ROI ... a ubiquitous but wrong metric of performance

Dear Colleagues

I was amused in the post Sarbannes-Oxley era of corporate financial reporting that ROI not only stood for Return on Investment, but also Risk of Incarceration.

But I have been less amused over the years at how ROI ... Return on Investment ... has been used to create the illusion of economic performance when in fact the reality was very different.

I trained as an engineer ... and only later on trained as an accountant. I like to think I know the difference between real engineering and financial engineering. I appreciate the importance and value of real engineering, and despise financial engineering.

When I was heavily involved in corporate management and management information systems, I was an advocate for the use of Return on Capital Employed as a core metric of performance. Using this metric helped to sort out the difference between the profit contribution that was arising in the conduct of the real business, and what was being contributed by creative financing. In my view, getting a healthy contribution from the real business was the key to sustainable performance. Any work that I was able to do with creative financing that helped the profit reporting depended in the end on the underlying real business. Any executive or manager that forgets this reality is doomed ... sooner of later.

Capital employed is what a business needs to operate ... cash, receivable, inventory, land and buildings, equipment, intellectual property. How all of these real things are financed is a separate question. Productivity is the relationship between the assets needed to operate and the profit contribution these assets are able to generate.

It is interesting to note how many of the well respected CEOs have made a name for themselves not by improving their Return on Capital Employed but merely by leveraging their balance sheet so that the same business seemed to be operating with less investment. The ability to do "off-balance-sheet" financing made a nonsense of most financial analysis in many capital intensive businesses, like for example airlines ... and, I would argue, the industry has paid a price for this financial engineering.

Community Analytics (CA) embraces the idea that performance is about the value adding that arises from real assets ... in other words productivity is not just about return on investment but about return on the assets employed. Clear understanding of these matters helps to clarify how expenditures can be used most effectively to improve performance.

While it is dangerous to generalize, it can be observed that in poor societies there is usually very little value adding on top of considerable resources, especially human resources. A small expenditure to remove a constraint on performance makes it possible for a big amount of resource to function more effectively. This is real leverage ... something of great value ... unlike financial leverage that has all sorts of downside while making it look like performance has improved.

Hopefully more and more the money accounting world will embrace Return on Capital Employed as a better metric of performance than Return on Investment which hides the financial engineering implicit in the concept!

What am I missing? Please let me know!

Peter Burgess