P 5-4: Economic Earnings A large consulting firm is looking to expand the services currently offered its clients. The firm has developed a new performance metric called "Economic Earnings," or EE for short. The performance and hence "a more rational platform for compensating employees and managers." The consulting metric is argued to be a better measure of both divisional performance and firmwide performance firm is seeking to convince clients they should replace their current metrics, such as accounting te income, ROA, EVA, and so forth, with EE. EE starts with traditional accounting net income but then makes a series of adjustments. The primary adjustment is to add back depreciation and then subtract a required return on invested capital. The consultants argue for adding accounting depreciation back because it is a sunk co It does not represent a current cash flow. For example, suppose a client has accounting net income calculated as: Client's Traditional Income Statement Revenues $5,700 Cost of goods sold (2,000) Gross margin $3,700 Depreciation (900) Selling, general, other (700) Interest (500) Earnings before taxes $1,600 Income taxes (40%) (640) Net income $ 960 Suppose the client has total assets of $6,000 and a risk-adjusted weighted-average cost of cap tal (WACC) of 25 percent. Then this client's EE is calculated as follows: Client's Economic Earnings Net income $ 960 Depreciation Capital charge* Economic earnings Total assets WACC 900 (1,500) $ 360 $6,000 25% Capital charge $1,500 Required: Critically evaluate EE as a performance measure. What are its strengths and weaknesses? P5-5: Performance Technologies