The goal of every business is do better and at a faster rate with less use of resources in the business activities of the organization. That is what every business process such as quality management or cycle time reduction are aimed at. However, as a result of complexity of the named business operations among other, there is need to use a method that can provide a quantitative measure of the organizations performance and provide a reliable means of organizing the organizations resources to improvement and management of organizations operations that in the long term enable the company to meets its goal. A number of companies that are concerned with the need of evaluating their performances have come up with effective measurement systems that are employed within the organization and useful in measurement of the company performance. Harbour confirms that it is critical for organizations who want to meet the goals to develop a quantitative measure of performance (2009).
Data collected from performance measures usually give information depicting the performance of a particular company and are useful in guiding decision making processes. Organizations that collect performance data often benefit from the ability to make more beneficial and economical decisions. Economic value added (EVA) is one of the performance measures that have been developed to aid organizations in evaluating the performances. Economic value added is one of the best known metrics that has found wide acceptance in the corporate world. However, a number of companies continue to use a number of traditional methods such as return on equity and operating income (Richard 2010). Economic value added also known as economic profit is defined as the operating profit that an organization realize after tax, less a charge for the use of capita. Richard (2010) explains that EVA is used to measure the magnitude of to which the operating results of the company exceeds the fundamental investor demands for the returns on their capital invested in the organizations.
The use of EVA is pegged on the principle that any business regardless of its size must generate returns that do exceed the capital invested in the business that must also exceed the opportunity cost of the capital invested. The use of other traditional methods of measuring evaluations has been found not to promote the creation of value in businesses and thus more improved methods like EVA are encouraged in organizations.
Application of EVA as performance measure in manufacturing companies
In any organization, the primary goal and objective is towards increasing the value that shareholders values have invested in the business. To achieve this goal, EVA is used as it is one of the best available metrics that can be used in measuring performance while at the same time encouraging creation on value in the business. When carrying out measurements using EVA, the results of this process yield the difference between the cost of capital invested in the business and the return resulting from the particular capital. EVA as a measurement metric can find use in a particular company or in a given section of an organization. According to Warren (2010), organization can only benefits from the use of EVA if the performance metric is used from the top down. This is because employees can only adapt their behavior to support the shareholders interest when they are motivated to do son.
Manufacturing companies can utilize EVA as a performance metric to gauge the organizations ability to drive values that are meant to provide returns to its shareholders. This is because EVA is necessary to address sufficiently the requirement of value creation as it uses “accounting anomalies” to generate an economic picture of the organizations performance rather than an “accounting picture” of the particular organization (Warren, 2010 p. 132). Hossein (2010) asserts that EVA can be used to define the difference to what should have been earned by a company compared to other investment of the company that has similar risks. A manufacturing company can calculate the measure of EVA by subtracting Weighted Average Cost of Capital from the firm’s return on capital and the resulted multiplied by the capital employed as below.
EVA=(r-c).k where r is the return on capital, c is the weighted average cost of capital and k is the capital employed
In a particular company, the results from calculation of EVA can be used to determine if the firm has value when the firm’s revenues exceed the costs incurred by the company. The use of EVA in manufacturing companies serves to provide comprehensives explanations of tradeoffs made by the company between the balance sheet and the company’s income statement. The utilization of these metric will be critical if it is linked with supply chain management metrics.
Manufacturing companies can use EVA to evaluate and help in the identification of functional managers from all the sections of the company and reward them accordingly. This will in turn provide motivation to the managers who will be instrumental in guiding behavioral change in workers within the company in order to meet the needs of the shareholders. The supply chain of a company, its financial value drivers and EVA helps in the decrease cost of capital and thus increasing the shareholder value. This will provide an opportunity for the company to capture the market share as the company can lower their unit prices, provide high quality service as well as expend more money in conduction research, promotion and advertisement.
The use of EVA as performance measurement metric is advantages to the particular firm employing it more than other traditional methods of measurements. Shane (2007) outlines a number of benefits that can be realized upon the use of EVA unlike the use of other traditional methods. The use of EVA in an organization will result in the reduction of distortions arising from GAAP where the company could correct reporting income as well as book asset by the addition of items such as differed tax back to capital and goodwill. This will in return make the adjusted company’s data closer to the cash flow and thus providing a more clear reflection of the company’s performance.
The use of EVA as a measurement metric is critical in the production of more accurate information where capital cost of a company will be recognized during the calculation of the performance measurement. This is useful in quantifying the value added to the shareholders capital as the exceeding of capital cost by the company’s income demonstrate growth in the company and that wealth has been created.
The utilization of EVA is also essential to the creation of unity between the interests of the company’s manager and shareholders who have invested their capital in the firm. This combination between EVA and the market value will aid in the defeat of manager’s risk –aversion techniques thus making them give more attention towards capital cost as well as the attainment of long-term strategy.
Gibbert (2010) reports that the use of EVA by ElectroCorp as a yardstick of measurement resulted in the transparency and consistency among its units and local companies after EVA was introduced with the aim of making the company’s business more specific and binding. The local companies therefore continued to increase their economic value added in order to maintain a competitive lead and retain their market share also.
Limitations of Economic value added
Despite the novelty of EVA has a widely accepted yardstick of measurement, its continued use as a measurement metric has pause a number of limitations worth looking at. To begin, Ignatiuk (2008) notes that, in a compensation plan that in founded on Economic Value added, the manager of an organization can reject the net present value whereas this holds the expected pay offs at later stages of the project being dealt with. Should evaluation be done at this period in time, the manager can be penalized for that may at the start have negative impact on the cash flow statement though the projects may have a substantial return at the latter time period
EVA as measurement metric has a cost when implemented as at times its complexity may outmatch the potential benefits expected from this measure. It is further argued by Ignatiuk (2008) that though the adjustment made on the “GAAP based accounting performance” does make economic sense, its practicability is under question (13).
Generally, it has been reported that researchers have found that due to the nature of EVA in terms of financial preference, managers can sometime manipulate information regarding the performance of the company for their own interest and thus can cause errors in projections and depicting the company’s true performance records (Ignatiuk, 2008).
As a result of corporate responsibility, the company may at time pursue alternatives based on EVA that may not be in line with the aspirations of the shareholders. This will result in the company engaging in activities that do not lead to the creation of wealth for the shareholders. This is therefore deemed as unhealthy to the company because it denies itself an opportunity to meet the present needs of its shareholders.
Improvement opportunities arising from the use of EVA
The use of EVA is not only restricted to offering guidelines in the capital market alone but also in the provision of opportunities and terms that can be used by organization to induces their managers into using the EVA to create and engage in activities that are aimed at creating value (Stern 2005).
According to Carlos et al (2010), the use of EVA can result in “incentive compensation measure” that will lead to advancement in the operating efficiency thus increase in the organizations asset turnover (14). Due to its simplicity, the use of EVA as a single measure provide a better means of liking the decision making process of the organizations to a common goal thus offering better chances of meeting the goals.
Organizations using EVA for performance measurement will realize the opportunities to maximize their management levels as well as resource allocation and building a rapport between the management and the investors who will benefits from the wealth created by the company.
Economic value added is a useful addition metric of measuring performance in business in the long term. EVA can be calculated using the data available in the organization in order to determine the difference between the organizations cost of capital and the return of capital. This information will be useful in effecting changes within the organization aimed at creating value to the stakeholder. Despite the limitation of EVA such as the ability of managers to manipulate data based in EVA, this measure can indeed be used to provide a compensation scheme for managers who are focused in creation opportunities aimed at realizing value for the company. Indeed, the use of EVA should be encouraged at all levels of organizations to in order to couple managerial performance to the level of organizations financial performance.