Article Summary: Using Activity Based Costing and Economic Profit to Grow the Bottom Line

Using ABC costing management technique as well as Economic Profit or EVA can dramatically improve the financial health of a Company as it presents the real picture or the factsheet, as the ABC tracks the cost objects consumed in the activities and therefore the resources consumed in those activities, to know accurate individual overheads instead of simply relating on the volume. The ABC concept is defined as costing technique that takes into consideration both factors – the resource drivers as well as the activity drivers to determine the price of a product/service.

The objective of this summary is to show that using Activity based Costing model and Economic profit unlike traditional financial management techniques can affect the profitability of an Enterprise in a major way.

It should be realized that the profitability of a company does not alone rely on the sales of the product/services but also on the expenses involved in the production of that particular product/service. In a case study of an Automotive parts manufacturing Company located in Norway, it was proved that only a small percent of their product line had a positive Economic Profit and Return on Sales. In fact when Operational profitability and the Economic Profit of their product line were categorized and columned side by side, it was eye opening.

As the companies usually mix up the overheads cost with the direct costs it may not be ended up the accurate price setting method of the product, so a scrutinizing of accounts on Bill of Materials (BOM) should be done. It was found that the Company’s largest product line had a very low operational profitability which in turn gave a negative EP. To be honest, sale of such products should be discontinued. In another study conducted on the same products, the SWOT (strengths, weaknesses, Opportunities and threats) framework was employed. It was found that the products that generated a positive EP had more weaknesses than strengths.

So to conclude, we can say that Activity Based forecasting model combined with or without EP is an effective financial tool in the management of a company.

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Economic Value Added(EVA) Approach - Features, Advantages.

In present scenario the Economic Value Added(EVA) is becoming popular. 


Economic Value Added definition:
EVA (Economic Value Added) is basically the excess amount left on after making a proper charge for the capital invested in the business.  It different ways economic value added calculation can be done. They are, 


Different types of Economic Value Added (EVA) Formula are: 


1. EVA = NOPAT - C* x CAPITAL.
2. EVA = CAPITAL (r-c*) 
3.EVA = [PAT + INT (1-t)] - C* CAPITAL
4.EVA = PAT- Kc EQUITY


Where,
NOPAT = Net Operating Profit After Tax.
C*= Cost of Capital
CAPITAL= Economic book value of the capital invested in the firm.
r= return on capital (NOPAT/CAPITAL)
PAT=Profit After Tax.
INT+ interest expense of the firm.
t=Marginal tax rate of the firm.
Kc= Cost of equity.
EQUITY= Equity utilized in the firm.


Important Features and Advantages of EVA Approach:

• It acts as performance measure which is linked to share holder value creation in all directions.
• It is useful in providing business knowledge to everyone.
• It is an efficient method for communicating to investors.
• It transforms the accounting information into economic quality which can be easily understood by non financial managers.
• It is useful in evaluating Net Present Value(NPV) of projects in capital budgeting which is contradictory to IRR.
• Instead of writing the value of firm in terms of discounted cash flow, it can be expressed in terms of EVA of projects.

FYI: This approach was developed by Stern Stewart & Co, and later with different names like Peter Drucker referred it as "measure of total factor productivity",  feature magazine as "today's hottest financial idea and getting hotter"

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