Cost of Capital, Economic Profit and ABC

rightly calculate the profits of any business. We will use the term “economic profits” to express real profit after operational costs and cost of invested capitalAccounting figures are limited to measure cost of capital. Such is the case of a depreciation account, which tries to measure the deterioration of the asset market value, though usually incorrectly. For example, computer hardware is depreciated in a longer period of time than its market value deterioration. However, a building has the opposite situation; usually, it can be sold to third parties at an amount far higher than book value or leased at a rent fee higher than accounting depreciation.

In the case of financial expense accounts, these figures are frequently far from the cost of all the money used to finance the business. The accounting figures depend on the financial strategy of the company, or on the debt-equity ratio. For example, if a company has an important proportion of debt with banks, financial expense accounts are high, but if it uses mostly shareholders capital, they are low. In the hypothetical case that the company is fully financed with shareholders capital without debt, financial expense accounts would be zero, because net worth has no cost in accounting books. But, as Finance Economics Theory teach us, the cost of shareholders capital is really higher than any cost of debt.

To clarify this thought, let us think about the personal computer that one can buy for US$ 3,000 fully financed with a 10% annual interest rate bank loan. If, after one year, the PC market value were US$ 1,000, the total economic cost of using this asset in your operations during one year would be US$ 2,300, compounded by US$ 2,000 of market value deterioration and US$ 300 of interests. But, as accounting depreciation would only be US$ 600 per year, the total accounting cost would only be US$ 900. If, additionally, the PC were financed with own money instead of a loan, the total accounting cost would only be US$ 600. In this last case, the total cost is more than US$ 2,300 because the cost of own money is more than 10%.

Another case to consider is the use of assets under financial leasing. Here, the asset value should be considered as part of the company assets and its cost as any other financial cost of debt, considering the effect of the enlarged tax credit. Commercial leasing is different, as here the accounting cost should express the market price of this service and should be considered as part of the operational costs.

For practical reasons, during an initial Activity Based Costing (ABC) project implementation it is useful to handle depreciation, financial leasing expenses and financial expenses with the available accounting figures. It is useful to focus on the ABC system architecture of operational costing of products, services, customers and channels, and to reconcile the model with financial statements. But cost of capital must later be rightly handled. The ABC project prepares the model to work later with the right cost of capital invested.

ABC methodology offers an excellent framework to track these costs and measure economic profit by product, customer or any other aspect of the business needed to cost. In an ABC system, operational costs goes to activities and then to cost objects according to how they are consumed, becoming a product, supplier, customer or sustaining cost; similarly the cost of capital must go to cost objects. We should work with the following adjustments:

Identify how each asset is dedicated to the business under the scope of the study. Some company assets can be related directly with individual products,

customers or suppliers. This is the case of raw material inventory, finished goods inventory or accounts receivable. Fixed assets are normally related directly with activities and related indirectly with products, customers or suppliers. There are also assets to sustain businesses or a whole organization, which are not related to specific products, customers, suppliers or channels. Finally, there are also assets related to other businesses, like financial investments.
Calculate the invested capital in every one of these assets at the closest possible market value. As a result, personal computers will be measured at lower value than books and the inverse will be the building example. Accounts receivable or payable should be considered at cash basis value, which means book value minus implicit interests expenses for the sales term, free of explicit interests charges and included into the price at any number of days.
Calculate a weighted average financial cost (k) for all the capital or money used in the company, including any type of debt and equity. This cost should be expressed as an annual rate before and after tax. The debt holders financial cost rate is mostly calculated from explicit interests and exchange rates differences, but the shareholders financial cost rate is implicit and expressed as an opportunity cost. Every cost of debt or equity is weighted according to the financial structure of the company. Any financial leasing amount and cost rate should be included as part of the debt.
Apply the financial cost of capital (k) to every asset value. FC of capital will be obtained as an amount of money for one year or a period. Any financial gain should be deducted from this cost.
Calculate the OC of capital for each asset. It should be measure either as the deterioration of the asset market value, or as an opportunity cost of not using the asset for other profitable purposes during the year or the period. Accounts receivable has provisions or losses due to non-collection, inventories have provisions or losses due to deterioration, fixed assets have economic depreciation, etc.

Following this logic, cost of capital calculation examples would be:

Accounts receivable: FC of capital for every account receivable should be directly assigned to the corresponding customer, market segment or channel. “k” is applied to the cash basis value of the receivable during the effective collection term, netting implicit interests included into the price and explicit interests gained in past due collections. OC of capital should include provisions or loss for non-collectable accounts.
Accounts payable: FC of capital (gains, as it is a negative asset) for every account should be directly assigned to every raw material or merchandise item and supplier. “k” is applied to the cash basis value of the payable during the effective payment term, netting implicit interests included into the price, and explicit interests paid for past due payments.
Raw materials or merchandise inventory: FC of capital should be assigned directly to every inventory item or supplier and to products. “k” is applied to the market value for the inventory outstanding term. OC of capital should include provisions for inventory deterioration or lossFinished goods inventory: FC of capital should be assigned directly to every product. “k” is applied to the cost value (or market value if it is less than cost value) for the inventory outstanding term. OC of capital should include provisions for inventory deterioration or loss.
Fixed assets: FC of capital should be assigned directly to every asset and activities supported. Throughout them it should go to products, customers or business sustaining. “k” is applied to the market value of the fixed asset for the whole year. OC of capital should include the market value deterioration or the opportunity cost of the asset.
Cash and financial investments: FC of capital should be assigned directly to these assets. If not needed by products or customers, then they should go to business sustaining as they are dedicated to support the organization or other businesses. “k” is applied to the market value of the asset for the whole year netting any financial gains and losses.

The cost of capital must be added to operational costs of activities and direct costs of products, to obtain total costs and real profits.

The following is an example on how a P&L of a company with three businesses could be. The ABC operational margin is calculated deducting from the revenues the operational cost of activities. The economic profit is calculated deducting from the ABC operational margin the cost of capital. These costs should be tracked for every product, customer, business or the whole company. In the case of business “Z” the operational margin is good, but the economic profit is not. The bottom line really matters.