Business cycle accounting

Business cycle accounting is an accounting procedure used in macroeconomics to decompose business cycle fluctuations into contributing factors. The procedure was introduced by V. V. Chari, Patrick Kehoe and Ellen McGrattan but is similar to techniques introduced earlier. The underlying premise of the procedure is that the economy has a long run trajectory which is perturbed by various frictions. These are called wedges and the earliest version of the procedure includes a productivity wedge, a labor wedge, an investment wedge and a government consumption wedge. Business cycle accounting decomposes fluctuations in macroeconomic variables, such as GDP or employment, into fluctuations of each of these wedges (and their combinations).
Business cycle accounting has been done for various countries and various periods of time. The procedure suggests for the U.S. after World War II most fluctuation in GDP is due to fluctuations in the productivity and labor wedges.

Calculating EVA

EVA is Net Operating Profit After Taxes (or NOPAT) less the money cost of capital. Any value obtained by employees of the company or by product users is not included in the calculations. The basic formula is:

where:

• , is the Return on Invested Capital (ROIC);
• is the Weighted Average Cost of Capital (WACC);
• is capital employed;
• NOPAT is the Net Operating Profit After Tax, with adjustments and translations for the amortization of goodwill, the capitalization of brand advertising and others.

EVA Calculation
EVA = (r-c) x Capital
EVA = (r x Capital) – (c x Capital)
EVA = (NOPAT- c x Capital
EVA = operating profits – a capital charge
where: r = rate of return, and

c = cost of capital, or the weighted average cost of capital.

NOPAT is profits derived from a company’s operations after taxes but before financing costs and noncash-bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterest-bearing current liabilities.
Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested.
The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk.
Another perspective on EVA can be gained by looking at a firm’s Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.
EVA = (Net Investments)(RONA – Required minimum return)
If RONA is above the threshold rate, EVA is positive.