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November 1996 Volume 1.4
Cost of Service
Market positioning in terms of the price for products
and services determines the revenue a company will receive. The
revenue received must cover the company's requirements for its profit
and for the cost of producing the products and services.
Revenue = Profit + Cost of Service
The profit required is set by the Board of Directors,
while the cost is determined by the management of the company. This
type of standard accounting practice fails to capture the entirety
of company costs as the cost of capital is ignored. A better way
of evaluating company financial success is needed.
While evaluation of capital intensive projects typically
considers capital costs, this approach has only recently been applied
to normal business costs. The classic case of problems caused by
a company not taking account of all its costs must be Salomon Brothers,
the New York investment company. While sorting out Salmon's problems
in the early 1990s, Warren Buffett said, "Rather strange,
frankly to me, thinking of having a business that employs close
to $4 billion of equity capital and not knowing exactly who is using
what".
Forty years earlier Buffett had sat in Benjamin Graham's
lectures at Columbia University marvelling at the first reliable
map for linking the intrinsic Economic Value of a company with the
price of its stock. For the first time Graham had looked at the
total cost of operating a business when determining its Economic
Value. Buffett later used this approach to become America's Number
1 investor.
Since the 1950s, other researchers have explored the
relationship between stock price and economic value. Using statistical
analysis, the Stern Stewart Company found a moderately strong linkage
(correlation of 0.5), between economic value and stock prices over
a range of industries. For the first time a mathematical link had
been found between what happens inside a company and the price of
its stock.
Economic Value is a simple concept: Revenue
= Operating Cost + Cost of Capital + Tax + Economic Value
Economic Value is what is left over when all costs
are taken into account. By definition a good Economic Value result
is zero as the cost of capital rate set by the Board has been met.
This rate is set to give a return to shareholders beyond the average
expected from investments in companies of similar risk. While Economic
Value is a good start in making the link to stock price, the low
correlation level indicates a need to look for other drivers.
(Stern Stewart & Co use their registered trademark,
EVA as shorthand for economic value added.)
Economic Value and
the Internet
While some might say that there is no profit to be
made in being an Internet Service Provider, let's look at how the
Economic Value approach might help our mythical companies W, X,
Y, and Z. The costs of providing Internet service are fairly straight
forward. The following model captures the main costs for an Internet
company:
This is a fairly high risk business. Jesse Berst,
a columnist on ZDNet's web site states, "Most Internet Service
Providers are losing money." So we need to set a high rate
for the cost of capital that covers the risk, say 40%. In the above
model the costs of each value driver will differ markedly according
to the way each company is operating.
Company W holds costs by keeping phone lines to a
minimum, as these are a major cost. Each night it takes over a data
circuit used by an international company and buys its internet traffic
service at low cost direct from a U.S wholesaler. Salary costs are
moderate as their Help Desk operates 8am to 5pm and on Saturday
morning. W's Yellow computer is moderately priced, and although
its modems are fairly expensive they can be upgraded cheaply. Cost
of operating capital is kept to a minimum as customers pay in advance
by automatic debit. Billing costs are very low as all accounts are
sent by e-mail. Company W has no marketing costs as it never advertises.
Company W is likely to provide positive economic value for its shareholders.
In keeping with Company X's high technical service
standards, it has a high ratio of dial-in phone lines to its customer
base. It buys Internet traffic service from a NZ based wholesaler.
Salary costs are high for X as it provides a 7 day a week Help Desk.
X's CEO decided to buy Purple Brain Box computers. He was particularly
impressed by the smiley face liquid crystal display on the computers
which tell you how happy the computers are. These computers are
very expensive and the 40% rate set for cost of capital means that
the cost of owning them is very high. Cost of operating capital
is also high as all billing is done in arrears on an hourly usage
basis. The billing is provided at moderate cost by a phone company.
Marketing costs are very high with large multi-colour newspaper
advertisements. This is a high cost model for running an Internet
company. X's CEO has stated that the company will not return a profit
for 3 years. In the Internet business a profit in 3 years means
no profit ever as new technology keeps changing the cost dynamics.
As X will have to replace its current modems with new high speed
models next year, it is unlikely that it will ever add any economic
value for its holding company.
The situation for Company Y is similar to that for
W, and while Company Z has excess costs in some areas, low revenue
is its real problem as customers slip out the door. While the economic
value approach has benefits for all companies, our mythical case
study companies would benefit by adopting the approach soon.
Melbourne
Melbourne certainly is a magic city. With the Festival
in October followed by the Spring Racing Carnival in November, it
certainly is a vibrant place to be at this time of the year. But
on a clear night its true magic can be seen from the Rialto tower.
Regards,
Rodger Gallagher
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