EVA as a Productivity Measure
Until a business returns a profit that is greater than its cost of capital, it does not create wealth, it destroys it.
Measuring total-factor productivity is one of the major challenges confronting the executive in the age of knowledge work. For manual work, measuring quantity is usually sufficient. In knowledge work, we have to manage both quantity and quality, and we do not know yet how to do that. We must try to assess total-factor productivity using the common denominator of revenues and expenses. By measuring the value added over all costs, including the cost of capital, EVA (economic value added analysis) measures, in effect, the productivity of all factors of production [or the true economic costs produced by all resources used].
Never mind that a business pays taxes as if it had earned a profit. It does not cover its full costs until reported profits exceed its cost of capital. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. And this is why EVA is growing in popularity. It does not, by itself, tell us why a certain service does not add value or what to do about it. It does show which products, services, operations, or activities have unusually high value. Then we should ask ourselves, “What can we learn from these successes?”
Information on Cost and Value
We cannot achieve results until we have information on cost and value.
Basic structural information is focused upon the value that is created for customers and the resources used to do so. The concepts and tools of accounting are now in the throes of its most fundamental change. The new accounting tools are not just different views of recording transactions but represent different concepts of what business is and what results are. So even the executive far removed from any work in accounting, such as a research manager in a development laboratory, needs to understand the basic theory and concepts represented by these changes in accounting. These new concepts and tools include: activity-based costing, priceled costing, economic-chain costing, economic value added, and bench-marking.
Activity-based costing reports all the costs of a product or service until the customer actually buys the product, and provides the foundation for integrating cost and value into one analysis.
The problem is not with technology. It is with mentality.
Traditionally, Western companies have started with costs, put a desired profit margin on top, and arrived at a price. This is cost-led pricing. In price-led costing, the price the customer is willing to pay determines allowable costs, beginning with design costs and ending with service costs. Marketing provides information on the price the customer is willing to pay for the value the product or service provides. A cross-functional team starts its analysis of costs by taking this price as a given. The team then subtracts the profit required to compensate the enterprise for capital investment and risk, and arrives at an allowable cost for a product or service. Then it proceeds to make the tradeoffs between the utility provided by a product and allowable cost. Under price-led costing, the entire economic framework focuses upon creating value for the customer and meeting cost targets while earning the necessary rate of return on investment.
Benchmarking for Competitiveness
Benchmarking assumes that being at least as good as the leader is a prerequisite to being competitive.
EVA (economic value added analysis) is a good start to assess the competitiveness of an enterprise in the global marketplace, but to it we must add benchmarking. Benchmarking is a tool that helps a firm tell whether or not it is globally competitive. Benchmarking assumes, correctly, that what one company does another company can always do as well. “Best performers” are often found in identical services or functions inside an organization, in competitor organizations, but also in organizations outside in the industry. Together, EVA and benchmarking provide the diagnostic tools needed to measure total-factor productivity and to manage it. They are examples of the new tools executives should understand to measure and manage what goes on inside the enterprise. Combined, they are the best measures we have so far available.