ROI Guide: Economic Value Added

Computerworld - Definition: Economic Value Added (EVA) -- a name trademarked by Stern Stewart & Co. - subtracts the capital charge (the capital investment times the cost of capital) from the net financial benefits of the investment.
What it means: Economic profit is wealth created above the capital cost of the investment. EVA prevents managers from thinking that the cost of capital is free.
Strengths: EVA focuses managers on the question, "For any given investment, will the company generate returns above the cost of capital?" Companies that embrace EVA have bonus compensation schemes that reward or punish managers for adding value to or subtracting value from the company.
Weaknesses: As with any metric, it's hard to link precise EVA returns to a specific technology investment. EVA is ideally suited to publicly traded companies, not private companies, because it deals with the cost of equity for shareholders, as opposed to debt capital.
If a company invests in manufacturing equipment or a warehouse, how much additional profit will be required to pay for it? Managers are intuitively aware of the importance of value creation to their businesses. EVA is a management philosophy and performance metric that elevates those goals from intuition to rigorous analysis and ensures that no investment escapes scrutiny.
Yes, that includes IT. The fundamental proposition of EVA is that capital isn't free and its cost must be factored into every benefit analysis or return-on-investment model when an investment in a plant, equipment or a new customer relationship management system is contemplated. Putting a finer point on this concept, EVA targets equity capital as opposed to debt capital. Managers often treat equity capital as free when it's not -- shareholders could have invested elsewhere.
Since IT represents a big percentage of a company's annual capital budget, whether a company factors in the cost of capital when deciding on some technology investment is hardly academic. The pure EVA calculation for the company as a whole is:
Net operating profit after taxes - capital charge (capital investment x cost of capital)
But, purely speaking, there is no net operating profit after taxes (NOPAT) arising out of an IT investment, so the net financial benefits of the IT investment are used as a replacement for NOPAT.
Consider, for instance, a case where the cost-benefit analysis reveals that a $50,000 IT investment will return $8,000 in net quantifiable benefits. The ROI is 16% ($8,000 divided by $50,000). The cost of capital in the company is 12%. Using the formula above, the EVA in this case is $2,000:
$8,000 net benefits - ($50,000 capital investment x 12% cost of capital) = $2,000 EVA
Another way to calculate EVA in this example is to simply deduct the 12% cost of capital from the 16% ROI, then multiply by the investment:
4% x $50,000 = $2,000 EVA
EVA is always expressed as a dollar amount.
"EVA doesn't make it easy to quantify IT benefits but creates clarity so that all the pluses and minuses of these IT decisions can be considered in ways that companies [that don't use EVA] find difficult to do," says Bennett Stewart, co-founder of Stern Stewart & Co., a New York-based consultancy that coined the term Economic Value Added, but not the concept.
Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise Cascade Corp., and his colleagues conducted for a storage investment. The decision was whether to keep storage assets or replace them with new technology that has lower maintenance charges. (The example is illustrative. Egan declined to provide real cost figures.)
The new storage technology costs $1 million, with maintenance costs of $100,000 per year. The maintenance expense on the old storage technology is $350,000. (For simplicity, we'll assume that the new storage equipment offers no benefits other than the lower maintenance costs.)
Boise's cost of capital is about 16%. Therefore, the capital charge for investing in the new storage is 16% x $1 million, or $160,000, which EVA says must be added to the $100,000 maintenance costs to get the true cost.
The result: The total cost of the new storage is $260,000, vs. $350,000 for the old storage. "In this case, have you lowered the operating cost enough to make up for spending the capital?" asks Egan. Yes -- $90,000 worth.
Boise is constantly reminded of the obvious point that technology isn't free. The company is also aware of the less obvious fact: neither is the capital to finance it.
Berry is an IT management consultant and analyst in Bend, Ore. Contact him at vision@according2jb.com.

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