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Economic Profit

The Elusive Notion of Profit

Product developers that use the investor's perpective want to make a profit on their product development investments. But what, exactly, is profit? There are many definitions.

Most people probably think of profit as the net earnings number that appears at the bottom of an income statement. Another classic definition, that of distributable earnings, is the amount the owners of a business can withdraw as dividends while allowing the business to continue functioning normally [1]. In the last few years, many companies have used something called "operating profit" to report the profit from just their operations, the idea being that income and expenses from activities outside of operations, such as investment interest and restructuring expenses, are not as important to investors as the results from the core business of the company.

Opinion

The best definition of profit for product developers to use in their decision making is one called "economic profit". Actually calculating economic profit requires a detailed analysis of and adjustments to a company's financial statements, but a reasonable simplified definition is:

Economic Profit

Profit from operations minus the profit the world expected given the amount of capital invested in operations.

For a more formal definition, and guidelines for how to calculate economic profit, see [1] or  [2].

Figure 1 illustrates the idea using a total value statement, and uses net earnings as an approximation for profit from operations.

You May Look Profitable but be a Value Destroyer

One interesting thing about economic profit is the number of big name, very successful companies that appear to be profitable but actually create an economic loss. Such losses actually destroy value, as the capital invested in those companies could have been put to a more productive use. Much of the corporate raiding in the 1980s was all about freeing up capital that was captive in companies that persistently destroyed value.

The consulting firm of Stern Stewart and Co. publishes economic profit figures for the Fortune 1000 each year [3] , and they are interesting to browse through. In 1999, for example, Lucent Technologies, AmericaOnline, Hewlett-Packard, and Time/Warner all reported positive net earnings but produced economic loss. They failed to beat the expected return in that year.

Here's a quick case study to illustrate economic profit. Suppose that Agyle Software has net earnings of $500K for the last year. Also, suppose that Agyle employed invested capital (i.e. all the capital invested in the company) of $10Million to produce that $500K. Invested capital is not shown in Figure 1 - it is derived from the company's balance sheet. The invested capital could have come from investors, lenders, profit from past years, etc. It's ALL the capital that the managers of Agyle had at their disposal to produce the past year's profit.

Now, the question is, are the investors satisfied with the $500K in profit? At first glance, one would think so. They didn't really work for that money, now, did they?

That's not only false but irrelevant. The investors will be satisfied if the 5% return on invested capital at least meets their expectations. Exactly what return they expected depends on what other investments they could have made with their money, and how the return and risk of those investments compare to their investment in Agyle.

Market Expectations Take Risk Into Account

For example, if treasury bills (T-bills) returned 5% in the past year, then Agyle's investors will be very dissatisfied. They could have made the same return in a virtually riskless investment - T-bills. Suppose instead that T-bills yielded only 2%, but that Stolid Power, a large utility, yielded 5%. In that case Agyle's investors would still be dissatisfied. While their 5% return in Agyle beat the T-bill return, they could have invested in Stolid instead of Agyle and received the same return with less risk. An investment in Stolid, like an investment in Agyle, is a risky investment, but Stolid's risk is nowhere near as high as that for a small software company like Agyle, and Stolid's return is the same. Stolid would have been a much better investment.

So, Agyle's investors expect a return that is commensurate with the risks inherent in Agyle's business. Investors in small software companies in today's equity market expect percent returns as high as in the low twenties. Only returns that high will increase Agyle's appeal as an investment, and therefore its value as a company.

That is a point worth reinforcing.

If a company fails to produce a return that at least equals the company's expected return, the value of that company will decrease.

Making a profit is not enough - you must beat the expected return to increase the value of your company. Note that this applies to projects within a company as well as a company as a whole. A project with a return that exceeds expectations creates value, and a project with a return below expectations destroys value.

The Cost of Capital is a Useful Estimate of Market Expectations

The expected return for a company is called its "cost of capital" or "weighted-average cost of capital". The term "weighted average" refers to averaging the cost of money from all sources, for example lenders and equity investors, to determine the overall cost of capital for a company.

So what does this esoteric financial theory have to do with product development? Well, every decision is a business decision, and now we see that a good decision is one that leads to economic profit. So, how well do typical project teams assess economic profit in their decision making?

Not very well. The best project teams are sophisticated enough to use metrics like break-even, opportunity cost, or cost of delay in their decision making. However, even teams using those metrics are likely to unknowingly destroy value because those metrics don't take into account the cost of capital in determining if a particular action creates value.

Practice

Adding the idea of economic profit to the investor's perspective makes possible a very thorough assessment of any investment decision.

A Case Study: Nibbler's Offer to Team Nimble

As an example, suppose you are in your first week on the job as manager of the Nimble product at Agyle Software. You are holding your first team meeting of the Nimble release 2.0 team when the door opens and Agyle's best salesman, Rev Reversal, walks in with great news.

"Nimble Team," he says, "I have a wonderful opportunity."

He turns to you and says, "A hot prospect, Nibbler Corporation, wants us to add a quick new feature (QNF) to version 1.0 of Nimble. They'll pay $15K to get QNF, but they need it right away."

He's looking at you for support, and continues: "I spoke with Bob and he says that he can do the work in about 40 hours." Bob is the lead software engineer on Nimble release 2.0, and he spent a day scoping QNF, thus impacting 2.0 without telling anyone. But, Bob sits proudly in his chair, because at Agyle everyone is a Change Rambo, and stopping work on release 2.0 to assess an interruption like QNF is not just acceptable, it's heroic.

"What do you say?" Rev smiles.

Now, what Rev expects from you is one of three answers:

a. "We won't do it because it's not in the plan." This answer will mark you as a bureaucrat who won't fit in at Agyle.

b. "I'll have to review it with the [fill in the blank: the team, my manager, Marketing, etc.]." Rev figures that since you're new, you'll take this approach. It buys you time.

c. "How much money has Nibbler spent on our products?" This would show that you are interested in supporting good customers, and will please Rev. It shows he has your interest.

The Total Value to the Customer - Start There

Your answer? None of the above. You ask "what is the total value to the customer?"

The room is silent. No one has ever heard this question before. And what business is it of yours, anyway, to ask what the value is to the customer?

It's absolutely your business. You are responsible for the success of Nimble. There is a very good chance that the total value to the customer of QNF is zero, and that they asked for it just as a negotiating point. On the other hand, the value of QNF could be huge - perhaps enabling a lot of future business for Agyle. So, checking on total value as the first step in your analysis is exactly what you should do.

Rev, being a good salesman, knows the answer. "It's about the same, relative to revenue, as the rest of the Nimble product. We figure that for the $15K they'll pay for it, they'll get around $7.5K in net benefit the first year. At least, that's the kind of return that they've achieved so far in using Nimble. They said so in the case study that they approved for release." Agyle is a good software company - it knows the total value of its products and services.

OK, so now you know that the customer has a real need, the deal is fair compared to past sales to Nibbler, and that the deal is not earthshaking. So, you and the team complete a quick analysis, stepping through an outline of the total value statement to analyze the likely return for Agyle. The result is in table 1 below. If you don't want to review the details, just note the net earnings amount at the bottom and continue reading.

You and the team have sketched this analysis on a white board, and Rev is ecstatic. The benefit is $15,000, the cost is $11,680 plus taxes of $564, and the risk is low (you and your team are confident in your estimates). A  low-risk profit of $2256 means that you'll proceed with QNF immediately, right? No, there's more:

The cost of capital at Agyle, i.e. the expected return, is 20% of invested capital. The incremental investment here is the total expenses, which is COGS of $500 plus operating expenses of $11,680 or $12,180. 20% of that is $2,436.

So the economic profit is $2,256-$2436 or -$180. That's an economic loss.

So, this looks like a bad deal, but there are more issues to debate.

A Dollar of Revenue is a Dollar of Revenue, and Costs the Same

Rev protests the $3,000 charged for Support, Marketing, and Admin. He argues that those costs are fixed and are independent of implementing QNF. However, you point out that even though QNF will not cause Agyle to add headcount, the time those people spend on QNF could have been spent on something else, and the $3,000 expense represents that lost opportunity. Therefore, their time should be charged to the revenue from QNF just as it would be for any other revenue. A dollar of revenue is a dollar of revenue, and Agyle must spend money to turn a dollar of revenue into a dollar of profit. Note that this is true regardless of how many hours people work, so arguing that everyone can just work more hours doesn't change the expenses or the analysis.

Rev need not give up hope, though. He has room to negotiate a higher price. He could argue that QNF creates options for Nibbler as well as Agyle, and add the value of those options to the analysis. The point is, he can now do those things all within the structure of the total value analysis that you, the project manager, started, and Rev has every reason to think you'll respect his analysis if he builds on yours. You and Rev should be able to come to an intelligent decision that makes business sense.

If a Change Produces Economic Profit, then Feel Good About It

Not only that, but you are as interested as Rev in finding value in this deal. If you can produce an economic profit, you and the rest of the team should feel good about doing the deal, despite the interruption it will cause, because you will have taken into account all the costs including the pain of delay. Not only that, but you will have an intelligent argument for the deal that should appeal to Agyle's management. Finally, any value you can create for Nimble should help you raise more funding for future releases, which will make it more likely that you and the team will get to continue playing the game.

This example was rigged to show how economic profit can help you avoid investments that at first appear profitable but are in fact value destroyers. Conversely, and perhaps more importantly, a total value analysis can help teams find value in investments that they would otherwise summarily reject due to bad habits or rigid process.

Everyday Economic Profit

Economic profit is a useful concept not just for formal investment analyses like the example. Like good design, customer satisfaction, and real options it's a concept that is generally useful. Here are a few suggestions that use hours, instead of dollars, to assess value:

• Estimating the value of a meeting. Multiply the length of a meeting, in hours, by the number of participants. Then ask if the meeting will save an amount of time, measured in people-hours, that justifies the people-hours spent on the meeting. How  many people-hours is that? It's equal to meeting-participant-hours*(1+cost of capital). So, if your company's cost of capital is 20%, then a ten person meeting for one hour would have to save 12 person-hours to justify itself. That's (1+20%)*10 person-hours. This can be an eye opener and reinforce the value of time.
• Assessing the value of adopting a new practice or tool. An analysis that compares hours invested to hours saved can illuminate the usual "we just have to do it" justification.
• Assessing the value of testing and fixing earlier versus later. Compare the typical find/reproduce/communicate/fix cycle for unit testing versus test group testing. Or better yet, do the analysis for internal testing versus customer (euphemistically "beta" testing). The investment is the time required for the earlier testing per defect. The benefit is the difference between the time spent later and the time spent earlier. There is often a lot of opportunity for clearer decision making in this area.

So, economic profit is a useful model for any situation where some metric of value is available. It's a useful way to think about decisions even when dollar figures are not available or don't apply - just ask "will this plan of action help us to beat expectations?"

Philosophy

Using economic profit as a key metric in decision making is philosophically valid because:

• It encourages making efficient use of capital, which is scarce. Capital represents past labor and sacrifice and deserves to be used efficiently.
• It shows that an inefficient profit is better than a loss in degree only, not in kind. A company that produces net earnings but economic loss is not a productive company. Such institutions slowly fritter away the capital invested in them despite their positive net earnings.
• It reveals what is necessary to increase the value of a company, i.e. to make a company worthy of additional investment.

Summary

• Making a profit is not enough. Creating value requires not just producing a profit but beating expectations as well.
• Use economic profit as the ultimate metric of the quality of an investment. It raises the bar on what constitutes a valuable investment.
• Broaden your notion of capital to include not just money but resources such as labor time and calendar time, and then use economic profit to make better decisions regarding process, practices, and other investments that are difficult to quantify financially.

References

1. G.I. White, A.C. Sondhi, and D. Fried, The Analysis and Use of Financial Statements, John Wiley & Sones, New York, 1998.

2. T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies, John Wiley & Sons, New York, 1996.

3. Stern Stewart & Co., The 2000 Stern Stewart Performance 1000, (accessed 9/6/02), <http://www.sternstewart.com/content/performance/info/us.pdf>.

Copyright 2002, Peter Bradshaw. All rights reserved.

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