Understanding the Impact of Investment Costs on Productivity and Profitability by Douglas T. Hicks CPA Annual Management Accounting Conference IMA Metro Detroit & Toledo Chapters

1. Understanding the Impact of
Investment Costs on Productivity
and Profitability
6th Annual Management Accounting Conference
IMA Metro Detroit & Toledo Chapters
March 22, 2012
Douglas T. Hicks, CPA
D. T. Hicks & Co.
6905 Telegraph Road – Suite 325
Bloomfield Hills, MI 48301
248.761.3706
www.dthicksco.com
© 2012 D. T. Hicks & Co.

2. Stage-Setting Concepts / Assumptions
• The goal of management
• The measurement of success
• Management economics vs. accounting
• Oxenfeldt’s rule
• The nature of “sunk costs”
• The “value” of an investment
• The cost of maintaining productive capability
• The cost of owners’ investment
© 2012 D. T. Hicks & Co.

3. The Goal of Management
Two Views
Insure the Short-Term Enrichment of the Company’s
Temporary Owners
Advance the Long-Term Wealth Creating Ability of
the Organization
© 2012 D. T. Hicks & Co.

4. Measurement of Success
Long-Term Ability to Generate an
Attractive Return on the Owners’
Investment in the Business
A superior, long-term, sustainable
return on Investment
© 2012 D. T. Hicks & Co.

5. Management Economics vs.
Accounting
Accounting is a backward looking discipline – it
observes the world from the stern of the ship and
measures its wake
Management economics is a forward looking discipline
– it observes the world from the bow of the ship and
helps navigate the vessel toward its desired destination
Accounting is for counting beans, management
economics is for growing them.
© 2012 D. T. Hicks & Co.

6. Oxenfeldt’s Rule
“An error in measuring the magnitude of an
effect usually is far less serious than mistakes
due to wholly overlooked consequences.”
- Dr. Alfred R. Oxenfeldt
© 2012 D. T. Hicks & Co.

7. Oxenfeldt’s Rule
Three blindfolded runners are about to run a
220-yard race:
• Runner #1 does not know there are hurdles
• Runner #2 knows there are 36” hurdles – but
only knows to within ±12” where they are
• Runner #3 knows there are 36” hurdles – and
knows exactly where they are
Which runner is in “big trouble?”
© 2012 D. T. Hicks & Co.

8. Hicks’ Rule
“It’s always better to estimate the right thing than
to precisely measure the wrong thing.”
- Douglas T. Hicks, CPA, CMC
© 2012 D. T. Hicks & Co.

9. Fundamental Economic Premises
Sunk Costs Are Irrelevant
At any point in time, an investment should be
measured by its value, not its original cost
Costs required to maintain a company’s
existing productive capability are legitimate
business costs
Owners’ investment in a business is not “free
money”
© 2012 D. T. Hicks & Co.

10. Accounting’s View of Capital
Investment
A company’s investments are valued at their
original cost less any accumulated depreciation
or amortization
The only “above the line” capital related costs
on a company’s books are depreciation and
amortization
© 2012 D. T. Hicks & Co.

11. Depreciation Expense
• Take the original (sunk) cost of a capital asset
• Select one of the allowable chronological lives of that capital
asset
• Select one of the allowable depreciation methods for that
capital asset
• Apply the selected life and method to the irrelevant, sunk cost
of the asset to arrive at depreciation expense
Does this arrive at a meaningful measure of cost?
© 2012 D. T. Hicks & Co.

12. Depreciation Expense
What if the company recently purchased all new assets
and is using the double-declining balance method?
What if the company just emerged from Chapter 11 and its
capital assets have no value on its books?
What if the company’s capital assets are old and already
fully depreciated?
© 2012 D. T. Hicks & Co.

13. Depreciation Expense
For decision making purposes, accounting
depreciation expense is an irrelevant, inaccurate,
and misleading concept and should be ignored.
HOWEVER…some provision must be made for
the costs required to maintain a company’s
existing productive capability
© 2012 D. T. Hicks & Co.

14. The Capital Preservation Allowance
The funds that must be collected as part of a
company’s ongoing revenue to preserve its
existing capital base
The on-going accumulation of the funds
required to maintain the company’s established
volume of business and technological position in
the industry – like a “sinking fund”
© 2012 D. T. Hicks & Co.

15. The Capital Preservation Allowance
Sinking Fund
$2,000
$1,500 Expenditure
$1,000 Requirements
$(000)
Sinking Fund
$500
Contributions
$0 Sinking Fund Balance
($500) 1 2 3 4 5 6 7 8 9 10
($1,000)
Years
© 2012 D. T. Hicks & Co.

16. The Capital Preservation Allowance
The two ‘drivers’ of the need to fund the
preservation of capital assets…
Time
The assets become obsolete
Usage
The assets wear out
© 2012 D. T. Hicks & Co.

17. The Capital Preservation Allowance
One additional complicating factor…
Leases
An ongoing – usually time-driven – cost of preserving the assets
© 2012 D. T. Hicks & Co.

18. The Capital Preservation Allowance
• Time-driven:
– Office equipment
– Technology
• Usage-driven:
– Production equipment
• Leases:
– Both of the above
© 2012 D. T. Hicks & Co.

19. The Capital Preservation Allowance
Time-Driven Usage-Driven
What if volume drops by 20%?
© 2012 D. T. Hicks & Co.

20. The Capital Preservation Allowance
No change Volume Down from Down from
Down 20% $170,000 $350,000
© 2012 D. T. Hicks & Co.

21. Investment in Capital Assets
At any point in time, how much does an owner
have invested in his or her capital assets?
• The amount paid for them?
• Their net book value?
• Their fair market value?
© 2012 D. T. Hicks & Co.

22. Investment in Capital Assets
Would you be willing to make the exchange?
© 2012 D. T. Hicks & Co.

23. Investment in Capital Assets
What is the basis for forward-looking decisions;
$1,000,000 or $750,000?
© 2012 D. T. Hicks & Co.

24. Investment in Capital Assets
What is the basis for forward-looking decisions;
$0 or $300,000?
© 2012 D. T. Hicks & Co.

25. Cost of Capital
Remember Oxenfeldt’s rule…
“An error in measuring the magnitude of an
effect usually is far less serious than mistakes
due to wholly overlooked consequences.”
© 2012 D. T. Hicks & Co.

26. Cost of Capital
Interest
Expense Owners’
Value of
Target ROI
Company Assets Return on Assets
Required to Meet
ROI Target
© 2012 D. T. Hicks & Co.

27. Cost of Capital
Owners’
Target Profit
Return on Assets
Required to Meet
ROI Target
© 2012 D. T. Hicks & Co.

28. Cost of Capital
© 2012 D. T. Hicks & Co.

29. Cost of Capital
© 2012 D. T. Hicks & Co.

30. Cost of Capital Equipment
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31. Profit Measurement
Closely track
Return on
Assets
© 2012 D. T. Hicks & Co.

32. Profit Measurement
$400,000 Cost of
Capital included
Which should be the primary measure of value?
EVA is a registered trademark of Stern Stewart & Co.
© 2012 D. T. Hicks & Co.

33. Profit Measurement
© 2012 D. T. Hicks & Co.

34. Profit Measurement
EVA is a registered trademark of Stern Stewart & Co.
© 2012 D. T. Hicks & Co.

35. Summary
• Depreciation expense is a meaningless measurement
• A Capital Preservation Allowance provides a true measure of
the future funds required for a company to remain in business
– Future capital requirements are a combined function of time and usage,
not simply time
• Profit as a percentage of sales is a misleading measure of a
sale’s value to a company – especially for a manufacturer
• Cost of Capital is a fundamental measure needed to understand
a sale’s value to a company – especially for a manufacturer
• Profit as a Percentage of Value-Added and Profit as a
Percentage of Activity Cost are simple surrogate measures of a
sale’s value
© 2012 D. T. Hicks & Co.