Build Family Values

Is failed banks risk vilification to pay executive bonuses, it is clear that the general public feels that there should be a direct link between performance and pay. The corporate world knows this problem well, and faces the task of finding a methodology to determine how much and individual manager has contributed to the overall performance of the organisation.

The central tenet of business is to pull the levers in the physical and financial supply chains, sales, marketing and operations that have the optimum effect on a company’s overall financial performance. Linking financial metrics to the daily tasks of everyone throughout the enterprise provides a much clearer map of how to achieve this, but it has always been hard to find the right language to describe these connections.

Now, that language is emerging and, while there has long been a perceived divide between finance and operations, the Economic Value Added (EVA) model is helping to change those perceptions. The EVA framework for financial management and incentive compensation is enabling companies to link the performance of managers at every level with overall corporate performance, and is doing so in a way that most people can comprehend. EVA gives a value for economic profit or shareholder value, and can be calculated in a number of ways, often net operating profit after taxes (Nopat) minus the cost of capital (see Explaining EVA box).

Finding the appropriate way to measure EVA and implementing it as a measure by which to calculate bonuses is a challenge more businesses are willing to take on. Like logistics and mail service provider DHL and its parent company Deutsche Post, many are deriving clear benefits.

Adopting EVA

In 2001, Deutsche Post went public and at that time cash was not an issue. The company had a road map that took in over 100 acquisitions in 15 years. This included the purchase of Exel in 2005, which implied a heavy cash outflow and left Deutsche Post in a negative cash position on its balance sheet. At the time, the company was paying its bonuses based on Earnings Before Interest and Taxes (EBIT), but wanted to implement a new and clearer measure. As a result after 2008 as the year of transition, 2009 will be the first full year in which bonuses are determined by the EVA model.

"We needed to bring in the cost of capital, so while we didn’t invent anything new, we did adopt the EVA model," says Nicola Verzura, CFO for Nordic and Baltic at DHL Exel Supply Chain.

Deutsche Post DHL wanted to ensure a smooth transition to a new model for calculating executive bonuses, so management was keen to see how quickly EVA could be embedded into the business model. It was implemented quickly, but was also flexible enough to fit into the DHL strategy.

"We needed to know if it could fit in a ‘plug-and-play’ way or whether it needed adaptation. We modified our approach. Each country manager was measured on EBIT, because they are responsible for earnings before financial and tax adjustments, which are handled centrally in Bonn," says Verzura.

"We moved towards EVA, which is the net income minus the cost of capital, but we did adjust things. Net income was reconverted into EBIT and instead of using the total capital employed, we used the so-called ‘business operating assets’ (BOA) which basically represents all of those balance sheet elements that are under the control of each country management team," he adds.

DHL’s calculation using EBIT and BOA removes tax and financial assets/liabilities issues from the calculation of EVA. Furthermore, the measures of EBIT and BOA are broken down into many other levels to include metrics around items such as fixed assets, net working capital, receivables, prepaid expenses and many more. The result is a detailed map of financial and operational metrics.

From this map elements that may determine bonus payments, such as Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO), can be pulled. There is greater transparency within the organisation and people start to understand what they have to do in order to contribute to shareholder value.

This understanding did not come without great effort, and DHL focused heavily on training sessions during the roll out of the EVA model to all its business units, particularly for mid-level managers and employees on the operational side of the business.

"Everyone needed to get the message about how our new approach affects their daily job. The breakdown of EVA must be clear for everyone from the CFO to the guys in the warehouse," says Verzura.

The intensive training effort has helped DHL to implement the new model quickly and effectively, not least by making it relevant to the familiar situations we all encounter in daily life.

"We made the balance sheet like a family budget, with prepaid items like holidays and regular outgoings like mortgage payments. People quickly find commonalities with family budgeting," Verzura explains.

A new vocabulary

EVA is an increasingly familiar concept in business, and DHL does not claim to be pioneering the concept, but it has shown other organisations that the model can be adapted in a way that provides a new language in which all parts of the business can join the discussion about corporate value.

Enrico Camerinelli, Celent’s senior analyst in Europe, is a devoted researcher in the area of supply chain metrics and their links to financial measures, and he sees DHL’s handling of the EVA model as an important step forward.

"The original element in its approach was not the use of EVA, but the fact that they made the effort to link components of BOA with operational metrics. They succeeded in giving executive managers the ability to understand how EVA relates to the day-to-day operations of their business," says Camerinelli.

"The result is that the whole organisation realises how it can contribute to EVA. DHL is putting into practice the linking of supply chain operations with financial results," he adds.

If EVA is properly implemented and its message is clearly communicated throughout an organisation, then people working in operations will understand the logic that links accounts receivable (AR) or accounts payable (AP) to DSO and DPO.

"The real innovation is to make the breakdown of the EVA tree relevant to the personal performance of everyone in the organisation, not just those people in the higher levels of management. The value of EVA is that it can become a common language throughout the organisation," believes Camerinelli.

The detailed mapping of relationships in DHL’s version of the EVA model may appear complex, but there are limits to the level of detail needed for the analysis to succeed. For instance, the model does not have to exactly define the percentage change on financial results from every operational task.

"We reduce it to the things that each manager can understand and control. It is enough for them to know that they are contributing directly to EVA, but they should not focus on by how much. They know they are contributing to shareholder value, and they know what to focus on," says Verzura.

"This helps people to be more creative on things like payment terms, and it gives them perspective on their role in the organisation," he adds.

Root and branch

The adapted EVA model has succeeded in bringing the many parts of DHL’s organisation closer together and focusing them on a common set of goals. This success was built largely on two things: a willingness to involve all levels of the business in the transition and the ability to learn during the process.

"It was not easy at first to explain the concept. Roll out took several months and we needed to modify the training programme after the first few months and developed course material on the feedback from trainees. We only had one chance to get it right, so we had to make some changes as we went along," says Verzura.

He stresses that everyone in the business is affected by the change, so everyone should have some level of input. Nevertheless, he believes it is important to move this dialogue forward at pace.

"I would advise organisations to encourage feedback from people at all levels in the organisation, to make sure they see how the EVA concept translates into their jobs. I would also advise them to keep the time frame short. I like the Big Bang approach. People don’t like change, so get it over with as quickly as possible," he remarks.

"Doing it quickly shows that it is an important change," he adds.

If the transition to EVA is to happen quickly, the CEO and CFO must be the ones driving the change. This was certainly the case at DHL, where the EVA model has taken root quickly. It has become part of the organisation’s DNA, and the results have all been positive.

"It empowers more people to have greater responsibility for the consequences of their activities on the overall business. It helps you get the best from new ideas at every level in the company," explains Camerinelli.

It is understandable that in the current climate some companies may show some hesitation about making the transition to a new model like EVA, but for Verzura there is no time like the present.

"There is much greater clarity in the organisation, and I am very optimistic about the EVA model. The economic crisis is perhaps the best time to make the change."

Using the EVA model, DHL takes into account the opportunity cost to investors of holding their cash, and including the cost of capital in the calculation that determines incentivised rewards means that – in the early stages at least – managers may need room to adjust to a relative reduction in bonuses. Nevertheless, once the model has become familiar, the clear relationship between bonuses, profit and their daily activities will no doubt act as an incentive in itself.

Explaining EVA

Economic Value Added (EVA), a measure of shareholder value developed by Stern Stewart, is also referred to as economic profit – a formula for calculating growth in business value that goes beyond EBIT or earnings per share by subtracting the weighted average cost of capital (Wacc) from net operating profit after taxes (Nopat) and multiplying that by the total capital (TC) invested. At DHL, Wacc is a number generated from group headquarters in Bonn.

Nopat – (Wacc x TC) = EVA

The DHL equation

The formula devised by Stern Stewart requires a few adjustments to be made to balance sheet items to calculate the value of EAC (EBIT After Asset Charge) which is an equivalent metrics of EVA. Business Operating Assets (BOA) is DHL’s definition of those balance sheet elements under the control of each country management team. BOA is then multiplied using the centrally provided Wacc to obtain a value equivalent to the cost of capital.

EBIT - BOA x Wacc = EAC (EBIT After Asset Charge)