2004 International Applied Business Research Conference San Juan, Puerto Rico

Some Aspects

Of Performance Measurement:

The Possibility Of Introducing Eva

In Slovenia

Metka Tekavčič, Ph.D., University of Ljubljana,

Urška Kosi, University of Ljubljana,


Several major developments that have happened in the last two decades brought together two kinds of activity and thinking – corporate finance and corporate strategy. These developments caused the capital to attain the highest degree of mobility and made managers understand that companies must not only be competitive in commercial markets, but they must also be competitive in capital markets. Focusing on value creation became the primary objective of managers and caused a revolution in performance measurement systems as well. The discontent with using financial measures to evaluate corporate performance introduced new methods of performance measurement that often supplement financial measures with non-financial ones. In the paper we will briefly introduce the characteristics of economic value added (EVA), as one of the recent performance measures. The discussion will concentrate on possibilities of implementing EVA to Slovenian companies and potential limitations of such implementation.


Due to a growing realization of the failure of traditional ways of measuring performance, recent years brought forth an increasing interest in performance measurement, as one of the major components of cost management (Brinker, 1996, p. xvii). Quantification has doubtlessly been the trend in business and economics for the past 50 years, but in Drucker’s opinion we still do not have the measurements we need – the measurements to give us business control (1996).

When talking about corporate performance, one must realize that there is a distinction between economic performance and performance which is conventionally determined by accrual accounting. The later usually refers to a shorter period of time and is only a fragment of a true economic performance of a business. On the other hand, economic performance corresponds to the difference between the final value of company’s equity and its initial value. If we want to define it more accurately, we need to take into account the period that matches a company’s lifetime. To determine the economic performance for a shorter period of time, one must calculate the difference between the market value of a company at the end of the chosen period and at the beginning of this period. However, determining the discrepancy of market values using the methods of firm valuation process, is time consuming and costly for one thing, and for the other short-term performance differs from the long-term performance, since the later is influenced by additional factors. Therefore, the analysis of short-term corporate performance continues to rely on accounting data that need to be adjusted to reflect the true economic performance as closely as possible (Pučko, 2001, p. 146-149).

Dissatisfaction with using financial measures to evaluate corporate performance goes back at least to the 1950’s but the current wave of discontent has a different intensity and nature of criticism directed at traditional accounting systems. Many academics and practitioners demonstrate that accrual-based performance measures are at best obsolete, if not harmful, since the figures these systems generate often fail to support the investments in new technologies and markets that are essential for successful performance in global markets. When senior managers recognized that new strategies and competitive realities demand new measurement systems, revolution started. The revolution represented a shift from treating financial figures as the foundation for performance measurement to treating them as one among a broader set of measures. Broadening the basis of corporate performance measurement started with quality measures, measures of customer satisfaction and competitive benchmarking. However, great improvement in information technology made a performance measurement revolution possible, since organizations are able to generate, distribute, analyze, and store more information from more sources, for more people more quickly and cheaply (Eccles, 1996).

Most of the recent performance measurement systems could be divided into two groups according to a different foundation they use (Bergant, 1998, p. 92-93):

  • Systems that supplement financial measures with other aspects of corporate performance (such as customer satisfaction, product quality, market share etc.);
  • Systems forming a uniform measure that is based on financial data.

Both kind of models rest on the criticism of traditional accounting systems that among others stimulate short-term thinking, encourage investments with more explicit returns, discourage internal innovation projects with less obvious benefits, and sometimes undervalue company’s capital. To the extend that managers focus on accounting-based measures they also have the incentive to manipulate the numbers they report (Bergant, 1998, p. 93).

The first group of measurement systems emphasizes that it is important for managers to understand the number of factors that affect the performance of individuals, groups and organizations at large. To be profitable in the long run, however, companies have to track not only financial measures, but also strategic variables in the fields of customer satisfaction, quality, innovation, flexibility, efficiency and effectiveness of processes. Some radical thinkers even argue not worrying about financial measures, because profits will take care of themselves if the company gives customers what they want (Brinker, 1996, p. xvii).

The manipulation of accounting figures led many managers, analysts and financial economists to focus on cash flows in the belief that they reflect company’s economic condition more accurately than its reported earnings (Eccles, 1996, p. A2-2). Therefore, measurement systems of the second group use cash flows and adjusted accounting data to improve the information content of financial data, but still measure performance within financial terms. Economic value added (EVA[1]) is a representative of this kind of models and will be presented in this paper. We will discuss the possibilities of using EVA in Slovenian companies and outline the limitations of EVA implementation.


In the last two decades, two kinds of activity and thinking – corporate finance and corporate strategy – have come together. Participants in the financial markets are increasingly involved in business operations and chief executives have led their companies to become increasingly active players in the financial markets. To managers, this new reality offers a challenge, as they need to manage value and focus on the value their corporate and business-level strategies are creating (Copeland, Koller, Murrin, 2000, p. viii). Although companies represent a number of (explicit or implicit) contracts between different interest groups or stakeholders (Buckley et al., 1998, p. 38), owners (shareholders) are considered most important since they offer sine qua non of a single company – its equity. Hence it follows that creating value for shareholders should be the paramount objective of every company (Brigham, Gapenski, Daves, 1999, p. 3).

Still there continues to be a vigorous debate on the importance of shareholder value relative to other measures such as employment, social responsibility and environment, and this debate is often cast in terms of shareholder versus stakeholder. In the US and the UK most weight is given to shareholders as the owners of the company, and the main objective of the company is to maximize shareholder wealth. On the other hand, a broader view of objectives has long been more influential in continental Europe (Copeland, Koller, Murrin, 2000, p. 3). Even if there might be a conflict of interest between shareholders and other stakeholders in the short run, there should be no conflict in the long run, as companies cannot operate successfully when having poor working conditions, low quality of products, strained relation with the community etc. (Stern, Shiely, Ross, 2003, p. 56).

When managers do not own the companies they manage, value creation might not be their top priority, because the value they may create belongs to others. Pursuing other goals that sometimes conflict with creation of value, such as market share, volume growth, customer satisfaction, jobs etc., results in destroying value. It is not that these objectives are undesirable, however, value-creating companies must not pursue them for their own sake, but because value creation for their shareholders is otherwise not possible. Even though earning competitive returns on capital as the most important objective sometimes gets obscured in large companies, more and more managers now recognize the pressures in deregulated capital markets to deliver ever-increasing profits. They have adopted new performance metrics to track management’s success in creating value for shareholders and to motivate the employees throughout the company to make their work consistent with value creation (Young, O’Byrne, 2000, p. 4).

The growing predominance of shareholder wealth model results from several major developments in the last two decades or so: active market for corporate control, importance of equity-based elements in the pay packages of senior executives, more equity holdings in household assets (Copeland, Koller, Murrin, 2000, p. 4), globalization and deregulation of capital markets, advances in information technology, more liquid currency and securities markets, the growing importance of institutional investors, and better informed and more demanding investors (Young, O’Byrne, 2000, p. 6). These developments caused the capital to attain the highest degree of mobility, and it will go where it is most appreciated. From the 1980s onwards, managers understand that for their companies to survive and grow they must be competitive in terms of operating costs. But, as recent events demonstrated, this is no longer enough and managers must also learn to compete in the market for corporate control, which requires competitive capital costs as well (Reimann, 1987, p. 1).

This ascendancy of shareholders has led many managers in most developed countries to focus on value creation as the most important metric of corporate performance, and as the evidence seems to show, shareholder value creation is not only good for shareholders but also for the economy and other stakeholders (Copeland, Koller, Murrin, 2000, p. 15).

Even though managers had long emphasized the importance of shareholder interests, the poor market performance of so many companies offered evidence that this objective often had not been achieved. The reason is that they did not know how to do it, as they could not see any consistent relationship between their companies’ strategic or financial performance and the market value of their companies. But a confluence of factors and circumstances in the last 20 years has led top managers to worry about the value that the capital markets are assigning to their companies. It has become very important for managers to learn how to manage and monitor the value creation process over time. As a consequence, the focus shifted from strategic variables to financial ones and financially-oriented methods made the key contribution to (finally) focusing on the concerns of shareholders. Nevertheless, relying too greatly on short-term, purely financial considerations could be dangerous, as longer-term qualitative aspects of strategy could get crowded out. Therefore, an approach to value-based strategic management was introduced to integrate the financially grounded focus on monitoring shareholder value creation and the more qualitative approach to developing and implementing successful longer-term business strategies (Reimann, 1987, p. 2-4). Until today, a lot has been written about value-based management and its set of tools that help managers to create value. Martin and Petty (2000) characterize value-based management as “corporate world’s most significant and effective response to the shareholder revolt”.

To survive in today’s highly competitive world, it is necessary for companies to focus on value creation. Managers need to understand the requirements of their shareholders and especially the tools, which help meeting these requirements (Knight, 1997). Several management tools – such as the free cash flow method, the economic or market value added method and the cash flow return on investment approach – have been introduced to help managers at value creation. In this paper we will look at economic value added in more detail, and discuss the possibilities of introducing this concept into Slovenian companies. The fundamental paradigm of value-based management is that companies earning higher rates of return than their cost of capital create shareholder wealth and those failing this test destroy it. A key consideration here is company’s internal measurement and reward system that should mirror the external capital market system as closely as possible (Martin, Petty, 2000, p. 3-8).

By implementing value-based management the mind-set of a company must change so that every single employee makes decisions based on the understanding how those decisions contribute to corporate value. A complete value-based management system should take the following elements into consideration (Young, O’Byrne, 2001, p. 18):

  • Strategic planning;
  • Capital allocation;
  • Operating budgets;
  • Performance measurement;
  • Management compensation;
  • Internal communication;
  • External communication (with capital markets).

Academics as well as practitioners emphasize that traditional methods of corporate performance analysis that are grounded on accounting (financial) performance measures do not offer all relevant signals for directing business operations. From the late 1980s more and more empirical evidence supports that traditional financial statements with typically financial information do not suffice to appraise the corporate performance of a company. Hence greater emphasis is laid on to non-financial performance measures or supplementing financial performance measures with non-financial ones (Rejc, 2002, p. 1).

Although analyzing corporate performance goes beyond analyzing financial consequences of decision making, performance measurement usually concentrates on financial analysis of a company. But assuming business performance reflects most heavily on financial results, this is not surprising. The financial perspective of the management system as a whole could be perceived as the linking part that is testing the adequacy of strategies and other elements of the management system (Brewer, Chandra, 1999, p. 9). In the paper we will adopt the same assumption and focus on financial results when analyzing performance of companies.

When trying to measure the creation of shareholder wealth, total return to shareholders seems to be the most logical gauge. But total return cannot really tell if a company is doing better than another, as company’s required rate of return (or cost of capital) rises with the risk of the underlying business and the degree of leverage in company’s balance sheet. The definite measure of wealth creation is market value added (MVA[2]), which represents the difference between total market value and total capital (Grant, 2003, p. 5)[3]:

MVA = Market value of the company – Total capital

= (Debt value + Equity value) – Total capital

As such it characterizes the cumulative amount by which a company enhanced shareholder wealth. Whereas MVA is a snapshot at a given point of time, the change of MVA over a period of time is more significant in assessing the performance of the current management of a company. Hence it follows that the goal of every company should be to create as much market value added as possible. But MVA has a significant limitation – it cannot be used as a guide to day-to-day decision making. For one thing, it can only be calculated if the company is publicly traded and has a market price. Second, changes in the overall level of the stock market can overwhelm the contribution of management in the short run. And because it can only be calculated at consolidated level it provides no help in assessing the performance of separate lower levels and managers, therefore, management has to focus on some other internal measure of performance that is closely linked to MVA. Economic value added is a measure that is highly correlated to market value added and at the same time provides the most reliable guide to whether and by how much management actions will contribute to shareholder wealth (Ehrbar, 1998).


In recent years, managers have been offered a plethora of metrics, such as economic value added, return on net assets (RONA) and cash flow return on investment (CFROI), that are organized around the same basic principle – creating shareholders value requires earning returns on invested capital that exceed the cost of capital (Young, O’Byrne, 2000, p. 5). In financial press the competition among consultants to introduce new models of corporate performance measures was described as metric wars (Myers, 1996). In this paper we will focus on EVA that measures the difference, in monetary terms, between the return on company’s capital and the cost of that capital. Compared to conventional accounting measures, it has important differences: it considers the cost of all capital, and it is not constrained by accounting standards.

An appropriate performance measure should be able to gauge how management strategy affects shareholder value. An appropriate performance measure to gauge the effectiveness of a given strategy must incorporate the required rate of return on invested capital, accurately measure the amount of capital used in the company, and correlate highly with the risk-adjusted rate of return earned by shareholders (Bacidore et al., 1997, p. 12).

Since investors have a wide spectrum of investment alternatives available to them, they are interested to know whether the return of the invested capital exceeds its cost. Therefore from the beginning of the 20th century performance measurement shifted from the earnings number to a ratio between earnings and capital invested – return on investment (ROI[4]). Although this shift represented an improvement in performance measurement there are still limitations to using ROI. Most of all ROI causes managers to focus on short-term performance instead of long-term performance. As a result, a new performance measure, called residual income, was introduced in the 1950s (Hočevar, Jaklič, Zagoršek, 2003, p. 218-220).

Economic value added is not a recent invention in economy. Comprehension that companies create value only when they earn more than their cost of debt and capital, goes back for centuries say Biddle, Bowen and Wallace (1999) that quote Hamilton’s notice from 1777. In 1890 Alfred Marshall introduced the definition of economic profit, regarding the real meaning of a business owner’s profit: if a company is to be profitable, its income must not only cover operating costs but also costs of capital. It is evident that economists’ definition of profit, namely a residual view of income or economic profit, is radically different from the accounting measures of profit in use today. This kind of perception is the foundation of today’s understanding of economic profit (Grant, Abate, 2001, p. 3).