The mere mention of the concept of economic value added can send some PQs into panic mode. Panic not – Geoff Cordwell is here to explain all.
There can be little doubt that one the most common topics that appears in the ACCA APM examination is economic value added (EVA). It is clearly a favourite topic of the examining team. And I am not surprised, because it is brilliant.
The holy grail of performance managers has always been to properly align the needs of the shareholders (for cash dividend and an increased market value of the business) with the performance management system (PMS) used to appraise the performance of the directors.
So often the PMS falls short here. For decades companies have chosen to assess performance using profit, ROCE or even RI and the question is, is this right?
The examiner wants you to be able to make the case for the suitability of the PMS, when compared to the needs of the shareholder.
Why? Because he wants you to be able to make the case even after you qualify. To improve the PMSs everywhere you go. To improve the reputation, even, of the accountant.
But here’s the rub. While there are some standard arguments outlined in many textbooks and course materials the examiner wants you to be able to apply yourself to a particular situation.
Is EVA a good approach for this business? What is wrong with a profit based appraisal here? And this is more difficult. This is why reading skills and writing skills are so important in APM. It is also why application skills are vital to a pass in this paper. It is also why both reading/writing skills and application skills are specific new modules in my digital courses. You have to be able to spot the clues in the questions by effective reading, be able to communicate your ideas, by concise and precise writing, and you must be able to apply yourself to the scenario.
So, let’s look at how the examiner has tested these ideas in a previous question. In Jenson, Lewis and Webb (JLW), from the March/June papers in 2017, the examiner planted clues for you to use to argue that EVA could be an appropriate performance measure for the businesses two profit centred divisions.
In JLW, one of the divisions had created a large provision for doubtful debts. There is nothing wrong with that of course, but provisions are so easily manipulated. So once created, the divisional manager can use it to reduce or increase reported profits as desired. In EVA, provisions are not allowed, partly because they are not a cash flow of course, but also because it removes the ability of the directors to manipulate results and mislead shareholders. A double benefit, therefore: EVA 2, profits 0! Also, in JLW the same division had spent $90,00 on advertising a new product.
Advertising new products is vital of course, but it’s pain today (the cost) for jam tomorrow (the revenue). A profit motivated manager might easily take a short-term route. Cut down on the advertising and ‘bank’ a bigger profit, then leave the business before the chickens come home to roost. In EVA, advertising for long-term gain can be capitalised in the EVA accounts thus removing the short-term pressure to show profit and ‘perform’. EVA scores again to lead 3-0.
The examiner is cunning though. He desperately does not want students to rote-learn all the arguments in favour of EVA and then write them down. This is a high-level exam so you must understand and apply.
So, in JLW the two divisions were very different. One traded only domestically and the other exported everything. Even a rudimentary knowledge of risk would tell you that exporting is riskier and if ‘return’ relates to risk (more risk demands more return) then the benchmark or target for the two divisions should be different. EVA does not reflect risk differences automatically. EVA scores an own goal! So, we’re in for a tense last few minutes.
The moral of this is that the examiner rarely sets up a question where there is no counter view. Be prepared to argue both ways and the markers will love you for it.
Can you put general arguments in your answer? Things you’ve studied. Things you’re just desperate to get out of you so that you can get on with your life. Well, yes, if they’re relevant and properly applied.
For example, you may have read that EVA is complicated. To be fair, it is likely you think it is pretty complicated yourself! And it is. So, can you get this valid point into the answer of JLW?
I think you can, I certainly put the point in my answer in my material, but you must make sure it is relevant and properly applied.
In JLW, the manager in charge of one of the divisions was described. She was arguing about controllable profits and that non-controllable costs should be excluded from her bonus calculation. And she’s right. It follows then, that this manager could understand EVA if it were introduced because it is likely she has the intellect and knowledge.
So, you need to be careful. The standard argument is that EVA is complex, and some might not understand it. Introducing performance measures that managers do not understand is a very bad idea. How can they react? How can they improve a measure that they do not understand? In JLW though that standard point is not quite valid. The manager would probably understand EVA, given her good knowledge of other performance management principles.
In house buying we are told that three things are important. Location, location, location.
In ACCA APM its application, application, application.