Entrepreneurial Objectives and ROI
The following exercise was developed in communication with Prof. Dr. Peter Mertens, Nuremberg, Germany, to whom we express many thanks.
When we looked at opportunity cost in Section 1.3.2, we mentioned that a particular objective in the four target areas (quality, costs, delivery, and flexibility) does not always support the primary entrepreneurial objective, which a company can seek to fulfill through maximum "return on investment" (ROI). For example, if investments to reduce lead time do not result in increased demand or a larger market share, then ROI decreases rather than increases.
How can this be shown more exactly, correlating the objective short lead time to factors in ROI? ROI can be expressed as follows:
$$
\begin{aligned}
\mathrm{ROI} & =\text { earnings } / \text { (investment or assets) } \\
& =\text { (revenue minus costs) } / \text { (current assets }+ \text { fixed assets). }
\end{aligned}
$$
A possible solution is based on the following line of thinking: Reduction of lead time can have the following consequences:
- It can increase the number of customer orders and thus revenue.
- It requires the elimination of bottlenecks. This can have the following consequences:
- It generally requires investments, which increases fixed assets and therefore capital costs.
- It can reduce inventories of work in order, which reduces current assets and therefore capital costs.
In this case, it is important to determine exactly whether the increase in revenue will be cancelled out by the increased costs (taking into account the increase and decrease in capital costs according to the line of thinking above). Since total assets appear in the denominator of the division, ROI decreases even when total assets increase with constant earnings.
Now, use similar arguments to try to elaborate the correlation of the following performance indicators in Section 1.4 (each corresponding to a different objective of the target areas in Section 1.3.1) to the factors in ROI;
- Scrap factor (objective: meet high demands for product quality)
- Inventory turnover (objective: low physical inventory)
- Capacity utilization (objective: high capacity utilization)
- Fill rate (objective: high fill rate)
- Delivery reliability rate (objective: high delivery reliability rate)