The relationship between profit-sharing/gain-sharing plans, productivity and economic value added

Journal of the Academy of Business and Economics, Jan, 2004 by Elizabeth Krauter, Leonardo Fernando Cruz Basso, Herbert Kimura

Martin & Petty (2000) point the following problems with these metrics:

1. The accounting profits and the cash flow are not equal, and it is the cash flow that is important for the creation of value for shareholders,

2. Accounting figures do not reflect the risk of operations, neither do they consider the cost of opportunity of equity and the value of money over time,

3. Accounting practices vary from one company to the next.

The companies are discovering that the traditional measures are not aligned with their cultures and their strategies. The search for better methods of evaluation is conducting companies to the adoption of measures of added value, that besides supplying a more consistent evaluation, align the objectives of the shareholders and of the executives (FLANNERY et al., 1997).

2.6.2 Value added measures. The two most widely known value added measures are Market Value Added (MVA[R]) and Economic Value Added (EVA[R]).

For value added measures, the company management is creating value when the returns obtained exceed all the costs, including the cost of equity (PETERSON & PETERSON, 1996).

Market Value Added (MVA[R]) is the difference between the market value of a company and the invested capital. MVA[R] reflects the present value of future EVA[R]s, discounted at the capital cost.

Economic Value Added (EVA[R]) is the operating profit less the cost of all the capital used to produce these profits (STEWART, 1999; YOUNG & O'BYRNE, 2001). It can be affected positively by an increase in operating profit without the need for an increase in the capital employed, and by the use of new capital in projects that yield higher rates than the total cost of capital. It can be negatively affected if the managers accept projects that yield less that the total cost of capital; and if the managers fail to accept project that yield more than the capital cost.

Ehrbar (1999) presents the following formula for EVA[R] calculation:

EVA[R] = NOPAT - C.(TC)

Where: NOPAT is the net operating profit after income tax; C is the capital percentage cost, and TC the total capital.

Since the total capital cost used for the EVA[R] calculation corresponds to WACC (Weighted Average Cost of Capital), the EVA[R] formula can be rewritten as follows:

EVA[R] = NOPAT - WACC.(TC)

Considering the standards employed in Brazilian literature, EVA[R] can be represented through the following formula:

EVA[R] = LO.(1-t) - WACC.(1-t).(AOL)

Where: LO is the operating profit; t the income tax rate; WACC the weighted average cost of gross capital and AOL the net operating assets (the difference between total capital invested and operating liabilities).

Productivity has always been considered a non-financial value creation driver. However, financiers have always encountered difficulties in establishing a clear connection between productivity and value creation (RAY, 2001).

According to Rappaport (2001), productivity is the basis for the creation of competitive advantage. A company creates competitive advantage when the value of its sales on the long term is higher than the total cost. When the market evaluates a company, it takes its long-term productivity generating capacity into account. Thus competitive advantage and the creation of value for shareholders are supported by productivity.