EVA in Godrej

8/3/2019 EVA in Godrej

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THE GODREJ BROTHERS

are on an EVA-nge-

listic trail. In the past

year or so, their cor-

porate presentations, commu-

niqus and meetings have all

taken on the hues of a sermon

and not a single opportunity to

convert friends and employees

to their new practices has been

let by.

Adi and Nadir, brothers and

owners of the Rs 2,200 crore

Godrej Soaps conglomerate,

have used public debates, sem-

inars and shareholder meetings

to spread the EVA word.

Through words and deeds, they

have convinced their employees

that EVA is not just a causeworth following but it is as im-

portant to corporate well being

as living is to mankind.

EVA, or economic value

added, is a corporate perfor-

mance measure that aligns em-

ployee incentives with share-

holder interests. Developed by

global management consultants

Stern Stewart and Co, it was

adopted by the Godrejs about a

year ago. Ever since, EVA has become the guiding principlebehind every investment decision, product launch or cost cut

that the group has announced. Though the entire Godrej group

is enamoured of EVA, it is actually being implemented only in

the Godrej Soaps wing headed by Adi and Nadir Godrej. The

Godrej & Boyce group headed by Jamshyd Godrej is also look-

ing closely at EVA, but has decided to go slow for the time be-

ing in order to avoid sidelining some other key initiatives of

the group.

The six companies in the Godrej Soaps group that have

currently adopted EVA are Godrej Consumer Products

(FMCG: soaps and toiletries), Godrej Sara Lee (household

insecticides), Godrej Foods

(processed fruit drinks and

edible oils), Godrej Industries

(oleochemicals and medical

diagnostics), Godrej Properties

(property development) and

Godrej Agrovet (agribusiness).

THE EVA PRIN CIPLE

GBennett Stewart III, whoalong with Joel Sternfounded the New York-based

Stern Stewart & Co, has said

that EVA is the financial per-

formance measure that comes

closer than any other to captur-

ing the true economic profit of

an enterprise. EVA, according

to him, works on the principlethat when managers employ cap-

ital they must pay for it just as

if it were a wage.

Put simply, economic value

is the net present value (NPV)

of a firms future free cash flows.

However, as Joel Stern pointed

out in a recent interview to IIM,

Bangalores Management Re-

view, the net present value of

free cash flows does not give you

a way to assess the quality of management on a year-by-yearbasis. It is not a good contemporaneous measure of perfor-

mance. To create value for shareholders, a firm has to try and

add value year after year to reward shareholders. Economic value

added helps measure the contribution of the companys man-

agement every year.

EVA is calculated by subtracting the weighted average cost

of capital (WACC) from a firms net operating profit after

tax (Nopat). Thats actually simpler than it sounds. While

Nopat is a statistic readily available with all companies, calcu-

lating WACC is tricky (See box: previous story). WACC varies

from company to company and sometimes even from

I N D I AN M A N A G E M E N T n JULY 2002 35

T H E M E/C A S E S T U D Y

The Godrej Soaps group led by

Adi and Nadir Godrej says that

even in the first year it has begun

reaping the benefits of

implementing an EVA-basedincentive system. Four of the six

companies have improved on

stretch targets, and employees

have been rejuvenated with

whopping bonuses

A R U N D H U T I D A S G U P T A

IS CAPTIVATED BY

EVA

WH Y GODREJ


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project to project and takes into account the

opportunity cost of capital. At Godrej, the

WACC for the properties business, for exam-

ple, is different from the rest. The use of an

appropriate WACC is critical to reap the ben-

efits of EVA.

The top management is unanimous that the

group has managed to give itself a sharper fi-

nancial focus with EVA. Speaking at an As-socham-organised event in Mumbai a couple

of months ago, Adi Godrej gave four reasons why the group

adopted EVA:

l To improve capital efficiency and overall business

performance

l To encourage greater owner-like and entrepreneurial

behaviour among employees

l To reduce the hockey-stick feature in corporate plans and

budgets (i.e. to even out performance), and

l To avoid undesirable behaviours seen in the previous

multi-step variable bonus plan.

EVA allows companies to calculate the amount of real wealththat an employee generates and then links it with income in-

centives. The higher the EVA generated, the higher the income;

uniquely, the higher the EVA generated, the greater is the like-

lihood of dividend payouts to the shareholder. Thus what we

see is that every investment or purchase decision is aligned closely

to its real return and that, in turn, is in the interest of the share-

holders. Nadir Godrej sums it up thus: The Godrej group was

attracted to EVA because it is a well designed compensation

system that rewards employees while taking care of the inter-

est of shareholders.

Although it is defined as a compensation system, EVA goes

far beyond an incentive measure or a corporate performance

indicator. It penetrates the decision-making process and allows

employees to take stock of the merits and demerits of every de-

cision taken, every step of the way. Says Hoshedar K Press, ex-

ecutive director and president, Godrej Consumer Products Ltd

(GCPL): EVA is the holy grail. Even day-to-day decision-mak-

ing is geared to EVA.

The results are there for all to see, even though it is just ayear since Godrej began romancing EVA. By putting all

projects under the EVA scanner, Godrej has managed to

bring down its capital costs substantially. This not only

bodes well for the company in pure economic terms but is also

reflected in higher managerial incentives and payouts to

shareholders. The last year has seen the dividend paid out

per share rise steadily the first interim dividend was Rs 2 per

share and the second Rs 3.50 per share. Extra cash has

been ploughed back into the ongoing buyback of outstanding

shares. As for managerial incentives, the jump has been almost

two-fold for most employees and in a few cases it has increased

several-fold.

Adi Godrej says that four of the six SBUs have improved

even on stretch targets, while the other two showed some im-

provement in business performance.

EVA IMPROVEMENT FY02 OVER FY01(Rs crore)

Company Stretch targets Actuals FY02

Godrej Industries (1.0) (3.6)

Godrej Consumer Products 6.0 9.4

Godrej Sara Lee 12 13

Godrej Foods 8 9

Godrej Properties 4 2.4

Godrej Agrovet 5 1.6

Press says that EVA works because it removes all ambigui-ties from the decision-making process. Its beauty lies in the fact

that once it is worked out it can be understood and applied by

all from the executive director to the sales manager to the

salesman. It is transparent and benefits both the employee and

shareholder at the same time.

THE BEGINNING

It all began around March-April last year. Adi and Nadir Go-drej came back after a series of meetings and presentationswith EVA experts Stern Stewart & Co and companies who had

THEME/CASESTUDY

36 I N D I A N M A N A G E M E N T n JULY 2002

EVA has become the guiding

principle behind every investment

decision, product launch or cost-cut

that the group has announced

Adi God rej: EVA enabler


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already switched to EVA. They were convinced that this was

the future and that Godrej had to be in it. Explains Nadir Go-

drej: EVA is the only financial measure that captures business

performance with one measure. His faith in the system is com-

plete and also infectious.

Press says that right from the beginning there was total com-

mitment from the top. There was never any doubt in their mind

that EVA was the best thing to happen to the group. This con-viction converted many. And once Stern Stewart were called in

for the implementation, EVA soon became a battle cry. The

group decided that they would switch to EVA for all their com-

panies from the financial year beginning April 1, 2001. The Go-

drej EVA has a three-year horizon and the targets were set ac-

cordingly. The companies began the process of reorganising and

streamlining their businesses to become EVA-friendly and ulti-

mately EVA-positive - if they werent already so.

Stern Stewart helped determine the cost of capital, identify

centres for which individual EVAs would be calculated and ap-

plied their EVA drivers' analysis to the companys operations.

EVA drivers are a set of diagnostic tools that trace the creation

of EVA to individual financial and non-financial performance

variables and helps managers throughout the organisation focus

clearly.

According to Press, EVA serves

the dual purpose of rewarding man-

agers and improving shareholder

wealth and emerged as a clear win-

ner when compared to compensa-

tion systems like ESOPs or the per-

formance-linked variable remu-

neration that was being followed at

Godrej earlier. Also, EVA forced

everyone to think long-term be-cause it operated with a minimum

three-year horizon.

IN ITIAL SKEPTICISM

It wasnt a breeze though.Initially, there were more skeptics than converts on the rolls.And the first task was to convert the non-believers into follow-

ers. Winning over employees to bring everyone on board, the

group organised a series of training workshops. Consultants and

trainers from Stern Stewart were brought in and an extensive

six-month training schedule was drawn up.The first response was typical. Lots of questions emerged:

What do we gain from this? How can I be sure that this

system is not going to do me out of my dues? Dr S S Sindhu,

head, human resources, at Godrej Agrovet, who was in

charge of these workshops, says that we had to make it clear

that this was not an attempt to do employees out of their

dues. Initially, that was the greatest fear. C K Vaidya,

executive director, corporate (personnel) with Godrej Indus-

tries, says that the workshops made it clear that EVA was not

only a more equitable system but would also lead to far higher

payouts on achievement of targets. Once everyone saw that, the

road was smoother. It was also clear

to all that EVA did not penalise an

individual for the non-performance

of other members in his team. This

is done by setting individual EVA tar-

gets along with that of a team or a

business department. Press says that

specific targets have been set for

nearly 70 per cent of the employees.This means that almost every em-

ployee has an individual action plan

based on EVA.

The downside of atomising action

plans and targets to this level is that

individuals can play foul. It is pos-

sible that a sales force or one member of a team can decide to

pursue his or her goals at the expense of another. These are is-

sues that we have educated employees about and taken care of,

says Vaidya, who also points out that such issues have been min-

imal in the first year of operations.

Another EVA-ntage, if one gives in to the jargon, liesin the manner of distribution of the incentive payout under

a ratio predetermined through discussions between

employees and the management. A part of the EVA-linked bonus

is banked. That is, it is not paid out in the year of accrual.

Explains Vaidya: They are treated as a notional deposit

that acts as a buffer against a bad year. Every year, the

employee earns fresh EVA bonuses and draws from the

reserves that are building up in his account. This builds

loyalty and allows the company to forestall disgruntlement

in a year when the going may not be so good due to market

conditions.

THEME/CASE STUDY


EVA allows companies

to calculate the amount

of real wealth that an

employee generates andthen links it with

income

Nadir Godrej:a true believer


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EVA SCHOOLING

Once it was clear that EVA offered a better deal and that thecompany was committed to its implementation, the work-shops focused on five learning objectives. These were :

l To understand the concepts and definition of EVA

l To understand that capital is not free

lTo understand that EVA-based decision-making works in cre-

ating value at the company

l To emphasise the importance of using drivers by involving

people in their regular decision-making and performance mon-

itoring of business/department/team

l To make employees see the control they have over key mea-

sures that ultimately impact the companys EVA.

The programmes were peppered with case studies and

hypothetical situations that employees might face in the

course of their work. This was absolutely necessary for

the employees to make a mental connect with the concept of

EVA, says Vaidya. I must know what I can do to improve EVA

and what that means for me this is what we call a clear line of

sight, he says.

The workshops helped employees focus beyond EVA as an

economic concept by breaking it down into a

formula that they could use to take decisions

and improve their performance incentives. For

example, one of the training programmes looked

at a case where a manager has to decide on a

strategy regarding the credit policy for a prod-

uct where one had to choose from four options

with varying credit periods and sales volumes.

Option A was a low sales volume with no

credit. Option B was a short credit period with

a slightly higher sales volume and Options Cand D were higher credit periods with pro-

portionately higher sales volumes. The man-

agers were given the net operating profit be-

fore tax, the cost of capital and the tax rate and

asked to make a choice. Once EVA was ap-

plied, it was clear that they should go in for option C where the

volumes sold were not the highest but the credit period was 120

days and this was the point where EVA was being maximised.

EVA also liberated managers from the chain of yearly sales

and profit targets. It looks at a three-year horizon thereby al-

lowing executives greater play on investment decisions. This

automatically removes all anomalies that result from decisionstaken to meet short-term targets.

Another advantage, points out Nadir Godrej: EVA bonuses

have no caps or floors and hence managers always have the in-

centive to perform better. EVA plans are typically three-year plans

and there is no resetting of goals. Both these factors ensure that

there is very little gaming of their bonus plans. The three-year

targeting helps managers look at long-term goals instead of

short-term gains. Also, the way the targets are set ensures that

there is no limit to what can be achieved, and earned. The pay-

out is plotted like a graph against the EVA earned per employee,

hence he or she is encouraged to continuously improve his or

her EVA. If this did not convince employees, pitting EVA against

similar measures definitely did.

EVA VS THE REST

The EVA advantage was clear when compared to the systemthat it replaced. Before EVA, Godrej followed a target-ledincentive system known as performance-linked variable remu-neration (PLVR). Vaidya says that the PLVR was a hierarchical

system that set targets for profits and revenue. Under PLVR, a

system that the group followed for about five years, there were

three levels of performance. Level 3 was the base level, Level

2 was higher than base and Level 1 was the highest. At each

level, employees were set a revenue and profit target. Both tar-

gets had to be met for each level for a team to qualify for the

bonus payout.

There were two problems here. Firstly, the targets looked only

at profits and secondly the levels themselves were restrictive.

For example, Vaidya says that one year it so happened that a

particular business department exceeded Level 1 on the profit

target but was short of Level 2 in terms of hitting the revenue

target. We were not sure how to reward. The practice was to

give Level 2 achievers twice and Level 1 achievers four times

the amount fixed for the base level goals, says Vaidya. Since

both revenue and profit targets had to be met, the group, despite

its excellent profit performance, fell into the base level bonus

category. Finally the dilemma was resolved by rewarding man-

agers of the concerned department with Level 2 bonuses.

It was clear that this system was arbitrary and left plenty ofroom for disgruntlement. With EVA, Vaidya - and all his col-

leagues are unanimous on this - believes that this arbitrariness

has been removed. Since EVA is like a graph where the incen-

tives are plotted against the EVA earned, there is no limit to what

the employee can receive and hence no limit to his ambitions.

With the popularity of other incentive mechanisms like ESOPs

on the wane due to bearish trends in the stockmarkets, EVA had

even fewer competitors last year. Every second employee at Go-

drej had a story to tell about how a friends personal fortune had

been wiped out because a large part of his income was offered

through ESOPs. And then, as S S Sapre, vice-president, finance,

38 I N D I A N M A N A G E M E N T n JULY 2002

THEME/CASE STUDY

Every year, the employee earns fresh

EVA bonuses and draws from the

reserves that are building up in his

account. This builds loyalty and

allows the company to forestalldisgruntlement in bad times


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and company secretary of Godrej Consumer Products points out:

Only some of the Godrej companies are listed. So ESOPs were

never really an option for the entire group.

The workshops left no doubt that EVA was a better system

but what employees wanted to know was whether it was as good

in practice as on paper. One criticism levelled against EVA was

that it might actually cut out all future investments by the group

since it focused so sharply on value added for each investment.And what about investments with long gestation periods? Be-

sides, a clear line of sight is easily done for sales and market-

ing but what about departments like training and development?

These doubts were addressed head on. It was accepted that

there may be businesses where EVA would need to be adapted

to the Godrej or Indian conditions. Says Vaidya: Sometimes

there are strategic adjustments that we have to make. As for

investment decisions being put on hold, the past year has shown

that such fears were unnecessary.

The group is setting up a factory in Assam to take advantage

of the tax incentives on offer there the decision was taken af-

ter calculating EVA. What this shows and what the Godrej teamis keen to point out is that not all capital expansion is good. Any

investment must look at the cost incurred on capital. If this is

so high as to wipe out the returns then it is definitely not good

for the shareholder, and if it does not help the shareholder, it is

not good for the company. EVA helps clinch the decision.

LIFE AFTER EVA

According to Press, EVA has helped bring focus and direc-tion to the group. Every employee knows what to do andhow to go about doing it. As Vaidya says: Every employee has

an EVA action plan. For instance, a finance man will always

try to get a lower interest rate so that the WACC is improved

and a sales person will try and get the best combination of sales

and credit for the highest EVA.

This is the first year of EVA. According to the EVA sched-

ule, there are two more years to watch out for before any deci-

sive judgement can be made on its impact on the group. Still,

the improvement in performance last year has been dramatic.For GCPL, the growth in almost all categories but one is ex-

pected to outstrip industry growth rates. Marketshare has gone up

and debt is down to zero. Also costs are down and profits are ex-

pected to grow by nearly 30-40 per cent. EVA is 40 per cent higher

than the estimates made for the years before it was introduced.

Also share prices have been on the rise all through the year.

Nadir Godrej points out that capital use has come down dras-

tically in all group companies. The unlimited bonuses have en-

ergised the group companies and many businesses have ex-

ceeded their targets leading to performances that are consider-

ably better than other companies in the same industry, he says.

He adds that GCPL has reduced its working capital and is now

a negative working capital company which throws up large

quantities of cash. This allows for large and frequent dividends

and, ultimately, the shareholder is the beneficiary.

Some of this could be the result of a good year but some def-

initely is the result of the refocusing that EVA forced upon the

organisation. Press says the group is slowing down annual in-

crements and introducing a higher EVA component in the pay.

Also, the higher the management layer, the greater the variation

of the EVA. At the highest level, EVA could go to even more

than 100 per cent of pay and the least it could be is 40 per cent.

The performance of companies and the incentives paid out

last year are sure to bring many more converts into the EVA

fold. On the downside, the acid test for EVA will come whenemployees actually face any diminution of pay due to severe

underperformance in a bad market. But for now, Godrejs man-

agers are fully captivated by EVA.l


THEME/CASE STUDY

Managementl Improvements in capital efficiency

l Greater focus on tax optimisation

l Greater focus on optimal capital structure

l Improved strategic and scenario planning

l More robust acquisition analysis tools

Motivation

l Long-term focus

l Greater alignment between shareholder and employee

interests

BENEFITS OF EVA - AS SEEN BY GODREJ

Hoshedar K Press: holy grail

EVA in Godrej

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