Article review for managerial accounting - Essay Example

Article Review for Managerial Accounting Economic Value Added (EVA) is a financial concept used to measure the actual profitability of a business operation (Tully and Hadjian 38). Investors and business managers can use EVA to learn stocks that are most likely to rise as well as determine if their business interests are going up in value. The accuracy and success of EVA is in the fact that the concept considers an operation’s total capital cost, a factor that is not included in other conventional measures.

The capital consists of the money tied up in computers, real estate or heavy equipment that is supposed to be productive for a given period after purchase, plus working capital that is mainly in the form of cash, receivables and inventories. Therefore, EVA can also be described as after tax profit less annual total cost of capital. Corporate groups and divisions that do not use EVA may not get the true picture of how much capital is tied up or the cost implications the capital bears. Although borrowed capital’s cost is reflected in the interest expenses of a company, equity capital’s cost is not shown in any of the financial statements.

EVA gives managers a way of determining if they have all their costs covered, and hence, adding value to the company. The key concept behind EVA is to earn more than capital costs, and it works well in both the industrial and service companies. However, some industries such as land or natural resources companies where assets do not depreciate but rather appreciate need special adaptations to workings of EVA. Some of the leading companies that successfully used EVA to turn around their income generation and cut down on capital costs include Coca-Cola, CSX, Quake Oats, Briggs & Stratton and AT&T.

According to the Coca-Cola CEO Roberto Goizueta, the company raises capital they use to manufacture concentrate, which is then sold at an operating profit for the shareholders (Tully and Hadjian 38). He first established that the most profitable division was the soft drinks business, and concentrated capital there. He then strategized on how to do more with the capital available or less. He shut down 12 plants in 10 years and reduced staff, and ended up producing more concentrate with 40 plants than the initial 52.

The company’s EVA grew by 27 percent annually for five years, and stocks rose from $3 to $43 in his tenure. The concept was supported by CSX CEO, John Snow. CSX ran a giant fleet of railcars, containers and locomotives. After considering all capital costs, Snow established that CSX operated at a $70 million loss in 1988. To grow the EVA, Snow reduced the usage of locomotives from 150 to 100, also reducing the number of days the locomotives stood idle in terminals from 14 days to five days. He also reduced the number of locomotives powering trains from four to three, cutting the fuel expenditure by 25 percent.

Effectively, this reduced speed of freight plus the waiting time at terminals before offloading, which initially translated into losses in terms of operating capital. He was able to increase freight volumes by 25 percent while reducing the number of trailers and containers to 14,000 from 18,000. According to Robert Allen, AT&T CEO, in support of EVA, his firm only lumped capital expenditure of the firm at group level, therefore, it was not known how much capital was consumed by individual services (Tully and Hadjian 38).

This made it difficult to tell which group was adding value to the company by earning in excess of its capital. His strategy was to direct the managers to group their operations into profit centers, which operated similar to independent companies. He was able to establish that other divisions had all along been operating at a loss, and put them on a strict timetable to turn up their profitability. The analysis of the article shows that EVA’s power is vested in the insight that managers cannot know if certain operations actually create value unless they apply the actual cost of the capital used.

The mistake most managers make is considering only borrowed capital costs, ignoring the cost of equity capital. Because they are not required to pay equity capital, they assume it is free, but is actually costlier than might be perceived (Tully and Hadjian 38). The true cost of equity represents what shareholders could be earning in terms of dividends and price appreciation, even if they invested elsewhere in a similar risk business. Economists view it as opportunity cost. Works Cited Tully, Shawn, and Ani Hadjian.

“The Real Key to Creating Wealth.” Fortune 128.6 (1993): 38. Print.