R

Economic Value Added

Handbook F-6 February 2001
Transmittal Letter

A. Explanation. This is a complete revision of Handbook F-6. Intended for use by

participants in the Economic Value Added (EVA) Variable Pay Program, this handbook
provides the mechanics of the EVA performance measurement and the EVA-based
incentive awards. This revision obsoletes Handbook F-6 dated August 1997.
B. Distribution.
1. Initial. This document is distributed to areas, performance clusters, and
Headquarters.
2. Additional Copies. You can download Handbook F-6 from the corporate intranet at
http://blue.usps.gov/cpim/ftp/hand/f6.pdf.
C. Comments and Questions.
1. Submit questions and comments about the content of this directive in writing to:
MANAGER BUDGET AND FINANCIAL ANALYSIS
US POSTAL SERVICE
475 L’ENFANT PLZ SW RM 8309
WASHINGTON DC 20260-5220
2. You may also send cc:Mail to “EVA Answer Line.”
D. Effective Date. This handbook is effective immediately.

Donna M. Peak Suzanne H. Milton

Vice President, Controller, Finance Acting Vice President
Employee Resource Management
 Contents

Contents

Chapters Page
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1-1 Handbook Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1-2 Why EVA? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1-2.1 CustomerPerfect! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1-2.2 Voice of the Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1-2.3 Advantage of EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1-3 Questions on EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 EVA — A Financial Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2-1 EVA Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2-2 EVA Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2-3 Net Operating Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2-4 Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2-5 Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2-6 Performance Cluster EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2-7 Area EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2-8 National EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2-9 EVA Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3 Managing With EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3-1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3-2 EVA Improvement Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3-3 Strategic Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3-4 EVA Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3-5 EVA Management Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Appendix A — EVA Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

A-1 Cost of Capital Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Appendix B — EVA Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

B-1 EVA Value Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
B-2 Calculating EVA for Operating Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
B-3 Income Statement and Capital Statement Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
B-4 Effect on Performance Cluster EVA of a Ten Percent Decrease in Fixed Assets . . . . . . . 24
B-5 EVA Schematic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

February 2001 iii

 Contents

Exhibits

Exhibit 1
The Relationship Between Equity Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Exhibit 2
EVA Value Driver Pyramid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Exhibit 3
Example Performance Cluster Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Exhibit 4
Example Performance Cluster EVA Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Exhibit 5
Example EVA Drivers Schematic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Exhibit 6
Example Detail EVA Drivers Schematic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Exhibit 7
Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Exhibit 8
Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

February 2001 v
 Introduction

1
Introduction

1-1 Handbook Organization

Handbook F-6, Economic Value Added, as revised, explains Economic
Value Added (EVA). This is a dollar measure that incorporates all factors
of financial performance — operating revenue generation, expense
control, and capital usage. National EVA funds the EVA Variable
Pay Program. Specific information on the EVA Variable Pay
Program is available in the EVA Variable Pay Program Management
Instruction (MI), MI EL-470-1999-6, Fiscal Year 2000 EVA Variable
Pay Program. MI EL-470-1999-6 is also available on the corporate
intranet at http://blue.usps.gov/cpim/ftp/manage/e470996.pdf and
http://blue.usps.gov/hrisp/comp/var-pay.htm. The Postal Service
reserves the right to make changes to Handbook F-6 at any time subject
to the obligation to consult with the management associations when
required to do so by law.

Each chapter explains a basic element of the EVA program:

H Chapter 1 explains why the Postal Service has adopted EVA as a
financial measurement tool.

H Chapter 2 defines EVA and basic EVA calculation and reporting.

H Chapter 3 shows how EVA is managed through the EVA driver

analysis process.

February 2001 1
Economic Value Added

1-2 Economic Value Added

Economic Value Added (EVA) measures operating performance, funds
the incentive credit, and when combined with CustomerPerfect!t goal
achievement, rewards employee performance.

1-2.1 CustomerPerfect!
The Postal Service implemented EVA as a way of managing our
business to meet the challenge of our increasingly competitive
environment. CustomerPerfect! has set three goals based on customer
needs and the competitive environment:
H Improve customer satisfaction.

H Strengthen employee and Postal Service effectiveness.

H Improve financial performance.

With CustomerPerfect!, the Postal Service is a more customer-driven

organization with products that provide the best value in America. Our
goal is to become a premier provider of postal communications. To
accomplish this, we developed a performance measurement that
focuses decision making equally on creating the best value for
customers, employees, and the organization. We adopted the following
three critical measures of our success:
H Voice of the Customer (VOC).

H Voice of the Employee (VOE).

H Voice of the Business (VOB).

This handbook focuses on the financial measure of EVA.

1-2.2 Voice of the Business

Voice of the Business measures financial performance. Initially, we
measured VOB success at all levels of the organization through
improvement in EVA. In FY 2000, we adopted other compensable
indicators for VOB in lieu of EVA. The VOB indicators are explained in
greater detail in the EVA Variable Pay Program management instruction
(MI EL-470-1999-6, Fiscal Year 2000 EVA Variable Pay Program). We
will soon publish technical and system aspects of EVA in a separate
handbook.

2 Handbook F-6
 Introduction

1-2.3 Advantages of EVA

National EVA is used to fund the incentive award program. EVA is also
calculated at the performance cluster and area levels.

Postal employees share in the financial successes measured by

national EVA and their organizational CustomerPerfect! goal
attainment. Employees are encouraged to build the value of national
EVA. To encourage sustained performance and promote continuous
EVA improvement, the incentive sharing with employees is paid out over
several years based on EVA results in those years. Accordingly,
long-term value enhancement is emphasized rather than short-term
actions that may improve current operating results to the detriment of
long-term value.

The advantage of EVA is that it is a single number that is applied across

the full spectrum of Postal Service operations. It makes financial
performance more relevant to all postal employees.

EVA emphasizes managing the whole business and creating value. Our
traditional focus on measuring annual performance against budget has
been transformed to recognize and include a measure of the returns
required on investments and operating performance. Management
attention is directed beyond short-term profitability to long-term return
on total assets and investments.

EVA directs our efforts toward growing our business and producing
long-term value through additional investments. It causes us to
challenge existing deployments of capital and turn our focus toward
continuous profitability improvement.

When linked to an incentive award system, EVA provides a measure to

evaluate success and a catalyst for continued performance
improvement. EVA links operating performance with customer
satisfaction and employee commitment because the funds generated by
national EVA are shared by Postal Career Executive Service (PCES)
and executive and administrative schedule (EAS) employees based on
their organizational CustomerPerfect! goal achievement. The benefits
of increased efficiency and improved service are passed on to our
customers through smaller and less frequent rate increases.

February 2001 3
Economic Value Added

EVA is a management tool to help all postal employees to do their jobs

better and, thus, the business runs more effectively. It is used to set
goals, measure progress, and to correct our course when required.

1-3 Questions on EVA

Employees should direct questions about EVA to Headquarters
Finance. Employees may also direct EVA calculation questions to the
cc:Mail address: EVA Answer Line. Questions on the EVA Variable Pay
Program should be directed to local personnel offices.

4 Handbook F-6
 EVA — A Financial Measure

2
EVA — A Financial Measure

2-1 EVA Defined

Economic Value Added (EVA) is a comprehensive measure of operating
performance. Put simply, EVA measures the change in financial worth
of an enterprise from one year to the next. It is a more comprehensive
financial measurement tool than net income (revenues minus
expenses) alone, because it includes the cost of the capital used to
generate that income. EVA is superior to other measures of financial
performance because of the following:
H EVA links the use of capital with unit financial performance and
provides a business focus for unit management.

H EVA provides an incentive to employees to minimize expense

and capital employed rather than to maximize the amount of
budget resources available.

H EVA empowers employees who are accountable for producing

maximum results and minimizing resources used.

EVA is calculated at the performance cluster, area, and national levels.

Since the beginning of FY 2000, EVA is not a compensable target under
Voice of the Business (VOB) because it funds the entire EVA Variable
Pay Program. Used in concert with the existing capital investment
approval process and a related incentive compensation system, EVA
becomes an evaluation tool for decision making by focusing on the
long-term costs and benefits of actions taken. It changes the focus from
short-term accounting results to long-term value creation. The impact of
each decision on EVA can be explicitly calculated. If the result improves
EVA on a long-term basis, then the action will benefit the Postal Service
and should be taken.

February 2001 5
Economic Value Added

2-2 EVA Formula

EVA measures what was earned over and above the cost of the capital
used. The national formula shown below explains it:

Unadjusted Net Operating Income

+/– Economic Adjustments (see Section 2-3)
+/– Indexing Adjustments (see Section 2-3)
= Net Operating Income
– Capital Charge (see Appendix A)
= National EVA

This formula is the essence of EVA — net operating income (NOI) minus
the cost of capital used to generate that income. The components of the
EVA formula are explained in sections 2-3 through 2-5.

The logo depicts the EVA drivers: revenue, expenses, and capital.

EVA

2-3 Net Operating Income

Net Operating Income or NOI is a means of expressing pure operating
results. In other words, financial results of NOI do not have the impact
of financing (borrowing), investing, or accounting adjustments, which
can distort a purely operational analysis. NOI is the amount of money
generated exclusively from operations.

To obtain such a measure of operating income, it is necessary to make

the following adjustments to net income reported in the Postal Service’s
financial statements.

6 Handbook F-6
 EVA — A Financial Measure

H Economic adjustments. Economic adjustments include

nonoperational costs, noncash accruals, capitalized costs, and
unusual costs. For example, we add the account, increase in bad
debt allowance, because this is a noncash accrual. We add the
account, capitalized research and development expense,
because it is capitalized. We add the account, inspector general
expense, because it was introduced after the 1997 base year for
EVA and is classified as unusual. We subtract from net income
amortized research and development because it is an expense.

Adjustments of this nature create a more objective representation

of economic operations than does the standard accounting
treatment for producing postal financial statements. Standard
accounting statements include nonoperating items and require
judgments regarding the future outcomes of current events.
Nonoperating adjustments are limited almost exclusively to the
national EVA calculation. The single nonoperating adjustment
affecting field units is described in section 2-6.

H Index adjustments. Indexing adjustments remove the effect of

rate increases and add the inflation index as determined by the
consumer price index for all urban consumers (CPI-U). Indexing
mitigates the impact of the rate cycle and our break-even
constraints. CPI is used as a proxy price cap and the focus is to
keep rates below the rate of inflation. Adjustments are calculated
using operating revenue.

2-4 Capital
All the economic resources invested in a business unit to enable it to
operate and create economic value are collectively referred to as capital.
For EVA purposes, capital is very broadly defined. It consists not only of
plant, property, and equipment (PP&E) but also the working capital
(cash, accounts receivable, inventories, minus short-term liabilities such
as payrolls and amounts owed to vendors) and certain other assets and
liabilities. For an enterprise to prosper, it must earn a return on its capital
investment in excess of the cost of capital.

February 2001 7
Economic Value Added

To facilitate capital management, capital statements are produced at the

performance cluster, area, and national levels. A briefing on capital
resources called capalloc.zip is available on the Finance home page on
the corporate intranet (http://blue.usps.gov/finance).

2-5 Cost of Capital

The cost of capital, expressed as a percentage, represents a minimum
acceptable return on the Postal Service’s capital investments.
Accordingly, we can view it as a target for creating value. The Postal
Service’s overall return on capital investments must meet or exceed this
rate to create economic value. An overall return on capital of less than
the cost of capital means that our capital resources have not been
optimally used. The cost of capital is assessed against capital employed
at the performance cluster, area, and national levels. The Postal Service
EVA cost of capital is currently 12 percent. The method used to develop
the cost of capital percentage is described in Appendix A.

2-6 Performance Cluster EVA

EVA is calculated for each performance cluster (i.e., an organizational
unit of the Postal Service). To calculate NOI at the performance cluster
level, a method to allocate revenue based on workload has been
developed. An allocation process is necessary to compensate for
revenue being recorded in one location and the work being performed
in various locations. Revenue is recorded on the Postal Service’s
account books at the post office where the mailer is assigned which is
usually, but not necessarily, the point of origin of the associated mail. The
majority of the workload associated with mail volume, however, is
incurred at the destinating end of the process. This disparity between
revenue recordation and workload necessitates a revenue reallocation
mechanism to “level the playing field” across geographic areas. Without
a direct relationship between workload and the associated revenue
credit, dysfunctional behavior such as competition between
organizational units for revenue might occur. The intent of reallocating
revenue is that all parties recognize that the Postal Service is a national
network and that success of individual units must not come at the
expense of the organization as a whole.

8 Handbook F-6
 EVA — A Financial Measure

Expenses for performance cluster EVA are essentially identical to those

found on the Postal Service Financial Report (PSFR) with one
exception. The financing component of lease expenses is deducted
from total expenses for EVA purposes. EVA is an operating measure,
and all leases include an embedded financing cost that is equivalent to
interest expense. Since this “interest” is not an operating expense, it is
inappropriate to include this expense in a calculation of net operating
income.

2-7 Area EVA

An EVA calculation is made for each area. Area EVA is essentially an
aggregation of the performance cluster EVA calculations within the area,
plus the expenses and capital of the area office and any organizational
units that report directly to the area office but are not a part of any
performance cluster.

2-8 National EVA

A separate EVA calculation is made at the national level. This calculation
comprises all area calculations and all Headquarters-related activities
and resources, including operating costs, such as air transportation and
unfunded retirement costs, that are charged at the national level only.

2-9 EVA Reporting

EVA is calculated on an accounting period (AP) basis to allow
employees to plot progress during the year. Evaluation of EVA is based
on year-end EVA calculations. The national EVA results and the
performance cluster and area EVA calculations are included in the
corporate information system, under Option 15, along with details of the
net operating income and capital calculations.

The Finance home page on the corporate intranet (http://blue.usps.gov/

finance) also reports EVA results.

February 2001 9
 Managing With EVA

3
Managing With EVA

3-1 Overview
The Postal Service has integrated Economic Value Added (EVA) by
making it available for managers and employees to use as a
comprehensive financial measure of performance. EVA incorporates
into the management equation the concept that capital has a direct and
measurable cost in all parts of the organization. To survive in an
increasingly competitive environment, the returns from capital invested
must exceed the cost of that capital. EVA helps managers explicitly
demonstrate those decisions that increase value and those that diminish
value. (See Appendix B, EVA Drivers.)

3-2 EVA Improvement Concepts

The objective of the Postal Service is to generate positive and growing
EVA. This is done in the following ways:
H Increase profitable revenue while maintaining expense and
capital levels.

H Reduce expenses while holding capital constant to produce the

same level of revenue.

H Increase revenue and hold down expenses using the same

capital.

H Achieve combinations of changes to revenue, expense and/or

capital management that increase net EVA.

The framework for using EVA analysis methods to make operating

decisions is simple: grow, operate, or harvest. These terms are
explained as follows:

February 2001 11
Economic Value Added

grow — Activities or products the Postal Service wants to grow are

those in which additional capital investments generate net operating
income in excess of the cost of capital.

operate — Activities or products the Postal Service wants to operate are

those that may not merit additional capital resources but can realize
better returns from the capital currently in use.

harvest — Activities and products the Postal Service wants to harvest

are those that neither gain from additional capital nor can be operated
to provide returns that exceed the cost of capital in the business.

3-3 Strategic Investments

Some decisions are controlled at the highest levels of the Postal Service.
Some investments consistent with the Postal Service public service
mandate may not be attractive if evaluated exclusively from an EVA
perspective. Further, there are organizational performance investments
that may not enhance EVA at the performance cluster level yet are
necessary for the good of the Postal Service as a whole.

Operating managers may be concerned that using EVA as a

decision-making tool discourages certain investment opportunities even
though the Postal Service benefits in the long term. For this reason the
Postal Service uses the existing capital investment review and approval
process to determine the economic basis for strategic and economic
investments. However, operating managers should understand the
impact of EVA because they ultimately are responsible for generating
EVA incentives. The impact of planned strategic investments is
incorporated into the Voice of the Business (VOB) goals.

3-4 EVA Drivers

EVA drivers are causal factors that create or destroy enterprise value.
Identifying the relevant Postal Service EVA drivers helps managers
determine the appropriate action to improve performance, create value,
and increase EVA.

12 Handbook F-6
 Managing With EVA

EVA drivers are classified in the following three primary categories:

H Revenue.

H Expense.

H Capital.

Altering one driver without altering the other drivers changes EVA. Each
EVA driver can be subdivided into specific, manageable levels of value.
For example:
H Increasing revenue and, at the same time, holding expenses and
capital constant increases EVA.

H Reducing expenses while holding capital constant and

maintaining the same revenue base results in productivity and
efficiency that increases EVA.

H Decreasing total capital invested (through a reduction of net

property, plant, and equipment employed in the business) with
revenues and expenses held constant increases EVA. Similarly,
increasing capital by investing in capital that returns expense
reductions greater than the cost of capital results in increased
EVA.

Appendix B provides an additional explanation of EVA drivers with an

example detailing the effects on EVA of a change in one value driver.

3-5 EVA Management Summary

EVA promotes accountability. Decisions can be evaluated within an EVA
framework to determine whether the decision increased, maintained, or
decreased EVA.

The EVA financial management and incentive system provides a

well-defined measurement that managers can use to assess the impact
of their decisions. Therefore, EVA provides an element of control and is
not subjective. It is self-funding because reserve accounts increase only
if there is positive EVA. It provides managers and employees with the
financial measurement tools and the personal and corporate
accountability to achieve continued success.

February 2001 13
 EVA Calculations

Appendix A
EVA Calculations

A-1 Cost of Capital Calculation

The cost of capital is the rate of return an investor in a business like the
Postal Service would expect to earn, compared with other investments
of equal risk. Therefore, investments the Postal Service makes in capital
should meet or exceed this rate if they are to provide value to the
business. At a minimum, the cost of capital must be earned if an
investment is to increase Economic Value Added (EVA).

Exhibit 1 graphically illustrates the relationship between increases in

equity risk and increases in required return.

Exhibit 1
The Relationship Between Equity Risk and Required Return

Return (%)

Premium

Risk-Free Rate

Risk (Beta)

The required return on any investment begins with a risk-free

investment — for example, long-term U.S. Treasury bonds. As risk
increases, so must the required return on investment. Thus, an
investment in a high-risk business must provide a considerable premium
over long-term Treasury bonds.

February 2001 15
Economic Value Added

As used in EVA, the cost of capital is determined using an implied level

of risk and a blend of debt and equity capital derived from peer group
analyses. Given the nonstandard capital structure, tax status, and
competitive posture of the Postal Service, a different approach was
required to determine an appropriate cost of capital.

A comparison of our own internal requirements for capital investment

returns and the level of other firms’ cost of capital indicates that a rate
of 12 percent is adequate for the Postal Service to ensure value creation
through EVA. This is the cost of capital rate we adopted for the initial year
of the EVA-funded incentive program. The Postal Service will review this
rate annually for changes in market conditions. The rate of return used
to calculate the cost of capital is communicated separately, along with
other aspects of the EVA program that are determined annually.

16 Handbook F-6
 EVA Drivers

Appendix B
EVA Drivers
This appendix provides a discussion of Economic Value Added (EVA)
drivers and how the drivers are linked to the decision-making process.

B-1 EVA Value Drivers

EVA drivers provide decision makers with the means to assess the
impact of business decisions on the economic value of a corporation or
business unit. By disaggregating the components of the EVA formula
(operating revenues, operating expenses, and capital charge) to a more
detailed level, managers can identify performance measures under their
direct control. Once identified, managers can focus on how these
measures affect, or drive, bottom-line EVA results.

Value drivers that may affect EVA, some of which are depicted in
Exhibit 2, may or may not have a direct dollar dimension. Inventory and
accounts receivable, for example, are quantifiable in dollar terms while
other drivers such as innovation may not have a definable dollar
dimension. EVA driver analysis requires decision makers to fully assess
the consequences of their actions, thus allowing managers to know the
business better in all of its value dimensions.

The EVA measure is derived from a combination of the financial

statements of an enterprise and the cost of capital invested in the
business. The combination of the income statement and capital
statement reflects enterprise growth, operating efficiency, and asset
management effectiveness.

February 2001 17
Economic Value Added

Exhibit 2
EVA Value Driver Pyramid

EVA

Asset Operating Growth and

Management Efficiency Rationalization

Replacement Delivery Time Vehicle

Cycle Maintenance New Product/Service
Cost Development
Product/
Overtime Customer Mix
Capacity Total Quality
Capital Utilization Management Higher Margin
Purchases Labor Cost Pricing Policy Products
Employee Mix
Cycle Time Network Selling for Value
Economics Procurement

EVA Drivers Pyramid

18 Handbook F-6
 EVA Drivers

B-2 Calculating EVA for Operating

Management
The components of EVA (revenues, expenses, and the capital charge)
define the primary driver categories. Within these categories exist the
entity-specific value levers that managers can use in the decision-
making process. The EVA equation for the operating manager follows:

Revenues
– Operating Expenses
– Capital Charge
= EVA

As previously noted, the EVA measure, and thus the drivers, are derived
from a combination of the financial statements of an enterprise and the
cost of capital invested in the business. The income and capital
statements in Exhibit 3 summarize the primary components of the
income and capital statements of a typical performance cluster and
provide the basis for the value driver decision-making example below.

The capital charge or the cost of capital invested is defined as:

H The rate of return expected on capital employed in any
investment of equivalent risk to that of the business.

multiplied by

H The amount of capital employed in the business.

A financial objective of every business is to undertake both projects and

investments that provide a return that exceeds the capital charges. The
goal for operating managers is to increase EVA by increasing revenues,
decreasing expenses, or decreasing capital charges.

February 2001 19
Economic Value Added

Exhibit 3
Example Performance Cluster Financial Statements

Capital Statement
Income Statement ($000s) (Average Balances) ($000s)
Total Allocated Revenue $ 232,599 Current Assets:
Operating Expenses – 205,393 Funds on Hand $ 1,033
Unadjusted Net Operating Income $ 27,206 Total Accounts Receivable 72
VMF Inventory 71
Total Current Assets $ 1,176
Net PP&E 41,394
Net Capital $ 42,570

As illustrated in the EVA formula, EVA equals revenue, less operating

expenses, less a capital charge. Exhibit 4 illustrates the EVA calculation
for a sample performance cluster. The calculation is based upon the
financial statements presented in Exhibit 5 with adjustments for
nonoperating expenses. The sample performance cluster generates
$27.2 million in net operating income (NOI) for the example fiscal year
and, based upon average capital employed during the year of $55.8
million, which includes the present value of non-capital leases, incurs a
capital charge of $6.7 million. The result for the year is the creation of
value (EVA) in the amount of $21.8 million.

Exhibit 4
Example Performance Cluster EVA Calculation

Net Operating Income Capital Charge

($000s) ($000s)
Operating Revenues $ 232,599 Avg Working Capital $ 1,176
Operating Expenses – 205,393 Avg PP&E 41,394
Unadjusted NOI $ 27,206 PV of Non-Cap Leases 13,234
Adjustments 1,323 Avg Capital $ 55,804
Net Operating Income $ 28,529 Less Cost of Capital % × 12%
Capital Charge $ 6,696

EVA
($000s)
$28,529 – $6,696 = $21,833

20 Handbook F-6
 EVA Drivers

B-3 Income Statement and Capital

Statement Components
The EVA calculation as illustrated in Exhibit 4 can be outlined in a driver
schematic that illustrates reaction channels that managers can pursue
to create value. The schematic defines the drivers as the components
that, when changed, affect the income statement or capital statement
and, thus, EVA. Managers should focus on the value levers over which
they have control and which will result in the greatest impact in value to
the enterprise. For example, a manager focusing on expense drivers by
reducing controllable selling and general and administrative expense
will cause EVA to increase.

February 2001 21
Economic Value Added

Exhibit 5
Example EVA Drivers Schematic

Operating Revenue Operating Expenses

100.00% to 88.30% to
Operating Revenue = Operating Revenue
Income
Statement
Operating Expenses Interest Expenses on
* 87.73% to + –0.57% Non-Cap Leases to
Operating Revenue Operating Revenue

Capital Charge Net Working

* 2.88% to 0.06% Capital Charge to
Operating Revenue = Operating Revenue

Net PPE Capital

) 2.82% Capital Charge to Statement
Operating Revenue

Other Assets
= 9.39% EVA Margin + 0.00% Capital Charge to
Operating Revenue

Net Operating
$232,599 Revenue ($000s)

= $21,833 EVA ($000s)

Note: Sum of parts may not equal totals due to rounding.

The interaction between the income statement and capital statement

can be further reduced into controllable value drivers as depicted in
Exhibit 6 (e.g., working capital charge is a function of the cost of capital
and the day’s revenue outstanding of all working capital items).

22 Handbook F-6
 EVA Drivers

Exhibit 6
Example Detail EVA Drivers Schematic

Operating Operating Expenses

Revenue to
100.00% Operating 88.30% to Operating
= Revenue
Revenue

Operating
Expenses to Interest Expenses 1.62 Cash
87.73% Operating –0.57% on Non-Cap.
– Revenue + Leases
+ 0.11 A/R
12%
Capital Net Net Working 1.84 DSO = + 0.11 Inventory
Charge to Working Capital to
2.88% 0.06%
– Operating Capital  0.51% Operating = ÷
Revenue = Charge Revenue
364 Days
Net
0.54% Leaseholds
to Operating
Net PPE Revenue
2.82% Capital
+ Charge = 12%
Land to
+ 2.11% Operating
Net Revenue
Other Net PP&E to
Assets Facilities =
+ 0.00%  23.49% Operating 16.98% to
Capital Revenue = Operating
Charge Net Building
Revenue
+ 8.63% to Operating
Revenue

Net Leases
+ 5.69% to Operating
Revenue
Net
Equipment
+ 3.89% to Operating
Revenue Net CSE to
= 0.25% Operating
Revenue
EVA
9.39% Margin
=
Net PSE to
+ 0.75% Operating
Net Operating Revenue
Revenue
 $232,599 ($000s)
Net MPE to
Net + 2.90% Operating
Vehicles Revenue
EVA + 2.62% to Operating
$21,833 ($000s) Revenue
=

Note: Sum of parts may not equal totals due to rounding.

February 2001 23
Economic Value Added

B-4 Effect on Performance Cluster EVA of a

Ten Percent Decrease in Fixed Assets
Exhibit 7 illustrates how a change in one value driver — a 10 percent
decrease in total property, plant, and equipment employed in the
business — with all other factors remaining constant, affects EVA.

Exhibit 7
Case Study

Net Operating Income Capital Charge

($000s) ($000s)
Total Allocated Revenue $ 232,599 Avg Working Capital $ 1,176
Operating Expenses – 205,393 Avg PP&E 37,255
Unadjusted NOI 27,206 PV Non-Cap Leases 13,234
Adjustments 1,323 Less Avg Capital 51,665
Net Operating Income $ 28,529 Cost of Capital % × 12%
Capital Charge $ 6,200

New EVA
($000s)

$28,529 – $6,200 = $22,329

Increase in EVA
($000s)
New Old
$22,329 – $21,833 = $496

24 Handbook F-6
 EVA Drivers

B-5 EVA Schematic

The previous analysis in Exhibit 7 can be summarized in the EVA driver
schematic format of Exhibit 8. Components of the schematic that
changed due to the 10 percent decrease in property, plant, and
equipment are outlined in bold.

February 2001 25
Economic Value Added

Exhibit 8
Case Study

Operating Operating Expenses

Revenue to
100.00% Operating 88.30% to Operating
= Revenue
Revenue

Operating
Expenses to Interest Expenses 1.62 Cash
87.73% Operating –0.57% on Non-Cap
– Revenue + Leases
+ 0.11 A/R
12%
Capital Net Net Working 1.84 DSO = + 0.11 Inventory
Charge to Working Capital to
2.67% 0.06%
– Operating Capital  0.51% Operating =
Revenue = Charge Revenue
364 Days
Net Leaseholds
0.49% to Operating
Revenue
Net PPE
2.60% Capital
+ Charge = 12%
Land to
+ 1.90% Operating
Net Revenue
Other Net PP&E to
Assets Facilities =
+ 0.00%  21.71% Operating 15.85% to
Capital Revenue = Operating
Charge Net Building to
Revenue
+ 7.76% Operating
Revenue

Net Leases to
+ 5.69% Operating
Revenue
Net
Equipment
+ 3.50% to Operating
Revenue Net CSE* to
= 0.22% Operating
Revenue
EVA
9.60% Margin
=
Net PSE* to
+ 0.67% Operating
Net Operating Revenue
Revenue
 $232,599 ($000s)
Net MPE* to
Net + 2.61% Operating
Vehicles Revenue
EVA + 2.36% to Operating
$22,329 ($000s) Revenue
=

* CSE = Customer Service Equipment; PSE = Postal Support Equipment; MPE = Mail Processing Equipment

26 Handbook F-6
 Glossary

Glossary
area — For administrative purposes, the Postal Service is divided into
geographical territories called areas. The areas encompass the entire
domestic service territory.

balance sheet — An accounting summary of an organization’s assets,

liabilities, and net worth as of a certain date.

capital — Historical measure of the investment made in the operations

of the business. EVA uses a broader than traditional definition of capital.
For example, EVA capital includes expenditures undertaken to improve
future performance such as research and development (R&D) expense.

capital charge — An amount deducted from net operating income to

derive EVA. Represents a charge for the operating capital used by an
operation. Equals total average capital times cost of capital.

capitalization — Transformation of an expense into an asset.

cost of capital — The rate of return required to compensate investors

for investing in the business. It represents the rate of return that an
investor could earn by choosing another investment with equivalent risk.
It is also calculated using a weighted average of a firm’s debt and equity
capital.

deferred retirement costs — Postal Service employees are covered

under two retirement systems: the Civil Service Retirement System
(CSRS) and the Federal Employees Retirement System (FERS). FERS
is dynamically funded; in other words, the Postal Service pays as it goes.
CSRS is not dynamically funded; hence, CSRS incurs additional
liabilities each year as the sum of the contributions made by employees
and employer do not fully fund the future retirement liabilities created.

drivers — Specific causal factors that affect or “drive” EVA performance

results.

February 2001 27
Economic Value Added

fiscal year (FY) — An accounting term for a year that ends on a date
other than December 31. The Postal Service uses two types of FYs: a
government FY that ends on September 30 and a postal FY that ends
364 days after the close of the preceding postal FY.

net operating income (NOI) — Used in the calculation of EVA; equal

to all revenue from operations, less all expenses from operations.

nonoperating adjustments — For the EVA calculation, accounting net

income is adjusted by removing all nonoperating items. For the Postal
Service, these adjustments include items such as OBRA expense,
interest income and interest expense, and noncash accruals.

OBRA — Omnibus Budget Reconciliation Act. Acts of Congress that

transfer costs from the federal government to the Postal Service.

ODIS — Origin–Destination Information System. A performance

measurement system used to record service transit times and mail
volumes between selected service territories.

performance cluster — An administrative unit used by the Postal

Service to assess performance. It is the smallest geographic area for
which EVA will be measured.

present value (PV) — A calculation that permits evaluation of

alternative financial actions by reducing future streams of cash flows to
a single number.

refinancing expense — A prepayment penalty charge taken by the

Postal Service in order to restructure its debt.

reserve account — An account maintained for each EVA program

participant containing the total accumulated incentive credits that have
not been disbursed. Reserve accounts are created to promote
sustained performance and continuous improvement.

revenue allocation — Because postal services are not always provided

at the point of revenue receipt, some method of estimating and allocating
the amount of revenue earned by areas and performance clusters is
necessary. EVA calculations use revenue allocations based on ODIS
volume flows and workload cost statistics.

28 Handbook F-6
 Glossary

self-funding — A descriptive term for an incentive program that creates

its own pool of funds available for payment solely through improved
performance. The EVA program is self-funding.

sharing ratio — The manner in which the incentive fund is distributed

among different employee groups. The ratio is higher for individuals in
employee groups that have greater levels of responsibility and have a
greater portion of their pay at risk.

strategic investment — Certain investments, necessary for the long

run and for the well-being of an institution, can have a short-run
diminishing effect on the amount of annual EVA. In the Postal Service
incentive program, these are evaluated on a case-by-case basis, and an
adjustment may be made to the EVA calculation so as not to penalize
appropriate behavior.

February 2001 29