That kind of approach can lead to serious misjudgments of the value created by the three units and to the misallocation of resources among them — as indicated by the fact that the traditional business has the highest value of the group, even though it has the lowest growth rate (Exhibit 2, part 2). How can this result be reconciled with the observed returns on capital in order to compare the true fundamental performance of the three units? It turns out that in this case, ROIC tracks the creation of value much less accurately than does economic profit divided by revenue. According to that measure, the economic performance of the three units is remarkably similar. All are creating value in absolute terms (all the ratios are positive), and they are creating value at a similar rate, with the traditional business slightly ahead.
Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.
Using the same approach, consider again attempts to compare the operating performance of the US high-tech manufacturer with that of its direct competitor (Exhibit 3). Owing to the high-tech company’s negative invested capital (a result of the outsourcing strategy), ROIC comparisons were meaningless. Margin comparisons were also tricky; a company that outsources would be expected to have lower margins than one that holds on to all parts of the value chain. But an analysis using economic profit divided by revenue made it clear that the outsourcing strategy as implemented wasn’t as successful as had been hoped; the high-tech company was still generating less value per unit of revenue than its competitor.
Executives of the large European industrial conglomerate mentioned previously ultimately decided to use economic profit, combined with value targets based on economic-profit-discounting models, as its measure for success. While this approach required a significant investment in training, the change reflected management’s goal of a consistent measure for value creation across capital-light and capital-heavy units.
Returns on capital will always be an essential metric for managers. Yet in businesses with low levels of invested capital, replacing ROIC with economic profit divided by revenue will make internal and peer comparisons much more meaningful.
About the Authors
Mikel Dodd is a partner and Werner Rehm is a consultant in McKinsey’s New York office.