Detailed analysis of Lipton’s current Economic Profit model has prompted immediate changes to how profit is recorded on the Product Line level. Proposed changes to the current Economic Profit include:
I. Leave the Working Capital Cost and CRV Depreciation Adjustment in the profit analysis II. Eliminate the Fixed-Asset Charge and OI&D
III. Only apply New Product Development charges to new products Goals of these proposed changes:
* Ensure product line managers are focused on improving the value of their product, not just on profit/loss numbers * Allow upper management to analyze product line performance on a level playing field * Provide divisional management with the unbiased authority to allocate fixed asset costs * Enable upper management to make decisions regarding a product line’s value to their division and the overall value of Lipton, and report required performance metrics to Unilever.
Unilever’s Evaluation Criteria include the following metrics: * Capital Turnover- Net Sales / Ave Gross Capital Expenditure * Return on Sales- Profit Before Tax / Net Sales
* Return on Capital- After Tax Return on Ave Gross Capital Employed Their Financial and Operating Objectives include:
* Sales growth by 10.5% per year
* After tax profit margin to improve by 6%
* Achieve 15% after tax return on ave invested capital (ATRIC) * Maintain AA Bond rating
The financial department has recently changed Product Line Profit and Loss (P/L) from “Trading Profit” to “Economic Profit.” The objective of this change was to reflect a more accurate contribution of each product line to the overall corporation. The chart below shows the changes implemented and the subsequent affects to the resulting Economic Profit:
Changes to Trading Profit| Resulting Affects to Proposed Economic Profit| Working Capital Charge| Reduce profit to account for interest cost of capital| CRV Depreciation Adjustment| Reduce profit to account for difference between CRV and historic depreciation| Fixed-Asset Charge| Reduce profit to account for fixed cost (as % of total fixed costs)| OI&D and other| Increase/Decrease profit depending on the benefits or costs to the brand| New Product Development Charge| Increase (unless the particular product line is a new product)|
It is our understanding that the financial department suggested these changes because the original Trading Profit did not evaluate individual product line performance at the same economic level as Unilever and corporate management. While the resulting Economic Profit does address some problems with the original Trading Profit, we believe that some of the changes are unnecessary. Additionally, the new Economic Profit evaluation could send mixed messages to product line managers since profit will be understated. Therefore, we propose the following changes to the Economic Profit structure.
Proposed Adjustments to the Economic Profit
Working Capital Charge
The corporate financial department was correct to include this negative adjustment to trading profit. The working capital charge makes product line managers responsible for their liquid assets. By assigning a cost of capital to the product line’s total working capital, product managers are penalized for keeping too much cash around. Instead, the managers are motivated to improve the economic profit by applying otherwise dormant working capital to product line efficiency. This cash can be used to update fixed assets (new technology), positively affect customer service, enhance product marketability, or even reduce debt. Reducing short and long term liabilities actually helps the overall company align their interests with Unilever’s desire to maintain a AA Bond rating. Meeting these liabilities lowers the overall risk of default in the eyes of debt holders. As a result, the rating agencies will score Lipton higher than they would if Lipton were not...