Accounting For Change

Sept. 21, 1998
The goal is to heighten finances strategic role while avoiding net losses and extraordinary charges.

Finances days as the unimaginative keepers of accounts payable and receivable and the narrowly focused controllers of costs are numbered. In the gathering global quest to create greater corporate value, CFOs, comptrollers, treasurers, and the thousands of other folks in finance and accounting are having to change not only the ways they look at business, but the ways they do business as well.

For example, such traditional corporate performance measures as ROE (return on equity) and EPS (earnings per share) are being relegated to second-class status as metrics such as EVA (economic value added), MVA (market value added), and CFROI (cash flow return on investment) become managements primary tools.

"People are realizing that you cant sell short your long-term future purely for the sake of hitting a certain quarters earnings-per-share," observes Chris Weidenhammer, a former Ford Motor Co. product manager whos now a principal at the George Group, a Dallas-based manufacturing consulting firm.

The new economic-value tools, says an approving Peter F. Drucker, enable executives to view the entire enterprise and to redeploy assets to generate the greatest yield. For the same reason, Drucker applauds the reintroduction of economic-chain accounting to U.S. industry in such firms as Ford and Corning Inc. Invented in America nearly a century ago and employed today by Japans largest exporters, economic-chain accounting overcomes traditional cost accountings inability to square factory performance and the impact of manufacturing changes on the entire business by allowing executives "to see the total costs and their yields through the entire economic process from supplier to ultimate consumer," Drucker stresses.

Significantly, too, as performance metrics and accounting methods are being substantively changed, the corporate quest for greater value creation, the drive to globalize, and the emergence of high-tech information exchanges called shared service centers are altering the traditional command-and-control structure of finance and accounting. Rigidity is out and hybrids of centralized and decentralized activities are in. Sophisticated systems permit the processing of sales, inventory, and other essential data to be consolidated even as a companys operating units around the world are gaining greater access to the numbers and being able to crunch them for local use.

As traditional practices are swept aside and conventional thinking is challenged, the bottom line is that finance and accounting people increasingly are active strategic partners in the fortunes of manufacturing firms in the U.S. and beyond its borders. Indeed, the world of the new manufacturing is also the world of the new finance.

Measuring Up

An international business landscape littered with acronyms is a dramatic illustration of how intense the corporate pursuit of value creation has become during the past half-decade. Smart marketers of performance measures have capitalized on rising demand, and a battle for clients rages, for example, between the folks who gave the world EVA and the people who came up with CFROI.

But, in part because its been so well promoted by Stern Stewart & Co., its New York-based developers, EVA is the most readily recognized of the new corporate-value metrics.

"It is now truly global," says John Ballow, a senior vice president at Stern Stewart who was introduced to EVA when he was working at Grumman Corp. in the early 1990s. Stern Stewart has worked with more than 300 companies in the U.S., Europe, Japan, Australia, New Zealand, Latin America, and South Africa. "We are dealing with companies that range from US$100 million or less to companies that are intergalactic in reach, like Siemens," Ballow states.

Drawing on data that already appear on the income statement and balance sheet, such firms as Atlanta-based Coca-Cola Co., Siemens AG, and Singapore Technologies Marine Ltd. do the basic EVA calculation by subtracting operating costs and the costs of capital from sales revenues.

By gathering "all the pluses and minuses of a decision into one measure," the unique arithmetic gives managers a superior tool with which to make (often-tough) tradeoffs, boasts G. Bennett Stewart III, senior partner and cofounder of Stern Stewart.

Roberto C. Goizueta, Coca-Colas late chairman and CEO, liked to tell a story about EVA and the decision to switch to cardboard soft-drink concentrate shipping containers from stainless steel, Stewart relates. The reusable stainless steel containers that sat on Cokes balance sheet were written off very slowly, something that helped to increase profit and profit margins. In contrast, shipping concentrate in single-use cardboard containers would raise unit cost and reduce profits and the profit margin -- but it would require very little investment of assets. The containers could be "expensed," written off immediately.

"If you run the EVA calculation, you find that the freeing up of assets on the balance sheet by switching to cardboard saves you a capital charge that overcomes any shrinkage in profit that you might incur," Stewart explains.

Ballow, his Stern Stewart colleague, asks, "Whats wrong with [doing a better job of] managing that capital?"

Indeed, senior financial officers of U.S. manufacturing companies believe that managements increased focus on leveraging and managing assets is one of the major benefits of economic value analysis, reveals a 1996 Manufacturers Alliance study. The Arlington, Va.-based trade associations study showed also that 33% of the responding companies had adopted some economic value performance measure -- and that another 10% were evaluating one. A more recent Sibson & Co. study of major U.S. manufacturers shows nearly half -- 49% -- using economic-value measures for business planning and financial management.

Economic value, whether arrived at by EVA or other financial-based measures, "is the best surrogate for total return to shareholders -- shareholder wealth creation. Many studies have shown there is very good correlation between economic value and stock-price appreciation and dividends," contends Jude Rich, chairman of Sibson & Co., Princeton, N.J., a global management consulting firm focusing on strategic implementation issues.

And economic value can be a better predictor of return to shareholders than traditional accounting measures because "it enables you to take into account both growth and the return on capital relative to the cost of that capital," Rich continues. "It incorporates critical elements that drive company value: the earnings or cash flow generated by a business, the capital requirements needed to generate the earnings or cash flow, and the costs associated with using that capital," Rich states.

One client company, which he does not identify, has no corporate goals -- just an economic value matrix -- to guide its moves. On the other hand, Coca-Cola and other well-known companies, Rich confirms, have used economic-value analysis extensively and often with impressive results "to develop strategies and evaluate acquisitions, divestitures, and specific investments."

Herman Miller Inc. has employed EVA since 1995 to help the Zeeland, Mich.-based office-furniture producer pinpoint where value is being created -- or destroyed -- along the business chain that links design, suppliers, production, distribution, and customers, relates Dave Guy, the companys vice president for finance. "We know that EVA can help us bring value out at all levels of that value chain," he states. "In our company, several years ago capital was viewed as free. Now we know better."

Significantly, Herman Miller also has promoted EVA among its employees to help raise economic literacy and linked compensation for 6,800 of its 7,500 managers and workers to EVA. With people understanding the performance metric and having their economic interest tied to it, "you dont need as much of a controlling environment as you might need in some other companies," Guy says.

However, among the worlds most financially savvy and best-managed firms it is notable that $80-billion General Electric Co. has not embraced EVA.

And the performance tool does have its detractors.

For example, while EVA makes all kinds of useful adjustments to a companys financial statements -- things that have significance in evaluating an acquisition or considering the divestiture of a business -- the metric by itself "is not very effective for sending any signals about how to run the business to management," Sibsons Rich asserts.

James Dodd, an associate professor of accounting at Drake University, Des Moines, Iowa, quarrels with the claim that EVA is the best tool for aligning management and stockholder interests. "If a firm adopts EVA with the intent of more closely connecting firm performance with stock returns, the firm is likely to be disappointed," he says.

And Dodd is concerned that companies using EVA might be paying less attention to such performance measures as quality and customer satisfaction. "I suggest that the balanced-scorecard approach of using multiple metrics -- financial and nonfinancial -- to manage todays firms makes more sense than relying on a single metric -- EVA [or] any other accounting metric."

Read more about operations best practices in the following articles:

At Work -- Not At Work

Hedging Bets -- Seizing Opportunities

About the Author

John McClenahen | Former Senior Editor, IndustryWeek

 John S. McClenahen, is an occasional essayist on the Web site of IndustryWeek, the executive management publication from which he retired in 2006. He began his journalism career as a broadcast journalist at Westinghouse Broadcasting’s KYW in Cleveland, Ohio. In May 1967, he joined Penton Media Inc. in Cleveland and in September 1967 was transferred to Washington, DC, the base from which for nearly 40 years he wrote primarily about national and international economics and politics, and corporate social responsibility.
      McClenahen, a native of Ohio now residing in Maryland, is an award-winning writer and photographer. He is the author of three books of poetry, most recently An Unexpected Poet (2013), and several books of photographs, including Black, White, and Shades of Grey (2014). He also is the author of a children’s book, Henry at His Beach (2014).
      His photograph “Provincetown: Fog Rising 2004” was selected for the Smithsonian Institution’s 2011 juried exhibition Artists at Work and displayed in the S. Dillon Ripley Center at the Smithsonian Institution in Washington, D.C., from June until October 2011. Five of his photographs are in the collection of St. Lawrence University and displayed on campus in Canton, New York.
      John McClenahen’s essay “Incorporating America: Whitman in Context” was designated one of the five best works published in The Journal of Graduate Liberal Studies during the twelve-year editorship of R. Barry Leavis of Rollins College. John McClenahen’s several journalism prizes include the coveted Jesse H. Neal Award. He also is the author of the commemorative poem “Upon 50 Years,” celebrating the fiftieth anniversary of the founding of Wolfson College Cambridge, and appearing in “The Wolfson Review.”
      John McClenahen received a B.A. (English with a minor in government) from St. Lawrence University, an M.A., (English) from Western Reserve University, and a Master of Arts in Liberal Studies from Georgetown University, where he also pursued doctoral studies. At St. Lawrence University, he was elected to academic honor societies in English and government and to Omicron Delta Kappa, the University’s highest undergraduate honor. John McClenahen was a participant in the 32nd Annual Wharton Seminars for Journalists at the Wharton School at the University of Pennsylvania in Philadelphia. During the Easter Term of the 1986 academic year, John McClenahen was the first American to hold a prestigious Press Fellowship at Wolfson College, Cambridge, in the United Kingdom.
      John McClenahen has served on the Editorial Board of Confluence: The Journal of Graduate Liberal Studies and was co-founder and first editor of Liberal Studies at Georgetown. He has been a volunteer researcher on the William Steinway Diary Project at the Smithsonian Institution, Washington, D.C., and has been an assistant professorial lecturer at The George Washington University in Washington, D.C.


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