Economic value added: A better measure of finances?

Remember Microeconomics 101? Maybe not. At any rate, the class would typically start with the professor striding slowly to the front of the room and announcing that "accounting profits are not economic profits." He would peer over his spectacles to see if any wide-eyed freshman had even a glimmer of the profundity of this statement, then he would sigh. No one gets it at first.

Unfortunately, it's a tenet that often confuses many business and information technology managers as well.

Basic accounting practices define a profit as revenue minus costs. If you spent $10 million on a new plant and earned $10.5 million from the sales of the products it produced, you would claim an accounting profit of $500,000. But that same investment might have generated $11 million or more if it had been invested elsewhere. Suddenly, that $500,000 accounting profit doesn't look so compelling, especially to investors.

According to economic theory, capital eventually moves to the investment opportunities with the best returns because investors want to maximize their profits. An economic profit means that a business generates returns similar to an investment in the stock market. Getting decision-makers to think about economic profits as they evaluate new business opportunities is the purpose of using economic value added (EVA).

Michael Contrada, executive vice president at Balanced Scorecard Collaborative Inc. in Lincoln, Mass., explains that "revenue minus costs doesn't tell you much about the cost of resources, such as equity and debt."

EVA says that assets used by a line of business have opportunity costs. Investments in one arena (such as distribution) detract from another (such as manufacturing) that may hold an opportunity for bigger returns.

For example, London-based Diageo PLC, which owns United Distillers & Vintners Ltd., used EVA to gauge which of its liquor brands generated the best returns. The analysis determined that because of the time required for storage and care, aged Scotch didn't generate as much profit as vodka, which could be sold within weeks of being distilled. As a result of the EVA analysis, management at United Distillers began to emphasize vodka production and sales.

A Better Way

The use of EVA has grown steadily as business managers have become increasingly disgruntled with standard accounting practices that often fail to generate information helpful to decision-making. Therefore, more companies have turned to performance measurement tools such as EVA to bolster their understanding of and ability to achieve profitability.

In the mid-1990s, EVA became a popular supplement to the balance sheet. Companies such as Hewlett-Packard Co. began using EVA to show investors just how profitable they really were. Fortune magazine even ranks companies by their EVA contributions to show which companies contribute most to overall economic growth.

Consulting firm Stern Stewart & Co. in New York is most often associated with EVA. While it didn't invent microeconomics, the firm has developed proprietary methods and metrics for constructing accurate assessments of EVA.

Al Ehrbar, executive vice president at Stern Stewart, says using EVA ccan change an organization's capital-allocation process.

This approach works because EVA is "like NPV with a memory," he says, referring to a net present value assessment, which estimates how much money a project will generate over a number of years and then determines how much the potential cash flow is worth today.

Typically, when managers build a business case for a large capital-allocation project using NPV -- like the investments and anticipated returns associated with creating an e-commerce channel -- they rarely check to see if the earnings projections met their goals, says Ehrbar.

He claims that managers use capital more efficiently when EVA measures are used. "Corporate acts more like a bank," Ehrbar says. So instead of asking for capital as if it were a free resource, managers have an incentive to use assets more wisely, particularly when EVA affects their bonuses.

David Young, an accounting professor at INSEAD, the prestigious business school in Fontainebleau, France, has studied EVA's effects on bonus and compensation systems. Managers on EVA-based incentive plans "are more inclined to buy used assets or refurbish existing assets rather than request capital budgets to buy new assets," he says. "The result is lower capital charges for the company and higher profits."

However, Young says he doesn't believe that an IT department should be measured on EVA standards. That's because EVA is a grand-scale measure; it doesn't break down costs and returns easily.

For example, you wouldn't issue a secondary stock offering or offer bonds to raise money for a new data warehouse. High-level components like gross sales and cost of capital are used to compute EVA.

Although EVA can give employees a sense of their firms' success, it is typically an executive's measurement tool.

When firms understand EVA, it affects how they invest, acquire and sell off assets, says Jon Low, senior research fellow at Cap Gemini Ernst & Young Center for Business Innovation in Cambridge, Mass.

EVA "gives senior executives a powerful lens for comparing subsidiaries" and assessing strategy, notes Low. But it's extremely difficult for the middle layer of an organization to pull the EVA levers, such as sales revenue or margin costs. And that's one of its biggest shortcomings.

"It's an excellent financial measure but may not provide much insight into other business drivers" such as customers or internal processes, adds Contrada.