A2X Consulting

One of the more interesting issues for companies to settle on as they develop metrics is, what is the ultimate measure of success? We know that it’s financial success – but how does that get measured? Profit is the traditional measure but it doesn’t represent true economic value. Economic value add (EVA) is an alternative to profit that does account for true economic value.

The right financial metric will allow you to track the company’s overall value. Profit is one indicator of overall financial success. The right metric for you ought to have long-term implications and the metrics need to align the interests of the owners, managers, and customers. EVA is one possible solution.

EVA is a measure of a company’s net operating profit after taxes minus the cost of capital. For many middle market companies, the cost of capital is most likely based on the retained earnings that the company reinvests. That cost of capital would be equivalent to what the company could earn by investing those retained earnings in an alternate investment of similar risk. This means that the company would be successful when their profit is greater than the interest that the company could earn from similar investments.

Another compelling reason to use EVA is that it capitalizes investment in brand development, training, and R&D (among others) rather than expensing it. We feel this presents a much more accurate view of the business. For example, if your company is to obtain product leadership, the firm needs to invest in the brand, training, and R&D. That investment will benefit the company over a number of years. Expensing those items will give a false measure in the early years.

Imagine that your company decides that profit is the financial metric that matters. The company is likely to show a decrease in profit in the first couple of years that it launches into a product leadership strategy. The company could invent several major products, obtain patents, build a brand, and yet the profit would indicate failure. EVA would provide a more balanced view of success.

That is the good news. Implementing EVA though is not trivial. It often requires new methods of accounting. More than anything it is a change in mindset that affects corporate culture. It affects the way managers are compensated. A decision to use EVA needs to be made in consideration of the cost of doing so.