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Posted on Jul 24, 2024

A paper published in the Harvard Business Review points out a new way to calculate economic profit that could be more appropriate for service firms

A paper published in the Harvard Business Review points out a new way to calculate economic profit that could be more appropriate for service firms and other people-intensive companies. Instead of focusing on investment and return on investment, the focus is on employee productivity, both in terms of generating revenues and reducing costs.

The approach is to first determine economic profit in the conventional way, except that we ignore taxes, so that economic profit is before tax, as follows:

Economic profit = Operating profit Capital charge

Assume the following information for a hotel chain that wishes to adopt the new method. The firm has $100 million in operating profit, $1 billion in investment, and uses a cost of capital rate of 5%, so the capital charge is $50 million and the economic profit is $50 million. Relevant calculations are contained in Part 1 of the following schedule. Use the following information in the table on the bottom.


Part 1: Economic Profit (in thousands, except cost of capital rate)
Revenue	$	500,000
Operating costs:
Personnel costs		300,000
Other costs		100,000

Operating profit	$	100,000
Operating profit before personnel costs (OPBP)	$	400,000
Investment (capital)	$	1,000,000
Cost of capital, rate		0.05

Cost of capital, rate	$	50,000
Economic profit = Operating profit Capital charge	$	50,000

Part 2: Economic Profit Calculated Using Employee Productivity
Number of employees		10,000
Employee productivity:
Operating profit before personnel cost per employee ($400,000/10,000)	$	40
Capital charge per employee ($50,000/10,000)		5

Employee productivity	$	35
Less personnel cost per employee		30

Economic profit per employee = Productivity Cost		5
Total economic profit, all employees	$	50,000
Note: All numbers in thousands except for number of employees

The next step is to decompose economic profit using employee productivity. To do this we first determine operating profit before personnel costs (OPBP):

OPBP	= Operating profit + Personnel costs
$400,000	= $100,000 + $300,000

Employee productivity can be determined by calculating OPBP less capital charge, per employee. For this example, since there are 10,000 employees, OPBP is $40,000 per employee and the capital charge is $5,000 per employee, so that productivity is $35,000 per employee. The next step is to determine personnel cost per employee, $30,000, and subtract that from employee productivity to obtain economic profit per employee, $5,000 (i.e., $35,000 $30,000). Total economic profit for all employees is thus $5,000 10,000, or $50 million, the same amount as determined in the conventional way. The value of the decomposition of economic profit into employee productivity and personnel costs per employee is that it provides measures that the hotel chain can benchmark to other hotel chains. It also provides a direct measure of the profit that is being generated per employee relative to the average personnel cost for each employee. Measures of revenue per employee and personnel cost per employee are widely used in the hospital, health and human services, and other people-oriented service industries.

Source: Felix Barber and Rainer Strack, The Surprising Economics of the People Business, Harvard Business Review, June 2005, pp. 8190.

Required:

Use the above approach and assume a chain of residential care facilities employs 15,000 people, has a cost of capital of 6%, and has the following information (000s).