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Chapter 7 ROI vs. ROS: Performance Evaluation For High-Technology Companies

Japanese and U.S. companies evaluate performance differently. U.S. company management places great emphasis on return on investment (ROI). ROl is particularly important information for investors in deciding on investments. In contrast, Japanese management generally place greatest emphasis on periodic income. Before the oil crisis of 1973, that tendency was particularly striking. In addition to weak stockholder’s strength, companies enjoyed large capital gains in this high-economic growth period by actively investing capital, even if the ROI was low. Recently, however, high-technology companies have shifted to using the return on sales (ROS) method. This change appears closely related to the slow economic growth and keen competition among companies since 1973. The movement to ROS has been hastened by the five Japanese business innovations, in particular the job rotation practice that aids the process.

Many U.S. companies, in particular, divisionalized companies, have used ROI since Dupont originated the technique in the 1920s. Three reasons predominate for using ROI: first, most people can understand ROI easily. Second, it combines three critical performance measure variables--sales, earnings and investment. Third, it is popular with financial analysts, investors, creditors and other external information users. Tts main flaw is that division managers are apt to reduce investment on R&D and equipment because the investment comes several periods before the return. Also, the size of the investment becomes less and less measurable the more it is divided up among departments, or products.

In contrast, Japanese managers normally evaluate divisional performance in ways beyond measures of profits. They do this because they place great importance on employees and banks, as well as on investors. Relatively few companies have a divisional form of organization, unlike what we see in the United States. Instead, large companies have many subcontractors and other affiliated companies. Consequently, when comparing performance measurement systems, the Japanese need to examine not only divisions but also affiliated companies. The most prevalent form of measuring profit has been periodic income.

There are three main reasons Japanese managers use periodic income to evaluate divisions and affiliated companies:

The tendency of ROI to slow down the motivation to invest: Return on investment Return on Sales X Turnover, or

	Income	=	Income	x	Sales
	Investment	=	Sales	x	Investment

Institutional differences: In the United States, because the stockholders hold great power, earnings per share and ROI dominate. In Japan, on the other hand, proportionately little equity capital exists and therefore the stockholders have little power arid short-term goals do not get emphasized. Furthermore, the Japanese tend to take a long-term view of manager performance. This tendency has roots in the lifetime employment tradition as well as the job rotation practice.

In the United States, ROI finds greater use for performance evaluation than for setting a company’s goals. Japanese managers, on the other hand, place greater emphasis on ROI when setting long-range goals than when evaluating performance. Typical Japanese managers find ROI important in formulating long- or middle-range business plans, though they make little use of ROI for short-run business operations.

Rapid economic growth: In high-growth economic conditions, it is natural to invest aggressively in order to increase sales volume, even with new investments that may exert an adverse effect on short-term profitability or ROI. During rapid economic expansion, those companies that grew slowly even with high ROI eventually disappeared. Furthermore, there was little or no pressure from stockholders. Thus, for many Japanese companies the best corporate goal was to expand sales volume, market share and income. As for profits, most companies aimed to increase ordinary income--the amount of profits after deducting interest.

ROI vs. ROS

Problems with ROI

In the 1980s economic growth slowed dramatically. The structure of manufacturing continues to evolve rapidly from large scale heavy industry to lighter, smaller scale manufacturing, employing the highest and most advanced technology. The life cycle of consumer products has been radically shortened, as has the life cycle of manufacturing equipment. Although the use of periodic income may have been appropriate for measuring the performance of large-scale heavy industry it may not be an appropriate measure for evaluating the performance of advanced industry where technology continuously improves.

Problems with ROS

The case against ROS is clear. As we see in the formula on the prior page, the turnover or the efficiency of capital is not included in the ROS formula, so that ROS is an incomplete measure of performance for overall evaluation.

Reasons for Using ROS

Most Japanese companies that have proceeded with automation place primary emphasis on ROS for strategic cost management. Are the companies that stress ROS being managed without concern for the efficiency of capital? While the companies that use ROS do so for different reasons, the following are Common reasons:

1. Using ROS when a variety of products are produced makes the profitability of each product clear.

2. When a company is using target costing it is easier to set target costs and prices for a variety of products. For example, if a four million yen automobile is ordered and the target profit is 20 percent, then the target profit will be calculated as 800,000 yen (4,000,000 X 0.2).

3. It is nearly impossible to justify the cost of attempting to compute the ROI on each product when producing a small volume of a variety of products.

4. The life cycle of equipment is very short in high-technology industries, so the amount of capital is likely to vary from period to period in these industries. As a result, ROI cannot be reasonably calculated.

5. Large investments of capital are generally needed in order to produce profitable products in high-technology industries. When one relies on ROI, however, desirable investments undertaken for the future are likely to be shown as unprofitable right now.

6. If demand is stable and there is no apprehension about declines in sales, ROI may be effectively employed. However, these conditions do not exist for high-technology products.

7. If there is either hardly any, or absolutely no, pressure from stockholders, then there is little need for ROI.

Hitachi has long considered ROI an important goal. But in 1979 it began evaluating performance according to ROS, with the Dupont performance evaluation index:

T(ROI) = U(ROS) x K(turnover)

By evaluating divisions or subsidiaries with the U rank (ROS), Hitachi could easily measure the profitability and competitiveness of each factory against the others. In the corporate headquarters, on the other hand, “T” (ROI), which depends on the overall index is emphasized.

Although we speak of companies making ROS the target, that does not mean that they are managing their companies ignoring the efficiency of capital. For example, such companies as Toyota and Matsushita try to increase their efficiency of capital in a format separate from ROS.

We should remember that JIT is an effective tool for reducing inventory the most important asset to be managed. Crucial to the asset-management activity is the job-rotation practice, which creates a cadre of extremely knowledgeable midlevel managers capable of making asset turnover increase.

Strategic Use of ROS

In the debit side of the balance sheet the assets are classified roughly as, (1) cash and accounts receivable, (2) inventories, and (3) plant and equipment. Japanese companies cannot expedite the recovery of accounts receivable without the risk of losing sales because terms of payment are customarily determined and exceedingly difficult to change. Reducing investment in fixed assets in order to pay high current dividends may appear advantageous to stockholders, but robs the company of its future. Thus, the critical asset among the three to reduce is inventories.

Why did Toyota originate the JIT system? Both the JIT and target costing are intimately related to using ROS to set target profit. Since the only assets suitable for reduction in the Japanese situation are inventories, it becomes indispensable that inventories be reduced when using ROS. Thus, we see that Toyota’s JIT is a policy designed to increase the efficiency of capital through reducing inventories, a specific form of assets. Similarly, Matsushita’s internal capital/internal interest system and standard balance sheet is also a means for increasing the efficiency of capital use that is similar to residual income (RI). The ability to increase efficiency of asset use depends on the network of business practices which deliver able, focused, and effective managers to the front line.

In this way the defects of ROI can be reduced by separating it into ROS and asset turnover. When thinking in this fashion, ROS becomes an effective means of management in the age of CIM.

Conclusion

Needless to say, although companies need high ROI in the long run, many companies managed by ROI have lost market share. The defects in ROI are not in the construction of the metric, but in its use by managers: As has often been pointed out, using ROI has also retarded investment in R&D. If Japan had not invested in new markets, expanded its facilities or renewed its equipment because of the substantial costs, and hence a lowering of ROI, it would not be as successful today.

We do not mean to argue that Japanese management has been absolutely correct up to this point. The Japanese tendency to ignore ROI may have artificially intensified domestic and international competition among companies. Tn addition, as economic growth in Japan slows and inflation dies down, the attitude of managers with respect to capital investment becomes conservative. Also, methods of obtaining capital have expanded to include numerous sources of funds, mainly equity capital. We predict that Japanese managers will become more conscious of ROI than in the past.

However, in high-technology companies, since the oil crisis, ROS rather than ROI has been increasingly used to set target profit. More and more, leading Japanese companies do not use ROI, and thus avoid its underlying faults.

Having considered the above, we argue that the strategic use of ROS originated by Toyota should be considered a management innovation along with the well-known ROI of Dupont, and the residual income (RI) of General Electric.

The crucial thing to remember is that the Japanese business environment enabled ROS to function by having such an intense operating focus on asset management that they could reduce the financial focus on the asset base. The Japanese pay even more attention to the size of the investment and its effectiveness than typical Western firms, and they do it in a different way.

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