Economic Profit is a measure of the economic rent that is being enjoyed by a business. As such, it is the ultimate measure of business performance and value creation used in Managing for Value.
When is it useful?
Economic Profit is a better measure to use for strategic analysis than any P&L measures that exclude Invested Capital. It will bring more accuracy to the key strategic question of where a business really makes money, and what is the trend over time
The key concept to grasp is that capital is not free, and therefore should be taken into account. There are many different ways to calculate it, EVA or Economic Value Added being a popular one, but these debates can be safely left to accountants.
How do you do the analysis?
The starting point for calculating Economic Profit is Earnings Before Interest and Tax (EBIT). Apply an adjusted tax charge to get Net Operating Profit Less Adjusted Tax (NOPLAT). Finally,
deduct from this a notional capital charge, equal to Capital Employed multiplied by the cost of capital.
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