Adding economic value

When you study economics, you are taught that the price of a good or commodity is determined where there is a balance between the supply and demand for that good. If more people demand it, then the price is higher and when less is supplied then the price is also higher. The challenge in an open market is that if you limit supply, the next guy will supply more and you would have lost out. This is the power of competition. While that explains why monopolies limit supply to increase prices – it does not give a clear guideline on how to create value.

 

Value added in economic terms is the difference between the price of the finished product/service and the cost of the inputs involved in making it. So measurement of value added shows the enhancement a company gives its product or service before offering the product to customers. Value added is used to describe instances where a firm takes a product that may be considered a homogeneous product, with few differences (if any) from that of a competitor, and provides potential customers with a feature or add-on that gives it a greater sense of value. This increases the demand for the product and so increases the price that can be asked for it.

 

A value-add can either increase the product’s price or value. In marketing one gets taught that customers are weighing different features and benefits of options to find the correct price. For example, offering one year of free support would be a value-added feature and would be compared by the customer to other products without such a feature. Additionally, individuals can bring value add to services that they perform, such as bringing advanced skills to a position in which the company may not have foreseen the need for such skills. The combination of what makes your organisation different defines the value that is added to the end consumer. Bad choices in terms of adding value may cost more than it generates.

 

This is where management comes in. Managers also add value. Their primary stakeholder for adding value is the shareholder. The basic cost of doing business is defined as capital expenditure and through the management process, economic value is added to shareholders. This basic insight led to the formation of the theory of economic value added and provides a measure of a company’s financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). This is also referred to as the “economic profit” and is a measure of how well management created operating profit. The formula for calculating EVA is:

 

EVA = Net Operating Profit After Taxes (NOPAT) – (Capital * Cost of Capital)

 

If the EVA is positive then the company created more value than expected by shareholders. If the EVA is negative – then the company performed lower than expected by the shareholders. Cost of capital is a measure of the return in excess of market that is expected by the shareholder.

 

Another similar measure is Shareholder Value Added, which follows the same type of idea and is expressed as

 

SVA = Net Operating Profit After Taxes (NOPAT) – Cost of Capital

 

This gives a value based performance measure of the worth of the company to shareholders as it measures the value that is added, considering the profit that is generated in excess of what is required to outperform the requirements of the issue of debt and equity considering the weighted average cost of capital. (This may sound daunting – but read more on the MBA Finance Module to find out more).

 

So it should be easy. As long as management creates value, shareholders should be happy. The separation of ownership from the control of capital by managers creates a conflict of interest. Managers who run the business need not necessarily be guided by the same principles as owners in terms of enhancing shareholders’ wealth – but act in their own best interest. This is called the agency problem. While more complex, some companies use the incremental increase of EVA as a management performance measure in order to maximize shareholders’ wealth. This includes some of the world’s largest corporations.

 

EVA makes people accountable not just for the results but also for resources utilized in achieving the results. For example, without an EVA-based incentive system, marketing people generally want more resources to sell more and earn larger sales-based compensation even when the marginal benefit to the organization is less than the marginal cost of increased sale. This would also apply to the marginal cost vs. benefit of an employee and many other measures within the business. An EVA based decision-making and incentive system would determine if there is an economic value that will be created by this decision. To motivate managers to act in shareholders’ interests, one option is to link their compensation to increases in EVA they produce. Managerial objectives based on increasing income or market share, increasing return on assets or equity or other traditional measures can provide incentives that are not consistent with maximizing the shareholders’ wealth. Maximizing EVA will in most cases produce incentives to maximize shareholders’ wealth.

 

Organisations are a complex variety of explicit and implicit contracts involving several stakeholders, including, employees, customers, suppliers, lenders, the community and shareholders. Each of these contracts or relationships is a decision that must add economic value. You may say that this is great – as our company provides services without a lot of capital. Both tangible and intangible capital represents a choice managers make daily and the cost of that capital determines if the business adds value to shareholders or not. So, through managing these complex contracts you add value to the brand and to the operations and this adds value to the shareholders.

 

Most companies estimate the marginal profitability of their product without regard to opportunity cost of equity capital. So often it happens that companies are willing to accept business at a margin that is profitable, without considering if we have other choices in terms of using the same operating capital.

 

To be practical – think of it this way. Every day you earn a salary. If you take this salary and divide it by 21 workdays you get a number of how much you earned today. If you take this number and multiply it by 10 it gives you a sense of how much value you should create daily. If you further take this daily value add number and you multiple it by the number of people in your section or division – you need to ask yourself if your business unit created that much value today through the work that you have done. If you did not – then there is better ways in which the tasks or objectives of your section or division can be structured to add more value. The value may not be for today – but you must have worked on items that created that much value today for it to be profitable for shareholders to pay you to do it tomorrow. You may argue that you are an employee of a non-for profit – the same logic applies. You may also argue that you work for the government – the same logic applies.

 

In summary

 

Value added is a vital part of the operations of any organisation and has direct links to marketing, sales and the operations of any organisation. If more organisations focused on the value addition process it would direct the use of capital into increasingly relevant areas and build long-term choices that add maximal value to shareholders and build more sustainable organisations.

 

Economic value added (EVA) is an important measure to determine if there is value added to shareholders and can form the basis of incentive and decision making systems.

 

As an individual it is important to measure my own value added daily to find ways to ensure that the efficiency of an organisation improves.