Accounting Article Review Economic Value Added (EVA) is a measure of the economic profit of a firm, which makes its estimates by comparing the net operating profit with capital’s total cost. EVA is based on the notion that an organization can only create value when its returns on economic capital exceeds that capital’s cost. EVA significantly indicates both the profitability of a firm’s projects as well as the performance of the managers. As practically shown by managers who introduced the concept, for example AT&T, Coca-Cola, Briggs & Stratton and Quaker Oats, a business may be termed as truly profitable only when it creates wealth for its shareholders.
The managers brought out the importance of using the cost of equity capital on top of that of borrowed capital in their calculation of the business’ profit by EVA concepts (Tully & Hadjian 38). As explained by Robert Allen, the CEO at AT&T, the company dealt in multiple products in its operations. Determining which products were profitable and which were not became difficult. To calculate the EVA of each division and product, Allen introduced job order costing.
Because of the variety of products, the costs are also different. His first step was to split the operations and maintain distinct records for each. He was able to trace individual projects and their capital costs, ultimately knowing which ones were not profitable. The CEO at CSX, John Snow, embarked on activity-based costing to arrive at the firm’s EVA. In comparison to conventional costing, activity-based costing assigns overhead costs into direct costs. For example, Snow reduced the locomotives used to power trains from four to three, hence reducing the freight speed.
Earlier, the company used more fuel on four locomotives, arriving too early at the destination and having to wait for too long before offloading. With three locomotives, he reduced the activity and fuel costs, but still arrived in time for offloading. The extra capital that had previously gone to waste was used to increase freight volumes, while at the same time reducing the number of trains (Tully & Hadjian 38). The two examples facilitated profit planning for the CEOs. They were able to develop plans that would use their operational budgets to generate maximum profits.
Managers are in a position to determine their companies’ EVA through profit planning, which focuses on the efficient use of the resources available. Profit planning guides them in analyzing costs of labor, maintenance of facilities, raw materials plus the cost of marketing and sales efforts. It enabled the Coca-Cola CEO find out that the cost of maintenance of 52 production plants outweighed the profits. His EVA rose significantly after he closed down 12 of them and only used 40 to give higher product volumes.
In the same way, the CSX CEO reduced the number of trailers by 4,000 but still grew freight volumes and profitability. That disclosed that the maintenance was eating into profits. Calculating EVA, therefore, enables the managers to determine the true worth of their organizations, because they can actually see if they have earned above their capital costs, borrowed capital as well as equity capital (Tully & Hadjian 38). Works Cited Tully, Shawn & Hadjian, Ani. “The real key to creating wealth”. Fortune 128.6 (1993): 38. Print.