What is EVA and what does it mean to purchasing?
Jim Morgan, Editorial Director Emeritus -- Purchasing, 9/11/2002 2:00:00 AM
Over the past several years the acronym EVA has been creeping into conversations all over the business landscape. EVA is important because it changes the thinking behind so many performance measures now used in industry. EVA is especially important to the rethinking taking place in the supply/sourcing/purchasing process.
In oversimplified terms EVA (economic value add) is a new way to measure profit ability performance. It tracks the value added by each of an enterprise’s component parts (a firm’s EVA is its profit minus its cost of capital). Factoring in cost of capital is what separates EVA from such traditional profitability measures as net return on sales, return on investment, or performance of a company’s stock.
EVA is important because in today’s capital-short economy, companies need to measure net earnings in terms of how they affect their cost of capital. A negative EVA number says that a firm’s cost of capital is more than its net income. A positive EVA number says its net income is greater than the cost of capital taking into account the whole asset base.
EVA’s main drawback is that it’s difficult to apply – especially in supply/sourcing/purchasing processes. Companies first need to provide for very specific linkages between everything that goes on in these processes and the end results that show up in the performance of the firm. In plain language companies using EVA models must show that the implementation of any economic process or strategy will produce a positive value add to the business.
Up to here most measurements in the supply/purchasing/sourcing process have been linked to price reductions and/or cost reductions. This cost/price focus will probably continue at some level for some time as companies build their EVA models and move the focus of their supply strategies to more total business unit and company-wide strategy models. Therefore, in the short term, the sharpest focus at many companies will be on cost reductions brought about through such things as headcount reductions and purchase price reductions. The e-business revolution is also beginning to play an especially important role in this focus on cost reduction and EVA metrics that will drive it.
But, over the next couple of years, expect to see the whole supply sourcing area become more focused on generating increases in revenues. But the focus will not just involve cost reduction. More and more, the target will be better management of the EVA process, including capital assets, cost reduction, and top-line revenue enhancement.
As EVA thinking becomes more widely used in performance measurement, purchasing/supply specialists will begin to see and use a number of new operating and purchasing performance measures. Many of these will be driven by specific business strategies aimed at creating more value add and additional revenue. The net effect on many firms will be greater use of the supply community to improve profitability is such areas as bringing new supplier technology to the table faster to enrich a company’s products or services, using enhanced sourcing resources to reduce purchase prices, making greater use of contract suppliers to produce and/or provide new technologies earlier and faster than previously possible.
Another good example of how EVA could affect will affect purchasing/supply professionals is in inventory reduction. Historically companies have managed to make their inventory numbers look good by shifting inventory to suppliers. This smoke and mirrors approach, say EVA proponents, soon begin to be replaced by metrics that measure elimination of unneeded inventory, both internally and at suppliers (so as to jointly improve processes).
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