What's Wrong With Economic Profit
Economic profit, also called economic value added (EVA), is net operating profit above a dollar hurdle rate, or capital charge. There is no one way to calculate EP, which can be tailored to a particular business, but it generally includes all revenues in the periods in which they are earned, and all costs--carefully distinguished as either annual expenses or amortizable investments--in the periods in which they are incurred. The distinguishing feature of EP versus other profit measures is that it charges for the time value of equity used to generate profits.
In this regard, EP is as close to a perfect period-to-period estimate of value creation as one can get in an accounting-based metric. But since it is unfamiliar to most managers, directors, and investors, the measure comes with significant implementation, training and communication costs.
What's missing from EP/EVA Most profit measures fail to include all of the investment costs, and thus can encourage overinvestment. EP includes all investment costs, including the full cost of equity, and can, in certain circumstances, discourage investments in value creating projects if the returns significantly lag the timing of the capital charges. This problem can be easily overcome for regular investments that represent a core function of the business, such as new stores for an expanding retailer, with an appropriate amortization template. Tailored amortization could also be created for unique strategic investments, but these exceptional cases can create governance issues that compound the communications problem with regards to directors and investors. When it works EP works beautifully for capital intensive companies with an established pattern of investment and returns.
