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The Fallacy of Profit as a Percentage of Sales: Part II

Assigning Cost of Capital to Activities
Once this blended rate of return on assets has been established, it can be assigned to activity centers in proportion to the value of the assets that are included in those activity centers.

Exhibit 3 shows the distribution of our manufacturing company’s assets among its activity centers, as well as the target return on assets that must be generated by the funds tied up within each of those activity centers if the owners are to realize their 15 percent return.

Hicks Exhibit-3

For example, $2 million of value is assigned to Building and Grounds; an activity center that accumulates the cost of owning, operating and maintaining a facility in which the business’ activities can take place and whose costs are subsequently assigned to other activity centers based on the percentage of the total facility they occupy. Ownership of the facility needs to generate $198,000 in pre-interest profit annually if it is to meet the owners’ targets. To determine how well this requirement is being met, the $198,000 cost of capital is included along with depreciation, maintenance, utilities, insurance, taxes and all the other costs associated with the real property to determine a facility cost “per square foot” that is assigned to the activities within the facility based on their “footprints.”

Similarly, the $1,875,000 of value assigned to Equipment Type C indicates that the use of this category of equipment must generate $185,625 in pre-interest profit for it to meet the owners’ financial target. The $185,625 would be incorporated into the machine’s “per hour” rate, just like its occupancy cost (the distribution from Building and Grounds based on its “footprint”) depreciation, utilities, maintenance, consumables and other machinerelated costs.

At the end of the process, the costing rates used to measure the cost of any product will include an appropriate cost of capital based upon the amount of investment required to support that product. By incorporating the company’s cost of capital in its cost model, the cost calculated for each product will represent the revenue it must generate to cover all of its costs, including the owners’ expected return on investment. In the case of our example manufacturer, its product “cost” will represent the price required to generate a 15 percent return on investment. Sales prices that exceed that cost generate a premium profit or add extra value to the company. Those whose prices fall below that cost are underachievers, if not losers, and their deficiencies must be covered by other products with extra value if the owners’ financial expectations are to be met.

For some products, meeting the owners’ return on investment expectations will require a very high profit–to-sales percentage and for others the percentage may be low, but in either case, the profit–to-sales percentage is irrelevant and misleading, because it fails to take into account the investment required by the product to cover its cost of capital.

During more than 25 years as a consultant, Doug Hicks has championed the development of practical, down-to-earth cost management solutions for small and mid-sized organizations. In that time, he has helped nearly 200 organizations transform their history-oriented accounting data into customized, value-enhancing decision support information that provides accurate and relevant intelligence needed to thrive and grow in a competitive world. He shares his experience through seminars conducted throughout the U.S., in trade and professional periodicals and two books, including I May Be Wrong, But I Doubt It: How Accounting Information Undermines Profitability. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

D.T. Hicks & Co.


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