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Objective:pi LLC
Focus on Profit:
The only way to manage IT
Objective:pi LLC
[Click Here for email address], http://www.objectivepi.com/
Abstract: Return on Capital Employed (ROCE or RONA) is often referred to as the primary profitability ratio. For every dollar invested in the business, ROCE dollars of earnings are being returned. ROCE is the result of two multiplicands: Net asset turnover and EBIT margin. IT projects should be chartered and managed as either a net asset turnover increasing project or a EBIT margin increasing project. ###more here###
1. The primary profitability ratio
Before we begin the discussion, let's cover some terms and concepts.
An investor hands money to a business and expects benefits to be returned by the business. The money put in to the business is the capital, which, in its purest forms is debt capital (bank loans) or equity capital (common stock).[1] The business uses the investors' money to purchase assets and operate the business. Profit is the benefit returned by the business to its investors.
The sum of the various forms of capital that have been invested in a business is called the capital employed by the business. (It's also called the net assets of the business.)
If one divides the profit produced by a business during a time period by the average capital employed during that time, the result is a ratio. This ratio indicates, for every dollar invested in the business, what the return was during the period. This ratio, the return on capital employed (ROCE), is considered the primary profitability ratio of business. (The ratio is also called return on net assets (RONA).)
2. The factors of profit
While business exist to make profit, much focus of business is on revenue. It is therefore useful to break ROCE down in a manner that shows revenue's contribution. This is done by separating ROCE into two factors:
Let's discuss the second factor, EBIT margin, first. EBIT is simply earnings before interest expenses and taxes — for a given time period, the revenue of the business minus all the costs of running the business (except interest and tax expense). EBIT is the basic profit of the business — the money that is available to return to the investors. Part of EBIT is paid to banks and bondholders as interest. Part of EBIT can be paid to common and preferred stock holders as dividends. EBIT can also be retained by the business as "self-funding" of the future activities of the business.[2]
EBIT margin is EBIT divided by the business' net revenue. In other words, for every dollar of net revenue, the EBIT margin portion of that dollar are yielded as earnings. Obviously, one way to become more profitable is increase the EBIT margin. This simply means reducing costs compared to revenue.
Now we turn to the first factor, net asset turnover. It is the net revenue divided by net assets. We've been using the phrase "capital employed" in preference to "net assets".
This ratio measures how "capital intensive" the business is — how much revenue is being produced for each dollar invested. A trendy name for this ratio is "velocity", using the metaphor of sales "moving faster" through the business. Improvements to net asset turnover come from getting more revenue compared to the assets of the company.
3. The proposal
Why does this B-school theory matter to IT? Simple — it's a great way to keep IT projects focused on profit.
It's quite common that IT projects are given a specific scope without a strong tie-in to the business context. Because of this, the projects' objectives can drift and become disconnected from the reality of the surrounding business environment. Also, projects can fail to recognize opportunities for additional business value when these arise.
IT projects should be chartered and managed as either a net asset turnover increasing project or a EBIT margin increasing project.
This provides a means of establishing a concrete focus on how the project will drive profitability. Project teams are able to make much higher quality decisions when they are given this important piece of the business context in which the project operates.
4. Net asset turnover increasing projects
The goal of a net asset turnover increasing project is simply to drive revenue increases faster than the investment required to do so. These projects are "investment amplifiers" and should be managed as such.
For example, in many businesses that deal in physical goods, inventory consumes a huge amount of the capital invested in the business. Systems that reduce inventory needs will allow the business to grow without having to raise proportionate capital for inventory.
A less conventional example: In a professional service firm, the professionals can be viewed as the "capital assets" of the firm. So, a project that improves the productivity of the professionals is a way to increase revenue with a constant investment.
5. EBIT margin increasing projects
EBIT margin increasing projects are chartered with the task of maximizing the part of every revenue dollar that is left after expenses. Here, the project's focus is efficiency of operations.
An example is a project that reduces the administrative costs of the company's customer order process. The costs of this process are a kind of tax on the revene stream of the company. By reducing the cost of sales, this project increases earnings, even if revenue remains constant.
[To be continued....]
Footnotes
- [1]
- Debt and equity capital are two forms of capital. Business are often financed via many types of securities, such as preferred shares, convertable notes, and so on. These other securities can be considered hybrids of debt securities and equity securities.
- [2]
- EBIT is a profit number that separates the means of financing from the rest of the business. The debt versus equity mix employed does not affect EBIT. (That's why interest expense is excluded from EBIT.) Net profit, by contrast, is a number that reflect some of the investors (debt holders) having been paid while others (equity holders) are yet to be paid.
References
Revised 2 August 2003
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