Chasing Profit – A bad idea

In the business world today, all is not quite as it seems

ROCE

Return On Capital Employed is regarded as one of those obscure terms that accountants use and can calculate for you if you are really interested. Even then there are arguments about what precisely comprises the Capital bit of the sum.

It is however the most important concept to understand! It is far more important to focus on ROCE than on profit. We can go further, focusing on profit as a measure of performance can seriously harm your ability to make money. And yet it is likely that neither your bank nor your accountant, the two organisations that regularly hand out gratuitous business advice, have ever discussed it with you.

SO WHAT IS THIS ROCE?If you had £1000 to invest and you were offered two different investments one paying 5% and one paying 50%, both equally safe, which one would you choose to invest your money in? One is giving you a 5% ROCE the other a 50% ROCE.

The answer is, of course, obvious! So why on earth should I ask the question? First, it explains very neatly what is meant by ROCE. It is the amount of money you can generate on your investment, your company's profit divided by the amount of money tied up in the company.

Second it makes it clear that if you are investing in anything it is important to know the ROCE.

ROCE = Profit . Capital Employed

Simple mathematics tells us that if I wish to increase ROCE I can either increase the Profit or decrease the Capital Employed.

Once again, obvious!

Now let us consider another curious little accounting calculation, the Economic Batch Quantity. This is a calculation widely used by manufacturing organisations but also by purchasing departments where it is known as the Economic Order Quantity.

You may not be involved in either activity but please concentrate anyway because it explains very neatly why a focus on profit is not just wrong but potentially dangerous.

There are many articles discussing this calculation but we will take the simple approach. If you are a printer for example you first have to install printing plates, add the right colour of ink, having ensured that the last colour has been cleaned out and load the press with the paper stock you are using. This takes, perhaps, 15 minutes so before you have printed a single sheet.

If you run the press at 6000 impression per hour it will take you 25 minutes to produce 1000, 35 minutes for 2000, 45 minutes for 3000 and so on.

Impressions Set-up time Production Total Time Time/1000

Time1000 15 10 25 252000 15 20 35 17.53000 15 30 45 154000 15 40 55 13.75

This will produce a line that is similar to the Production cost line in the graph below.

Obviously the more you produce the lower the production cost. However, as you produce more you have more stock, you have to pay for warehousing it, you have to pay interest on the money tied up in it, you have to insure it and so on. This is the holding cost and it rises in a straight line related to the quantity held as in the graph above.

Add these two costs together and you have the total unit cost for any given batch quantity.

It is not difficult to recognise that the lowest unit cost is achieved by producing at point X. And if you sell at price P then your profit can be calculated by measuring the difference between P and the Total Unit Cost line.

Clearly the profit increases till you reach point X and then begins to decrease. It is very easy to plot the graph for this - it is simply the inverse of the cost line and is shown below. In other words the point of maximum profit is also at point X.

But bear in mind that the Quantity axis is just that. It is a quantity of stock that has a value. It is in fact Capital Employed. Now consider what happens if you halve the batch quantity. In this case your profit per unit will drop by about 10% but your capital employed has almost halved resulting in an increase in ROCE of almost 100%.

So here we have a curiosity. It is blindingly obvious that we should be seeking to maximise ROCE but almost the entire business community involved in batch manufacturing pursues a policy that significantly reduces ROCE from the optimum.

The importance of this graph is not what it tells you about manufacturing industry, it is that it highlights the importance of ROCE. The fundamental lesson to draw from this is that your business decisions must be based on what maximises ROCE and not on what maximises profit. This will have profound effects on your strategy regardless of industry. It will affect your investment decisions, operational strategy, the formulation of your sales propositions (because it also applies to your customers).

It will affect the way you regard your key resources and capabilities. It has, for example, resulted in one company recognising that its core resource was in its operations control and not in its plant; by matching its strategy to this recognition it increased turnover significantly and very quickly, accepted a lower unit profit but reduced its Capital Employed by 90%. Its ROCE increased by more than 10 times! 1000%!1

It also starts to explain why sales (we’ll call it throughput) is far more important to focus on than cost.

1 You may note that there is clearly a significant amount of additional capital employed in the operation, plant, premises, debtors etc. The important thing to appreciate is that this additional capital is already employed, what you are concerned with is the return on additional capital.