Using Economic Profit to Assess Performance: A Metric for Modern Firms.

Publication: Business Horizons

Publication Date: 01-JAN-01

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COPYRIGHT 2001 JAI Press, Inc.

EP and other similar measures warrant the attention they have been receiving, particularly when supplemented by an appropriate non-financial measure.

Economic Profit (EP), Economic Value Added (EVA), Economic or Shareholder Value Increase (EVI or SVI), and other similar acronyms are becoming more and more popular for measuring and maximizing shareholder wealth. The calculation of these measures usually involves a number of adjustments to accounting data, but they are based on fairly simple concepts. Their displacement of accounting profits and widespread use in businesses seems surprisingly rapid.

The popularity of EP-type measures seems to be based on their contribution to solving the central problem of optimizing organizational architecture: Front-line personnel and first-level managers who have the best customer and operating information must be empowered and motivated to make decisions on maximizing shareholder value. Aligning shareholder, managerial, and operating personnel interests is a nontrivial problem that becomes more critical at lower levels of the hierarchy. Lower-level personnel generally find it harder than upper-level managers to relate to overall corporate profitability goals, but often have better information about business opportunities and related decisions. Moreover, losses or negative profits seem to receive more attention from front-liners than do shortfalls in profits from some target or goal. The internal use of EP-type measures can reduce such managerial and intra-firm agency problems by helping motivate people at all levels to make decisions that lead to returns in excess o f the cost of capital used.

This recent rise in the business use of EP-type measures is also consistent with the reengineering of the finance function away from a narrow technical role to that of a change agent. Contributing more widely to achieving strategic goals, the use of EP can also enlarge the role of finance by transforming corporate strategies into operating metrics useful for guiding and motivating managers and other employees. However, despite the importance of these measures in reducing intrafirm agency costs, this issue has received little attention.

What are the issues associated with the use of EP-type measures and their role in helping optimize the architecture of decision rights in a firm? What are their advantages and disadvantages? And how effective are they as internal performance metrics? For example, although they can be useful in reducing intrafirm and managerial agency costs, what about the need to ensure a focus on longterm value creation? Indeed, it is clear that the use of EP-type measures is not a substitute for continuing attention to the fundamental drivers of long-term value in a business. So how should a firm use EP and other such measures? And how should investors evaluate these efforts?

Economic Versus Accounting Profits

EP, SVI, and EVA all represent the net value added by the operations of a business over a given time period, usually a year. (A related measure, Market Value Added, or MVA, is often defined as the present value of future EPs.) Unlike accounting profits, all of these Firm Value Increase Measures (FVIMs) or Value Added Measures (VAMs) reflect the additional costs of both debt and equity capital used in operating the business:

EP = After-Tax Operating Income - [(Capital used) (Average cost of capital)]

Thus, they are simply revenues reduced by operating costs and the costs of all capital used in the business. The differences between accounting profits and these value-added measures reflect mainly differences in what constitute appropriate capital and its costs. Generally, EP-type measures also adjust accounting profits for a number of extraordinary items and focus more on economic value accounting than do accounting profit measures. In the interests of not contributing further to the proliferation of alphabet soup in this area, EP will represent all economic profit type measures--SVI, EVI, EVA, FVIM, and VAM-throughout the rest of this discussion.

Popularity of EP Measures. The widespread use of EP is clearly growing. Initially limited to the internal assessment of business performance and as a basis for designing incentive compensation systems, EP is now also used...

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