The goal of calculating EVA is to determine true economic profit after taking into account the opportunity cost of capital invested.
For example, say you made a $20,000 capital investment in your company. Your operating profit, after taxes, is $10,000.
The opportunity cost of that investment, meaning the money you could have earned if you invested the money elsewhere, is 10%.
Your capital charge is $20,000 times 10%, or $2,000.
$10,000 – $2,000 = $8,000. Your EVA, or economic profit, is roughly $8,000. (Granted that was an intentionally simple calculation that left out a few steps, so all you accountants can hold your fire.)
The goal of EVA is to take into account the cost of capital invested in the company. If you have $50,000 and you invest that money in your company, you should receive a return… but you might not, at least not right away.
But if you instead invest the $50,000 in a CD yielding 4% you could earn $2,000 a year in interest. So, in EVA terms $2,000 is the cost of capital and should be deducted from your operating profits to show your true profit. The goal of EVA is to determine whether the company has generated a greater return on a capital investment than it could have received by investing the money elsewhere.
Here’s another example. Say you have $8,000 you plan to invest in website upgrades. You feel that investment will generate additional profits of $2,000 a year.
That sounds good, since you’ll pay off the investment in four years, but let’s factor in EVA.
You could invest the money in a CD yielding 4%. With a CD there’s no risk. You know you’ll receive that return.
There is risk investing the money in your website, though, because it’s impossible to know whether the upgrades will actually pay off. As a result you decide you need to make at least 10% on your investment because of the risk you incur. (Think of the 10% as a quasi-IRR.)
So you make the investment and do generate the $2,000 in additional profits you anticipated.
But wait; your cost of capital is $8,000 X 10%, or $800. $2,000 – $800 = $1,200; that’s your true economic profit. In those terms it will take six or seven years to pay back the investment after you factor in the opportunity cost. (Again, intentionally rough calculations. If you’re an accountant and you want to share a comprehensive example, feel free to do so in the comments.)
The goal of EVA is to answer this question: If I make an investment, will it generate profits that outweigh the risk, and truly add value to the company?
Unless you’re deciding whether to make significant capital investments in your company, that’s a question you probably don’t need to answer.
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JEFF HADEN learned much of what he knows about business and technology as he worked his way up in the manufacturing industry. Everything else he picks up from ghostwriting books for some of the smartest leaders he knows in business. @jeff_haden