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Management Control Systems

Notes equal to the minimum rate on investment specified by top management as part of the corporate
strategic plan. Example A division has a budgeted income of ` 10 lakhs and a budgeted investment
of ` 60 lakhs. The average cost of capital for the firm is 12 %. The budgeted residual income is:
Divisional Income ` 10 lakhs
Interest charge
12% on ` 60 lakhs 7.20

Residual income/Economic value added 2.80
Different interest rates may be applied to different components of investment like Fixed assets,
inventories, receivables and cash.

4.8.1 EVA Approach (Stern Stewart Approach)

During the 1990s, residual income has been refined and remained as Economic Value Added
(EVA) by Stern Steward Counseling Organization and they have registered EVA (TM) as their
trademark.

The EVA Concept extends the traditional residual income measures by incorporating adjustments
to the divisional performance measures against distortions introduced by generally accepted
accounting principles (EAAP).
EVA can be defined as = Conventional divisional profit ± Accumulated adjustment – cost of
capital charge on divisional assets.
Adjustments are made to the chosen, conventional divisional profit measures in order to replace
historical accounting data with a measure of economic profit and asset values. Stern Stewart has
developed approximately 160 accounting adjustments, but most organisations will only need to
use about 10 of the adjustments. These adjustments result in the capitalization of many
discretionary adjustments such as: research and development, marketing and advertising by
spreading these costs over the periods in which the benefits are received. Therefore, adopting
EVA reduces some of the harmful side effects arising from using financial measures. Also,
because it is restatement of the residual income measure compared with ROI, EVA is more
likely to encourage goal congruence in terms of asset acquisition and disposal decisions. Managers
are also made aware that capital has a cost and they are thus encouraged to dispose off
underutilized assets that do not generate sufficient income to cover their cost of capital. There
are a number of issues that apply to ROI, residual income or its replacement (EVA). They
concern determining which assets should be included in a division’s asset base and adjustments
that should be made to financial accounting practices to derive managerial information that is
closer to economic reality.
EVA is, essentially, the surplus left after making an appropriate charge for the capital employed
in the business. It may be calculated in any of the following apparently different, but essentially
equivalent ways:
1. EVA = Net operating profit after tax-cost of capital  economic book value of the capital
employed in the firm.
2. EVA = Economic book value of the capital employed in the firm ( return on capital – cost
of capital)
3. EVA = [Profit after tax + Interest (1-marginal tax rate of the firm)] – cost of capital 
economic book value of the capital employed in the firm.

4. EVA = Profit after tax – cost of equity  equity employed in the firm.

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