ROI: False Conclusions
05 May 2010 | Category: uncategorized | Author: admin
Drawing false conclusions from Return on Investment analysis can be embarrassing and it can be costly.
Here's an example from business in managing risk and calculating Return on Investment ROI:
The management of company A wanted to decrease the cost of manufacturing a key product. This was in light of new technologies that had just become available.
They have 60% of the available business with this product and their closest competitor, Company B, has 14% of the market.
Company C has about 10%.
The other 16% is held by several small companies that sell a substitute product of lower cost but inferior performance.
Company A calculated the cost of reducing manufacturing cost. They then calculated the return on investment (ROI). The return was less than the 15% required by company management.
A Board member with an accounting degree and banking experience said the technology looked "shaky" to him.
Some board members agreed with him.
The company's engineering director said the assumption was wrong, that the technology would function as described.
The Board rejected the modernization plan.
Company A continued to undersell company B because of their current lower manufacturing cost.
The Chairman of the Board said, "All is well!"
Company B did the very same analysis at the same time. Company B decided to make the investment because it would lower their manufacturing cost, increase production capacity, and they would be able to undercut Company A's current prices by 5%.
Company B used the probable increase of their market share in their ROI calculations.
When Company B completed the improvements in manufacturing, which took two (2) years including planning, they learned that the manufacturing cost dropped another 5% below what they had predicted.
They dropped their prices considerably below what Company A was charging.
Their market share increased to 45% during the first six months of the new operation and then gradually increased to 65% during the next two years.
During this period, Company A realized they should have included something in their analysis concerning the probability of their competitors taking market share. They started the modernization of their factory.
The owners of the company were very dissatisfied with the performance of the company. After sacking the Board and certain members of management, they sold the company to Company B.
To the Chairman of the Board who had said, "All is well!" the owners said, "Farewell!"
Company B accelerated the modernization of the facilities of Company A to increase their production while lowering costs.
This was done in the face of the fact that Company C had lost market share to Company B but had responded rapidly and had just completed their modernization which would help them regain what they had lost and perhaps do more damage to Company B.
The war price war was on.
The above example is similar to that given at a management conference on managing technology I attended some years ago in Miami, Florida. The executive who gave the presentation was from the General Electric Company. Unfortunately, I don't remember his name.
The bottom line is that if your analysis is not comprehensive, and you don't consider the possible actions of your competitors, you can fail miserably.
You must also consider who has the best background and education to make technical decisions and who has the best background and education to make financial decisions. Opinions are not always evaluations.
The End
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