Economic profits as a performance metric

Students in MBA 505 learn about pay for performance and economic profits.  Yesterday's WSJ reports that economic profits (total revenue less taxes, operating costs and the cost of capital) is increasingly being used as a metric in pay-for-performance plans.  In a recent PriceWaterhouseCoopers survey, 27% of the respondents said they were using economic profits, whereas only 19% were using stock prices. 

Why are economic profits becoming more popular as a measure?  After all stock price is what shareholders should be caring about, so stock grants and stock options would be the best way to align the interest of managers and shareholders.  However, stock prices are a forward looking measure taking into account a wide range of variables, many of which are outside the realm of control for middle or even top managers.  Economic profits are an indicator of cash flow, a variable that is much easier for managers to control, either through increased revenue or lower cost. 

One thing Pepsi and Coke have in common is that both reward execs using economic profits as the basis for bonus calculations. 

Contrarian Advice for Businesses Serving the Poor

C.K. Prahalad argued in his classic HBR article that companies trying to serve the bottom of the economic pyramid must be high volume, low price and low margin operations.  Cornell prof and HBR blogger Erik Simanis questions this widely accepted wisdom.  Noting that operating costs in low income overseas markets often run well above expectations and that getting to scale takes much longer, Simanis argues that higher profit margins are absolutely necessary to build up the capital needed to take on the challenge.

Companies and those that criticize their efforts are not doing D and E consumers any favors by clinging to the low-margin philosophy, which is unable to generate economic returns that are competitive with alternative uses of a company's capital — the true benchmark of business success. Precious few of the ventures that failed to generate such profit levels have survived, leaving low-income consumers without access to products and services that could have improved their lives and stimulated economic activity in poor areas.