ECONOMIC VALUE ADDED & PROFITABILITY ANALYTICS

During a meeting the other day the topic of Economic Value Added came up. Surprisingly, it solicited quite a few negative responses. One member of the group stated that “Economic Valued Added is a farce.” A professor in the group said, “I included Economic Value Added in my grad course work in the 90s when it was hot, but only because it was a hot topic. It is a band aid approach.” My take is a little different.

All business “fads” catch on for a while because they contain some element of truth that appeals to folks with a particular perspective. For example, the ABC promoted in the late 1980s and early 1990s addressed one-direction causality, but ignored the other 80% of the problems with the way people measure and use cost information. In my book, it was a “dud,” but it did contain the important truth that valid cost models must be based on causality.

Economic Value Added does contain certain “truths” that are important to Profitability Analytics. First, it emphasizes that investment matters. If the financial objective of an organization is a superior, sustainable return on investment, decision makers need to include the cost of investment in their deliberations. Second, profit reported on financial statements is misleading – the impact of what I call “The Deadly Virus of GAAP” must be corrected. Both of these “truths” have been incorporated into the Profitability Analytics model.

The third thing I like about Economic Value Added is that, when used as a means of determining incentive compensation, deferred bonuses can be lost if the performance metrics that determine that bonus don’t continue over a period of years. It helps discourage the “game playing” done by executives to maximize their short-term bonuses at the expense of long-term performance. It gives them an incentive to be “stewards” instead of “game players.”

The Profitability Analytics model – particularly the “Investment” Row of the Profitability Analytics model – raises three key points: 1) investments aren’t just in physical assets; they can be made in R&D, sales and marketing, HR and other areas, 2) depreciation expense is a dysfunctional and misleading measurement; some form of providing for capital preservation going forward should replace it, and 3) a cost of capital should be attached to the assets in activity centers so management can measure how well the use of those assets meets the overall ROI target of the organization.

What’s your take on Economic Value Added and its value to decision makers?