Comparing Performance When Invested Capital Is Low

Return on capital is the benchmark for comparing performance between businesses. But new math is needed when a company's capital intensity is low.

Executives and investors have reliable tools for measuring performance in capital-intensive sectors such as manufacturing, retailing, and consumer goods. In general, the math is simple: when managers generate returns on invested capital (ROIC) above their cost of capital, they create value. That formula makes it relatively easy to compare the creation of value among business units or between companies.

But what if the invested-capital side of the equation approaches zero, as it increasingly does among companies that use outsourcing and alliances and thus reduce the capital intensity of parts of their businesses? Other businesses, such as software development and services, also have inherently low capital requirements or take advantage of atypical working-capital dynamics, including prepayment by customers for licenses and payment by suppliers for inventory. Even traditional businesses are shedding capital: the median level of invested capital for US industrial companies dropped from around 50 percent of revenues in the early 1970s to just above 30 percent in 2004.

When a company’s or a unit’s business model doesn’t call for substantial capital or even involves negative operating capital, the ROIC is usually extremely large (whether positive or negative), very sensitive to small changes in capital, and highly volatile and thus often inappropriate as a tool for comparing the performance of business units or companies. What’s more, executives who continue to use ROIC as their main point of comparison are likely to measure and manage performance unproductively. They might hesitate to invest additional resources in low-capital businesses (Exhibit 1) or, still worse, ignore capital altogether and focus on margins alone as the primary performance metric.

A more useful way to measure performance is to divide annual economic profit by revenue. Grounded in the same logic as conventional ROIC and growth measures, this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn’t make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Same Company, Different Economics

A large European industrial conglomerate provides an example of the difficulties of using ROIC to compare business units with different levels of capital intensity. The company’s executive board decided to take advantage of a trend in traditional industries toward adopting the next generation of process automation software and services by launching a business unit that exclusively offered software solutions based on standard off-the-shelf hardware. The new business naturally had a low level of invested capital, since its assets were essentially people and no manufacturing was involved. The willingness of customers to pay in advance for software development moved the level of operating invested capital below zero.


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