CASE STUDY: ECONOMIC VALUE ADDED

While ‘value’ is a general term, “value added” has specific meanings. I teach Management Accounting and when I say “What is value added?” most of the students would say that it is ‘adding a feature to a product’. It may be product development but not necessarily value addition. I point to a multimedia hanging from the ceiling and say “This is presently rotated manually. Its present price is Rs.45,000. If the manufacturer introduces a feature for rotating through a remote control at an additional cost of Rs.15,000, would it be called value addition?” Most maybe inclined to say, “Yes Sir”, but it is “No Sir.” Why, no one would pay a hefty sum of Rs.15,000 for the new feature. Even if someone is willing to pay, it still does not add any value. It is only when the manufacturer can fetch say Rs.65,000, value addition has occurred. In this way, by using a feature costing Rs.15,000, the manufacturer has realized an additional Rs.20,000 thereby increasing the bottom line by Rs.5,000.

In my earlier Case Study: Activity Based Costing, a mention was made of a Steel Parts Making Plant.  The example is extended a little further and its Profit & Loss Accounts for the last year are given below:

An entity can increase Value addition by (i)bringing up new products or services which have a higher value in the eyes of a customer than the cost of inputs used such as materials, components and services used to make them, (ii) capture un-tapped market of new segments or geographical areas, (iii) improving quality and raising prices, (iv) reducing costs by switching over to cheaper raw materials, size reduction and combinations, and finally (v) reducing, as far as possible, non-value added activities such as setup, storage, transportation, wait and inspection.

In economics, the value addition is calculated by the following formula:

Value Added = Value of sales less the cost of bought-in goods and services.

In this formula, only cost of bought-in goods and services has been accounted for. It completely ignores labour cost, depreciation, markup etc. In fact, they are factors of production (land, labour and capital). They provide “services” which raise value of “inputs” to a much higher realized value. The difference would be shared among them.

The Valued added in our example and its distribution is shown in the side table:

THEN WHAT IN THE HELL IS ECONOMIC VALUE ADDED?

Economic Value Added (EVA) concentrates only on one of the factors of production i.e. Capital. It measures surplus value created by total investments which include funds provided by banks, bond-holders and share holders. It is more useful than Rate of Return (ROI) or Internal Rate of Return (IRR) in evaluating operations of an enterprise.

Accounting professor Steven Orpurt from Singapore Management University explains: “One of the primary insights from the EVA concept is recognition that growing earnings does not necessarily increase firm value or stock price. EVA focuses attention on how a firm uses its capital by asking, “Is a firm generating earnings above and beyond that expected by the market (the providers of the capital)?”

How relevant is EVA today? Responds Stern, “Some may say that EVA was a fad of the 1990s, but earning more than the cost of capital is not a fad. It is what all companies should do all of the time. That they do not is surprising. All of the talk on governance, also not a fad, never demanded this simple requirement. Until boards do, EVA will remain as relevant as it was in the 1990s.”

 

The relevant formula is:

EVA= (Return on Capital - Cost of Capital) x Total Capital

We need three figures:

  1. NOPAT
  2. Investment
  3. WACC

By dividing NOPAT with Investment, we get returns in percentage. From this, we deduct AWCC which is also in percentage; the difference would show %profit per rupee. By multiplying this with total capital, we capture EVA in rupee-terms.

Indus Machine Tools Ltd is a Private Ltd Company at Multan, a city in Punjab, Pakistan. Its Balance Sheet is given on the right-hand side. EVA is calculated as under:

  • NOPAT is Rs.1,028,160 against total capital of Rs.10,484,000, the Return on Capital being 9.81%
  • The Cost of capital, as calculated below, is 12.42%
  • Obviously, the company has ran into economic loss since it could even cover the cost of capital.
  • Using the formula given earlier, EVA comes to a minus figure of Rs.274,112.

The poor performance of the company can be seen from the fact that as against Dividend Expectation of 20%, the company is hardly in a position to pay half of it or 10%. This would make share of the company as un-attracative and the investors would not be interested to keep the shares. If they sell the shares, the share value would further drop. The company would not get equity investment if it desired to go for expansion.

EVA can be calculated product wise and it can be combined with ABC, which gives much better insight on true cost of a product.

ABC-EVA would be my next article.

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Comments 22 comments

sophiewf profile image

sophiewf 7 years ago from US

Great Hub! Very informative with lots of sound advice. Works for me!


khalidkhawar 7 years ago

a very informative study.


hafeezrm profile image

hafeezrm 7 years ago from Pakistan Author

Thank you sohpiewf for your kind comments.


Chucks 6 years ago

More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

http://www.kpmgaccountingfirm.info


flameater profile image

flameater 6 years ago

Hi Hafeez,

Again thank you for such a succinct and clear explanation of the concept of value-add.

Your last bit on the topic of fads in value-add is an interesting one. Not about whether EVA is or is not a fad. However, on the importance of fads on value add.

If only we can put on a special set of eye glasses with which we can view the world economics. Imagine that with such an eye glass we would be able to view and segregate the current value of all economic products into time-based segments. It would allow us to see the values of currently best selling movies, most fashionable smartphones, latest operating systems and software, etc in one month's time, six months' time, a year's time.

What I am trying to get at is this - that fad is a very important factor in value add. And the time factor plays an important role in it.

For countries and economies that uses Value Creation concepts for planning their economic and industrial plans, it is just as important to talk to a trend-spotter, a technology evangelist, as well as an accountant and an economist in formulating their plans.

We don't see any time and cyclical sensitive measures being incorporated in any of the typical EV formulas. How can a more comprehensive body of knowledge that recognizes the importance of these factors be developed?


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

Thanks for your comments. I would certainly study more and come up with an answer.


Jayantha 6 years ago

Dear Sir,

This is good stuff. Thank you so much for sharing your knowledge with lesser mortals like us.

Jayantha


Jhumur Maity 6 years ago

This is a clear concept to value add.It is really useful to me.Thanks a lot.


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

Thanks Vibha, Jayantha and Jhumur Maity for your comments,


farooq 5 years ago

this is a good explanation. however, how do you calculate returns on bank loan, debt and equity? Is this the same thing as cost of bank loan, debt and equity?


hafeezrm profile image

hafeezrm 5 years ago from Pakistan Author

Thank Farooq for your comments. Cost and Returns would be the same in some way. For example, markup is cost to borrower but return to lender. There is no way, one can calcuate separately returns on bank loan and return on debt since all borrowed funds are pooled up and used in the business. However, overall returns are indicated by IRR or ROI. In case if equity, we can calculate ROE i.e. Return on Equity.


manju 5 years ago

thanks a lot for your articles

looking forward more topics on management accounting.

I have one problem i am student of CMA i am weak in costing and accounting please suggest how to over come and also recommend some basic books for costing and accounting

please mail me

patil7manju@yahoo.com

regards.

Manju


asadayub profile image

asadayub 5 years ago

Respected Sir, a very informative article, because before your class of Project Management, i always says "Yes Sir" when the concept of Value Addition is asked from me, as given example in the article. But, after i've taken classes of Project Management from you and after reading this hub, i'm pretty much clear on the concept of Value Addition. Nevertheless, the concept of EVA is also really well explained in this hub. Thank You so much for sharing such informative hubs.


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thanks Asad Ayub for your comments.


pankaj jain 4 years ago

thanks A lot of informative


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thanks Pankaj Jain for your comments.


shobhit sharama 4 years ago

Sir

I wanted to ask you a question that how should we relate EVA with a case study because it is based on theory only and how can we like explain it did mixing it with case study.


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

@Shobhit Sharama - This is real life case. You may copy it on the MS Excel, erase original figures and replace them with those give in a balance sheet of your choice. It would calculate the EVA.


shirley 4 years ago

...an excellent study tnx for this Mr.hafeez...now, its more clearer to me about the concept of eva...it made enlighten my un answered questions...


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thanks Shirley for your comments.


Thilini 4 years ago

Thank a lot for your article


Sanket 2 years ago

HI Hafeez,

Thanks so much for writing the blog. I am taking the course on EVA by Joel Stern himself at Univ. of Cape Town, GSB, SA.

I want to valuation (EVA) of Shakti Pumps India as part of my course assignment , which will be assessed by Joel Stern himself.

Can you please share some piece of advice regarding the nuances of Accounting practices in India. Please EVA model Excel template.

Regards,

Sanket

Sanket.jk@gmail.com

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