Which performance measurement is best for your company?

Publication: Management Accounting Quarterly

Publication Date: 22-MAR-03

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COPYRIGHT 2003 Institute of Management Accountants

HERE IS AN ANALYSIS AND COMPARISON OF EVA[R], TRACKING STOCKS, AND BALANCED SCORECARDS AS PERFORMANCE MEASUREMENT SYSTEMS.

An ongoing concern of companies is how to measure performance in ways that support a long-term, forward-thinking strategic view across the entire organization. Many systems and measures purport to accomplish this goal. Three measurement systems, Economic Value Added (EVA[R]), tracking stocks, and balanced scorecards, take distinctly different approaches to measuring firm performance. (1) In this article we examine strategic considerations in determining which of these measures, or combination of measures, a company should use. We begin by discussing each of the three methods, then compare all three, and then address measurement combinations. Our recommendations are incorporated throughout.

We conclude that tracking stocks are more appropriate for large firms and situations where a market-determined measure of performance is needed. Tracking stocks are less appropriate when detailed information about performance is needed. Balanced scorecards and EVA are more appropriate for smaller firms and situations where information beyond that provided by a market measure of performance is needed. The difference between balanced scorecards and EVA is that balanced scorecards should be considered when a functional focus is desired, and EVA should be considered when a project focus is desired. Combinations of these systems can be used in the same firm, but the benefit of multiple systems must be carefully balanced with the added cost, increased complexity, and potential conflict and suboptimization of implementing multiple measures.

EVA

Economic value added has become a popular measure of firm performance since the early 1990s. Stern Stewart & Co., which developed the technique, says it has worked with more than 300 companies to adopt EVA procedures. (2) EVA is measured as a company's operating profit less the cost of capital employed to produce the earnings. Its basic formula is:

EVA = NOPAT-(CC x IC)

Where: EVA = Economic Value Added

NOPAT = Net Operating Profit After Tax

CC = Cost of Capital

IC = Invested Capital

EVA purports to have an advantage over other measures of performance such as net income because it considers the cost of all sources of capital--both debt and equity. In addition, adjustments are made to the accounting numbers in the computation of NOPAT. These adjustments include removing the effect of non-recurring charges such as extraordinary events and capitalized research and development expenses, as well as advertising expenses. These adjustments are intended to recognize the long-term benefit of the expenditures, thereby measuring the company's current performance more accurately.

EVA provides a method for measuring incremental firm value much the same way as net present value (NPV). In fact, under certain conditions, maximizing EVA is equivalent to maximizing NPV. (3) Thus, managers can view each division and each project individually in decision-making processes. Decisions can be made based on how the project will affect the EVA of the firm. Moreover, EVA can serve as a basis for measuring performance of divisions and managers. Stern Stewart & Co. argues that compensation schemes based on EVA align the interests of managers and stockholders. (4) Because EVA allocates profits to various projects, managers can be compensated based on the amount of EVA their project contributes to the firm.

While the benefits of EVA have received much publicity, some in the academic world have criticized the technique. There is little or no relationship between shareholder returns and a firm's EVA. (5) Further, Terrance Jalbert, Brian Boscaljon, Chenchuramaiah T. Bathala, and Ramesh P. Rao found minimal evidence of a difference between the market returns of firms that use EVA compared to firms that do not use EVA. (6)

In addition to the lack of consistent market benefits, there are at least three difficulties associated with implementing EVA. The first lies in calculating NOPAT. Computing NOPAT requires as many as 160 adjustments to financial statements compiled in accordance with generally accepted accounting principles. (7) Computing these adjustments is costly and leaves room for errors and inconsistent interpretations.

Determining the amount of invested capital the firm uses is the second difficulty in computing EVA. Invested capital can be computed as the total assets of the firm less any noninvested capital. The difficulty lies in determining what constitutes noninvested capital, which is liabilities that are interest-free. These liabilities might include trade liabilities such as accounts payable and accrued liabilities. The difficulty in measuring noninvested capital occurs when firms pay a high price for an item in order to receive free financing. While the liability has no explicit interest charge, the cost of financing is built into the sales price.

Figuring out the cost of capital underlies the third difficulty of computing...

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