ISSN: 2278-3369 International Journal of Advances in Management and Economics Available online at www.managementjournal.info RESEARCH ARTICLE Economic Value Added: A Better Technique for Performance Measurement Bharata Bhusan Sahoo1, Alok Kumar Pramanik*2 1Department of Commerce, Nilgiri College, Nilgiri, Odisha, India. 2Department of Commerce, Bhatter College, Dantan, Paschim Medinipur, West Bengal, India. *Corresponding Author: Alok Kumar Pramanik Abstract Measuring performance in a day to day business to corporate managers. The job is very much important for corporate performance also. Rewarding out performers and treating under performers are today’s norm to establish equity to work place. Aptly, lots of techniques have been developed so far to address this issue. Each technique has its own parameters and conceptual underpinning. Conceptualization of techniques with their limitations and challenges are very much important before their application. This paper gives an overview of different performance measures emphasizing Economic Value Added (EVA). An attempt is made to compare EVA with other performance measures to give the readers a more focused orientation with the EVA. Literature review is used as a methodology with qualitative orientation of research. Keywords: Performance measures, Economic Value Added, Residual Income, Market Value Added and Return on Investment. Introduction The performance of corporate entities are United States have become interested to this measured commonly on the basis of “Net concept and adopted as a new way to Profit Margin (NPM), Operating Profit measure financial performance. Ultimately, Margin (OPM), Return on Investment (ROI), Economic Value Added (EVA) has been Return on Net Worth or Return on Capital getting plenty of attention in recent years a Employed (RONW or ROCE) etc. Return on new form of financial performance Investment is still recognized as the most measurement. In a fortune, article entitled popular yardstick of profitability “The Real Key to Creating Wealth”, the measurement. But it is now increasingly felt author claimed that “using EVA can give you in Western countries that ROI may not a marked competitive advantage” over necessarily indicate maximum value of the competition. The author also states that business. In fact, some people have starting EVA is “to-day’s hottest financial idea and calling “ROI” as a short-term indicator. getting hotter”[1]. Moreover, the above measures, including ROI lacks in proper benchmark for Simply, Economic Value Added is net comparison. In each measures, “industry operating profit after tax (NOPAT) minus an average” or “nearest competitors’ appropriate charge for the opportunity cost performance” is used as benchmark ignoring of all capital invested (WACC) in an expectation of shareholders. organization. EVA is an estimate of “economic profit” or the amount by which To overcome the limitations of these types of earnings exceeds or fall short of the required accounting based measurement technique of minimum rate of return that shareholders financial performance of companies, M/s and lenders could get by investing capital in Stern, Stewart & Co., the New York based other securities of analogous risk. global consultancy firm had devised an accounting method, called “Economic Value EVA as a tool of financial measurement Added’. As a result, scores of companies in enlightens us whether the operating profit is Bharata Bhusan Sahoo & Alok Kumar Pramanik| Nov.-Dec. 2016| Vol.5| Issue 6|01-12 1 Available online at www.managementjournal.info enough to cover the cost of capital. The EVA Century. This idea was propounded in framework, which is becoming more and Church in 1917 and further defined by more admired tool for measuring the Scovell in 1924. Later this concept appeared financial performance of corporate, offers a in management accounting literature in the consistent approach to set goals and 1960s [2]. Also, Finish academics and measure performance, communicate with financial Press discussed the concept in the investors, evaluate strategies, allocate 1970s. The EVA concept is often called capital valuing acquisitions and determine “Economic Profit” (EP) in order to avoid incentive bonuses. However, the EVA problems caused by the trade marking. implementing and improvement process is one of the several on-going initiatives for a On the other hand, the name “EVA” is so new corporate. popular and well-known that all residual income concepts are often called EVA The Economic Value Added is not really a although they do not include even the main new concept. It is essentially the same as elements defined by Stern, Stewart & Co., residual income-a concept that has been Critics of EVA also argues that it is nothing there in management text book for few more than NPV re-packaged at years. EVA is a registered trade mark of departmental, divisional and firm-wide Stern, Stewart & Co., and is a wonderful levels. They argue that Stern Stewart & Co’s example of “how it is always possible to sell only real contribution to the capital old wine, as long as you can get hold of a budgeting and incentive compensation new bottle and buzzy brand name. process is the development of measures with which to implement NPV on scales larger Peter Drucker, a contemporary management than a project basis. Such measures include intellectual, claimed that he discussed EVA capitalizing advertising, R&D and certain at a considerable length long back in 1964 in other expenses in order to ascertain the his book “Managing for Result”. As exact capital. After identifying the capital examined by Peter Drucker,”EVA is based on base, the firm is then able to use NOPAT to something we have known for a long time: find its return on capital and, ultimately, it’s what we call profits, the money left to EVA. service equity, is usually not profit at all. Until a business returns a profit that is Joel Stern (1990, 1997) and Bennet G. greater than its cost of capital, it operates at Stewart (1990) of Stern Stewart & Co., a loss. Never mind it pays taxes as if it has a (1996) propagated and popularized the genuine profit. The organization returns less concept of Economic Value Added which was to the economy that is devours resources supported to provide a risk-related ………… until less it does not create wealth performance measurement of value creation it destroys it.” by a company. Stewart (1991) advocated the abandonment of earnings for two major An accounting performance measures called reasons, which are: residual income is defined as operating profit subtracted with capital charge. EVA is Earnings are subject to manipulations thus, one variation of residual income with when a company is permitted to choose adjustments to how one works out income among alternative accounting methods ; and capital. EVA , simply is the gain that and remains after levying a charge against after- Earnings calculation is problematic tax operating profits for the opportunity cost because of the arbitrary rules specified in of all capital-equity as well as debt used to Generally Accepted Accounting Principles produce these profits. Stern, Stewart & Co., (GAAPs). coined for its particular variety of economic profit, a concept that has been the part of The technique of Economic Value Added mainstream economic thinking for more (EVA) has already acquired acceptance as a than a century. Alfred Marshall mentioned tool for assessing the existing financial the residual income concept in 1980. status and predicting the future According to Dodd and Chen, the idea of performance of a company. It encompasses residual income appeared first in accounting all aspects of a co’s financial management theory literature in the early part of the last from capital budgeting, acquisition pricing to Bharata Bhusan Sahoo & Alok Kumar Pramanik| Nov.-Dec. 2016| Vol.5| Issue 6|01-12 2 Available online at www.managementjournal.info strategic planning and shareholders’ Economic Value Added is similar to communications, apart from identifying the conventional measures of profit but with two “value addition to shareholders by the important differences: organization during a specified period”. “Economic Value Added considers the cost of From the financial management point of all capital, and it is not constrained by the view, the goal of a firm to be the generally accepted accounting principles maximization of shareholders’ wealth. (GAAP) that governs corporate financial Financial management decisions are reporting”. supported to be taken with those objectives and the proponents of EVA based on The net income figures reported in financial management and incentive company’s income statement considers only compensation system claims that it (EVA) the most visible type of capital cost – successfully works in that directions. interest – while ignoring the cost of equity finance. Financial accountants do not EVA is possibly the most popular value measure the cost of finance provided by the proposing financial performance indicator in company’s shareholders because these costs the corporate parlance in recent times. To like all opportunity cost, cannot observe understand Economic Value Added properly, directly. Although estimating the cost of it is necessary to understand “Market Value equity is a highly subjective exercise, Added (MVA)”, which is also one of the measurement of performance that ignores principal tools for measuring the such cost and not reveals how successful a shareholders’ value. company has been creating value for its owners. So Economic Value Added which Market Value Added is the difference also consider the cost of equity, represent a between Market Value of the firm and its company’s profit of the net cost of both debt invested capital (including equity and debt) and equity capital. contributed to the firm. Mathematically, MVA can be expressed as Economic Value Added is an easy to under: understand measure that recognizes improvement in earnings to the extent this Market Value Added = (Market Value of exceeds the cost of the capital employed or Equity + Market Value of Debt)-(Book Value invested capital to secure it.