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 extremely
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.
 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 partial

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
 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)

 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.
Chapter Four- Implementation of EVA

Model for the implementation of EVA in a corporate setup has been highlighted. Stern’s 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 company’s 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 one’s 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.
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.
 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 a contemporary 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

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
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 people’s

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

audit (Ulrich, 1997)

 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..................................5
Research 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
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 Stewart’s 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............................................................................................................62
6.2 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
7.3 Implementing EVA @ Godrej..............................................................................80

Chapter 8 Bibliography ________________________________________________82

 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 today’s 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 find them

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.

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

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 exerting

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 “today’s hottest financial idea”.
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.

 Chapter 2 Economic Value Added (EVA)

“EVA is based on something we have known for a long time: what we call profits, the
money 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 taxes
as 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)
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 1960’s.

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 firm’s 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 owner’s fund deployed in the business. Only then, the owner of the business can claim

to have earned a profit. (Chakrabarati,2000)

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

expect a minimum return of say, 12% on their investment, they don’t begin to make

profits until profits rise above that.

2.4.Calculating EVA
EVA is computed as:

Exhibit 2 : Measuring EVA

EVA =

NOPAT - c* x capital 1

Capital (r-c*) 2

[PAT + INT (1-T)] - c* x capital 3

PAT - Ke EQUITY 4

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.

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

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

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 firm’s capital structure. This is called as the WACC. The formula to

compute WACC is

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

+
Percentage of Equity * Cost of Equity.

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 Assets

Equity 100 Fixed assets Net sales 300

Debt 100 140 Cost of goods sold 258

 Net current PBIT 42

200 60 Interest 12

Assets PBT 30

20 Tax 9

0 PAT 21

Company XYZ’s 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 company’s 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 * 8.4 0.5 *18.0

WACC =
+ = 13.2%

Cost of debt Cost of equity

XYZ’s 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, XYZ’s EVA many be computed in four different yet equivalent

ways:

Formula Value EVA

NOPAT – c* x Capital 29.4 – (0.132) * 200 Rs.3 million
Capital (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 million
PAT – 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.

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 today’s 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

market’s assessment of the effectiveness with which a company’s 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 company’s 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 India’s biggest wealth creators:

Company MV MV Rank MVA MVA Rank

Reliance industries 59,113 1 11577 4
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 493
ITC 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 : “India’s 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

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 :

Investor
relations Aspects of
Individual
EPS managing departments
Strategic a business Budgeted cost
planning
Market –
share,
Earnings Incentive based
Convention compensation
growth
Capital al
investment
Discounted cash Manageme Arbitrarily
flow nt – determined targets
Divergent Acquisitions
Corporate
financial goals approach Contributions to
earning growth
EPS & Net worth Individual
business lines
Return on assets
Exhibit: Conventional management

(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. Investor

are built on theStrategic

The EVA based management system relations premise that EVA provides a single, unified
Individual business lines planning
and accurate measure of value and performance. It eliminates conflict among various parameters
EVA: criteria. It can start with strategy and move all
by incorporating all business issues into integrated
Integr
Corporate ated Capital
the way down to daily operating decisions in the context of impact on EVA. Hence it allows all
financial goals measu investment
financial decisions to be planned, directed,remonitored, controlled, evaluated, communicated and

Individual
Acquisitions departments
Incentive based
compensation
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:

Exhibit: Management under EVA

(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 and

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)
 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.

 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 shareholder’s 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
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

organization’s 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
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
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.

 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
 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).

 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)
 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:
 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 you’ll 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
 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 the
reason 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.
 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.

M1 M2
MEASUREM MANAGEME
ENT NT

M3
M4
MOTIVATIO
MINDSET
N

(Adapted from www.eva.com)

Exhibit: Stern Stewart’s 4-M EVA framework

4.1.Stern Stewart’s 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 Stewart’s rationale for these adjustments is

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

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 Treatment Nature of Adjustments

GAAP based
Accounting is Adjusted

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

Deferred taxes Record as asset Reverse recording of asset

and/or liability and/or liability to reflect cash
basis reporting

Purchased goodwill Record as asset; Reverse amortization to

Amortize over up to 40 years reflect original asset amount

Operating leases Expense Record asset and amortize;

Bad debts and warranty Estimate accrual Reverse accruals to reflect

costs 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 Remove from assets and

and earnings earnings

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

Exhibit: Examples of typical Stern Stewart Adjustments for Alleged Accounting Distortions
Filters used to identify these adjustments

The first thing in calculating EVA for any one company is to decide on which adjustments to make to

the GAAP accounts. Stern Stewart has identified more than 160 potential adjustments to GAAP and to

internal accounting treatments. However organizations do not make all these adjustments – rather 5-6

adjustments are made, which is identified on the basis of certain criteria. The filters used to identify

the adjustments are as follows: (Ehrbar, 1998)

Filters applied

160 adjustments proposed by

Stern Stewart
The adjustment is relevant to the
business and makes a significant
impact on results
The necessary data available
The change is understandable
and
can be explained to employees,
Directors
The changeand shareholders.
aligns calculated
5-6 adjustments EVA
applicable to the
more closely with
organizationthe market
value
Exhibit: Filters applied to identify adjustments to be made to GAAP account
of the firm
(Adapted from “The real key to creating wealth” by Al Ehrbar, 19998)

2. Management (M2)

While simply measuring EVA can give companies a better focus on how they are performing, its

true value comes in using it as the foundation for a comprehensive financial management system

that encompasses all the policies, procedures, methods and measures that guide operations and

strategy. The management phase of the implementation brings EVA into action to drive better

decision-making throughout the organization The EVA system covers the full range of

managerial decisions, including strategic planning, allocating capital, pricing acquisitions or

divestitures, setting annual goals-even day-to-day operating decisions. Included in this

component are the reviews of key projects and the development of spreadsheet- based decision
tools to help improve the analysis of business issues, consistency of decision-making,

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 continued

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

foundation and maintains the momentum of these ideas.

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 Card’s 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 company’s accounting system,

performance and reward management system.

8 Length of time for EVA implementation;

9 Adequacy of the accounting system in supporting EVA;

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 company’s 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 & O’BYRNE, 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 & O’BYRNE, 2001).

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 & O’Byrne (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 company’s 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)

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. Varity’s 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 Varity’s 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 arrangement—and it do, in spades—outsourcing 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 Cisco’s behalf. The vendors in effect pass an asset
rental charge through Cisco’s cost of goods sold. Compared to in-house operation, Cisco’s

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 Cisco’s 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:
 1. Taxes are calculated wrongly because in this method they depend on capital base and not

on the result

2. Capital costs are defined too high and thus in operating activities capital is viewed more

expensive than it really is and thus optimal inventory etc. levels are not maintained

 Capital costs and solvency ratio: Capital costs should always be defined with target

solvency ratio and not with actual solvency ratio because otherwise units can improve their

EVA with unproductive investments (by financing them with debt). The steering should

operate as if every single dollar invested more in business would be financed with a target

blend of debt and equity

 All the assets cause capital costs: In order to calculate EVA correctly all the capital must be

allocated to units. Usually ROI is calculated so that only capital affectable to units is taken

into account. With EVA the same procedure can not be used. If all the capital is not taken

into account then the EVA-figures are upward biased (with ROI this has not caused any harm

since the level of ROI has not been important)

B. EVA is not used at its full potential

 Many companies use and train EVA only in the upper levels of organization

 Thereby a lot of potential in lower levels is lost - especially at lower levels, in operating

activities, the concept helps in finding the right actions

 Similar “under capacity-situation” is likely if EVA is not trained properly and thus employees

do not know how to use the concept or are reluctant to use it

C. Little investment on Employees

 Although EVA is a simple concept it will not be used properly if the advantages and

justification of EVA is not told to employees

 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
 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.
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
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 didn’t

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 discounted,

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.

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 = Net Operating Profit After Tax – Capital

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

measuring performance ex post on 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
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
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. We’ve 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.

Price elasticity of demand is a measure that indicates the percentage change in the quantity of a

good demanded resulting from a 1% change in price. This determines what happens to total

revenue when prices are changed and quantities demanded react to these price changes. The

analysis may be performed at the company level to include the effects of competitive response or,

at the industry level, to examine macro consumer response.

2. Cost Structure

The ultimate impact of price changes depends not only on the demand curve but also on the cost

structure. The drive for lower unit costs and higher margins often leads to investments in
capacity, equipment and new technology. However, these investments often destroy value

because profits don’t rise by enough to cover the cost of additional capital employed. For

example, the domestic textile industry has seen large investments in new capacity and new

technology, increasing both efficiency and capacity. With excess capacity wreaking havoc on

both pricing and return on capital, the long-term solution clearly calls for more offshore sourcing

and domestic capacity closures. But the lowest cost value proposition is not easy to find. We have

found cases where it is the new, “low-cost” capacity that needs to be closed for several reasons

such as lower cost of closure, higher salvage value, higher cash operating costs, taxes, more

realizable overhead reductions, and misleading profitability (benefiting from higher allocated

utilization or higher margin product mix).

3. Terms of Trade

In addition to fixed assets, an important issue in low-level economic profitability analysis is the

net working capital requirements of customers and/or products. Different customers require

different levels of working capital. These parameters are ignored by traditional profit measures.

But in an EVA system, they are additional levers in the value proposition. We performed an

analysis of capital turns and profit margins by customer in an effort to identify customers with

whom there were large potential gains. In cases where a customer was unwilling to accept a price

increase, an attempt was made to improve payment terms (fewer

days outstanding) or reduce inventory requirements. Sufficient improvements in this area could

mean the difference between serving and not serving a customer.

5.5 Managing For Both The Short And Long Term

Our Readiness-To-Serve (RTS) framework gives insight into short- and long-term decision

making.2 The framework breaks economic profitability of customers and products into two

groups. The first group includes only the direct operating costs. It includes the direct variable
costs of manufacturing and selling products as well as a charge for the net working capital tied up

in running the business. The second group consists of longer-term costs of capacity. These costs,

called Readiness-To-Serve costs, are often quite independent of volume. The value of the model

comes from its ability to “layer” costs and define value creation on different levels. The EVA

Contribution Margin shows whether the business is value accretive in the short term, covering the

variable costs, including variable capital costs. Full Cost EVA shows whether the business is

value accretive in the long term, covering all costs (including all fixed cost and capital, such as

the cost of capacity) associated with that business. Thus, products and customers fall into one of

three categories (see Figure 5):

Category 1: Both EVA Contribution and EVA are negative.

Category 2: EVA Contribution is positive, EVA is negative (i.e. the customer/product earns

its directly attributable costs).

Category 3: Both EVA Contribution and EVA are positive (i.e., all costs are covered).

In the short run, where the costs of capacity and overhead are “sunk” period costs, it is

advantageous to serve all customers that have a positive EVA contribution. All category 2 and

category 3 customers should be served. But in the longer run, all costs have to be covered or

capital should be reallocated and capacity and related overhead costs should be shed. Capacity

will be based on the long-term outlook for category 3 customers and products, including category

2 businesses that can be migrated to category 3 through a better value proposition.

Figure 6 presents a typical profile for a company in a competitive sector facing margin pressures

and excess capacity. Often, as illustrated in Figure 6, the short-term decision to serve category 2

customers becomes the company’s long-term production strategy.

This company, at some point, had excess capacity, which it filled by producing for large

customers. At that time, the large customer contributed to covering fixed costs. However, longer
term planning often overlooks the excess capacity issue. In this case capacity continued to expand

through operational improvements, new equipment and acquisitions. In the airline industry, this

behavior often pushes the company into financial distress. For example, airlines have the ongoing

challenge of filling up planes, first with full-fare customers, such as business travelers, and then

with restricted fare passengers. The low-fare seats cover variable costs and contribute to fixed

cost coverage. Having set a timetable and a predetermined number of planes, the only relevant

costs, in the short run, are operating costs. However, when it comes time to redefine the fleet size

(i.e. the capacity of an airline), this decision should depend primarily on the projected number of

full-fare (category 3) customers. Technological constraints and the “lumpy” nature of capacity

costs can often dictate a minimum capacity (e.g. there are few small aluminum smelters). In these

cases, capacity should be filled first with category 3 customers and then with the most profitable

category 2 customers, because they, at least, contribute to fixed cost coverage. This scenario

assumes the fixed cost contribution of category 3 customers is equal to or greater than the fixed

cost shortfall of category 2 customers, so that overall plant EVA is still positive. If this is not the

case, then neither category 2 nor category 3 customers should be served. Overall, the long-term

outlook for these customers defines the profitable capacity level. The RTS model can support a

constant monitoring of cost and capacity, especially when demand is soft. The model is also a

useful tool for determining profitable capacity.

5.6 The problem of Excess capacity

Using Figure 6 as an illustrative example, nearly 80% of all sales were in category 2, but this

number is made up of a handful of large accounts. The profitability of these customers was quite

sensitive to value drivers such as terms and inventory requirements. After preliminary

negotiations with the key accounts, management believed that it would be able to turn half of

these category 2 sales into category 3 sales. Relative to actual capacity, the firm needs to reduce

capacity by approximately 50%. However, the firm produced goods in two plants (A and B) of
similar size, equipment, and cost structures. So which one should be closed? Figure 7 presents the

numbers for these two plants. Plant A is running at capacity whereas Plant B has a utilization rate

of 60%. Plant A produces more premium goods while plant B produces more “value”

merchandise. Differences in direct costs (material) reflect the higher quality inputs used to

manufacture premium products. Utilities and other fixed costs are higher in Plant B in the

Standard Cost approach since the overhead is unitized over a smaller quantity.

Based on Standard Profit, Plant A is much more profitable and the correct decision would seem to

be to keep A and shut down plant B. However, this line of reasoning is flawed because of two

distortions. First, plant A is more profitable partly because it runs at full capacity, which reduces

standard unit cost. Second, premium products are produced in plant A. The capacity problem can

be addressed by using throughput accounting. To compare plant cost structures, both should be

measured based on the same utilization rates. “Throughput profit” corrects for the utilization

problem; plant B now appears more profitable, but still less than plant A.

To correct for the distortion caused by different product prices, we removed the unit price and

looked only at unit cash and economic costs. After making this adjustment, plant A was only

marginally better than B. So the question still remained, which plant should we close? The final

factor is the amount of capital tied up in each plant. While we could simply look at the accounting
books to see the historical value of the plant and equipment, a better measure would consider only

the opportunity (not historic) cost of capital. To do this, we recognized that if a plant is shut

down, the manufacturer realizes a liquidation value based on the salvage value of property, plant

and equipment, severance payments, tax liabilities and the sale of the land (Net Realizable Value,

see above). If it is decided to keep a specific plant, this is the amount of capital tied up and

subject to an opportunity cost. In this case, plant A had a much higher NRV and therefore a

higher opportunity cost of not being shut down. Including this opportunity cost in the analysis

showed that plant B was actually the “cheaper” of the two. The manufacturer decided to close

plant A, realize the significant liquidation value and reduce outstanding debt.

5.7 Summary
Management must be able to measure accurately economic profitability at both the firm and

granular levels. Common granular profitability measures, such as Standard Profit, have the same

problems as standard accounting numbers: They lack a charge for capital employed in the

business. Using an economic profit measure, management gets a clearer view of where it is

making money and where it is losing. This is the first and most important step toward developing

and executing a successful corporate portfolio strategy. The topics covered in this paper should be

considered an ongoing management process, from measuring and identifying value creation

opportunities, to renegotiating the terms of money loosing activities to the right short and long-

term decisions and adapting capacity to the medium and long term economic outlook.

Continuous monitoring of value creation and value destruction and quick response to the

changing economic environment is key to succeed in an economy now characterized by

uncertainty and global competition.

 Chapter 6 EVA & Portfolio Management

6.1 Introduction
With the NASDAQ down 40% this past year and many of last year’s hottest IPOs already gone

or heading off to dotcom heaven, many managers are feeling a little relieved, if not vindicated,

for “staying behind” in the Old Economy. But misery loves company, and many blue chip

stalwarts like Montgomery Ward, Xerox and GM have also failed, may fail soon, or are under

strain.

We have seen a resurgence of interest among managers and investors alike in the fundamentals.

Once again, the value objective lies at the heart of successful business models and strategies, in

terms of both intrinsic value and operating performance. Of course, operating performance is not

net income, but profit growth and sustainability sufficient to earn competitive returns on the

capital employed … motherhood and apple pie to value-oriented managers . But how to manage

for value? It is not, as we will show, just a case of mechanically acting on your numbers. Cases of

successfully managing portfolios for value—Molson, SPX and Herman Miller—show these

companies are careful to apply and interpret numbers in the formulation and execution of value-

based strategies. In this article, we look at how to do this and what common pitfalls to avoid.

6.2 What does it mean to manage for value ?

Annual reports reveal much about the collective view of managers. Rather than a sense of shared

purpose, we find that overreaching goals seem to vary widely, expressed in terms of market

share, revenue dollars, gross margins, expense ratios, earnings growth, price/earnings ratios,

returns on capital and share price performance. This confusion may help explain an observation

by Warren Buffett:
“When managers are making decisions it’s vital that they act in ways that increase per share

intrinsic value and avoid moves that decrease it. This principle may seem obvious but we

constantly see it violated.”

Warren Buffett, 1998 Berkshire Hathaway annual report

Income statement measures still dominate our language in business, yet profit and profit margin

measures often drive overproduction, over-investment and uneconomic vertical integration

because they overlook capital and its cost. Furthermore, we increasingly see different businesses

and business models consuming varying levels of capital at varying costs. In sum, managers are

often drawn to businesses that, on the surface, may seem attractive but in fact destroy value. For

example, profits are invariably enhanced with newer production capacity and technology but they

must be to compensate for the higher levels of investment. As profit is an incomplete measure

that ignores capital, it is inappropriate to handle the many business decisions that trade off

between income statement and balance sheet. Tied to incentive compensation, this can lead to

very dysfunctional behavior among managers. While the goal ultimately must be expressed in

terms of shareowner returns, an operating measure provides a more actionable proxy. The

contribution to intrinsic value in any given Period is best captured with a measure known as

Economic Value Added (EVA®) the annual contribution to intrinsic value, or net present value

(NPV).

1 But does managing for value—be it a portfolio of businesses, products, brands or customers

mean that each manager should grow his positive EVA businesses (those earning returns above

their cost of capital), and sell or close all businesses with negative EVA (those earning returns

below their cost of capital)? Despite the appealing simplicity, we would strongly argue against

this approach to value-based strategic portfolio management. Consider these common pitfalls.
1. Inadequate Time Horizon

Often times, a company makes a decision or undertakes an investment with negative EVA,

declaring the move to be strategic. But unlike one executive who once said, “we define ‘strategic’

as investments and holdings that never pay off,” we would instead suggest that strategic holdings

or investments are ones currently earning less than their cost of capital (negative EVA) that will

earn sufficiently more than their cost of capital (positive EVA) in the future.

EVA is a period measure, yet value is determined by the present value of performance in this

period plus all periods going forward. A company, SBU, product or customer may represent

negative EVA now; yet represent considerable value if it is likely to be sufficiently positive in the

future to offset the cost of holding the negative. The early years of negative EVA might be

considered the price of a call option on future years of positive EVA real option.

2. Mistaking Book Value For Real Value

In our experience, confusion between accounting and economics often stops managers from

making value accretive acquisitions and divestitures within their portfolio of businesses.

Bookkeeping entries often create needless friction that reduces market liquidity for transactions.

For example, idle assets and loss-making businesses that could otherwise be disposed of in return

for cash are often needlessly kept just to avoid booking a loss on sale a non-cash accounting entry

of no economic meaning beyond the possible signaling value of an overdue correction. Just as the

distraction of book values should not prohibit value-creating sales, they need not unduly drive

judgment against a business. While earning a return below your cost of capital is by no means

desirable, these returns are typically calculated on a book value, not a market value. Regardless of

whether a company has positive or negative EVA, its value is equal to the present value of its

future cash flow generation, or capital plus the present value of all future EVA. Thus, determine

the potential for future EVA and compare the present value of ongoing operations to other

alternatives (grow, divest, or shutdown). For example, the liquidation value of a smelter may be
less than the value of continuing operations, despite very negative EVA. The breakup value may

be less for a variety of reasons, including high closure costs, resale values well below book

values, operating synergies, etc. The point is that continuing operations may well have a higher

value than the shutdown or liquidation of this business. But negative EVA is usually a flag that

indicates the strategy of a business should be reviewed to ensure it is the alternative with the best

net present value. Likewise, a negative EVA company can even be a strong “buy” if it is expected

to improve in the future or

6.3 Measuring Performance In Your Portfolio

The calculation of EVA involves three components of data—revenue, expense and capital. The

cost of capital can be considered as a given, an economic determination rather than data input. At

the levels of both consolidated and the operating groups, an EVA calculation is reasonably simple

with few issues of data availability and clarity. Similarly, intrinsic value can also be determined

and benchmarked wherever a financial outlook can be estimated. But at more granular levels

(product, brand, SKU, customer) three important measurement issues arise. Can the economic

benefit (attributable revenue) be appropriately captured and tracked? How are indirect cost and

capital allocations best handled? As an important element of EVA, how are standard unit costs

best measured? Three measurement pitfalls are outlined below.

1. Unrecognized Cross-Subsidies & Inappropriate Transfer Pricing

Unrecognized cross-subsidies and inappropriate transfer pricing often mask true economic

performance and value, particularly at more granular levels within a company’s portfolio. Cross

subsidies not adequately addressed via transfer prices will invariably create incorrect signals of

performance and value within the portfolio. Sub-optimization can occur where we see only part

of the picture; decisions can maximize the value of some parts, functions or processes, but the

value of total is not maximized because of our incomplete view of the economic picture. We’ve
all heard how Polaroid cameras are used to feed the sale of film and that razor blades subsidize

razors. Similarly, casinos regularly lose money on food and lodging to capture larger gaming

profits. Drug companies try to leverage high research costs across more therapeutic areas. One

large printing company loses money on a high profile magazine filled with photos in order to

showcase its production quality capabilities. Some car retailers nearly give away new cars in

order to generate used car, service, insurance and financing business .

These strategies need to be closely managed. What many don’t realize, for example, is just how

unprofitable car financing really is. Our work with financial institutions, manufacturers and

retailers consistently finds that after appropriate cost-of-funds transfer pricing and the cost of

associated risk capital, the highly competitive business of consumer lending might be best left to

the majors. The three activities of the car-financing business (origination, servicing, investment)

are also frequently bundled, without transfer pricing to reveal where a company makes and

destroys value. Businesses need to know the true economic cost of consumer financing as well as

whether some of the sub-activities (e.g. servicing, investment) might not be better outsourced.

2. Misallocations

The misallocation of indirect costs and assets can also create misleading signals of performance

and value. These allocations are often of overhead costs, or may notionally represent an allocation

of fixed costs like capacity. In part, it is the variability of fixed costs that creates issues (see

below), but allocations are also often made without any reference to the underlying cost drivers.

Allocations encompass a broad variety of line items, including external purchases, overhead

allocations, sharing of joint and common costs, etc. Recall that costs are not limit

3. Improper Costing

We often find that improper costing of fixed costs and capital, such as the cost of capacity,

creates misleading signals of performance and value in a business portfolio. First, traditional
costing systems today ignore the cost of capital. Second, the treatment of excess capacity is often

incorrectly treated as a unit cost instead of the period expense that it truly is. Indirect overhead

costs are often capitalized to inventory rather than expensed as period costs. Capitalization of

overhead costs where there is no cost for capital actually makes these costs “free” and creates

short term incentives to overproduce rather than build to order. This characteristically leads to

month, quarter and year-end production spurts, planning problems, excess inventory, trade-

loading, and stale, discounted product pushed onto the customer.

A classic death spiral can result from the unitization of fixed costs. Unitization exists where fixed

costs including excess capacity – are represented as variable costs. For example, a UK brake parts

facility had $300 annual depreciation, capacity for 100 units, prior year utilization of 50% (50

units), but a budgeted utilization of only 30% (30 units). With a true fixed depreciation cost (at

capacity) of $3 ($300/100) per unit, prior year measured fixed cost per unit was $6 ($300/50), and

budgeted per unit fixed cost was $10 ($300/30). This perceived rising unit cost further reduced

volume, even to internal customers, pricing the plant out of business !

Below we illustrate the profitability of French brands within a multinational company and the

complexity a country manager faces in making real portfolio decisions. Lighter bars show the

EVA contribution for each of eight products in the portfolio. Each contributes positively toward

indirect costs and capacity, except for low margin “H,” which is unable to cover even direct

economic costs material, labor and the carrying cost of directly attributable working capital.

Figure 1. Can Capacity Be More Economically Reconfigured?

While short - term portfolio decisions are likely to include the potential discontinuation of

product “H,” the more pressing strategic issue may be the longer- term one regarding total

capacity. Direct EVA was determined with full economic costs allocated. Volume variance was

expensed as a period cost, not unitized into product cost, yet still many products are barely

capable of covering their true full cost.

6.4 Measuring Value In Your Portfolio

While many companies are publicly traded, businesses within the corporate portfolio (SBUs,

products, brands, etc.) generally are not. Thus, strategic questions must be addressed through

their likely impact on intrinsic value – estimated through fundamental valuation. By projecting

and then discounting future EVAs, the analyst can link EVA directly to intrinsic value. Intrinsic

value can then be expressed as the sum of two components of value: capital plus current EVA

capitalized as a perpetuity (Current Operations Value), and the present value of all expected

future EVA improvement, or EVA growth (Future Growth Value ) .

Market Value = Capital + Capitalized Current EVA + PV of EVA Growth

Because intrinsic value is dependent on expectations, it is sensitive both to capitalized

current EVA as well as changes in EVA outlook. For example, most stocks trade with a

very significant amount of value dependent on expectations of growth. In the case of

branded food stocks, future growth values accounted for about 61% of the average stock

prices at 1997 year-end, with the other 39% contributed by the present value of the

current operations. We illustrate the components of 1997 value for the case of branded

food stocks – Market Value (MV), Current Operations Value (COV) and Future Growth

Value (FGV). Smaller branded foods companies (Hormel, McCormack, Smuckers)

consistently had much less future growth value, trading largely on only their current
operating value. Are their profit levels less sustainable? Do they have fewer opportunities

for international growth, etc.?

This analysis can help support forecast and terminal value assumptions, as well as an empirical

strategic review of COV and FGV drivers. We can also disaggregate future growth value into an

EVA forecast better to gauge market prices.2

6.5 EVA Forecasting

While it is unreasonable to expect perfect forecasting, every alternative investment analysis

suffers from the same problem: All multiples and terminal value assumptions themselves contain

implicit assumptions about expectations in the future, but subsume the entire future
Our assumptions support trend line sales growth of 8.5%, flat margins, modest overhead cost

leveraging, and conservative improvements to a working capital position that lags the industry. A

market-multiple terminal value implies a decline in future growth value from 68% to 64%.

6.6 Implications For Terminal Values

Terminal values frequently contribute 50% or more of a net present value in an EVA analysis.

(Terminal values are even higher in the case of a discounted cash flow because capital is

expensed rather than capitalized as it is with EVA. Thus, EVA-based NPV analysis is less

dependent on terminal value assumptions.) Yet terminal values are one of the most under

researched and overlooked issues in modern corporate finance. They are the weak link in

valuation. We present several approaches and their rationale below.

1. Perpetuities
The simplest approach assumes an indefinite “steady state” at the end of a forecast period, say,

three to five years. Final year NOPAT remains constant into perpetuity. Any new investment

equals the annual depreciation expense, so capital is also constant. Present value the terminal

value by multiplying by the appropriate discount factor. Unfortunately, this finite-growth model

does not reconcile empirically with how the market values securities because it assumes

a forward future growth value of zero. While a single product may have a finite life, a company,

business or product with brand, technology or franchise value need not resign itself to such a sad

fate.

Some businesses and products have an opportunity to continually reinvent themselves and rebuild

future growth values. As can be seen from Figure 2, few if any companies ever trade like a bond

with no FGV. This is especially true in cases that are able to earn much more Analysts often

address this roughly with simple perpetual growth assumptions, such as inflation plus real GDP

growth. Others prefer a market solution. For example, we have found a strong correlation

between return on capital and the perpetuity growth rate implied in many market values, allowing

us to build industry-specific tables of appropriate perpetuity growth rates by industry and re turn

on capital. However, any renewal of FGV requires future investment in research and

development, brand building, technology, capacity, etc. A fade or decay in real economic returns,

toward the cost of capital, might alternatively be assumed where no future investment or renewal

is planned.

2. Market-Multiples

Market multiples are a common empirical solution to the terminal value dilemma, particularly

where sensible valuations (i.e. they reconcile with the marketplace) require a large amount of

FGV in the terminal value. Typically income statement focused (e.g. 1x sales, 5x EBITDA, 20x

earnings), they may also be EVA-based to more systematically incorporate the fact that variables

such as margins, asset turns and re turns on capital can each affect market multiples. EVA
multiples not only explain more of the variance in market values (73% for food companies) but

also demonstrate less standard error. For any multiple, the next step is to subtract the future

ending capital from the estimated future value, and to then present value this amount.

Any multiple is best established empirically from sound theoretical constructs of value and then

derived from market values. However, note that cyclicality will limit the relevant range of history

for any market-based multiple – multiples are lowest in good times and highest in poor times.

6.7 Mapping Performance & Value In Your Portfolio

To address strategic questions through their likely impact on intrinsic value, recall that intrinsic

value is not maximized solely through the maximization of Current

Operations Value (COV), but through the simultaneous maximization of the sum of both COV

and Future Growth Value (FGV), including real option value. Ultimately the context of value-

based strategy requires leaders to address both the renewal of FGV through investments in

intangibles and the future, as well as the conversion of opportunities into performance, via

execution or operational excellence. The implications for business strategy, financial policy,

financial management and compensation are far-reaching.

6.8 The Performance / Value Matrix

Returning to our illustration of French brands, Figure 4 depicts a useful tool to frame the

superstars with good potential of EVA growth from that of poor performers.
As with any tool, it must be applied dynamically, looking at trends over history, and more

important, interpolating prospectively. How and where can we best grow value?

Quadrant I (Superstars) (e.g. Honda, Dell, Southwest) are perennial high performers that enjoy

full valuations, and have strategies to invest in the intangibles (brands and capabilities) that drive

FGV, convert FGV to COV through operational excellence and perpetually renew FGV for their

future. From Figure 4, product “F” enjoys this position but had been neglected due to its smaller

size and lower margins. However, “F” uses little capital, creating a superior EVA margin.

It is also highly scalable due to a global brand and ease of contract manufacture, giving

“F” tremendous upside to develop. In contrast, the EVA margin of “D” might best be

improved before any investment to scale this business.

Quadrant II (Expensive) is often where we find the “hot” stocks and sectors with high

expectations for upside, or poor performers (TWA, Polaroid) that would be worth far less except

for their minimum valuation floor, often due to the threat of takeover or break - u p .

Businesses in this quadrant can often be candidates for immediate sale or liquidation unless there

is sufficient reason to believe the extreme expectations implied in the valuation really will be

achieved.

Within this company’s portfolio, product “H” – with negative EVA contribution – is a legacy

brand in need of rationalization. Nor does “H” bring indirect benefits to the portfolio . Its highly

positive FGV is just the mathematical product of negative profits and a positive liquidation value.

Product “E” should be put on watch; its massive size (both revenue and capital) make any

decision critical, yet it is presently not viably covering its cost of capacity and is a potential

candidate for sale.

Quadrants III (Turnarounds) are often perennial disappointments awaiting breakthrough

change (Sears, Xerox). Within Figure 4, product “G” is such a case. The prospects for “G” need

to be swiftly and realistically evaluated. The low FGV implies little upside and only a marginal

contribution that does not justify the cost of the capacity it consumes. The cost of closure or low

realizable proceeds may make it a better turn a round than a sale. Relocate to cheaper Poland?

Quadrant IV (Bargains) are often out-of-favor stocks and sectors or cyclical facing a downturn

that require strategies to make performance more sustainable, or costs more variable. They may

also be strong performers with a valuation constraint an unscalable business model–candidates

for strategic investment (strong regional, orphaned brands, unscaled technologies).

Within this company’s portfolio, Products “A”, “B” and “C” each exhibit the low growth values

characteristic to low growth businesses or cyclical businesses unable to sustain

6.9 Value-Based Strategies & Tactics

Although countless individual operating actions that can create value in any given business,

eventually they must all lead to one of four categories measured by an increase in EVA.

Specifically, EVA can be increased through strategies that employ the following four means.

1. Fix. Improve the returns on existing capital through higher prices or margins, more volume,

or lower costs. Economic-profit margins subsume both profit margin and asset utilization:

• Industry initiatives to pool and optimize industry-specific assets or activities, perhaps as an

independent, jointly owned and operated network to improve utilization .

• Mathematically, the PV of Expected Annual EVA Growth can be derived from growth

annuity mathematics as being simply Future Growth Value x cost of capital /(1 + cost of

capital). “Virtual” vertical or horizontal integration to provide transparency where

improved supply and demand visibility can improve efficiency and utilization.
 • Dynamic EVA optimization of fulfillment economics for companies those move/make

things. Production economics remain largely misunderstood, under managed and sub-

optimized.

2. Harvest. Rationalize, liquidate or curtail investments in operations that cannot generate

returns greater than the cost of capital:

• Outsourcing unprofitable activities, in sourcing capacity that cannot be viably sold or

closed, restructuring a manufacturing footprint, divestitures, withdrawing from unprofitable

markets.

• Creative business sale strategies, such as employee, customer or management Purchases,

demergers, spin-offs and other forms of financial restructuring.

3. Grow. Profitable growth through investing capital, where increased profits will cover the cost

of additional capital. Investments in working capital and production capacity may be required

to facilitate increased sales, new products or new markets:

• Making investments that are recorded as expenses – “soft revolution” intangibles (brands

and capabilities) that drive FGV such as institutional processes and technologies.

• Invest in real options (grow, switch, defer, abandon) and scalability. A three -

year option to buy Amazon at three times today’s share price is worth 11 times a

similar option to buy GE.

• With “vanilla” acquisitions increasingly prohibitive, explore creative acquisition

Strategies such as EVA earn outs, creeping acquisitions, asset swaps and “code sharing”

structures.

4. Optimize Cost of Capital. Reduce the cost of capital but maintain sufficient financial

flexibility to support the business strategy through the prudent use of debt, risk management

and other financial products

6.10 Conclusion
The return of rationality to the values in our capital markets has again put the pressure on

managers to perform. Value-based portfolio management puts the tools for strategic decisions and

tactical execution into the hands of value-oriented managers. Yet the application and

interpretation of these tools demands care. Despite the seemingly simple call to maximize value,

choices are complex as both performance measurement and valuation are hard

Chapter 7 Case study - EVA @ Godrej Industries Ltd.

7.1 About Godrej LTD.

The Godrej Group was established in 1897 and is an inseparable name from the daily life

in India. Companies operating under this group are involved in a wide range of business –

from locks and safes to typewrites, from refrigerators and furniture to machine tools and

processing equipment, from engineering workstations to cosmetics and detergents, from

edible oils and chemicals to agro products.

The various companies in this group are :

GODREJ Consumer Products Limited, GODREJ Industries Ltd, GODREJ Sara Lee,

GODREJ Foods Ltd, GODREJ Agrovet Ltd. And GODREJ Properties and Investments

Ltd.

Following the footsteps of global giants like Coca cola, Unilever, Johnson & Johnson etc, even
EV
they have implemented EVA in their organization.
A
Implementing contemporary management practices in not new to this organization. They have
BS
already implemented other practices as shown in the following diagram
C
PLV
R
TQ
M

1996 1998 1999 2001

Chronology of events in implementing EVA

Apr
2004

Beginning of the second EVA cycle

Apr
2001 –
Mar 1st EVA Cycle comprising of three financial years
2004 viz 01-02, 02-03, 03-04

EVA implementation process I.e. Stage 1 and 2 of

Dec the implementation framework
2000 –
July Talks with Stern Stewart and the decision to
2001* Implement EVA

Nov
the 1st EVA financial year began in Apr 2001, the implementation process i.e.
*Even though 2000

measurement and mindset (training phase of EVA dragged on till February March 2001. Hence

EVA based goal setting and performance bonus started only from July 2001.
GODREJ can be considered as a pioneer in implementing EVA in India (TCS did start a little

earlier)

The company has been able to implement EVA in its entire Godrej and all managerial and officer

cadre employees are compensated on the basis of EVA.

The grueling 8 months implementation process has resulted in benefits for the

organization at the end of 3 year EVA cycle.

7.2 Decision To Introduce Eva

It was decided that EVA implementation would improve overall capital efficiency, ensure that the

company was moving forward in the right direction, employees would begin to think like owners,

eliminate the problem of multi-step targets, would become possible to have bonus plans with no

upside limits and it would be an excellent indicator of wealth creation.

But the most important question is: Will it be Effective?

Within the 1st Quarter of FY 2001-02, GCPL has substantially reduced its working capital usage

by more than Rs. 23 crore and is now operating on negative working capital, thereby substantially

improving its EVA. It reported an EVA of Rs. 6.5 crore in the first quarter of this year.

On a corresponding quarter basis, sales of Godrej brands improved 2% to Rs. 1067 million, while

PAT showed an 8% appreciation to Rs.138 million, delivering quarterly earnings per share of Rs.

2.40. EVA also increased 14% to Rs. 111 million.

The financials of GCPL are:

 Years PAT (Rs. Mn) EPS ROE P/E
2002 419.75 7.1 78.9 9
2003 535.57 9.31 117.59 11.2

EVA=NOPAT- (Cost of Capital x Capital)

EVA Calculations

1. Calculation of NOPAT 2001-2002(cr)

PBT 63.2
Interest 2.5
Net operating profit before tax 65.7
Cash operating tax on PBT 15.4
Cash operating tax on interest 0.9
NOPAT 49.4

2. CALCULATION OF WACC 2001-02

Leverage (l) 0.63
Market risk premium (m) 10%
Equity risk premium (l x m) 6.3%
Risk free return (r) 11.5%
Cost of equity (r+(lxm)) 17.8%
Equity/market value (e) 0.96
Wt cost of equity ((r+(lxm))e 17.1%
Pretax cost of borrowing (p) 14%
Retention rate (1-tax rate) 65%
Debt/market value (d) 0.04
Wt cost of debt 0.4%
WACC 17.5% (18%)

3.Calculation of EVA: EVA parameters 2001-2002 (in crore)

NOPAT 49.4
Capital charge 19.3
EVA 30.1
Definitions

1. Market premium: The extra income demanded by the market to invest in risky, non-

contractual claims to corporate cash flow.

2. Leverage: Company specific risks over and above the market premium. It is the ratio of the

coefficient of variation of stock prices compared to the market prices

GCPL’s average capital employed for 2001-02 was 107.05 crore. Given a weighted average cost

of capital of 18%, this translates into Rs. 19.3 crore cost of capital employed.

7.3 Implementing EVA @ Godrej

STAGE 1: LEADING CHANGE

Recognizing the change imperative:

Factors within the Godrej industries changes in the external environment were a

harbinger of the changes required in the organization. These factors were as follows

(Gupta, 2002):

 The company started witnessing tough competition in all its segments from global majors

with deep pockets and the ability to withstand losses. It hadn't been always so rosy for

Godrej. There was a time when the company was struggling to keep pace with the changes of

liberalization and the challenges of competition

 Post the dissolution of Godrej's JV with P&G in 1996, there was a lot of introspection, which

led to the realization that there was a need to change dramatically to achieve progress. Not

only did a lot of managers walk out along with JV partners, the group did not attract enough

talented people with the advent of MNCs in India.

 The internal surveys on HRD climate and employee satisfaction reflected that young people

in the organization felt underutilized, and uninvolved in strategic decision-making.

 There was no single measure to performance of all employees in the organization. For e.g.

Business performance was evaluated on PBT and sales revenue, managers and officers on

Revenue, long-term investment in ROCE and IRR.

 The existing performance linked variable pay system was not resulting in the desired

alignment between employee and organizational goals. The company's figures suffered as a

result of groupthink and short term orientation.

Thus there was clearly gap in communication between the management and the employees.

Something needed to be done to ensure that the company was on track. A measure was needed

that would align the interests of the employee, the Godrej industries the shareholder.

Building credibility
Credibility for a process is built when the leadership espouses, owns and commits to the

process. In Godrej, it was the Chairman himself who proposed EVA as a management

tool for the organization. The chairman regularly participates in the World Economic

Forum. He was introduced to EVA through a presentation made by Stern Stewart. The

Chairman came back and discussed the same with the Group Management Committee

(GMC). He asked these members to go back and understand EVA better and share their

independent views on EVA. The ideas and papers on EVA by Stern Stewart were read

and then discussed by the GMC. After the GMC was convinced that this was a tool that

many corporates round the globe had found to be extremely useful, they thought it would

help them too and thus they called in for Stern Stewart.

Stern Stewart made presentations showing how companies had benefited from EVA.

Godrej was particularly impressed by the study that showed a positive correlation

between companies adopting EVA and increase in their stock prices.

Shaping a vision

The management committee articulated a vision of creating a world class FMCG company that

will create value for its customers and shareholders. The vision built around EVA was “A system

of internal governance that will guide all employees and motivate them to work in the interest of

the company”

EVA would help them achieve this vision by:

 Improving capital efficiency and overall business performance.

 Encouraging greater owner-like and entrepreneurial behaviour among employees

 Utilizing a single metric to measure performance across the organization.

 Avoiding “undesirable behaviours” seen in the previous multi-step variable bonus plan.

(Dasgupta, 2002)

Thus Godrej created a shared vision by showing a perfect alignment between the

company’s vision and the benefits offered by EVA, and the direction and commitment

provided by the top management.

Identifying process owners

This stage involved identifying people who would own and drive the process in the organization.

Teams at all levels in the organization were formed so that the process percolates at every level in

the organization.

Steering Committee - This team comprised of the chairman as well as the directors and business
heads who were responsible for all policy decisions.

EVA Implementation team – A 7-member implementation team comprising of the business

heads, functional heads from the entire group was formed. These members were people who had

a strong business and finance sense and were convinced and committed to the EVA process.

The role of this team was as follows:

 Developing implementation blue prints.

 Monitoring overall project progress, ensure organization wide coordination across various

business units and functions, and achieve full knowledge transfer.

 Handling queries and apprehensions that rise with regard to the process.

The steering committee divided the responsibility amongst its members. As mentioned earlier,

Stern Stewart’s EVA rests on a 4-M pillar. These 4 M’s were divided among the steering

committee members.

Consultant Team - A team was deployed by Stern Stewart who worked in tandem with the

Steering Committee to guide the implementation process. Even the Stern Stewart team divided

amongst itself the 4M’s and each member worked with the corresponding member in the Steering

Committee.

Teams at SBU level – Teams comprising of 20-24 people was formed at each business level.

Since it was to be implemented in the entire organization, a cross-functional team drawing people

from all functions were formed.

The role of this team was as follows:

 Tailor EVA according to the specific business requirements.

 Develop training material according to the needs of each business and train all the line

managers.

 Identify EVA drivers at each level in the organization.

Informal teams – The formal teams in each SBU, then garnered the support of other employees

and formed informal teams within each department to drive the EVA process. This ensured

engagement of employees at all levels in the organization towards the process. Further this also

ensured that even before EVA is formally introduced in the management system, all employees

are aware and equipped to work and reap the benefits of EVA.
 Steering Committee

EVA consultant team

from EVA Implementation team
Stern Stewart
Team Team
managing Team managing Team
measureme managing measureme managing
nt and motivation nt and motivation
managemen and mindset managemen and mindset
t t

Cross-functional team at
SBU level

Informal
teams at
each SBU
level

Exhibit : Structure of the EVA implementation team at Godrej

STAGE 2: Mobilizing Commitment

Modifying systems and structure:

We can understand the modifications made to the system by utilizing Stern Stewart’s 4M

framework.

Measurement system:

Objective:

 Keep the adjustments to the minimal

 Try and standardize the adjustments across the various divisions.

 Enable identification of EVA at every level in the organization

Outcome:

 In tandem with the objectives, only 4-5 adjustments were made to the accounts. This

again included the standard adjustments like Research and Development, Depreciation.

 For sake of simplicity the WACC for the entire group was set at 18%.

(The computation of the WACC is given in annexure__)

 Identification of EVA Drivers – To ensure line of sight and drive the EVA metric deeper

into the organization, each division identified EVA drivers for all its employees. These

drivers were financial and non-financial depending upon the function and the

responsibilities. Value driver trees were constructed by breaking each function into its

components to understand how each person can impact EVA. Few examples of Drivers

are as follows:

Value Examples of Value Strategies to create value

creating drivers
function
 1
Human One of the initiatives taken up by the HR
resources Employee benefits department was outsourcing the housing loans
to IDBI. Earlier, housing loans were given at a
subsidized rate of 5% to the employees. IDBI
was offering this facility at 11%. The
remainder was passed on as a benefit to the
employee. To the extent outsourced, the
capital was freed up. The company may also
outsource its vehicle loans and discontinue
company owned cars.

The company has implemented a unique

program by which employees participate in
Talent development training programs through an online initiative,

& aptly called E-gyan. In collaboration with

Satyam, this new knowledge initiative helps
Retention employees improve their skills and knowledge
without having to remove themselves from
their work environment
The sales team was to be assessed not only on
Marketing & Sales orders booked but also on optimal credit
sales period as it is this that has a direct impact on
the ROCE (return on capital employed)
New inventory management systems
Production Cost reduction Reducing working capital
(They have been operating on negative WC
since EVA implementation).
Setting up of production facility decisions
based on EVA (E.g. The decision to set
facilities in Guwahati for availing tax benefits
was based on EVA)
Generally EVA is computed for over a period
Finance EVA if time. Thus a new investment plan may
cause a deviation in the target set. Hence the
1
 strategy was to consider this new investment
as separate and calculate EVA only on this
investment. If it generates the desired return,
one could proceed with the project.

Management System

Objective:

 Integrating value-based thinking into the various management process, and developing

relevant tools and frameworks to guide management in their strategic, operating and

financial decisions to improve their business EVA.

Outcome:

 The company has already implemented several management tools like TQM, Balanced

Score Card, and Performance linked Variable pay. EVA was integrated with this system.

For instance EVA was incorporated in the financial perspective of the Balanced Score

Card.

 Techniques like Scenario Planning has helped them envision the possible futures. Tools

like Crystal Ball, Monto Carlo Simulations, help them in measuring EVA volatility and

how even bonus and compensations gets altered due to these changes.

 Implementation of a complex Web-based initiative that involved putting in place a

collaborative planning, forecasting and replenishment (CPFAR) model across the

company’s sales and distribution network. The objective was to make sure that the supply

chain runs smoothly and the right product is available in the right quantities at the right

place, on a continuous replenishment basis. Greater efficiencies in the supply chain

automatically created a virtuous circle. . CPFAR involves reduction of inventories,

 improved efficiencies right through the extended supply chain, speeding up the

investment turnover and educating CFAs on improved logistics methods.

 Godrej already has a strong MIS system based on SAP. The measurement and

management process was greatly facilitated due to the availability of information on this

system.

Motivation
This entailed a modification in the existing performance linked variable pay system and

introducing an EVA linked compensation.

The existing PLVR system:

 Hierarchical target- led incentive system.

 Targets based on profits and revenue

 Under PLVR, there were three levels of performance.

Level 3 –
Highest level

Level 2 – Higher than

Base level

Level 3 –Base level

Exhibit : PLVR system at Godrej

 At each level, employees were set a revenue and profit target. Both the targets had to be met

for each level for a team to qualify for the bonus payout.

 Level 2 achievers were given twice and level 1 achievers were given four times the amount

fixed for base level goals.

Anomalies in the system
 Levels were restrictive – In one year it may happen that a particular business department

exceeds Level 1 on the profit target but falls short of Level 2 in terms of hitting the revenue

target. Now the issue was how to reward them. Since both the revenue and profit targets had

to be met, despite its excellent performance, the team fell in the base level category. Finally,

the dilemma was resolved by rewarding managers of the concerned department with Level 2

bonuses. This made the system arbitrary and left room for disgruntlement.

 Developed a myopic view among employees – A fall out of the levels was reporting of

under performance by employees. For example A salesperson who had reached level I would

never aspire to do more unless he was sure to touch level II, because he would not get any

additional bonus for being midway. It would be more beneficial for him to report it in the

next financial years' sales.

Objective of the EVA based incentive system

 Motivate the managers to think and act like owners

 Inculcate a long term performance orientation among the employees

Outcome:

 3-year bonus plan system that incorporated the concept of the bonus

bank.

 Employees were initially apprehensive about EVA based plans because

they felt that the payouts will be less under EVA. Hence the in the 1st year, the payout was as

high as 80 percent. Now they progressively moving towards the conventional bonus bank

system of 1/3: 2/3-payout ratio. Every year employee earns fresh EVA bonuses and draws
 from the bonus bank that is building up in his account. This builds loyalty and allows the

company to forestall disgruntlement in bad times.

 Since EVA is a line graph where the incentives are plotted against EVA

earned, there is no limit to what an employee and earn and hence no limit to his ambitions.

 Prior to the implementation of EVA, considerable time was spent in the

annual planning process. But EVA plans over a time frame of three years. Thus the time

consuming annual goal setting period has taken a back seat. Thus EVA is considered as a

better way of goal setting.

Training the front line staff

A great deal of time and effort was dedicated to educating and training employees about

EVA
Lev The HR
Trainer Target audience department
el
carried out
Steering committee & top sessions on
Stern
1 management compensation
Stewart
at all levels
Stern Cross-functional internal A special
2
Stewart trainers in SBU training on
analysis of
Internal Middle and Junior capital
3
trainers Management expenditure
was carried out
Internal for the finance
4 Officers
trainers managers.

Exhibit : Levels in training program at Godrej

Program design:

Themes Train the trainers

Awareness training
Training

Duratio 2 days 2 days

n
Conten
t Understand the concept and definition of EVA
Understand how EVA based decision making creates
wealth for the organization
To emphasize the importance of using drivers by
involving people in their regular decision-making and
performance monitoring of business/ department/
team
How to become a trainer in EVA.
Tools
used Notes and reference material
Simulations and case studies
Train the trainer manuals

Exhibit: Design of training program at Godrej

 The notes and the reference material served as a ‘ready reckoner’ to EVA. It provided

details on the basic concept and computation of EVA

 To make line of sight clear and help each manager understand, how he/she impacts EVA,

case studies depicting day-to-day work was developed. Foe example, there was a case where

a manager had to decide on a strategy regarding the credit policy for a product where one had

to choose from four options with varying credit periods and sales volume.

 Option A was a low sales volume with no credit

 Option B was a short credit period with a slightly higher sales volume

 Option C and D were higher credit periods with proportionately higher sales

volume.

The managers were given the cost of capital, NOPAT and tax rate and were asked to make a

choice. Once EVA was applied, it was clear that they should go in for Option C where the

volumes sold were not he highest, but the credit was 120 days and this was the point where EVA

was being maximized.

Such case studies were developed internally for all functions. The line managers would

develop the case and Stern Stewart Consultants vetted them.

 Godrej opted for the ‘trainer the train’ route to drive the concept in the organization. This was

a philosophy that the company had adopted since it implemented Total Quality Management

in the organization. The manuals and training material was developed in a format that could

be used by the participants when they themselves become trainers.

 To ingrain EVA culture in every employee, even the Management Trainees and Lateral

recruits who join Godrej, go through a half day orientation program on EVA during their

induction.
Building ownership

 In Godrej prior to incorporating EVA in the management practices, education about

EVA was imparted to all employees. Only after majority of the people were

convinced about EVA and how it will benefit the individual and the organization, did

they implement EVA.

 Next, people at all levels in the organization were involved during the implementation

phase.

 Constant communication and sessions of clearing apprehensions were carried out.

 By developing EVA diver trees each individual was convinced that he could

contribute to EVA, which in turn will benefit him though, better rewards.

Thus constant training, dialogue and showing a purpose in the initiative built ownership

for the process in the organization.

STAGE 3: SUSTAINING MOMENTUM

Monitoring progress:

Godrej Industries has completed its first EVA cycle of three years starting from 2001.

Some of the ways to monitor the progress has been as follows:

 Regular meetings by Group Management Committee on EVA progress in the organization

 Monthly newsletter sent to all employees to update them on the progress made by EVA as

against the set target.

 Tracking stock prices of the listed group companies

 However they have not instituted any formal system to measure the effectiveness of EVA.

 Every year the year targets are reviewed to provide for adjustments in case of change in

capital charges or other external factors.

Measuring Results:

Implementation of EVA has resulted in benefits for the organization. Some indicators of

the same are as follows:

 All SBU’s have improved business performance; four of them are well ahead of their stretch

targets (the term for the expected EVA improvement. (See annexure). These four companies

now work on negative working capital, an achievement that substantially contributed to

improving EVA. (One of the group company has reduced its working capital requirement

from Rs.7 crore to a negative 15 crore in 2001.)

 The CPFAR model discussed earlier has improved the Supply chain management immensely

which are as follows (Jain, 2003):

 Increase in coverage of directly covered retail outlets by 8 to 10 percent. Improved the reach

of the 5 crucial power brand of the company

 New metrics to measure the sales people’s EVA (optimal credit period), the company has

reduced its debt from Rs.69 crore to Rs.22 crore over 12 months.

 The bonus earned by employees has actually increased three to four times as over the old

PLVR system.

 The consumer products company has outperformed its peers in the FMCG sector on EVA.

(its EVA has changed 133 per cent over January 2002) and this has created better value for its

shareholders, who got a fifty percent increase in the MVA compared to the sector’s negative

19 percent.(Business Today, 2003)

Making it last:
 Godrej will soon enter the second EVA cycle called the “EVA improvement cycle”. Some

divisions have already completed their planning for this new cycle and goal setting for the next

EVA cycle has been carried out.

Some of initiates that they intend to carry out are

 Feedback from people at all levels on the high and low points in the first cycle.

 Conduct refresher-training programs in a dialogue fashion where inputs and views come in

from all constituencies in the organization.

 Identifying newer ways to add EVA in the organization.

7.4 Analysis about EVA@ Godrej

Parameters Godrej Industries

To create shareholder value

Need for EVA To align compensation with value creating activities
(Arranged in the To align manager’s interest with share holders
order of To facilitate the use of single measure
importance)
Level of senior High. Followed a collaborative approach towards implementation
management
support
Identification of Cross functional team comprising senior management employees
EVA champions
Extent of Compensation for managerial cadre based on EVA
compensation
integration
Use of external Yes. Stern Stewart helped in EVA implementation
consultant
Frequency of Use All decisions made to enhance EVA. Value drivers have been
of EVA in identified to show how each activity impacts EVA
decision making
Preliminary  Study of the existing compensation system
analysis  Study of correlation between EVA and share prices
conducted before
EVA
 Systems  Balanced score card
facilitating EVA  PLVR system
 Strong MIS

Length of time to  8-10 months

implement EVA
Challenges faced  People mindset
Training  Training completed before EVA financial year started
Trainers  Trainer the trainer route adopted
Adjustments to  Yes
accounts

It has been observed that an FMCG sector is less capital intensive and hence the EVA figures

were positive right from the year of implementation, unlike the steel sector where the exercise did

not show positive EVA for quite some time.

GCPL was able to create a positive EVA of Rs. 30.1 crore during the year 2001-02 as shown in

our calculations above. According to our calculations, the company has achieved an EVA of Rs.

9.7 crore for the Quarter ended 30th June 2002 as against Rs. 6.5 crore for the corresponding

Quarter last year, an increase of 49%.

From the analysis, it is concluded that for Godrej, the EVA implementation surely was a

rewarding experience. Since the employees were clear about how they are contributing to

increasing the EVA, it worked as a tremendous motivator for them. The objective of continuously

working towards increasing EVA ensured that capital efficiency improved and that shareholders

were happy.

On the downside, Godrej is yet to see the full impact of linking pay to EVA because this had

been implemented only in the second year as a part of a step-by-step implementation. There was a

possibility that new issues would emerge. For example, in an exceptionally bad year when the
company reports a negative EVA, it will result in a reduction in employee compensation having

an adverse impact on employee moral.

Similarly, analyzing the impact on the shareholders. Example. If GCPL invests in a robust brand-

building exercise, its market valuations will go up but due to the capital input, the EVA will go

down.

Assumption: The brand building exercise is successful and leads to increase in market share,

sales, and profits.

UNDER CONVENTIONAL UNDER EVA TECHNIQUE

TECHNIQUE
The capital expenditure will be written off The entire capital cost will be deducted to
over the years hence its effect on the profits calculate the EVA figure and hence there will
of the single year will be marginal. At the be a reduction in absolute terms vis-à-vis
same time with increase in the brand value previous year.
leading to an increase in the market share and
the sales.

IMPACT ON SHAREHOLDERS IMPACT ON SHAREHOLDERS

This will result in an increase in ROE as Despite the company’s progress shareholders
profits have increased despite the additional will feel that their wealth has declined
capital expenditure charge written off in the
year and equity remaining same, indicating
an increase in shareholder ‘s earnings

Suggestions

 It is suggested that GCPL should do an exhaustive scenario planning (the what-if

technique) and determine what one should do under adverse situations before

implementing the EVA linked compensation plan. It must adopt a more flexible plan so

that it can adjust to the changing states in the economy. This will make the impact of

EVA on their compensation clear and direct, under various scenario and help them have

realistic expectations regarding their pay. This will in turn ensure high employee morale.
 Huge capital expenditure ( in the case taken, a brand building exercise) could reduce the

EVA for about 2-3 years leading to a negative impact on the shareholders . However,

whether it remains on the downturn will depend on the nature of the risk/project. A sound

business plan should eventually result in better EVA. In the year of negative EVA, the

company can elaborate on the reasons for the same in the Director’s Report, in a press

release or in the Annual General Meeting (AGM) .The company may also supplement

this with ROE and PAT figures (as under the conventional technique) helping to reassure

the shareholder about the growth and progress of the company.

 It is vital for the company to educate the shareholders that EVA should be seen in totality

with the other financial indicators.