Driving Outperformance: The Power and Potential of Economic Profit

Abstract

A team of practitioners summarize actionable, research-based suggestions for overcoming barriers to effective corporate capital allocation in the current business environment. The authors studied more than 30 companies that use economic profit (EP) in executive compensation and found they materially outperformed their respective peers as well as the SPY ETF in terms of TSR.

Interviews with several CEOs and CFOs highlight the organizational benefits of an EP-based value management system, such as improved investment decisions resulting from an ownership mentality, shared language for value creation, and more meaningful dialog with investors. These same business leaders leverage an enterprise-wide focus on EP to facilitate cultural transformation toward better collaboration and strategic alignment.

The authors diagnose drawbacks in current EP usage and offer solutions to address the tendency to penalize new investments, especially in intangible assets like R&D, brands, and human capital. They also explain the need to decouple performance target-setting from operating plans and budgets.

The research uncovered essential managerial lessons for successfully implementing EP that include rigorous change management with visible senior leadership support for ongoing communications and adaptive training. To properly influence decision-making and shape behaviors, executives also need to integrate EP with key planning and resource allocation processes. And compensation committees should make deliberate choices about how to build EP into annual and long-term incentives.

To help support its recommendations, the article shares observations from several company leaders and a case study of CSX Corporation’s recent EP implementation. The authors anticipate more activist shareholder interventions, raising the stakes for senior executives to use EP to credibly articulate how they plan to achieve current results without sacrificing profitable future growth.

Keywords: Economic profit, Capital allocation, Transformation, Ownership culture, Incentive compensation, Investor relations, Working capital, Total shareholder return, Residual cash earnings, Value management, EVA