1995: How do you charge managers for the incremental capital they employ?

AUDIENCE MEMBER: I’m Jim Vardaman (PH) from Jackson, Mississippi.

In describing the — your allocation of capital to your wholly-owned subsidiaries, you wrote in the annual report that, quote, you “charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release,” end quote.

How do you determine this high rate, and how do they determine how much capital they can release?

WARREN BUFFETT: Well, what we try to do with those — the question’s about incentive arrangements we have with managers or other situations, where we either advance capital to a wholly-owned subsidiary or withdraw it — usually, that ties in with the compensation plan.

And we want our managers to understand just how highly we do value capital. And we feel there’s nothing that creates a better understanding than to charge them for it.

So, we have different arrangements. Sometimes it’s based a little on the history of the company. It may be based a little bit on the industry. It may be based on interest rates at the time that we first draw it up.

We have arrangements depending on the — on those variables and perhaps some others and perhaps just, you know, how we felt the day we drew it up, that range between 14 percent and 20 percent, in terms of capital advanced.

And sometimes we have an arrangement where, if it’s a seasonal business where, for a few months of the year, when they have a seasonal requirement, we give it to them very cheap at LIBOR.

But, if they use more capital over — beyond that, we start saying, “Well, that’s permanent capital,” so we charge them considerably more.

Now, if we buy a business that’s using a couple hundred million of capital, and we work out a bonus arrangement, and the manager figures out a way to do the business with less capital, we may credit him at a very high rate — same rate we would use in charging him — in terms of his bonus arrangement.

So, we believe in managers knowing that money costs money. And I would say that, just generally, my experience in business is that most managers, when using their own money, understand that money costs money.

But sometimes managers, when using other people’s money, start thinking of it a little bit like free money. And that’s a habit we don’t want to encourage around Berkshire.

We — by sticking these rates on capital, we are telling the people who run our business how much capital is worth to us.

And I think that’s a useful guideline, in terms of the decisions they’re making, because we don’t make very many decisions about our operating business. We make very, very few. I don’t see capital budgets, in most cases, from our hundred percent-owned subsidiaries.

And if I don’t see them, no one else sees them. I mean, we have no staff at headquarters looking at this kind of thing.

We give them great responsibility on it. But we do want them to know how we calibrate the use of capital. And so far, I would say, it’s really worked quite well.

Our managers don’t mind being measured, and they like getting a — I think they enjoy seeing a batting average posted. And a batting average that does not include a cost of capital is a phony batting average.

Charlie?

CHARLIE MUNGER: Well, I certainly agree. (Laughter)

WARREN BUFFETT: And his name isn’t even Buffett. I mean — (Laughter)