Why Godrej Is Captivated by EVA

THEME/CASE STUDY

The Godrej brothers are on an EVA-ngelistic trail. In the past year or so, their corporate presentations, communiqués 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, seminars and shareholder meetings to spread the EVA word. Through words and deeds, they have convinced their employees that EVA is not just a cause worth following but it is as important to corporate well being as living is to mankind.

EVA, or economic value added, is a corporate performance measure that aligns employee incentives with shareholder 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 principle behind 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 looking closely at EVA, but has decided to go slow for the time being 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 PRINCIPLE

G Bennett Stewart III, who along with Joel Stern founded the New York-based Stern Stewart & Co, has said that EVA is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA, according to him, works on the principle that when managers employ capital they must pay for it just as if it were a wage.

Put simply, economic value is the net present value (NPV) of a firm's future free cash flows. However, as Joel Stern pointed out in a recent interview to IIM, Bangalore's Management Review, "the net present value of free cash flows does not give you a way to assess the quality of management on a year-by-year basis. It is not a good contemporaneous measure of performance". 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 company's management every year.

EVA is calculated by subtracting the weighted average cost of capital (WACC) from a firm's net operating profit after tax (Nopat). That's actually simpler than it sounds. While Nopat is a statistic readily available with all companies, calculating WACC is tricky. WACC varies from company to company and sometimes even from project to project and takes into account the opportunity cost of capital. At Godrej, the WACC for the properties business, for example, is different from the rest. The use of an appropriate WACC is critical to reap the benefits of EVA.

The top management is unanimous that the group has managed to give itself a sharper financial focus with EVA. Speaking at an Assocham-organised event in Mumbai a couple of months ago, Adi Godrej gave four reasons why the group adopted EVA:

* To improve capital efficiency and overall business performance

* To encourage greater owner-like and entrepreneurial behaviour among employees

* To reduce the "hockey-stick" feature in corporate plans and budgets (i.e. to even out performance), and

* To avoid "undesirable behaviours" seen in the previous multi-step variable bonus plan.

EVA allows companies to calculate the amount of real wealth that an employee generates and then links it with income incentives. The higher the EVA generated, the higher the income; uniquely, the higher the EVA generated, the greater is the likelihood 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 shareholders. 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 interest 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 decision taken, every step of the way. Says Hoshedar K Press, executive director and president, Godrej Consumer Products Ltd (GCPL): "EVA is the holy grail. Even day-to-day decision-making is geared to EVA."

The results are there for all to see, even though it is just a year 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 improvement in business performance.

Press says that EVA works because it removes all ambiguities 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 Godrej came back after a series of meetings and presentations with EVA experts Stern Stewart & Co and companies who had already switched to EVA. They were convinced that this was the future and that Godrej had to be in it. Explains Nadir Godrej: "EVA is the only financial measure that captures business performance with one measure." His faith in the system is complete and also infectious.

Press says that right from the beginning there was total commitment from the top. There was never any doubt in their mind that EVA was the best thing to happen to the group. This conviction 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 companies from the financial year beginning April 1, 2001. The Godrej EVA has a three-year horizon and the targets were set accordingly. The companies began the process of reorganising and streamlining their businesses to become EVA-friendly and ultimately EVA-positive - if they weren't already so.

Stern Stewart helped determine the cost of capital, identify centres for which individual EVAs would be calculated and applied their EVA drivers' analysis to the company's 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 managers and improving shareholder wealth and emerged as a clear winner when compared to compensation systems like ESOPs or the performance-linked variable remuneration that was being followed at Godrej earlier. Also, EVA forced everyone to think long-term because it operated with a minimum three-year horizon.

INITIAL SKEPTICISM

It wasn't a breeze though.

Initially, there were more skeptics than converts on the rolls. And the first task was to convert the non-believers into followers. 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 Industries, 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 targets 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 employee 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 possible 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 issues that we have educated employees about and taken care of," says Vaidya, who also points out that such issues have been minimal in the first year of operations.

Another EVA-ntage, if one gives in to the jargon, lies in 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.

EVA SCHOOLING

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

* To understand the concepts and definition of EVA

* To understand that capital is not free

* To understand that EVA-based decision-making works in creating value at the company

* To emphasise the importance of using drivers by involving people in their regular decision-making and performance monitoring of business/department/team

* To make employees see the control they have over key measures that ultimately impact the company's 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 product 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 C and D were higher credit periods with proportionately higher sales volumes. The managers were given the net operating profit before tax, the cost of capital and the tax rate and asked to make a choice. Once EVA was applied, 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 allowing executives greater play on investment decisions. This automatically removes all anomalies that result from decisions taken to meet short-term targets. Another advantage, points out Nadir Godrej: "EVA bonuses have no caps or floors and hence managers always have the incentive 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 payout 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 system that it replaced. Before EVA, Godrej followed a target-led incentive system known as performance-linked variable remuneration (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 targets 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 managers of the concerned department with Level 2 bonuses.

It was clear that this system was arbitrary and left plenty of room for disgruntlement. With EVA, Vaidya - and all his colleagues are unanimous on this - believes that this arbitrariness has been removed. Since EVA is like a graph where the incentives 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 Godrej had a story to tell about how a friend's 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, 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? Besides, a clear 'line of sight' is easily done for sales and marketing 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 after calculating EVA. What this shows and what the Godrej team is 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 direction to the group. Every employee knows what to do and how 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 schedule, there are two more years to watch out for before any decisive 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 expected to outstrip industry growth rates. Marketshare has gone up and debt is down to zero. Also costs are down and profits are expected 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.

BENEFITS OF EVA - AS SEEN BY GODREJ

Management

* Improvements in capital efficiency

* Greater focus on tax optimisation

* Greater focus on optimal capital structure

* Improved strategic and scenario planning

* More robust acquisition analysis tools

Motivation

* Long-term focus

* Greater alignment between shareholder and employee interests

Nadir Godrej points out that capital use has come down drastically in all group companies. "The unlimited bonuses have energised the group companies and many businesses have exceeded their targets leading to performances that are considerably 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 definitely is the result of the refocusing that EVA forced upon the organisation. Press says the group is slowing down annual increments 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 when employees actually face any diminution of pay due to severe underperformance in a bad market. But for now, Godrej's managers are fully captivated by EVA.

(This article appeared in the July 2002 issue of Indian Management magazine)