Economic Profit (EP) is an old method that Stewart Stern & Co. reintroduced under the now more well-known name Economic Value Added (EVA). The purpose of EP is to indicate to what extent and where economic value is generated.
EP is defined as follows;
– Cost of Capital
= Economic Profit
A positive EP indicate that book value is increasing which over time will yield a positive shareholder value. A negative EP, however, indicates that the capital of the organization is being eroded, that is, operations are not profitable enough to support the cost of capital, or the organization has too much capital for its operations. This information is vital for any for-profit organization, yet it is remarkably few companies that employ the EP concept.
EP can become even more powerful in conjunction with Activity-Based Costing (ABC) as ABC ensures much better attention direction in cost management than any other cost management method. However, ABC stops at operating costs and ignores the cost of capital. Therefore, the combination of the two gives organizations revolutionary (as one of our customers described it) insight into their costs, the formation of costs and profitability.
Needless to say, this information is crucial for;
- Strategic decisions
- Product- and process design
- Product mix including pricing decisions
- Product life-cycle decisions
- Investment decisions