INTRODUCTION

What is Performance Measurement (PM)?

Historically, PM systems was developed as a means of monitoring and maintaining organisational

control, which is the process of ensuring that an organisation pursues strategies that lead to the
achievement of overall goals and objectives.
PM plays a vital role in every organisation as it is often viewed as a forward-looking system of
measurements that assist managers to predict the company's economic performance and spot the need
for changes in operations. In addition, PM can provide managers, supervisors and operators with
information required for making daily judgements and decisions. PM is increasingly used by
organisations, as it enables them to ensure that they are achieving continuous improvements in their
operations in order to sustain a competitive edge, increase market share and increase profits.

Reasons for adapting performance measurements:-

1. To evaluate the performance of firm/department/individual.

2. To control different activities so that it leads to achieve organizational goal.
3. To budget according to the future requirement.
4. To motivate by giving people significant goals to achieve and then use performance measures
to provide periodic sense of accomplishment.

Traditional measures
Traditional PM has mainly been financial measuring ratios such as ROI (Return on Investment), RI
(Residual Income), and EPS (Earnings per share). These metrics accounts for the costs associated
with capital and help firms spot areas in which capital is being invested unprofitably. Although these
financial data have the advantage of being precise and objective, the limitations are far greater,
making them less applicable in today's competitive market. Organisations, that have adopted the
traditional PM, have experienced great difficulty in trying to fit the measures with increasing new
business environment and current competitive realities.

While the traditional financial metrics are value-based, they are nonetheless lagging indicators. They
offer little help for forward-looking investments, where future earnings and capital requirements are
largely unknown investments such as new product introductions and capital or new market entry.

• Fail to measure and monitor multiple dimensions of performance, by concentrating almost

exclusively on financial measure.
• They solely concentrate on minimising costs and increasing labour efficiency while neglecting
other operational performance measures such as quality, responsiveness and flexibility.
• Allowing managers to use slow-reacting and tactical management control system such as
'budgets'. These budgeting measures mainly focus on short-term value creation as it only attempts
to control and improve existing operations.
• Moreover, most companies motivate their worker through reward system. Traditionally,
employees are rewarded with bonuses at the end of the year once a specific target has been

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 achieved. However, this reward system causes short-termism as employees are seen to narrow
down their focus by just targeting the 'rewarded' goal.

WHAT IS ECONOMIC VALUE ADDED (EVA)?

EVA® (Economic Value Added) was developed by a New York Consulting firm, Stern Steward & Co
in 1982 to promote value-maximizing behavior in corporate managers. This term has been used in the
book named “The Quest for Value” which was published in 1991. Stern Steward & Co claims EVA
to be their registered trade mark, while Peter Drucker claimed that he discussed EVA in 1964 in his
book, “Managing for Results”. It cannot be denied; however, without going into argument as to who
invented EVA first that the concept became popular only after Stern Stewart & Co. marketed it.

EVA is a value-based measure that was intended to evaluate business strategies, capital projects and
to maximize long-term shareholders wealth. Value that has been created or destroyed by the firm
during the period can be measured by comparing profits with the cost of capital used to produce
them. The detailed analysis using EVA may enable the managers to find out activities which are less
profitable, and where the profits are being ‘eaten-up'. EVA, therefore enables the management to,
invest in projects that are critical to shareholder's wealth. This will lead to an increase in the market
value of the company. However, activities that do not increase shareholders value might be critical to
customer's satisfaction or social responsibility. For example, acquiring expensive technology to
ensure that the environment is not polluted might not be of high value from a shareholder's
perspective. Focusing solely on shareholder's wealth might jeopardize a firm reputation and
profitability in the long run.

Researchers have found that managers are more likely to respond to EVA incentives when making
financial, operational and investing decision (Biddle, Gary, Managerial finance 1998), allowing them
to be motivated to behave like owners. However this behavior might lead to some managers pursuing
their own goal and shareholder value at the expense of customer satisfaction.

Unlike traditional methods of performance measurement, EVA focuses on ends and not means. In
other words, we can say that it does not state how manager can increase company's value as long as
the shareholders wealth is maximized.

If we talk about the corporate houses, Cola-Cola is one of the many companies that adopted EVA for
measuring its performance. Its aim, which was to create shareholders wealth, was announced in its
annual report. The EVA calculation showed that Coca-Cola's investor received $8.63 wealth for every
dollar they invested

Mathematically, the EVA can be calculated as

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 EVA = NOPAT – (WACC X Capital Employed)

Where,
NOPAT means Net Operating Profit before Interest and after Tax
WACC represents Weighted Average Cost of Capital.
4 M’S OF EVA

Stern Stewart describes four main applications of EVA with four words beginning with the letter M.:-

1. MEASUREMENT

EVA is the most accurate measure of corporate performance over any given period. Fortune
magazine has called it "today's hottest financial idea," and Peter Drucker rightly observed in the
Harvard Business Review that EVA is a measure of "total factor productivity" whose growing
popularity reflects the new demands of the information age. It brings goal congruence or matching of
employees and shareholders. It provides significant information beyond traditional accounting
measures like ROI, ROCE, EPS, etc

2. MANAGEMENT SYSTEM

While simply measuring EVA can give companies a better focus on how they are performing, its true
value comes in using it as the foundation for a comprehensive financial management system that
encompasses all the policies, procedures, methods and measures that guide operations and strategy.
The EVA system covers the full range of managerial decisions, including strategic planning,
allocating capital, pricing acquisitions or divestitures, setting annual goals-even day-to-day operating
decisions. The management can use the EVA for accessing the performance of the business units or
segments within the company. If the segment is making surplus after achieving the cost of capital
then it makes sense to invest into it.

3. MOTIVATION

To instill both the sense of urgency and the long-term perspective of an owner, Stern Stewart
designed cash bonus plans that cause managers to think like and act like owners because they are paid
like owners. Indeed, basing incentive compensation on improvements in EVA is the source of the
greatest power in the EVA system. Under an EVA bonus plan, the only way managers can make
more money for themselves is by creating even greater value for shareholders. This makes it possible
to have bonus plans with no upside limits. In fact, under EVA the greater the bonus for managers, the
happier shareholders will be.

4. MINDSET

When implemented in its totality, the EVA financial management and incentive compensation system
transforms a corporate culture. By putting all financial and operating functions on the same basis, the
EVA system effectively provides a common language for employees across all corporate functions.

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EVA facilitates communication and cooperation among divisions and departments, it links strategic
planning with the operating divisions, and it eliminates much of the mistrust that typically exists
between operations and finance. The EVA framework is, in effect, a system of internal corporate
governance that automatically guides all managers and employees and propels them to work for the
best interests of the owners. The EVA system also facilitates decentralized decision making because
it holds managers responsible for-and rewards them for-delivering value.
OTHER APPLICATIONS OF EVA-

Value-focused Decision Making

To maximize shareholder wealth, decision makers at all levels must be value-focused. The market
value of any firm is a function of its expected future performance, which in turn is a function of the
effectiveness of management. For Eg: - Stern Stewart & Co. helped clients improve performance by
better understanding the value inherent in their strategy and operations.
To assess the value of an acquisition target, analyze the economics of a product portfolio, formulating
the structure of a compensation plan, or introducing a new financial management framework, the
approach for all projects can be done from one vantage point -the strategy best maximizes the value
creation of the business over time i.e. EVA.

Managers Who Think and Act like Owners

The most effective way to motivate managers is to make value-based decisions is to link their
incentives to goals that relate directly to value creation itself. Under this type of incentive structure,
managers stand to gain substantially when, for example, EVA increases; when EVA falls, their
incentive compensation should be at risk. It helps in designing compensation system for managers
based on EVA. This approach effectively makes a manager think like an owner, and provides strong
motivation to make decisions that focus on the continuous improvement in EVA – decisions that the
market will reward.

A Commitment to Continuous Improvement

A final condition for maximizing wealth is to focus on continuous improvement rather than short-
term goals. Investors don't reward companies because managers have met their annual budget; they
reward companies when managers regularly seek out and undertake initiatives that improve long-term
performance. Stern Stewart encourages clients to stay focused on continuous improvement.

Value Based Strategy and Management

Stern Stewart's mission is to help clients establish clear, accountable links between management
action and the creation of shareholder wealth. In his view, the most effective way to align
management initiatives with shareholder interests is to implement a framework for decision-making
that is based on the proprietary EVA measure. EVA has gained broad acceptance in the business
community for its ability to help managers increase the value of their companies. More than 400
major corporations, globally, have adopted our EVA framework and been rewarded with significant
improvements in corporate performance and share price.

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EVA Vs. TRADITIONAL PERFORMANCE MEASURES

Conceptually, EVA is superior to accounting profits as a measure of value creation because it

recognizes the cost of capital and, hence, the riskiness of a firm’s operations. Furthermore EVA is
constructed so that maximizing it can be set as a target. Traditional measures do not work that way.
Maximizing any accounting profit or accounting rate of return leads to an undesired outcome.
Following paragraphs seek to clarify the benefits of EVA compared to conventional performance
measures.

EVA, NPV vs. IRR, ROI

Return on capital is very common and relatively good performance measure. Different companies
calculate this return with different formulas and call it also with different names like Return on
investment (ROI), Return on invested capital (ROIC), Return on capital employed (ROCE), Return
on net assets (RONA), Return on assets (ROA) etc. The main shortcoming with all these rates of
return is in all cases that maximizing rate of return does not necessarily maximize the return to
shareholders. Following simple example will clarify this statement: -

Suppose a group with two subsidiaries. For both subsidiaries and so for the whole group the cost of
capital is 10%. The group names maximizing ROI as target. The other subsidiary has ROI of 15% and
the other ROI of 8%. Both subsidiaries begin to struggle for the common target and try to maximize
their own ROI. The better daughter company rejects all the projects that produce a return below their
current 15% although there would be some projects with return (IRR) 12% - 13%. The other affiliate,
in turn, accepts all the projects with return above 8%. For a reason or another (e.g. overheated
competition) it does not find very good projects, but the returns of its projects lie somewhere near
9%.

Let’s suppose that both subsidiaries manage to increase their ROI. With the better subsidiary ROI
increases from 15% to 16% and with the not-so-good subsidiary ROI increases from 8% to 8.5%. The
company’s target, increasing ROI, is achieved but what about the shareholder value? It is obvious that
all the projects of the not-so-good subsidiary decrease shareholder value, because the cost of capital is
more than rate of return (and so the shareholders money would have been better off with alternative
investments e.g. in the markets). But the actions of the better subsidiary are neither optimal for
shareholders. Of course shareholders will benefit from the good (return over 15%) projects but also
all 12%-13% (actually all above 10% = cost of capital) projects should have been accepted even
though they decrease current ROI. These projects still create and increase shareholder value.

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As the above example demonstrates operations should not be guided with the goal to maximize the
rate of return. As a relative measure and without the risk component ROI fails to steer operations
correctly. Therefore capital can be misallocated on the basis of ROI. First of all ROI ignores the
definite requirement that the rate of return should be at least as high as the cost of capital. Secondly
ROI does not recognize that shareholders’ wealth is not maximized when the rate of return is
maximized. Shareholders want the firm to maximize the absolute return above the cost of capital and
not to maximize percentages. Companies should not ignore projects yielding more than the cost of
capital just because the return happens to be less than their current return. Cost of capital is much
more important hurdle rate than the company's current rate of return.

Observing rate of return and making decisions based on it alone is similar to assessing products on
the "gross margin on sales" -percentage. The product with the biggest "gross margin on sales"
-percentage is not necessary the most profitable product. The product profitability depends also on the
product volume. In the same way bare high rate of return should not be used as a measure of a
company's performance. Also the magnitude of operations i.e. the amount of capital that produces
that return is important. High return is a lot easier to achieve with tiny amount of capital than with
large amount of capital. Almost any highly profitable company can increase its rate of return if it
decreases its size or overlooks some good projects, which produce a return under the current rate of
return.

The difference between EVA and ROI is actually exactly the same as with NPV (Net present value)
and IRR (Internal rate of return). IRR is a good way to assess investment possibilities, but we ought
not to prefer one investment project to the other according to their IRR. Assume two good and
exclusive investment projects, Project 1 and Project 2. Project 1 has lower IRR but is much bigger in
scope (bigger initial investment and bigger cash flows and bigger NPV). Project 1 (the project
offering lower IRR) is better for shareholders even though it has lower IRR. That is because it
provides bigger absolute return than Project 2. The reason is exactly same as with ROI: maximizing
rate of return percentage does not matter. What matters is the absolute amount of shareholders’
wealth added.

In the corporate control it is worth remembering that EVA and NPV go hand in hand as also ROI and
IRR. The formers tell us the impacts to shareholders wealth and the latter tell us the rate of return.
There is no reason to abandon ROI and IRR. They are very good and illustrative measures that tell us
about the rate of returns. IRR can always be used along with NPV in investment calculations and ROI
can always be used along with EVA in company performance. However, we should never aim to
maximize IRR and ROI and we should never base decisions on these two metrics. IRR and ROI
provide us additional information, although all decisions could be done without them. Maximizing
rate of returns (IRR, ROI) does not matter, when the goal is to maximize the returns to shareholders.
EVA and NPV should be in the commanding role in corporate control and ROI & IRR should have
the role of giving additional information.

Return on equity (ROE)

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ROE suffers from the same shortcomings as ROI. Risk component is not included and hence there is
no comparison. The level of ROE does not tell the owners if company is creating shareholders wealth
or destroying it. With ROE this shortcoming is however much more severe than with ROI, because
simply increasing leverage can increase ROE. As we all know, decreasing solvency does not always
make shareholders’ position better because of the increased (financial) risk. As ROI and IRR, return
on equity (ROE) is also an informative measure but it should not guide the operations.

Earnings and earnings per share (EPS)

EPS is raised simply by investing more capital in business. If the additional capital is equity (cash
flow) then the EPS will rise if the rate of return of the invested capital is just positive. If the additional
capital is debt then the EPS will rise if the rate of return of the invested capital is just above the cost
of debt. In reality the invested capital is a mix of debt and equity and the EPS will rise if the rate of
return of that additional capital invested is somewhere between cost of debt and zero. Therefore EPS
is completely inappropriate measure of corporate performance and still it is very common yardstick
and even a common bonus base. EPS and earnings can be increased simply by pouring more money
into business even though the return on that money would be entirely unacceptable from the
viewpoint of owners. EPS, earnings and earnings/EPS growth should therefore be abandoned as
performance measures.

COMPONENTS OF EVA

Net Operating Profit After Taxes

NOPAT is easy to calculate. From the income statement we take the operating income and subtract
taxes. Operating income is sales less cost of sales and less selling, general and administrative
expenses.

Net Operating Income

Net Operating Income or NOI is a means of expressing pure operating results. In other words,
financial results of NOI do not have the impact of financing (borrowing), investing, or accounting
adjustments, which can distort a purely operational analysis. NOI is the amount of money generated
exclusively from operations.

Calculating Cost of Capital

Many businesses don’t know their true cost of capital, which means that they probably don’t know if
their company is increasing in value each year. There are two types of capital, borrowed and equity.
The cost of borrowed capital is the interest rate charged by the bondholders and the banks. Equity
capital is provided by the shareholders. An investor’s expected rate of return on an investment is
equal to the risk free rate plus the market price for the risk that is assumed with the investment. The
risk of a company can be decomposed into two parts. An investor can eliminate the first component
of risk by combining the investment with a diversified portfolio. The diversifiable component of risk
is referred to as non-systematic risk. The second component of risk is non-diversifiable and is called

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the systematic risk. It stems from general market fluctuations which reflect the relationship of the
company to other companies in the market. The non-diversifiable risk creates the risk premium
required by the investor. In the security markets the non-diversifiable risk is measured by a firm’s
beta. The higher a company’s non-diversifiable risk, the larger their beta. As the beta increases the
investor’s expected rate of return also increases.

Measuring Capital Employed

Accounting profits differ from economic profits. Under generally accepted accounting principles,
most companies appear to be profitable. However, many actually destroy shareholder wealth because
they earn less than the full cost of capital. EVA overcomes this problem by explicitly recognizing that
when capital is employed it must be paid for. In financial statements, created using generally accepted
accounting principles, companies pay nothing for equity capital. As discussed earlier, equity capital is
very expensive. Economic profits are defined as total revenues less total costs, where costs include the
full opportunity cost of the factors of production. The opportunity cost of capital invested in a business
is not included when calculating accounting profits
.
Long Term Debt
Long Term Debt includes bonds, mortgages and long term secured financing.

Calculation of EVA
EVA is sales less operating costs (including taxes) less all financing costs. Put another way, EVA is
net operating profit after tax (NOPAT) less the cost of all capital, equity as well as debt.

EVA = NOPAT - (Cost of Capital x Total Capital)

EVA Vs ROI

Rate of Return on Investment (ROI)

Meaning

A performance measure used to evaluate the efficiency of an investment or to compare the

efficiency of a number of different investments. To calculate ROI, the benefit (return) of an
investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

Formula:

ROI = Profit After Tax

Capital Employed

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Return on investment is a very popular metric because of its versatility and simplicity. That is, if
an investment does not have a positive ROI, or if there are other opportunities with a higher ROI,
then the investment should be not be undertaken.

Advantages:

 ROI allows management to assess both profitability and efficiency in using assets.

 Divisions of unequal size can be compared.

 Management is provided with information to make decisions on where to invest
additional company funds. The company knows where it is getting "the most bang for its
buck."

Disadvantage:

 If a manager is evaluated based on ROI, he or she will not invest in any project that will lower
the division's ROI, even if it would increase the company's profitability.

Difference between ROI and EVA

1. ROI is an accounting measurement tool and EVA is performance measurement tool.

2. ROI is a traditional concept, EVA is a modern concept.

3. ROI is expressed in term of Percentage, EVA is in currency (rupee or dollar).

4. ROI does not take the cost of capital into consideration, EVA includes cost of capital.

5. ROI can be used to compare with the competitors and industry, EVA cannot be used for
comparison.

EVA has four advantages over ROI:

1. With EVA all business units have the same profit adjective for the comparable investment.

2. Decisions that increase a centre ROI may decrease its overall profits.

3. Different interest rates/ depreciation rates may be used.

4. EVA has strong positive correlation with changes in company market value, the best proxy for
shareholder value at the business unit level is to business unit managers to create and grow
EVA

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CASE STUDY

Objectives of the Study

This study has the following objectives:

1. To examine whether Hindustan Unilever Limited (HUL) has been able to generate value for its
shareholders.

2. To compute the performance of the company by applying traditional performance indicator like
ROI and the new corporate performance measure EVA.

Following is the performance measurement of HUL for 5 years from 2002 to 2006 based on
information given.

(ALL FIGURES IN Rs. Crore)

PARTICULARS 2006 2005 2004 2003 2002

1. Debt 163 360 1588 881 45
2. Equity 2515 2200 2116 2899 3351
3. Capital employed(1+2) 2678 2560 3704 3780 3396
4.Profit after tax (PAT) 1540 1355 1199 1804 1716
5.ROI % (4/3) 57.51 52.93 32.37 47.72 50.53
6.Cost of Debt, post-tax % 5.9 3.38 5.19 4.88 6.45
7.Cost of Equity % 16.38 15.5 14.77 12.96 14.4
8.Weighted Average Cost of Capital % 15.74 13.8 10.66 11.07 14.3
(WACC)
9.Cost Of Capital Employed (3*8) 421.5 353.2 394.8 418.4 485.6
2 8 5 5 3
ECONOMIC VALUE ADDED(EVA)
10.Profit after tax (PAT) 1540 1355 1199 1804 1716
11.Add:Interest,after taxes 7 12 82 43 6
12.Net operating profits After 1547 1367 1281 1847 1722
Taxes(NOPAT)
13.COCE ,as per (7) above 421 353 395 418 486
14.EVA:(12-13) 1126 1014 886 1429 1236

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Economic Value added and ROI for the last five years is given below:
Rs.
Crores

YEARS EVA CAPITAL EVA AS % OF RETURN ON

EMPLOYED CAPITAL INVESTMENT
EMPLOYED (ROI)

2002 1236 3396 36.4% 50.53%

2003 1429 3780 37.8% 47.72%

2004 887 3704 23.9% 32.37%

2005 1014 2560 39.6% 52.93%

2006 1125 2677 42.0% 57.51%

RETURN ON INVESTMENT (ROI) FOR HUL

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ECONOMIC VALUE ADDED (Rs. Crore) OF HUL

The above table shows that divergence exists between the performance results given by traditional
measure (based on ROI) and percentage of EVA on Capital Employed. The Return on Investment
(ROI) does not reflect the real value addition to shareholders’ wealth and it is not possible to judge
the efficiency of any decision, value creation or value addition aspect is of utmost importance in the
present backdrop of corporate governance but EVA based performance measurement system give an
idea clearly about the shareholders value addition or value destruction. The company has been
successfully able to create value for its shareholders during the study period.

This clearly shows that HUL is creating value for its shareholders based on EVA calculated over a
period of 5 years. Thus Economic value Added (EVA) is increasingly being applied to understand
and evaluate financial performance of an organization.

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ADVANTAGES AND DISADVANTAGES OF EVA

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a motivational,
compensation-based management system that facilitates economic activity and accountability at all
levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed their competitors
when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

• EVA eliminates economic distortions of GAAP to focus decisions on real economic results
• EVA provides for better assessment of decisions that affect balance sheet and income
statement or tradeoffs between each through the use of the capital charge against NOPAT
• EVA decouples bonus plans from budgetary targets
• EVA covers all aspects of the business cycle
• EVA aligns and speeds decision making, and enhances communication and teamwork

Academic researchers have argued for the following additional benefits:

• Goal congruence of managerial and shareholder goals achieved by tying compensation of

managers and other employees to EVA measures
• Better goal congruence than ROI
• Annual performance measured tied to executive compensation
• Provision of correct incentives for capital allocations
• Long-term performance that is not compromised in favor of short-term results
• Provision of significant information value beyond traditional accounting measures of EPS,
ROA and ROE

Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available sample
evidence on the evidence of EVA adoption on firm performance is an in-house study conducted by
Stern Stewart and except that there are only a number of single-firm or industry field studies.

• EVA does not control for size differences across plants or divisions
• EVA is based on financial accounting methods that can be manipulated by managers
• EVA may focus on immediate results which diminishes innovation
• EVA provides information that is obvious but offers no solutions in much the same way as
historical financial statement do.
• Given the emphasis of EVA on improving business-unit performance, it does not encourage
collaborative relationship between business unit managers
• EVA although a better measure than EPS, PAT and RONW is still not a perfect measure

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CONCLUSION

EVA is both a measure of value and also a measure of performance. The value of a business depends
on investor’s expectations about the future profits of the enterprise. Stock prices track EVA far more
closely than they track earnings per share or return on equity. A sustained increase in EVA will bring
an increase in the market value of the company.

As a performance measure, Economic Value Added forces the organization to make the creation of
shareholder value the number one priority. Under the EVA approach stiff charges are incurred for the
use of capital. EVA focused companies concentrate on improving the net cash return on invested
capital.

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