Q.3.

Which one do you prefer as the most rational base for measurement of profitability, sales, cost or capital employed?
Profitability, sales ,cost & capital employed are one of the most important factors that contribute to a organizations overall growth. The most appropriate measurement of these variables are Return on investment (ROI) and Economic value added (EVA)

Return on Investment - ROI

The return on investment ratio is a ratio of investments. The return is profit and investment on capital employed . It is determined as follows ROI=PROFIT MARGIN*CAPITAL TURNOVER = PROFIT___ 100 Capital Employed * The rate of return primarily reflects how effectively the available resources are being put to work. ROI is an important means of measuring management success in profitably investing companies assets .

Economic Value Added-EVA

One of the most dynamic performance measurements to account properly for all ways in which value can be added or lost is EP. Note: Economic Profit (EP) and Economic Value Added are synonymous. The ability to generate profit is no longer a test of profit adequacy. Ability to generate economic value added is the only test of profit adequacy. Any surplus generated from operating activities over and above cost of capital is known as economic value added. Thus EVA is, excess profit of a firm after charging cost of capital. A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".) The formula for calculating EVA is as follows: = Net Operating Profit after Taxes (NOPAT) - (Capital * Cost of Capital)

Economic profit is a residual income measurement which subtracts the cost of capital from net operating profits after tax generated in the business.

Economic profit will increase if: * New capital is invested in any project that earns more than the cost of capital. * Capital is diverted or liquidated from business activities which do not cover the cost of capital. * NOPAT increases without increasing the economic capital employed. Economic profits advantage is that it is the only performance measurement which links directly with the intrinsic value of the business.

Advantages of EP or EVA as a performance measurement

* By forecasting economic profit for each year it shows how much value will be added to the capital employed each year. * It is the only method that can clearly connect capital budgeting and strategic investment decisions with a methodology for subsequent evaluation of actual performance. * By forecasting economic profit amounts it automatically produces a series of targets for management to achieve in order to justify the valuation. * It can be readily communicated to and understood by operational management. * Through the computation of economic profit amounts economic profit creates a meaningful performance measurement which can be used to judge subsequent performance. (The cash flow performance of one business just cannot be compared with another). * For a project to be favourably considered, market value added must be positive. On the other hand free cash flow may fluctuate from positive to negative and back again over the life of the project. * Economic profit focuses managements attention on the fundamental three ways to create value. These are:* Improve profits without making a further investment in additional capital. * Only invest in projects where earnings exceed the cost of capital. * Dis-invest from projects where the savings on the capital cost exceeds earnings foregone. Discounting the benefits of these strategies in free cash flow terms makes them difficult to understand. * Because economic profit is a powerful overall measurement of managements performance, it is an ideal method for setting corporate goals, management incentives and the payment of performance bonuses. This cannot be achieved with cash flow. * It links planning to performance.....and performance to value.

Conclusion
The creation of wealth can be achieved in the real world through the use of economic profit as a performance measurement linking strategy to value. The managers of many well known international corporations have succeeded in substantially increasing the value of their business entities by using this valuable tool. The economic profit methodology can be applied to create wealth for the owners of businesses from the size of the corner store to that of the multi-national corporations. We are now able to use economic profit as a performance measurement which directly links strategy to value and is therefore the key to wealth creation.