Summary.While many executives and investors were thrown by last year's interest rate increases, the cost of capital needn't be a threat. Companies that integrate the cost of capital into their strategy and planning reap real benefits. When something is cheap, people waste it. With the cost of capital back to normal levels, it's simply irresponsible not to make it a management discipline that changes the way you do business. To do that, executives need to rediscover the concept of economic profit (EP) — that is, revenue minus not just operating and administrative costs, but also the cost of the capital needed to produce that revenue. The authors have found that executive teams that bring the disciplines of the capital market inside a corporation deliver shareholder returns more than 50% above their industry peer indexes. That staggering difference attests not just to the value created by managing with economic profit, but also to the value squandered by ignoring it.
How should businesses cope with today's higher cost of capital? Many executives and investors were flummoxed by last year's interest rate increases. Indeed, when our colleaguessurveyed3,100 executives about forces that had disrupted their business last year, interest rates and inflation topped the list. When the executives were asked about threats to their business in 2024, interest rates and inflation again led the list, ahead of other issues such as politics, regulation, AI, or climate change.
The cost of capital needn't be a threat. For one thing, although rates rose, it was to normal levels, after a decade when they had been unusually low. Businesses have plenty of experience operating when capital costs are at levels like today's — they just have to retrieve and reapply it.
More important, companies that integrate the cost of capital into their strategy and planning reap real benefits. When something is cheap, people waste it. With the cost of capital back to normal levels, it's simply irresponsible not to make it a management discipline that changes the way you do business. To do that, executives need to rediscover the concept of economic profit (EP) — that is, revenue minus not just operating and administrative costs, but also the cost of the capital needed to produce that revenue.
We have been doing that for more than 30 years. Over that period, we havedocumentedthat executive teams that bring the disciplines of the capital market inside a corporation deliver shareholder returns more than 50% above their industry peer indexes. That staggering difference attests not just to the value created by managing with economic profit, but also to the value squandered by ignoring it.
Discovering Economic Profit
The fundamental reason EP is so powerful is this: In virtually every company, rigorous analysis reveals that value creation is highly concentrated. In big companies, we typically find that less than 40% of capital employed generates more than 100% of the company's shareholder value, while 25 to 35% of the capital employed is destroying value. We find this at every level of granularity, from industry to business unit to product to channel to customer.
For example, in work we did with a major brewer, we looked at the growth of economic profit in the U.S. beer industry and discovered that the majority of EP growth was concentrated in imports (mostly Hispanic), in southern and southeastern states, in a few channels (gas stations and convenience stores, not groceries), and in just a few SKUs (six-and 12-packs, not single cans or kegs). Basically, when you added in the cost of capital, the profit from less than 20% of the industry's overall revenue was paying the freight for everything else.
We have seen the same situation in baby food, razors and blades, heavy equipment and machinery, and countless other B2C and B2B industries. Look, for example, at how Apple's iPhone, while not the bestselling mobile handset for decades, has produced far more economic profit and the vast majority of the industry's total profits and much more wealth for its investors.
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When a company knows specifically where EP is created (and where, although it may generate earnings, the capital it uses costs more than the margin it produces), it can direct its investments where they will perform best, and away from sinkholes. That job — allocation of capital — is the very definition of what CEOs and boards do, and the more expensive capital is, the more crucial it becomes.
Say a company earns a 15% return on equity, pays 3% a year to shareholders, and reinvests 12%. Compound that: In just six years, the CEO and board have allocated more equity than the company had at the start. Knowing how to direct that capital gives a company a reinvestment advantage — the ability to invest more productively than competitors — year after year after year.
The benefits cascade out from the boardroom. By managing so as to maximize EP, companies can shift spending to create an operating advantage. Remember the saying, "We know half of our advertising money is wasted; we just don't know which half"? Well, that brewery knew: When managers learned that value creation was concentrated in a few SKUs for a few brands in a few channels in a few states, they redirected their commercial efforts to those areas. That enabled them to outspend bigger rivals in the markets that mattered — increasing sales and profits while the other guys poured money down the drain.
The Benefits of Incorporating EP into Strategy
It usually takes a couple of years before a management team becomes fully fluent and effective in considering cost of capital and integrating a granular view of economic profit into strategy and planning; then the reinvestment and operating advantages really kick in. When they do, their compounding impact shows up in four ways:
More focused margin and cost management
Usually, a company finds opportunities to quickly adjust pricing (for example, to better tie prices to volume or relationship value) and marketing and promotion (such as withdrawal from clearly value-destroying activities), or to refocus and accelerate cost-reduction programs. Many of these price, promotion, and cost improvements can be undertaken quickly, pay off in three to nine months, and help fund reinvestment in long-term growth opportunities. Equally important, knowing EP can steer you away from destructive cutbacks. Everyone knows that an across-the-board "haircut" isno way to reduce costs; EP helps guide the shears.
Smarter growth
But bigger benefits come from using EP to guide investment and spending, by adding resources and capabilities to high-profit zones. A pharmaceutical company we worked with knew that most of its products were profitable, even after allocating indirect costs and capital. But by understanding the differences across products, prescribers, customers, and channels, the company improved the focus of its sales force, simultaneously improving efficiency and growing sales.
You need to measure not just where EP is today, but where it is growing.Forecastingcan be an invitation to politics or wishful thinking, but measuring EP makes for better — and brutally honest — conversations about where to invest, why the strategy will succeed, and how much capital is needed.
The same discipline applies to acquisitions, where companies must typically overcome a 20 to 30% acquisition premium just to break even on a deal — and where a higher cost of capital raises rates further. Being clear about where profit pools are helps target the right acquisitions, and knowing what will be required to win share of those profit pools provides a sobering and practical view of the cost and revenue synergies that will be required for (and makes for better) post-merger-integration.
A more powerful planning toolkit
When it comes to planning, budgeting, and cost management, most business-unit or product-line leaderstake an income-statement view of their business— forecasting sales, direct costs, and perhaps taking a charge for shared services or other indirect costs. That's fine as far as it goes, but seeing and understanding EP at a granular level — by product, customer, channel, etc. — produces business plans that are aligned with strategies and resource allocation that delivers more economic profit, more predictably. It has a similar impact on capital budgets, and is particularly helpful when top management needs to choose among investment proposals from different businesses.
A more constructive partnership with finance
In our experience, informed, granular discussions about economic profit are eye-openers for senior executives, functional and line management, and finance leaders alike. Many line managers have never seen — let alone been accountable for — capital costs in the businesses under their purview. Functional leaders, likewise, rarely see how their expenditures align with specific segments, channels, and business outcomes. Many finance executives, even senior ones, pay attention to capital only at high levels of aggregation and are unfamiliar with the choices managers make "down in the business." For the CEO and CFO, managing EP creates a provable chain of cause and effect between day-to-day work, long-range planning, and shareholder value.
Clearing the Obstacles
If economic profit is so powerful, why doesn't everyone use it? Executive teams that want to integrate cost of capital into their strategies need to prepare to overcome obstacles in the following three areas:
Measurement
To calculate economic profit, you start with net operating profit after tax (NOPAT) and subtract the cost of the capital the business employs, which is fixed assets plus working capital multiplied by the weighted average cost of capital (WACC). Thus:
EP = NOPAT – (Average Invested Capital × WACC)
At the corporate level, the math is straightforward. The exercise gets complicated when measuring business units, products, or customer segments because that requires allocating costs and capital. What percentage of the cost of a warehouse should be borne by the gadget division, the widget division, and the thingamajig division? How much of the marketing budget? How much working capital?
The complexity is an invitation to political wrangling, or it can produce endless rounds of activity-based costing. At some point AI might clean the data or reveal clusters of customers or profitability, but it is no substitute for informed judgment about the right level of granularity or where to look for growth potential or when enough is enough.
Tenacity
This isn't a one-and-done initiative, or a tool to be hauled out at budget season. Integrating the cost of capital into commercial, operating, and investment decisions should be a process that continually identifies and quantifies the highest value-at-stake issues and opportunities for the enterprise and each business unit. Over time, the numbers will change: A hot market segment will cool, or a division that was wasting capital will become efficient.
CEOs who have navigated this transition know that it demands consistent, repeated communication and reinforcement — especially when managers review their strategies, investment requests and budgets, and performance. Miles White, former chairman and CEO of Abbott Labs, told us:
You need to recognize this is about changing the way you manage the company. It's decision processes. It's what you measure. It's what you reject. It's what you reward. You have to be consistent with everything. How do you get your management teams to move faster? You keep putting in front of them the same themes, the same tests, the same metrics, the same measures, the same comparisons.
Education, empowerment, and incentives
Incentives are part of this process, but changing incentives alone — or too early — just invites gaming and frustration. Managers who are told their scorecard now has a new cost added — the cost of capital — and that they're being rewarded based on EP will naturally try to reduce that cost.
In the short term, a company can increase its return on invested capital by slashing inventory, but that's a bad decision if the inventory in question supports sales growth of their most profitable products. Longer term, they might skimp on investment in technology and facilities. Managers'everyday decisions make or break a strategy. So they need to understand where and why EP growth potential exists; agree on strategies, resources, and actions to capture that growth; and sign up with the CEO on performance milestones. Those commitments then translate into KPIs and, alongside them, incentives.
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When executives overcome these obstacles, they no longer see the cost of capital as an impediment to their plans. It is, instead, something that makes them smarter — and, even better, smarter than their competition in the markets, where it really matters — and able to deliver the benefits of that intelligence to the wallets of shareholders.
Previously published Harvard Business Review Home.
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