Added Value

This is the third post in a series on the C12 Group‘s Tri-Value model for measuring the performance of the leadership in a business. In the first post, I did an overview of the Tri-Value model and its purpose. In the second post, we looked at Team Value Added component of the model. Here, in the third post, we will focus on Economic Value Added (EVA) component.

Simply put, EVA measures whether the business’ value is being sufficiently increased or spent by the leadership responsible. Let’s start by taking a look at the formula itself:

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Operating Profit – Taxes – Cost of Capital Employed = EVA

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Breaking It Down

Operating Profit is easy to define: Gross Sales – (Cost of Goods Sold + Selling, General & Administrative Costs). Taxes are also easy to understand and quantify. It is the true Cost of Capital that causes a little more confusion.

The first response is usually to consider the cost of capital as what is paid to borrow it. This is not necessarily incorrect, but it only tells a small part of the story. We really need to dig a little deeper to get the rest of the story.

This description from the C12 material says it better than I can:

The total of all the invested capital tied up in the business (i.e. real estate, equipment, inventory, working capital, assets of all kinds) should be producing a return equal to or greater than the same amount if used to purchase another investment of equal risk.

While it is not critical that we go into too much detail about the risk, it is generally agreed that a conservative risk return is 10% for most businesses. I would argue that it should be higher, but you really need to settle on a number that is comfortable for you.

The Risk

Quite simply, if you sold the business and everything you have invested in it, how much cash would you have? If you invested that cash, over a long period of time in a similar-risk investment, what return would you expect to receive? Go with that number here. Why would you accept less? (There are arguments here, but we will save those for later!)

Taking that number (we will use 10%), along with the total market value of your business, you should be able to finish the equation. To make it easier to follow, I will use sample numbers assuming the following:

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(Market Value = $500,000) X (Return = 10%) = Cost of Capital $50,000

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Now, in this example, the leadership produced $20,000 in added value. If Operating Profit had been less than $80,000 for the year, then they would have actually spent value, rather than adding it.

Of course, this is not the ultimate measurement. C12 still recommends benchmarking the performance of your business against comparable businesses in your industry. You also need to know your own critical metrics for your business – those numbers that drive the health and performance of the company.

How did your business do in this exercise?

Are you showing added value or spent value?

If you are spending value, what needs to change?