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ROI for the 21st Century

Put aside traditional financial tools and thinking. A new mindset and toolbox are needed to support today’s changed investment priorities.

Dan Marcus, TDC Consulting Inc., Amherst Wisconsin

(Click here to see the story as it appears in the October issue of Modern Casting.)

Business students are today learning the same finance and accounting concepts and tools I studied when working toward an accounting degree back in the 1970s. Likewise, the analytical framework and tools that underpinned my college education were little different from those imparted to my parents’ and grandparents’ generations of accounting and finance students.

What else in business has remained essentially unchanged for the past 100 years? Not much, and even less at companies best positioned for success in the 21st century.

These industry leaders have embraced Theory of Constraints and other contemporary manufacturing management systems. They’ve implemented market pricing and the rest of profit-oriented marketing, and they are transforming their approach to human resources management. Yet virtually all retain a 19th century financial mindset and its outdated set of analytical tools, including ROI (return on investment).

I entered the world of work fully steeped in that mindset and continued to “believe” for a long time, a fact still on display in a feature article about ROI penned for Modern Casting in May 1999.  But that mindset could not stand up to the realities of managing and profit-making I only fully internalized in the years since then. Looking ahead, metalcasters need to think beyond the traditional menu of equipment- and capacity-centered investment choices, as industry maturity has turned it toxic. Likewise, we need alternatives to the usual metrics and method of calculating return, as ROI has become an obstacle to serious profit improvement and to supporting our industry’s most pressing early 21st century investment imperative—human resources.

ROI and Growth

Developed as a tool for evaluating and justifying capital investments, ROI anticipates the profit increase such expenditures could generate if a multitude of assumptions come to pass and historical relationships between revenues and expenses hold true. If these major league uncertainties aren’t enough to give one pause, this should: ROI has a strong internal bias for growth, and the 19th century finance orthodoxy which gave rise to that bias continues to tempt metalcasters to invest in capacity expansion—in an industry devoid of market growth for nearly 35 years.

Today, most segments of the metalcasting industry remain decidedly mature, as they have since around 1980, while some have more recently tipped into decline. Traditional ROI and other financial analytics were developed in the 19th century when America’s industrial economy was young and prospects for growth appeared to be limitless. Growth does much to mask bad management decisions, and the absence of growth in our industry has illuminated ROI as an unsound decision making tool. Simply put, investing for growth is folly in a zero-growth environment, and regardless of wishful thinking disguised as financial analysis, the only thing such investments guarantee in today’s world is increased debt.

Moreover, debt- and capacity-driven top line growth rarely generates the desired bottom line result, as maturity compels growth-oriented investors to disrupt the all-important and increasingly fragile relationship between supply and demand, wage war over market share and, invariably, drive prices down, take on unforeseen costs, generate too much scrap and alter the relationship between revenues and expenses in such a way that meaningful profit improvement becomes nearly impossible. Worse yet, such ROI-fueled exercises distract us from more pressing and profit-oriented investment opportunities.

ROI and Manufacturing Management

“Operations guys” love new equipment. ROI invariably validates this fixation through its assumption- laden bias for growth and by its unmatched ability to divert attention from contemporary profit-making realities, including the fact that for plants other than scale-driven production shops, equipment has almost nothing to do with profitability. Some of the most modern foundries I’ve seen have been at liquidation auctions, and many of today’s most profitable metalcasters – businesses earning upwards of 15 percent pre-tax—proudly describe their facilities as “older than dirt.”

When they do think about reducing costs, operations guys and their financial accomplices tend to think about job costs and higher molding speeds. But job costs are literally not real, and major investments in increased molding speed too often result in companies being run into the red at higher speed. When genuine cost reduction projects do arise, ROI tends to favor isolated, penny-wise and pound-foolish savings that help optimize one part of the plant but too often ignore or even work against optimizing the whole.

This reality illustrates another major flaw in the ROI approach, and highlights the extent to which it is out of step both with maturity and contemporary manufacturing management. Theory of Constraints and similar systems eschew isolated cost reductions and instead emphasize systemic improvements that boost productivity and/or shrink the business’s cost structure. In other words, they seek to improve the overall system of production, knowing that doing so will shrink cost structures, increase capacity for free, boost productivity and turbocharge profitability. This kind of thinking, and the analytics required to support it, are beyond traditional financial tools like ROI.

ROI for the 21st Century

Facilities and equipment were the most important competitive weapons in the late 19th and early 20th centuries, when “More production!” was what really mattered and growth seemed limitless. It was in the 1920s that the Harvard Business Review anointed ROI as the latest and greatest management tool, and its use was most beneficial in the following 40 years.
Quality, productivity and lead times became the key competitive weapons later in the 20th century, as growth gave way to industry maturity, global competition intensified, and customers demanded quality, delivery and price. Now, more than a decade into the new century, management thinking in our industry has only partly evolved from growth to maturity, as for most the 19th century financial mindset and investment model continues to be the go-to source for solutions to what are uniquely different challenges.

Managing for maturity means embracing the new century’s key competitive weapon—human resources—and removing traditional financial return as an obstacle to investing there. Managing for maturity also means putting a stop to investing in equipment and for capacity expansion and growth. Instead, metalcasters need to invest in people and to shrink cost structures and boost competitiveness via improved quality and short lead times. Likewise, managing for maturity means finding better ways to think about and measure the costs associated with scrap and non-competitive lead times, and it means exploring new ways to steer investment dollars to improving performance in these critical areas.

In maturity, and along with market pricing, scrap is metalcasting’s most important profit driver. This essential truth is transformed into business strategy via Compatibility. Despite the fact that much has been written about this profoundly important profit-making concept, scrap’s true impact on profitability remains underappreciated, as does scrap elimination as an investment imperative. Moreover, the metrics used to quantify poor quality are inadequate, as the sales value of defective castings is a far cry from scrap’s total cost, and even the broader cost of quality falls short of what is needed to spur new thinking and new investment. Further, serious quality trouble can only rarely be solved with new production machinery. These factors too have caused many to look past scrap elimination when allocating investment dollars.

Just so with lead times. Investing to remove time from the system of production is also an investment imperative, one like scrap that has been obscured by our continued allegiance to an ROI-based and growth-oriented investment model. Like quality, time is a systemic-level concept, one that we understand too little, spend inadequate time thinking about and measuring, and fail to invest in sufficiently. Like scrap, removing time shrinks cost structures, increases capacity for free, enhances productivity and turbocharges profitability. Uniquely, investments that remove time also attract new work and ward off low priced offshore competition by virtue of short lead times and speed to market. But don’t confuse time with molding speed; removing time from the overall system of production not only boosts competitiveness and customer satisfaction, it also removes real dollars from the cost of goods sold. Allowing unreal job costs to con us into investing in new equipment actually (more often than not) accomplishes the opposite.

Scrap elimination and lead time reduction are most effectively advanced by investing in human capital, and our management mindset and toolbox must adapt to this new investment priority. Doing so first requires that we stifle the reflexive reaction that such investments merely “bloat the payroll” or “increase fixed costs.” Next, we need to employ new methods for evaluating the benefits and costs of such investments, ones like the model shown in flowchart form in Fig. 1. This model originated in the 1970s and differs most from traditional ROI in its rigorous focus on measuring an investment’s actual, after-the-fact, costs and benefits. Instead of pretending to justify an investment up front via biased predictions of growth and return, this newer approach allows the impact of non-traditional investments to be objectively and accurately “monetized” and their true profit impact quantified.

Serious investments in HR are now essential for metalcasters to thrive and for bottom lines to grow in the years ahead. They are required no matter what the traditional metrics and methods may indicate. Human capital investments that metalcasters have found to be highly profitable include advanced production scheduling and management training in the theory and practices relating to Compatibility and Process Reengineering. Investments to recruit and build high caliber production supervisors and hourly workers have been similarly effective. Especially important right now are initiatives aimed at recruiting tomorrow’s production workforce—minorities, women, non-English speakers, and Millennials (those born after 1980)—as these prospective employees are decidedly different from their predecessors and pose unique recruiting and acculturation challenges. Investments aimed at improving quality and productivity via employee education and training, and others which boost job satisfaction and retention through mentoring, community involvement, employee engagement, wellness programs, and profit sharing have likewise been proven valuable.

Making all this happen will require management teams to evolve a 21st century investment mindset and take on a new financial toolbox which could include, as just one example, throughput accounting, which was developed to support Theory of Constraints installations and promotes systemic performance improvement as measured by throughput at system constraints. But for those farsighted enough to see the inherent limitations of throughput accounting, and convinced as I am in the centrality of scrap and lead times, new metrics are called for. One such measure is lead time reduction, calculated as the product of a baseline average lead time number divided by a current, hopefully improved one. Another is the true cost of poor quality, which encompasses the usual prevention, appraisal, and failure costs along with the tangible and opportunity costs associated with lost capacity, diminished productivity, and damaged customer satisfaction.

Management teams need to employ these and other contemporary thought processes and tools to unleash the power of non-traditional investments, drive systemic improvement, and dramatically improve profitability. Doing so will also enable them to fully embrace the transition from growth to maturity and support a transformational approach to human resources management, one which champions essential investments to recruit, develop, and retain a 21st century workforce.  

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