The merits and limitations of Economic Value Added


Financial performance measurement and control are playing an ever-important role in the pursuit of organisational effectiveness. The creation of Economic Value Added (EVA) by Stern Stewart, one of the world largest consulting firms, indicates an evolution in management performance control field is taking place gradually. Along with it, there is a heated discussion between the proponents and opponents. The objective of this paper is to analysis merits as well as limitations of EVA. And it will be started with describing the technique and contexts it is used and ended with some examples of the use EVA to evaluate performance and strategy implementation.

EVA is a concept based on economic accounting, which takes full cost of capital into account. In essence, EVA is simply the surplus left after deducting the cost of capital employed in the business. To increase shareholders wealth, the EVA should be positive, which means that the generated returns exceed the required returns MGT ACC. According to the formula of EVA [1] , in order to maximum EVA and thus to maximum shareholders wealth, managers may try to increase NOPAT, reduce capital invested or reduce the required rates of returns. EVA, therefore, affects managerial behaviour significantly. and can be used for purpose of management control, performance evaluation and management compensation

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As to the performance measurement of EVA, it will be mainly assessed from three aspects: sensitivity, noise and distortion. There are a variety of comparative merits possessed by EVA. First of all, by simply setting a target of increasing EVA, managers are encouraged to take into consideration a broader set of managerial action choices than other metrics do. Take net income for example, it focuses more on revenues and expenses, capturing only part of effects of investment and charges for equity financing. Conversely, EVA summarizes the total returns after making a charge for capital employed. If measured by EVA, managers may seek to use assets more efficiently rather than invest in new capital. Therefore, EVA can be used to avoid short-term over investment and to allow managers to have discretion and run their divisions as separate business enterprises. Besides that, EVA-based performance appraisal is recommended to link with reward systems in order to alleviate dysfunctional consequences. The most commonly used system is known as bonus bank system (O'Hanlon and Peasnell, 1998). Depending on managers' performance in accomplishing the pre-set managerial targets, managers can award bonuses which are not immediately paid and the payment is associated with their subsequent performance.

Additionally, it has been argued (Hopper, Northcott & Scapens 2007) that EVA captures value creation better than alternative metrics . For example, compared with ROI, EVA analysis is more consistent with the aim of value creation of companies (). ROI analysis is inclined to reject projects with ROI lower than average ROI, in case the new projects would reduce the division's ROI. However, many of these projects would have positive EVA, adding economic value to the division. ROI is thus criticized for paying much attention to short-term performance targets at expense of long-term overall performance goals (Freeman 2004, p. 60). EVA, on the other hand, conceptually accepts all projects as long as their total returns exceed required returns.

EVA is not a perfect measure. There are some limitations of EVA analysis and difficulties in making EVA calculations accurate and useful. Firstly, parochial behaviour problem is one of the often-mentioned limitations facing the EVA. Although, we have mentioned in the above part that EVA is a complete measure that summarizes fully the effects of decisions for which the management is responsible for, ever-increasing interdependence between different profit centres at lower level in organisations has created problem that EVA does not capture. For example, when one sub-unit's output is input fir another sub-unit, externalities problem appears, because the company may want managers of these two sub-units to consult and cooperate with each other so that the company can gain more overall value. In this case, EVA fails to fully measure the affects of decisions made by managers. In fact, this limitation is not obtained by EVA alone. For instance, profitability shares this limitation as well. So far, there seems no approach to fully avoid this limitation. Several approaches can be used as remedies. The first one is to let managers perform not for divisional EVA but for joint EVA. The other one is to appoint a higher-level manager, working as a coordinator and responsible for the joint projectors. These approaches, however, will inevitably harm managers' motivation and weaken their free range creativity, which preciously is the novelty part of EVA.

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Besides the case of interdependence, EVA is also criticised for susceptible to myopia problem it tends to encourage managers to reduce excess capacity and discourage them to invest in new projects. This viewpoint has been emphasised by Kleiman (1999) that there are few differences between EVA adopters and non-adopters except that adopters intensify their asset disposition. Under high pressure of increasing EVA, managers may choose some riskier projects even when the returns are not sufficient to compensate for the risk. This criticism of EVA can be alleviated by above-mentioned bonus bank system, which combines bonus with managers' performance in long-term targets.