Managing Costs & Revenues Professor William F. O’Brien, MBA, CPA Spring 2011

Session 6 n EVA ® n The Goal n Baldwin Bicycle Case n Reichard Maschinen Case

MANAGING COSTS AND REVENUES Economic Value-added Analysis EVA® n Measurement Alternative for Shareholder Value n Elements

MANAGING COSTS AND REVENUES Let’s Define EVA® When the Cost of Capital is less than the Operating Income from that Capital, you create EVA®!!! Sources of Capital -Debt -Equity “Stuff” Generates Income Capital Buys “Stuff”

MANAGING COSTS AND REVENUES EVA® Elements n Cost of Debt Financing n Cost of Equity Financing n Components of Capital n Adjusted Net Operating Income

MANAGING COSTS AND REVENUES Cost of Debt Financing n Interest Expense n After-tax Impact n Consider all Debt, Excluding A/P

MANAGING COSTS AND REVENUES Cost of Equity Financing n Shareholder Hurdle Rate n Price Appreciation n Dividend Rate n “Six Percentage Point” Rule

MANAGING COSTS AND REVENUES Components of Capital n Net Working Capital n Net Long-lived Tangible Assets n R & D Spending n Employee Development Spending

MANAGING COSTS AND REVENUES Adjusted Net Operating Income n Substitute R&D and Employee Development Costs with Annual Amort. n Use Net Income from Continuing Operations n Adj. Net Op. Income Minus Cost of Financing Equals Economic Value Added

MANAGING COSTS AND REVENUES EVA® Uses n Planning Tool n Business Unit Evaluation n Incentive Compensation Base n Merger and Acquisition Analysis n Capital Asset Analysis

MANAGING COSTS AND REVENUES Corporate Examples n CSX n Quaker Oats

MANAGING COSTS AND REVENUES Ways to Raise EVA® n Increase Profits n Reduce Capital Spending n Reduce Investment in Working Capital n Increase High-margin Capital Investments

MANAGING COSTS AND REVENUES EVA® Implementation n Top management buy-in n Make it a way of life n Implement Gradually n Keep it Simple n Train the users

MANAGING COSTS AND REVENUES Theory of Constraints n The Concept n The Process n The Measures

MANAGING COSTS AND REVENUES The Concept n Presented in Eliyahu Goldratt’s The Goal n The goal of a business is to make money…consistent with customer satisfaction n Continuous flow n Avoid the “herbies” n Eliminate the bottlenecks first

MANAGING COSTS AND REVENUES The Process n Identify the constraints n Exploit the constraints (reduce the bottlenecks) n Subordinate everything else n Elevate the constraints (remove the bottlenecks) n Reiterate the process

MANAGING COSTS AND REVENUES The Measures n Throughput-Net income n Inventory-ROI n Ops. Expenses-Cash Flow