Page 81 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes The EVA method (2nd portion of the calculation – EVA Method) corrects these inconsistencies in
the following manners: the investments, multiplied by appropriate rates are subtracted from
the budgeted profit. The resulting amount is the budgeted EVA. Periodically, the actual EVA is
calculated by subtracting from the actual profits, the actual investment multiplied by the
appropriate rates.
Limitations of EVA Analysis

1. The EVA analysis does not necessarily eliminate the problem of comparing the
performance of large and small divisions.

Example: A company has three divisions each of which earns a 25% return on its total net
assets. However, the EVA of the divisions is significantly different.

Below are the data for three divisions:
Division
X Y Z
Total net assets ` 100,000 ` 500,000 ` 1000,000
Net income ` 25,000 ` 125,000 ` 250,000
ROI on net assets 25% 25% 25%
Target net income (15% of net assets) ` 15,000 ` 75,000 ` 150,000
EVA (net income – target net income) ` 10,000 ` 50,000 ` 100,000
Each division earned the same rate of return on net assets, and each has the same percentage

target net income requirement. Still the EVA measures are dramatically different among
the divisions. This approach has a tendency to highlight the divisions that generate the
largest rupee profits for the firm.
2. Most of the problems in measuring the divisional income and divisional investment base
are also present in the measurement of EVA.

3. There is additional risk of selecting a fair and equitable measure of the required cut-off
percentage (i.e., the cost of capital).
4. EVA can be readily transformed into ROI and many firms tend to convert EVA into ROI.
The relationship between EVA and ROI is as follows:

EVA
ROI = + K
I
Where ROI = return on investment
EVA = Economic Value Added
I = Investment
K= Cost of capital

The two methods, however, may show different results. In face of such a conflict, a question may
arise, which of two must be considered more reliable?

Possible Investment Bases

The base that is used for measuring invested capital may appropriately differ between companies
and within segments of the same company.

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