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eva

eva

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Published by anujajoshi8

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Published by: anujajoshi8 on Apr 15, 2010
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INTRODUCTION
What is Performance Measurement (PM)?
 Historically, PM systems was developed as a means of monitoring and maintaining organisationalcontrol, which is the process of ensuring that an organisation pursues strategies that lead to theachievement of overall goals and objectives.PM plays a vital role in every organisation as it is often viewed as a forward-looking system of measurements that assist managers to predict the company's economic performance and spot the needfor changes in operations. In addition, PM can provide managers, supervisors and operators withinformation required for making daily judgements and decisions. PM is increasingly used byorganisations, as it enables them to ensure that they are achieving continuous improvements in their operations in order to sustain a competitive edge, increase market share and increase profits.Reasons for adapting performance measurements
:-
1.
To evaluate the performance of firm/department/individual.
2.
To control different activities so that it leads to achieve organizational goal.
3.
To budget according to the future requirement.
4.
To motivate by giving people significant goals to achieve and then use performance measuresto provide periodic sense of accomplishment.
Traditional measures
 Traditional PM has mainly been financial measuring ratios such as ROI (Return on Investment), RI(Residual Income), and EPS (Earnings per share). These metrics accounts for the costs associatedwith capital and help firms spot areas in which capital is being invested unprofitably. Although thesefinancial data have the advantage of being precise and objective, the limitations are far greater,making them less applicable in today's competitive market. Organisations, that have adopted thetraditional PM, have experienced great difficulty in trying to fit the measures with increasing new business environment and current competitive realities.While the traditional financial metrics are value-based, they are nonetheless lagging indicators. Theyoffer little help for forward-looking investments, where future earnings and capital requirements arelargely unknown investments such as new product introductions and capital or new market entry.
Fail to measure and monitor multiple dimensions of performance, by concentrating almostexclusively on financial measure.
They solely concentrate on minimising costs and increasing labour efficiency while neglectingother operational performance measures such as quality, responsiveness and flexibility.
Allowing managers to use slow-reacting and tactical management control system such as'budgets'. These budgeting measures mainly focus on short-term value creation as it only attemptsto control and improve existing operations.
Moreover, most companies motivate their worker through reward system. Traditionally,employees are rewarded with bonuses at the end of the year once a specific target has been
1
 
achieved. However, this reward system causes short-termism as employees are seen to narrowdown their focus by just targeting the 'rewarded' goal.
WHAT IS ECONOMIC VALUE ADDED (EVA)?
EVA
®
(Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Coin 1982 to promote value-maximizing behavior in corporate managers. This term has been used in the book named
“The Quest for Value”
which was published in 1991. Stern Steward & Co claims EVAto be their registered trade mark, while Peter Drucker claimed that he discussed EVA in 1964 in his book,
“Managing for Results”.
It cannot be denied; however, without going into argument as to whoinvented EVA first that the concept became popular only after Stern Stewart & Co. marketed it.EVA is a value-based measure that was intended to evaluate business strategies, capital projects andto maximize long-term shareholders wealth. Value that has been created or destroyed by the firmduring the period can be measured by comparing profits with the cost of capital used to producethem. The detailed analysis using EVA may enable the managers to find out activities which are less profitable, and where the profits are being ‘eaten-up'. EVA, therefore enables the management to,invest in projects that are critical to shareholder's wealth. This will lead to an increase in the marketvalue of the company. However, activities that do not increase shareholders value might be critical tocustomer's satisfaction or social responsibility. For example, acquiring expensive technology toensure that the environment is not polluted might not be of high value from a shareholder's perspective. Focusing solely on shareholder's wealth might jeopardize a firm reputation and profitability in the long run.Researchers have found that managers are more likely to respond to EVA incentives when makingfinancial, operational and investing decision (Biddle, Gary, Managerial finance 1998), allowing themto be motivated to behave like owners. However this behavior might lead to some managers pursuingtheir own goal and shareholder value at the expense of customer satisfaction.Unlike traditional methods of performance measurement, EVA focuses on ends and not means. Inother words, we can say that it does not state how manager can increase company's value as long asthe shareholders wealth is maximized.If we talk about the corporate houses, Cola-Cola is one of the many companies that adopted EVA for measuring its performance. Its aim, which was to create shareholders wealth, was announced in itsannual report. The EVA calculation showed that Coca-Cola's investor received $8.63 wealth for everydollar they investedMathematically, the EVA can be calculated as
2
 
EVA = NOPAT – (WACC X Capital Employed)
Where, NOPAT means Net Operating Profit before Interest and after TaxWACC represents Weighted Average Cost of Capital.
4 M’S OF EVA
Stern Stewart describes four main applications of EVA with four words beginning with the letter 
M
.:-
1.MEASUREMENT
EVA is the most accurate measure of corporate performance over any given period. Fortunemagazine has called it "today's hottest financial idea," and Peter Drucker rightly observed in theHarvard Business Review that EVA is a measure of "total factor productivity" whose growing popularity reflects the new demands of the information age. It brings goal congruence or matching of employees and shareholders. It provides significant information beyond traditional accountingmeasures like ROI, ROCE, EPS, etc
2.MANAGEMENT SYSTEM
While simply measuring EVA can give companies a better focus on how they are performing, its truevalue comes in using it as the foundation for a comprehensive financial management system thatencompasses all the policies, procedures, methods and measures that guide operations and strategy.The EVA system covers the full range of managerial decisions, including strategic planning,allocating capital, pricing acquisitions or divestitures, setting annual goals-even day-to-day operatingdecisions. The management can use the EVA for accessing the performance of the business units or segments within the company. If the segment is making surplus after achieving the cost of capitalthen it makes sense to invest into it.
3.
MOTIVATION
To instill both the sense of urgency and the long-term perspective of an owner, Stern Stewartdesigned cash bonus plans that cause managers to think like and act like owners because they are paidlike owners. Indeed, basing incentive compensation on improvements in EVA is the source of thegreatest power in the EVA system. Under an EVA bonus plan, the only way managers can makemore money for themselves is by creating even greater value for shareholders. This makes it possibleto have bonus plans with no upside limits. In fact, under EVA the greater the bonus for managers, thehappier shareholders will be.
4.MINDSET
When implemented in its totality, the EVA financial management and incentive compensation systemtransforms a corporate culture. By putting all financial and operating functions on the same basis, theEVA system effectively provides a common language for employees across all corporate functions.
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