Economic Value Added (EVA) and the Supply Chain

Economic Value Added (EVA) isolates the funds available to all of the suppliers of capital and then relates that amount to the amount of capital supplied.  The reason it is termed “Economic Value” is because value is created only if the firm earns a rate of return that exceeds its cost of capital (usually measured by the weighted average cost of capital or WACC).  RI approaches this idea, but it does not provide the measure of “profit.”

 

Operating income (Earnings Before and Taxes, or EBIT) is found by deducting the cash cost of goods sold, cash operating expenses, and the non-cash operating expenses of depreciation and amortization from revenue.  An assumption in EVA analysis is that reinvestment in assets must occur in the amount of the depreciation and amortization if the business is to continue in its present form and size.  The reinvestment in assets does not appear in the income statement because it is not an expense.  Nonetheless, it is a cash outflow, which makes EBIT the appropriate measure for the purpose of computing EVA.  The amount of cash available to all suppliers of long-term debt and equity is found by multiplying EBIT times (1- the corporate tax rate)

 

The following example shows how to compute EVA.  Assume the following for this particular company:

 

EBIT – $1,600,000

Tax Rate – 34.615%

WACC – 10%

Long Term Debt – $3,900,000

Equity – $8,200,000

 

EVA = $1,600,000(1-.34615) – (.10) ($3,900,000 + $8,200,000)

 

         = $1,046,160 – (.10) ($12,100,000)

         = $1,046,160 – $1,210,000

         = -$163,840

 

This company has a negative EVA.  Based on the WACC and the amount of long-term funds invested in the firm, investors expect the company to generate $1,210,000 as an amount available to them.  When this amount, termed a capital charge, is levied against the amount available, as measured by EBIT (1- Tax Rate), EVA is determined to be -$163,840.  Investors will bid down the firm’s stock price because management has failed to produce the amount of value expected, even though the firm has a positive return on sales and assets, and it probably produces a positive net cash flow as well.

 

EVA is a true measure of economic profit or loss, and is accepted in the professional financial community.  It is also being encouraged as a “overall” supply chain metric, although an overall supply chain metric does not exist as of yet.  Many firms use EVA to gauge their performance or test the economic advantage of proposed investments.  There are three generic ways in which a firm can increase its EVA through intelligent asset management:

  • ·         Improve operating efficiency so that the firm can generate more EBIT (operating profit) on the asset base.  We know that the supply chain directly impacts operating profit through sales and cost of goods sold, which is a function of inventory and supply chain expenses.
  • ·         Invest additional capital in assets that earn a rate of return that exceeds the cost of capital.  We will learn more about this during our learning about capital budgeting.
  • ·         Eliminate assets that earn a rate of return that is less than the cost of capital.

 

Many companies implement EVA as a managerial tool to provide a practical, periodic performance measure for the overall company and for individual divisions and/or operating units.  When used at the divisional and/or operating unit level, the parent company allocates capital to the individual units.  Parent companies use EVA to determine the difference between the units’s net operating profit (EBIT) and a capital charge (WACC). Companies encourage management to devise and implement plans that increase EVA.

 

EVA can also help assess management’s longer term performance because it can be linked a company’s stock price through a measure called market value added (MVA).  EVA is a year-by-year computation, but MVA represents the accumulated impact of successive EVA results since the firm’s inception.

 

MVA is observable and measured as the market value of a company’s debt and equity less its book value of debt and equity.  If the market value of the firm’s long-term debt and equity exceeds the book value, management has created value for shareholders.  If it is less, management has destroyed shareholder value.  Many large, well-known companies report positive accounting profit and produce positive cash flow while destroying shareholder value because they fail to earn their cost of capital.

 

The supply chain creates shareholder value not only through efficiency and cost containment, but also through enhancement of a product, outstanding customer service, and sustained competitive advantage.  Through managing all facets of its supply chain, a firm can realize its corporate goals and objectives as well as increase its share price.