CONTRACTING FOR VALUE: EVA AND THE ECONOMICS OF ORGANIZATIONS

Abstract

EVA becomes more difficult to apply the farther down in the company you go, especially in organizations with more traditional “functional” designs. Because centralized functions are not independent self‐contained entities with direct control over their own revenues, costs, and capital, the performance measures used to evaluate them are necessarily incomplete; they reveal only part of the picture. For example, Marketing may increase sales and operating income—the measures on which it is evaluated—but at the same time drive excessive use of capital in the Manufacturing plants. Manufacturing may reduce unit cost through long production runs, thereby minimizing changeovers and setups, but create excess inventory in the process. Costreducing measures could also lead to declining quality and customer satisfaction, ultimately eroding the company's reputation. In short, each critical function influences results in other parts of the company, and focusing only on activities under a manager's direct control can result in myopic and misleading measures of performance.In organizing key processes as internal EVA Centers, joint costs and benefits shared by different corporate functions or business units can be built into financial measures in a way that encourages collaboration.As one example, a firm can attempt to replicate market forces internally by requiring each marketing region to contract for capacity with the internal manufacturing group. In a traditional management system, Marketing reserves (and relinquishes) manufacturing capacity at no cost; the consequence is excessive demand for resources. An internal pricing mechanism that requires Marketing to pay a fee for capacity will force its managers to assess trade‐offs as if it were contracting with an outside party.Such a system effectively requires that functional managers take a more company‐wide view of their responsibilities. By including the cost of capital, it forces managers to define costs more carefully. By including the impacts on other functions, it also forces a broader definition of costs. And by using multi‐year contracts among different divisions, the framework extends the time horizon over which costs and benefits matter.