In an organization, you take up a project to ensure that it makes profits. Before you consider taking up a project, you evaluate it for its economic value added to the organization. Economic value added is an estimate of an economic profit, which is the economic value that a project creates over and above the capital investment by the organization. You can also define economic value added as the net profit after deducting the cost of investment.
You use economic value added by the project as a measure of its financial performance with respect to the residual wealth calculated after you deduct its cost of investment from its operating profits. Operating profit of a project is the profit after you adjust taxes on cash basis, also known as profit after tax. Therefore, economic value added is a true economic profit that a project makes for the organization. It is a surplus value created by the project over and above the investment the organization has made in the project.
To calculate the economic value added by the project to the organization, you can use the following formula:
EVA=Net Operating Profit After Tax-Capital Invested in the Project
If the economic value added from a project is negative, then the project does not generates any value against the investments that the organization makes in the project. However, if the economic value added from the project is positive, then the project generates value against the investment that the organization makes in the project. Always remember that the economic value added is calculated in monitory value and not as a percentage.
The main goal of the calculating economic value added is to measure the cost of investment in a project and assess if the project generates enough cash to consider if it is wise to make investments in the project. Note that the cost is the minimum revenue that the project must generate to make the investment of the organization worthwhile. Any positive value of the economic value added indicates that the project generates revenue more than the required minimum revenue. If the value is negative, then the project is not worth considering.
The calculation of economic value added by the project has the following advantages:
- Assesses the performance of the project.
- Indicates the success of the project.
- Establishes the idea that a project is profitable only when it creates wealth for the organization.
- Forces a project manager to be aware of assets and expenses of the project when making any decisions.
- Helps the project manager to decide on the project to be selected among the candidate projects. The project manager selects the project that has highest economic value added for the organization.
- This not only a tool to evaluate candidate projects, but also to monitor the progress of the project over its life cycle and make appropriate decisions.
The calculation of economic value added by the project has the following disadvantages:
- The calculation of economic value added is completely based on the cash invested in the project. It does not consider other investments in the project.
- It is mostly suitable for the mature organizations that are rich in assets and are stable.
- It might not suite the organizations that do not have tangible assets.