Question

When Roberto Goizueta became Coke’s CEO in 1981, he took over a poorly performing company that had diversified into unrelated businesses ranging from water purification to shrimp farming. One of his first initiatives was to analyze Coke’s various businesses using economic profit. The analysis concluded that only Coke’s core carbonated beverage business was creating shareholder value. The other businesses, while generating revenue, were actually consuming value. Consequently, they were divested or shut down. Goizueta then focused on Coke’s core beverage business using its substantial competitive advantages: global brand, worldwide distribution system, and sales and marketing expertise. The result was 18 years of success.

Similarly, when Bob Lane took over a poorly performing John Deere in August 2000, he quickly identified Deere’s biggest problem: spending too much money to make money. Factories tended to overproduce, leading to a large number of very expensive, large farming machines simply sitting on dealer floors. Lane began looking at economic profit. He decided managers were treating capital as a free resource. He charged each division manager 1 percent each month of the cost of the assets they used and required that at the end of the year their financial results exceed the charges. Deere has done well in the succeeding years.

What is the appropriate measure of a firm’s performance?

What does a focus on economic profit as opposed to a focus on accounting profit mean for a firm and its investors?”

Answer 1

INTRODUCTION

Profit is a highly debated economic concept and this is one of the reasons why the purpose of the following analysis is to highlight the link between the economic profit and the economic performance of the company. There have been numerous attempts and methods to define and explain the notion of profit. Thus, profit can be defined “in terms of the positive difference between the revenue gained after the sale of the goods produced by a business entity and the costs incurred during production, understood as a measure of economic efficiency”.

Broadly speaking, profit is the monetary benefit or advantage gained after performing an economic activity. The business entity cannot exist and cannot sustain its further development if it doesn’t recover its costs and gain surplus revenue. As a result of the economic activity, seen as a gap between the revenues and the expenditures of a business entity, all the lucrative activities performed in an economic system are believed to have profit as a main objective.

The appropriate measure of a firm’s performance:

There is no satisfactory definition of the term profit. In simple terms, profit can be understood as all the revenue generated by an individual or company. Profit is the goal of any business. There is no business. There are two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between money brought in and money paid out. When calculating accounting profits, the things that are considered include leased assets, non-cash adjustments/transactions for depreciation, provisions, allowances and capitalizing development costs. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, it’s economic success depends on its economic profit. When calculating economic profits, several things, like opportunity costs, residual value, inflation level changes, tax rates, and interest rates on cash flow, are considered

The accountant and economist think differently. The accountant would consider production costs and how they affect company’s profitability. They would consider themselves as a production cost. On the other hand, when an economist describes the costs, they are more interested in how the company has decided to run the business or why they decided to imply a strategy and what impact those strategies will have on the rest of the economy.

  To better understand the difference between economic and accounting profit, assume the total revenue of X business is 400,000. The explicit cost (utility bill, interest payments, mortgage, raw material cost, transport, storage cost, packaging cost, labour cost and more) is 150,000. So, the accounting profit would 400,000 — 150,000 = 250, 000 (total revenue — total explicit costs) and the economic profits 400,000 — (150,000 + 200,000) (total revenue — (total explicit costs + total implicit costs)) is 50,000. The accounting profit is interested in earnings more than what is going on in the marketplace. In this case, X made 50,000 more than marketplace income, hence that is X’s economic profit. Accounting profits are simply what you take home after deducting your explicit costs from your company revenues.

To sum up we can say the performance of the business unit cannot be associated with the accounting profit, but with a comprehensive income that is superior to what had been achieved in a previous time period and higher than what the competition has earned. Performance is not a mere confirmation of the accounting profit; it is the result of a comparison between the earnings and the objectives. Therefore, performance is always the result of a comparison. The economic performance of a business entity entails competitiveness, competitive advantage, efficiency and effectiveness. An efficient business conveys value for equity investors, meets the needs of its clients, takes into account the opinions of its employees and preserves the natural environment. The accounting profit is calculated at the end of each accounting period, while economic performance is achieved in time and not at one single moment. The replacement of the accounting method used by the business unit influences the accounting profit, but not the overall performance of the business. Performance can be assessed if the business is believed to continue indefinitely into the future. Note that accounting prudence discourages the rational assessment of the accounting profit and, implicitly, of the economic performance. The matching principle applied throughout the accounting period and the presence of accrual accounting can generate several accounting and financial consequences.

What does a focus on economic profit as opposed to a focus on accounting profit mean for a firm and its investors:

since accounting profit has generally more evidences; it can be more reliable comparing to economic profit, but economic profit considers all aspects, and it is more relevant than accounting profit. Consequently, using both profits can have more effectiveness. When a business studies an investment project, it firstly looks for estimating economic profit. The mentioned economic profit is estimated using input flows (incomes) and outputs (costs). The business should pay in cash the final price of acquiring required assets. This payment shows a missed opportunity cost which could be used for more efficient alternative options. Hence, the business should measure future net costs. Clearly, accounting profit does not reflect initial need for input and output flows of cash money in the future years and it is merely for economic profit that reflects real cash transactions related to investment projects. The investors are seeking high reliability of input flows in their analysis in order to guarantee the primary investment and approach of economic profit can fulfill management analysis of the investment. To calculations’ view, the economic profit has less calculation ambiguity compared to the accounting profit. There are a number of various methods for available sharing in the stocks, cost allocation and calculating depreciation to calculate accounting profit, so that different net profits will be gained as accounting procedures. Obviously, an economic approach which is based on valuing a project is not more than this circumstance and it holds an accounting approach. In the end, the economic profit focuses on “time value of money” by denying its own calculations, whereas it ignores accounting approach of it. Reference to usual regulations of accounting, invoice is registered as an income while this document may stay there untouched for months and years without flow of any cash money. In contrast, costs are registered upon being fulfilled without any real payments. However, although accounting profit is a very useful criterion to assess performance, it is not a complete criterion for decision-making. Thus, from perspective of capital management, an economic approach can supply a better basis to estimate future investment resources.