ehrbar, executive vice president at Stern Stewart, says using
EVA can change an organization's capital-allocation process.
This approach works because EVA is "like NPV with a memory," he
says, referring to a net present value assessment, which estimates
how much money a project will generate over a number of years and
then determines how much the potential cash flow is worth today.
Typically, when managers build a business case for a large
capital-allocation project using NPV - like the investments and
anticipated returns associated with creating an e-commerce channel -
they rarely check to see if the earnings projections met their
goals, says Ehrbar.
He claims that managers use capital more efficiently when EVA
measures are used. "Corporate acts more like a bank," Ehrbar says.
So instead of asking for capital as if it were a free resource,
managers have an incentive to use assets more wisely, particularly
when EVA affects their bonuses.
David Young, an accounting professor at INSEAD, the prestigious
business school in Fontainebleau, France, has studied EVA's effects
on bonus and compensation systems. Managers on EVA-based incentive
plans "are more inclined to buy used assets or refurbish existing
assets rather than request capital budgets to buy new assets," he
says. "The result is lower capital charges for the company and
higher profits."
However, Young says he doesn't believe that an IT department
should be measured on EVA standards. That's because EVA is a
grand-scale measure; it doesn't break down costs and returns easily.
For example, you wouldn't issue a secondary stock offering or
offer bonds to raise money for a new data warehouse. High-level
components like gross sales and cost of capital are used to compute
EVA.
Although EVA can give employees a sense of their firms' success,
it is typically an executive's measurement tool.
When firms understand EVA, it affects how they invest, acquire
and sell off assets, says Jon Low, senior research fellow at Cap
Gemini Ernst & Young Center for Business Innovation in
Cambridge, Mass.
EVA "gives senior executives a powerful lens for comparing
subsidiaries" and assessing strategy, notes Low. But it's extremely
difficult for the middle layer of an organization to pull the EVA
levers, such as sales revenue or margin costs. And that's one of its
biggest shortcomings.
"It's an excellent financial measure but may not provide much
insight into other business drivers" such as customers or internal
processes, adds Contrada.
Shand is a freelance writer in Arlington,
Mass.
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