The Capital Preservation Allowance

By now you know my thoughts about using financial accounting’s depreciation expense when developing cost information designed to support internal decision making. In short, I believe it’s “the dumbest idea in the history of management accounting.” Management accounting is a future-oriented discipline. While depreciation expense may be appropriate for a history-oriented discipline like financial accounting, it fails completely when applied to managerial cost information used to support internal decision making. Managerial costing needs a substitute for depreciation. To come up with one, let’s use a technique worked well for Albert Einstein. We’ll do a thought experiment.

Imagine you’ve been put in charge of your family’s manufacturing business; a business that has been generating a handsome income for your family for decades. It is hoped that you will be able to lead the business for at least the next twenty years. During your tenure, you will be expected to sustain the business at its current volume and level of financial success while pursuing growth opportunities if, and when, they present themselves. The most important objective, however, is to preserve the momentum built up by your predecessors and provide that steady income for the family. It is focused on the entirety of your anticipated twenty-year tenure. Individual months, quarters, and years are irrelevant. Your job is to sustain the business for the entire twenty-year period, generate profits that will provide the necessary income for the family, and leave the business in as good a financial position when you step down as it was when you took over.

You take over an organization with a base of capital assets that can effectively support the current volume of business. In twenty years, you are expected to leave with a capital base that can continue to support that volume of business. To accomplish this objective, you must ensure that the funds required to preserve the capital base are generated through the sale of the company’s products. This means that the EBIDA generated by the company’s sales must be sufficient to provide the required income for the family and those capital preservation funds.

The challenge is to determine the amount of capital that will be required and how to accumulate that capital by including it in the price of the products the company will be selling. The obvious first step is to develop a long-term capital plan for preserving the capital base. Since a twenty-year capital plan requires a look too far into the future, you decide to project your capital needs for the next five years. You can always modify that plan as the future unfolds. This plan has nothing to do with the original cost or book value of the existing assets. Neither does it necessarily have to do with the cost of purchasing newer versions of the existing assets. Its focus is on sustaining the company’s existing capabilities. Although that may mean replacing the existing assets with newer editions of those assets, it may also mean replacing them with entirely new technologies.

It also does not mean accumulating the funds required to purchase each of those assets prior to the time they must be purchased. Your perspective is five years, not a monthly, quarterly, or annual. If you will need spend $5 million over those five years, you’ll need to accumulate $5 million during those five years. Some years you’ll have to borrow funds to purchase the required assets and in others you’ll use the funds to pay off those loans. You can view the accumulation of capital funds like a sinking fund.

Having determined that you will need to accumulate $5 million over the next five years, the next questions is how to incorporate those funds into the prices you charge your customers. The simple answer might be to include $1 million each year into your company’s product costs. But volumes vary from year to year. In the years with lower-than-normal volumes, it will make your product costs appear higher as the $1 million is spread among a smaller number of units. It might also make you less competitive if you try to pass that higher cost per unit along to customers. In the years with higher-than-normal volumes, it will make your product costs appear lower as the $1 million is spread among a higher number of units. This will make your profits appear higher and, perhaps, cause you to distribute some of those required capital funds along to the family.

Linking the accumulation of capital funds to volume would avoid the problems inherent in treating them like annual costs. A simple way would be to assign them to products as a percentage of conversion costs (assuming most of the capital required relates to the conversion process). If you project conversion costs over the next five years to be $100 million, you could add 5% to the conversion cost of each product. That would provide for the accumulation of the required capital preservation funds without distorting product cost from year to year.

Another way would be to link them to the use of the capital assets themselves. If you project that the equipment will be used to product products 250 thousand hours during the five-year period, you could include a $20 per hour Capital Preservation Allowance (CPA) in the equipment cost. You could also break the Capital Preservation Allowance into categories, or capability pools, of assets with a different CPA for each category, or pool, of assets.

I’m sure there are other means of accomplishing the objective; namely, to accumulate the required funds to preserve your existing capital asset base without distorting product costs from accounting period to accounting period. Remember, those accounting periods that are so important for financial accounting are irrelevant for the long-term sustainability of your business. What is important, is understanding the long-term sustainable economics that underlie your organization’s operation. Armed with that knowledge, you’ll make higher quality decisions and increase the likelihood of your company’s financial success in the years to come.