Return on Invested Capital (ROIC)

The objective of most incorporated organizations is to create economic value. Those who have
money invested in the enterprise want to see a return on their money-a return that exceeds the
return that they would get if they invested their money differently, for example, in a bond, a savings
account, or a competing organization.

Economic value is created whenever the return on invested capital (ROIC) in a corporation
exceeds the cost of capital (the weighted average cost of capital, WACC, is an important concept
from the field of corporate finance).

This is visible in the basic value equation:

Economic Value Created = Invested Capital X (ROIC - WACC)

The cost of capital cannot be changed easily in the short term; our focus here is on the return on
invested capital.

ROIC Tree (KPI Tree) is the first set of tools that support in analyzing the operational performance
of a company and to guide them in increasing the overall value of the firm by improving its
operations.

Building An ROlC Tree

Stakeholders of the firm are primarily interested in creating economic value and thus in increasing
the ROIC of his firm. The idea behind building an ROIC tree is to cascade the high-level financial
metric into its key operational ingredients, thereby revealing the levers a manager can use to
improve ROIC.
Return
𝑅𝑂𝐼𝐶 = Invested Capital

Now, let's do a simple algebraic manipulation and write

Return Return Revenue
𝑅𝑂𝐼𝐶 = Invested Capital = × Invested Capital
Revenue

The first ratio, Return/Revenue, is the company’s margin. The second ratio, Revenue/Invested
Capital, is called the company’s capital turns.

Decomposing of ROIC into margin and asset turns is referred as the DuPont model.

Return = Revenue - Fixed Costs – (Production Volume X Variable Costs)

Let’s use "Flow Rate" instead of "Production volume." Revenue = Flow Rate X Price,

we can rewrite the previous equation by dividing both sides by Revenue, which yields

Return Revenue 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐹𝑙𝑜𝑤 𝑅𝑎𝑡𝑒 ×𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡

= – –
Revenue Revenue 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Return 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐹𝑙𝑜𝑤 𝑅𝑎𝑡𝑒 ×𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡

=1– –
Revenue (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒) (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒)

Return 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡

=1– –
Revenue (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒) (𝑃𝑟𝑖𝑐𝑒)
 Revenue (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒)
=
Invested Capital 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Overall ROIC equation can now be written as

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒)

𝑅𝑂𝐼𝐶 = [1 – (𝐹𝑙𝑜𝑤 𝑟𝑎𝑡𝑒 𝑋 𝑃𝑟𝑖𝑐𝑒)
– (𝑃𝑟𝑖𝑐𝑒)
] ×
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

HOW TO CREATE AN ROIC TREE

1. Start with the objective (ROIC) on one side of the tree.

2. Decompose a variable into its components.
a. Example: ROle = Income/Invested Capital
b. Relationships of variables can be a + b, a - b, a/b, or a x b
3. Decide which branches of the tree have an impact and are important.
a. What are the main cost drivers (80/20 rule)?
b. What are the strategic levers of the company?
c. Which inputs are most likely to change?
4. Expand important branches (return to step 2).
5. End with measures that can be tied to operational strategy.
6. Populate the tree with actual numbers.
7. Reflect on the tree to see if it makes sense.
a. Benchmark performance.
b. Perform sensitivity analysis.

Basic Structure of an ROIC Tree

Price

Return Fixed Cost

Revenue
Flow Rate

Variable Cost
ROIC
Flow Rate

Revenue
Price
Invested Capital
Invested Capital
Price is normally fixed and it is beyond operational decisions
Variable cost is driven by input or material cost and is equal to price of raw material times sum of
RM in final good and processing loss)
Flow rate is minimum of demand and supply.
Let’s take example of a small time restaurant by name “Foodinn”.

“Foodinn” is a small restaurant which is a basically a fine dine category. The Restaurant is opened
300 days a year. There are 10 multiskilled staffs which are working in this restaurant. These
workers are paid an average of Rs. 10 / hour and work normally for 6 hours. The average food bill
cost Rs. 200. Raw material cost is Rs. 30 per dish. Since it is in heart of the city, the restaurant is
always full of customers. The average time for ordering, eating, payment & cleaning are 10 mins,
30 Mins, 10 mins and 10 mins respectively. The rent for the year is Rs. 20,000. Marketing and
advertisement expenses are Rs. 10,000 per year. Other overhead and furnishing expenses are
Rs. 5,000 each. The owner has put in Rs. 3,00,000 as capital. Rs. 2000 and Rs. 1000 are held up
as inventory under raw material and WIP respectively. Also 10% advance is to be paid for the
material cost. 5% of the sales are done under advance booking.

Now looking at the above scenario, we have to draw a ROIC tree for this restaurant. As we
proceed, we will describe each and every component of the ROIC tree. We have made this tree in
excel and found that ROIC comes out to be 3.24%. Taking it further lets create different scenarios
as by improving certain parameters can we improve the ROIC of the given restaurant.

The different touch points can

1. No of Workers
2. Hours worked by each worker
3. Cost of labour
4. Cost of material
5. Serving time.

Let’s change each touch points and check the change in ROIC
1. No. of Worker: increase in number of worker increases the ROIC till the time the invested
capital is set off. Currently number of workers employed is 10. Please find the change in
ROIC when we add workers in an increment of 10. An addition of 10 workers increases the
ROIC from 3.24% to 7.62%. If we plot the data on a graph we get the following graph. The
critical point is 79 workers. On adding next worker, the ROIC becomes negative as working
capital becomes greater than invested capital. Now more capital funding is required.

80 180%
No of Workers ROIC
70 160%

140%
60
120%
50
100%
40
80%
30
60%
20
40%

10 20%

0 0%
1 2 3 4 5 6 7
 2. Hour Worked by each worker: increase in number of hours each worker worked
increases the ROIC. The graph is a linear incremental graph.

18 14%
No of Hours ROIC
16
12%
14
10%
12

10 8%

8 6%

6
4%
4
2%
2

0 0%
1 2 3 4 5 6 7

3. Labour wages rate: increase or decrease in wages does have an inverse change in the
ROIC. However such changes have no major impact on the ROIC. This fact can be utilized
by management to motivate employees. They can give a 50% hike in wages but the
corresponding decrease in ROIC would be very miniscule.
4. Cost of material: increase or decrease in material cost does have an inverse change in the
ROIC. However such changes have no major impact on the ROIC.
5. Serve rate: If we decrease the order time, payment time and cleaning time from 10 mins to
5 mins we can increase the ROIC from 3.24% to 4.62%. This can be achieved by many
ways.
 We can encourage taking advance orders i.e. online booking. We have many
benefits of this.
o We get our payment in advance (great as per accounting principal)
o We can schedule the jobs & purchases as per the order
o We can in fact go away with ordering and payment time theoretically
o In fact we can reduce the preparation time too.
 We can engage some worker to who were engaged in order taking and payment
process to make the table ready for the next customer.

So we have seen that by changing the different critical touch points we can change the ROIC.