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07 Apr 12
Todd Suomela"Brown noted a simple fact: Return on equity can be broken down into a three-part equation. It is logically the product of return on sales times the ratio of sales to assets times the ratio of assets to equity. By parsing ROE into the DuPont Equation (very rapidly to become a business school mainstay), he provided the basis for organizations divided into functions with their own objectives. He reasoned that if marketers worked on maximizing return on sales, production managers were rewarded for the sales they squeezed out of their physical plant, and finance managers focused on minimizing the amount of equity capital they needed, ROE would take care of itself.
Thus Brown not only sowed the seeds of the today's hated silos, he also set three "runaways" in motion. That is to say, he created objectives with such strong feedback loops that they were pursued single-mindedly, even to unhealthy excess. "-
The lesson: Return on Equity, like peacock tail splendor, is a very poor guide for allocating resources. It fails for two reasons. First, fixating on ROE fails to maximize the benefit of business to society because it measures value in terms of returns to only one stakeholder; second, it allocates human resources as if maximizing the efficiency of financial capital were critical to growth of social welfare.
So it's time to address our measurement system seriously at the firm level. It would help to have a new equivalent of the DuPont Equation that propels individuals and organizations forward just as powerfully but does not send capitalism off the rails. What might that look like? Most fundamentally, the objective of business must be broadened beyond ROE.
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- The value of an organization's innovation per person affected
- The number of people affected by an innovation
- The frequency with which the entity innovates
A new DuPont equation would measure the growth in value created by innovation (and again, that is value defined broadly). And like the original, NuDu would decompose this measure into three components:
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How does this guide decisions and actions in a different way? First, by stressing that the point is innovation. A dynamic economy requires growing companies—those that increase their value-added contribution over time. To maximize this, a company should prioritize the innovation that leads to the greatest value. That value must be measured across all stakeholders.
Second, an innovation should have the widest possible market. As the late C. K. Prahalad pointed out, the "bottom of the pyramid" is a market and not a social problem. In a recent talk at MIT, Infosys founder Narayana Murthy put it this way: "Technological innovation is all about reducing cost, reducing cycle time, making life more comfortable. Therefore: who needs new technology more than the poor?
And third, the battleground of competitiveness now goes beyond time to market, to include the frequency with which a firm brings valuable innovations to market. GE, by creating independent local development teams, is adding to the diversity of ideas and the opportunity to recombine them, and hence the likelihood of having innovations to bring to market more often. "More products at more pricepoints" is their name for this strategy.
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04 Apr 12
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The lesson: Return on Equity, like peacock tail splendor, is a very poor guide for allocating resources. It fails for two reasons. First, fixating on ROE fails to maximize the benefit of business to society because it measures value in terms of returns to only one stakeholder; second, it allocates human resources as if maximizing the efficiency of financial capital were critical to growth of social welfare.
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So here's our candidate: we believe that corporations would do better for all their stakeholders and avoid the risks of runaways by focusing on Return on Innovation.
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Measurement systems first educate people on what's valuable, then enlist them in figuring out unanticipated ways of creating that value, and finally degenerate into mindless games played for artificial advantage.
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21 Oct 11
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