Part 1: Measuring Current Economies of Scale
CREATING COUNTABLE MEASURES OF PRODUCTIVITY
Capsule: Every business is a composite of three ultimate Building Block Costs: People, Purchases and Capital.
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We start our physical measures of the cost side of Productivity by counting Input costs. Every company uses People, outside Purchases, and Capital. These are the Company's irreducible cost Inputs, the Building Block Costs. Every cost the Company incurs falls into one of these categories. The Company identifies the key units of each of these Building Block Costs for its Productivity measurement. We will discuss each of these Inputs in turn.
People
The People costs include all costs related to the employees of the Company. These costs include the obvious costs of salaries, wages and benefits. These may also include costs that would increase or decrease directly with the number of people in the organization. People costs may thus include some costs that might be included as Purchase costs. Such costs might include office supplies, telecommunications, insurance programs, and pension management costs, among others. The inclusion of these purchases with People costs is optional.
The countable unit of measure for this Building Block Cost is one person working full time. This measure is often expressed as full time equivalent (FTE). The FTEs in an organization include all full time personnel plus all part time employees, who are counted as a fraction of an FTE according to the percentage of the year or period that the part time employee works. For example, a part time employee working half time would be counted as one half of an FTE.
We also further divide the full time equivalent people into at least three compensation levels of employee in the organization: Think Employees, Supervise Employees and Do Employees. The Company assigns its employees to these categories by using salary grades. Think Employees set policies and have middle managers reporting to them. They are the most “fixed” employees in costs in the organization. Supervise Employees have a few people reporting to them. They may also include the technical specialists in the organization. These employees tend to vary more directly with the growth in the business, but still have a high “fixed” element in their cost and numbers. Do Employees are the primary executers of the Company’s activities. These employees vary most directly with the growth in the Company’s activities. The Company should count the number of Think, Supervise and Do FTEs separately because they should have different Economies of Scale as the business grows. We discuss the use of this concept in a later page, Measuring Economies of Scale by People Type .
Purchases
Outside purchases include the costs of items the Company buys in order to keep the business running and to produce its products. These costs include purchased materials, energy, royalties, property taxes, and so forth.
The unit of measure for purchases focuses on the physical measure of the materials and supplies purchased. These measures include measures of weight or dimensions in physical quantities, such as tons of steel or paper, or square footage and linear footage for building materials. Where the Company uses outside assistance, it may use measures such as number of man-hours of assistance purchased.
Capital
Capital costs are the costs the Company pays in order to buy and carry the assets it uses. Land, buildings, equipment, inventories, accounts receivable and cash to run the business are all assets. The Company finances these assets with Capital. Capital includes all forms of equity, all funded (i.e., interest bearing) debt and leases.
The Company does not need as much Capital to run the business as it has assets. The Company gets some free sources of money to finance its assets. These are the Free Liabilities of the business. Accounts payable to suppliers would be an example of a Free Liability. The suppliers sell to the Company on credit. The Company takes delivery of the purchased asset from the suppliers before it pays for these purchases. The suppliers allow the Company to use the products they supply for fifteen to sixty days before the Company pays for them. These free sources of money to finance assets have no interest costs so they are called non-funded (i.e., non-interest-cost bearing) liabilities.
Capital is the source of money the Company uses to finance all the assets that the free sources of money, Free Liabilities, do not cover. There are two forms of this Capital: debt and equity. Debt is the promise the Company makes to repay the people who lend it money, either for a period of less than one year (short-term debt) or for a period of more than one year (long-term debt). All forms of debt have an interest cost, so they are called funded (i.e., interest-bearing) liabilities. Leases also bear an interest cost and are usually “capitalized” and included on the Company’s balance sheet. This means that the leases are recorded on the balance sheet at an amount equivalent to the debt the lease includes.
The second form of Capital is equity. The primary form of equity is shareholders' equity. The cost of shareholders' equity is usually called the cost of equity Capital. The weighted cost of all forms of Capital, both debt and equity, is called the Cost of Capital. This Cost of Capital, expressed as a percentage rate per year, may be applied to the amount of Net Capital Employed by a product, by an asset or by a customer relationship.
Some assets have costs that the Company already measures. Many of these are manufacturing assets where some companies have employed costs per machine hour in their management cost systems for some years. Most assets, however, do not carry specific Capital costs in the average company’s financial system.
The cost of Capital, and how to account for assets using Capital, often confuses people without a financial background. We suggest using some simplifying assumptions to get to a reasonable estimate of the costs of Capital at a departmental or business level. This approach finds an annual payment that would pay for the Capital and its costs over its expected life. Here is how it works:
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Ask the financial function of the Company for the pre-tax cost of the Company’s Capital (including both debt and equity).
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If the pre-tax Cost of Capital is not available, ask for the after-tax Cost of Capital figure and the Company’s average tax rate (usually around 35%). Divide the after-tax Cost of Capital by (1 minus the tax rate, as a decimal) to arrive at the pre-tax Cost of Capital:
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After-tax Cost of Capital = 8%
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Tax rate = 35%
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Pre-tax Cost of Capital = 8/(1 – .35) = 12.3%
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Ask the financial or operations functions for the average life of the asset for which you seek to calculate a Capital cost.
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Use a calculator or computer to find the annual payment (also called an annuity) which pays for the Capital, over its expected life, at a rate equivalent to the pre-tax Cost of Capital. For example, let’s assume that the Company would like to calculate the Capital carrying costs for a new asset that has a cost of $20,000 and an expected life of six years. The calculation would proceed as follows:
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Amount of the asset = $20,000
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Expected life of the asset = 6 years
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Pre-tax Cost of Capital = 12.3%
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Annual Capital Cost for the asset (done by calculator) = $4906
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This simplified approach to finding the carrying Cost of Capital provides answers accurate enough for all the work of cost management you will undertake.
The countable unit of Capital is a unit of local currency. There are other countable measures of units of Capital that the Company may also use. These include days of accounts receivable, days of inventories, machine hours, building costs per square foot and inventory or receivables turns.
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Building Block Costs Questions
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The Productivity, or Economies of Scale, that we analyze in this section of StrategyStreet creates a measure of Inputs ÷ Outputs. The units of measure for People (e.g., FTEs of Do people), Purchases (e.g., tons of raw materials), and Capital (e.g. dollars of Net Capital Employed) are the key countable measures of the Company’s Inputs. In the next section, we assign these Inputs to the cost functions of the organization.
Basic Strategy Guide Users Return to Step 27
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| Summary Points | Next: Cost Functions |