How to Apply EVA to IT

Jim Pecquex doesn’t flinch when he says that his IT organization is truly adding value to the business and is not just a service unit. That attitude isn’t just the product of a practiced poker face. Pecquex (pronounced peck-cue), CIO of The Manitowoc Co., 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 Manitowoc, Wis.-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 8 percent and 16 percent 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 $164 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), one in three finance managers uses EVA to help make technology investment decisions. And 15 percent use EVA as their primary finance metric for evaluating IT projects. Shareholders benefit because when executives employ EVA they have a realistic focus on maximizing 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 organizations 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 organization. “There was a concern in the organization 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.

EVA as a Metric

As metrics go, EVA is simple enough. The calculation is roughly as follows:

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

Since there is no pure NOPAT from an IT investment, the calculation has to take a modified form for IT proposals. For instance, a cost-benefit analysis reveals that a $50,000 software and hardware investment will return $8,000 in net benefits after costs are deducted. The ROI is thus 16 percent. If the cost of capital to the company is 12 percent, EVA in this case would be $2,000. That figure is derived from the following calculation: EVA = $8,000 – ($50,000 x 12 percent) = $2,000.

A simpler way to calculate EVA in that example is to deduct the 12 percent cost of capital from 16 percent (the ROI percentage), then multiply by the total investment: 4 percent x $50,000 = $2,000.

For Boise Cascade, EVA calculations are a simple, flexible and powerful decision-making tool for investment assessment. Robert Egan, vice president of IT at the Boise, Idaho-based paper company, used an EVA assessment to compare the cost of keeping existing storage assets with the cost of replacing them with new storage devices that would have lower maintenance charges. (The following example is illustrative. The actual costs and investments have been changed.)

New storage costs $1 million, with maintenance charges of $100,000 per year. The annual maintenance expenses on the old network storage were $350,000. For purposes of this example, we’ll assume the new storage equipment offers no appreciable benefits or quantifiable innovations other than lower maintenance costs. “You wouldn’t want to spend the million dollars just because the maintenance is lower,” Egan says. “You would say, We’re spending a million dollars, and yes the maintenance is lower, and by the way, we have a capital charge against the million dollars. So the maintenance has to be so much lower that it covers the capital charge.”

Boise’s cost of capital is calculated at approximately 16 percent. To get at the real cost savings of the new storage, run an EVA calculation: $1 million x 16 percent = $160,000. This cost must be added to the $100,000 maintenance fees if Boise invests in the new storage, so the total comparative cost is $350,000, versus $260,000. “If you didn’t pay attention to the cost of capital, you’re saying the million dollars is free,” Egan says. “In this case, have you lowered the operating cost enough to make up for spending the capital?” The answer is yes, to the tune of $90,000 per year in cost savings.

Another way to directly calculate the EVA in this case is to subtract the benefits (the maintenance savings the company would gain with the new storage) from the new investment and cost of capital: $250,000 – ($1 million x 16 percent) = $90,000.

Might Boise have still forged ahead had the resulting cost savings been negative? Arguably no?the company could have gotten by with its existing storage infrastructure until the new storage investment proved EVA-positive.

In practice, however, there may be times when EVA is initially negative yet there are compelling reasons to make the capital investment anyway. That is precisely the case with Manitowoc’s recent investment in a PeopleSoft HR system. Pecquex says the company has doubled in size during the past two years by acquiring several foreign companies. He ran the assessment numbers and determined EVA would be in the red early on. Manitowoc went ahead with its investment anyway since EVA moved positive substantially?approximately 150 percent?several years out as the up-front costs were eliminated and the asset base depreciated.

Consultancy Stern Stewart says an early negative EVA doesn’t mean the project should be automatically dropped. A low initial result is fine as long as the trend is moving positive. This precept actually reinforces a fundamental principle of EVA. Its importance is not reflected in a single calculation at a specific time. Rather, the goal should always be increasing EVA from month to month or fiscal year to fiscal year.

EVA as a Management Philosophy

EVA is more than just a metric?it’s a way of managing a business. CIOs might roll their eyes when they hear phrases like “cultural shift” and “corporate philosophy,” but EVA can have powerful effects on IT management. It keeps everyone focused on wringing the most benefit out of the capital asset base. “It’s got to be part of the blood of every member of my organization,” Pecquex says. “We’re building these words into practices.”

This is no mere academic exercise. Measuring EVA is critical to reaching shareholder value goals. Effective EVA implementations also require a formal compensation plan that puts bonus money at risk. Boise, Manitowoc and manufacturer Grupo Vitro have all structured compensation plans in which bonuses are tied to yearly EVA performance. Depending on the actual EVA target and company performance, employees can end up with significantly larger bonuses, or no bonus at all if EVA falls below target.

Stern Stewart argues that fundamental EVA-driven performance improvements occur only when employees behave as if the company money they spend is their own. And they do when a cost-of-capital charge is taken against project returns and managers are responsible for meeting targets beyond that hurdle.

Since this shift in mind-set suddenly has employees thinking like owners, a higher level of discipline informs all IT decision making. “An employee will see this inventory and wonder, What are the carrying costs of all those logs?” Egan says. “They didn’t used to consider it that way. They probably would have looked at those logs in the past and said, This is good. We have a lot of logs. Now they say, How much capital is tied up in that and how’s it [affecting] my EVA payout next year?”

Spend, Then Measure

Looking at expenditures through the EVA lens, post-investment measurement also becomes a necessity. An EVA company will know if it’s generating residual income for shareholders only if it can track returns on any investment above the cost-of-capital hurdle. The requirement to rigorously measure benefits after making the investment provides the opportunity to tweak systems or offer user training if returns are not following plan. That was the case at Boise, and following a recent, large-scale software deployment, Boise’s Egan assembled nearly 70 colleagues from IT and operations to determine how to get workers to use all the functionality of software configured for paper production.

Post-investment measurement may seem like a radical shift, since many pre-investment IT assessments get lost after the CFO signs off on the expenditure. Failure to validate the pre-investment ROI profile with post-investment performance data can turn some IT managers into used car salesmen. “A lot of IT organizations will exaggerate the figures of the benefits from an IT project in order to get the financial resources to do the project,” says Gustavo Benitez, the IT manager with the glass container division at Grupo Vitro, a $2 billion glass products manufacturer based in Monterrey, Mexico. Grupo Vitro has used EVA calculations for investment assessment for nearly five years.

These days, Benitez is deep into post-implementation tracking of a major i2 Technologies supply chain investment. The EVA business case showed concrete benefits above its 11.4 percent cost of capital, so Benitez is tracking metrics such as better working capital management, inventory efficiencies and missed shipment reductions. “We are not at a point where we can see all the benefits,” says Benitez, “but sales forecast accuracy has improved.”

In the end, EVA provides a realistic assessment of the value of any IT investment or project. This clear-eyed view, and the fact that it speaks the language of the CFO, can be a significant benefit to CIOs struggling with the task of demonstrating the value of their IT investments.