EVA Implementation Issues: The Story of One Company
Leisa Cagle
Controller
McKee Foods Corporation
Collegedale, TN
Thomas I. Smythe, Jr.*
Assistant Professor of Economics and Business Administration
Furman University
3300 Poinsett Highway
Greenville, SC 29613
John Fulmer
First Tennessee Professor and Head
Department of Accounting and Finance
The University of Tennessee at Chattanooga
*Corresponding author: thomas.smythe@furman.edu , Phone – 864-294-3112, FAX – 864-294-2990
Abstract
As the 1990’s progressed, corporate managers, investors, and others became
increasingly enamored with the idea of increasing and measuring shareholder
value. A variety of techniques have been developed to overcome the primary
weakness of accounting measures of performance, namely the exclusion of the
required return to shareholders. One of the most popular techniques is EVA,
which explicitly includes the cost of capital to determine if a firm creates
shareholder value. To date, the literature has focused almost exclusively on the
benefits of EVA or how well it measures performance. In contrast, there has
been no discussion of the implementation process faced by companies choosing to
implement EVA. This article reports the non-trivial issues faced, and decisions
made, by a privately owned company as it implemented EVA. Issues include
how or whether to link EVA to compensation, identifying the needed
adjustments to capital and operating profit, identifying EVA Centers and center
adjustments, and calculating the capital charge along with other miscellaneous
issues.
Biographical Information
Leisa Cagle is a CPA and the Controller for McKee Foods Corporation in
Collegedale, TN. John Fulmer, PhD, is the First Tennessee Professor of Finance
and Head of the Department of Accounting and Finance at the University of
Tennessee at Chattanooga. Thomas I. Smythe, Jr., PhD, is the Robert E. Hughes
Professor of Economics and Business Administration at Furman University in
Greenville, SC.
EVA Implementation Issues: The Story of One Company
Introduction
A company always faces implementation issues and decisions when it
seeks to install new financial concepts into its operations and processes.
Economic Value Added (EVA) is a relatively new concept that is being adopted
by an increasing number of firms. The existing literature regarding EVA
generally focuses on the benefits it provides in terms of enhancing shareholder
value. Additionally, empirical studies examine whether EVA provides more or
better information than traditional accounting measures of performance. To date,
there has been little discussion of the implementation process faced by companies
choosing to implement EVA. This article reports the issues faced, and decisions
made, by a privately owned company as it implemented EVA. Issues faced
included how or whether to link EVA to compensation, identifying the needed
adjustments to capital and operating profit, identifying EVA Centers and center
adjustments, struggling with capital charge decisions, and other miscellaneous
issues. The decisions made in the implementation process are critical; we report
the experiences of one firm.
Background
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McKee Foods Corporation, a privately owned snack food company, was
introduced to EVA in 1996 when one of the owners attended a workshop on the
use of Economic Profit as a measurement tool while attending a seminar on the
Balanced Scorecard. EVA, also known as economic profit, residual income, or
operating profit less a capital charge, is a performance measure and evaluation
system that explicitly recognizes the cost of equity and the cost of debt. In its
most basic form,
EVA = Net Operating Profit After Taxes (NOPAT) - Capital Charge.
The EVA measure is meant to develop a value creation culture when used in
financial management practices and when linked to compensation. EVA is
increased by investing capital in high return projects, using less capital, or earning
more profit without using more capital. At McKee, the operating budgeting
process has historically been independent of the capital budgeting process.
Having no direct link between the two processes encourages the spending of
capital dollars in search of productivity increases while inadvertently
discouraging managers from spending operational dollars in search of incremental
revenues. The owner attending the workshop thought that EVA might be the
performance measure that would help link the operating and capital budgeting
processes.
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McKee began the EVA evaluation process by conducting research and
attending training. Initially, several accounting managers attended workshops
conducted by Stern Stewart & Co. In November 1998, the company contracted
with Stern Stewart & Co to conduct an internal seminar for McKee's top
management team and to provide consulting related to the implementation
process. Stern Stewart worked with the accounting management team to establish
a timeline for the rollout of EVA, assisted in the calculation of the cost of
capital, and helped identify appropriate adjustments to capital and Net Operating
Profits after Taxes (NOPAT). As the process developed, McKee discovered that
the roll out of EVA was a major project demanding dedicated resources, similar
to other major projects. Over time, the roll out of EVA was pushed further and
further into the future as other major projects (e.g. systems upgrades and
integration) took priority. Despite research and advice to the contrary, McKee
decided to measure EVA for at least one year prior to any further consideration
of linking it to compensation. In late 2000, McKee began reporting EVA as an
additional measure of performance for the company to the board of directors and
senior management.
Linking EVA to Compensation
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There were a number of reasons for not initially linking EVA to
compensation. The first was to give management time to become familiar with the
measure. Historically, McKee and other firms have used traditional accounting
measures such as return on equity and return on assets to measure performance.
Their usage is driven by tradition and management's preference for percentagebased measures over dollar-based measures. At issue is that none of these
accounting measures takes the cost of capital into account. By measuring and
reporting EVA, management would have time to develop an understanding of
the measure and become comfortable with EVA as a dollar-based measure. For
EVA to be successful, it is essential for top management to support and
understand the measure.
The second reason for delaying the link to compensation is that the
company would need to make a major commitment to training. This would
involve developing a complete training program including training materials,
tools and having permanent training personnel. Additionally, developing a link to
compensation can be rather involved and requires a number of management
decisions such as who should participate, determining bonus allocation
percentages based on contributions to local and corporate centers, establishing
targets, and developing payout standards and banking options. McKee believes
such decisions could be made only after the measure is fully understood at all
levels of the organization.
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The decision to wait, however, is not without value. Specifically, if the
company finds that the EVA measure provides no marginal benefit over existing
performance measures, the costs of training and implementation on a broader
level can be avoided. This decision point is in effect a real option for the firm.
McKee's existing profit-sharing plan has been in place for many years and
employees are generally comfortable with how it operates. Changing the plan to
link EVA to compensation would impact all employees and must be carefully
considered.
Adjustments to Capital and NOPAT
The actual EVA calculation involves determining which adjustments
should be made to both capital and NOPAT. There are several possible
adjustments, which fall into the following categories: better matching of expenses
with revenue generated, financing versus operating, operating versus nonoperating and reality/accountability. In determining which adjustments to make,
McKee considered materiality, simplicity, and cost impact of the adjustments.
After much consideration, McKee settled for approximately six critical
adjustments to capital and ten critical adjustments to NOPAT. The adjustments to
capital and NOPAT are summarized in Table 1.
[TABLE 1 About Here]
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McKee Foods identified several independent EVA centers to focus on
and adjustments varied based on the center in question. Generally, only capital
and income/expenditures controllable by the EVA center are included in the
EVA calculation for any given reporting center. The smaller the EVA centers
the fewer the adjustments to either capital or NOPAT.
Capital Adjustments:
Advertising and Research and Development Expenditures are capitalized
and amortized over a three-year period. Only those advertising and research and
development activities determined to benefit future periods are capitalized. The
present value of operating leases is determined by taking the minimum lease
payments disclosed in the annual financial statements and discounting them back
to the present, using the interest rate built into the operating leases. One of the
adjustments that generated the most internal discussion was the elimination of
construction work in process from capital. McKee self-constructs most of its
fixed assets—both buildings and production equipment. As a result, construction
work-in-process often exceeds several million dollars. Initially, the decision was
made to remove this amount from capital since the assets are not yet revenue
generating and the lead time for getting the equipment operational is often several
months.
However, by not including construction work-in-process in capital for
EVA purposes, the incentive to complete the asset as quickly as possible,
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without reducing quality, and begin producing revenue is diminished. This
creates the possibility of sending a message to engineers and those approving
capital projects that funds used for asset construction are “free” and no return is
required on invested funds while assets are under construction.
If a company
must borrow to obtain the funds or simply tie up retained equity, the cost of the
capital employed is real to the company. Without debt or publicly traded equity,
the opportunity cost of capital is easily overlooked, i.e. out of sight, out of mind.
Since the initial implementation, additional analysis convinced senior
management that including construction work-in-process would correct this
oversight. As a result, construction work-in-process is no longer excluded from
the capital charge. Other non-operating assets are removed from capital based on
the EVA center. For example, excess cash and short-term investments, as well
as investments in business continuity planning programs, are also removed for
most of the EVA center calculations.
NOPAT Adjustments:
All income and expenses related to the company's financing activities,
including interest income and expense, are excluded from NOPAT. Current year
advertising expenditures and research and development expenditures are excluded
from NOPAT while amortization of those expenditures and prior year
expenditures are used to reduce NOPAT. McKee considered excluding the
capitalization and amortization of research and development and advertising
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expenditures because they are approximately the same amount each year and
effectively offset each other. However, a decision was made to continue the
current practice, since spending in these areas increases periodically. As is
common, income taxes are handled on a cash-operating basis. One upward
adjustment to NOPAT for most EVA centers is for charitable contributions. As
a privately held company, McKee is a generous company that strives to give back
to the community proportionally as it has been blessed. Each year the Board of
Directors determines the amount to be given as charitable contributions. Since
this amount is a board decision, an adjustment is made to exclude Charitable
Contributions from NOPAT in determining EVA for all reporting centers other
than the Board EVA measure.
EVA Center Selection and Adjustments
One of the critical tasks for senior management has been to identify the
corporate units that will have EVA responsibility. As such, it is appropriate to
discuss the reporting centers that McKee chose for measuring EVA. EVA
centers and responsible parties include the following:
Centers
McKee Consolidated
McKee Parent
McKee Plants
McKee Corporate
Responsible Parties
Board of Directors
Company Officers
Plant Management Teams
Company Officers
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The McKee consolidated calculation is the most sophisticated and complex of the
EVA calculations. It includes all of the adjustments listed previously. The plant
calculations are the most direct and include inventory, fixed assets, and the
present value of operating leases as capital. NOPAT for the plant calculation is
better described as plant operating profit before taxes (POPBT) and is simply the
plant contribution to cover corporate overhead adjusted for interest on operating
leases. For responsible parties to buy into the calculations, they must be easy to
understand and controllable by the parties. For this reason, McKee elected to
keep the plant EVA calculations simple. Since all revenue for McKee is assigned
to the production facilities, the NOPAT for the corporate EVA center is better
described as corporate operating expenses (COE). The EVA calculation for the
corporate center has been the most difficult to explain. Generally an increase in
EVA is a good sign, but for this reporting center a decrease in the EVA
measure represents improvement since it represents a cost center.
There are some problems associated with breaking EVA down into
divisional measures that could lead managers to take actions to enhance divisional
profits to the detriment of company-wide performance. Breaking EVA down by
reporting center often ignores the synergies that exist among the centers and
implies that reporting centers are freestanding entities, which is not the case. An
example of this problem for McKee is that company revenue is recognized based
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on the production facility producing the goods. McKee has a higher pricing
structure for products sold in certain parts of the country. This additional revenue
is intended to cover the additional costs of distributing the products in these areas.
The additional revenue goes into the plant EVA measure yet the expenses it is
intended to offset are included in the Corporate EVA measure. As a result, plant
EVA is overstated and corporate EVA is understated.
Another example of this problem is that the corporate headquarters are
located in Tennessee at the site of four of the company’s manufacturing facilities.
These facilities benefit directly from being at the same location as corporate
headquarters. For example, the corporate engineering department is located at
corporate headquarters, which benefits the Tennessee location since corporate
engineers can help troubleshoot maintenance problems and assist with capital
projects. This results in lower costs for the Tennessee location. Another problem
associated with breaking EVA down into divisional centers is identifying what
to do with assets shared among reporting centers. Currently, McKee allocates
shared assets to the reporting center on the most appropriate basis—often revenue.
Even without the problems associated with breaking EVA into smaller
EVA centers, it is nearly impossible to get buy-in at any level of the organization
without developing calculations controllable by the reporting centers. As a result,
McKee chose to break EVA into the reporting centers outlined above realizing
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that synergies among the different reporting centers are not reflected in the
measures, except for the overall measure of EVA. One way companies using
EVA overcome the synergy problem is by tying all or a part of compensation to
overall EVA performance. Other companies allocate shared costs and benefits to
the reporting centers. McKee chose not to allocate these costs to keep the
measures simple and controllable by the reporting center.
Capital Charge
The most critical component of EVA and the item that differentiates it
from alternative performance measures is the capital charge. The capital charge is
the product of the firm's weighted-average cost of capital (WACC) and the
amount of book capital at the measurement date. For McKee, estimating the
WACC is made more difficult because it is a privately held company with no
published market value, adding complexity to the calculation of WACC. As is
common, McKee uses its target capital structure to determine the weights for
equity and debt. In determining the cost of equity, the Capital Asset Pricing
Model was used. For the risk-free rate, McKee used the 30-year US Treasury
bond rate, a 6% Market Risk Premium, and an industry specific beta. To
calculate the cost of debt, the 30-year industrial bond for companies with
comparable bond ratings was used. For simplicity and ease of use, McKee
rounded the cost of capital to the closest whole number. The cost of capital is
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then multiplied by the dollar amount of capital at the measurement date in
arriving at the capital charge that is deducted from NOPAT. Some argue that the
appropriate measure of capital is the average over the time period examined, but
for simplicity and ease of use, McKee chose to use the capital at the measurement
date. McKee calculates the WACC on an annual basis.
One issue related to the cost of capital for capital budgeting purposes is
how to alter the WACC to reflect the below or above average risk associated with
specific capital budgeting decisions. Historically, McKee has used various riskadjusted rates for evaluating capital projects, depending on whether the project
was seen to have low, average, or high risk. All of the rates are above the cost of
capital used in the EVA measure. Confusion is created by using different and
higher rates for capital budgeting than the cost of capital used in the EVA
measurement. For capital budgeting purposes, the company is stating that a
project will not be undertaken unless it generates an expected risk-adjusted return
that exceeds some hurdle rate — for example, 18 percent. However, for EVA
purposes, the company states that the cost associated with projects already
completed and capital employed is a much lower 10 percent. The solution is to
use the risk-adjusted cost of capital for EVA purposes. (The company must
develop an “average” risk-adjusted rate for each Center). This assumes that the
company adjusts for risk by adjusting the WACC. Alternatively, if it adjusts for
risk by adjusting the cash flows, then it uses a risk-free rate for the capital
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budgeting process. However, it would still use risk-adjusted rates for EVA
purposes.
Miscellaneous issues
Once the three inputs (NOPAT, capital, and the cost of capital) are
determined, then the EVA measure is calculated. Book capital is multiplied by
the cost of capital to arrive at a capital charge. The capital charge is then
deducted from NOPAT to arrive at EVA. However, McKee has chosen to focus
on the change in EVA and not its absolute value. Some companies establish
targets for the net change in EVA and incentive compensation is usually based
on achieving the targeted increase in EVA. McKee is continuing to evaluate the
best way to measure and report EVA. Owners are more familiar with percentage
measures such as ROE and ROA. As such, McKee is considering a measure of
EVA as a percentage of capital rather than using the percentage change in
EVA. However, there appears to be no support for this measure in any of the
research conducted by the company. This is likely due to the fact that EVA is an
incremental measure and targets are based on incremental changes.
Let us return to the compensation issue. McKee plans to report EVA on
a quarterly basis for at least a year prior to considering a tie to compensation.
There are a number of factors McKee will need to consider when developing a
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link to compensation. As stated previously, the company must determine who
will participate, determine bonus allocation percentages based on contributions to
local and corporate centers, establish targets, and develop pay out standards and
banking options.
There are a number of other implementation issues that must be addressed
once a decision is made to complete the rollout of EVA and tie it to
compensation. There will need to be a major commitment to training and the
development of training materials, including an EVA handbook, value drivers by
location, case studies and decision templates. Additionally, a communication
plan will need to be developed for EVA, and communication will need to occur
frequently and through multiple channels.
Implementing EVA is no simple task. It requires a commitment of
resources—human and monetary—for training, consulting, communicating,
measure development, and maintaining separate books for preparing the measure.
It should be undertaken only with the commitment to devote these resources. At
this point, EVA is just another measure at McKee; it is not a way of life. As a
privately held company, the impact of EVA on enhancing shareholder value, that
is, stock price performance, is not readily available as it is for a public company.
This makes
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measuring the effectiveness of EVA difficult and makes it a tough concept to
sell if share price is not positively correlated to changes in EVA.
Conclusion
The use of EVA is clearly a worthwhile consideration. However, there
are significant implementation issues. Many decisions must be made when
linking EVA to compensation. Special considerations must be made when
making adjustments to capital and NOPAT. Further, there are several factors to
consider when selecting Centers for measuring EVA, and accounting
adjustments must be made for these Centers. Moreover, capital charge decisions
must be implemented, and there are numerous miscellaneous considerations.
While each firm is different, the experiences of one firm, as reported in this
article, should aid others in the implementation process.
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Table 1 - Adjustments to Capital and NOPAT
Capital
Additions to Capital
Allowance for Bad Debts
Capitalization of Advertising Expenditures
Capitalization of Research & Development Expenditures
Present Value of Operating Leases
Subtractions from Capital
Excess Cash and Short-term Investments
Non-operating Assets-excess cash, business continuity planning
NOPAT
Additions to NOPAT
Interest Expense including Interest on Operating Leases
Current Year Advertising Expenses
Current Year Research & Development Expenditures
Increase in Bad Debt Reserve
Charitable Contributions
Income Tax Expense
Deductions from NOPAT
Interest Income
Cash Operating Taxes
Amortization of Advertising Expenditures
Amortization of Research & Development Expenditures
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