Academic journal article Research-Technology Management

R&D in an EVA World: As a Valuable Financial Metric, Economic Value Added Reinforces the Role of R&D as an Investment in the Future of the Corporation

Academic journal article Research-Technology Management

R&D in an EVA World: As a Valuable Financial Metric, Economic Value Added Reinforces the Role of R&D as an Investment in the Future of the Corporation

Article excerpt

The valuation of R&D has been the subject of numerous publications (1) and recently, a comprehensive book by F. Peter Boer (2). Most of these publications use a variety of financial metrics such as net present value and return on investment. Some also treat the so-called "soft side," behavioral issues that are associated with applying such metrics to technology.

Economic Value Added, or EVA[R] (registered trademark of Stern Stewart & Co.), is a financial tool (3-6) that has been gaining adherents among company managers and investors (7). Fortune magazine called it "today's hottest financial idea and getting hotter" (4). The investment house Goldman Sachs cited EVA models as being "reliable indicators in 1) assessing overall enterprise performance, 2) identifying the primary drivers that enhance shareholder value, 3) determining the capital efficiency of a company, and 4) aiding the equity valuation process" (7c).

For the scientist, it is perhaps tempting to view EVA as simply one more in a long series of financial metrics. This is not the case, however. EVA fundamentally changes the accounting landscape by treating R&D as a strategic capital cost rather than an expense. In addition, it provides an accurate measure of value creation/ destruction. This enables the R&D manager to use EVA as a tool for strategic R&D portfolio management. Finally, EVA also has the potential to affect cultural issues surrounding R&D.

In Boer's book, EVA and the pros and cons of capitalizing R&D receive passing treatment (2, pp. 102-103 and 76-77, respectively). This is, perhaps, justified since of the thousands of corporations, only a handful use EVA. However, this number appears to be growing (3-7) and a diverse set of companies including Monsanto, AT&T, Eli Lilly, Briggs & Stratton, Coca-Cola, and Millennium Chemicals have been using EVA, both as a barometer for financial performance and as a cultural mantra (see listing, next page).

The purpose of this article is to introduce EVA to the scientist, engineer and R&D manager. Simple examples will illustrate the effect of R&D on EVA accounting and suggest ways in which R&D can be used to drive EVA growth. Finally, benchmarking across a series of EVA-driven companies is used in an effort to probe the cultural effects of EVA on R&D.

Economic Value Added (EVA)

The idea behind EVA is simply that a company is creating wealth (value) when it makes more money than its cost of doing business plus its cost of capital. From a more financial perspective, EVA is the company's net operating profit after taxes and after deducting a capital charge.

  EVA = NOPA T - CC, where
NOPAT = net operating profit after taxes and
   CC = capital charge
      = cost of capital x economic capital.

The merits of using EVA as a tool for decision making and financial evaluation have been presented elsewhere (3-7) and are only briefly summarized here.

EVA is a measure of a company's true economic profit. Thus, it can be argued that EVA reflects "economic reality" more accurately than traditional measures such as net operating profit, earnings per share, return on equity, and free cash flow. These measures reflect an "accounting reality" that can be more easily distorted by accounting practices.

Scientists and engineers are well aware of a simple example that illustrates the difference between "economic" and "accounting" reality. Consider the case of a short-sighted business manager whose bonus is driven by net operating profit. An easy way to increase net operating profit is to decrease costs. Since R&D is a relatively large cost center not directly associated with immediate sales, our business manager might be tempted to cut R&D and thereby quickly raise her net operating profit. This is the "accounting reality." However, by making such a move, she is likely to mortgage away part of the company's future. …

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