Reference no: EM132650875

A large consulting firm is looking to expand the services currently offered its clients. The firm has developed a new performance metric called "Economic Earnings." or EE for short. The performance metric is argued to be a better measure of both divisional performance and firmwide performance, and hence "a more rational platform for compensating employees and managers." The consulting firm is seeking to convince clients they should replace their current metrics, such as accounting net income. ROA. EVA. and so forth, with EE.
EE starts with traditional accounting net income but then makes a series of adjustments. The primary adjustment is to add back depreciation and then subtract a required return on invested capital. The consultants argue for adding accounting depreciation back because it is a sunk cost. It does not represent a current cash flow.

For example, suppose a client has accounting net income calculated as:

Client's Traditional

Income Statement

Revenues $5,700

Cost of goods sold(2,000)

Gross margin$3,700

Depreciation(900)

Selling, general, other(700)

Interest (500)

Earnings before taxes $1,600

Income taxes (40%) (640)

Net income$ 960

Suppose the client has total assets of $6,000 and a risk-adjusted weighted-average cost of capital (WACC) of 25 percent. Then this client's EE is calculated as follows:

Client's Economic Earnings

Net income$ 960

Depreciation900

Capital charge 1.500)

 Economic earnings$ 360

Total assets$6,000

WACC 25%

Capital charge$1,500

Question 1: Critically evaluate EE as a performance measure. What are its strengths and weaknesses?