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Throughout my experience i have just encountered just a few controllers aware of the appropriatness of the features of the cost center system in place that justified the kind of strategic evaluation of their managers' performance.

 
What was on place was unarguable and immutable.

Moreover the approach to measure and evaluate a Strategic Business Unit can be requested to change over the time due to some behaviours of the managers that try to elude their responsibility for the costs incurred or to be incurred in their cost center.

That's the reason why a smart controller should be monitoring the kind of costs into a BU over the time and set up the corrective actions either by requiring a change in the measurement and evaluation method or by making BU's managers "get back on track".

 

But let's make step by step.

 

Many companies have their measurement and evaluation system of the performance of the cost center looking at the short term and as result to take into great consideration the financial aspect.
At his point the basics of the cost analysis come into play.

We divide costs according to their sensitivity to the business's output variation into variable and fixed ones.

This sensitivity translates into a higher degree of controllability of the variable costs compared to the fixed ones and this, as we have seen in different articles on this webage, produces different impacts on the choices of the top management during the business's life.

One of these effectcs concerns the settings of the cost center's manager performance evaluation that shift their focus following the predominance of the variable costs over the fixed ones or viceversa.

 

Let's suppose that a cost center sees a higher share of fixed costs and the strategy of the business is to compete based on the Cost Leadership.

This strategy in practical terms should mean limiting the investments and the most attention is on the planning stage that is the beginning of the reference period when the forecast amount to spend on those costs is restricted.

The performance evaluation at the end of the period is less important since the variation of the fixed costs, within some ranges, is not linked to the variation of the firm's output.

 

Following the same principle, when the business'strategy turns to innovation/differentiation of products-services to the customers and the cost structure is again mainly "fixed", the manager's performance evaluation based on financial aspects at the end of period is even less important since the budgeted amount of cost is higher the the previous case.

Both in the former and in the latter case the strong suggestion is to accompany the evaluation system in place with nonfinancial performance indicators even the focus of all that is the short term.

 

What about the opposite case?

 

When the variable costs are predominant into a cost center the focus of the performance evaluation goes to the end of the reference period just because most part of their ongoing amount is to be traced back to the decisions and skills of the concerned managers.

All the kinds of the variance analysis take as a result more value in assessing the managers.

Be aware not to charge the responsibilty of some external causes to the accountabilty sphere of the managers because this could be see as unfair and bring about lack of motivation.

 

In the lines above I mentioned the attention a controller should pay also to the behaviour of the managers of the cost centers just with regards to the financial performance evaluation purposes.

Many managers choose to address spending decisions that consist mainly of fixed costs in order to subtract them from the basis of their evaluation.

This phenomenon is called Cost Shifting.

 

Another case to be considered is the Budget Slack that happens mainly when costs are mainly variable.

Many managers when negotiating the money to be spent on the activities of their cost center aim at setting a target as high as possible so that their goals could be hit more easily and this is even more true when the strategy of the business consists of the Cost Leadership!!

 

The most appropriate framework of a cost center's manager performance evaluation is to be taken into great account not only for rewarding them in a fairly and motivating way but even for the health of the whole company in view of the cascade issues potentially arising in a hyperconnected reality like a company.

 

Further details about this topic are to be considered and that's why I invite you to check the website publications out regularly!!!

 

 

When talking about business valuation many go along with one of the method s without considering the appropriatness with the business case and with the time they live in.

Yes, you have understood well the time they tima they are living in.

This issue affects even the techniques a manager m akes use of to determine the value of a business regardless of the size oif the unit, of the reason he will make the valuation on and of the listing or not of the company on the stock exchange.

This large involvment derives from the very large uncertainty of some factors that are the basis of the methods involved.

Before to explain my concept a bit of introduction of the techniques is needed.

 

Managers, investors and analysts rely on two major methods.

 

Discounted Cash Flow and Multiples of some performance measure, such as earnings or sales.

 
The former is considered to be a valuation, internal to a company, that relies on the discount of the predicted cash flows by a rate that factors in the structure of capital (equity and debt).

The predicted cash flows are expression of an expected growth, generally by averaging different scenarios of projected cash flows and profits.

The latters, Valuation multiples are the quickest way to value a company, useful first of all in comparing similar companies (comparable company analysis) by considering also the mood of the market (Share Price and Market Capitalization) where the company operates.

They want to capture the expected growth in a single number, multiplying the ratio between two appropriate numbers by some financial metrics to achieve an enterprise or equity value.

Please notive the both of them can be used for listed and unlisted companies even if their use for the unlisted ones is more difficult since the calculations of some inputs involved need to find the respective values of the listed companies more similar to the business whose valuation is going to be done and in order to average them.

Generally they are used in Merger and Acquistion cases but in the other valuation opportunities for comparable analysis, too.

 

Without goung deep into the technical dissertation, I will make some examples ot the Multiples used in order to have more clear the reasons on which "nowadays" I prefer them to the DFC method.

VALUATION MULTIPLES

 

We have 2 kinds:

- Equity multiples.

 
- Enterprise value multiples.

 

 

EQUITY MULTIPLES

 

Price-to-Earnings (P/E) Multiple

 
Without a doubt the most common equity multiple used to valuate stocks is the P/E multiple.
It is equal to Share Price To Earnings per Share (EPS).

A company with a high P/E is considered to be overvalued. Likewise, a company with a low P/E is undervalued.

You can see the easiness of valuation when comparing shares of different companies, as a matter of fact they are readily available on many financials information tools, but they don't take into account the different capital structures of the companies involved mainly because they use denominators relevant only to equity holders, EPS.

 

Most forward-looking equity multiple is the PEG ratio similar to the P/E ratio since this metric also takes the company's expected earnings growth rate into account.

However even PEG presents the same negative aspect just seen.

 

This drawback is overtaken by using a particular Equity Multiple, Price/Sales, but in this sense the following EV multiples are more complete since also the numerators comes in to consideri the debt holders.

 

Enterprise Value Multiples

 

There are many Enterprise Value (EV) multiples but all of them have EV in its numerator.

EV shows very simply how much money you need to buy a company.

 
EV of a company is calculated by taking the company's market capitalization (Market Cap = Current Share Price * Total Number of Shares Outstanding), adding total debt (including long-term and short-term debt), and subtracting all cash and cash equivalents.

In my opinion, that suffices to be a better tool since it is more transparent by giving a more complete picture of a company's valuation.

However, let's give dome examples to focus on the features of EV multiples.

 

Examples of this kind of multiples?

EV/EBITDA Multiple

EV/EBIT Multiple

EV/Sales Multiple

 

- The first is used generally by investors to compare companies in the same industry before making an investment decision and it gives a good "idea" of the firm's cash flows.

Of course, being a comparison tool it will be "good" or "bad" enterprise multiple will depend on the industry.

- The second is preferred by some analysts for its ability to give a more complete picture ot the actual worth but in my opinion it is rather linked to the book value of the fixed assets hence a bit backward-looking.

It is advisable using it for less capital-intensive companies that have in their Income Statements small Deprectiation and Amortization.

Both EV/EBITDA Multiple and EV/EBIT Multiple are useful for understanding if companies might be undervalued or overvalued.

 
- The third is the most forward-looking tool because it takes into account the value potential of a company per Dollar Sales that can be higher or lower than that of many companies of the same cindustry even if the profits are lower or even negative.

 

 

As you can see EV multiples have denominators relevant to all stakeholders, not only shareholders, since the numerator Enterprise Value in itself (Market Cap = Current Share Price * Total Number of Shares Outstanding) concerns both stock and debt holders.

Moreover they are less impactesed by accounting differences, since the denominator is taken higher up on the income statement.

 
As to EV multiple uses other than M&A, such as transnational comparisons, all of three are useful because it ignores the distorting effects of individual countries' taxation policies.

Multiple valuation, finally, captures the mood of the market, a variable mostly ignored with the DCF method.

 

Once we have seen all of these feature my preference goes towards since the Enterprice Valuation Multiples compared to DCF mainly since today the uncertainty of the factors considered by the latter method is greater and more pivotal in consideration of the fact it's not tempered by an external and complete analysis like that of the market.

I will be more clear.

The cost of debt, part o the discount rate in DCF method, is linked to the future interest rates, around which the Central Banks are making a severe crackdown for cutting inflation by aiming at causing a recession.

You will see, as a result, how both the interest rates and not only the future Cash Flows are hard to forecast in their timing and extent.

Not to say about the current geopolitical situation (year 2023) that brings about more unpredictability.

That's the reason where the mood (expressing more complete knowledge and more reliable predictive analisys) of the market (Share Price and Market Capitalization) incorporated into the multiples is more reliable than an intrinsic valution as the DCF is.

The changing structure of capital (M&A, spinning off) is another factor to be considered in the future just because of this uncertainty and that's the further reason I now judge EV multiples most good at valuating a company.

 

If you put into their denominators the company's expected EBIT/EBITDA, that expresses an expected growth rate, my preference becomes even greater.

 

Have you ever heard of OKRs if never used in your company?

 
If not or just in a broad sense this is the time to write about them and linking them to the Finance function, just how the author wants to do in this article.

First of all a general dissertation on these tools is appropriate and we will deal with it by making use of some comparisons and examples.

A way to understand OKRs is comparing them with MBOs and OKRs and analysing the main differences.
When done it is possible to dissert about OKRs and their strategic use in the finance function.

 

What’s the difference between OKRs and MBOs?

Both are used to achieve some goals within the strategy framework of the business but some specific characteristics make them different.

First of all the definitions.

 

MBO: Management by Objectives

OKR: Objective and Key Results

 

The main difference is that MBOs set what the goals are, while OKRs dig deeper into the process and indicate a set of measures of progress towards the goal achievement.

Another difference concerns the decision level.

 
A a matter of fact MBOs come from Top Management that decides and directs the organization's goals for a 12 month period, while OKRs derives usually also from the bottom and the reference period is the quarter.

What about the addressees!?

MBOs are directed to the single workers/employees, whose bonus is tied to the degree of the objective achievement, while OKRs are intended for teams.

The employee's autonomy is usually larger in MBO set than it is in the OKR frame since what is important is the success in hitting the goal set.

As a result of this, the breakdown is greater in OKRs where its specifications, the Key Results (3/5 for each Objective), are a set of Initiatives monitored weekly.

The degree of achievement difficulty is higher in OKR framework than it is in the MOB one.

 
The Objectives and Key Results are very challenging.

 

We could keep on analysing both measures but we should move the focus of the article that doesn't imply to dig deep into each of them and it's to highlight the strategic role of OKRs into the Finance dpt.

That's why we are going to do the same when recalling KPIs (Key Performance indicators).

 

At this point an example will make the difference perceivable and at this first stage we'll consider just one Key Result within the OKR frame just to highlight the difference.

 

MBO goal for Sales Department:

Increase sales revenue by 20%.

 

OKR goal for Sales Department:

Objective:

 
Increase sales revenue by 30%.

KR 1: Enlarge the market share by decreasing Sales Prices (according to Cost Leadership Strategy, for instance)

As you can see at this first glance the goal in OKR is more ambitious and moreover there is an intermediate and more detailed result (KR 1) throughout the path towards the definitive achievement of the objective.

 
As a matter of fact and as I wrote in the above lines, these intermediate results are usually 3/5 that are field indications of the progress and efficacy of the team involved in the achievment of the target (Objective).

 

We won't stop here since we are aware that the existence of other tools can create confusion.

Another comparison comes into play!

 

KPI vs OKRs

In particular the most appropriate comparison is between KPIs (Key Performance Indicators) and the metrics of OKRs, the 3/5 results derived from the Objective reference of the OKR concerned.

 
Key Performance Indicators are used to evaluate performance over time of an organization.

Usually you can find these indicators within a Balanced scorecard where they are first of all:

 

- Linked to strategic goals.

- Measured against targets.

 

Said in this way no difference emerges between the two figures considering also that both are directed to a department and not to an individual as MBOs are instead and the fact KPIs are usually meausered monthly against the weekly measurements of OKRs doesn't suffice to highlight the distinction.

In my opinion the main point is that OKRs are very challenging while KPIs are difficult but attainable through a mere high commitment of the dpts concerned.

 

You don't see the difference, yet?

 

The example approach is the best one and we'll take into consideration once more the Sales dpt just because the differences are more easily perceivable in this context.

 

OKR for Sales DPT:

 

Objective:

 
Increase in Sales Revenue by 42%

 

Through:

- 1st KR: Improved Retention to 90%

- 2nd KR: 200 New Customers

- 3rd KR: 15% Marketing Lead Increase

 

KPIs for Sales DPT:

- Higher Sales per Rep
- Higher Sales Revenue
- Improved CAC (Customer Acquisition Cost)

As you can see that OKR without a doubt is broken down into more detailed specific actions even when compared to KPIs and that is one of the reasons why it is considered a more challenging stimulous.

 

Haven't I been able to explain the differences amongst MBOs, OKRs and KPIs yet!?

 

Ok, I will try to state these equations:

 

MBOs = Health

 
KPIs = Improvement

OKRs = CHANGE

 

Now we have identified the OKR picture it is possible to move on to the strategic use of this tool in the Finance dept.

 

 

Strategic Use in the Finance Dpt

 

As a matter of fact, Finance Managers can take advantage out of OKRs to achieve the same goals of other dpartments' teams that are transparency about what the finance team is working towards, accountability for the team’s progress towards the results or for the missed results, better internal and external communication and a higher focus on what is most important.

 

Let's pay our attention to the strategy of the business and the usefulness of OKRs in the Finance function that allow to get the right insights on the allignment of the Business actions with its goals.

 

To make this aspect more clear we prefer using the method by example that causes the manager to draw the correct conclusions and decide the potential corrective actions.

 

Let's suppose that a company has a Customer-Oriented approach and focuses its activities on an accurate differentiation of products and services according to the related market segments it addresses.

Of course, the different products and services offered absorbe resources in different quantity and in different quality so that an accurate costing system is needed that may help managers cost correctly the products/services and as a result make a correct pricing based.

 

At this point the Head of Finance decides together with his team to set a specific OKR.

 

The OKR coming into play is this:

Objective: Optimize Cost Accounting System

 

KR 1: Reduce the time to go through with the month-end accounting close by 20%

KR 2: Increase the accuracy of product cost calculations by 30%

KR 3: Set a deeper breakdown of the variance analysis

 

in particular KR n2 in the view of the Head of Finance is crucial since a correct and precise breakdown of the costs incurred for each market segment would increase the quality of the related profitability analysis  and would be a right basis for the decisions to make on each of the market segments (for instance pricing).

Let's guess the accuracy of the costing is achieved or is going to be achieved to the highest degree but according to the latest financial reports the profitability of the whole business has decreased.

The "strange thing" is that Revenues have increased so that the sticking point is represented by the increase in costs.

If KR 2 is achieved but the whole profitability decreases, it means the Strategy of the business isn't being realized successfully and one of the most probable reasons is that the costing system used is inappropriate although the accuracy level has been enhanced to the highest level.

 
In particular the costing method in use erroneously spots some customer as more expensive and some others as "cheaper", obtaining as a result a wrong decision-making basis.

At this point a smart Finance Manager could opt for an Activity-Based Costing approach that would help him solve this specific issue.

 

Some other examples could be made in consideration of the large number of OKRs potentially usable within the Finance dpt but the goal of this article was not to deal with the technicalities of this tool but just making the great strategic role of OKRs clear as much as possible.

Hope to have hit the target.

 

The uncertainty and the risk over the investments in real assets, meaning both tangible and intangible assets, has been dealt with on this page in some articles, but now we want to dig deep into the value of the Flexibility, needed more than ever in these times.

 
Any model based on the Discounted Cash Flow concept is based on the passive acceptance of the results from the decision makers.
In other terms if the outcome (for instance the Net Present value-NPV) is positive then the project is lauched, if not it is rejected.

This Yes-or-No approach doesn't fit well many industries and the current times when the uncertainty and the lack of knowledge about the events analysed and other related info are so high that a dynamic decison model should be very very advisable.

The managers should be allowed to wait for some time to make the decison to kick off the project or to change it about its size or some features or to abandon it.

The model that factors in these options is called Real Options.

A real option is a valuable right to make, modify or abandon some choice that is available to the managers of a business, often concerning business projects or investment opportunities.

It is referred to as “real” because it concerns the projects concerning a tangible asset (such as machinery, land, and buildings.....) or intangible (such a new information system) and not a financial instrument.

The difference between financial options and real options is that the formers, referring to a derivative financial instrument, such as call and put options contracts, have a numerical value in terms of its price or premium one can get on a trading market (exchange), whilst the latters are more subjective and the value they have is not considered into the traditional captital-budgeting decision approaches.

By making use of a combination of experience, and financial valuations, managerst should weigh to a good degree the value of the project involved and whether it's worth the risk.

Real Options can serve as a strategic tool without a doubt and that is one of the goals of this article but first of all the release of some technical explanations is needed to see how it works.

In general we have two ways to incorporate the value of the Real Options when examining some investments/long-term projects; in other words we want to weigh the value of the Flexibility of the choice a manager should face:

- Scenario Analyses and the related decison tree.

- Thee Option-Pricing Models.

 

In the first approach you incorporate the Real Options modelinto a traditional Discount Cash Flow analysis.

The second approach includes different techniques and we will deal with one of the latter methods: the Black-Scholes model.

 

We are going to start from the components of the formula about the price of a financial option in order to translate them into the applications and terms about the the capital budgeting world.

Here it is how a Call option value is calculated, to which we can compare some "real" cases such as the defferal of the start of the investment to a a later date.

The abandonment of project after the first disappointing results can be compared to a Put option, instead.

 

Black-Scholes Formula:

 

C = Se-δt*{N(d1)} - Xe-rt*{N(d2)}

 

 

Where:

C = current call value

S = current stock (or other financial tool) price (also Spot Price)

δ = dividends

t = time until expiration (expressed in years)

N(d1) = the probability that a value in a normal distribution will be less than d

X = strike price of the option

e = 2.71828, the base of the natural logarithm

r = risk-free interest rate

N(d2) = the probability that the option will be in the money by expiration; in other terms the probability that the call option will be exercised on expiry when the S is higher than X

 

Note that e-δt is e to the power of -δt as well as e-rt is e to the power of -rt.

 

Where

d1 = {ln(S/X) + (r-δ+σ2/2)t}/σ*√t

d2 = d1-σ*√t

and

ln = natural logarithm function

σ = uncertainty: standard deviation of the stock’s annualized rate of return (in coninuous compounding)

 

Some requirements/clarifications exist for the Black-Scholes model.

 

Here are some of them:

- The financial instrument does not pay a dividend before expiration.

- There shouldn't be any change in interest rates and variance before expiration.

- Black-Scholes calculates the premium for a call, but also put premium can be calculated by using the socalled put-call parity formula.

- From the Black-Scholes formula, the standard deviation, σ, which measures volatility, can be calculated if the other variables are known.

 

Having said that, what is important is to translate these financial terms into the Real Asset world to make the Black-Scholes (and other Option-Pricing techniques) formula fit for the valuation of the real asset investment.

 

Here are the real-market equivalents of the previous factors:

 

- Spot Price(S) is compared to the present value of cash flows expected from the investment/long-term project on which the option is purchased.

- Exercise price(X) is the present value of all the fixed costs expected over the lifetime of the investment/long-term project.

- Uncertainty(σ) means the unpredictability of future cash flows related to the asset; in other terms it is expressed by the standard deviation of the growth rate of the value of future cash inflows.

- Time to expiry(t) is the duration of the validity of the investment opportunity/long-term project- This will depend on multiple factors such as technology, contracts (licenses, patents, leases) and potential competitive advantage.

- Dividends(d) is the lost value over the duration of the option. This could be the costs incurred to preserve the option (for instance to keeping the opportunity alive), or the cash flows lost to competitors iputting their mony in the investment/the long-term project.

- Risk-free interest rate(r): the yield of a riskless security with the same maturity as the duration of the option. Those flows (Exercise Price) are discounted by a rate that could otherwise be earned for doing nothing.

When exercise price and dividends raise the value of the option goes down.

Instead, increases in spot price, uncertainty, time to expiry, and risk-free interest rate increase it.

 

Example

 
In order to see the importance of the Real Options Model and appreciate the difference with the traditional DCF one an example will be useful.

Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in strategic and financial analysis. Consider the example of a mining company of copper, which has the opportunity to acquire a five-year license on a block.

When developed, the block is expected to yield 80,000 tons of copper. The current price of a ton from is $ 10,000 and the present value of the development costs is $ 1 billion.

 

The result calculated through a traditonal NPV method is:

 

$800 million - $1billion = -$200 million.

 

According to this valuation the company would leave the opportunity.

 

The uncertainty is not recognized from this valuation tool but as a matter of fact there are at least two factors that mustn't be neglected: the volume and the price of the copper.

Let's guess the company estimates that these two sources of uncertainty jointly yield a 20 percent standard deviation (σ) around the growth rate of the value of operating cash inflows.

The company managers expect to incur the annual fixed costs of keeping the reserve active of $ 20 million (dividend amlount). This represents 4 percent (that is, 20/800) of the value of the asset.

The duration of the option, t, is four years and that the risk-free interest rate, r, is 6 percent.

 

Applying the Black-Scholes model we have:

 

Real Option Value = Se-δt*{N(d1)} - Xe-rt*{N(d2)} =

 = 800e-0.04*4*{(0.58)} - 1.000e-0.06*4*{(0.32)} = +$ 71 million.

 

Note that e-δt is e to the power of -δt as well as e-rt is e to the power of -rt and as a result  e-0,04*4 is e to the power of  -0,04*4 as well as e-0.06*4 is e to the power of -0.06*4.

 

At this point the company may benefit from holding the option up to five years and assess whether and when to exercise it or not, having had on its hand throughout that period new info about that opportunity.

You can notice a $ 271 million difference between the two techniques, but what is it like and where does it come from?

It is the value of the flexibility that the traditional techniques don't take into account.

 

I will be more clear by making another example.

 
Let's take a call financial option on an exchange, available at $ 20 for an exercise price of $ 75 when the stock/financial tool is trading at $ 85.

A buyer who exercised the option immediately would have a payoff of $10 but at the same time he would be loosing $ 5 (that is the option would be out of pocket), since he paid $ 15 for the option

The $ 5 loss is the value of the flexibility of not having to decide whether to make the investment immediately, a flexibility NPV analysis would recognize as zero.

 In our "copper" example: $ 271 million worth is the equivalent of the $ 5.

 

Real Option flaws

 
Real options analysis is still often considered to be "too" heuristic even if based on sound financial criteria.

Some argue that real options recognize the value embodied in the flexibility of choosing among alternatives but their objective values cannot be mathematically determined with an acceptable degree of certainty.

For instance the estimation of the uncertainty is to a certain extent subjective. The base of this estimation is usually the historical volatility/uncertainty but that is not necessarily a very good indicator of how volatility will be in the future.

 

It can represent a reasonable approximation of future volatility where the future is likely to be similar to the past but nowadays the uncertainty about the related events fligh very high and important deviations are possible.

The choice of the quantitative model itself (Binomial, Black-Schole, Lattice model....) used to value a real option is based on judgement of the managers depending on their experience and knowledge.

 

Beyond the Valuation Tool

 

Real Options can be used not only as a good investment valuation tool that higlights and measures the flexibility factor but a strategic instrument that earns money to the company.

 This advantage results just from the fact business managers have that subjective power above mentioned that enables them to use their skills to improve an option’s value before they actually exercise the option.

I will give just one example to make this aspect even more clear.

 

Before doing that you have to take into account that the managers' power is capitalized on by using the those levers that we saw in the previous lines (good for many of the option-pricing techniques).

Here again the levers we are talking about: spot price, uncertainty, time to expiry, risk-free interest, exercise price and dividends.

Our reall example will focus on the lever of the dividends: it is the lost value over the duration of the option. This could be the cost sincurred to preserve the option (for instance to keeping the opportunity alive) or the cash flows lost to competitors investing in the opportunity/long-term project.

In a real case, the cost of waiting of a business is high when a competitor makes the first "move and the first-mover advantages are important.

In this case the dividends are correspondingly high, thus reducing the option value of waiting.

 

What can a manager do to reduce the value lost to competitors?

 

He can "persuade" them not to exercise their option by seizing up the main customers in advance (through for instance marketing actions) of that segment market or lobbying, when this is possible, for regulatory constraints.

 

This is the end of the article and some further analysis of this current and fascinating topic are available if requested on page Contacts.

 

What a headache!

 

- Straight Line Depreciation Method

- Diminishing Balance Method

- Sum of Years’ Digits Method

- Double Declining Balance Method

- Sinking Fund Method

- Annuity Method

- Insurance Policy Method

- Revaluation Method

- Discounted Cash Flow Method

- Depletion Method

- Output Method

- Working Hours Method

- Mileage Method

- Group or Composite Method

- Others

 

Which is the most suitable method for my business to make an appropriate profitability analysis?

 

The issue is remarkable for the tangible assets a business operates during its processes and our dissertation is particularly consistent with this case.

 

Let's start dealing with the issues involved.

 

One should know all the existing methods that may be applied and choose from them or resort to some very qualified consultant able to do it and aware of all the benefits and disadvantages of each of them, not to be neglected.

 

Some argue for instance that Depreciation is a Sunk Cost and as such it is a cost of the past already incurred and capitalized in the Balance Sheet in the first year of its life and as a result no longer to be considered in any profitability analysis and different kinds of decision making in the following reference periods concerning both the whole business unit and the single products/cost objects.

As a matter of fact, according to this view for istance pricing based on a mark-up on the product costs may lead to an extra amount that in the end puts the business out of play in many price-sensitive markets.

 

Nonetheless, although these settings present some good reasons other experts believe that since it's a cost related to long-lived assets, you should know to what extent the operations of the BU "consume" the same fixed assets each year of their life and measure this "consumption" in order to get a reliable profitability standing.

 

This assumption is correct but at the same time a deep knowledge of the different methods of depreciation that enables to measure it as realistically as possible is needed and many of the methods above listed should be excluded and intended only either to the Taxable Income calculation or some other reasons that don't have to do with the profitability aspect and related decision makings.

 

In my opinion a specific method is to be applied in order to have a profitability analysis that can serve as a basis for all the issues involved such as for instance, among others, a reliable performance measurement and assessment of the Business Units concerned as well as a reliable pricing reference.

 

Prior to showing this methodology it would be better make a brief introduction to the matter by explaining just some of these approaches?

 

Let's get started with a "recall" of the reference factors to be considered since involved in the depreciation methods that could be useful to the least conversant people with the subject.

 

These are:

 

- Cost of the asset/historical cost. It is the purchase price of the fixed asset plus further costs incurred to get the asset into working condition.For instance installation cost, freight and transportation and insurance.

 

- Salvage value/residual value known also as the net residual value. It is the net realizable value of an asset at the end of its useful life. It's an estimated value of course.

It consists of of the difference between the sale price and the expenses necessary to dispose of that specific asset.

 

- Estimated Useful Life is the commercial or economic life of an asset.
We mean by that not its physical life but the duration of its effective use to the advantage of the business.

 

Having said that we are going to deal with some of the least known methods, putting aside those very common within the finance people such as the Straight Line Depreciation and Diminishing Balance, in order to let us understand how the objectives underlying this choice are different and how all the reasonings you can make this calculation on are all conventional and predetermined.

All of this jeopardizes the achievement of the best profitability analysis.

 

Sum of Years Digits Method

This method accelerates depreciation with a very fast rate.

The base concept is that an asset when moving towards the end of its useful life produces less benefits than it does in the first periods.

As to the technical aspects, the depreciable amount of an asset is charged to a fraction over different accounting periods.

What do I mean by fraction?

This fraction is the ratio between the remaining estimated useful life of an asset with reference to a given period and sum of the years digits. It turns out that the capital blocked or the benefit coming out of the asset is the highest in the first year.

 

As a result the highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then.

Conversely, the lowest depreciation amount is charged in the last year as the largest share of capital invested has been recovered.

 

Here is the related Depreciation Formula.  

 

Depreciation = Depreciable Cost x (Remaining useful life of the asset/Sum of Years Digits)

Depreciation = (Cost of asset – Salvage Value) x (Remaining useful life of the asset/Sum of Years Digits)

 

Where:

Sum of years digits = (n(n +1))/2 (where n = useful life of an asset)

 

In my opinion, altough the base prerequisite of this method leading to the highest depreciations in the first years may be accepted, we can easily see how we are dealing with a predetermined measurement regardless of the realistic asset use.

 

Now we will look through briefly, in my opinion, the most tortuous of the accelerated methods due to the adjustments it causes following an overdepreciated asset at the end of its life.

 

Double Declining Balance Method

According to this method depreciation is charged on the value of the fixed asset at the start  of the year, reduced in the years following the first one by the depreciation accumulated.

This is just like the diminishing balance method.

The second step is to apply a fixed rate of depreciation just as we do in case of straight line method but twice as high as that.

This method leads to an overdepreciated asset at the end of its useful life as compared to the anticipated salvage value, so that some adjustments are needed.

 

Like other acceelrated approaches to the Depreciation the Double Declining method is used because suitable for depreciating assets with a higher degree of usage or loss of value earlier in their lives or  for fiscal purposes.

 

What about the "financial" Depreciation methods?

 

Lets's deal with one of them.

Annuity Method of Depreciation

It is commonly used with assets  that have a large purchase price, that are expected to last for many years, such as property or buildings that a company might lease, and to have a fixed (or at least constant) rate of return.

 

On the technical side, the calculation of the rate of return of an asset is needed, just as if it was an investment.

It requires the determination of the internal rate of return (IRR) on the cash inflows and outflows of the asset, so that we can multipliplying it by the initial book value of the asset and the result is subtracted from the cash flow for the period.

That amount is the period depreciation that can be taken.

 

The annuity method assumes that the sum spent on buying an asset is an investment that should be yielding some money.

The concept is that, if the buyer had invested an equal amount elsewhere instead of purchasing that asset, it would have earned some sort of return on it.

 

Depletion Method

Another method that concerns the productive assets and as a result that falls into the product cost calculation is the Depletion one.

It is a specific approach that belongs usually to a particular industry.

Yes we have even some "dedicated" methods and the headache goes on!!

 

It is used for the natural resource extraction industry and it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.

 

Its accounting and financial reporting purposes are intended to accurately identify the value of the assets on the balance sheet and to record expenses in the appropriate time period on the income statement.

 

How does it work?

It is a  sort of use-based methos since when the costs associated with natural resource extraction have been capitalized (the basis fo the depletion), the expenses are allocated across different time periods based upon the resources extracted.

As a result the costs are held on the balance sheet until expense recognition happens.

 

 As to the depletion base, the main factors to cosidere are four:

 

- Acquisition: Costs associated with purchasing or leasing the property rights to land.
- Exploration: Expenses linked to digging under the land that was leased or bought.
- Development: Costs incurred to prepare the land for the extraction of the natural resources.
- Restoration: Expenses to the land to its original condition after completion.

 

We have two ways of applying the Depletion approach:

- Percentage Depletion method.

- Cost Depletion method.

 

The percentage depletion method requires a lot of estimates and it is not based on the effective use recalling the straight line depreciataion method that applies a fixed percentage.

That's why I like to dive deep into the cost depletion method.

 

The cost depletion is calculated by taking the property's basis, total recoverable reserves and number of units sold into account.

The property’s basis (capitalized costs) is spread out among the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the capitalized costs by returning the period depletion (depreciation).

 

For example, the capitalized costs of $2 million yields 10,000 tons of timber.

In the first year, if 2,000 tons of timber are extracted, the depletion expense for the period is $ 400,000 (2,000 tons * ($2,000,000 / 10,000 tons)

 

Some limits are present about this method but it is not the right place where to debate on these but for sure the depletion method under the form of the cost depletion way (not the percentage one) reflects a good approach to give the depreciation procedure a better and more reliable period's profitability index of the assets involved.

 

After showing some of the different methods with the purpose to make it undestood how the choice of a depreciation method good for internal informative requirements and not only for statutory and fiscal aspects is linked to many reasons, I am going to show my favorite in order to get the best decision-making  and assessment basis with regards to the profitability side.

 

My turn

My favorite is a category: the use-based one that takes into account that best driver representative of the real "work" of the asset involved. i

This driver may concern the machine hours, the units manufactured and even the mileage: the choice depends on  the kind of asset involved.

 

Nonetheless, some adjustments in my opinion should be made in order to streamline the significance for the all the decisions based also on the depreciation consideration and that is all the more true in the capital-intensive businesses.

The steps are the folllowing:

 

1) Once the choice abut the most suitable driver is made, at the start of the asset life, the Depreciable Cost (Cost of asset – Salvage Value) has to be divided by the drivers units achievable throughout that life based on a practical capacity "amount".

 

2) At the end of each reference period falling within the asset life, the unit cost per driver we have achieved at the prior point has then to be multiplied by the practical capacity units that we can get or we could have got (depending on you are on an estimate or on an actual) in that single period.

The amount calculated this way is the depreciation amount of that period.

 

3) The latter has to be divided into two components:

 - The share falling into Cost of Goods Sold (Unit Cost per driver multiplied by the driver units worked for the output units sold in the period considered.

 - The share named Unused Asset Capacity that is the difference between the total period depreciation of the point 2 and the share falling into the Cost of Goods Sold.

 

This way of getting the valorization of the Unused Asset Capacity by taking out of the Cost of Goods Sold is important since it allows to measure the inefficiency in the use of the Assets involved and moreover not to charge it to the customers when a cost basis for pricing is used (a way to determine a full valorization of the Unused Capacity and of its elements, when possible,  it is dealt with at n 40 and 31 on this webpage).

Of course when the Asset Useful Life expires, the related depreciation procedure doesn't apply any more.

 

Here is how the Operating Income Statement should be:

 

 Exhibit 1 - Operating Income Statement with the Adapted Use-Based Depreciation 

 

Revenues
Cost of Goods Sold
Gross Profit
Unused Asset Capacity
Sales & Mark.
Admin.
R&D
Operating Income
Invest. Income
EBIT
Interests
Pre-Tax Income
Taxes
Net Income

 

Some further adjustments are possible if we consider that the other accounting items are at the current values while the items concerning the depreciation (accounting item inside the Cost of Goods Sold and the Unused Asset Capacity) are calculated based on the historical cost of the Asset.

When possible we can remedy this mismatch by adopting any kind of revaluation method that updates the value of the depreciation the period considered.

An example could be the Revaluation Depreciation Method I will show hereunder.

 

Revaluation Method

It provides the asset value is assessed at the start of the period considered and at its end.

The resulting difference between them is the depreciation to be charged.

 

To be more precise here is the formula:

 
Asset Depreciation of the period  = (AV)sy + A – D – (AV)ey

Where:

 

(AV)sy = Asset value at the start of the period

 

A = Additions during the period

 

D = Deductions during the period

 

(AV)ey = Asset value at the end of the period

  

At this point the revaluated amount of the period depreciation calculated in this way has to be divided into two components that we get by taking into account the period practical capacity of the asset involved in terms of the driver chosen, just as we have seen in the lines above:

 

 - The share falling into Cost of Goods Sold (Unit Cost per driver multiplied by the driver units worked for the output units sold in the period considered).

 

 - The share named Unused Asset Capacity, that is the difference between the  period depreciation and the share falling into the Cost of Goods Sold.

 

This approach of course presents advantages and disadvantages that won't be shown here and on these reasons I invite you to dive deep as you find it appropriate to do.

Nonetheless, any kind of revaluation of depreciation you will adopt, the resulting Operating Income Statement should contain also the accounting item dedicated to reconciliating te the differences between amount recorded under the Statutory Income Statement and the amount revaluated.

 

Here is the final scheme:

 

Exhibit 2 - Operating Income Statement with the Adapted and Revaluated Use-based Depreciation 

 

Revenues
Cost of Goods Sold
Gross Profit
Unused Asset Capacity
Sales & Mark.
Admin.
R & D
Operating Income
Statutory Reconciliations
Investment Income
EBIT
Interests
Pre-Tax Income
Taxes
Net Income

 

See you soon for the next publication