Companies look better on paper when they own less and think short term
Capital is now cheap and plentiful, but the old rules for guarding it push managers away from the long bets that create real growth.
Talks at Google · Where Does Growth Come From? | Clayton Christensen | Talks at GoogleManagement professor Clayton Christensen argues that American companies are not short of money or ideas. They are short of growth because finance taught them to keep score the wrong way.
The first problem is an old habit. Finance says to guard rare and pricey inputs with great care, and to worry much less about common and inexpensive ones. Christensen's example is platinum, which must be used sparingly, versus sand, which can be wasted. Capital was once expensive and hard to find, so companies learned to ration it carefully. Now, Christensen says, capital is abundant and cheap, but companies still manage as if every dollar must be rationed.
The second problem is the scorecard. Starting in the mid-1980s, with the spread of the spreadsheet, analysts began to judge companies by ratios instead of whole numbers like dollars of profit. A ratio can compare two very different companies, because everything is reduced to a fraction with a numerator and a denominator.
That math quietly changes behavior. Return on net assets, known as RONA, puts profit on top and assets on the bottom. A manager can raise it by earning more profit, but Christensen says it is much easier to shrink the denominator by outsourcing assets and getting them off the balance sheet. Either move lifts the ratio.
Internal rate of return, known as IRR, works the same way. It is a speed of return score, profit over the time it takes to get the cash back after the money goes out. Raising profit is hard, but picking only fast payback projects is easy, so managers keep doing that.
That creates a loop. Cost cutting projects that let a company make more with less throw off free cash. When managers ask where to put the cash, analysts reject proposals to build new, disruptive businesses, simpler and cheaper products that reach many more buyers, because those need assets and pay off in five to 10 years. Another round of cost cutting pays off in six months to three years, with no risk and a ready market. So the company does that again, gets more cash, and faces the same choice, with growth slipping further away.
Questions people ask
What exactly is RONA?
RONA stands for return on net assets. It divides after-tax profit by the plants, equipment, inventory, and other assets needed to produce it. A higher number means a company earns more profit per dollar of assets, which is why selling or outsourcing assets can raise it without any rise in sales.
What exactly is IRR?
IRR stands for internal rate of return. It is the annualized return on an investment, based on when cash goes out and when cash comes back in. Projects that return cash sooner score higher, even if a slower project would eventually earn more total dollars.
What is the difference between an efficiency innovation and a disruptive innovation?
An efficiency innovation lets a company make more with less, such as outsourcing, automation, or lean production. It cuts costs and jobs but frees up cash. A disruptive innovation makes a complicated, expensive product simple and affordable, so many more people can buy it, which creates jobs and growth but usually takes years and requires investment in assets.