An article in the Harvard Business Review (HBR) offers a new way to calculate "economic profit" for service firms and other "people-intensive" companies. Instead of focusing on investment and return on investment (ROI), the focus is on employee productivity, both in terms of generating revenues and in terms of reducing costs. The approach is to first determine economic profit in the conventional way, except that we ignore income taxes, so that economic profit is before tax, as follows: 

Economic profit = operating profit - charge for capital 

Assume the following information for a hotel chain that wishes to adopt the new method. The company has $100 million in profit, $1 billion in invested capital, and uses a 5% cost of capital rate (so that the charge for capital employed is $50 million and the economic profit is $50 million).

Problem Information

Part 1: Economic Profit (in thousands, except cost of capital rate)

Revenue ................................................... 500000

Operating costs:

Personnel costs ................................................... 300000

Other costs ....................................................... 100000

Operating profit ...................................................... 100000

Operating profit before personnel costs (OPBP) ................. 400000

Investment (capital) ................................................ 1000000

Cost of capital, rate ................................................ 0.05

Capital charge ....................................................... 50000

Economic profit = Operating profit - Capital charge ............. 50000

Part 2: Economic Profit Calculated Using Employee Productivity

Number of employees ................................................... 10000

Employee productivity:

Operating profit before personnel cost per employee ............ 40

Capital charge per employee ....................................... 5

Employee productivity ........................................ 35

Less: Personnel cost per employee .................................... 30

Economic profit per employee = Productivity - Personnel Cost ....................................... 5

Total economic profit, all employees ................................... 50000 

Note: All numbers in thousands except for number of employees

To decompose economic profit using employee productivity, 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, $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 decomposing 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. 

Requirements

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

Revenue ......................................................... 600000

Operating costs:

Personnel costs ............................................. 360000

Other costs ................................................... 150000

Operating profit .................................................. 90000

Determine the productivity per employee, personnel costs per employee, and the amount of economic profit per employee.