Capacity Utilization & Return On Invested Capital (ROIC)

Capacity utilization & Return on Invested Capital (ROIC)

ROIC is a measure of the productivity of Invested Capital. As Invested Capital is used to acquire a variety of operating assets, increased utilization of productive capacity results in improved ROIC. Improving real capacity utilization is the focus of our consulting approach and expertise.

Profit is meaningless without reference to the amount of invested capital (debt & equity) employed to generate it.

A $10 million-dollar Net Operating Profit earned by investing capital of $100 million represents a 10% Return on Invested Capital (ROIC). A $10 million-dollar Net Operating Profit earned by investing capital of $1 billion represents only a 1% return. While ROIC may be manipulated by writing down the value of Goodwill and other Assets periodically, reducing Shareholder Equity, it remains an excellent starting point for evaluating the potential to improve enterprise capacity utilization.   

ROIC outcomes vary widely within the US and globally. Low performers have enjoyed a relatively low cost of capital over the last 20 years. This has allowed some to sustain excess capacity indefinitely. The focus on real capacity utilization has become marginalized, partially due to the record low cost of capital and a series of arbitrage opportunities which have been easier to execute than confronting excess capacity (arbitrages include the labor cost, cost of debt versus equity, currency yields and tax rate arbitrages).

While ROIC is not difficult to measure, the underlying utilization of operating capacity is more difficult to measure and control. A true measure of capacity utilization must evaluate the economic value of production output.

Output which contributes nothing to operating income is effectively discarded. However, many companies are myopically focused on measuring the activity of operating assets and fail to systematically determine what proportion of output adds economic value to the enterprise. Capacity utilization is a cross functional measure. 

Our programs begin by measuring the true capacity utilization of the enterprise as a whole. Classic measures of assets utilization are obvious and usually focus almost exclusively on production functions. These typically represent only half the opportunity to improve ROIC. We address the economic and hidden elements of discarded capacity.

The truly insidious means of discarding capacity can’t be measured without reference to price, margin, asset value and the integrity of operating standards. We improve profit (the ROIC numerator) and reduce the invested capital required to meet demand (the ROIC denominator).

US Capacity Utilization-All Industries (FRED)
Capacity utilization & Return on Invested Capital (ROIC)

ROIC is a measure of the productivity of Invested Capital. As Invested Capital is used to acquire a variety of operating assets, higher utilization of productive capacity results in improved ROIC. Lifting capacity utilization is the focus of our consulting approach and expertise.

Profit is meaningless without reference to the amount of invested capital (debt & equity) employed to generate it.

A $10 million-dollar Net Operating Profit earned by investing capital of $100 million represents a 10% Return on Invested Capital (ROIC). A $10 million-dollar Net Operating Profit earned by investing capital of $1 billion represents only a 1% return. 

ROIC outcomes vary widely within the US and globally. Low performers now use more capital to achieve the same profit outcomes and suffer only a marginally higher cost of both debt and equity. The focus on underlying asset utilization has become marginalized, because the cost of capital hasn’t been as low since the mid 1950’s.

While ROIC is not difficult to measure, the underlying utilization of operating capacity is not easy to measure or control.

Our programs begin by measuring the true capacity utilization of the enterprise as a whole. Most systems focus only on the obvious causes of lower utilization experienced within operational functions. These typically represent only half the opportunity. We address the economic and hidden elements of discarded capacity.

The truly insidious means of discarding capacity can’t be measured without reference to price, margin, asset value and the integrity of operating standards. We lift profit (the ROIC numerator) and reduce the invested capital required to meet demand (the ROIC denominator). 

Bank Prime Loan Rate 1950-2016 (FRED)

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