Learning Outcomes
After reviewing this article, you will be able to explain the rationale for value-based management metrics, particularly Economic Value Added (EVA) and capital charge. You will understand how EVA is computed and adjusted, how it supports shareholder value creation, and how the capital charge reflects the cost of capital. You will be ready to apply, evaluate, and interpret these metrics in ACCA APM scenarios.
ACCA Advanced Performance Management (APM) Syllabus
For ACCA Advanced Performance Management (APM), you are required to understand value-based management measures for both whole businesses and divisions. Revision should focus on:
- The concept and calculations of Economic Value Added (EVA)
- The role of the capital charge in evaluating performance
- The strengths and weaknesses of EVA versus traditional profit-based measures
- How value-based approaches improve goal alignment and reduce dysfunctional behaviour
- The application of adjustments to profit and capital for a true economic view
- Interpretation and evaluation of EVA results in business situations
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the main purpose of Economic Value Added (EVA) as a performance measure?
- Which costs are typically added back or adjusted in the EVA calculation?
- Why does EVA include a capital charge, and how is this figure determined?
- True or false? A division with positive EVA always creates value for the whole company.
- Briefly outline one advantage and one limitation of using EVA instead of ROI or RI for divisional appraisal.
Introduction
Businesses are increasingly judged on their ability to create lasting wealth for shareholders, not just on short-term profit measures. Classic financial ratios like ROI or ROCE can encourage short-termism and distorted decisions. Value-based management (VBM) metrics such as Economic Value Added (EVA) aim to overcome these weaknesses by focusing squarely on true value creation after charging for the capital used. This article explains EVA, its calculation, the role of capital charge, and issues to watch for in practice.
Key Term: value-based management
An approach where organisational strategies, objectives, and activities are directed to maximise long-term shareholder wealth by focusing on value drivers and economic profit, not just accounting profits.Key Term: Economic Value Added (EVA)
A measure of financial performance showing a business’s true economic profit, calculated as net operating profit after tax (NOPAT) less a charge for the cost of capital.Key Term: capital charge
The notional cost incurred by a business or division for using capital, calculated as the value of capital employed multiplied by the weighted average cost of capital (WACC).
Economic Value Added (EVA): The Rationale
Senior managers and investors are interested in whether a business creates wealth above the cost of the resources it uses. EVA addresses this by charging managers not only for operating costs, but also for tying up investors’ capital. A positive EVA indicates value creation; negative EVA shows value destruction.
Why use EVA?
- Aligns management focus with shareholder wealth rather than short-term accounting profit.
- Encourages decisions that genuinely increase enterprise value.
- Makes the cost of capital explicit—a critical cost often ignored in standard profit measures.
EVA and the Capital Charge
EVA’s core principle is that profit must be earned after charging for the capital invested. The capital charge ensures that management does not simply focus on maximising profit without regard for the resources tied up in the business.
Worked Example 1.1
Maira Corp's division earns a controllable operating profit (after tax) of $6 million for the year. The divisional capital employed at the start of the year is $40 million. The company's weighted average cost of capital is 10%. Calculate the EVA for the division.
Answer:
Capital charge = $40 million × 10% = $4 million.
EVA = $6 million – $4 million = $2 million.
Interpretation: The division has created $2 million of value after covering all operating and capital costs.
Calculating EVA: Adjustments and Steps
The basic EVA calculation is: EVA = NOPAT − (Capital Employed × WACC)
However, accounting profits can be distorted by non-cash items or accounting policies that do not reflect economic reality. Common adjustments include:
- Add back accounting depreciation; substitute with economic depreciation if possible.
- Capitalise and amortise R&D, marketing, or staff training costs where these provide future benefits.
- Exclude non-cash provisions and unrealised gains or losses.
- Use the replacement cost rather than net book value for capital employed where possible.
- Calculate taxes on a cash basis and adjust for the tax shield on interest.
These refinements ensure EVA measures economic profit, not distorted accounting profit.
Worked Example 1.2
NovaCo’s profit after tax is $5 million. This figure includes an accounting depreciation charge of $700,000, while economic depreciation for the year is assessed at $1 million. During the year, $1.2 million was spent on R&D, expensed in the accounts but expected to benefit the next three years. Capital employed (start of year) is $30 million, and WACC is 9%. Adjust profit as needed and compute EVA.
Answer:
Step 1: Adjust profit.
Add back accounting depreciation: +$0.7m
Deduct economic depreciation: −$1.0m
Add back R&D expensed: +$1.2m
Amortise R&D (over 3 years): −$0.4m (1/3 of $1.2m)
Adjusted NOPAT = $5m + $0.7m − $1.0m + $1.2m − $0.4m = $5.5m
Step 2: Calculate capital charge: $30m × 9% = $2.7m
EVA = $5.5m − $2.7m = $2.8m
Conclusion: Economic profit of $2.8 million after charging for capital.
Adjusting Capital Employed
For a more precise EVA, use the replacement cost of fixed assets rather than their book value. Add back any provisions if these represent over-prudence.
Exam Warning ACCA exam scenarios may expect you to identify and justify adjustments to profit and capital employed when calculating EVA. Do not just accept the financial accounts; always consider whether the components reflect economic reality.
Interpretation and Behavioural Impacts
A positive EVA means value has been added for shareholders. If a division or project has negative EVA, it fails to cover its full costs—including the return expected by capital providers.
EVA helps reduce dysfunctional behaviour compared to ROI or profit-based measures. Managers cannot inflate their performance by underinvesting in new assets or prolonging the life of old ones—the capital charge penalises idle or inefficient capital.
However, EVA can be complex due to numerous adjustments. Managers may not always understand or accept the metric, so training and communication are important.
Worked Example 1.3
A division manager earns a bonus based only on operating profit. She decides against investing in a new asset, which would lower her short-term profit but would deliver a positive EVA for the business. What is the risk of this approach?
Answer:
The focus on operating profit (not on EVA) has led to dysfunctional behaviour. By avoiding a profitable investment (on an EVA basis), the manager misses an opportunity to increase long-term shareholder value for the benefit of her own bonus.
Strengths and Weaknesses of EVA
Strengths
- Focuses on economic profit, not just accounting earnings.
- Explicitly charges for all capital used, discouraging waste.
- Aligns management decisions with shareholders’ interests.
- Recognises the value of intangible assets and long-term investments.
Limitations
- Requires numerous adjustments to profit and capital figures, which can be time-consuming.
- Accurate economic depreciation can be difficult to estimate.
- Complex for managers unfamiliar with finance or the required adjustments.
- EVA is an absolute measure—may not allow straightforward comparisons between divisions of different sizes.
Revision Tip
Focus your revision on being able to explain each major adjustment to accounting profit for EVA, and the reason for charging a capital cost even in divisions within the business.
Summary
EVA is a value-based metric that reflects the economic profit a business generates after covering all costs, including the provider’s expected return on capital. It requires adjustments to profit and capital employed to strip out non-economic or non-cash entries. The inclusion of a capital charge promotes goal congruence and discourages short-term optimisation at the expense of long-term value.
Key Point Checklist
This article has covered the following key knowledge points:
- Describe the rationale for value-based management and Economic Value Added (EVA)
- Explain how EVA is calculated and why adjustments to profit and capital are needed
- Define and apply the capital charge and explain its effect
- Evaluate the behavioural advantages of EVA over standard profit-based metrics
- Recognise the strengths and weaknesses of EVA as a performance measure
- Apply and interpret EVA in ACCA APM case scenarios
Key Terms and Concepts
- value-based management
- Economic Value Added (EVA)
- capital charge