Profit is not everything

Everyone is excited about profits.  They get more excited when profit showed growth i.e this year’s profit is better than last year.  In accounting they call it as variance analysis.  It become more meaningful when the variance is  converted  into percentage; such as 50% growth rate.

Little do this simple readers realise that more analysis need to be done to measure real performance.   Was there efficiency in the utilisation of costs or capital to generate the profits?

Cost benefit analysis

The above tool is used to measure management efficiency in managing costs.  How much profits could be generated from RM1 costs incurred?   Any income exceeding costs should be a good indicator.   Again ratios should be used to analyse efficiency i.e profits over costs.  A percentage of 30% means that for every ringgit costs 30 sen is being generated as profit.

Return to capital employed

Although you may be efficient in utilising costs, you might not be efficient  in managing capital.  The ROC is a ratio where profits is divided by capital to arrive at a ratio that gives you total performance evaluation.

Return to equity

ROC measures efficiency in capital usage regardless of whether it is your own funds or borrowed.  However, if you want to measure performance on your shareholders capital contribution or equity, another ratio is relevant i.e Return on equity where profits is divided by equity.

Lets put them in figures

The figure RM10 million profit is not enough to show a true picture of performance.  It could be generated by RM1,000 million costs which in terms of cost benefit analysis it is just 1% profits.  If the capital employed is RM2000 million, the ROC is only  0.05%.  However if out of the capital employed RM500 is equity, the ROE shall be 20% which looks better.

Alternative presentation

	Revenue	RM1,010		Costs benefits	1%
	Costs	1,000		ROC	0.05%
	Profits	10		ROE	20%

Positive Change next year by  RM2 million profits

		1st year	2nd year
	Revenue	1,010	2,012		1st year	1.010	Less efficient
	Costs	1,000	2,000		2nd year	1.006
	Profits	10	12		20% growth

If variance analysis were used, there is positive indication of 20% growth.  However, on detailed analysis efficiency has in fact deteriorated.

This is exactly what we are trying to highlight.  Measuring only bottom line results may not show the true  performance.  We need to check deeper to gain better understanding of its operational efficiency.

Lets summarise what we did earlier.  In analysis we prefer to  convert figures into ratios and relate outcome to costs or capitals or other meaningful variables.  In addition to bottom-line evaluation, we need to check operational efficiency.

Graphic presentation for a better understanding.  (wait for the next posting)