Managerial Accounting – Evaluating & Motivating Performance through EVA

Companies evaluate their employees in numerous ways. Some of the most common ways I have seen include asking for peer and self feedback, surveying clients (if the role is client facing) and in some cases, these are a complete mystery. In this post, I am going to focus on two specific ways of evaluating and motivating performance

1. Economic Value Added (EVA)
2. Balanced Scorecard

I want to make it clear that while these might be great performance metrics if you are the protagonist but these don’t always work best for front line and low level employees. These work best for executives and mid level managers that have teams of their own or are in charge of significant resources.

1. Economic Value Added (EVA)

The primary benefit of this method of evaluating performance is that it focuses solely on the creation of value for the investors of the company. It already accounts for the company’s capital structure and changes therein, hence accurately measuring how much true economic value was created by the management of the company by operating in the way that they did. In essence, it is a number which makes it very objective. However, it does have a drawback. It works better for asset rich companies like Airlines/Real Estate holding companies etc. due to how it is calculated which I will show in just a moment. For companies with significant intangible assets like Technology companies, the model does not quite hold. An additional point whether you look at it as an advantage or otherwise is that under EVA, everyone is evaluated using a single metric and that metric is a form of Return on Investment. Simply put, certain considerations need to be take place before EVA is implemented as a evaluation technique.

Economic Value Added (EVA) = NOPAT – (Assets – Liabilities)*WACC

NOPAT = Net Operating Profit After Taxes

WACC = Weighted Average Cost of Capital

Assets – Liabilities = Owner’s Equity

The owner’s equity is the amount of equity that the stockholder’s have in the company. The WACC is the expected rate of return that these stockholders expect at a minimum from the company. When you think about what the above equation means then is that EVA is the amount of economic value over the minimum required return created by the management in a certain period. It is important to note that EVA can be negative or positive depending on if the Operating profit after taxes was higher or lower than the minimum expected rate of return from the investors.

A positive EVA then means that the management created more than expected returns for the investors of the company while a negative EVA means that value was destroyed. Hence you may award the former and put the latter event under further scrutiny.

If you want to read more about the WACC, click here to read about it on Investopedia.  I will update the link when I get to writing about the WACC.

Balanced Scorecard is also coming on a subsequent post.