Addressing Capital Recovery — The Need

In our cases, Old Line and High Tech have fixed costs at 10 percent of total cost (refer to Table 27.3). On the other hand, Process has a structure with 40 percent fixed cost, most of which is capital investment. For purposes of illustration, we will consider those costs to include all capital recovery items for both working capital (e.g., inventory, receivables) and fixed asset investments (e.g., land, plant and equipment). 

One can readily spot the importance of capital recovery in a company such as Process where fixed costs are high. Even High Tech has 10 percent of its total and almost 20 percent of its internal cost in the fixed category. With traditional accounting, capital costs reside in overhead accounts such 

The last point is directly applicable to this book. And we would respond with a resounding Yes to that question. Meaningful partnerships require investments in both physical assets and systems. So an agreement on accounting for these is mandatory if partners are to move beyond arm s length relationships. 

Another important driver is the point about market cap. Capital markets value a stock more to the extent it earns profits beyond the certain return of a government bond. However, few companies have the means in place to ensure that threshold is reached. 

The idea of combining capital recovery into measurement of current financial performance is not new. A method called residual income has been practiced for decades. Residual income subtracts the cost of capital employed from the income statement. For example, Acme s 600,000 NC machine, described in Chapter 26, would be charged a capital cost of ownership of 90,000 (15% x 600,000) against the expected benefits. This is because Acme s hurdle rate is 15 percent. Because interest is deductible for tax purposes, many adjust the cost of capital to include the impact of taxes and asset life. 

---