EVA A CATHARTIC CHANGE?!

Prof. Zhaoyang Gu Course 45-701

By: Neha Arya Marc Brands Anil Konjalwar Alok Satyawadi

EVA: North American Dermatology Division

We will first calculate the 1999 actual EVA retroactively and if our figure matches Vyaderms then we will use that method to calculate EVA for 2000 and 2001. 1999 EVA Calculation:
In 000s Operating earnings add R& D expense minus R & D amort. add ad expense minus ad amort. add goodwill NOPBT less taxes NOPAT 1999 20,000 20,000 14,972.8 45 41.34 2500 27530.86 7875 19655.86 In 000s NOA add cap R&D add ad expense add acc. goodwill Capital 1999 110000 34597.8 43.66 7500 152141.46

EVA = NOPAT [Capital * Cost of Capital] EVA = 19655.86 [152141.46 * 0.11] EVA = 2920.29 ~ 2920 Since this is the figure calculated by Vyaderm, we have arrived at the figures presented below using the same technique. The figures requested by Maurice Vedrine: 2000 EVA for the North American Division $31,361,000 2000 EVA bonus payout - $252,000 2001 EVA for the North American Division $(6,587,000) 2001 EVA bonus payout - $0 The numbers used for the calculation of division EVA are presented in Exhibit 1. These were used to arrive at the report given in Exhibit 2. The methodology and assumptions for 2001 are outlined in Exhibit 3. As is evident from the ending bank balance of the manager for 2001, not only will she not get any bonus for the year 2001 but will have to work off the negative balance for the year 2002 and onwards. However, the lump sum she gets in 2000 is very large compared to her usual annual bonus. In fact it is more than 4 times her bonus in 1999. Since she knows her bonus may not materialize for many years (it depends on factors that are not entirely in her control), whats stopping her from taking the bonus this year and quitting the next? The current system is obviously flawed but not irredeemably so. One suggestion is having a cap and a threshold for bonus payouts of exceptionally good and bad years respectively. This does not mean that the managers earned bonus will be capped for good years, it will just stay in his bonus bank. Similarly for really bad years some threshold payout will still be made and in case the bank balance is zero or negative it will be treated as a loan from

the company which has to be paid back interest free, the manager will have the option of refusing this loan. The next sections deal with a thorough analysis of EVA at Vyaderm and our recommendations based on the above anomaly in the system.

The Merits of EVA: An Evaluation

To evaluate the claims made in the Executive presentation, we have looked at all six claims individually and tried to analyze each in the context of Vyaderm. The first three points are related to the traditional system. 1. Caps limit incentive for exceptional performance Agree o Once a salesperson/manager achieves their cap, there is no incentive to go beyond the cap. Though there is no explicit reference to how the caps were set in Vyaderm, but the case does mention that the old compensation system included an annual bonus. 50% of the bonus was based on objective operative results. The other 50% was based on subjective evaluation of the managers personal contribution. Furthermore, an inherent flaw in the system was managers spending more time negotiating the subjective part of their bonus rather than worrying about generating more profit. But o Caps are negotiated targets between owners and managers. The systems might actually work if they are set-up sensibly. For a manager who has been consistently meeting/exceeding her targets, the targets could be revised appropriately to keep her challenged. As shown in Exhibit 4, the cap does not need to be a flat line starting from point X, as seen in Figure 1. It could be set to have a gradient (Figure 2) after achieving a certain target. 2. Thresholds encourage short-term decision making Agree o Just like a cap is a limit on the bonus axis, threshold is like a floor (opposite of cap) on the performance axis. Any situation where there is a good chance of not meeting the threshold levels, managers will have a very short-term vision. The natural tendency will be to make decisions that get them above the thresholds for that period and worry about future later. Again, referring to Exhibit 4, Figure 1, a manager at a performance level Z2, trying to meet a threshold (Y) will try to do anything to be at (Y). o For managers who are way below the threshold may just give-up and perform even worse. This refers to performance level Z1 in Exhibit 4, Figure 1. If the managers knew before hand that there was no possible

way to meet their targets (due to controllable or un-controllable factors like changing market conditions), they would have absolutely no incentive to maximize their performance. 3. Negotiated targets promote sandbagging Agree o Sandbagging is a technique managers use to smooth out their results and make their lives easier. It works when they know they are going to exceed quota in a given month, and rather than doing so, divert some of the sales to the next month. This way it is easier for them to reach their quota each month. But o The solution to the problem does not lie in the incentive scheme so much as in the sound day-to-day management by the sales manager. EVA based incentive program, to be introduced in Vyaderm in 1999, was to address some of these issues mentioned above. Though, as we see later in this report, it had its own problems. The next three points were deemed the positives of this system 4. Equity Like share fully in gains and losses Agree o According to Maurice Vedrine, EVA was a better way to demonstrate to the investment community that he intended to continue Vyaderms profitable growth. It seemed to do so as can be noted in the stock price spike after Oct 99. EVA, by definition, measures the extent to which a companys after tax operating profits cover the shareholders cost of capital. By coupling the employee bonus with EVA, Vedrine wanted every manager to share the responsibility of keeping the company on the path of growth. Every manager would be accountable for any gain or loss the company saw. 5. Unlimited upside and downside incentive Agree o As opposed to a capped incentive scheme, which has some limitations as identified in the previous section, EVA incentive scheme at Vyaderm had an unlimited upside or downside incentive. This was good for upside since a manager who was in a division that was performing consistently better, had an incentive to work even harder and make the division more profitable, which implied better EVA numbers, which in turn meant more wealth for the shareholders. But o Unfortunately, on the downside this does not produce good results. For a division that did not do well, this system could put it into such a big

hole that it would be difficult to come out for many years. The Diagnostic business ran into this problem in the first year of the implementation of this system. In order to correct the situation, Vyaderm executives had to give them a fresh start the following year, which set a very bad precedent for the other divisions. o The constant up and downs of bonus banks will have a negative emotional impact on staff morale and high turnovers may become a problem. o The base pays may have to go up to keep new recruits coming in. 6. Objective targets, not linked to budget negotiations Agree o Vyaderms old compensation system had annual bonus for all managers. 50% percent of that bonus was based on objective operating results, 50% was based on a subjective evaluation of a managers personal contribution. Furthermore, there was no explanation as to how the bonus amounts were calculated. By introducing EVA, Maurice was able to create more objectivity in the process. The entire company was divided into 4 EVA centers North America, Europe, Asia and Latin America). Each global group calculated its own EVA target. EVA targets for each EVA center were cascaded down to the individual operating units that comprised the division.

EVA-not a robust performance measure: Reasons Why

The point of a good performance measure is to measure based on the Managers Controllables. The central tenet of Responsibility Accounting. The EVA structure at Vyaderm does not do so. For example, a Regional Divisional Presidents bonus was a function of Global Business and Regional Business (weighted 50% and 50% respectively). Regional business would be in her control but the business in that geography would not and her bonus should ideally reflect that lack of control. This system holds the manger responsible for extraneous uncontrollables as well. What happened with the North American Dermatology Division was a one time only deal that had nothing to do with the performance of its managers. There is no need to reward them to such an extent and set a precedent. EVA is backward looking. It focuses on past performance rather than what managers are doing to create future shareholder value. The constant up and downs of bonus banks will have a negative emotional impact on staff morale especially if they can do nothing to control it personally. This system does not take into account this aspect of human psychology. Also, if the EVA Bank Balance has been negative for a couple of years, it will be really

difficult to get to a positive zone and could actually de-motivate managers, leading to employee turnover. EVA does not provide good line of sight. In the traditional compensation system, managers have a good line of sight of the performance measure. For example, A sales manager needs to boost period sales, an operating manager needs to cut down on fixed and variable costs etc. With the EVA structure this direct line of sight is lost and is replaced by EVA targets set at executive level. Translating EVA targets to day-to-day objectives could be difficult at lower echelons of management. Contrary to claims, the current EVA structure does not provide managers an incentive to perform above par because a significant portion of their bonus comes from Uncontrollables. Their utility curve will result in a point where their bonus is maximized vis--vis their effort and they will stick to this level. This is because additional effort will have such a small effect on total bonus (because of the Uncontrollables) that the cost of that effort will not be met. Sandbagging could still be an issue, although to a lesser extent. And that is because the solution to the problem does not lie in the incentive scheme so much as in the sound day-to-day management by the manager.

Recommendations
The introduction of the EVA system had some obvious positive effects on the stock price of the company. However they begin to fall after March 2000. We believe that the way the bonus is being calculated right now will not be accepted for long because of the various problems outlined above. We suggest assigning goal weights in such a way so as to measure Controllables to a maximum. This is presented in Exhibit 5. Please note that by giving more emphasis to EVA drivers we hope to measure more Controllables and provide better line of sight. An alternative to the above is simple reinstituting the original system with elements of EVA. This would look like figure 2, Exhibit 4.

EXHIBIT 1
NOPAT Operating earnings add R& D expense minus R & D amort. add ad expense minus ad amort. add goodwill NOPBT less taxes NOPAT 2000 51000 39000 20638.2 50 45.34 2500 71866.46 18,725 53,141 1995 10,673 2134.6 2001 20000 20000 22140.8 45 46.67 2500 20358.53 7875 12,483 1996 12487 2134.6 2497.4 1997 14610 2134.6 2497.4 2922 CAPITAL NOA add cap R&D add ad expense add acc. goodwill Capital Cost of Capital 2000 135000 52960 48.32 10000 198008.3 11% 2001 110000 50819 46.65 12500 173365.7 11%

R&D Expense

1998 17094 2134.6 2497.4 2922 3418.8

1999 20000 2134.6 2497.4 2922 3418.8 4000

2000 39000 2497.4 2922 3418.8 4000 7800 20638.2 113,864 60904.4 52,960

2001 20000

R&D Amortization under EVA Cumm. R&D 10,673 less cumm. amort. 2134.6 Capitalized R&D

23,160 6766.6

37,770 14320.6

54,864 25293.4

74,864 40266.2

2922 3418.8 4000 7800 4000 22140.8 133,864 83045.2 50,819

Ad Expense

1996 34 11.33

1997 38 11.33 12.67

1998 41 11.33 12.67 13.67

1999 45 12.67 13.67 15

2000 50

2001 45

13.67 15 16.67 45.34 208 159.68 48.32

Ad Expense Amortization under EVA Cumm. Ad expense less cumm amort. Capitalized Ad Expense 2000 EVA 2001 EVA 31360.5448 -6586.6915

34 11.33

72 35.33

113 73

158 114.34

15 16.67 15 46.67 253 206.35 46.65

EXHIBIT 2
($ 000s except bonus) Divisional EVA Calculation: Actual EVA EVA Improvement Goal EVA Target EVA Interval Profit & Loss: Income before following items: Research & Development Expense Consumer Advertising Expense Goodwill Amortization Net Income Before Tax Current Years-Income Tax Payments Balance Sheet: Net Operating Assets From Footnotes: Accumulated Goodwill Amortizabon Capital Charge for EVA Purposes Divisional Manager's Bonus: Base Salary Bonus Target Bonus Payout 1996 1997 1998 $ 1999 2,920 $ $ $ $ 2000 31,361 2,150 5,070 12,000 $ $ $ $ 2001 (6,587) 2,150 33,511 12,000

$24,694 $12,487 $ 34 $ $12,173 $ (4,260)

$ 31,512 $ 14,610 $ 38 $ 2,500 $ 14,364 $ (5,902)

$ 36,584 $ 17,094 $ 41 $ 2,500 $ 16,949 $ (6,807)

$ $ $ $ $ $

42,545 20,000 45 2,500 20,000 (7,875)

$ $ $ $ $ $

92,550 39,000 50 2,500 51,000 (18,725)

$ $ $ $ $ $

42,545 20,000 45 2,500 20,000 (7,875)

$66,949

79,000

93,220

110,000

135,000

110,000

2,500

5,000

7,500

10,000 11%

12,500 11%

$ 200,000 n.a. $ 60,000

$ $

200,000 60% 252,000

$ $

200,000 60% -

EXHIBIT 3
Year 2000 EVA = Net Operating Profit after Taxes - (Capital * Cost of Capital) EVA = 53141- ( 198008.3* .11) = 31361 Actual Improvement = This years actual EVA - Last years actual EVA Actual Improvement = 31361 - 2,920 =28441 EVA Performance = 1 + [(Actual Improvement - Improvement Goal) / Interval] EVA Performance = 1 + [(28441 - 2,150) / 12,000] = 3.2 Bonus = Target Bonus * EVA Performance Bonus = 120,000 * 3.2 = 384,000 Bonus payout = Max (0, Target Bonus + 0.5*Remaining Balance) Bonus payout = Max (0, 120,000 + 0.5*(264000) = $252,000 Bank Balance at the end of the year =132,000 Year 2001 EVA = Net Operating Profit after Taxes - (Capital * Cost of Capital) EVA = 12483- (173365.7* .11) = -6587 Actual Improvement = This years actual EVA - Last years actual EVA Actual Improvement = -6587 - 31361 =-37948 EVA Performance = 1 + [(Actual Improvement - Improvement Goal) / Interval] EVA Performance = 1 + [(-37948 - 2,150) / 12,000] =-2.3 Bonus = Target Bonus * EVA Performance Bonus = 120,000 * (-2.3) = -$276,000 New Bank Balance = 132,000 - 276,000 = -$144,000 Bonus payout = Max (0, Target Bonus + 0.5*Remaining Balance) Bonus payout = 120,000 + 0.5*(-144,000) but not to exceed bank balance therefore its zero Assumptions: Year 2001 figures are same as 1999 figures.

EXHIBIT 4

Bonus

Figure 1

Target Bonus

Y
Z1 Z2

Performance Bonus

Target Bonus

Figure 2

Performance

EXHIBIT 5
Corporate EVA Business Unit EVA Global Business EVA Region EVA EVA Drivers

Corporate 9 MCOs staff officers corporate staff Global Business Global Staff Regions Regional division President Regional Mktg. Heads Regional staff Country Managers and Controllers Commercial Directors

100% 100% 50% 50% 100% 50% 25% 25%

50% 50% 50% 100% 75% 75%