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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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INCORPORATING THE COST OF CAPACITY

A cost of capacity framework is necessary for insight into the short term versus long term. This framework breaks economic profitability of customers and products into two groups. The first group includes only the direct operating costs. It includes the direct variable costs of manufacturing and selling products as well as a charge for the net working capital tied up in running the business. The second group consists of longer-term capacity costs, often step costs that are quite independent of volume.

Short Term versus Long Term

The EP contribution margin shows if the business is value accretive in the short term, covering the variable costs and including variable capital costs. Full cost EP shows if the business is value accretive in the long term, covering all related costs (including all fixed cost and capital, such as the cost of capacity). For example, we evaluated the profitability of global food company portfolio.

Lighter bars show the EP contribution for each of the eight products in the portfolio. Each contributes positively toward indirect costs and capacity except for a low margin product unable to cover even direct economic costs, such as material, labor, and the carrying cost of directly attributable working capital.

Though short-term portfolio decisions are likely to include the potential discontinuation of this product, the more pressing strategic issue may be the longer-term one regarding total capacity. Direct economic profit ...

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