Behavioral aspects of EVA

A number of companies have discovered that EVA helps to encourage the right kind of behavior from their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s reliance on the true cost of capital. In many companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate expense. If a division builds inventories and investment, the cost of financing that investment is passed along to the overall income statement. It does not show up as a reduction from the division’s operating income; investment seems free to the divisions, and of course, they want more. As a result, EVA should be measured for subsets of the company. For example, Briggs and Stratton, manufacturer of engines, divided up the company into areas according to types of engine and critical function (e.g., manufacturing and distribution). It then calculates EVA for each  area. The result is to make the performance of different areas of the company clearer

Suppose that Supertech, Inc., has two divisions, the Hardware Division and the Software Division. Operating income statements for the divisions are as follows:

It looks as if the Hardware Division is doing a good job, and so is Software. Now, let’s consider each division’s use of capital. Suppose that Supertech’s weighted average cost of capital is 11 percent. Hardware, through a buildup of inventories of components and finished goods, use of warehouses, and so on, uses capital amounting to $10 million, so its dollar cost of capital is $1,100,000 (0.11 x $10,000,000). Software does not need large materials inventories, but it does invest heavily in research and development and training. Its capital usage is $2 million, and its dollar cost of capital is $220,000 (0.11x$2,000,000). The EVA for each division can be calculated as follows:

Now, it is clear that the Hardware Division is actually losing money by using too much capital. The Software Division, on the other hand, has created wealth for Supertech. By using EVA, the Hardware Division’s manager will no longer consider inventories and warehouses to be “free” goods. Instead, the manager will strive to reduce capital usage and increase EVA. A reduction of capital usage to $8 million, for example, wouldboost EVA to $120,000 [$1,000,000 - (0.11 x $8,000,000)].

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