John Stretch explains what measurements you can put in place when return on equity fails.
One of my clients owns manufacturing, farming and service businesses in four African countries. They wanted to find a universal financial measure that could be applied to all their divisions and business units, of different sizes and in different locations, and which discriminates clearly between excellent, average and poor performance.
They had lost faith in their current measure, return on equity (ROE), which for all its strengths, provides a percentage figure to management and, as one manager said: “You don’t put percentages in the bank.”
ROE enables the group to rank business units in terms of relative profitability to each other through measuring capital efficiency in percentage terms. However, it does not measure absolute value in Rands returned to shareholders by each business unit.
My client has some small business units with limited growth potential, but very high ROEs, that generate relatively few dollars. It also has some very large business units with low ROEs.
The group’s top management had found that measuring and rewarding performance in percentage terms alone had led to some managers eliminating products, customers or activities that did not meet the percentage targets, and ending up with a much smaller business making higher percentage returns, but generating fewer absolute dollars for shareholders. This negative process is known in the group as “shrinking to excellence”.
In addition, the head office finance function wants to use the chosen measure to ensure that scarce capital is allocated to the right business and projects, and that incentive bonuses are fairly awarded to each division, taking both size and profitability into account.
In the early 20th century, General Motors CEO Alfred Sloan put forward the idea of residual income as a measure of divisional performance, as an extension of ROE.
In Sloan’s book “My years with General Motors”, he stated: “Just as the costs associated with sales are deducted in order to arrive at the profit component of the return, so too should the cost of the capital that is tied up by the investment.”
General Motors adopted the internal measure of residual income to measure the performance of each business unit. The measure is calculated as net income less a charge for the cost of capital used by each business unit. The principle is that each business unit uses part of the group’s equity capital. Divisions are charged for the capital they use based on a cost of capital percentage for each country, calculated each year at group head office and independently verified by external auditors or actuaries. This cost of capital can be regarded as a charge for the use of capital or a “franchise fee” for the equity given to each business unit.
John Deere managing director Bob Lane introduced a financial measure he called shareholder value added (SVA). Lane defined this as the “difference between operating profit and the cost of capital”.
John Deere’s profits fluctuated violently from year to year as divisions built up stock of finished products regardless of changes in farming cycles.
Lane then introduced a simplified version of SVA where division managers throughout the world are charged one percent of the value of the assets on their balance sheets at the end of the month. At the end of the year, each division’s profits must exceed the one percent charge.
Lane drove SVA into the culture of the organisation. The SVA calculation was explained to staff members through hundreds of workshops in John Deere factories around the world. Within six months all 18,000 employees had written goals and performance incentives directly aligned with the shareholder value metric.
SVA succeeded in changing behaviour in the organisation. John Deere divisions now only invest capital if they believe the resulting profit will be greater than the 1 percent cost of capital. Shareholders have also benefited. Seven years after introducing SVA, John Deere shares had increased to four times their prior value.
The John Deere four principles for successful implementation:
- Simplify the metric as much as possible
- Cascade it throughout the organisation - don’t keep it at head office
- Set written goals and incentives that are aligned with the metric for all employees all the way down to shop floor
- Invest in education and training
I’ve suggested this approach to my client and they are evaluating it with reference to their past two years’ audited results. Everyone’s very interested in the impact on the incentive bonus scheme.