The Finance Gem 💎 Week #27: CEO's KPI, CAPEX vs. OPEX, Profitability and Returns

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• The CEO KPI Checklist

• The Overhead ABC

• EBITDA vs. EVA vs. RI

• ROI vs ROE vs ROA

• CAPEX vs. OPEX

It’s tough being a CEO.

Every decision impacts financial health, employee morale, and stakeholder satisfaction.

To succeed, you’ll need to measure and monitor performance.

And to closely track everything you want to impact.

Financial and Non-Financial Metrics.

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Here are 50 KPIs a CEO should monitor and manage.

The Key KPIs across key 6 areas.

1. Financial Metrics

2. Non-Financial Metrics: Employees & Workplace

3. Non-Financial Metrics: Environmental, Social, and Governance (ESG)

4. Non-Financial Metrics: Market & Customers

5. Non-Financial Metrics: Strategy & Operations

6. Non-Financial Metrics: Stakeholders & Compliance

Download a PDF copy here. It’s free for you as a subscriber, but only for a limited time.

aka Activity Based Costing.

Here’s what you need to know.

🎯 What is Overhead?

Indirect costs or operating expenses not directly attributable to a specific product or service

⚫ Overhead can nevertheless be manually allocated to products and services to ensure all relevant costs are included when determining total cost and profitability per product or service

⚫ Rent, utilities, and indirect labor fall under overhead costs

🎯 How is Overhead allocated?

2 methods:

1️⃣ Traditional costing 

⚫ A costing methodology where overhead costs are amalgamated into a single cost pool and then allocated based on a single so called “cost driver” like direct labor hours or machine hours

2️⃣ Activity-Based Costing (ABC) 

⚫ A costing methodology that provides better cost information than traditional costing

⚫ Particularly beneficial in complex environments where resource consumption by products or services isn’t uniform

🎯 How does ABC work?

⚫ by identifying business activities and assigning their costs to products and services based on how much each product and service uses that activity

⚫ the outcome is that more indirect costs (overhead) get treated as direct costs

⚫ the benefit is that with better direct cost understanding comes better pricing for improved profitability

🎯 How do you implement ABC?

1️⃣ Identify and classify all business activities that consume resources

⚫ machinery setup, design changes, running machinery

2️⃣ Allocate costs to activities

⚫ activity costs typically represent a mix of direct and indirect costs

⚫ for example, imagine a trying to allocate the cost of running your machinery in a factory (the business activity)

>> your direct costs include labor costs of machine operators and the cost of raw materials used

>> your indirect costs include the machine depreciation, the portion of utility costs incurred to operate the machines, and the portion of the factory rent for the space occupied by the machines

>> your total cost will be the sum of the direct and indirect costs assigned to this activity

3️⃣ Identify cost drivers

⚫ cost drivers are factors that drive the cost of activities

⚫ most companies use labor hours, machine hours or number of units, but those are rarely directly driving the cost of production activities.

⚫ examples of true cost drivers include: the number of setups, the square footage, the number of purchase orders, the number of design changes

4️⃣ Assign activity costs to cost objects

⚫ use the identified cost drivers to allocate the costs of the various business activities to the cost objects (products or services) that made use of that activity

🎯 What’s challenging about ABC?

Several things.

⚫ Complex and Costly because it requires a detailed analysis of activities and resources

⚫ Data Intensity because it requires a significant amount of data collection and analysis

⚫ Subjective because different assumptions for cost drivers can lead to different cost allocations, potentially reducing the consistency and comparability of cost information

🎯 What’s the middle ground between ABC and Traditional Cost Allocations?

It’s complicated, but here’s what you can try.

⚫ Use ABC for Key Decisions Only and apply selectively for critical, strategic decisions vs company-wide implementation

⚫ Combine ABC with Traditional Costing and use traditional costing for routine financial reporting and ABC for internal decision-making

⚫ Implement a Simplified ABC Approach where you choose a less intricate ABC model by grouping similar activities or using broader cost drivers

⚫ Leverage Technology and rely on software and ERP systems to reduce the ABC implementation costs and complexity by automating data collection and analysis

Are your accounting profits sufficient to cover:

🎯 the opportunity cost of equity

🎯 the opportunity cost of debt

🎯 or both?

The short answer is:

❌EBITDA pays no rent.

⚫ RI pays explicit rent to shareholders.

✅ EVA pays rent to shareholders and debt holders.

The “rent” is the opportunity cost of capital required to get from Accounting Profit to Economic Profit.

➡️ If economic profit is positive, it means the company is generating returns above the opportunity cost of all resources used, not just the costs recorded on the books

But

➡️ EBITDA doesn’t account for any opportunity costs.

➡️ RI explicitly accounts for only for the cost of equity capital.

➡️ Only EVA accounts for the opportunity cost of both debt and equity capital.

🎯Here’s what you need to know:

1️⃣ Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

- Formula: EBITDA = EBIT + Depreciation + Amortization

- Caveat: EBITDA does not consider the cost of capital (debt or equity) and might also provide a distorted picture of financial health, especially for companies with high levels of debt or substantial capital investment needs

2️⃣ Economic Value Added (EVA)

- Formula: EVA = EBIT x (1-Tax Rate) - (Total Invested Capital * Cost of Capital)

- Caveat: EVA might be less relevant for companies whose value primarily comes from internally generated intangible assets (like intellectual property or brand recognition), as these are not traditionally recognized on the balance sheet or factored into the cost of capital

3️⃣ Residual Income (RI)

- Formula: RI = EBIT - Interest - Tax - (Equity Capital * Cost of Equity)

- Caveat: The accuracy of RI is highly dependent on the cost of equity estimation plus it does not expressly consider the cost of borrowing, making it less suitable for companies with significant levels of debt.

🎯 So which one should you use?

Ideally, EVA at the company level, RI at the divisional level.

🎯 And what about EBITDA?

Don’t use it to assess value creation.

A trifecta of powerful financial metrics to help you assess:

➡️ the profitability of an investment

➡️➡️ the effectiveness of total asset management

➡️➡️➡️ the efficiency of a company's use of shareholders' equity

But beware:

⚫ ROI distorts profitability and could lead to financial trouble, because it doesn't consider the time value of money and it doesn't account for risks involved in the investment

⚫⚫ ROE can be manipulated by management decisions that artificially reduce equity (share buybacks) and could lead to deteriorating business financial health by encouraging management to take on too much debt in the effort to increase returns

⚫⚫⚫ ROA could also lead to deteriorating business financial health by ignoring asset financing choices (debt vs equity) and it can also make comparisons across industries challenging by coming in disproportionately low for capital-intensive businesses

🎯Here’s what you need to remember:

1️⃣ Return on Investment (ROI)

- Formula: ROI = (Net Profit / Cost of Investment) * 100%

- Caveat: ROI doesn't consider the time value of money, which makes it less useful for multi-period investments, plus it ignores the investment risk profile

2️⃣ Return on Equity (ROE)

- Formula: ROE = (EBIT - Interest - Tax) / Equity

- Caveat: ROE can be heavily inflated by excessive use of leverage and artificially reduced equity balances

3️⃣ Return on Assets (ROA)

- Formula: ROA = (EBIT - Interest - Tax) / Total Assets

- Caveat: ROA includes depreciation so it will be lower for capital-intensive businesses which already have higher Total Asset balances

CAPEX vs. OPEX

Capitalizing vs. Expensing

Here’s what you need to know:

Capitalizing = recognizing a cost on the balance sheet as an asset, and then regularly reducing the value of that asset by a depreciation expense on the income statement.

Statements impacted:

⚫Balance Sheet >> increased non-current asset balance

⚫Income Statement >> reduced profitability from increased depreciation expense

⚫Cash Flow Statement >>increased investing cash flows, and reduced ending cash balance or increased financing cash flows

Key ratios impacted:

⚫Return on Assets

⚫Return on Equity

⚫Debt to Equity Ratio

⚫Asset Turnover Ratio

⚫Earnings per Share

Examples:

➡️ software development costs that meet capitalization criteria

➡️ storage costs of whiskey barrels incurred in the process of ageing it

➡️ legal fees for developing your capitalized patent assets

Expensing = recognizing an expense on the income statement in the same period it was incurred, rather than spreading it over several periods as in the case of capitalized expenses.

Statements impacted:

⚫Income Statement >> reduced profitability from higher total expenses

⚫Balance Sheet >> reduced cash balance or increased liabilities

⚫Cash Flow Statement >> reduced operating cash flows

Key ratios impacted:

⚫Return on Assets

⚫Return on Equity

⚫Debt to Equity Ratio

⚫Earnings per Share

⚫Interest Coverage Ratio

Examples:

➡️ research costs to determine feasibility of developing your new software

➡️ storage costs of warehoused whiskey awaiting delivery to your customers

➡️ legal fees to defend against a supplier lawsuit

Key questions to answer:

- When to recognize: when future economic benefits associated with the item are probable and the cost of the item must be reliably measured

- How much to recognize: initially must be recorded at cost, which includes all costs necessary to bring the asset to working condition for its intended use

- When to start depreciation: when the asset is available for use and continues until the asset is derecognized.

- What about maintenance CAPEX: it is expensed (maintains asset current condition and performance)

- What about improvement CAPEX: it is capitalized (increases asset capacity, efficiency, or lifespan)

- What about Tax implications:

- expensing the cost of an item reduces the business taxable income, and lowers the tax payment for that year

- capitalizing the cost of an item spreads the tax benefit over the useful life of the asset with only the annual tax depreciation expense being available to reduce the business’s taxable income every year

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Thanks so much for reading. See you next week.

Oana