By Gerrit Van Wyk.
Accounting for systems.
When I was at business school, the concept of return on investment (ROI) was hammered into our heads. There is a formula for calculating the profit on the money you invest: divide your profit before interest and taxes by the net assets employed.
What happens when you follow out the real-world dynamics behind that, paints a different picture of the usefulness of the formula. That’s the part they didn’t show us. It looks something like this.
What the formula says is to increase the profit on your investment, you should increase your profit before interest and taxes, and/or reduce the assets you employ to make that profit.
You can increase your profit before deductions by increasing turnover, or reducing costs. Turnover is increased by selling and producing more of the product, which is a positive feedback loop, or juggling the price of the product, which at some point affects sales, turnover, and profit. Increasing sales and production increases costs which reduces profit.
You can reduce the cost of selling the product by reducing administration costs, direct costs, manufacturing costs, or distribution costs. Reducing administration costs at some point impacts production and sales and therefore turnover and profit negatively. Direct costs can be reduced by reducing the cost of materials, labor, or expenses, all of which eventually affect production negatively, and in addition, shaving material costs can affect quality, which affects sales negatively, hence reducing turnover and profit. Distribution costs include research and development and marketing. Reducing research affects production and sales, and reducing marketing reduces sales. In short, everything you do to reduce the cost of selling eventually turns production and sales into a negative feedback loop reducing turnover and profit.
One can reduce net assets employed by reducing current liabilities, which can reduce cash flow to the point it affects production, or reducing assets, which can reduce production and sales. In other words, reducing assets used to produce and sell eventually reduces turnover and profit as well.
Ultimately, everything you do as a manager to increase your profit, risks doing the opposite, which it often does within economic activity, not as a clockwork that can be fine-tuned, but as a system consisting of interconnected parts that all affect each other. Any change, no matter how small, in a system affects everything else.
Secondly, relying on a number by calculating the return on the money you invest gives a very simplistic static snapshot in time of what goes on behind it. Something as complex as this constantly changes, often unpredictably, in response to your interventions, which affects that number, which changes from moment to moment. Another problem is a formula ignoring the context behind it, as most formulas in the business world do, creates an illusion of control.
Why then, did they teach this to us? The foundation of business courses is the clockwork model simplifying complexity to give us the illusion of control. The basis of management, we were taught, is planning, leadership, organizing, communicating, and control. It’s not designed for a circus clown trying to keep multiples balls in the air at the same time, and yet, that’s the reality of management in practice.
In the real world, managers must respond to and act on constant change, and the decisions they make flow through the human social system we call an organization, which increases the complexity and unpredictability of their decisions. We live in a world pretending things work differently, as if things are simple and manageable.
Chess is played on a board with 204 squares and 32 chess pieces. There are 6 different pieces which move according to simple rules. Despite the underlying simplicity of a chess game, no-one can memorize all possible moves, hence even grand-masters lose chess games. Organizations are much more like chess games than the tick-tack-toe 2×2 and 4×4 games we were taught at business school. Perhaps, one day business schools will wake up to reality and ditch their simple game. In the meantime, they will continue teaching make believe which mangers will discover don’t work in practice. It’s not unreasonable to use ROI, but then you must also understand the dynamics behind it.
Ultimately, we use return on investment as a tool in a very complex social game, and for very complex reasons will continue doing so. For equally complex social reasons, we will perpetuate the use of this tool, irrespective of whether it works or not.