Category Archives: three sets of books

contribution margin

April 15, 2015 By in contribution margin, three sets of books Tags: , , , , Leave a comment

three sets of books

A couple of years ago, I wrote a post about the three sets of accounts that a publicly traded company maintains:

–tax books, where the objective is to pay the smallest amount of tax legally possible–in other words, to fool the IRS,

–financial reporting books, where a more liberal view of when and how revenues and expense occur allow a company to put its best foot forward with owners–in other words, to fool shareholders, and

–management control books, also called cost accounting books, which the company uses to actually run its operations.

contribution margin

Contribution margin is a cost accounting concept.

The first thing to note is that despite its name it’s not really a margin–that is, it’s not a percentage.

Instead, it’s the amount by which an activity or a  line of business exceeds its own direct costs and makes a contribution to corporate overhead.  This isn’t the same as making a standalone profit, meaning after covering total costs.

Take a restaurant that’s now open for lunch and dinner and makes money doing so.

Should it open for breakfast, as well?

In the simplest case, the question is whether the restaurant can generate enough revenue to offset the cost of paying for the food and the staff.  If so, it makes a positive contribution margin.  If we were to allocate, say, 20% of the restaurant’s total expense for rent, electricity and depreciation of equipment,  breakfast might be bleeding red ink.  But those costs are there anyway, whether breakfast is or not.  As long as the contribution margin is positive, the firm is better off with breakfast than without.  (Yes, the actual situation is more complicated   …is the wear and tear higher because of breakfast?   …does breakfast cannibalize the other meals?   But I’m keeping it simple to illustrate a point.)

Another case.   Some lines of business may never have been intended to create growing profits, or may no longer be capable of doing so, even if they once were.  A manufacturer may make precision components in-house.  The component division will typically be run as a cost center, not a profit center.  It’s mission will be to provide high quality parts at the lowest price, not to maximize profits.  Its managers will be evaluated by their ability to provide output more cheaply than third-party alternatives can.  Again, the division may not be profitable after allocation of its share of corporate overhead.  Still, it may be very valuable.  Its value will be measured by contribution margin, defined as the difference between in-house and third-party component costs.

Why is this important?

It’s a mindset thing.  Not every part of a company may be intended to grow.  Rising stars may eventually turn into cash cows as businesses evolve.  It’s important both for company management and investors to understand the role an activity should be playing in the overall enterprise.

 

 

capitalizing, expensing and the internet (ii)

July 31, 2013 By in capitalizing vs. expensing, Constructing a Portfolio, Current Market Thoughts, depreciation, Portfolio management, Stock ideas, three sets of books Tags: , , , , , 2 Comments

Back when I entered the stock market, and when the CFA Institute was run by professional investors, that organization published an industry-by-industry guide to securities analysis written by veteran industry specialists.

The section on technology was a real eye-opener.  It was a litany of virtually every accounting fraud known to man.  The abuses ran in two related areas:

–capitalizing (and therefore delaying recording as expense) almost everything, especially research and development expense, and

–setting unrealistically lenient schedules for depreciating or amortizing these balance sheet accounts.

The result (and intent) of this chicanery was income statements that showed profits far in excess of the “real” amounts–even paper “profits” when a company was actually bleeding red ink.

The abuses were so blatant that the accounting rules were changed in the US to force virtually all companies to expense R&D costs as incurred, rather than store them up on the balance sheet.  Virtually all companies still write off against income the cost of their plant and equipment much more slowly in their financial reporting to shareholders than they do in their tax reporting to the IRS.

Fast forward to the present.

What effect does the long-ago change in accounting rules for R&D have on today’s publicly traded companies?  For hardware-dependent firms, not that much.  Yes, computers may wear out or become obsolete much faster than, say, a cement plant.  But the presentation of profits to actual and potential shareholders of a semiconductor foundry, a server farm or a steel mill allow for a more or less apples to apples comparison.

Not so for software-oriented firms.

Let’s take AMZN as an example and do a back-of-the-envelope calculation.

During the first half of 2013, AMZN spent $2.97 billion on technology and content.  If we assume that all of that were capitalized instead of expenses (an aggressive assumption) but that any resulting financial reporting profits were subject to tax at the very-high US rates, then I figure AMZN would have shown earnings of $4.50 per share so far in 2013 instead of the $.46 actually reported.  This would suggest, in ballpark figures, $10 a share in EPS for the full year.

Maybe the multiple isn’t so crazy.

Just as important, the same adjustment should apply to any other R&D-centric firm.   R&D may be creating important long-term intellectual property assets for a company, but the accounting rules (for sound historical reasons) portray this activity as a minus.

 

 

capitalizing, expensing and the internet (i)

July 30, 2013 By in capitalizing vs. expensing, Current Market Thoughts, depreciation, three sets of books Tags: , , , , , Leave a comment

finitude and stocks

I’ve been having memento mori thoughts recently.

No, not about me personally or anyone I know.  Instead, I’ve been thinking about the role of value investing in today’s world.

Several things have turned my mind in this direction:

–as I travel, I can’t help but notice the increasing numbers of businesses that are giving up the ghost in rural and suburban areas–restaurants, inns, whole strip malls either shuttered or never opened

–I realize that I’m part of the problem as, to my wife’s dismay, I order increasing amounts of stuff through Amazon

–I sometimes wonder what investors are thinking when they pay over $300/share for AMZN, a company whose book value is under $20 and whose high-water mark for earnings was $2.53/share, pre-Great Recession.  Don’t misunderstand me–I’m not saying there aren’t reasons for buying AMZN (after all, I own SPLK (Splunk–great name).  I don;t own AMZN, though.).  I just wonder whether people have thought through what they’re doing or whether they’re just going with the flow.

value investing

What does this have to do with value investing?

When a company spends money, it has two basic choices about how to account for the expenditure.  It can:

–record the money as an expense against current earnings.  In this case the money appears on the income statement as a cost–e.g., raw materials, marketing expense, salary…–and then disappears forever, or

–record the spending as an asset on the balance sheet and dribble the amount as a cost into the income statement over a long (possibly very long) period of time.  The fancy name for this process is capitalizing and it’s normally done only with assets that have long useful lives, like office buildings, stores or factories.  (The company will disclose the rules it uses for the gradual writeoff of asset value in the footnotes to its financial statements.)

The money has already left the building in either case.  The difference is a decision about what revenues to use to match what costs to.

is capitalizing a problem?

I think so.

Value investors like to look at per share book value (also called shareholders’ equity, or net asset value)–i.e., the value of the assets listed on the balance sheet minus any liabilities–and compare this with the stock price.  They consider a stock trading at a discount to book value to be a potential bargain and one trading at a premium (or, like AMZN, at 15x book!) to be potentially overvalued.

The rationale behind this is that:

–the asset base is a defense against competition.  A potential rival would presumably have to spend a similar amount just to enter the business.

–book value is based on the actual prices paid, and is not adjusted for inflation.  A company with a long history may well have assets whose value has increased over time but whose cost has already been partly or completely written off against income.  Therefore, book value may significantly understate the actual value of the company’s assets.

I have two concerns

In the current time of deep social and technological change, having a lot of capital sunk into yesterday may not be such a great thing. After all, it didn’t help Toys R Us or Borders or Circuit City.

Also, my experience is that US companies are very reluctant to decrease the balance sheet value of not-so-hot assets.  And auditors are not inclined to push the issue.  The more dead real estate I see, the more I wonder whether corporate balance sheets are as up-to-date as they’re supposed to be.

 

Amazon is the polar opposite of the book value enthusiast’s ideal stock.  How much of that is reality, how much accounting quirks?  That’s tomorrow’s topic.

contribution margin

July 18, 2013 By in Accounting, depreciation, three sets of books Tags: , , , , , , , Leave a comment

several sets of corporate books

As I’ve written in a previous post, publicly listed companies have three sets of books:

–financial reporting books, which tend to portray a rosy picture to shareholders,

–tax books, that tend to show a relatively grim picture of profitability to the taxman, and

–management control or cost accounting books, by which the company is actually run.

Contribution margin is an important concept for this last set of books, the management control ones.

what contribution margin is 

The first thing to be clear on is that people call contribution margin is not always a margin, that is, a percentage.  More often a contribution margin is expressed in absolute dollar amounts.  Don’t ask me why.

But what is it?

It’s the amount by which the revenue from selling an item exceeds the direct cost of production and thus “contributes” to defraying corporate overhead. It can be positive or negative.  Negative is very bad. The concept can be used at every level of corporate activity, from an individual widget made in a plant, to the total output of the plant, to a mammoth division inside a multi-line company. It’s not a measure of profit; it’s the basic measure of cash generation.  The question it answers at any level is, “Does this operation generate a positive return,  before loading in charges for corporate ‘extras’ –like the CEO’s salary, R&D, image advertising, the corporate jet fleet…”

why it’s an important concept

It makes you focus on incremental cost, not total cost.  For example,

1.  It tells you the point at which a company begins to consider shutting an operation down–namely, when the contribution margin turns negative.

I was reading a report the other day about the gold industry that maintained the gold price was in the process of bottoming because the “all in” or “fully loaded” price of producing an ounce of gold for the global gold mining industry is about $1,100 an ounce.  How embarrassing for the author!  That’s not right.  Yes, at under $1,100 an ounce, a generic mine may be showing a financial reporting loss.  But it’s still generating cash–in fact, the lowest-cost mines are probably generating $500 in cash an ounce.  Only the highest cost operators will think about ceasing mining.

What will firms do instead?  They’ll cut corporate overhead, for one thing.  If they decide that the value of their plant and equipment is permanently impaired, they’ll write off part of the carrying value of this investment on their balance sheets.  That will lower ongoing depreciation charges, by. let’s say, $100 an ounce (a number I just made up).  That will magically transform the financial accounts from red ink to black.  But this change won’t alter the cash flow generation from operations.

2.  It highlights an operation’s value.  Suppose an operation has a contribution margin of $1 million a year, but all that–and more–is eaten up by corporate charges.  It can be sold to, or merged with, another operation in a similar situation.  The ” synergy” of eliminating duplicative administrative functions may turn two apparent losers into a combined money-maker.  In any event, the $1 million yearly contribution to overhead has a significant value.

3.  It invites you to look at breakeven points–and the often explosively strong effect that finally covering overhead costs can have on profits.  Hotels are the example I often thing of.  As a general rule of thumb, a hotel is breakeven on a cash flow basis at 50% occupancy.  It breaks even on a financial reporting basis at 60% occupancy.  Above that, profit flows like water into the accounts.  IN this case, a relatively modest shift in occupancy can change the profit picture dramatically–and that’s without regarding the possibility of room-rate increases.

one company, three sets of accounting records

February 15, 2013 By in cash flow, cash flow/share vs. earnings/share, project accounting, three sets of books Tags: , , , , , , , , , Leave a comment

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books,  in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

—management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.