EVA & Strategy. Stern Stewart, April ABC, Balanced Scorecard & EVA Stern Stewart, April TakeAway Points

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1 EVA & Strategy Stern Stewart, April 2000 ABC, Balanced Scorecard & EVA Stern Stewart, April 1999 TakeAway Points

2 In business circles,the term strategic seems to be a synonym for negative present value

3 New management techniques are based on economic theory rather than being tied to accounting frameworks Traditional financial measures confuse accounting anomalies with the underlying economics of of business An accountant measures profit earned, while an economist looks at what could have been earned ABC, BSC & EVA, Stern Stewart, April 1999

4 MVA Components Invested capital Level Velocity Current operations value (COV) Discounted stream of returns (EVA) Especially for mature businesses Future growth value (FGV) Internal / external In the money or out of Real Options

5 Capital Flexible vs. rigid (e.g. plants & equipment) Tangible vs. intangible (brands, intellectual capital, organizational software, etc) Equity vs. debt (which is self-disciplining) Low cost vs. matched to needs

6 EVA Objectives Decentralize ownership & accountability Develop strong business literacy Get all employees speaking the same language Confer economic discipline at all levels Act like owners Institutionalize a high performance culture

7 EVA Measuring profits after subtracting the expected return to shareholders (capital charge) Creating sustainable improvement in EVA is synonymous with increasing shareholder wealth Switch from managing earnings to managing value A management system, not just a metric ABC, BSC & EVA, Stern Stewart, April 1999

8 EVA: Integrated performance measurement, management, and reward system Planning Portfolio management Decision-making: strategic, tactical Total compensation

9 Increasing EVA Improve returns on existing capital Prices, margins, costs, volume Grow profitability Increased sales, new products, new markets Harvest underachieving parts Curtail investment, rationalize, divest, liquidate Optimize cost of capital

10 Value Creation Profiles High Prospects Superstars FGV % of MVA Benchwarmers Steady Veterans Low Negative Positive EVA /Capital

11 Traditional Performance Metrics

12 Traditional Performance Metrics Too blunt (vs. sharp focus) Numerous & complex not aligned or integrated Not systematically tied to value creation Often, represent negotiated settlements prone to understate and underperform potential Not easily internalized by employees Key: balance accuracy & simplicity get employees to think and act like owners

13 Dysfunctional Behaviors Influenced by traditional accounting-based performance measures Rampant short-termism EPS focus End of month, quarter, year Underpricing of capital Overinvestment (especially mature businesses) Misallocations (feed dogs, starve stars) Underachievement (below WACC) Excessive vertical integration Versus outsourcing, partnerships, alliances Cooked books Acquisition accounting, accruals, transaction timing

14 Stock Option Downsides Ownership is beyond most employees sightlines Often fail to provide clear and direct linkage between actions and results Shared risk / return desired in bull markets, discouraging in bear markets

15 Other Performance Management Methodologies

16 Activity Based Costing (ABC) As product and customer mix become more diverse, the assignment of overheads becomes grossly misleading, distorting the cost of individual products and services. So, ABC is used to identify all activities, direct and indirect, and allocate the costs associated with these activities more precisely. May (most) ABC systems only capture P&L costs. Should also be capturing the cost of capital (e.g. more inventory associated with a product is an economic cost). ABC is most useful for operations with high indirect costs (overhead), complex transfer pricing issues, and shared processes or facilities. ABC, BSC & EVA, Stern Stewart, April 1999

17 Balanced Scorecard Translates vision and strategy into objectives Typically, 4 broad categories with 2 to 5 objectives each Financial & non-financial objectives Lagging (e.g. accounting P&L) and leading indictors (e.g. customer satisfaction) Deployment and Alignment* Deployment: consistent from top down (vertical) Alignment: consistent across functions (horizontal) Issue: lacks a single focus of accountability ABC, BSC & EVA, Stern Stewart, April 1999 * Lecture Notes, K.E. Homa, 2001