Capital Management Objective

Capital management relates income produced to the amount of capital required to produce it. This determines the value of the firm, and its ability to attract more capital to increase production.

Capital management looks at

· Profitability (economic, not accounting – economic profit includes cost of capital)

· Adding, modifying, or eliminating capital investments

· Return on assets and capital (both within a company and between companies and/or industries)

· Comparisons of returns to stock price (e.g. P/E ratios)

Every profit center has a break-even volume level required to show a profit, based on its fixed cost and marginal rates. For example, if a store has monthly fixed costs of $20,000 and marginal cost rate of 75% of sales, the store must have sales of $80,000 per month ( $20,000 / (1-.75) ) to show a profit.

Hypothetical Store A has shown steady sales growth, but has not yet reached the breakeven level. (In 1996 and 2002, the last period of the year included an extra week, so sales in those two periods exceeded the breakeven level.) If current trends (and cost relationships) continue, this store should soon begin exceeding its breakeven sales level.

This store experienced a strike in 1998. Note how variable costs declined during the strike, but fixed costs did not. Sales did not cover fixed costs during the strike. Sales are currently covering variable and fixed costs (direct and indirect), and are making a contribution to cost of capital.

If the store is not reaching its breakeven sales level, there are three ways to fix it:

Increase the sales level (without adversely affecting the fixed and marginal cost values)
Decreasing the fixed cost
Decreasing the marginal cost

Hypothetical Store B was not reaching its breakeven sales level. In 1997 the store was remodeled. The breakeven point increased as a result of the capital investment, but the increase in sales has pushed the store well above even its new higher breakeven

level.

Direct fixed cost and cost of capital increased due to the renovation. This capital improvement was worthwhile because the increased sales that resulted more than covered the increased costs.

Obviously, it is not always possible to make these changes. If there is no hope that sales will reach the breakeven level, the action to take depends on the level of sales vs. costs, and on the nature of the fixed costs.

· If the store is not even covering its variable cost, it should be closed. It is losing more money being open.

· If the store is covering its variable cost, but not all of its fixed costs, it may make sense to keep operating it. If some of the fixed costs can not be eliminated (perhaps there is a long-term lease with no possibility of subletting), operating the store will at least contribute towards the fixed cost. Note that any indirect fixed costs that are allocated to a profit center would not be eliminated by closing the unit. Those costs would have to be allocated to the remaining units.

· If the store is covering its variable and fixed cost, but not its cost of capital, you need to consider how much capital can actually be recovered by closing the store. If the capital is in the form of improvements which can not be transferred or sold to someone else (for example, the built-in Starbucks cabinets), closing the store will not change capital investment. When considering elimination of a capital investment, you should evaluate how much capital will actually be freed up.

When considering a new capital investment or modification to an existing capital improvement, you want to consider the entire amount of capital investment required, regardless of whether it is recoverable at some point. The calculation of return of the new investment should be based on the entire amount of the required investment. If some of the capital invested can not be recovered, that is a risk factor to be considered when evaluating the risk-return payoff.

Profitability Case Studies

Specialty Department Store Profitability

This case study compares profitability for Pier 1 Imports, which is large and established, with Cost Plus World Market, which is smaller and growing.