Part 1: Quantifying Cost Reduction Objectives
Measuring Current Shortfalls in Financial Performance
Capsule: The Company uses public financial data to establish reasonable targets for return on investment and its two major components. It, then, measures its financial gap and sets priorities to close it.
For helpful context on this step:
Symptoms and Implications:
The Company relies on comparisons of some kind to indicate whether its cost levels are appropriate. These comparisons are signposts directing the Company toward its ideal cost position in the industry. The Company reaches this ideal when it attains, and maintains, the low-cost position among competing suppliers serving its target customer segments. When the Company earns the highest returns on investment in its industry, it may assure itself that it has reached the low cost position in the industry.
Public financial data can be difficult to use because it is often very broad. Still, the Company may wish to use the available public financial data to gauge its overall cost position as well as its results on operating costs and its efficient use of capital. In order to make these comparisons, the Company needs three pieces of information about itself and its competition: operating costs, total capital, or assets, employed in the business, and sales.
These three components combine into the three separate ratios that measure the Company's cost performance: Return on Investment, Return on Sales and the ratio of capital, or assets, to sales. In using these measures, we have found that size alone is not enough to promise the Company high returns in its industry. We discuss these concepts in detail in the following sections:
Return on Investment
The Company may compare itself against competing companies on measures of total return on investment to determine its overall cost position. The Company has a choice among three measures of total return on investment:
The first two relate to the total Company, the third relates to a business segment.
These Return on Investment measures cover the Company’s overall cost position by combining operating profit performance, which measures primarily the Company’s ability to manage the costs of people and outside purchases, with a capital measure in the form of equity, net capital employed or total assets.
At the level of the total Company, Return on Equity measures the total after tax cost position of the Company compared to other companies. Return on Equity is the ratio of after-tax profits divided by the total of shareholders’ equity. The Return on Equity ratio measures the combination of the operating costs of people and purchases as well as the capital costs of equity capital-all this in one measure.
The Company with the highest Return on Equity in an industry enjoys the lowest overall cost position. All competitors in the industry face the same pricing environment. If one competitor could raise its prices relative to the others, it would do so. Similarly, if a competitor could reduce its prices in order to gain more market share, it would be likely to do that. Any company has limited degrees of freedom in changing its price in the normal competitive market place. If all companies face the same pricing environment, they manage their Returns on Equity by managing their Building Block Costs more effectively than do their competitors. Low costs of people and purchases produce high after-tax profits, the numerator in the Return on Equity ratio. The use of relatively few assets in the business requires less capital, especially the costly form of equity capital, than competition. Equity capital is the denominator in the Return on Equity ratio.
Return on Net Capital Employed (RONCE) is another measure of the overall Company cost position. Return on Net Capital Employed is the ratio of the Company's earnings before interest and taxes (EBIT) divided by the net capital employed in the Company. Net Capital Employed is the sum of all interest bearing liabilities plus all forms of equity. The Company with the highest Return on Net Capital Employed has the industry's lowest overall cost position, before considering leverage in the financial structure.
RONCE measures the performance of operating managers, while ROE incorporates the role of senior management as well. The Return on Net Capital Employed measure differs from the Return on Equity measure by removing the effects of tax and financial management strategies on the business. The Return on Net Capital Employed figure provides a better measure of performance of the operating managers, who have no control over the tax or financial structure of the Company. Return on Equity, because it accounts for all forms of leverage, is a better measure of the final cost position of the Company compared to its competition. The senior management of the Company, rather than operating management, makes all decisions with regard to financial and tax policies. These decisions derive, in one part, from the operating performance of the Company and, in another part, from the aggressiveness of the Company's senior management in the use of debt in the capital structure.
A similar measure of over-all cost position exists for the individual business segments of many companies, the Return on Allocated Assets of the business segment. The SEC requires a company to report sales, operating profits, and allocated assets for any business segment accounting for at least ten percent of the Company's total sales. These publicly available data enable the Company to compare its business segment's cost position to those of the business segments of its competition using the Return on Allocated Assets measure. This Return on Assets ratio divides a business segment's operating profits by its allocated assets. The business segment with the best Return on Assets in the industry is the segment with the lowest overall costs. The operating profits measure the costs of the segment's people and purchases. The level of assets the Company allocates to the business segment measures the use of capital in the segment.
In general, the Company would want to compare its performance against that of its peer competitors in its industry. These competitors establish the benchmarks for good performance within the industry. However, the Company often competes for capital in the larger public markets as well. Accordingly, the Company should also ensure that its Return on Investment performance, through the business cycle, would enable the Company to compete effectively for capital on the bigger stage of the public capital markets.
The Benchmarks section of the web site provides information for the Company to compare its returns against the returns of a large number of other industries. Publicly available information provides the data for these measures. The information in the Benchmarks/Quartile Rankings Reports reveals that the median return on investment performance for the leading market share companies in the U.S. public markets is:
If the Company beats these measures, it should compete well for Capital.
The Company sets its targets for financial performance at a Return on Investment figure that reflects its industry position, while still considering its performance in the broader public market. This Return on Investment target reflects a realistic estimate of the Company’s potential performance in its industry over the next three years. This target considers the outlook for industry prices and the Company’s likely performance in the industry.
Each of these three overall Return on Investment measures has two basic cost components: operating costs and assets or capital. The Company may use these two cost components in combination with sales to get further insight on its cost position. The measure of Return on Sales, the ratio of operating costs to sales, indicates the Company's performance compared to competition on managing people and purchases. The ratio of assets, or capital employed, to sales measures the Company's relative capability in deploying capital.
Return on Sales
The Company with the highest ratio of operating profits (i.e., Earnings Before Interest and Taxes, or EBIT) to sales has the industry's lowest operating costs of people and purchases. The differences among competitors in sales measure primarily the units that one company is able to sell compared to another. As discussed above, each of the industry's competitors competes in the same pricing environment. While there may be some modest differences in price from one competitor to the next, most of the differences in sales levels from one competitor to another reflect differences in units of product sold. Each competitor’s ratio of operating profits as a percentage of sales measures the total operating cost required for the competitor to produce its units of product. If one competitor has a higher total operating profit as a percentage of sales than another competitor, the first competitor is superior in its management of people and purchases.
The Company may use the Return on Sales ratio to measure its operating cost performance at either the Company or business unit level. The Benchmarks/Quartile Ranking Reports
The Return on Sales measures are most useful within the Company’s particular industry. Average Return on Sales percentages vary greatly from one industry to the next. Industries with high capital intensity, a measure discussed in the next section, and those with proprietary products have higher Return on Sales levels over time. Industries with low capital intensity tend to have lower Returns on Sales as well.
Capital or Assets to Sales
The performance on the ratio of allocated assets to sales in a business segment, or of Net Capital Employed (NCE) to sales in a company, measures the efficiency of capital used in the business. In this ratio, sales reflect primarily the units of product each company sells. The cost of the assets, or capital, employed in a business has two components: a percentage rate of cost and a total amount of assets, or capital, used. The ratio of allocated assets to sales in a business segment, or of net capital employed to sales in a company, does not measure the rate component of capital or asset costs. It measures only the total amount of assets or capital employed in the business. Since most business managers control only the amount component of capital, assets or NCE becomes the major focus of the measurement of asset or capital efficiency. The Company with the lowest ratio of allocated assets or NCE to sales is the most efficient Company in the industry in using its capital to produce sales.
The Benchmarks/Quartile Ranking Reports show that the median measure for asset or capital intensity in the U.S. public markets is:
Businesses with higher percentages than these median figures are in capital intensive industries. Management of assets takes on increased importance in the more capital intensive industries.
Size and Returns
As the Company plans its return on investment targets and its operating and capital to sales ratios in support of that target, it should be careful not to assume that the growth of the Company in the industry, by itself, will produce better returns than those of competition. There is a benefit in being the largest competitor, though the benefit is much smaller than most of us would assume. The relationship between market share and relative profitability is not particularly strong.
We evaluated the returns on investment figures for 240 industries that each had five or more competitors reporting line of business sales of at least $50MM. In each of those industries, we ranked the top four competitors in the market, based on sales, and then calculated the returns on investment for each competitor. We calculated the percentage of time that the Company that ranked first in market share also ranked first in Return on Investment. Random probability would have predicted that any one of the top four competitors would lead its industry in return on investment 25% of the time.
Size does count. In our study we found that the first ranked competitor in market share led the industry in Returns on Investment 29% of the time. This 29% was only 4% more than the random chance of 25%. Over 70% of the time, the industry leader in market share failed to lead its industry in returns.
The performance of industry market share leaders in Hostile industries is even worse. In those industries, the industry market share leader had the highest return in the industry only 20% of the time, significantly less often than in a non-hostile industry, and well below the 25% random chance result.
In order to achieve high returns on investment in an industry, most industry market share leaders, and virtually all market share followers, must take an active role in managing the improvement of their costs as the business grows. This will be the subject of the next several sections in Activity 4.
One approach that some companies have used to achieving their financial goals is to use an method we call design to value. Using this approach, the Company would set its objectives for operating margins and capital intensity to meet or exceed the levels of the low cost competitor in the marketplace. It would, then, go about the task of designing its cost structure to meet these performance targets within the planning period.