The Factors before Implementing Economic Value Added - Essay Example

The Factors before Implementing Economic Value Added Table of Contents The Factors before Implementing Economic Value Added 1 Introduction 2 Factors that must be considered 2 Conclusion 4 References 6 Introduction Economic Value Added which is better known as EVA is one of the most important concepts of in the field of financial management. The core concept of EVA is deep rooted in theory of classical economy. According to James Lawrence Grant, the idea of EVA is based on two important assertions – (1) a company cannot be described as a truly profitable company unless the return on capital investment is grater than the ‘opportunity cost of capital’ and (2) the creation of wealth takes place when managers of the firm make optimistic NPV investment related decisions for the company’s shareholders (Grant, 2003). Like the concept itself, the implementation process of EVA is also very important for any organization. This paper is prepared with the objective of providing a clear picture regarding the factors that are required to be considered before implementing EVA. Factors that must be considered One of the most crucial factors that are likely to have significant influence over the implementation process of EVA is the support and commitment from top management of the organization. Since the concept of EVA involves change in attitude and behavior, it is very important to have acceptance from the top level. Researches show that EVA and all other aspects that are associated with it will be completely accepted by the employees when they will identify that the top management of the firm has already accepted it. Often it is found that the senior executives are actually half-heartedly committed to the concepts like EVA as their understanding regarding value creation is vague. As a consequence entire implementation process gets affected and this in turn affects the company’s performance in the long run. However, according to Stephen F. O'Byrne and S. David Young, making the senior management as well as the board understand regarding the value based management and EVA is just a start of the entire implementation process (Young & O'Byrne, 2001). They have also opined that the executives and consultants have to take additional responsibilities and convince the top management and board of the company regarding the importance of value creation and the role of EVA (Young & O'Byrne, 2001). Once, this starting phase is completed, key strategic decisions regarding program design have to be taken. It is very important to consider the factors like EVA centers. It is crucial to define the EVA centers for a particular organization. In other words, organizations need to identify how far down the organizational hierarchy the EVA concept will be implemented. In order to define the EVA centers, existing profit centers can be taken into consideration. In addition to this there are two other important factors that have to be taken care in the process of implementing EVA in an organization. These two are overhead allocation policies and transfer pricing. Both of these are important because they have the potential to influence one of the most crucial advantages of EVA i.e. its capability of make all managers irrespective of their level to think like owners rather than employees. Another crucial factor that has to be taken under consideration is the training of those employees whose incentives are likely to be connected to EVA. Organization must ensure that the employees have a clear understanding regarding the process through which their individual EVAs will be measured as well as the process through which the EVAs will be associated to compensation (Epstein & Young, 1999). Organizations must have proper strategies to link up the compensation to the EVA and in this process it is very crucial to have a proper incentive policy in place. Another important factor that has to be considered during the course of implementation of EVA is the appreciation and understanding of the role of EVA by various departments like human resource, operations. A successful EVA implementation requires support from all the important departments of the organization. Valuable resources like time and money are also crucial factors that are required to be given enough significance in the entire process. Sufficient amount of various important resources is likely to help the managers in understanding the role of EVA in the process of value creation. In addition to all the above mentioned factors there is one more factor that is likely to have significant influence over the implementation process of EVA in an organization and this is the ‘problem of underinvestment’. According to Stephen F. O'Byrne and S. David Young, “one common fear of EVA is that it can lead managers to underinvestment, both physical assets and in assets of a less tangible nature, such R&D and brand equity” (Young & O'Byrne, 2001). This fear is actually the result of the capital charges that are imposed by EVA. It is also the result of the belief that managers are likely to attempt to boost their EVA and EVA linked bonuses. Conclusion In the present competitive business scenario each and every business organization is focusing more on value creation with the purpose of retaining their success in the long run. Such attempts have given the birth of concepts like EVA which is shortly defined as the profit that is obtained after the deduction of the cost of capital that is invested with the purpose of generating the profit (Gey, 2007). The core concept of EVA is mainly based on the theories of classical economy. The implementation process of EVA is one of the crucial activities as it is influenced by several factors which are already discussed earlier. One of the most important such factors is the involvement of top management and board of the organization. Apart from this, valuable resources and coordination and support from various departments are also considered as important factors. References Epstein, M. J. and Young, S. D. 1999, Greening with EVA, Management Accounting Grant, J. L. 2003, Foundations of economic value added, John Wiley and Sons Gey, R. 2007, The EVA Model as a Tool for Performance Measurement, GRIN Verlag Young, S. D. & O'Byrne, S. F. 2001, EVA and value based management: a practical guide to implementation, McGraw-Hill Professional Read More