The accountants' method is faulty for two reasons. First, you don't get the same return from every dollar you spend. Some earn you big bucks, and some don't get you much at all. Nevertheless, accountants dump all investment dollars into one big line item called "investment" and do the math from there. Of course, you might argue that you need all that hardware to support operations, whether you get a lot from it or not. And you could be right, but you could be dead wrong, too. Too often, manufacturers don't really need many of the assets that aren't contributing to their bottom lines. Do you really need the plant in Puerto Rico? What would be the difference if you closed it? If all assets don't provide the same returns, stuffing them into the same line item will hide those that don't get you much.
Here's the second problem, and it's subtler. Every firm has "assets" that aren't line items on the balance sheet, and sometimes, they are more important than those that are.
For example, a construction equipment company we know is pretty good at building its products, but its most important asset does not appear on the balance sheet. It's the company's dealer network, the distribution system that gets the company's products quickly and efficiently to the end users. Not having the resources needed to build the products--the company's most important investment, according to its balance sheet--would likely improve ROI significantly, using the traditional calculation!
Here's another example. A bakery in Mexico is able to get same-day fresh bread to the most distant and remote grocery store it serves. Like the previous example, actually baking the bread is less important, and less valuable, than having the logistics to get it distributed quickly and cost-effectively. And, the distribution system does not represent much of a line-item investment, compared with the ovens, mixers and packaging equipment.
Another firm we know has an extensive roster of producing assets, totaling nearly $1 billion dollars in net investment. However, the firm's most important asset is not its investment in fixed assets. We argue it's the talented management team that oversees the firm's operations, adding investments where the margins are improving or can be improved, and divesting those that are in decline.
These examples clearly show that the most important assets your firm owns may not show up on your balance sheet. Moreover, they might not be as obvious as those we've used as examples. Here's a way to sort it out:
Identify all the assets, tangible and intangible, that make up your asset base. Don't look only at those you've spent a lot of money on. Consider distribution systems, management talent and other intangibles.
Measure the benefit each of these assets contributes and compare that to the investment you've made for each one. Use that data to establish the ROI from each item. Prepare to be amazed at what you've built and what opportunities you find to make it better.
Finally, start peeling off the poor producers. Get someone else to do the work and carry the investment, much like automakers are doing today. You're likely to get some strong arguments against eliminating them. However, we argue that overdoing it is better than underdoing it.
Watch your ROI improve and with it your market capitalization, shareholder value, and your ability to weather business downturns.
What's your opinion? Whether you agree or disagree, Don Ewaldz will welcome your comments. You can contact him via the Bourton Group's Web site. Just point your browser to www.bourtongroup.com and click on "Contact Us".