Economic Value Added: What It Means for a Family's Money

Most families keep two kinds of money in their heads. There is borrowed money, which costs interest and feels expensive. And there is their own money, sitting in savings, which feels free to spend. That second feeling is one of the most expensive habits a household can have, and a business idea called economic value added explains why.

Large companies once had the same habit. Managers treated the money their shareholders had put in as if it cost nothing, because nobody sent them a monthly interest bill for it. When they started charging themselves for every dollar of capital, including their owners' money, many of them saw their decisions in a new light. Nelson Nash, the author of Becoming Your Own Banker®, noticed the story and asked a simple question: what would happen if a family did the same?

This guide explains the idea from the start, in plain words. You will see how economic value added works in a company, why Nash used it, how to apply it to your own decisions with numbers you can check, where a participating whole life policy fits and where it does not, and the limits of the comparison. It is written by someone who is paid by insurer commissions when a policy is bought, which is worth knowing as you read.

What is economic value added?

Economic value added is the profit left after you charge yourself for all the capital a decision uses. It counts the cost of borrowed money and the cost of your own money. A result above zero means the decision earned more than its capital cost. A result below zero means it did not.

In business language, economic value added is operating profit after tax, minus a charge for all the capital used to produce it. The charge is the amount of capital multiplied by what that capital costs. For borrowed money, the cost is the interest. For the owners' own money, the cost is what those owners could reasonably have earned by putting it somewhere else. Economists call that an opportunity cost.

The formula fits on one line:

Economic value added = profit after tax minus (capital used × cost of capital).

Accountants have a close cousin of this idea called residual income. The version known as economic value added was developed and promoted by a New York consulting firm, which registered the name as a trademark and added its own adjustments to how profit and capital are measured. You do not need those adjustments to understand the idea, and a family never needs them.

The important word is "all". Ordinary accounting already subtracts the interest a company pays on its loans. What it usually does not subtract is any cost for the owners' money. So a company can report a profit and still be earning less on its capital than that capital could have earned elsewhere. Economic value added catches that gap.

How does it work in a company?

Take a company's profit after tax and subtract a charge for every dollar of capital it uses. The same profit can add value or destroy it, depending on how much capital it needed and what that capital costs.

Illustrative example, not any real company. A company earns $150,000 of operating profit after tax. It uses $1,200,000 of capital, part borrowed and part put in by its owners. Suppose that capital, taken as a whole, costs 9% a year.

• Capital charge: $1,200,000 × 9% = $108,000.
• Economic value added: $150,000 − $108,000 = $42,000.

The company earned $42,000 more than its capital cost. Now keep the same profit and suppose the company needed $1,800,000 of capital to earn it.

• Capital charge: $1,800,000 × 9% = $162,000.
• Economic value added: $150,000 − $162,000 = −$12,000.

The profit on the income statement is identical in both cases. In the second case, though, the owners would have been better off with their money somewhere else. That is the whole point of the measure: it puts a price on capital that would otherwise look free.

Figures are illustrative round numbers chosen to show the arithmetic.

Why did Nelson Nash write about it?

Nash saw a family version of the old corporate mistake. Families treat their own savings as free, so paying cash feels costless. He used economic value added to show that every dollar a family owns has a cost, and that ignoring it leads to poorer decisions.

In Part I, Lesson 11 of his book (page 21 of the fifth edition), Nash tells readers that they finance everything they buy. You either pay interest to someone else, or you give up the interest your own money could have earned. In the same lesson he turns to economic value added. He quotes a Fortune article by Shawn Tully, published in September 1993, which described the measure and put its heart in one line: "Earning more than the cost of capital is about the oldest idea in enterprise."

Nash's point was about behaviour. When companies began to charge themselves for all capital, managers stopped wasting the owners' money, because it no longer looked free. Nash thought families could learn the same lesson. A household that gives its own savings a price starts asking better questions before a purchase: what does this capital cost me, and what will it earn or save?

Nash then used the idea to support the financing approach he described in his book, known as The Infinite Banking Concept®, where a family builds capital in participating whole life policies it owns and finances purchases through advances from the insurer. That approach is covered in the cornerstone guide. This page stays with the measuring idea itself, because it is useful to any family, with or without a policy.

Why does your own money have a cost?

Because money you use for one purpose can no longer earn anything for another. If your savings earn 3% after tax and you spend them, you give up that 3% until you rebuild them. That lost earning is the cost of your own capital.

Think of $20,000 sitting in a savings account or a tax-free savings account. If it earns 3% a year after tax, it grows by about $600 in the first year. Spend it on a car, and that $600 does not arrive. Nobody sends you a bill. The cost is still real, because your family is $600 poorer at the end of the year than it would have been.

This is what economists call the opportunity cost. It is measured against the most valuable alternative you actually had, not against a dream. If the only realistic place for the money was an account earning 3%, then 3% is its cost. If you were about to pay down a card charging 20%, then the real alternative was 20%, and that is the cost.

Three rules keep the number honest:

• Use after-tax rates on both sides. Interest earned in a taxable account is reduced by tax. Interest paid on a personal loan is usually not deductible. Compare what you actually keep and what you actually pay.
• Use the rate for the use you would really make. Not the highest return you have heard of, but the realistic next use of that money in your family.
• Keep safety in the picture. An emergency reserve earns little, but it protects you from far more expensive borrowing when something breaks. Its value is not only its interest rate.

How do you calculate economic value added for a family decision?

Find the yearly benefit of the decision after tax, find the capital it ties up, multiply that capital by its yearly cost, and subtract. The result tells you whether the decision earns more than the capital it uses.

Here is the method in five steps.

1. Name the decision. A renovation, a car, a loan repayment, an equipment purchase for a small business.
2. Measure the yearly benefit after tax. Money saved, money earned, or a cost avoided. Use realistic figures you can check.
3. Measure the capital it uses. The amount of money tied up by the decision.
4. Price that capital. The interest rate if you borrow it, or the after-tax rate your savings would otherwise earn if you use your own money.
5. Subtract. Yearly benefit minus (capital × cost of capital).

Illustrative example: an energy retrofit. A family considers new windows and insulation for $20,000. The contractor estimates the work will lower heating bills by about $1,500 a year. Heating savings are after-tax money, because they are a cost avoided, not income earned. The simple yearly return is $1,500 ÷ $20,000 = 7.5%. Now look at three ways to find the $20,000.

Illustrative figures only. Rates are assumptions chosen for the arithmetic, not the terms of any lender or insurer, and a line of credit may cost less than a policy loan. This is a first-year view that ignores repayment, the life of the windows and any change in energy prices.

The same windows, with the same savings on the heating bill, add value in two cases and lose a little in the third. The decision did not change. The price of the capital did. That is exactly what Nash wanted families to see.

Illustrative example: paying off a loan. A family has $10,000 left on a car loan at 7% and $10,000 in savings earning 3% after tax. Paying off the loan saves about $700 of interest a year. Keeping the savings earns about $300 a year. The value added by paying off the loan is about $400 a year. Before acting, the family should ask whether it would still have an emergency reserve afterwards, because borrowing on a card after a repair bill would cost far more than $400.

What does it look like across a whole household?

Add up the interest your family pays to outside lenders in a year, and the earnings given up when you pay cash. That total is the yearly price of the capital your household uses. Economic value added asks how much of it your decisions actually earn back.

Illustrative example. A family looks at one year of statements. It finds about $1,400 of interest on a car loan, $900 on a credit card balance carried from month to month, and $700 on a line of credit. That is about $3,000 a year paid to outside lenders, before the mortgage. Over ten years, at the same pace, that is about $30,000, not counting what that money could have earned.

This is where Nash's two ideas meet. You finance everything you buy, and every dollar of capital has a price. A family that sees the whole price can decide, one purchase at a time, where its capital should come from and what it must earn. Some of that money may be better spent paying off the card first. Some may be better held as savings. Over years, some families choose to build part of it inside life insurance they own, which is the subject of why Nash said your premiums should match your income.

The point is not to make every choice with a calculator. It is to stop treating your own money as free.

How can a family start using this idea this month?

Start with one decision, not the whole budget. Write down what the decision brings in each year, what capital it uses, and what that capital costs. Do it for three decisions in a row, and the habit of counting your own money will start to form on its own.

Most people do not need a new spreadsheet. They need a short routine they can repeat. Here is one that fits on a single page.

1. List the capital you already use. Write down every loan, card balance and line of credit, with its rate. Then write down your savings and what each account earns after tax. This is your menu of capital, with a price on each item.
2. Pick the next decision. It can be small: a new appliance, a car repair, a course, or paying down a balance. Write down what it will save or earn in a normal year, in dollars.
3. Choose the source of capital on paper first. Look at your menu. Which source is cheapest after tax? Which one keeps your emergency reserve whole? The cheapest source on paper is not always the right one if it leaves you with no cushion.
4. Do the subtraction. Yearly benefit minus capital charge. Write the result, even when it is negative.
5. Decide, then note the reason. Sometimes you will go ahead with a negative result for comfort, health or safety. That is fine. The note keeps you honest about why.

Illustrative example. A family needs a $1,200 furnace repair. The card charges 20%, the line of credit 8%, and the savings account earns 3%. On paper, savings is the cheapest source, at about $36 a year of lost earnings. But the savings account holds only $2,000, and the family wants to keep a reserve. It uses $1,200 of savings, then sets up a payment of $100 a month back into the account for twelve months. The repair is done, the card is untouched, and the reserve is rebuilt within a year.

Nothing in this routine needs a policy, a professional or special software. It needs a pencil and the habit of asking what every dollar costs. Over time, the same routine shows where your household leaks the most interest, which is usually the most useful thing a family can learn from it.

Where does a participating whole life policy fit?

A policy can be one source of capital for a family, with its own costs and rules. An advance from the insurer carries interest, which belongs in the capital charge. The policy's cash value continues under its contract, but that is not a free return and it is never a reason to ignore the cost.

In the financing approach Nash described, a family builds cash value in participating whole life policies over many years. When it needs capital, it can ask the insurer for an advance secured by that value, and repay it on a schedule. Three facts matter for economic value added.

• The advance has a price. The insurer sets the loan rate and can change it. The interest is owed to the insurer. In the retrofit example above, that price is the 6% in the third row.
• The cash value stays in the contract. Borrowing against it does not remove it. The contract continues under its terms, and participating dividends, which are never guaranteed, may be declared. Some contracts treat borrowed values differently when dividends are declared, so the effect of a loan on your own policy is a question for the insurer.
• Building the capital costs money first. A new policy's costs weigh most heavily in the early years, and cash value available for a loan starts small. The capital has to be built before it can be used, which is why capitalization comes before use.

Tax is part of the price as well. Under section 148 of the Income Tax Act, a policy loan is a disposition, and the part above the policy's adjusted cost basis is included in income in the year you receive it. Interest on the loan is deductible only when the money is used to earn income, as the Canada Revenue Agency explains on its page about carrying charges and interest expenses. Ask your accountant before you borrow.

A policy is life insurance first. It belongs in a family's plan when there is a lasting need for life insurance, and never only because a spreadsheet shows value added.

What mistakes do people make with this idea?

The common mistakes are treating cash as free, comparing rates before tax, leaving out the costs of a policy, counting the same benefit twice, and forgetting safety. Each one makes a decision look better or worse than it is.

• Treating your own money as free. The original mistake. If your savings would earn something, spending them has a cost.
• Comparing rates before tax. A 3% savings rate in a taxable account is worth less than 3% after tax. A 7% loan rate on a personal loan costs the full 7%, because the interest is usually not deductible.
• Leaving out the costs of building capital. Premiums, the insurance charges inside a policy and its early years all belong in the picture when a policy is the source of the capital.
• Counting a benefit twice. If the cash value continues to grow while an advance is outstanding, that growth is part of the contract, not an extra profit from the purchase. Do not add it to the purchase's benefit.
• Using a dream rate. The cost of your capital is the realistic next use of that money, not the highest return you have read about.
• Forgetting safety. A reserve that earns little can still be worth a great deal on the day the furnace fails.

How is economic value added different from return on investment?

Return on investment gives a percentage. Economic value added gives the dollars left after the capital is paid for. You need both, because a high rate on a small amount and a modest rate on a large amount tell different stories.

Return on investment divides the benefit by the capital: the retrofit returns 7.5%. That tells you the rate, but not whether it beats the cost of the money. Economic value added subtracts the cost of the capital and leaves a dollar amount: plus $900, plus $300 or minus $100, depending on where the money came from.

A small project with a high rate may add only a few dollars. A large project with a modest rate above its cost of capital may add much more. Looking at both keeps a family from chasing high percentages on small sums while ignoring the large decisions that shape its finances.

What are the limits of the comparison?

A family is not a company. Its benefits are not always money, its risks are personal, and its capital must also keep it safe. Economic value added is a useful lens, not a rule that decides for you.

Companies measure economic value added with audited accounts, a defined cost of capital and a board that reviews the results. A family has none of that. Some of the most important benefits of a decision cannot be priced: a safer car for a teenager, a home that is warm, time with children. A negative result on paper does not mean a decision is wrong. It means you know what it costs.

Rates also move. The rate on a line of credit, the loan rate an insurer sets and the interest on savings can all change over the years, so a result that is positive today may not stay positive. And a household's capital has a job that a company's often does not: protecting the family in a bad year. Keep that job first.

What should you ask before using this idea?

Ask what the decision really saves or earns after tax, what the capital costs from each possible source, and what happens to your safety margin afterwards. Then ask the professionals who can check each part.

Questions for yourself:

1. What does this decision save or earn each year, after tax, in money I can check?
2. How much capital does it tie up, and for how long?
3. What would that capital cost from each source I actually have?
4. Will I still have an emergency reserve afterwards?

Questions for your accountant:

1. Is any of this interest deductible in my situation?
2. How is the interest my savings earn taxed?
3. If I use a policy loan, what is my adjusted cost basis, and would the loan create income?

Questions for the insurer or your representative:

1. What is the current loan rate, and how can it change?
2. How does an outstanding loan affect dividends on my contract?
3. What happens to the contract if the loan and its interest grow larger than the cash value?

What this page will not tell you

It will not tell you what rate your savings or your loans will carry, because those are set by your own accounts and contracts and they change. It will not tell you whether a particular purchase is right for your family, because the most important benefits of many decisions are not money. And it will not tell you that any policy or product adds value, because economic value added is a way to measure decisions, not a promise about any of them.

Who this does not suit

This way of thinking helps almost anyone, but acting on it with a life insurance policy does not suit everyone. If your family carries expensive debt from month to month, has no emergency reserve, or cannot count on steady surplus income in an ordinary year, the value added by paying down that debt and building a cushion usually comes first. A participating whole life policy suits a family with a lasting need for life insurance, a long horizon and money to set aside for years without strain. If that is not your situation today, the idea on this page is still yours to use, starting with the next purchase you make.