Economic value added (EVA) are used in some occasions to assess the success in the implementation of company strategy as reflected in the short run financial performance of a firm. This essay will analyze the roles, merits and limitations of EVA calculations in evaluating short run financial performance. The essay will offer a descriptive and critical view of this issue, illustrating the description and critical analysis with relevant examples taken from academic literature and case studies.
In order to achieve the mentioned objectives, the essay will be divided six main thematical points: the first point will cover the concepts of strategy and strategy implementation, in order to inscribe EVA and other methodologies in the category of strategy implementation assessment tools; the second point will present a descriptive overview of EVA methodology and will explore the arguments that suggest that EVA may be an efficient methodology to assess the implementation of corporate strategy and, more concretely, the effectiveness in the implementation of corporate strategy in its financial dimension; the third point in the essay will describe the differences between EVA and other methodologies to measure short run financial performance, such as Return on investment (ROI) or Residual income; the fourth point will be of a critical nature and will explore EVA's main weaknesses, such as the difficulties to make EVA calculations accurate and useful for companies; the fifth point will explore what types of companies may benefit from the implementation of EVA and what other types may find the system inappropriate; finally, the sixth point in the essay will offer illustrative examples of the use of EVA to assess strategy implementation and financial performance.
STRATEGY AND STRATEGY IMPLEMENTATION
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A first concept that needs to be defined is the concept of strategy in a corporation. Corporate strategy may be defined as the corporation's approach to the future. This view of the future involves an examination of the current and anticipated factors which affect and will affect the organization in terms of customers, competitors (external environment) and in terms of the company itself (internal factors). Once this analysis has been performed, the company formulates a plan to optimize its management of the differed factors found to have an influence in the business. Finally, the last step on corporate strategy is the implementation of the plan and the monitoring of the effectiveness of the abovementioned plan and implementation (Johnson et al., 2004).
Within this framework, accounting systems are used by corporations as one of the means to help set a strategy and as a mean o evaluating the effectiveness of the strategy adopted.
Once a company has formulated a strategy, a new phase of strategy implementation begins. It is imperative during this phase that the firm has some kind of system in place to control whether the strategy selected is being effectively implemented. A number of methods to assess implementation exist. Among them, one of the most popular is the "balanced scorecard" method (Bhimani et al., 2008).
In order to understand whether the selected strategy is being implemented effectively and to assess whether the strategy needs any refinement or modification, a company needs a number of financial and non financial indicators covering different time frames. Out of these indicators, an essential one needs to assess whether the strategy being implemented is effective in financial terms. Various accounting systems can be used for this purpose. Some well known indicators are Return on Investment and Residual Income. Economic Value Added (EVA) is one of these indicators. In the following paragraphs of this essay, this method will be described and analyzed (Bhimani et al., 2008).
DESCRIPTION OF ECONOMIC VALUE ADDED (EVA). ITS STRONG POINTS.
EVA is a financial performance indicator that measures the value created by a company beyond the required rate of return demanded by the company's stakeholders. In a more specific fashion, EVA can be defined as the net operating profit after taxes minus the cost of capital in real monetary terms. In other words, EVA represents the profit generated by the company after stakeholders and taxes have been paid (Young and O'Byrne, 2000).
The cost of capital for a firm represents the opinion of stakeholders (debt and equity holders) on the level of risk of the company overall and on the particular strategies that are being implemented. EVA is therefore a good method to understand whether the strategy implemented by the company is being more successful than investors were expecting. One of the key positive points that favor EVA's use in business is the fact that this methodology measures economic and not accounting profit.
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The implementation of EVA must be adapted from company to company and some companies, as it will be discussed further in this essay, are not well suited for EVA methodology. Even in these cases, other equivalent methodologies using the fundamentals of value based management can be applied.
EVA must be implemented in most cases, in conjunction with performance compensation systems, which will help motivate employees and managers to achieve company objectives and implement successfully the strategy selected by the company.
ECONOMIC VALUE ADDED AND COMPARABLE ACCOUNTING APPROACHES TO MEASURING SHORT RUN FINANCIAL PERFORMANCE
A number of comparable accounting approaches to EVA exist. Among them the most common are Return on Investment (ROI), Residual Income (RI) and Residual Cash Flow. When comparing EVA with other financial performance measurement tools, the main advantages of this methodology are (Young and O'Byrne, 2000):
ROI does not recognize the inflows and outflows of capital in the company. In this manner, a company might be operating with a very good ROI but, if investors for one reason or another decide not to lend or invest in the company, the sustainability of the business will be jeopardized.
EVA is a more practical methodology than ROI or RI and is more easily understandable. EVA is also easier to explain to employees, as it is a performance measure based on hard income statement data.
ROI may hide capital inefficiencies in the company, like tying funds in accounting items such as inventories or receivables.
EVA is an unambiguous measure, as increasing EVA invariably increases the position of shareholders in the company.
DIFFICULTIES IN MAKING EVA CALCULATIONS ACCURATE AND USEFUL IN COMPANIES
While EVA is a very praise methodology in the corporate world, the methodology presents some negative aspects in its conception and implementation (Young and O'Byrne, 2000):
When EVA is applied to business units in a short term basis, managers may find themselves discourage from undertaking new projects, as they would impact negatively on EVA in the initial states. While this may present a serious problem in the implementation of EVA methodology, a number of solutions have been developed. Among them, the use of accounting techniques to spread out the impact of those investments so as to smooth the short term EVA.
Measuring EVA at a divisional, sub divisional or departmental level can be a difficult task if resources are shared between different division, sub divisions or departments or if the existence of vertical integration permits a higher level of control of the value chain. It is imperative for companies to device systems which do not allow manager to increase artificially the EVA of their departments by allocating higher percentages of cost to other departments. Some practical measures that can be implemented in order to avoid this problem are: the adoption of different value drivers, used as a proxy from EVA at the micro level in the company; assessing performance at group level and not at division, sub division or department level; the use of an allocation system that allocates costs to divisions, sub divisions and departments using division, sub division and department profitability as a criteria.; the use of activity based costing to allocate costs, versus traditional allocation systems based on volume; using new approaches to transfer pricing, such as auctions.
TYPES OF CORPORATIONS THAT WOULD FIND EVA USEFUL; TYPES OF CORPORATIONS THAT WOULD FIND EVA INAPPROPRIATE
The implementation of EVA is different from company to company. While it is difficult to generalize if a company is suitable or not for the implementation of EVA, a number of guidelines exist on the characteristics that a company should have to obtain more benefits from the implementation of EVA (Young and O'Byrne, 2000).
EVA is more likely to be successful in organization in which employees and managers (especially business units or departmental managers) have long term objectives and are compensated based on those long term objectives.
The methodology is more likely to produce positive results if top management (starting by the CEO or the company) firmly believes in the methodology.
EVA is more easily implemented in organizations whose business units do not share significant amount of resources, as this complicates significantly the implementation process of EVA. As mentioned in the previous section, a number of options exist for companies wishing to implement EVA while having complex interdepartmental schemes to share resources.
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EVA is more effectively implemented when coupled with strong performance based pay systems, especially for divisional, sub divisional and departmental managers.
ILLUSTRATIVE EXAMPLES OF THE USE OF EVA TO EVALUATE PERFORMANCE AND STRATEGY IMPLEMENTATION
One of the most notable examples of the successful implementation of EVA is the case of Coca Cola.
The company started using EVA in 1987 and the implementation of the new methodology coincides with a sharp increase in the stock price of the company. EVA was successfully implemented in Coca Cola partially because two key factors mentioned in the previous section were fulfilled: the use of strong pay for performance management plans and the strong belief of the company's CEO, Roberto Goizueta, in the advantages and potential of EVA (Fernandez, 2002).
While Coca Cola represents an example of the successful implementation of EVA, a number of other companies have also tried the method without success: AT&T, Georgia-Pacific, Monsanto, among others (Young and O'Byrne, 2000).