What is the difference between Economic Value Added and Return on Investment?

Answer 1

ROI was developed by the DuPont Powder Company in the early 1900s to help manage the vertically integrated enterprise (Johnson & Kaplan, 1987). The intent of this measure is to evaluate the success of a company or division by comparing its operating income to its invested capital. A firm can improve ROI in two ways. First, the profit margin earned per sales dollar can be increased. Second, the sales revenue generated per dollar of invested capital can be increased (this is known as asset turnover). Exhibit 1 shows ROI in equation form and includes a brief numerical illustration of the ROI calculation.

The appeal of ROI is that it controls for size differences across plants or divisions. For example, assume the managers of divisions A and B earned $1,000,000 and $800,000 in operating income respectively. A naive interpretation of these differences in operating income would be that the manager of division A outperformed the manager of division B. This viewpoint is naive because the source of division A's higher income may be its greater size relative to division B. To control this problem, ROI is used to measure each division's income relative to the asset base deployed, thereby standardizing the computation into a ratio while deemphasizing the absolute amount.

The primary limitation of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole (Morse, et al., 1996). For example, Exhibit 2 (Panel A) contains a fact scenario involving The Ohio Company's printing division. Currently, this division, which has a weighted average cost of capital of 10%,(3) is focused on the magazine publishing market niche, which has a projected ROI of 15%. The printing division manager is contemplating two new investment opportunities - home repair books and garden catalogs - both of which could potentially be funded by The Ohio Company. A financial analysis shows that the home repair books investment opportunity would generate an ROI of 13.7%, while the garden catalogs alternative would generate an ROI of 18.8%.

Assuming the printing division manager is compensated based solely on ROI, she will be motivated to pursue only the garden catalog option because it would increase the projected ROI of 15% currently being earned in magazine publishing. She would not pursue the home repair books alternative because it would lower her projected ROI and adversely affect her performance evaluation and compensation. Conversely, the company would prefer that she pursue both alternatives because each exceeds the 10% cost of capital.(4) Should the printing division manager be blamed for not being a team player? Well, imagine the frustration of making investment choices in the best interests of the company and being "rewarded" with a pay cut because ROI declined from the prior year!

EVA helps overcome the goal incongruence that exists between the manager and the firm in this situation. Using EVA instead of ROI to reward the printing division manager would motivate her to accept any investment alternatives that generate a return greater than the company's 10% cost of capital. Exhibit 2 (Panel B) shows the EVA calculations for each of the printing division's investment opportunities. The home repair books investment option generates $192,000 of EVA, thereby creating wealth for the company and boosting the division's total EVA from $750,000 to $942,000. The garden catalogs option produces EVA of $350,000, thereby generating wealth for the company and further raising the division's total EVA to $1,292,000.

Exhibit 3 summarizes the primary difference between ROI and EVA. With ROI (see Panel A), any investment alternative that offers a return less than the cost of capital will not be supported by division managers or the company. In this situation, the ROI measure encourages division managers to exhibit decision making behavior that is congruent with the goals of the company. Similarly, any investment opportunity that offers a return greater than the anticipated ROI will be viewed favorably by division managers and the company. Again, ROI elicits goal-congruent behavior from the division manager. However, any investment alternative that offers a return equal to or greater than the cost of capital, but less than the division's anticipated ROI, will be viewed unfavorably by division managers, despite being viewed as desirable by the company as a whole. The problem with using ROI to reward employee performance in these situations is that managers are penalized, in terms of financial compensation, for making decisions that lower their ROI while increasing the firm's wealth. Accordingly, the manager's conduct may lead to underutilization of available capital that could have earned a return in excess of the company's cost of capital. From the firm's perspective this is viewed as dysfunctional decision making. From the manager's perspective, the over-reliance on ROI as a performance indicator gives her no choice.

With EVA (see Exhibit 3, Panel B), goal-congruent behavior is always elicited from division managers. Any investment opportunity with an EVA greater than zero (or a return greater than the cost of capital) will be viewed favorably by division managers and the company. Investment options with an EVA less than zero (or a return less than the cost of capital) will be viewed unfavorably by division managers and the company. Thus, the primary strength of EVA is that it provides a measure of wealth creation that aligns the goals of divisional or plant managers with the goals of the entire company.

* Limitations

Despite EVA's advantage over ROI, this measure has four limitations that are presented under the following headings: size differences, financial orientation, short-term orientation, and results-orientation.

[TABULAR DATA FOR EXHIBIT 3 OMITTED]

Size Differences. EVA does not control for size differences across plants or divisions (Hansen & Mowen, 1997; Horngren, et al., 1997). A larger plant or division will tend to have a higher EVA relative to its smaller counterparts. For example, refer to the data in Exhibit 2 and let us assume for a moment that magazine publishing, home repair books, and garden catalogs represent three separate divisions of The Ohio Company with actual (as opposed to projected) results as shown. Using only EVA to compare performance across the three divisions, Exhibit 2 (Panel B) indicates that magazine publishing has been the most successful by generating $750,000 in EVA. However, the garden catalog division could make a valid argument that it was more successful than the magazine publishing division because it more efficiently deployed its assets generating an ROI of 18.75%. The managers of this division could argue that if they were afforded a $15 million asset base they could have generated operating income of $2,812,500 ($15,000,000 x 18.75%). The sole reason garden catalogs' EVA is less than magazine publishings' is due to a size difference in the two divisions' investment bases. Notice, the "catch 22" here. While EVA is more effective than ROI at aligning plant managers' goals with corporate goals, it does not control for size differences across organizational units like ROI does.

Financial Orientation. EVA is a computed number that relies on financial accounting methods of revenue realization and expense recognition. If motivated to do so, managers can manipulate these numbers by altering their decision making processes (Horngren, et al., 1997). Three examples will help illustrate this point.

First, managers can manipulate the revenue recognized during an accounting period by choosing which customer orders to fill and which to delay. Highly profitable orders may be expedited at the end of the accounting period and shipped to the customers a few weeks before the agreed-upon delivery date, while less profitable orders may be delay and shipped after the end of the accounting period and after the agreed-upon delivery date. The end result of this scenario is a boost to current period EVA and an adverse blow to customer satisfaction and retention. Second, discretionary expenditures can be terminated to boost EVA. For example, an employee training program conducted by an outside consulting firm can be terminated towards the end of an accounting period. The savings in consulting fees resulting from the cancellation reduce the expenses recognized during the current period, thereby increasing EVA, but what about the commitment to workforce training? Third, managers may decide not to replace completely depreciated assets. Keeping the outdated equipment on the accountant's books lowers the asset base and ensures that no depreciation expense charges are recognized, thereby increasing EVA; however, product quality and customer satisfaction may suffer if outdated manufacturing equipment continues to be used.

Each of these examples reflects a choice on the part of managers for personal gain over corporate welfare. From the standpoint of the company, these choices are viewed as dysfunctional and perhaps even unethical. From the standpoint of managers, the over-reliance on EVA to evaluate their performance is viewed as dysfunctional. The temptation to manipulate the accounting numbers would be genuine for any manager who knows they dramatically improved their performance in ways that are not immediately reflected in the Accountants' ledgers. Nothing demotivates managers faster than being unjustly penalized by a financial measure, such as EVA, that fails to accurately depict their true level of effort and performance.

Short-Term Orientation. The intent of a performance measurement system should be to match employees' effort, ingenuity, and accomplishments with their compensation. If a manager conceives of an innovative idea, researches it, organizes it, presents it to superiors, and begins implementing it in the current accounting period, some measure of compensation should be afforded to the manager in the current period for the effort and ingenuity expended. However, that is not how financial measures, such as EVA, work when they are used to evaluate employee performance.

EVA overemphasizes the need to generate immediate results; therefore, it creates a disincentive for managers to invest in innovative product or process technologies. After all, every investment in innovation has the same economic profile. The costs or expenses associated with the project are recognized, at least in part, by the accountants immediately. The benefits or revenues associated with the initiatives are not recognized by the accountants until a few years down the road. The net effect for managers investing in innovation is a lower EVA in the current period accompanied by an unsatisfactory pay raise or perhaps even a bypassed promotion, demotion, or layoff. Granted, the possibility exists that innovative ideas may lead to greater pay raises in the future; however, all managers understand "time value of money" concepts and the notion of risk. Money in the pocket today is a certainty and is worth more than the prospect of money earned in the future, which is worth less and is more uncertain. In an influential Harvard Business Review article entitled "Managing Our Way to Economic Decline," the authors state: "Although innovation, the lifeblood of any vital enterprise, is best encouraged by an environment that does not unduly penalize failure, the predictable result of relying too heavily on short-term financial measures - a sort of managerial remote control - is an environment in which no one feels he or she can afford a failure or even a momentary dip in the bottom line" (Hayes & Abernathy, 1980). In an environment of financial control, the risks of innovation exceed the potential rewards. EVA is another form of managerial remote control that forces managers to put undue emphasis on the short-term bottom line.

Results Orientation. Over the years, accountants have earned a reputation as the co-workers who arrive on the scene after a period of disappointing performance to "bayonet the wounded" with their historical financial reports. The accountants' reports state the obvious - that performance was less than expected - but they do not help offer solutions to the nonaccounting business managers who are responsible for continuously improving the value delivered to customers. Like its predecessor financial metrics, EVA is guilty of this charge.

For example, engineers and operations managers are most interested in taking nonfinancial measures such as yield and throughput and focusing on the root cause drivers of these measures (McKinnon & Bruns, 1993; Johnson & Kaplan, 1987). Statistical process controls may be put in place to help ensure that machine calibrations stay "in control," thereby enhancing yields. Or, activity analyses may be performed in bottleneck operations to identify nonvalue activities that can be eliminated, thereby increasing throughput (Campbell, 1995). The focus is more on process-oriented (nonfinancial) measures than on financial measures. The only financial information potentially useful to engineers and operations managers is disaggregated activity-based cost information that may help in the following ways: (a) create an awareness of the cost associated with performing nonvalue added activities, (b) prioritize continuous improvement initiatives by quantifying the potential savings of competing alternatives, and (c) provide justification for cash outlays by quantifying the savings that may be realized from capital investments (Brinker, 1995). Aggregated, results-oriented financial numbers, such as EVA, that are accumulated at the end of an accounting period do not help point towards the root causes of operational inefficiencies; therefore, these measures offer limited useful information to people charged with the responsibility of managing business processes.