Getting to the Bottom of ROIPerspective |
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The Great Recession has sent companies scrambling to cut costs and preserve cash. Caught in a sinking tide, many realized how much excess capital — both fixed and working — they were using. Unfortunately, for most organizations this purging exercise is an infrequent, discrete effort, triggered by economic exigencies. While companies incent management to grow earnings (the numerator of ROI), there is considerably less infrastructure and discipline devoted to optimizing the ROI denominator (capital employed). Thus many businesses lose value over business cycles due to weak capital stewardship, with capital intensive businesses suffering most. Ensuring the right level and mix of capital investment, over time, is critical to optimizing ROI.
Why do basically well run companies struggle to manage capital? The first culprits are data availability, metrics and incentives. Companies regularly produce profit and loss statements for their operating businesses, yet the capital used by these businesses is often measured at the consolidated corporate level. Corporate leaders set the year’s capital budget with business unit allocations based on growth expectations, corporate strategy and past corporate capital budgets. Capital projects often compete for capital dollars using established processes (e.g., decision stage gating) and metrics (e.g., NPV, IRR). Unfortunately, diligent application of these evaluation processes and tools often results in poor investment choices, both in level and mix.
In some ways, good upfront processes and tools — while necessary — create a false sense of security. Capital must be managed against the multiyear benefits in its business case. Yet, for many reasons, including intra-company management mobility, multiyear monitoring is uncommon. Weaknesses in capital life cycle data, visibility, discipline and accountability often result in excessive capitalization and a breakdown in real discipline around capital management. It is common for projected benefits for investments to systematically outstrip the actual benefits realized, hurting ROI performance.
How can an organization improve its capital utilization? First, get the data right. Where feasible, set up a working analysis of the capital used for business units using established accounting cost and asset allocation methods. Ensure that the capital costs (for both fixed and working) are explicit and charged to that part of the company where the investment is held. For multiyear capital investments, put the right post decision measures and processes in place. Because benefits usually accrue for years for fixed capital allocations, an annual post audit is critical. While accountability is crucial, these look backs are for learning — not retribution — and should contain data and metrics visible to enterprise leaders and included in key managers’ and leaders’ performance reviews. For improvements in working capital management, learning comes from ongoing, rigorous modeling of linkages between key components of working capital and their underlying drivers (expectations for growth, revenue and operating costs).
These practices can allow the average level of capitalization for most organizations to decrease over a full business cycle. Measurement is key to promoting better capital stewardship. While attaining best-in-class ROI performance is difficult, the best managed companies have the internal discipline, information systems, processes and people to get the ROI balance right.
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Richard Woodward,
PRINCIPAL
