The Right Blend of EVA

The appeal of business models based on Economic Value Added (EVA) is rapidly growing, as companies see the advantage of making clear, comprehensible links between operational metrics and financial metrics. Such models bring finance and operations closer together, helping the many parts of an organisation to rally around common goals, and businesses of all kinds are reaping the benefits.

EVA has already been used to great effect by many companies looking to optimise supply chain management, as it allows them to clarify the effects of strategic and operational decisions on the overall financial performance of the organisation. Yet they have also proven that there is no ‘one size fits all’ version of the model. It is undoubtedly a valuable tool, but it is important to understand that EVA on its own is not necessarily the starting point, nor indeed the only component, in optimising supply chain operations.

“We started a new three-year business plan and we wanted to use this model to understand the impact on the supply chain, as well as the cash value added and costs,” explains Stanislao Fabbrino, CEO of Fruttagel, which is currently implementing a version of the EVA model.

“The starting point was a redesign of the entire supply chain. The aim was to understand the financial impact of this redesign of the operational framework,” says Flavio Bordignon of Aprile, a small business engineering company that advises enterprises such as Fruttagel on financial supply chain efficiency.

Fruttagel is a strategic partner for agribusiness and the food market, which specialises in processing fruit and vegetables into frozen products, either for third parties or to produce personalised products under its partners’ own labels. Given this role, stock is vitally important to the company’s operations, so supply chain efficiency is a high priority.

“We have a high working capital problem and stock is the most important thing for the company. We have to change our perspective and we need a strategic change. We need a new language and a new way of thinking in order to overcome the challenge of working capital,” says Fabbrino.

In tackling the supply chain redesign Fruttagel chose to implement an EVA-based model in order to get a different and clearer view of the company’s operations, as well as to assess the impact of operational decisions on financial metrics and, ultimately, corporate strategy.

“The first part of the project was to rework the supply chain to reduce costs and change the company’s business model. We identified some actions to redefine the value of Fruttagel’s activities, such as how to change forecasting methods to reduce stock and packaging. We also found ways to reduce the cash flow demand of 80% of total turnover and increase earnings. We understood immediately that we needed a plan for those activities to happen and define how to invest in them,” says Bordignon.

“We decided to start with an EVA-based model to balance and integrate those actions into the company’s strategy. For instance, we understood that to focus on increasing revenues would have been bad for the company, as it would have reduced its ability to invest in innovation and new technology. EVA allowed us to identify staged changes to the company’s product mix and operational activities,” he adds.

Partnering EVA and CVA

Using EVA to link operational KPIs to financial KPIs has enabled Fruttagel to define links between measures such as forecast accuracy, stock value and total debt in a form that could be understood by both financial and operational people within the company. It now has a clear map of how operational changes will impact items on the company’s balance sheet, which allows decision-makers to better plan the supply chain in light of the organisation’s desired financial goals.

Fruttagel, under the guidance of Aprile, conducted a sensitivity analysis for each business scenario in order to understand the impact of velocity on goal achievement. This defines how sensitive the financial metrics are to changes in specific operational measures. With this analysis in mind it could establish a plan based on clear choices about what to change and when, in order to balance profit with financial coverage, value and operational effectiveness.

Scenarios emerged in which, for instance, Fruttagel could reduce working capital by up to 45% on raw materials and 30% on finished products, with a concomitant increase in profit of between 2% and 3%.

The next stage is to extend this plan to balance business opportunities with financial coverage and strategic investments. Already, however, the use of EVA has enabled the company to unearth investment opportunities that could dramatically affect supply chain efficiency. Fruttagel had, for instance, planned to construct an automated warehouse but had not had the financial coverage to do so. Using EVA, it revealed ways to free up the cash to invest in this project.

In essence, the new approach to analysis has radically changed how Fruttagel prioritises and plans its investments in a more effective way. This has not, however, been exclusively based on EVA. In extending standard financial indicators the company also chose to look at Cash Value Added (CVA). While EVA can help companies understand Value creation, it is weak in evaluating the impact of strategic investments. CVA sheds light on how much cash can be devoted to strategic investments.

“The EVA model is proven. The links between metrics are the same for every company, but what is specific is the sensitivity of financial metrics to operational actions. Nevertheless, we worked on a completely new model over four months that included CVA. This was to address the company’s ability to invest in innovation,” explains Bordignon.

“We are a manufacturing company, so we have to invest in order to follow the market. We need to increase cash flow and increase the amount of free cash we have to invest. That is not necessarily clear from the EVA model. We used EVA language to describe the company and provide a different perspective on operational decisions,” adds Fabbrino.

While the implementation of the model is ongoing, the ability it has given the company to release cash within the organisation to invest in innovation and new technology has had an immediate impact. As a result, EVA and CVA are now firmly established as the basis for Fruttagel’s three-year business plan.

Creating a common language

For EVA and CVA to work as tools for analysis it is crucial that they be understood throughout a company. Only when the links between operational and financial metrics are comprehensible to managers at every level will this model have a beneficial impact on operational decisions. A key challenge, therefore, is to equip managers and their teams with a new language to define their business plans.

At Fruttagel, this process of education has been relatively easy, largely because it has been based on models that use the company’s historical data. Managers have, therefore, been learning the new language in a context they fully understand. The ultimate goal is for the CFO, the COO and the supply chain manager to understand how their activities impact each other.

“The shift to the new language has been easy because we started from the operational perspective, not the financial perspective. You need to link everyone together – the CFO, the COO, the supply chain manager and so on. So, every manager must understand the new language. Then the CFO can understand the impact on debt of the work done by people doing forecasting, the supply chain manager can understand the impact of his process on debt and the value of the company,” says Bordignon.

For Bordignon, the key message in implementing a model in the way Fruttagel has is that EVA, while a useful starting point, is not the complete solution. The success of this implementation is due to a balance of three points of view: EVA, CVA and traditional financial metrics.

Together, these measures provide a 3-dimensional view of the company and provide the language in which operations can understand the needs of finance, and vice versa.

If this balance can be successfully achieved, the effects can change a company’s strategy in the most fundamental way and reveal tangible business benefit.

“EVA is not usually part of the Italian manufacturing culture. It is a new language for the whole company and we will increase this sensibility in the future,” says Fabbrino. “The commitment has been built in the company. As CEO, I have taken control of the project because it is a strategic issue for us.”