Considering the Cost of Capital
When Roberto Goizueta became Coke's CEO in 1981, he took over a poorly performing company that had diversified into unrelated businesses ranging from water purification to shrimp farming. One of his first initiatives was to analyze Coke's various businesses using economic profit. The analysis concluded that only Coke's core carbonated beverage business was creating shareholder value. The other businesses, while generating revenue, were actually consuming value. Consequently, they were divested or shut down. Goizueta then focused on Coke's core beverage business using its substantial competitive advantages: global brand, worldwide distribution system, and sales and marketing expertise. The result was 18 years of success.
Similarly, when Bob Lane took over a poorly performing John Deere in August 2000, he quickly identified Deere's biggest problem: spending too much money to make money. Factories tended to overproduce, leading to a large number of very expensive, large farming machines simply sitting on dealer floors. Lane began looking at economic profit. He decided managers were treating capital as a free resource. He charged each division manager 1 percent each month of the cost of the assets they used and required that at the end of the year their financial results exceed the charges. Deere has done well in the succeeding years.
- What is the appropriate measure of a firm's performance?
- What does a focus on economic profit as opposed to a focus on accounting profit mean for a firm and its investors?"