CASE STUDY: ECONOMIC VALUE ADDED
Value is a generic word. It is used in many areas particularly in business, economics, accounting, ethics, and mathematics. In economics, it means a fair return or equivalent in goods, service, or money for something exchanged.
- VALUE ADDED
Convertion of raw materials into finished products of more value, the difference being VALUE ADDED provided:(i) someone is willing to pay for it, (ii)done for the first time and (iii) the action must somehow change the product in some way.
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:
- ECONOMIC VALUE ADDED (EVA)
Indicates financial performance of a company based on its economic profit. In accounting profit, no compensation is included for the entrepreneur. Deducting from accounting profit, a fair return to owners would show Economic Profit or Loss
The EVA is a registered trademark by its developer, Stern Stewart & Co.
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:
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.