Stratrix

Quick reference

Key formula / structure

Economic profit = profit - (capital used x expected return)

Memory aid

A profit is not a profit until it covers the cost of all the capital it uses.

TL;DR

Take the business's operating profit after tax. Add up all the capital it uses. Multiply that capital by the return its owners could expect elsewhere, and subtract the result from profit. What is left is economic profit: positive means value added, negative means value lost. Then ask which lever would raise it more, earning more or tying up less capital, and track it by business every year.

What Is Economic Profit?

Economic profit is profit minus a charge for capital. The charge is the capital a business uses, multiplied by the return its owners could expect to earn on that money elsewhere. If the profit is bigger than the charge, the business has added value; if it is smaller, it has lost value, even though it reports a profit. The idea is usually traced to Alfred Marshall in 1890; Stern Stewart popularized it in the 1990s as EVA.

There is everything sensible and nothing new in the idea that capital has an implicit cost -- an opportunity cost -- and that it is the return on capital that matters.

— Roger Lowenstein, "EVA: The Latest Economic Elixer," Wall Street Journal (February 13, 1997)

Most people judge a business by its profit, and the income statement helps them do it. It subtracts interest on borrowed money but nothing for the money shareholders have put in, so equity looks free. It is not. Economic profit fixes that by charging every dollar of capital, borrowed or owned, at the return it could earn elsewhere. The 1997 Wall Street Journal put the result in one line: EVA "equals a company's profit less what it would have earned with an 'expected' return on capital." The same article named the idea's appeal: "to express in a single number two concepts: net profit and rate of return." Written that way, the sum has two levers, not one. A business can raise its profit, or it can need less capital to earn the profit it has. The second lever is the one plans tend to miss: a company that ties up less money in inventory, plants and receivables pays a smaller charge on the same profit.

Economic profit in three lines

The sum the income statement leaves unfinished.

Profit

What the business earned

→

Minus the charge for capital

Capital used times the expected return

→

Equals economic profit

Value added, or value lost

Origin & context

A 2009 working paper by Roberto Ghiselli Ricci and Carlo Alberto Magni says the notion of profit above a normal profit "is usually traced back to Marshall (1890), presumably inspired by Hamilton (1777)," and that the term residual income dates from David Solomons in 1965, who used it for the income left "after covering a capital charge (opportunity cost)." The same idea goes by many names; as the paper puts it, "A huge number of synonyms have been coined to denote excess profit." The best known is EVA: in 1997 the Wall Street Journal reported that "Stern Stewart, a New York consulting firm, trademarked EVA as a tool for measuring business performance." For economic value added, the paper cites G.B. Stewart's The Quest for Value (1991).

Builds on: Alfred Marshall (1890), Principles of Economics, Macmillan (the usual origin of the idea, per Ghiselli Ricci and Magni, 2009); David Solomons (1965), Residual income, the term for income left after a capital charge (per Ghiselli Ricci and Magni, 2009); G.B. Stewart (1991), The Quest for Value (economic value added, or EVA, a name Stern Stewart trademarked); Roberto Ghiselli Ricci and Carlo Alberto Magni (2009), Axiomatization of residual income and generation of financial securities, MPRA working paper 14438.

Economic Profit in action

Dell

Shrinking the capital instead of growing the profit

In early 1984 Michael Dell started his company with about $1,000. He could not afford to build computers and stack them in a warehouse hoping someone would buy them. So he took the order and the payment first, then bought the parts to fill it. "Basically, we just didn't have any capital to mass-produce," he said later. The model was born of being broke, not of a grand plan.

The habit stuck as the company grew. By the strategy+business account of the late 1990s, Dell held about 12 days of inventory, against about 30 for direct competitors. And in the second quarter of 1997, the magazine reported, "Dell's return on invested capital reached 167 percent," nearly 10 times the industry average.

Stratrix's Take: that is economic profit's second lever in action. The sources give no cost of capital for Dell, so its economic profit cannot be worked out from them, and the case does not show Dell measuring it. But the arithmetic says why the model mattered. The charge for capital is capital times the expected return. A business that needs a fraction of its rivals' capital to earn its profit pays a fraction of their charge, and almost all of its profit is left over as value added.

The model outlived its origin, though not unchanged. Decades later Dell still collected cash before it paid its suppliers, but by then the gap came mainly from paying suppliers later rather than from holding almost no inventory.

Read the full story: Dell got paid before it paid its suppliers →

Using it in the room

Use it when capital is being handed out: the annual budget, a large capital project, a portfolio review, or a change to how managers are paid. It is most useful for businesses that report steady profits and have not been asked what their capital costs.

Questions to ask

  • ?How much capital does this business tie up, including inventory and what customers owe us?
  • ?What should that money earn, and does the profit cover it?
  • ?Would economic profit rise more from earning more or from using less capital?
  • ?Which adjustments to profit are we making, and would we make them if they lowered the answer?
  • ?Are managers here paid on profit, or on profit after the charge for capital?

The 30-minute version

Five minutes to agree the expected return. Ten minutes to list each business's profit and capital. Five minutes to compute the charge and economic profit for each. The last ten minutes on the two or three businesses whose ranking changed most once capital was charged, and the lever for each.

Core Components

1

Profit

The operating profit the business earns, after tax and before paying for its capital. Definitions vary, and how a company defines profit changes the answer.

Example

In the Wall Street Journal's example, the company earns $120.

2

Capital used

All the money tied up in the business: plants, equipment, inventory and the cash customers owe it, net of what it owes suppliers.

Example

$1,000 of capital in the same example.

3

The expected return

What the owners and lenders could expect to earn on that money elsewhere, often called the cost of capital or the hurdle rate.

Example

A 10% target.

4

The charge for capital

Capital used times the expected return. It is the line the income statement leaves off.

Example

$1,000 times 10% is $100.

5

Economic profit

Profit minus the charge for capital. Positive means value added; negative means the business earned less than its money could have earned elsewhere.

Example

$120 minus $100 is $20 of value added.

Warren Buffett, asked about EVA at Berkshire Hathaway's 1995 annual meeting, said: "I don't think it's a very complicated subject... . I didn't need [it] to know that Coca-Cola has added a lot of value."

When to Use Economic Profit

Scenario 1

Judging a business that reports a profit

Problem it solves: A unit shows a profit every year, and nobody asks whether the capital it uses could earn more elsewhere.

Real-world application

A finance team charges each unit 10% on its capital and finds one profitable unit that has not covered its charge in five years.

Scenario 2

Approving a capital project

Problem it solves: The project's profit forecast looks healthy, but it needs a large plant to earn it.

Real-world application

The board asks for the project's profit after the charge on the plant, year by year, before it votes.

Scenario 3

Choosing a business model

Problem it solves: Two ways of serving the same customers earn similar profits on very different amounts of capital.

Real-world application

A manufacturer compares building to stock with building to order and finds the second needs far less money tied up in inventory.

Scenario 4

Setting incentive pay

Problem it solves: Managers are paid on profit growth they can buy with more capital.

Real-world application

A company pays its unit heads on profit after the charge for capital, so a new warehouse has to earn its keep.

A pay plan with no charge for capital pays for value lost

The same 1997 article worked through Coca-Cola's 1995 grant of options on one million shares to its chairman: "If the stock rises 5% a year, he makes $36 million; at 10% a year (still less than Coke's 11% hurdle rate), $91 million." A reward that ignores the hurdle pays out even when owners earn less than their money should.

How to Apply Economic Profit: Step by Step

Before you start

  • →The business's operating profit after tax
  • →The capital it uses: fixed assets plus working capital
  • →An agreed expected return, or cost of capital
Tools:The income statement and balance sheet for each businessAn agreed cost of capitalA spreadsheet
1

Define the profit

Take operating profit after tax, before interest. Write down any adjustments, and apply the same ones every year.

Tips

  • ✓Keep adjustments few and explainable to a nonspecialist

Common mistakes

  • ✗Adjusting profit until the answer looks better
2

Count all the capital

Add up the money tied up in the business: plants, equipment, inventory and receivables, less what it owes suppliers.

Tips

  • ✓Include capital that belongs to the business even if another unit's budget carries it

Common mistakes

  • ✗Counting only borrowed money and treating the owners' money as free
3

Agree the expected return

Set the return the capital should earn, with finance, and keep it stable unless conditions change.

Tips

  • ✓Use one rate across units of similar risk so the comparison is fair

Common mistakes

  • ✗Arguing about the rate to the second decimal while ignoring the size of the capital
4

Subtract the charge

Multiply capital by the expected return and subtract it from profit. The result is economic profit.

Tips

  • ✓Show the profit, the charge and the result side by side

Common mistakes

  • ✗Reporting only the final figure, which hides which lever moved
5

Find the lever

For each business, ask whether economic profit would rise more from earning more or from using less capital.

Tips

  • ✓Look hardest at inventory and receivables, which grow without a vote

Common mistakes

  • ✗Only ever asking for more profit
6

Track it over time

Report economic profit for each business every year, and tie at least part of managers' pay to it.

Tips

  • ✓Watch the trend; one year's figure says little

Common mistakes

  • ✗Computing it once for a strategy offsite and never again

Showing the result

One slide for the board: each business as three bars, profit, the charge for capital and economic profit, ranked by the last. Mark the businesses whose rank changes most once capital is charged.

On the slide

  • ✓Profit, charge and economic profit side by side
  • ✓The expected return used, in one line
  • ✓The lever for each business that falls short

Left off

  • ✕Every adjustment to profit (put them in an appendix)
  • ✕Decimal places on the expected return
  • ✕A single company-wide figure with no breakdown

Value & Outcomes

Primary benefit

It shows whether a profit is big enough to pay for the money it uses, which a profit figure alone cannot.

Additional benefits

  • ✓Makes capital visible to managers who otherwise treat it as free
  • ✓Puts profit and return on capital into one number
  • ✓Shows a second road to value: using less capital for the same profit

What you'll learn

  • →How to compute economic profit from profit, capital and an expected return
  • →Why a reported profit can still lose value
  • →Where the definitions can be bent, and how to keep them honest

Typical outcomes

A ranking of businesses by value added, not profitA list of the businesses that have not covered their chargeCapital released from inventory, receivables or idle assets

Best Practices

📋 Preparation

  • •Agree the definitions of profit and capital before the first number is run
  • •Set the expected return with finance and keep it stable
  • •Compute it for every business, not only the ones under suspicion

🚀 Execution

  • •Show profit, charge and result side by side
  • •Ask which lever moved: profit or capital
  • •Keep adjustments to profit few, written down and the same every year

🔄 Follow-Up

  • •Report it every year by business
  • •Tie part of managers' pay to it
  • •Revisit the expected return when rates or risks change

💎 Pro Tips

  • •Look at working capital first; it is the capital nobody votes for
  • •Be wary of any adjustment that only ever raises the answer
  • •Use it to ask better questions, not to settle every argument
Pull both levers

When a business falls short, ask two questions, not one: how could it earn more, and how could it earn the same with less capital tied up?

Limitations & Pitfalls

⚡

The idea is not new, and branding it does not make it more precise. The 1997 Wall Street Journal called the underlying idea "sensible and nothing new."

Mitigation: Use the plain arithmetic, and be skeptical of anyone selling the adjustments

⚡

The answer depends on how profit is defined. The same article said Stern Stewart's changes to the definition of profit were "by turns sensible and dubious."

Mitigation: Write down every adjustment and apply it the same way every year

⚡

The expected return rests on contested theory. The article said Stern Stewart's rate relied on the capital-asset pricing model, and that "academics have shot the theory full of holes."

Mitigation: Pick a reasonable rate, keep it stable, and test whether the answer changes at a point higher or lower

⚡

It looks backward at one year. A business building something new can show negative economic profit for years before it pays.

Mitigation: Judge new businesses on milestones, and show their economic profit separately from established ones

⚡

As a stock-picking tool it adds little that simple ratios do not. The article's verdict: "a good idea -- if you can't divide."

Mitigation: Use it to run a business and allocate capital, not to pick shares

What comes before and after

Run first

Cost of capital →

Sets the expected return the charge is built on.

Unit economics →

Checks that each sale makes money before asking whether the whole business covers its capital.

Run next

Cash conversion cycle →

Shows how much capital is tied up in inventory and receivables, the second lever's first target.

BCG Growth-Share Matrix →

Decides where the money goes next, once you know which businesses pay for their capital.

Where this comes fromUsually traced to Alfred Marshall; popularized as EVA by Stern Stewart introduced this (1890).

Sources & further reading

More Management Frameworks

Other frameworks in the Stratrix library.

Business Models & Revenue

Value-Based Pricing

A pricing strategy that sets prices based on the perceived or actual value delivered to customers rather than on cost-plus margins or competitor benchmarking.

Business Models & Revenue

Platform Business Model

A platform business model makes money by connecting groups who need each other, such as buyers and sellers. Each side is worth more as the other grows, so one side is usually let in cheap or free. Which side pays is the real strategy: the side you charge is the side a rival can take.

Business Models & Revenue

Value Driver Tree

A value driver tree breaks a company's value into growth, return on invested capital and the cost of capital, then into the margins and capital beneath them. Its branches trade against each other, and its real use is to show which one a decision spends.

Business Models & Revenue

Subscription Business Model

A revenue model where customers pay a recurring fee (monthly/annually) for ongoing access to a product or service, creating predictable revenue streams and long-term customer relationships.

Business Models & Revenue

Razor-and-Blades Model

A business model where a base product (razor) is sold at low cost or given away, creating a captive market for high-margin consumables or complementary products (blades) that generate ongoing revenue.

Business Models & Revenue

Freemium Model

A pricing strategy offering a free basic version of a product to attract a large user base, then converting a percentage to paid premium versions with additional features, capacity, or capabilities.

Tools to try

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