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Economic value added (EVA) has been getting plenty of attention in recent years as a new form of performance measurement. In a recent Fortune article entitled "The Real Key to Creating Wealth," the author claims that using EVA can "give you a marked competitive advantage" over the competition (Tully, 1993). Furthermore, the author states that EVA is "today's hottest financial idea and getting hotter." An increasing number of companies are responding to this kind of hype by relying heavily upon EVA to evaluate and reward managers from all functional departments.
The purpose of this article is to educate managers on the uses and limitations of EVA. Specifically, the article answers four questions: (1) What is the definition of EVA? (2) Is EVA a new form of performance measurement? (3) What are the strengths and limitations of EVA? and (4) How should EVA be used to evaluate employee performance?' Armed with the answers to these questions, business managers will be able to converse knowledgeably with their colleagues from the finance department about the benefits and limitations of EVA as a performance measure.
What is the Definition of EVA?
EVA is a financial performance measure based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital).2 The three elements used in calculating EVA are operating income after tax, investment in assets, and the cost of capital (Hansen & Mowen, 1997). The formula to measure EVA is:
EVA = After tax operating income -(investment
in assets x weighted average cost of capital). EVA is a dollar amount. If the dollar amount is positive, the company has earned more after-tax operating income than the cost of the assets employed to generate that income. In other words, the company has created wealth. If the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth. A company's goal is to have positive and increasing EVA.
Is EVA a New Form of Performance Measurement?
Though EVA is relatively new to the financial press, its conceptual foundation is not. The term EVA was recently copyrighted by the consulting firm Stern Stewart & Company (Stewart III, 1994); however a very similar measure...