Indicator of the month: return on invested capital
As countries begin to lift their pandemic restrictions and business leaders look to post-COVID-19 business models, it’s important to ask yourself if the investments you made in 2020 (or before) still have one direction. Repricing these investments can free up cash and enable investments in areas that generate long-term value.
Return on investment (ROIC) is a metric that brings clarity to these conversations. ROIC measures the amount of gain realized on the capital invested relative to the cost of the investment. The metric gives an organization the ability to track how well it is using its money to generate returns. Return on investment can be calculated by dividing an organization’s after-tax net operating income by the amount of capital invested and should be expressed as a percentage.
APQC finds that the top performers on this measure (those in the 75th percentile) see a return of 12.8% or more on their invested capital. That’s nearly double the return of underperformers (those in the 25th percentile), who see a 7% return on their invested capital.
These numbers represent a cross-industry view of APQC benchmarking data for ROI. It’s important to compare this metric within your industry, as ROI can vary significantly from industry to industry. Healthcare organizations such as hospitals have much lower profit margins and may not see as much return on invested capital compared to a software company. Regardless of the industry, a higher percentage is always better for this metric.
Increase return on investment
The primary way to improve ROI is to ensure that investments are aligned with the organization’s strategy. While this alignment should occur at least once a year during strategic planning, many organizations may need to revisit these conversations more frequently to account for the changing COVID-19 landscape.
For example, now is the time to rethink real estate footprints. If you have real estate-related investments but are moving towards a hybrid workforce model, you may be able to reduce those investments.
Performing well on ROIC means investing more efficiently. In some cases, this may mean spending more money up front on new software or equipment, rather than continuing to maintain older equipment that is rapidly becoming obsolete.
Investing more efficiently also means reducing certain investments. Plan thoroughly, thoughtfully, and collaboratively with your team to understand the investments you really need to generate a return, because every investment has a point of diminishing return. If your $10 million expansion can be an $8 million expansion and still get the same returns, you’ve just freed up money to invest elsewhere.
Once you’ve made investments, it can be difficult to isolate the returns. Some investments don’t pay off or don’t pay off right away. Investments in capital assets such as new equipment ultimately generate cost savings as these investments help prevent machine downtime and other problems. Customers won’t necessarily choose you over your competitor because you’ve just installed new self-service payment terminals. But they might choose your competitor over you if your self-checkout kiosks are down and customers have to wait in long lines. These investments are just as important as those that generate more visible returns.
An emerging post-pandemic business environment may require new investments or scale back older investments that no longer make sense. Review your investments with your team to ensure invested capital aligns with business strategy in 2022 and beyond.
Perry D. Wiggins, CPA, is chief financial officer, secretary, and treasurer of APQC, a nonprofit benchmarking and best practices research organization based in Houston, Texas.