"The Hidden Costs"

Capital Costs - The Hidden Costs

By Dr. Stephen G. Timme, President FinListics® Solutions and CFOEd™

Copyrighted © 2001 by FinListics Solutions

Imagine planning your monthly household budget and overlooking the mortgage or rent payment! You probably wouldn't get very far. Yet this is how many companies manage their business. Managers typically are not accountable for the equivalent to the mortgage or rent payment - capital costs, which is a fair return to investors on investments in capital.

Capital includes:

• Net Working Capital.
  • Inventory.
  • Accounts Receivable
  • Accounts Payables
• Fixed Assets
  • Warehouses, Fleets and other Distribution Assets
  • Manufacturing Facilities
  • Other Property, Plant and Equipment

I have conducted numerous informal surveys when making presentations and found the following.

• When asked how many managers have some kind of operating cost metric on their scorecard, over 95% respond yes.
• When asked how many have a customer service level metric on their scorecard, over 75% respond yes.
• When asked how many are assessed a capital charge for the inventory, warehouses, fleets, plants, etc. they manage, less than 5% respond yes.

If capital costs were not a significant part of total costs, then accounting for them likely would not lead to better decisions. However, capital costs are significant!

• For example, the roughly 400 companies in the S&P Industrials have close to $500 billion invested in inventory and over $1,500 billion invested in fixed assets.
• As shown later, capital costs comprise, for example, 25% of total supply chain costs (operating expenses such a transportation, warehousing, etc. + capital costs).
• When a company is in the initial phases of improving, for example, its supply chain management, the capital costs benefits resulting from lower days in inventory and improved fixed asset utilization typically exceed the operating costs benefits.

Optimal decisions must incorporate both operating costs and capital costs. Accounting for on-going the capital costs leads to better supply chain decisions.

• Better balance is achieved between operating expenses and investment in supply chain capital (e.g., transportation costs vs. inventory levels, ownership of warehouses and fleets vs. outsourcing, network optimization).
• Total costs (operating expenses + capital costs) are better managed.
• Capital utilization improves.
• Competitive advantage is achieved.

Capital costs are capital times the Cost of Capital.

• The cost of capital is a blend of the after-tax cost of debt and a fair return to shareholders.
• The cost of capital is 10% - 13% for the average company.
• It is the opportunity cost a company incurs in using debt holders' and shareholders' funds since these funds could have been invested in other companies.
• The concept of the cost of capital is similar to the expected return on one's personal investment portfolio.
  • Suppose your portfolio has 30% invested in relatively safe investments that have an expected return of 5%.
  • The remaining 70% is invested in stocks with an expected return of 12%.
  • The weighted average expected return on your portfolio is approximately 10% (30% x 5% + 70% x 12%).
  • In evaluating the future value of retirement savings and other decisions, you would use the blended rate of 10%.

An Example: Supply Chain Capital Costs
Supply chain capital costs are the cost of capital times the amount invested in supply chain capital. Exhibit 1 shows a percentage breakdown of capital and operating costs for the distribution component of the supply chain. It shows that capital costs are 25% of total costs.

Examining the percentage of operating profits absorbed by capital costs highlights their importance. And how better management of capital costs helps create a competitive advantage. Exhibit 2 shows the percentage of profits absorbed by the capital cost for inventory - typically one of the largest components of capital. The analysis is conducted for selected industries' median and upper quartile companies.

In Exhibit 2, inventory carrying costs' absorption of operating profit is calculated as:

                                 %Absorption   =  Investment In Inventory x Cost of Capital
                                                               Operating Profit
                         

The results in Exhibit 2 show:

• Inventory capital costs absorb a significant percentage of operating profits for the median company.
  • For Automotive and Consumer Products these costs absorb approximately 40% of operating profits.
  • For Retail and Electronics the absorption is over 100%!
• There is a significance difference between the median and 1st quartile companies.
  • In Automotive, inventory capital costs absorb nearly twice as much in profits for the median company than for those in the 1st quartile.
  • For Consumer Products the difference is three times as much, whereas for Electronics the difference is a factor of 4!

The results in Exhibit 2 highlight two key implications associated with managing of capital costs.

• Companies with lower capital costs, such as those in the 1st quartile in Exhibit 3, provide better returns to investors.
  • They have better capital utilization.
  • A larger percentage of their profit is reinvest back into the business.
• Lower capital costs provide a competitive advantage.
  • Products can be sold at lower prices or profit margins.
  • This aspect of managing capital costs is becoming increasingly important as profit margins continue to be squeezed by increasing competition, customer demands and new technologies.

In summary:

• Most companies do not incorporate on-going capital costs into business decisions.
• Capital costs comprise a significant portion of total costs for many companies.
• Capital costs absorb a large percentage of operating profits for most companies.
• Companies with lower capital cost have a competitive advantage.
• To better manage capital costs, they must be incorporated into managers' scorecards.