ROCE – FROM AN OPERATIONAL PERSPECTIVE
We all want a good return on our savings, superannuation and investments, we get a shiny report each year that tells us how they performed in great detail, the question is do we take that rigor into our factories and supply chains. We Should…
ROCE or Return On Capital Employed has traditionally been the sole domain of the CFO and investment analysts, but more and more we are seeing this measure cascaded down though organisations. But what is it? why is it important?
In simple terms it is an efficiency ratio used as an indicator on how well a business is doing, or more accurately how well a business uses its cash and assets to deliver profit. It may be declared in your company’s annual report and is one of the indices used by fund managers in assessing company performance. ROCE is shown as a percentage, with higher values indicating better performance however it should not be viewed in isolation, it needs to be read in the context of the business decisions that are being made and its overall trend. It is also normal for the ROCE to change over the lifetime of a business. As an example a company may have a strong ROCE, but a major investment in production capacity, to meet increasing sales demand can lead to a reduction in the ratio. While there may be no direct impact of a poor ROCE, it could be real indicator of a decline in the overall business and can prove to be a real challenge when seeking external funding.
Why is it important to operations? The old adage “what interests my boss, fascinates me” could easily be extended to those who control the purse strings. Getting capital investment approved can be a challenge, Do you understand the language your CFO speaks, and more importantly can you deliver the goods on their terms.
To understand ROCE we need to look at how it is calculated and the levers that can be pulled to influence it. The calculation is a simple one, it is found by dividing an operating profit (EBIT) by the Capital Employed. Correspondingly the levers are also remarkably simple, anything that increases EBIT or decreases the capital employed will improve the ratio.
So when the CFO ask how does this improve ROCE? As an Operations manager you need to know what levers you can pull?
Anything you can do to improve profit will have a significant impact including the usual Operations KPIs such as reducing waste, increasing throughput, decreasing labour and increasing plant utilisation. But the real trick in the ROCE calculation is ensuring that capital project benefits are delivered and your investments are made where the business returns are available, not just shared across whomever shouts the loudest.
A consistently managed portfolio of capital investment is important to ensure a balance that drives profit and growth as well as delivering quality and safety improvements. If ageing equipment needs to be replaced always ensure that the latest technologies are consider to deliver further improvements in efficiencies thus supporting lower costs and improved profit. In multisite businesses, do sites really get that the best move for the business is to free up funds to invest into another site where the ROI of a project is higher and work together in true portfolio management rather than compete for spend at what would be a lower overall ROCE.
We have all seen the junkyard of failed capital investments which quite often are still being depreciated. This has a huge impact on ROCE, tying up cash and delivering nothing on the bottom line.
These junkyard exhibits are what nobody wants to be associated with. Phased investment strategies or running at an operating loss by using good old humans knowing you can invest to automate when volumes are stable are on way to get this right. The other is to be sure in the outcome by using digital modelling to test both the needs and the final results before you even invest.
On the other side of the equation is the option to minimise the need for cash and assets. The easiest levers to influence are inventory levels including raw, pack, consumables and spare parts as well as ensuring longer terms for payment of suppliers. The timing of investment in new assets is also a significant driver, while sweating old assets is beneficial, it needs to be balanced against delivering improved efficiency and reliability.
Leasing used to be a common way to avoid direct investment in assets thus minimising the capital employed, however care should also be taken when considering leases as under the new accounting standard operating leases may now need to be taken into account on the balance sheet.
From an operations perspective just about every decision and action you take will impact the ROCE. I would like to say it’s easy and all under control, but you will find every lever you pull has consequences, many of these you already now, but when comes to capital investment the impacts on ROCE are far greater and can swing from positive to negative very quickly, so put the hard work in on finding the right solution and make sure the business case is well and truly tested.
Scott Varker; Director of Pollen Asset Advisory
First published in Inside FMCG: