Journal of Applied Corporate Finance

S U M M E R 1 9 9 7 V O L U M E 10 . 2

EVA and Total Quality Management

by Jeffrey M. Bacidore,
University of Michigan,
John A. Boquist,
Indiana University,
Todd T. Milbourn,
London Business School, and
Anjan V. Thakor,
University of Michigan
EVA AND TOTAL QUALITY by Jeffrey M. Bacidore,
University of Michigan,
MANAGEMENT John A. Boquist, Indiana University,
Todd T. Milbourn,
London Business School, and
Anjan V. Thakor, University of Michigan

ith increasing pressure on firms to deliver shareholder value, there

has been a resurgence of interest in two key issues. The first has
W to do with how to improve productivity within the firm as well as
relationships with customers, both of which should ultimately lead
to increased shareholder wealth. The second is concerned with the measure-
ment of the firm’s progress in meeting its shareholder value goals. More
specifically, it has to do with devising measures of corporate financial
performance and incentive compensation plans that encourage managers to
increase shareholder wealth.
Although not commonly recognized, these are related issues. The first issue
is most often discussed within the context of Total Quality Management, or
“TQM” for short. The goals of TQM are to do a better job of satisfying the
customer’s needs and to improve productive and distributional efficiency, both
through a lowering of costs and an enhancement of product quality. It seems
self-evident that the accomplishment of such goals should lead to higher profits
and greater shareholder wealth.
The second issue, although typically discussed in the context of measuring
performance in financial terms, is also concerned with motivating managers to
do what is best for shareholders. The idea is to tie managerial compensation
to performance measures that are linked to changes in shareholder wealth in
order to strengthen managers’ incentives to maximize shareholder wealth. The
most direct of such measures is, of course, the firm’s stock price itself. But stock
prices—or measures such as shareholder returns that are derived from stock
prices—have the drawback that they are driven in part by factors outside the
control of even the CEO. For this reason, tying top executives’ compensation
in a significant way to the company’s future stock price could cause them to
bear more than the optimal amount of risk. In this case, the executives are likely
to require higher expected levels of total compensation than if their bonuses
were tied instead to internal operating measures such as earnings or cash
flows—measures over which they have more control. And, as one goes farther
down into the organization, the problem becomes even more acute as lower-
level employees have even less impact on the stock price.

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1997 FINANCE
 Economic Value Added, or EVA, is an increas-
ingly popular corporate performance measure—one
that is often used by companies not only for evalu-
ating performance, but also as a basis for determining
incentive pay. Like other performance measures, EVA
attempts to cope with the basic tension that exists
between the need to come up with a performance
measure that is highly correlated with shareholder
wealth, on the one hand, but at the same time
somewhat less subject to the “random” fluctuations in
stock prices. This is a difficult tension to resolve, and
it explains the relatively low correlations of all
accounting-based performance measures with stock
returns, at least on a year-to-year basis.1
The objective of this paper is to attempt to
clarify the relationship between EVA and Total
Quality Management. At a superficial level, EVA and
TQM seem to be in direct conflict with each other.
Whereas the focus of EVA is on eliminating conflicts
of interest between managers and shareholders, and
thus on creating shareholder wealth, TQM focuses
on the elimination of potential management con-
flicts with non-investor stakeholders such as custom-
ers, suppliers, and employees. And because of its
focus on multiple, non-investor stakeholders, TQM
does not address the issue of how to make value-
maximizing trade-offs among different stakeholder
groups. It fails to provide answers to questions such
as: What is the value to shareholders of the increase
in employees’ human capital created by corporate
investments in quality-training programs? And, given
that a higher-quality product generally costs more to
produce, what is the value-maximizing quality-cost
combination for the company?
This failure of TQM to address such trade-offs
may be one of the main reasons why the adoption of
TQM does not necessarily lead to improvements in
EVA.2 Consider two companies, Federal Express and
Wabash National. Federal Express is a company that
1. Over horizons of one year, no accounting-based performance measure
explains more than 10% of the variation in stock prices. See P. Easton, T. Harris,
J. Ohlson, “Aggregate Earnings Can Explain Most Security Returns,” Journal of
Accounting and Economics 15 (June/Sept. 1992), pp. 119-142. Over five years,
earnings explain 33%. Over periods of ten years, accounting-based perfor-
mance measures, including GAAP earnings, explain up to 60% or more of stock
returns.
2. The empirical evidence on this is mixed. For example, a study (Interna-
tional Quality Study) conducted by the American Quality Foundation and Ernst and
Young surveyed 584 firms in the U.S., Canada, Germany and Japan that had
adopted TQM. It found that quality improvement strategies in these firms did not
improve shareholder value. On the other hand, a GAO study (see United States
General Accounting Office, Management Practices: U.S. Companies Improve
Performance Through Quality Efforts, (1991)) of companies that had been site-
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has not only adopted TQM but is frequently cited by
quality advocates for its outstanding customer focus.
Yet the EVA of Federal Express was negative in every
year between 1991 and 1995. On the other hand,
Wabash National, a Northern-Indiana-based manu-
facturer of customized truck trailers, has successfully
translated its TQM initiative into consistently positive
EVAs over a similar time period.
As we argue below, a financial management tool
like EVA has the ability to guide managers in making
trade-offs among different corporate stakeholders
and, in so doing, it can be used to complement and
reinforce a TQM program. For this reason, we argue
that the alleged conflict between TQM and EVA, and
thus between TQM and shareholder wealth, is more
illusory than real. In the short run, of course, there are
trade-offs among different corporate constituencies,
and management must make hard decisions de-
signed to make the most of limited corporate re-
sources and investor capital. But, in the long run,
TQM and EVA are mutually consistent and reinforc-
ing. In theory—and if applied properly in practice—
both methods can be used to motivate and reward
continuous improvement along dimensions that lead
to increased shareholder wealth.
AGENCY COSTS AND AN EFFICIENCY
FRONTIER INTERPRETATION OF TQM
A fundamental problem in most public corpo-
rations is that the separation of ownership and
control creates conflicts of interest, or “agency
problems,” of various kinds. These agency problems
lead to frictions that reduce the value created by the
corporation for its various stakeholders. This insight
is as old as the theory of the firm itself.3
What is not often recognized, however, is that
the conceptual heart of the TQM philosophy is an
extension of this insight.4 In his 1990 book The New
visited by the Baldridge Award examiners found that these firms’ financial
performance exceeded that of a control group.
3. And its many implications for corporate behavior have been skillfully
articulated by various authors from Berle and Means to Jensen and Meckling. See
A. A. Berle and G. C. Means, The Modern Corporation and Private Property,
Macmillan, New York, 1932; Michael Jensen and William Meckling, “Theory of the
Firm: Managerial Behavior, Agency Costs and Ownership Structure”, Journal of
Financial Economics 3-4, 1976. For more recent elaborations, see Michael Jensen,
“Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American
Economic Review 76-2 (1986) and Michael Jensen, “Eclipse of the Public Corpo-
ration,” Harvard Business Review, September-October 1989.
4. This point, as well as the efficiency frontier interpretation that follows, is
based on the discussion in Greenbaum and Thakor, Contemporary Financial
Intermediation, Dryden Press, 1995.
FIGURE 1
THE COST-QUALITY
EFFICIENCY FRONTIER
Economics,5 Edward Deming argues that agency
frictions related to poor leadership, worker alien-
ation, and diminished morale account for the major-
ity of productivity losses within organizations. More-
over, most failures in organizations are caused by
systemic flaws rather than individual errors. Such
flaws prevent companies from achieving levels of
quality, or productivity, that they might otherwise be
capable of achieving.
One way to visualize Deming’s insights is by
constructing an “efficiency frontier” for a production
process for a product or service. The cost-quality
efficiency frontier shown in Figure 1 is a collection
of combinations of per-unit-cost and quality where
each point represents the highest quality attainable
at that cost, or the lowest cost at which that quality
can be produced. The curve F1F2 represents the cost-
quality efficiency frontier for a hypothetical product.
The shaded area inside the frontier shows cost-
quality combinations that are inefficient, whereas
each point on the frontier represents an efficient
cost-quality combination.
In Figure 1, one’s attention is immediately
focused on the cost-quality tradeoffs along the F1F2
frontier. Should we be satisfied with quality qy,
which costs Cy per unit, or should we strive for a
higher quality qz, which costs Cz? The assumption
implicit in this illustration is that the existing meth-
5. See W. Edwards Deming, The New Economics, MIT Press, 1990.
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ods of production are the most efficient possible, and
that we are either operating at the frontier, or we are
stuck at some point, like x, that falls well short of it.
One important insight of TQM is that most
organizations never get to the frontier because of
internal conflicts and misguided management. And,
to the extent this is so, then there is no need to worry
about trade-offs between quality and cost. A firm
that is at x can move to the frontier by producing a
higher quality qx at the same cost, or by producing
the same quality good at lower cost. This is the sense
in which, as Philip Crosby puts it, “quality is free.”6
But TQM does not even view the frontier as
given. In Figure 1, for example, the frontier may be
pushed out from F1F2 to F1F3 by process improve-
ment. The implication is that the firm need not
accept the trade-offs at the frontier as a constraint on
its cost-quality combination choice. Management
gurus have recently proclaimed their ability to
deliver “discontinuous” quality improvements—that
is, 50% to 60% improvements as opposed to the 5%
or 10% implicit in “continuous” quality improve-
ment. And such discontinuous improvements are
tantamount to creating a “new frontier.”
How does TQM work the magic of getting to the
efficiency frontier or pushing it out? We address this
question next by taking an agency-cost perspective
on TQM.
6. See Philip B. Crosby, Quality is Free, McGraw Hill, 1979.
SUMMER 1997
TQM and the Agency Problem
Agency problems abound in organizations.
Employees are agents of their supervisors. These
supervisors act as principals with respect to their
subordinates and as agents with respect to their
superiors. Thus a hierarchical organization consists
of multi-layered agency relationships. Each agency
relationship involves moral hazard in the sense that
an employee may shirk in providing effort because
it is personally costly to the agent.
The classical hierarchical organization deals
with this moral hazard, or agency problem, by
asking supervisors to monitor subordinates and by
providing rewards in the form of wage incentives
and punishment in the form of job termination
threats. But monitoring and incentive mechanisms
generally are not completely effective in eliminating
the problem. That is, employees continue to behave
at least in part like agents. In supervisory relation-
ships, moral hazard at higher levels has a cascading
effect throughout the organization. A higher-level
supervisor who shirks in monitoring a lower-level
supervisor causes the latter to shirk as well, and the
effect of this ripples through all levels below.
TQM suggests a different approach to control-
ling agency problems. Recognizing that supervision
and monitoring create adversarial relationships, it
prescribes instead a cooperative approach with
greater delegation of authority than in the traditional
hierarchical organization.8 Lower-level employees
are “empowered” by being given greater control
over their activities. This greater decentralization
and relaxation of control flattens the organization
and distributes power rather than concentrating it at
the top. Moral hazard problems are addressed by
making employees take greater “ownership” of the
productive processes they control, thereby reducing
the reliance on monitoring. The idea is to make
employees behave more like owners than agents by
expanding their decision-making authority.
But there are some potential disadvantages of
empowering employees. The absence of an appro-
priate measurement and reward system could be a
source of problems, since employees lacking suffi-
cient monetary incentives may exercise their new
7. See James Mirrlees, “The Optimal Structure of Incentives and Authority Within
an Organization,” Bell Journal of Economics, 7-1, 1976 for a formal analysis using this
perspective. See also Gerald Garvey and Peter L. Swan, “Optimal Capital Structure
for a Hierarchial Firm,” Journal of Financial Intermediation 2-4, December 1992.
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decision rights in ways that fail to increase firm value
(and this, as we take up later, is the problem EVA is
designed to remedy). But another possible draw-
back is lack of relevant information. In cases where
they lack the skills or knowledge of their superiors
in making certain decisions, empowered employees
may commit unnecessary errors. For this reason,
employee training is a necessary prerequisite and
ongoing component if a TQM program is to be
successful.
But these drawbacks aside, TQM has demon-
strated that it has the potential to alter attitudes and
behavior, improve motivation, and reduce agency
costs by eliciting the best efforts from all organiza-
tional stakeholders. These best efforts can eliminate
waste and enhance productivity significantly.
TQM AND SHAREHOLDER WEALTH
How does TQM relate to the objective of
maximizing profits or shareholder wealth? As we
said earlier, whereas EVA and shareholder wealth
maximization are focused on only one group of the
organization’s stakeholders, TQM seeks to eliminate
the productivity losses in organizations that arise
from conflicts among all stakeholders. And so, if
shareholder wealth is to be increased at the expense
of other stakeholders, there may be a tension
between TQM and shareholder wealth maximiza-
tion. For example, the single-minded pursuit of
shareholder value could lead managers to expropri-
ate wealth from the firm’s bondholders by increas-
ing the riskiness of the firm’s assets. Or managers
could attempt to create value, at least in the short run
(and at the potential cost of demoralizing employ-
ees), through wage-cutting that exploits temporary
supply-demand imbalances in the labor market.
As another example, suppose a firm is faced
with the decision of whether or not to recall one
million units of a product that is already in the hands
of customers. All units are outside the warranty
period, and a design defect has been discovered that
causes the product to break down periodically and
requires repairs at the customer’s expense. Never-
theless, it does not pose a safety hazard for the
product user, and so there is no legal liability. To
8. For a defense of the superiority of cooperation over competition as a
motivational device, see Ram Ramakrishnan and Anjan Thakor, “Cooperation
Versus Competition in Agency,” Journal of Law, Economics and Organization, 7-
2 (1991).
recall the product, correct the design flaw, and ship
the product units back to the customers is likely to
cost the firm over $100 million. Replacing the defec-
tive units with new units would cost even more.
This company is thus on the horns of a di-
lemma. A product recall will obviously hurt profits
and hence shareholder wealth. It is also possible that
the stock price will decline. On the other hand, TQM
would suggest that the customer is an important
stakeholder that needs to be served, and so the
product should be recalled. What should the com-
pany do?
How management answers this question may
depend on the company’s time horizon for judging
the consequences of its actions. If the time horizon
is relatively short, then recalling the product is
probably not a good idea since it will hurt share-
holder wealth in the short run. On the other hand,
if the time horizon is sufficiently long, then recalling
the product is probably the right thing to do. It
would be a strong gesture of goodwill to one million
customers, a powerful signal of customer focus, and
an unmistakable sign of commitment to the long
term. There would be enormous customer loyalty
benefits as well as benefits due to the positive
advertising associated with the recall. Eventually,
the present value of all these benefits to the share-
holders may be well in excess of $100 million.
The Case of L.L. Bean
L.L. Bean, the Maine-based sporting accessories
manufacturer and marketer, faced a similar di-
lemma when it was a young company. It had sold
numerous “waterproof” hunting boots that it later
discovered had a design flaw. When customers
stepped in water, the leather upper often separated
from the waterproof bottom. The company decided
to recall every single pair of boots and replace them
with redesigned boots that were truly waterproof.
The cost of doing this nearly put the company out
of business, but that single act has served as an
enduring guiding principle for the company whose
reputation for customer focus has proved enor-
mously profitable for its shareholders.
9. As an example of the reputation analogy, see Douglas Diamond,
“Reputation Acquisition in Debt Markets,” Journal of Political Economy, 97-4
(1989), which shows how a concern for credit reputation may cause a firm to resist
measures that expropriate bondholders and increase shareholder wealth in the
short run.
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This above discussion illustrates an important
point. While a tension between TQM and share-
holder wealth exists in the short run, TQM can be
fully consistent with shareholder wealth maximiza-
tion in the long run. The enhancement of produc-
tivity from an effective TQM program should lead to
lower costs, higher quality, and increased market
share, all of which ultimately result in greater
shareholder wealth.
Thus, when one speaks of a possible inconsis-
tency between TQM and shareholder wealth maxi-
mization, it could simply be the tension between
short-run and long-run objectives that is the issue.
In this context, the insights provided by the “eco-
nomics of reputation” are relevant.9 In particular,
companies that seek to maximize near-term cash
flows to shareholders at the expense of other
stakeholders may damage their credibility with
these stakeholders. Such myopic behavior can ag-
gravate conflicts among stakeholders and sacrifice
productivity gains that would benefit shareholders
in the long run.
Thus, the central message of TQM is this:
Corporate performance can often be improved by
reducing conflicts and achieving a greater alignment
of incentives among different groups of stakehold-
ers. As we shall now show, EVA seeks the same
outcome, but by managing more specific kinds of
agency problems.
EVA AND AGENCY COSTS
As we noted earlier earlier, EVA focuses prima-
rily on reducing conflicts of interest between man-
agers and shareholders. Besides encouraging man-
agers to make the most efficient possible use of
investor capital, EVA is also designed to eliminate
the incentives for both corporate overinvestment
and underinvestment that are provided by more
conventional accounting measures such as earnings
growth and ROE. And we now briefly discuss each
of these problems.
The Corporate Overinvestment Problem.
Among the many agency problems that exist within
the firm, those pertaining to management’s failure to
put the corporate assets at their disposal to their
SUMMER 1997
highest-valued use have received considerable at-
tention. In particular, it has been alleged that many
firms are overcapitalized relative to the value-
maximizing deployment of capital projects. The
blame is often placed on flawed compensation
schemes and corporate objectives that cause man-
agers to focus on earnings and market share. Both
of these common measures of corporate success can
often be elevated by pumping in additional capital,
even if this is done at the expense of shareholder
value.10 Even though equity capital is costly to the
shareholders, the measurement system treats it as
costless, and managers accordingly behave as if it is
free. And so managers rewarded solely on the basis
of earnings or earnings growth quickly recognize
that they can increase their incentive bonuses simply
by increasing the amount of capital at their disposal.
In this fashion, earnings-based compensation leads
managers to “manufacture” earnings by overinvest-
ing capital to the detriment of the shareholders.11
The Corporate Underinvestment Problem.
Many companies compensate managers based on
rate-of-return measures such as Return on Equity
(ROE) or Return On Net Assets (RONA). Unfortu-
nately, this can cause managers to underinvest in
capital. To see this, consider a manager whose
present portfolio of investments yields an average
RONA of 20%. The firm’s weighted average cost of
capital is 10% and it has $10 million in net assets.
Suppose the manager is faced with the opportunity
to invest an additional $1 million in a project with
a RONA of 15%. Should the manager invest in this
project?
The answer depends on what the manager
wishes to maximize. If he seeks to maximize share-
holder wealth, the answer is obviously yes. But
10. Indeed, it can be argued that by rewarding managers based on perfor-
mance measures like sales growth, profit growth, earnings growth, and market
share growth, companies create strong incentives for managers to substitute capital
for effort, creativity, and innate ability. See Todd T. Milbourn and Anjan V. Thakor,
“Intrafirm Capital Allocation and Managerial Compensation,” London Business
School IFA Working Paper 238, 1996.
11. Earnings-based compensation also interferes with the self-selection
process whereby more talented managers opt for more difficult tasks that
promise higher rewards. This self-selection process works as follows. Suppose
there are two tasks, T1 and T2, where T1 is “easy” and T2 is “difficult”. Also
suppose there are two types of managers, one of high innate ability who we
will call “talented” and the other of lower innate ability who we will call
“average”. Ability differences are of little consequence for the output from T1,
so suppose that the expected output in this case is the same for both types of
managers if they work equally hard and invest the same amount of capital. On
T2, however, the expected output is higher for the talented manager than for
the average manager, conditional on identical effort and capital inputs.
Moreover, for the talented manager, expected output with T2 is higher than with
T1, and for the average manager, expected output is lower with T 2 than with
T1.
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suppose his compensation is tied directly to RONA.
In that case, he may wish to pass up the project
because it lowers the average RONA (by blending
20% with 15%).
This example illustrates a general point. Typi-
cally, there is a law of diminishing marginal returns
at work, which means that growth in capital invested
is likely to be achieved by investing in projects with
lower rates of return than those the company
invested in previously. This means that, especially in
the case of already successful companies, expansion
of capital investments is likely to lower RONA. And,
for this reason, if managers are compensated solely
on the basis of RONA, they may pass up positive-
NPV projects.
How Does EVA Help?
The driving force behind these distortions,
then, is that the manager is not “charged” for the
capital he uses, and is not compensated for the
incremental shareholder value he creates. The goal
of a good financial performance measure is to reveal
how well the firm has performed in terms of
generating operating profits in a given period, given
the amount of capital that was tied up to generate
those profits. The idea is that the firm’s financiers
could have liquidated their investment in the firm
and put the liberated capital to some other use.
Thus, the financiers’ opportunity cost of capital
must be subtracted from operating profits to assess
the firm’s financial performance. And, indeed, this
is the most fundamental insight of EVA. It rewards
managers for earnings and profits, but also taxes
their capital usage. Expressed as a formula, EVA is
defined as:
With this setting, it is clear that if the firm fixes the amount of capital that the
manager can invest, average managers will rationally opt for T1 and talented
managers will opt for T2. This sort of task assignment, which is efficient from the
shareholders’ standpoint, occurs naturally without any coercion of managers or
prior knowledge of their innate abilities.
A problem with this mechanism is that we have to fix the capital input, rather
than have the choice made by the manager using the capital. There may be
circumstances in which this is not efficient. In particular, because of his knowledge
of local conditions, constraints and capabilities, the manager using the capital is likely
to be much better equipped than anyone else to determine how much capital would
be value-maximizing. It therefore makes sense to delegate the determination of the
level of capital deployment to the manager requesting that capital allocation. This
leads to a situation in which the manager is effectively delegated the responsibility
for jointly determining both the capital and effort inputs to the project.
Unfortunately, this can frustrate the self-selection process described earlier. The
reason is that an average manager can substitute capital for innate ability and elevate
his expected output from T2 to be above that from T1 simply by acquiring a sufficiently
large amount of capital. This would then induce him to opt for T2 and, in the absence
of perfect knowledge of innate managerial ability, would cause a breakdown of the
self-selection process by which managers self-select tasks based on ability.
EVA = NOPAT - WACC × Net Assets
where
NOPAT = net operating profit after-tax,
WACC = weighted average cost of capital,
and
Net Assets = adjusted book value of net capital at
the beginning of the period.12
Thus, to the extent managerial compensation is
tied to EVA, the manager’s inclination to consume
capital is now tempered by the fact that he must pay
a capital charge evaluated at the weighted average
cost of capital on the net capital he uses. But, at the
same time, the use of EVA encourages managers to
take all projects that promise to earn more than their
cost of capital, thus mitigating the underinvestment
problem.
Why EVA is More a Behavioral than an
Analytical Tool
Of course, we would also like to know how
well EVA correlates with shareholder value. Unfor-
tunately, the empirical evidence on this subject is
still in a relatively primitive stage, and so offers little
help.13
In theory, however, the present value of a
company’s future expected EVA is equal to its
Market Value Added (MVA), which is defined as the
difference between the market value of the firm and
the (adjusted) book value of its assets. Moreover, the
present value of the expected future stream of EVA
also equals Net Present Value, or NPV.
A commonly-asked question then is: What does
EVA add to conventional NPV analysis? The short
answer is: nothing. For purposes of strategic plan-
12. Estimating the economic value of a firm’s net assets can be a daunting task.
The balance sheet is supposed to represent the amount of capital financiers have
invested in the firm. Unfortunately, because of a variety of accounting distortions,
the total asset value on the typical balance sheet does not accurately represent
either the liquidation value or the replacement-cost value of the assets in place.
It is thus of limited use for asset valuation purposes and must be transformed.
Proponents of EVA, most notably Stern Stewart & Company, are careful to
adjust this accounting balance sheet before arriving at an estimate of the value of
the firm’s assets in place. They first recommend netting the non-interest-bearing
current liabilities (NIBCLs) against the current assets to better represent the
permanent capital structure of the firm. Such netting also recognizes that the cost
of NIBCLs, like accounts payable, are accounted for in the cost of goods sold.
Moreover, a variety of common debt and equity adjustments are also made. The
adjustments include adding back to equity the gross goodwill (i.e., adding
cumulative amortized goodwill back to total assets), restructuring and other write-
offs, capitalized value of R&D (and possibly advertising), LIFO reserve, etc. The
debt balance is adjusted for the capitalized value of operating lease payments. The
overall effect of these suggested adjustments is to produce a balance sheet that
reflects economic values of assets in place more accurately than the inherently
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VOLUME 10 NUMBER 2
ning, or when evaluating any multi-year capital
project, EVA-based financial analysis will not (and
should not) alter the conclusions reached on the
basis of cash-flow-based NPV analysis. But this
equivalence of EVA to NPV is a strength, not a
drawback. However, it naturally causes people to
ask why they should bother to change their financial
analysis procedures to accommodate EVA.
The reason why such questions arise is that EVA
tends to be viewed by many primarily as a tool of
financial analysis.14 This is a mistake. EVA should be
viewed primarily as a behavioral tool—one that
gives managers the strongest possible incentives to
make value-adding investment and operating deci-
sions. That is, it should be tied to compensation (or
not used at all) and viewed essentially as an HR tool.
Its use in financial analysis should be mainly to
support its role as an important compensation
variable, rather than to supplant cash-flow-based
financial analysis of strategic investments.
In fact, we advocate using both EVA and cash
flows for financial analysis. Doing so not only
provides a richer perspective on possible future
outcomes but also permits one to cross-check the
answers obtained by using the two approaches.15
If EVA-based NPV and cash-flow-based NPV
are identical, why is it that EVA is useful for
compensation and NPV is not? The reason is that one
needs flow measures of performance for periodic
compensation since compensation is designed to
provide a flow of rewards. EVA is a flow measure,
whereas NPV is a stock measure. Moreover, of the
available flow measures, EVA is the only one that
explicitly takes into account the cost of the capital
provided by shareholders. In this respect, it is
superior to another flow measure, cash flow.
conservative, historical-cost-based balance sheet that is guided by generally
accepted accounting principles.
13. See, for example, Gary Biddle, Robert Bowen, and James Wallace,
“Evidence on the Relative and Incremental Information Content of EVA, Residual
Income, Earnings, and Operating Cash Flow,” unpublished manuscript, 1996;
Pamela Peterson and David Peterson, “Company Performance and Measures of
Value Added,” The Research Foundation of the Institute for Chartered Financial
Analysts (1996); Jonathan Kramer and George Pushner, “An Empirical Analysis of
Economic Value Added as a Proxy for Market Value Added,” Financial Practice
and Education 7 (1997); Stephen O’Byrne, “EVA and Market Value,” Journal of
Applied Corporate Finance, Vol. 9 No. 1 (1996); and Jeffrey M. Bacidore, John A.
Boquist, Todd T. Milbourn, and Anjan V. Thakor, “The Search for the Best Financial
Performance Measure,” Financial Analysts Journal, May/June 1997.
14. See, for example, Bennett Stewart, “EVA Works - But Not If You Make These
Common Mistakes,” Fortune, May 1, 1995, which bemoans the fact that some
companies adopt EVA solely for financial analysis and do not tie compensation to EVA.
15. In our experience, this helps to detect errors made by financial analysts
in their spreadsheets, errors to which the analyst is alerted when the free-cash-flow
and EVA-based NPVs do not coincide.
SUMMER 1997
THE RELATIONSHIP BETWEEN TQM AND EVA
So what, then, is the relationship between EVA
and TQM? Is EVA consistent with TQM, or its use
likely to undermine such programs.
As we saw earlier, TQM has the potential to
bring about continuous improvements in compa-
nies’ cost-quality positions in part by doing a better
job of managing conflicts among various corporate
stakeholders. And, to the extent it succeeds in raising
revenues or reducing costs, a successful TQM
program may have the effect of turning negative-
NPV projects into value-adding projects. But a TQM
program does nothing to eliminate the incentives
provided by earnings-based compensation to over-
invest corporate capital. Indeed, by placing the
corporate focus on measures of customer satisfac-
tion or employee development instead of share-
holder value, a TQM program could easily lead to
overinvestment.
What’s more, TQM programs themselves in-
volve an investment of corporate resources, includ-
ing outlays for employee training and the costs of
management time in making changes in the organi-
zation. And not all TQM programs succeed in raising
revenues or reducing costs enough to justify the
investment. Moreover, as Brickley, Smith, and
Zimmerman argue (in another article in this issue),
At some point, most (if not all) companies face
diminishing marginal returns from further invest-
ments in quality programs... Management’s job is to
find the value-maximizing amount of quality—
neither too much nor too little—based on its markets
and internal capabilities.
When viewed in this perspective, the central
message of TQM can be recast as follows: Compa-
nies can often add value by reducing conflicts and
achieving a greater alignment of incentives among
its different groups of stakeholders. But TQM also
involves an investment of corporate resources; and,
as in the case of all kinds of corporate investment,
the benefits must exceed the costs by a sufficient
margin to provide the firm with an adequate return
on investment. EVA (along with NPV) provides a
financial framework both for evaluating adoption of
a TQM program and for monitoring the longer-term
effectiveness of such a program. By subjecting TQM
16. James Brickley, Clifford Smith, and Jerold Zimmerman, “Management Fads
and Organizational Architecture,” Journal of Applied Corporate Finance, Vol. 10
No. 2 (Summer 1997).
88
JOURNAL OF APPLIED CORPORATE FINANCE
to the discipline of EVA, management is in a better
position to ensure that its investment in TQM is
translating into increased shareholder value. At the
same time, a TQM program tempered by EVA can
help managers ensure that they are not underinvesting
in their non-shareholder stakeholders.
CONCLUSION
Most financial economists agree that the aim of
public corporations is to maximize total firm value—
and that the only way such a goal can be translated
into practice is by focusing on the maximization of
shareholder value. Both TQM and EVA can be
viewed as organizational innovations designed to
reduce “agency costs”—that is, reductions in firm
value that stem from conflicts of interest between
various corporate constituencies. TQM programs
can be viewed in large part as attempts to increase
value by reducing potential conflicts among non-
investor stakeholders, between management and
employees, employees and customers, employees
and suppliers, and so forth. EVA, by contrast,
focuses simply on reducing conflicts between man-
agers and shareholders by aligning the incentives of
the two groups. EVA reinforces the goal of share-
holder value maximization by giving managers
incentives to operate as efficiently as possible and to
undertake all investments that promise to earn more
than the cost of capital, and to reject all others.
It is important to recognize, however, that the
focus of EVA, and of financial economics more
generally, on shareholder wealth does not imply
that corporate stakeholders other than stockholders
are not important in managment’s decision-making.
The most aggressive maximizer of stockholder
wealth must care about its employees, customers,
and suppliers. Maximizing value, in fact, means
investing corporate resources—to the point where
marginal costs equal marginal benefits—to all groups
or interests that affect firm value, whether to influ-
ence the terms on which they contract with the
company, to maintain the firm’s reputation, or to
reduce the threat of restrictive regulation.
In this sense, there is no conflict between
management’s service to its stockholders and to
other corporate stakeholders. And, by the same
logic, there is no fundamental conflict between the
aims of TQM and EVA. TQM can help EVA by
ensuring that companies make the proper invest-
ment in human capital, and, more generally, in their
non-investor stakeholders. At the same time, an EVA
JEFFREY BACIDORE
is a Visiting Lecturer at the University of Michigan.
JOHN BOQUIST
is the Edward E. Edwards Professor of Finance, Indiana
University.
89
VOLUME 10 NUMBER 2
system can be used to discipline a TQM program by
discouraging management from overinvesting in
such stakeholders. In short, the goals of TQM and
EVA are mutually consistent, and both systems can
be used effectively to reinforce each other.
TODD MILBOURN
is an Assistant Professor of Finance at the London Business School.
ANJAN THAKOR
is the Edward J. Frey Professor of Banking and Finance,
University of Michigan.
SUMMER 1997
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