Economic Value Added

1. Many experts regard Economic Value added (EVA) as a concept is superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment centers. Explain this phenomenon, with illustration, if necessary.

We strongly advocate the use of EVA as a performance measurement tool. EVA, however, does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets, unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the passage of time. Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system:

Moreover, some assets may be undervalued when they are capitalized, and other when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in startup costs, new-product development, dealer organization, and so forth, may be written off as expenses and therefore will not appear in the investment base. This situation applies especially to marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.

Considering these problems, some companies have decided to exclude fixed assets from the investment base. These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Controllable assets are essentially working capital items. Business unit managers can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur quickly: for example, if creased; if inventories are too low, production interruptions or lost customer business can result from the stock outs.

Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the anticipated cash flows in fact materialized. This is far from completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable system usually will not identify the savings attributable to each product.