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ROI planning and control
J. FRED WESTON
ROI PLANNING AND CONTROL A dynamic management system J. Fred Weston is a faculty m e m b e r in the area o f business economics and finance at UCLA.
Defects in the application of the ROI method of planning and control have been disclosed by its originator, du Pont, arid by a study of firms that adopted the method relatively late. None o f the errors, the author observes, is inherent in the ROI method; the central error is the confusion of goals and processes. Both businessmen and theorists have treated the firm's objectives as ends in themselves. ROI systems or other systems have been installed, and targets and standards used bureaucratically. Targets and standards should be viewed as instruments for engendering healthy adaptive learning processes in organizations. The R O I system can provide information on every element of the balance sheet, income statement, and other comprehensive performance statements, serving as a vehicle for dynamic communication, feedback, and adjustm en t. The problem of departmentation, involving the grouping of activities and the use of specialist expertise, is a problem faced by
AUGUST, 1972
firms of all sizes. A very small firm that has not yet grouped or specialized its activities faces the question in seeking to improve the efficiency of operations. A related continuing issue, regardless of the firm's size, is whether to buy specialist expertise as required through the external market place or to obtain the flow of services through a generalized contractual relationship. Indeed, the organization and management questions involved are applicable to all purposive organizations. The basic issue is the general problem of seeking optimal production functions by effective grouping of activities and utilization of specialist expertise. 1 In turn, this raises a number of problems concerning the delegation of authority while achieving effective control of decentralized operations. One widely used method of divisional control is the return on investment (ROI) technique, which has been widely criticized. Economists have regarded ROI objectives as indicative of market control. Management specialists have described defects in the method for achieving effective control of decentralized operations, and behaviorists and accountants alike have questioned the motivational consequences of such control. Field surveys of corporate resource allocation policies have developed evidence that many of the criticisms are directed against a static concept of the ROI control system with inadequate recognition of its dynamic process characteristics. This proposition will be developed in three parts: first, the prevailing
1. Compare R. H. Coase, "The Nature of the Firm," Economica (1937), pp. 336-38, and J. Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, N.J.: Prentice-
Hall, Inc., 1970), pp. 11-12.
35
j. FRED WESTON
description of ROI and the criticisms made of it; second, the nature and significance of ROI as a dynamic process; and third, an evaluation of the criticisms of ROI control in the framework of its actual characteristics.
THE STATIC FORM OF ROI
36
Short-term business planning as reflected in the financial budgeting process has been referred to in the literature as "planning mad control for profit, . . . . management b y objectives," or "the du Pont system. ''2 The du Pont Company pioneered the ROI system, widely used b y divisionalized firms as well as by effectively managed small firms. Surprisingly, altho.ugh du Pont began to develop and utilize the system before 1910, there was no description in the literature of the system's details until after the late 1940's. Even the early presentations covered only the mechanical aspects of the system. The concepts were not really brought alive until Alfred Sloan's book in 1964. In addition to confusion about its implications, there is also misunderstanding about the system itself. This is reflected in Dearden where the "case against ROI control" is directed against its static, not its dynamic, elements. 3 The static form of the du Pont system focuses on a formula chart showing the relationship of factors affecting ROI, which is the end focus of the chart. This is shown as the product of the turnover of investment multiplied by the margin on sales, to emphasize that the ROI can be increased either b y minimizing investments per dollar of
2. The reference to "planning and control for profit" has caused confusion by such writers as J. K. Galbraith in associating planning with control. This article will seek to clarify the relationship. Management by objectives (MBO) involves processes similar to ROI planning and control. 3. J o h n Dearden, 'q'he Case Against ROI Control," Harvard Business Review, XLVII (May-June, 1969), pp. 124-35.
sales, or b y controlling costs so that the profit margin on sales is improved. The formula chart then fans into details of all the elements of operating investment: cash, receivables, inventories, and fixed assets (gross). The income statement provides details for all of the factors affecting the profit margin, with emphasis on the nature and behavior of the cost elements. Even in its static form, the ROI m e t h o d of control has a number of positive attributes, which have been summarized effectively b y Dearden. First, it is a single, comprehensive measure, influenced by everything that has happened which affects the financial status of the divisions. Every item in the du Pont chart is related to its effect on either turnover or profit margin, and through either of these to its effect on ROI. If an alternative organization of the financial planning and control system is desired, the required information for doing so has been assembled. The second advantage is that ROI measures how well the division manager has used his resource allocations, thereby providing a means for detailed post-auditing capital investment proposals. A third advantage is that ROI is a c o m m o n denominator so that comparisons can be made directly among divisions within the company, with outside companies or with alternative investment of funds generally. Fourth, it is also claimed that since the manager is evaluated on his ability to optimize ROI, he will be motivated to do SO.
Criticisms of this m e t h o d of control have also been expressed. A list of technical defects is well covered in the Dearden article. 4 These include oversimplification of a complex decision-making process, failure to distinguish the required rate of ROI in c o m m o n assets used in different divisions that may have different ROI targets, and difficulties arising out of accounting methods measuring ROI. A
4. Dearden, "The Case Against ROI Control."
BUSINESS HORIZONS
ROI Planning and Control
review of these technical defects suggests that m a n y of them are arbitrary procedures not inherent in the m e t h o d . Many criticisms of this m e t h o d of planning and control stem from the predilection of accounting systems for recording the expiration of historical costs, and hence reflect the limitations of traditional accounting methods. A second difficulty is that of assigning responsibility. Inherently, m a n y decision areas involve the joint participation of a number of divisions and different levels of authority. Consequently, assigning responsibility for results is difficult under a static method. The third and most fundamental criticism is that any static control system is likely to have motivational defects. Any static control m e t h o d will invite a wide range of practices for beating the system. In addition, there are important additional positive values not captured b y the static concept. Therefore, it is important to view the du Pont system in its correct e x p o s i t i o n - t h e du Pont planning and control system as a dynamic process.
ROI AS D Y N A M I C PROCESS
In its dynamic aspects, the du Pont system represents the creation of a significant addition to management technology. Detailed analysis of operations is provided in a series of individual charts on each element of investment, revenue, or cost. It is in connection with review of these individual charts that a dynamic process is generated. For each asset or investment account, historical data are provided on an annual basis for five years with the sixth or current year presented on an annual basis to date and on a forecast basis for one year. In addition, data are provided on a m o n t h l y basis for the previous year and for the current year to date. Periodic forecasts are made for four quarters into the future. The forecast is repeated periodically. When the forecast and review are on a quarterly basis,
AUGUST, 1972
the one-year forecast is expressed b y m o n t h for the proximate quarter and b y quarter for the remainder of the year. Thus, on a quarterly forecast and review basis, each quarter will have been projected and reviewed four times before the actual events are experienced. (In highly dynamic departments the forecast review may be m o n t h l y and even weekly.) Similar analysis is made of expenses expressed as a percentage of sales and transfers. Expenses as a percentage of sales are placed in perspective by showing production as a percentage of capacity since volume influences per unit cost. The mechanics of the du Pont planning and control system have been described. The review process makes this a dynamic system with three main elements: the review itself, process rather than goal orientation, and the adaptive learning process.
The Review Process
37 The process begins with periodic meetings of the firm's finance committee when divisional proposals for funds are presented. The prospective ROI represents one of the criteria used to evaluate the alternative investment opportunities and to allocate corporate resources. Initial projections are related to the potentials for the individual areas. The subsequent analysis compares performance to projections. A periodic presentation is made by the responsible managers of divisions or departments to a review committee comprised of men with years of experience in diverse areas of operations of the company. The committee as a whole has experience covering a range so wide that the review of any department is an informed review. The data are a vehicle for the significant aspect of the p r o c e s s - t h e review of the data and the adjustment of policies. Performance is related to potential and not to any absolute standard. Thus the evaluation system provides a two-way information flow in an effective communication system. In its evaluation of an
J. FRED WESTON
38
individual division or department, the review committee takes into account not only optimization for that segment, but also over-all optimization for the firm. Analysis of the data and comparisons of forecasts with actual results lead to policy modifications. A reward and penalty system closes the loop in this process of stimulating, guiding, and motivating effective managerial performance. A salary and bonus committee allocates promotions, salary adjustments, and bonuses by departments. This committee typically includes members of the finance committee responsible for the originalallocation or resources, and members of the review committee engaged in a continuing evaluation of performance. Three aspects of the review process represent a dynamic system. First, there is a detailed information flow on key decision areas. This provides feedback in the information system loop. Second, the review process represents a monitoring of the data and other forms of information. Third, on the basis of the information, review, and discussion, policies and decisions are adjusted in the attempt to improve performance. Thus, the entire process represents a m e t h o d of adjusting to changes in the total economy, the industry, and actions of competitors, s
potential for the division, and not to any absolute standard. A manager who is able to limit the loss in a division in a product market characterized by severe excess capacity .may be rated higher than a manager who achieves a positive 20 percent returfl in a product market area where at least temporarily the sales/capacity relations may have made possible a 30 percent return. Similarly, if the risks of a divisional operation are high, there will be a minimum screening standard or investment hurdle rate that will be higher than for a less risky division. For example, the ROI for oil exploration will be higher than that on the investment in the land on which a filling station is located; obviously, the results of the operations of the filling station are more predictable than the outcome of oil exploration. Or a company contemplating the establishment of a manufacturing operation in a foreign country, subject to a wide range of political as well as commercial and foreign exchange fluctuation risks, will require a greater return on that activity than the return on expanding its capacity to produce and sell through established channels a staple consumer nondurable good.
Information and Adaptive Learning Goals vs. Process The ROI system must properly be seen as a process. Managers are not evaluated on the basis of the size of the ROI their division earns. Performance evaluation is related to the
5. In their research o n implementation of the management by objectives approach, Carroll and Tosi found that frequency of review is highly related to goal clarity and indexes of organizational effectiveness. Their attempts to quantify the quality of the review process yielded less conclusive results. See S. J. Carroll, Jr., and Henry L. Tosi, "The Relationship of Characteristics of the Review Process to the Success of the "Management by Objectives Approach," Journal of Business XLIV (July 1971), pp. 299-305.
The review process focuses on the difference between the actual performance of a division and the projection that the managers had made. This comparison is more important than specific goal orientation because errors in forecasts in either direction result in misallocation of resources. In the corporate allocation of resources b y the finance committee, a project may promise a 10 percent return, resulting in an allocation of $1 million for that investment. But if the expected return had been 20 percent, perhaps a $4 million investment would have been allocated. Hence, errors in either direction result in a misallocation of resources.
BUSINESS HORIZONS
ROI Planning and Control
"The dynamic ROI system recognizes important variables external to the firm: changes in the economy and competitive conditions, elements of costs change . . ."
But it would be inaccurate to characterize the ROI system as emphasizing that results conform to budgets or forecasts. The dynamic ROI system recognizes important variables external to the firm: changes in the economy and competitive conditions, elements of costs change, and so on. Such changes are taken into account in evaluating managerial performance. The informed review process thus provides a basis for achieving an efficient two-way information flow. The forecasting, information flow, review and adjustment process provides for both formal and informal multiple flows of information. The evaluations are not mechanical. The review discussions aim at an informed evaluation of performance. This increased understanding provides a basis for a dynamic adaptive learning process. The fundamental objective of the ROI system as a dynamic process is to shorten reaction time to change or error, thereby making the firm an effective learning and adaptive mechanism.
EVALUATION PROCESS
OF
THE
DYNAMIC
Most of the criticisms of the ROI control method are applicable only to the static formulation. The use of any type of static control system develops incentives in the wrong direction, leads to the development of devices for beating the system, and results in the wrong motivations. But in the dynamic management control system described, this major defect of the static ROI method is eliminated. Particularly, the informed review process and the two-way information flow system make for good communication and understanding. The process then becomes a
AUGUST, 1972
vehicle for continued improvements and provides strong motivations in the proper directions. A major problem in the utilization of the ROI method of control is the failure of companies to adopt its dynamic elements. One reason for this failure is that so many firms came to the method relatively late. The systematic literature on the "principles of management" developed after the mid-1950s. Particularly, the literature on long-range planning did not appear until after 1955. The emergence of second-generation computers with their increased information processing and retrieval capabilities gave impetus to formal methods of planning and control. Widespread adoption of decentralized responsibility utilized the device of profit centers. Implementation of the profit center concept involves determination of the amount of profit and relating it to some base to determine a profitability rate. Thus, to some degree, the development of measures of performance of investment centers represents an index of the extent to which an important development in planning and control activities had taken place. As of mid-1965, 60 percent of 2,658 respondents indicated the use of investment centers. ~ Of those firms not using investment centers, about two-thirds indicated that they did not have two or more profit centers or that capital assets were relatively less significant in determining the performance of their business. It is difficult to assess whether the
6. John J. Mauriel and Robert N. Anthony, "Misevaluation of Investment Center Performance," Harvard Business Review XLIV (March-April, 1966), pp. 98-105.
39
J. FRED WESTON
40
firms not employing profit centers should have done so for effective planning and control of their operations. Perhaps of greater significance is the timing of the adoption of investment centers in performance measures of decentralized divisions. Of 851 large American firms that responded to an inquiry with respect to how they utilized the analysis of investment center performance, 60 percent indicated that they had adopted the method after 1955, and over 37 percent had adopted the method after 1960. When the learning aspects of the dynamic control system are taken into account, it is sobering to reflect upon persistent differentials in organization effectiveness that may have been caused by the lag in the adoption of modern management control methods in a large number of American corporations. Hence, one reason why the ROI method of control is used in its static form may stem from its late installation by so many large companies. In its static form, the method is relatively mechanical in its installation and operation. It is thus easier to understand and easier to install. Furthermore, the review and information flow process cannot be installed as an ongoing dynamic system from the very beginning. There is an important learning element involved. This may require various forms of experimentation by companies in order to superimpose a dynamic control system on the methods of management control processes then in use. Indeed, the difficulties of applying the ROI method in a flexible and dynamic way appear to have been experienced at the du Pont Company itself. The key element has been relations with the review committee, which plays the critical role in the effective functioning of a dynamic planning and review process. The review committee at du Pont is the executive committee, consisting of the president of the company and eight vicepresidents. Some recent changes in its methods of functioning have been described:
The c o m m i t t e e meets each Wednesday. It receives m o n t h l y reports f r o m d e p a r t m e n t managers, and every quarter each manager appears to discuss w h a t h a p p e n e d , why, and the o u t l o o k . For decades, these reports were illustrated b y a series of financial charts hung f r o m movable overhead trolleys. A m a n f r o m the treasurer's office presented the data in a stylized m a n n e r while the general manager waited for questions. T h e crucial charts focused on the d e p a r t m e n t ' s return-on-investment, a very rigid concept. All this has changed. The trolleys and the chart r o o m are gone. Instead of sitting theater-style, the executive c o m m i t t e e n o w sits a r o u n d an oval table. The charts are at hand in page f o r m , b u t , 'unless we have a question or unless the general manager wants to talk f r o m t h e m , we d o n ' t pick t h e m up . . . . The old system l o o k e d b a c k w a r d rather than forward. N o w , the thrust is to the future.
Apparently, an effective information and review process could not be achieved by the periodic presentations to the total executive (review) committee. An important organizational change was, therefore, made: Last spring, M c C o y b r o k e with a n o t h e r du P o n t tradition b y giving each executive c o m m i t t e e m e m b e r an assignment as liaison m a n to a d e p a r t m e n t to improve the c o n n e c t i o n b e t w e e n the operating groups a n d the policy level, and to give us b e t t e r understanding of our problems.
The advantage of this new approach was expressed by one of the general managers in the following terms: "Instead of worrying about keeping nine men i n f o r m e d . . . I can clue my man anytime. He deals with the committee and I have more time to run m y business." Another important development was a more flexible approach to the application of the ROI concept: N o w , return-on-investment is redefined every so often, says e c o n o m i s t Charles L. Reeder, to accept reality. Where once the m i n i m u m was fixed, t o d a y it varies--higher w h e n the risks are greater, lower w h e n the results are m o r e certain (a tribute to venture analysis techniques n o w p e r m e a t i n g the c o m p a n y ) or when an i n v e s t m e n t supports an established business. 7
7. "Lighting a Fire Under the Sleeping Giant," Business Week (Sept. 12, 1970), pp. 40-41. The first quotation suggests that the process orientation of the effective utilization of ROI planning and control has b e c o m e bureaucratized and mechanized at du Pont.
BUSINESS HORIZONS
ROI Planning and Control
The implication that a fixed minimum ROI rate had been a rigid requirement of all types of opportunities, regardless of the degree of risk, suggests the application of the method in a mechanistic way. The du Pont experience emphasizes the requirement of a dynamic, flexible continuing review process rather than a bureaucratic application. Further, strategic planning was not effectively integrated with operations planning and control at du Pont. But the recent du Pont experience offers no evidence that the failure to integrate financial planning and control with long-range or strategic planning is inherent in the ROI system. There is nothing in the method that inhibits a firm from effective integration. Indeed, Sloan emphasized that bringing the du Pont system to General Motors in the early twenties facilitated the development of longrange strategy. The installation of the du Pont system in General Motors at a time of financial crises in the early 1920s enabled Sloan and his management team to bring the operation under control. They were then able to take the long-term view in developing a strategy for increasing their share of the market. 8
THE ROLE OF ROI CONTROL ~___,,,~[11][1[[1,] Defects in the application of the ROI planning and control method have been disclosed by its originator, du Pont. Even worse errors were observed in a large number of firms that adopted planning and control efforts relatively late. Direct interviews with a number of these companies indicated three major types of difficulties. First, the most widespread errors involved a static approach to planning and control. A related error has been the reflection of the
8. Alfred P. Soan, Jr., My Years With General Motors (Garden City, N.Y.: Doubleday & Company, 1964).
AUGUST, 1972
emphasis of classical management theory of a strict top-down planning approach in which the standards of performance were imposed from above. The resulting rigidity has resulted in continuing conflicts between the corporate office and the operating divisions. Second, these problems have been aggravated by the domination of short-term budgeting operations by traditional accounting practices. The third major defect was the closed systems approach in which budgeting was carried out without effective integration with strategic or long-range planning. None of the observed errors is inherent in the ROI method. The central error is in the confusion of goals and process. But both businessmen and theorists have committed the error of treating these objectives as ends in themselves. Without a full understanding of the dynamics of planning and control systems, business firms have installed ROI or other forms of management information systems, using the targets and standards bureaucratically. Economists have also misinterpreted targets as goals rather than as instruments for coordination of decentralized divisions. Specific management function areas such as a marketing or engineering departments are likely to place greater emphasis on the importance of targets than the general office executives. In surveying such departments an exaggerated impression of the role of targets may be obtained. But the targets and standards by which managers seek to make the goals of the firm operational are not ends in themselves. Rather, they should be viewed as management instruments for engendering healthy processes in the firm. Targets and standards can be employed to contribute to an information and feedback process that is dynamic in quality, has favorable effects on the development of the firm's personnel, and can facilitate fast reaction time to change. The ROI system of planning and control is a useful vehicle for assembling relevant infor-
41
J. FRED WESTON
mation. It is not critical whether that information is focused on ROI or other "organization objectives." ROI is useful in providing information on every element of the balance sheet and income statement as a basis for further analysis. As a vehicle for a dynamic communication, feedback, and adjustment process, ROI, as well as other management information systems appropriately employed, can potentially be a useful system for developing healthy processes in successfully functioning firms.
This article draws on field studies supported by a grant from the McKinsey Foundation to the UCLA research program in competition and business policy for a study of corporate resource allocation policies. This paper benefited from the comments of G. Buckman, M. Fujimori, Y. Imai, C. G. Krouse, R. O. Mason, and W. G. Vatter. The goals of the firm include maximization of stockholder wealth, consumer satisfaction, and contributions to society as a whole to which the firm bears a central responsibility. Expanding the capabilities of its personnel and their development as human beings and citizens is also a primary goal. In the effort to achieve these goals, a number of operational objectives and standards are formulated. These include ROI, growth in size and earnings per share, favorable valuation relations, growth in the firm's market share, and favorable trends in the morale of its personnel as measured by low separation rates and high ratings on social indicators.
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42
In a n y p r e o c c u p a t i o n w i t h t h e devices o f m a n a g e r i a l c o n t r o l , o n e s h o u l d n e v e r o v e r l o o k t h e i m p o r t a n c e of c o n t r o l t h r o u g h p e r s o n a l o b s e r v a t i o n . Budgets, charts, r e p o r t s , ratios, a u d i t o r s ' r e c o m m e n d a t i o n s , a n d o t h e r devices o f c o n t r o l can b e h e l p f u l , if n o t essential to c o n t r o l . B u t t h e m a n a g e r w h o relies o n these devices a n d sits, so to speak, in a s o u n d p r o o f c o n t r o l r o o m r e a d i n g dials a n d m a n i p u l a t i n g levers can h a r d l y e x p e c t to d o a t h o r o u g h j o b o f c o n t r o l . M a n a g e m e n t , a f t e r all, has t h e task o f seeing t h a t t h e e n t e r p r i s e objectives are a c c o m p l i s h e d b y people, and, a l t h o u g h m a n y scientific devices aid in m a k i n g sure t h a t p e o p l e are d o i n g t h a t w h i c h the m a n a g e r has h o p e d a n d p l a n n e d f o r t h e m , t h e p r o b l e m o f c o n t r o l is still o n e of m e a s u r i n g activities o f h u m a n beings. I t is a m a z i n g h o w m u c h i n f o r m a t i o n an e x p e r i e n c e d m a n a g e r can get f r o m p e r s o n a l o b s e r v a t i o n even f r o m an o c c a s i o n a l w a l k t h r o u g h a p l a n t or an office. - - H a r o l d K o o n t z a n d Cyril O ' D o n n e l l
Principles of Managem en t OOOOD(3OO~OOOOOOOOOOOODO(3OOOE~OOOOooorrq
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BUSINESS HORIZONS
ROI PLANNING AND CONTROL A dynamic management system J. Fred Weston is a faculty m e m b e r in the area o f business economics and finance at UCLA.
Defects in the application of the ROI method of planning and control have been disclosed by its originator, du Pont, arid by a study of firms that adopted the method relatively late. None o f the errors, the author observes, is inherent in the ROI method; the central error is the confusion of goals and processes. Both businessmen and theorists have treated the firm's objectives as ends in themselves. ROI systems or other systems have been installed, and targets and standards used bureaucratically. Targets and standards should be viewed as instruments for engendering healthy adaptive learning processes in organizations. The R O I system can provide information on every element of the balance sheet, income statement, and other comprehensive performance statements, serving as a vehicle for dynamic communication, feedback, and adjustm en t. The problem of departmentation, involving the grouping of activities and the use of specialist expertise, is a problem faced by
AUGUST, 1972
firms of all sizes. A very small firm that has not yet grouped or specialized its activities faces the question in seeking to improve the efficiency of operations. A related continuing issue, regardless of the firm's size, is whether to buy specialist expertise as required through the external market place or to obtain the flow of services through a generalized contractual relationship. Indeed, the organization and management questions involved are applicable to all purposive organizations. The basic issue is the general problem of seeking optimal production functions by effective grouping of activities and utilization of specialist expertise. 1 In turn, this raises a number of problems concerning the delegation of authority while achieving effective control of decentralized operations. One widely used method of divisional control is the return on investment (ROI) technique, which has been widely criticized. Economists have regarded ROI objectives as indicative of market control. Management specialists have described defects in the method for achieving effective control of decentralized operations, and behaviorists and accountants alike have questioned the motivational consequences of such control. Field surveys of corporate resource allocation policies have developed evidence that many of the criticisms are directed against a static concept of the ROI control system with inadequate recognition of its dynamic process characteristics. This proposition will be developed in three parts: first, the prevailing
1. Compare R. H. Coase, "The Nature of the Firm," Economica (1937), pp. 336-38, and J. Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, N.J.: Prentice-
Hall, Inc., 1970), pp. 11-12.
35
j. FRED WESTON
description of ROI and the criticisms made of it; second, the nature and significance of ROI as a dynamic process; and third, an evaluation of the criticisms of ROI control in the framework of its actual characteristics.
THE STATIC FORM OF ROI
36
Short-term business planning as reflected in the financial budgeting process has been referred to in the literature as "planning mad control for profit, . . . . management b y objectives," or "the du Pont system. ''2 The du Pont Company pioneered the ROI system, widely used b y divisionalized firms as well as by effectively managed small firms. Surprisingly, altho.ugh du Pont began to develop and utilize the system before 1910, there was no description in the literature of the system's details until after the late 1940's. Even the early presentations covered only the mechanical aspects of the system. The concepts were not really brought alive until Alfred Sloan's book in 1964. In addition to confusion about its implications, there is also misunderstanding about the system itself. This is reflected in Dearden where the "case against ROI control" is directed against its static, not its dynamic, elements. 3 The static form of the du Pont system focuses on a formula chart showing the relationship of factors affecting ROI, which is the end focus of the chart. This is shown as the product of the turnover of investment multiplied by the margin on sales, to emphasize that the ROI can be increased either b y minimizing investments per dollar of
2. The reference to "planning and control for profit" has caused confusion by such writers as J. K. Galbraith in associating planning with control. This article will seek to clarify the relationship. Management by objectives (MBO) involves processes similar to ROI planning and control. 3. J o h n Dearden, 'q'he Case Against ROI Control," Harvard Business Review, XLVII (May-June, 1969), pp. 124-35.
sales, or b y controlling costs so that the profit margin on sales is improved. The formula chart then fans into details of all the elements of operating investment: cash, receivables, inventories, and fixed assets (gross). The income statement provides details for all of the factors affecting the profit margin, with emphasis on the nature and behavior of the cost elements. Even in its static form, the ROI m e t h o d of control has a number of positive attributes, which have been summarized effectively b y Dearden. First, it is a single, comprehensive measure, influenced by everything that has happened which affects the financial status of the divisions. Every item in the du Pont chart is related to its effect on either turnover or profit margin, and through either of these to its effect on ROI. If an alternative organization of the financial planning and control system is desired, the required information for doing so has been assembled. The second advantage is that ROI measures how well the division manager has used his resource allocations, thereby providing a means for detailed post-auditing capital investment proposals. A third advantage is that ROI is a c o m m o n denominator so that comparisons can be made directly among divisions within the company, with outside companies or with alternative investment of funds generally. Fourth, it is also claimed that since the manager is evaluated on his ability to optimize ROI, he will be motivated to do SO.
Criticisms of this m e t h o d of control have also been expressed. A list of technical defects is well covered in the Dearden article. 4 These include oversimplification of a complex decision-making process, failure to distinguish the required rate of ROI in c o m m o n assets used in different divisions that may have different ROI targets, and difficulties arising out of accounting methods measuring ROI. A
4. Dearden, "The Case Against ROI Control."
BUSINESS HORIZONS
ROI Planning and Control
review of these technical defects suggests that m a n y of them are arbitrary procedures not inherent in the m e t h o d . Many criticisms of this m e t h o d of planning and control stem from the predilection of accounting systems for recording the expiration of historical costs, and hence reflect the limitations of traditional accounting methods. A second difficulty is that of assigning responsibility. Inherently, m a n y decision areas involve the joint participation of a number of divisions and different levels of authority. Consequently, assigning responsibility for results is difficult under a static method. The third and most fundamental criticism is that any static control system is likely to have motivational defects. Any static control m e t h o d will invite a wide range of practices for beating the system. In addition, there are important additional positive values not captured b y the static concept. Therefore, it is important to view the du Pont system in its correct e x p o s i t i o n - t h e du Pont planning and control system as a dynamic process.
ROI AS D Y N A M I C PROCESS
In its dynamic aspects, the du Pont system represents the creation of a significant addition to management technology. Detailed analysis of operations is provided in a series of individual charts on each element of investment, revenue, or cost. It is in connection with review of these individual charts that a dynamic process is generated. For each asset or investment account, historical data are provided on an annual basis for five years with the sixth or current year presented on an annual basis to date and on a forecast basis for one year. In addition, data are provided on a m o n t h l y basis for the previous year and for the current year to date. Periodic forecasts are made for four quarters into the future. The forecast is repeated periodically. When the forecast and review are on a quarterly basis,
AUGUST, 1972
the one-year forecast is expressed b y m o n t h for the proximate quarter and b y quarter for the remainder of the year. Thus, on a quarterly forecast and review basis, each quarter will have been projected and reviewed four times before the actual events are experienced. (In highly dynamic departments the forecast review may be m o n t h l y and even weekly.) Similar analysis is made of expenses expressed as a percentage of sales and transfers. Expenses as a percentage of sales are placed in perspective by showing production as a percentage of capacity since volume influences per unit cost. The mechanics of the du Pont planning and control system have been described. The review process makes this a dynamic system with three main elements: the review itself, process rather than goal orientation, and the adaptive learning process.
The Review Process
37 The process begins with periodic meetings of the firm's finance committee when divisional proposals for funds are presented. The prospective ROI represents one of the criteria used to evaluate the alternative investment opportunities and to allocate corporate resources. Initial projections are related to the potentials for the individual areas. The subsequent analysis compares performance to projections. A periodic presentation is made by the responsible managers of divisions or departments to a review committee comprised of men with years of experience in diverse areas of operations of the company. The committee as a whole has experience covering a range so wide that the review of any department is an informed review. The data are a vehicle for the significant aspect of the p r o c e s s - t h e review of the data and the adjustment of policies. Performance is related to potential and not to any absolute standard. Thus the evaluation system provides a two-way information flow in an effective communication system. In its evaluation of an
J. FRED WESTON
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individual division or department, the review committee takes into account not only optimization for that segment, but also over-all optimization for the firm. Analysis of the data and comparisons of forecasts with actual results lead to policy modifications. A reward and penalty system closes the loop in this process of stimulating, guiding, and motivating effective managerial performance. A salary and bonus committee allocates promotions, salary adjustments, and bonuses by departments. This committee typically includes members of the finance committee responsible for the originalallocation or resources, and members of the review committee engaged in a continuing evaluation of performance. Three aspects of the review process represent a dynamic system. First, there is a detailed information flow on key decision areas. This provides feedback in the information system loop. Second, the review process represents a monitoring of the data and other forms of information. Third, on the basis of the information, review, and discussion, policies and decisions are adjusted in the attempt to improve performance. Thus, the entire process represents a m e t h o d of adjusting to changes in the total economy, the industry, and actions of competitors, s
potential for the division, and not to any absolute standard. A manager who is able to limit the loss in a division in a product market characterized by severe excess capacity .may be rated higher than a manager who achieves a positive 20 percent returfl in a product market area where at least temporarily the sales/capacity relations may have made possible a 30 percent return. Similarly, if the risks of a divisional operation are high, there will be a minimum screening standard or investment hurdle rate that will be higher than for a less risky division. For example, the ROI for oil exploration will be higher than that on the investment in the land on which a filling station is located; obviously, the results of the operations of the filling station are more predictable than the outcome of oil exploration. Or a company contemplating the establishment of a manufacturing operation in a foreign country, subject to a wide range of political as well as commercial and foreign exchange fluctuation risks, will require a greater return on that activity than the return on expanding its capacity to produce and sell through established channels a staple consumer nondurable good.
Information and Adaptive Learning Goals vs. Process The ROI system must properly be seen as a process. Managers are not evaluated on the basis of the size of the ROI their division earns. Performance evaluation is related to the
5. In their research o n implementation of the management by objectives approach, Carroll and Tosi found that frequency of review is highly related to goal clarity and indexes of organizational effectiveness. Their attempts to quantify the quality of the review process yielded less conclusive results. See S. J. Carroll, Jr., and Henry L. Tosi, "The Relationship of Characteristics of the Review Process to the Success of the "Management by Objectives Approach," Journal of Business XLIV (July 1971), pp. 299-305.
The review process focuses on the difference between the actual performance of a division and the projection that the managers had made. This comparison is more important than specific goal orientation because errors in forecasts in either direction result in misallocation of resources. In the corporate allocation of resources b y the finance committee, a project may promise a 10 percent return, resulting in an allocation of $1 million for that investment. But if the expected return had been 20 percent, perhaps a $4 million investment would have been allocated. Hence, errors in either direction result in a misallocation of resources.
BUSINESS HORIZONS
ROI Planning and Control
"The dynamic ROI system recognizes important variables external to the firm: changes in the economy and competitive conditions, elements of costs change . . ."
But it would be inaccurate to characterize the ROI system as emphasizing that results conform to budgets or forecasts. The dynamic ROI system recognizes important variables external to the firm: changes in the economy and competitive conditions, elements of costs change, and so on. Such changes are taken into account in evaluating managerial performance. The informed review process thus provides a basis for achieving an efficient two-way information flow. The forecasting, information flow, review and adjustment process provides for both formal and informal multiple flows of information. The evaluations are not mechanical. The review discussions aim at an informed evaluation of performance. This increased understanding provides a basis for a dynamic adaptive learning process. The fundamental objective of the ROI system as a dynamic process is to shorten reaction time to change or error, thereby making the firm an effective learning and adaptive mechanism.
EVALUATION PROCESS
OF
THE
DYNAMIC
Most of the criticisms of the ROI control method are applicable only to the static formulation. The use of any type of static control system develops incentives in the wrong direction, leads to the development of devices for beating the system, and results in the wrong motivations. But in the dynamic management control system described, this major defect of the static ROI method is eliminated. Particularly, the informed review process and the two-way information flow system make for good communication and understanding. The process then becomes a
AUGUST, 1972
vehicle for continued improvements and provides strong motivations in the proper directions. A major problem in the utilization of the ROI method of control is the failure of companies to adopt its dynamic elements. One reason for this failure is that so many firms came to the method relatively late. The systematic literature on the "principles of management" developed after the mid-1950s. Particularly, the literature on long-range planning did not appear until after 1955. The emergence of second-generation computers with their increased information processing and retrieval capabilities gave impetus to formal methods of planning and control. Widespread adoption of decentralized responsibility utilized the device of profit centers. Implementation of the profit center concept involves determination of the amount of profit and relating it to some base to determine a profitability rate. Thus, to some degree, the development of measures of performance of investment centers represents an index of the extent to which an important development in planning and control activities had taken place. As of mid-1965, 60 percent of 2,658 respondents indicated the use of investment centers. ~ Of those firms not using investment centers, about two-thirds indicated that they did not have two or more profit centers or that capital assets were relatively less significant in determining the performance of their business. It is difficult to assess whether the
6. John J. Mauriel and Robert N. Anthony, "Misevaluation of Investment Center Performance," Harvard Business Review XLIV (March-April, 1966), pp. 98-105.
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J. FRED WESTON
40
firms not employing profit centers should have done so for effective planning and control of their operations. Perhaps of greater significance is the timing of the adoption of investment centers in performance measures of decentralized divisions. Of 851 large American firms that responded to an inquiry with respect to how they utilized the analysis of investment center performance, 60 percent indicated that they had adopted the method after 1955, and over 37 percent had adopted the method after 1960. When the learning aspects of the dynamic control system are taken into account, it is sobering to reflect upon persistent differentials in organization effectiveness that may have been caused by the lag in the adoption of modern management control methods in a large number of American corporations. Hence, one reason why the ROI method of control is used in its static form may stem from its late installation by so many large companies. In its static form, the method is relatively mechanical in its installation and operation. It is thus easier to understand and easier to install. Furthermore, the review and information flow process cannot be installed as an ongoing dynamic system from the very beginning. There is an important learning element involved. This may require various forms of experimentation by companies in order to superimpose a dynamic control system on the methods of management control processes then in use. Indeed, the difficulties of applying the ROI method in a flexible and dynamic way appear to have been experienced at the du Pont Company itself. The key element has been relations with the review committee, which plays the critical role in the effective functioning of a dynamic planning and review process. The review committee at du Pont is the executive committee, consisting of the president of the company and eight vicepresidents. Some recent changes in its methods of functioning have been described:
The c o m m i t t e e meets each Wednesday. It receives m o n t h l y reports f r o m d e p a r t m e n t managers, and every quarter each manager appears to discuss w h a t h a p p e n e d , why, and the o u t l o o k . For decades, these reports were illustrated b y a series of financial charts hung f r o m movable overhead trolleys. A m a n f r o m the treasurer's office presented the data in a stylized m a n n e r while the general manager waited for questions. T h e crucial charts focused on the d e p a r t m e n t ' s return-on-investment, a very rigid concept. All this has changed. The trolleys and the chart r o o m are gone. Instead of sitting theater-style, the executive c o m m i t t e e n o w sits a r o u n d an oval table. The charts are at hand in page f o r m , b u t , 'unless we have a question or unless the general manager wants to talk f r o m t h e m , we d o n ' t pick t h e m up . . . . The old system l o o k e d b a c k w a r d rather than forward. N o w , the thrust is to the future.
Apparently, an effective information and review process could not be achieved by the periodic presentations to the total executive (review) committee. An important organizational change was, therefore, made: Last spring, M c C o y b r o k e with a n o t h e r du P o n t tradition b y giving each executive c o m m i t t e e m e m b e r an assignment as liaison m a n to a d e p a r t m e n t to improve the c o n n e c t i o n b e t w e e n the operating groups a n d the policy level, and to give us b e t t e r understanding of our problems.
The advantage of this new approach was expressed by one of the general managers in the following terms: "Instead of worrying about keeping nine men i n f o r m e d . . . I can clue my man anytime. He deals with the committee and I have more time to run m y business." Another important development was a more flexible approach to the application of the ROI concept: N o w , return-on-investment is redefined every so often, says e c o n o m i s t Charles L. Reeder, to accept reality. Where once the m i n i m u m was fixed, t o d a y it varies--higher w h e n the risks are greater, lower w h e n the results are m o r e certain (a tribute to venture analysis techniques n o w p e r m e a t i n g the c o m p a n y ) or when an i n v e s t m e n t supports an established business. 7
7. "Lighting a Fire Under the Sleeping Giant," Business Week (Sept. 12, 1970), pp. 40-41. The first quotation suggests that the process orientation of the effective utilization of ROI planning and control has b e c o m e bureaucratized and mechanized at du Pont.
BUSINESS HORIZONS
ROI Planning and Control
The implication that a fixed minimum ROI rate had been a rigid requirement of all types of opportunities, regardless of the degree of risk, suggests the application of the method in a mechanistic way. The du Pont experience emphasizes the requirement of a dynamic, flexible continuing review process rather than a bureaucratic application. Further, strategic planning was not effectively integrated with operations planning and control at du Pont. But the recent du Pont experience offers no evidence that the failure to integrate financial planning and control with long-range or strategic planning is inherent in the ROI system. There is nothing in the method that inhibits a firm from effective integration. Indeed, Sloan emphasized that bringing the du Pont system to General Motors in the early twenties facilitated the development of longrange strategy. The installation of the du Pont system in General Motors at a time of financial crises in the early 1920s enabled Sloan and his management team to bring the operation under control. They were then able to take the long-term view in developing a strategy for increasing their share of the market. 8
THE ROLE OF ROI CONTROL ~___,,,~[11][1[[1,] Defects in the application of the ROI planning and control method have been disclosed by its originator, du Pont. Even worse errors were observed in a large number of firms that adopted planning and control efforts relatively late. Direct interviews with a number of these companies indicated three major types of difficulties. First, the most widespread errors involved a static approach to planning and control. A related error has been the reflection of the
8. Alfred P. Soan, Jr., My Years With General Motors (Garden City, N.Y.: Doubleday & Company, 1964).
AUGUST, 1972
emphasis of classical management theory of a strict top-down planning approach in which the standards of performance were imposed from above. The resulting rigidity has resulted in continuing conflicts between the corporate office and the operating divisions. Second, these problems have been aggravated by the domination of short-term budgeting operations by traditional accounting practices. The third major defect was the closed systems approach in which budgeting was carried out without effective integration with strategic or long-range planning. None of the observed errors is inherent in the ROI method. The central error is in the confusion of goals and process. But both businessmen and theorists have committed the error of treating these objectives as ends in themselves. Without a full understanding of the dynamics of planning and control systems, business firms have installed ROI or other forms of management information systems, using the targets and standards bureaucratically. Economists have also misinterpreted targets as goals rather than as instruments for coordination of decentralized divisions. Specific management function areas such as a marketing or engineering departments are likely to place greater emphasis on the importance of targets than the general office executives. In surveying such departments an exaggerated impression of the role of targets may be obtained. But the targets and standards by which managers seek to make the goals of the firm operational are not ends in themselves. Rather, they should be viewed as management instruments for engendering healthy processes in the firm. Targets and standards can be employed to contribute to an information and feedback process that is dynamic in quality, has favorable effects on the development of the firm's personnel, and can facilitate fast reaction time to change. The ROI system of planning and control is a useful vehicle for assembling relevant infor-
41
J. FRED WESTON
mation. It is not critical whether that information is focused on ROI or other "organization objectives." ROI is useful in providing information on every element of the balance sheet and income statement as a basis for further analysis. As a vehicle for a dynamic communication, feedback, and adjustment process, ROI, as well as other management information systems appropriately employed, can potentially be a useful system for developing healthy processes in successfully functioning firms.
This article draws on field studies supported by a grant from the McKinsey Foundation to the UCLA research program in competition and business policy for a study of corporate resource allocation policies. This paper benefited from the comments of G. Buckman, M. Fujimori, Y. Imai, C. G. Krouse, R. O. Mason, and W. G. Vatter. The goals of the firm include maximization of stockholder wealth, consumer satisfaction, and contributions to society as a whole to which the firm bears a central responsibility. Expanding the capabilities of its personnel and their development as human beings and citizens is also a primary goal. In the effort to achieve these goals, a number of operational objectives and standards are formulated. These include ROI, growth in size and earnings per share, favorable valuation relations, growth in the firm's market share, and favorable trends in the morale of its personnel as measured by low separation rates and high ratings on social indicators.
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42
In a n y p r e o c c u p a t i o n w i t h t h e devices o f m a n a g e r i a l c o n t r o l , o n e s h o u l d n e v e r o v e r l o o k t h e i m p o r t a n c e of c o n t r o l t h r o u g h p e r s o n a l o b s e r v a t i o n . Budgets, charts, r e p o r t s , ratios, a u d i t o r s ' r e c o m m e n d a t i o n s , a n d o t h e r devices o f c o n t r o l can b e h e l p f u l , if n o t essential to c o n t r o l . B u t t h e m a n a g e r w h o relies o n these devices a n d sits, so to speak, in a s o u n d p r o o f c o n t r o l r o o m r e a d i n g dials a n d m a n i p u l a t i n g levers can h a r d l y e x p e c t to d o a t h o r o u g h j o b o f c o n t r o l . M a n a g e m e n t , a f t e r all, has t h e task o f seeing t h a t t h e e n t e r p r i s e objectives are a c c o m p l i s h e d b y people, and, a l t h o u g h m a n y scientific devices aid in m a k i n g sure t h a t p e o p l e are d o i n g t h a t w h i c h the m a n a g e r has h o p e d a n d p l a n n e d f o r t h e m , t h e p r o b l e m o f c o n t r o l is still o n e of m e a s u r i n g activities o f h u m a n beings. I t is a m a z i n g h o w m u c h i n f o r m a t i o n an e x p e r i e n c e d m a n a g e r can get f r o m p e r s o n a l o b s e r v a t i o n even f r o m an o c c a s i o n a l w a l k t h r o u g h a p l a n t or an office. - - H a r o l d K o o n t z a n d Cyril O ' D o n n e l l
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BUSINESS HORIZONS