Economics schools business on ROI’s faults
It is actually much simpler than that: education. What we learn about economics in school, and elsewhere, seems to have little to do with real businesses. And business schools tend to look at economics courses the way an engineering school might view a course in baroque music — interesting, possibly, but we really don’t have time for that stuff.
In both theory and real-world applications, though, the two disciplines can learn a lot from each other. When an economic principle is illustrated while it is at work in the business world, then, it is good to pay attention. Just recently, Bennett Stewart brought one to light.
Stewart, who is the CEO of EVA Dimensions, recently wrote an excellent short essay on why chief financial officers should stop using ROI (return on investment) as the primary way to decide how to allocate resources. He makes a strong argument that an ROI-driven company undermines its own potential for innovation, growth and profit. The devil, as it turns out, is in the details.
The details in this case involve math, and it turns out that economists, in their own devilish way, had worked out the profit maximization problem over a century ago — long before the proliferation of financial ratios like ROI.
The problem with ROI comes about because the profits from a business operation or project do not stay the same throughout its lifetime. Profits tend to rise to a certain point — “as good as it gets” in technical terms — and then decline.
The reason for the rising profit is that fixed costs, by definition, are fixed; they do not change with output. What happens then is that all of those costs, including the startup costs, get loaded down on that first unit produced … calamitously if you stopped the business or simply calculated your profit at that point.
With fixed costs per item declining — because we divide by the increasing number of items we sell — our profit will increase as sales go up. Eventually, though, profit will stop increasing and begin to decline. The reasons vary for each business, but often it is because the item or service we are selling is aging or facing more competition and its price is softening. It could also be that our variable costs — production materials, wages, etc. — are rising.
From a profit and loss standpoint, it doesn’t really matter what kind of business we are looking at. Each business has its own structure and that has a significant effect on how costs are allocated and revenue recognized, especially for tax purposes. For each and every one of the enterprises, though, total profit equals total revenue minus total cost.
The units of production could be anything from an automobile, a tablet computer or a large pizza with extra cheese to services like accounting reports, legal advice or being a balloon man at a child’s birthday party. They could even be a television sitcom, which, like so many of today’s businesses, contains both product and service elements.
A fundamental economics principle tells us that maximum profit for the business comes when the selling price for the last product or service sold is equal to the marginal cost of making it available for sale. That is also the point where ROI is highest. From there it will begin to decline.
Is that when we should stop? In some cases, yes, we should, but not always. Businesses do not run at peak profitability all the time. They wouldn’t be peaks then, would they? Continuing in the business past peak profitability can bring in piles of money, especially as fixed costs are wound down. Unless there are very good reasons to get out and there sometimes are, continuing an operation makes good sense.
What doesn’t make good sense is to let ROI make the decision. ROI is a financial ratio, a by-product of our accounting systems. Accounting is really painting a picture of our businesses, and selecting ROI as being the most important part would be like saying that “green” is the most important color in the masterpieces on display in the Metropolitan Museum of Art.
All of the colors, like all of the financial reports, are part of the picture. There are no magic numbers, no magic formulas, no magic that we can, or should, substitute for good decision-making. That’s our job — in business and in economics.
James McCusker is a Bothell economist, educator and small-business consultant. He can be reached at firstname.lastname@example.org.
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