Economic Value Added

Application Area

A cost and performance measurement system is presented that integrates Activity-Based Costing (ABC) method with Economic Value Added (EVA) value-based financial performance measure. This ABC-and-EVA solution is an engineering management tool that helps to manage company costs and capital.

Main objective of the most privately held-for-profit companies is to make money in present and over the long run. If a company is not able to generate enough economic profit over time, its survival is questionable. Moreover, companies making little or no profit are not very attractive for potential investors looking for returns.

Activity-Based Costing (ABC)

 Activity-Based Costing (ABC), a costing system that has recently gained popularity is based on a simple idea: in an enterprise, overhead (or operating) expenses are generated by a number of activities needed to successfully perform manufacturing and business processes. Since activities consume overhead resources, and products (or projects or processes) demand activities, the cost of products is related to the cost of resources. By design, ABC provides not only relatively accurate cost data, but also information about the origin of the cost. Costs were kept in-line through the removal of non-value-added activities, process improvement, or outsourcing. Even the most impressive cost reductions, however, do not automatically imply an improvement in value creation; often the shareholder value remained unchanged or was reduced. This results from the fact that the ABC method, however sufficient in the calculation of operating costs, is deficient in the handling of full capital. While the depreciation (a part of capital cost) is considered in the ABC calculation, the interest charges for capital invested in a company are not taken into account.

Economic Value Added (EVA)

In contrast, Economic Value Added (EVA) focuses on capital cost and shareholder value. EVA motivates managers to create shareholder value. If EVA is positive, the company creates shareholder wealth. Negative EVA indicates that shareholder wealth is destroyed.

Methodology

EVA consists of net operating profit (NOPAT) minus appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return those shareholders and lenders could get by investing in other securities of comparable risk.

EVA = NOPAT – (Capital * Cost of Capital)

If a company is not able to show an economic profit at least as high as the capital charge, shareholder wealth is decreased. As management considers particular investment opportunities in specific projects, products or processes, a reasonable approach would be to split the total capital charge among the activities while calculating cost information. If this allocation of capital charges to activities is done arbitrarily, costs could be distorted, especially in the case where capital costs are not proportional to operating costs.

ABC-and-EVA system suggested here distinguishes two different activity costs: operating cost and capital charge. Operating costs mirror resource consumption in a company, while capital charges describe the company’s capital investment cost. Operating costs and capital charges have only non-negative values.

Implementation Procedure

Implementation steps for ABC-and-EVA system are similar to those for a traditional ABC system. Main difference is the determination of the total cost for each activity (Step 4). This step is to be discussed in greater detail, while remaining steps of the implementation procedure are mentioned briefly.

Step 1 - Review the company’s financial information

Standard solution extracts all needed financial information from the company income statement and balance sheet. On the contrary to the standard bookkeeping, which examines the enterprise activity from the creditor’s view, our solution mirrors the investor’s view. For example, major differences between these systems are marketing and research expenses - are they current or future period expenses?

Whereas other solutions take calculation data from the ledger, EVA costing uses data directly from Dynamics AX (Axapta) operation modules. This allows using investor’s point of view and significantly increasing the precession of solution.

Step 2 - Identify main activities

Identify the main activities describing the manufacturing and business processes of the company that consume operating resources or are responsible for capital investments.

Step 3 - Determine operating cost for each activity

Calculate the operating cost for each activity. Costs should mirror overhead resource consumption for each activity.

Step 4 - Determine capital charge for each activity using Activity-Capital Dependence Analysis

This step does not exist in traditional ABC calculation. Since many activities consume not only resources but also capital investment, the full cost for many activities is higher than the cost calculated in an ABC system. As a result, ABC tends to underestimate the object cost. The integrated ABC-and-EVA system calculates the capital charge for activities demanding capital investments or tithing capital. This information is obtained by converting data on the company’s balance sheet into capital costs or charges. These capital charges are then added to the cost for each activity previously calculated by the ABC system.

Step 5 - Select cost drivers

This step is similar for the traditional ABC implementation. Cost drivers are used to trace the cost of activities to products based on their consumption rate. Thus, operating cost drivers can trace operating costs and capital cost drivers can trace capital charges to the products. Using the data from Dynamics AX (Axapta) operation modules, instead of Ledger information, improves the quantity and precision of the cost drivers.

Step 6 - Calculate product cost

Operating costs and capital costs are traced to the products.

Conclusion

Usage of Economic Value Added (EVA) solution gains the following advantages for an enterprise:

  • It helps to answer the following important question: how good is a manager from the view of increasing the company actives, compared to certain average level of management? Therefore, is appears to be a part of company valuation and a very popular tool of bonus payment for top-level managers.
  • Shareholders can pre-estimate and post-valuate the effectiveness of management in separate divisions of their company.
  • EVA is a good indicator of management decision quality. Permanent positive EVA is a sign of active growing of the company.
  • It determines a norm of return on capital (ROC). This helps to mark out a part of cashflow to return on capital.
  • 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.