Looking at IT investments through the lens of an EVA analysis can help quantify and demonstrate their value in language your CFO will understand
ECONOMIC VALUE ADDED (EVA) = NET OPERATING PROFIT AFTER TAXES (NOPAT) - (CAPITAL X COST OF CAPITAL)
- How Economic Value Added forces a realistic look at the value of IT investments
- How measuring investments through EVA gets the CFO on your side
- How to consider variable EVA results over the life cycle of the application
Jim Pecquex doesn't flinch when he says that his IT organisation is truly adding value to the business and is not just a service unit. That attitude isn't just the product of a practised poker face. Pecquex (pronounced peck-cue), CIO of The Manitowoc Company, is certain his team contributes demonstrable returns. What has him convinced? All capital IT investments are measured through an Economic Value Added (EVA) analysis.
Manitowoc's decision in 1992 to make EVA the core of its management practices across the Wisconsin-based manufacturer's food service, crane manufacturing and marine operations acknowledges a simple distinction that economist Alfred Marshall made more than 100 years ago: standard accounting methods treat capital as if it were available for free. In contrast, an economic profit analysis calculates a business unit's after-tax cash flow, minus the cost of capital used to generate that cash flow.
EVA, developed by New York City-based consultancy Stern Stewart, is a riff off this distinction. EVA equals the net operating profit minus any applicable capital charges. Net profit after taxes, as defined in accounting terms, considers equity capital as if it were available without cost, since net profit doesn't account for a charge for equity capital. Yet it isn't actually free - prevailing interest rates mean it typically costs anywhere between 7 per cent and 16 per cent to borrow funds for capital spending, depending on the company's business risk and bond rating. EVA accounts for that charge.
Stern Stewart maintains that continuously increasing EVA will ultimately generate higher shareholder value. It's working for Manitowoc. From 1995 to 2001, the company generated $US164 million in economic value for shareholders, which has followed its steadily increasing stock price. CIOs who subscribe to these arguments and drink the EVA Kool-Aid along with other executives will experience a whole new level of technology investment assessment. Every investment is subject to an internal capital charge up front. That lowers the expected returns and injects some sobriety into investment discussions and decisions, which business unit leaders will appreciate when considering technology acquisitions.
Since EVA calculates a company's true economic profit, it keeps the CFO happy. According to a recent survey conducted by CFO Research (the research arm of CFO magazine US), one in three finance managers uses EVA to help make technology investment decisions. And 15 per cent use EVA as their primary finance metric for evaluating IT projects. Shareholders benefit because when executives employ EVA they have a realistic focus on maximising true shareholder value. EVA is therefore well-suited for attaching a demonstrable financial value to any project or IT investment.
However, it can still be hard for CIOs to implement because of the age-old difficulty of quantifying returns from IT investments. The challenge for all EVA-driven IT shops is pinning down those hard-to-measure benefits so that they are intellectually honest. Many enterprise software projects introduce casual ambiguities that frustrate EVA-focused CIOs to no end.
Still, the relentless attachment of financial return to any technology or business initiative keeps all those involved working toward the same goal. "EVA-centric organisations have a stubborn focus on EVA," says G Bennett Stewart, cofounder of Stern Stewart. "This [encourages] people who are cross-functional to communicate and bring those perspectives together. It makes people accountable for the capital invested and the risks in doing so. This is why you tend to get better decisions of all kinds up front coming out of this process, including IT."
When Pecquex was interviewing for the CIO position at Manitowoc, before he began his tenure in January 2001, he brought the wisdom of experience from other companies where IT management was not as tightly focused. His background is originally as a CPA, not IT. He knew about EVA and its potential when applied to running an IT organisation. "There was a concern in the organisation about how spending in IS might get out of control," he says. "To put the business fears to rest, I said: 'Don't worry about that because, quite frankly, I'll request an EVA analysis for every IS investment.'" Naturally, he got the job.
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