But while the move made strategic sense, operational reviews among the conglomerate’s business units became meaningless. Executives insisted on comparing them only on the basis of ROIC and growth performance, which meant that much time was spent arguing about the negative ROIC of the new business and whether it created or destroyed value and was on track to become a profitable undertaking. Nobody could assess the performance of the software business against that of the conglomerate’s traditional businesses. Discussions about the allocation of resources became heated — in particular because the growing software business needed to hire staff while older units were cutting back.
Since business models within a single industry may diverge, similar problems bedevil many executives trying to compare overall corporate performance. A U.S. high-tech manufacturer that pursued an aggressive facility-outsourcing strategy combined with a just-in-time inventory system eventually drove its invested capital below zero. As a result, the company’s ROIC was negative and therefore meaningless. A direct competitor also acted to improve its efficiency but kept its manufacturing assets in house. This decision left it with significantly higher levels of invested capital but also with higher margins. It thus had a substantial positive — and meaningful — ROIC, which made apples-to-apples comparisons between the two companies impossible. Furthermore, the ROIC of the first company fluctuated wildly, as minor changes in its invested capital sharply altered the results of the ROIC calculations.
Board members and investors of this first company frequently wondered if it was outperforming its competitor and wanted to know how management was judging the performance of its strategy and business model. In frustration, the company’s executives and board increasingly focused on margins as their key operating metric. But the appropriate level of margins for their low-capital strategy was difficult to judge. They recognized that a business whose capital intensity was low as a result of outsourcing should have lower margins than one that retained its manufacturing assets and thus substantial capital, but they struggled to determine how low a level was reasonable.
A Different Measure
To understand how a metric based on economic profit and revenue can eliminate such distortions in measuring value, consider a hypothetical company with three business units, each with $1 billion in revenue (Exhibit 2, part 1). Two newer business units — a software business and a services business — have very low or negative invested capital. The company’s more asset-heavy traditional business can extract a profit margin of 12 percent (compared with 7 percent for the other units) because it doesn’t outsource any parts of the value chain and has an established, captive customer base that faces high switching costs. It is growing more slowly, however — by 4.5 percent a year, compared with 6 percent for the new businesses.
Using these data, the return on capital for the software business is a negative 700 percent while the ROIC of the services business is a positive 700 percent, even though the actual difference in the invested capital of the two units is only 2 percent of revenue. The traditional business has a 30 percent ROIC. A conventional evaluation of performance would compare the two newer businesses on the basis of their margins (because their capital is so small as to be deemed meaningless) and scold the traditional business for its high capital intensity.