EVA :: A Case Study of the Implementation Issues



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

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.

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

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 percentage-based 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.

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 non-operating 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]

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, 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 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 Responsible Parties

McKee Consolidated Board of Directors

McKee Parent Company Officers

McKee Plants Plant Management Teams

McKee Corporate Company Officers

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 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 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 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 risk-adjusted 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 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 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

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.

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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