For the purpose of incentive compensation, there are basically two advantages of using EVA i.e. economic value adding as compared to the traditional use of GAAP earnings. We know that the Whole Food Market computes the EVA performance metric as equal to the NOI i.e. net operating profits after taxes less a charge for considering the cost of capital required to generate these profits.
The major difference in the GAAP earning and EVA as a performance metric is the non-operating losses and gains which is considered in the GAAP earnings, however it is not recognized in the EVA as it realizes the operating net profits. This reduces and completely erases the noise created by the non-operatingprofits and losses in the performance metrics, and hence make sure that the managers have their focus on generating operating profits for their performance building.
Moreover, another major difference is the realization of the cost of capital in the Eva based performance metric. It is important in this sense, that a regional manager, whose compensation is linked with the GAAP earnings, can increase its compensation through the increased earnings, or through reducing the operating costs, and by opening new stores. However, the opening of new store causes to incur cost of capital. However, the GAAP earnings does not realizes this part of the cost, i.e. the cost of capital, which has been incurred to increase the earnings. Moreover, it is necessary to note that the earnings would only be profitable if it is greater than the cost incurred to generate it. Therefore the realization of a charge of the cost of capital in the EVA is very practical and makes the store managers consider the cost as well while taking decisions.(VENANZI, 2011)
The Whole Food Market has mentioned in its proxy statement of 2014 that the stock prices are not being used as a factor in the annual cash compensation because of the reason that the fluctuations in the stock prices is not necessarily due to the performance of the executive officers, and there are various factors based on which the prices of the stock depends, which is necessarily not in the control of the executive officers. There are also other ways of encouraging executives for increasing shareholder value other than the annual compensation. It may include the mechanism of the stock grants, and stock options, where by one executive is made the shareholder of the company. As shareholder of the same company, the stock grants and stock options encourages the executives to work for increasing their shareholder, value and their interest are thus aligned with the interest of the shareholders.
At the Whole Foods Market, the EVA Economic Value Added measure, as mentioned above is based on the operating income or the operating earnings of the company. This provides the managers to use accounting tricks to increase the earnings part of the EVA. In many other firms, it is a common practice to erase the use of many of the accounting heads like liquidation profits, LIFO, and discretion of management over the bad debts which may distort the EVA computation. This type of adjustments make it less likely for the use of accounting tricks for the boosting of the earnings and consequently the bonuses.
The EVA bonus of the annual basis for a specific team is at first deposited in a pool, and after that a portion or part of that pool balance is paid to the executive on annual basis. The amount of the payout portion is dependent on the hundred percent of the pool up to the specified dollar amounts for a certain job, and a part of the excess. If it is the case the team member cash compensation is greater than the salary cap because of the payout amount of the team member, the excess amount above the salary cap is fortified however, the full payout amount is deducted from the pool. This is no doubt a complicated process, but its intention is to balance the payouts of the incentive compensation and the salary cap of the company.
For understanding the use of the EVA bonus pool for overcoming the tendency of the management to only focus on the short term, we can take an example of a certain manager. Assuming that the manager can boost its EVA by $100,000 through the cost cutting on the expense of advertising, the bonus for the manager will be $20000. However, only a portion of this EVA pool that is $5000 will be paid to him in that year. The remaining part of the payout pool is left for the possible payout in the next year that is $15000. The advertising expense cut down can affect the future earnings, and hence the future Eva of the company, and therefore affecting the bonus award as well. The remaining pool balance of the manager is at risk if the Eva balance is below the target point, therefore causing the managers to not take decisions, which are of only short term benefits, and may hurt the company in future.
The use of the weighted average of the six performance metrics in place of a single metric will encourage the managers to not fall behind in any of the factors that is important for the company and the shareholders of the company. This weighted average of the performance metrics allows the firm to assign the appropriate portion for the relevant performance metric that are important for the firm and its shareholders. Moreover, the managers would not be only focusing on a single factor, like increasing earnings and not focusing on the capital expenditures that may result because of the increased earnings. This mechanism ensures that the managers and executives focuses and works while keeping in mind all the important factors of the performance metrics that are designed as per the requirement of the firm and shareholder’s interest to keep guard on the interests, and profits of the company and the shareholders.