Editor's Note: For many years chief executive officer Columnist Jonathan Burns died He passed away on May 7 at age 75 after a long and courageous battle with cancer. An MIT professor, consultant, and co-founder of Profit Isle, he was a brilliant mind, a thoughtful businessman, and a kind person. We will miss him. This column is one of several he sent us before his death.
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Recently, I was involved in a discussion about a large strategic investment that a company was considering — a potentially game-changing investment that involved the development of a significant new business capability for its most profitable customers.
The key question was, “Do the expected benefits exceed the costs, resulting in a return that exceeds the cost of capital?” After all, this is the standard way most financial managers evaluate investments.
Strategic and Tactical Investments
The problem, and opportunity, is that evaluating strategic initiatives is fundamentally different from evaluating tactical investments.
Tactical investments that bring incremental improvements to a business are well suited to traditional capital budgeting, characterized by net present value and return on investment analysis that compares well-understood costs with benefits over time.
But the world of large strategic investments requires an entirely different financial evaluation process that doesn't just add up costs and benefits, but also reflects strategic justification and payback periods.
Bad Profits
Should you make every investment that passes the capital cost recovery test? The answer is surprisingly “no.”
The key point is that profitability alone is not enough to evaluate a strategic (game-changing) investment. Another important aspect is whether the investment is strategically appropriate.
An enterprise profit management solution is a critical first step in determining whether a potential large investment is strategically sound. Our years of experience with EPM (a transaction-level SaaS profit improvement system that creates a complete P&L for every invoice line item) have shown us that nearly every company has a characteristic profit segmentation pattern:
- Peak Profit Customers – Typically, about 20% of customers generate 150% of a company’s profits.
- Profit-robbing customers – Typically, about 30% of your customers will erode about 50% of these profits.
- Profit Desert Customers – Typically, remaining customers generate minimal profit but consume around 50% of the company's resources.
The same pattern occurs with a company's products, suppliers, salespeople, stores, and almost any other aspect of a company.
For example, investing in providing services that are primarily required by large, loss-making Profit Drain customers is almost certain to make no strategic sense and should be avoided even if the investment would be profitable. On the other hand, investing in a showcase project to discover a significant new customer need that will accelerate business with Profit Peak customers may be very valuable in the long term even if it does not produce an immediate return.
But a simple capital budgeting business case would prioritise the former investment and discourage the latter.
Consider a profitable investment that is not strategically relevant but passes the cost of capital test. This investment actually has two hidden costs (other than the opportunity cost of investing in a more strategically relevant project) that do not usually show up in a business case calculation:
First, investments in large new business initiatives almost always exponentially and unforeseenly increase business complexity and drive up the overall cost structure of the business. (Increasing the volume of existing business generally increases costs arithmetically, whereas increasing business complexity generally increases costs geometrically.)
Second, such investments create an inevitable demand for further resources in the future, because management generally does not act for purely economic reasons — after all, they cannot really estimate the costs and benefits of providing a service 5-10 years into the future. Moreover, if a company does not adopt EPM, it will not be able to identify profit peaks and profit drains, increasing the risk of getting stuck with its biggest loss-making customers (and measuring “success” based on revenue growth rather than customer profitability).
Moreover, at the C-suite level, top managers often act to ensure “fairness” – that is, the executive in charge needs a chance to show what they can do with this new opportunity. Also, starting an attempt to grow an opportunity is much easier than closing it down – the former is easier to measure, whereas the latter is harder because turning things around is always “around the corner.”
Instead, it's very helpful to think about strategic investments in four categories:
- Strategic investments Both profitable and relevantIt is not a sure-win investment (remember, it must remain profitable and relevant throughout the investment lifecycle, even as companies and industries change).
- Strategic investments No interest or relevance This must be avoided as it will definitely result in loss.
- Strategic investments Profitable but not relevant It produces “bad profits” that are “quicksand” that pull you deeper and deeper until your company loses strategic focus and wastes resources that should be put into building a competitive edge.
- Strategic investments Relevant but not profitable Be brave. The most important thing you can do is focus your resources on building high-profit strategic positions with your Profit Peak customers (and those who will be) that will deliver years of defensible, profitable growth.
These four principles will guide you in maximizing long-term resource productivity when making strategic investments.
The cost of disruption
I remember working for a large telephone company in the early days of deregulation. The company served a large geographic area that included a large metropolitan area with many global companies concentrated in a few dense locations. These customers were the prime targets for new competitors.
As competitors moved into cities, laid fiber optics, and offered new services, gobbling up the phone companies' Profit Peak customers, the incumbents were overwhelmed and unable to keep up. They were losing their most important blocks of business.
The root cause of this fatal error is that the traditional business case process requires explicit estimates of the costs and benefits of each investment; and To prevent The benefits of preventing competitors from taking over existing business and staving off the attrition of key customers were deemed too “difficult” to quantify and therefore not counted as a return on investment by the finance department.
Here, the company nearly lost its most profitable business because it misused the traditional business case investment appraisal process to evaluate a key strategic investment.
Managing big risks
How do executives actually evaluate major strategic investments? A major study conducted several years ago found that one of the most common metrics used by executives in practice was a discredited metric: “payback period.”
Payback period is the number of years needed to recoup an investment. It is less reliable than NPV and ROI because it does not take into account the time value of money. Two investments may have the same payback period, but the first investment may produce most of its benefits immediately and the second investment may produce most of its benefits at the end of the period. Although they may look the same on the payback period scale, the first investment is clearly better.
Why do top managers pay so much attention to payback period when evaluating major strategic investments? Because major strategic investments, by definition, change the business paradigm, create new value, and often provoke a competitive response. Measuring costs and benefits is therefore very difficult, if not impossible. It may also cripple a company's ability to make significant change for some time. In these situations, a key question for top managers is, “When can we make our next major strategic move?” Payback period provides key insight into this important question.
Evaluating Tactical Investments
Tactical investments make incremental changes to an existing business, such as buying new, more efficient machinery or marketing an expanded product line.The textbook cost of capital here is the weighted average of a company's cost of debt and cost of equity (with some adjustments).This seems obvious.
In reality, the answer is not that obvious.
Although this seems like a technical question, it is actually a very important managerial issue since it implicitly determines the asset productivity of a company.
The cost of capital is composite in nature and is a weighted average of the company's risk/return profile. portfolio A portfolio of investments that make up an existing business (from buying new machinery for an existing process to developing a new product line). This portfolio is made up of investments with very low risk and return, investments with very high risk and return, and investments in between.
Compare investing in a well-tested new machine to improve the efficiency of an existing process versus investing in developing a new product line. The former investment has a lower risk profile and is therefore a wise investment even if it produces a higher return than the old machine but is less than the company's composite (overall) cost of capital. The latter has a higher risk profile and therefore requires a higher return than the company's composite.
The key point is that it would be a mistake to evaluate each investment on the basis of the company's overall cost of capital; instead, the correct measure is how its risk-adjusted return compares to related investments with similar risk/return characteristics in the company's portfolio.
For example, in my graduate class at MIT, I teach a case study on estimating the capital cost of inventorying nuts and bolts used in manufacturing home appliances. During the discussion, I ask whether the same discount rate (the cost of capital) should also apply to developing a product extension to sell new large lime-colored refrigerators. The answer is clearly no. A useful discussion would explain why this is the case.
Realistically, you can split risk/reward levels into three: low, medium, and high, which makes the task of specifying a hurdle rate (the appropriate cost of capital) much easier.
Effective investment evaluation
Carefully evaluating investments is key to maximizing both asset productivity and strategic success.
For tactical investments, the key is to set a hurdle rate that reflects a cost of capital appropriate to each investment's risk/return profile. As a practical matter, let's organize potential investments into three groups: high risk/return, medium risk/return, and low risk/return. Each group requires a different hurdle rate that reflects a different cost of capital. In this context, the traditional valuation metrics NPV and ROI are very useful.
But strategic investments are fundamentally different from tactical projects. They require an entirely different evaluation process that goes beyond traditional cost-benefit analysis to reflect strategic justification and payback period.
Strategic justification has significant hidden costs built into it: complexity and future opportunity costs, and the payback period presents a chess-like problem of when a company will be able to make its next major strategic move. The investment evaluation process is critical and fraught with pitfalls. Thinking clearly about how to evaluate key strategic investments and many tactical investments can set you on a sure path to years of profitable growth.
