Your company, division or product line is making lots of money. That’s good. But is it enough? And, for that matter, what does “enough” mean, anyway?
is when your economic profit exceeds your cost of capital.
I wrote at length about the cost of capital and how to measure it
. Simply stated, it is the weighted average of the cost of equity plus the cost of debt, with each component costed at current market rates.
Financial accounting does
charge for the cost of equity, so you have to take that out of your profits. Also, financial accounting charges for the cost of debt
at the rate your company borrowed, not today’s market rate. So, an adjustment needs to be made for that. This adjustment is most significant for term debt with fixed interest rates, including the rate fundamentally embedded in capital leases.
There are two other common ways financial accounting often differs from true economic profits.
The first is having the wrong depreciation period for fixed assets. For example, I worked with a high-end party rental company that amortized tables, chairs and assorted furniture over five years. Why five years? Because that depreciation rate was called for to do a tax return; only one depreciation schedule needed to be maintained.
This problem can surface in amortization rates for tooling and so forth. Also, the rate of depreciation may vary as the asset ages. A simple example is owning a car. The value drops a lot as soon as it is driven off the lot, then quite a bit the next year, but by less each successive year. So, if accounting uses straight line depreciation, the cost is understated in the early years and overstated in the later years.
The second common way is
when market rates or costs differ from what is used for accounting purposes. One example is when the rent charged to the operating entity by the real estate entity is below market, something that often occurs when the real estate has risen substantially in value. Another common example is when there is a dramatic change in price of the cost of goods (in either direction), but inventory is not adjusted accordingly.
Big companies have even more cost of capital pitfalls to be aware of.
Conceptually, markets give big companies a blended cost of capital based on the specific business units they may operate. A weighted average of sorts. Two things often happen. Companies delude themselves and think some or all of their businesses have a lower cost of capital than they really do. In the cases of particularly complex companies, investors often give up and just use a number. This is one of the reasons big companies may spin out business units — it allows investors to value the (now) two businesses at the proper cost of capital for each.
Likewise, and regardless of overall business size,
new products and ventures are riskier than core products. In most cases, these should also have a higher cost of capital.
Big companies have complicated profitability measurement system based on all sorts of allocations. This is further complicated by the desire to slice and dice by business unit, product line, customer and more. There are all sorts of tradeoffs that are made in these complicated measurement systems that, when used improperly, can give misleading results.
True cost of capital and economic profitability.
Given all of the above, how do I go about making business decisions? Consider these factors…
- Know your cost of capital. I refer you again to my earlier newsletter, but the easiest thing to do is to hire an expert, one with access to the needed market data.
- Use realistic depreciation rates.
- Keep things simple. Look at the true economic return periodically and as needed. Take the cost of capital into account when setting hurdle rates (of return) for new projects. Make other market-based adjustments as needed, too. Look at the true economic return of projects as part of capital or project reviews. (Read more here.)
- Translate the economic measures to accounting measures. For example, what approximate return on equity (ROE) is needed to make an economic profit? This means business units need to have a balance sheet for which they are responsible.
- Have a good profitability measurement system that measures profit for products, customers and markets. Know its limitations, especially when it comes to costing and allocations.
What does it mean when you have a large economic profit that amply exceeds the cost of capital? There are two general possibilities. One is that your market is not competitive, likely due to the government through patents, copyrights, permits and licenses, or because there are other significant barriers to entry. The other is that your market
is competitive, and competition is (or will soon be) knocking on your customers’ doors!
“Making Money” is an imprecise term, one with several possible definitions depending on the measures used and the circumstances involved. To grow your business consistently and successfully, make sure you understand your cost of capital and that you translate it accurately into practical business measures and decisions.