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CASE STUDY - Intergrated ABC & EVA Approach
This Hub is a continuation of my previous two Hubs: (1) ABC and (2) EVA. In this Hub, ABC & EVA would be combined. As would be observed later in the report, this integrated approach outsmarts both TCA and ABC. The integrated approach is more reliable as it traces the use of capital to different products which, in turn, enables the management in better decision-making and strategic planning.
ABC is a valuation system which assigns values to different production on the basis of direct benefits obtained by them from resources of the enterprise. It results in improved operating efficiency. On the other hand, EVA is a financial performance indicator and is helpful in improving financial efficiency. A combined approach would enable the managers to take into consideration all costs, manufacturing and non-manufacturing, relating to their products, jobs or services.
There are ample examples of companies showing excellent operating profits but ending in huge losses due to heavy payments of interest and penal interest.
Financial statements of the company are given as per Table 1 & 2.
As explained in the Hub on EVA, some adjustments were made in profit, total capital invested. Similarly, Weighted Average Cost of Capital (WACC) was calculated. On the basis of these working, EVA was arrived at as follows:
- Net Operating Profit After Tax . Rs.1,028,160
- Less Cost of Capital … … … … .Rs.1,302,272
- EVA … … … … … … … … … … .Rs. (274,112)
Once we know, there is an economic loss, we would try to find out which product caused this loss. Apportioning costs arbitrarily would punish the “bread-winners” and would hide the parasites.
Just like in ABC, while computing EVA for each product, we need to find how the financial cost would be distributed among the products. This is uphill task and involves a number of techniques like:
- CAUSE & EFFECT RELATIONSHIP – Funds of a business are tied up in inventories and Trade Receivables. Mark up on working capital loans can be distributed through analyzing purchase account, finished goods stock position and trade receivable. If a particular product is strictly sold against cash, it should not be loaded with trade finance.
- DIRECT TRACING – if a bank loan was raised for a particular product it can be allocated to it.
- TIME & MOTION STUDIES – Fixed Assets are financed through Debt & Equity. Naturally, some markup and dividend expectations are linked with fixed assets acquisition. Through time and motion study, it can be ascertained as to which product has taken how much time in the process. Finally, a rough estimate can be made for allocation of financial costs on the basis of fixed assets usage by different products.
Based on the foregoing, the Cost of Capital of Rs.1,302,272 was apportioned between the two products as shown below:
- Table 3 – Working Capital and Fixed Assets Costs were studied and allocated to two products in %ages.
- Table 4 – Actual balance under working capital and fixed cost were split on the basis of percentage arrived at Table-4. This was necessary to calculate weighted %Total
- Finally, the total Cost of Capital was apportioned for the purpose of calculating EVA as shown in Table 5.
Economic Value Added (EVA)
Under TCA, Large Parts were rated very high as they appeared to contribute 85% of profits. Under ABC, this percentage slides down to 69% or down by 16%. Worst was still to come when EVA disclosed that the Large Parts were making extensive use of capital. When incorporated to our financial model, it became evident that Large Parts are causing havoc and the enterprise is sustaining on the contribution made by the Small Parts which were originally belittled due to distortion in financial information.
If there is a reward system, all those engaged in small part operations should be rewarded and those in the large part section should be asked to look for way and means to cut costs and also review their product costing and pricing policies.