Profit as a Yardstick
Measurements of profit are interesting, because they show how much is “left over” for the shareholders, when everything and everybody else have been paid for, and paid. However, as every accountant worth his salt knows, there are so many ways to distort one year´s profit figure that the truth is in the eye of the beholder. Research and development are sometimes treated as an investment, sometimes as a cost. If a company displays increased profit, because of reduction in R&D, is that a real profit or not?
Reported profits of employee-owned companies are customarily very small, since the desire to demonstrate the organization´s success, is more than outweighed by the desire to avoid paying a penny more in company tax than is absolutely necessary. And how do you value work in progress? Hidden factors like invoicing being delayed or brought forward can heavily influence the reported figures. Large effects on the reported profit figures are often due to unidentified changes in intangible assets. This multiply the problems even further. Profits are simply not a good yardstick for comparing companies with large intangible assets. The least helpful profit indicators are Return on Equity or Return on Assets. More useful are Profit in % Sales or (best) Profit in % Value Added.
Profit margin is a key indicator that describes the profit-generating capacity of the flow of revenue. Profit margin is an important indicator of how attractive it may be to invest money in a knowledge company, but it does not tell much about the actual efficiency of its employees. Nevertheless, profit margin is generally a better measure of efficiency than return on equity or investment, for example, which is totally irrelevant in companies where financial capital plays an insignificant part.
Profit margins vary a great deal from one industry to another. Where profit margin expresses profit as a percentage of turnover, you must try to determine the composition of the revenues, for they may include varying proportions of commissions, expenses, hardware sales, etc. A better way of expressing profit margin is therefore to use the ratio of profit to value added.
Efficiency and Effectiveness
Although often used as synonyms, efficiency and effectiveness measure different things. Efficiency is calculated solely on input variables; effectiveness is calculated with both input, and output variables. Efficiency measures of show how well an organization is using its capacity, regardless of what it produces. A criterion of efficiency, often used by consultancy firms is billable time; time billed to clients, as a proportion of time available. This measures how much time consultants are paid for. It is a simple and good indicator of short term profitability because it measures capacity usage but it says nothing about what the consultants accomplish in that time. Effectiveness measures how well an organization is satisfying the need of those it serves.
The needs of the various parties concerned may, of course, differ; shareholders are interested in dividends; customers are interested in service levels, and quality. Firms should, therefore, employ different efficiency measures, for different audiences. ROI (return on invested capital) is a criterion of efficiency popular in financial circles. It measures profit generated by the capital invested in a company, or a project and is thus a very important indicator of efficiency, to both creditors and the owners of the invested capital. For shareholders, the most important figure is what they earn after tax, in the form dividends on the capital they have put into the company; the return after tax on their own equity, often shortened ROE.
The management must also track the return on the firm´s total capital, and on particular investment projects, so that they can control their allocation of capital. Unfortunately, this technique cannot be applied to intangible assets, so various income statement, and non-monetary measurements, must be used instead to calculate efficiency.
Effectiveness is difficult to measure also because one must often go outside one´s own organization. For measuring customer satisfaction, an important indicator for effectiveness, one must rely on customer polls. Therefore effectiveness is seldom measured. Even if it is not practically possible to measure effectiveness, it is never-the-less valuable to think in effectiveness terms. What gives the most revealing picture of performance? To focus on the costs of people or on the revenues they bring in? Cost focus is efficiency oriented, revenue focus is effectiveness oriented.