Calder Industrial: ROI, Residual Income and a Loss-Making Key Account
Calder Industrial's components division has invested capital of $40m and budgeted operating profit of $6m. The group's after-tax cost of capital is 10%. The divisional manager's bonus pays on a sliding scale once divisional ROI exceeds 15%, and the division sits exactly on that threshold. A proposal to automate the deburring line needs $8m and would add $1.0m of operating profit a year at unchanged risk; the manager has quietly shelved it. Meanwhile the division's largest customer, 16% of revenue, buys $9.4m a year at an 18% gross margin but takes 78 days to pay against a division average of 45, and demands expedited freight ($620k), special packaging ($350k), volume rebates ($480k), returns ($210k) and a dedicated account manager ($150k). The cost of working capital is 8%. The manager is proud of retaining the account.
1. Explain why the manager shelved the automation project, quantify the divergence using ROI and residual income, and state what the numbers say about the investment.
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Why the manager said no
| Now | After investing | |
|---|---|---|
| Operating profit | 6.0 | 7.0 |
| Invested capital | 40.0 | 48.0 |
| ROI | 15.0% | 14.6% |
| Bonus trigger | Met | Missed |
Accepting the project takes the manager below the 15% threshold and cuts her bonus, even though the project earns 12.5% on the incremental $8m against a 10% cost of capital. She is optimising her measure, not the firm's value.
Residual income test
| Now | After investing | |
|---|---|---|
| Profit | 6.0 | 7.0 |
| Capital charge (10%) | 4.0 | 4.8 |
| RI | 2.0 | 2.2 |
RI rises by $0.2m, which is exactly the NPV in perpetuity: 1.0 − 0.8 = $0.2m a year forever at 10% = $2.0m of value.
Diagnosis: ROI is a ratio and therefore penalises any investment earning above the cost of capital but below the division's current average. It systematically drives managers to shrink assets, defer maintenance and refuse good growth. RI (or EVA) charges for all capital at a single rate and is additive - a project with positive RI always increases the division's RI, so goal congruence holds.
Caveats before switching: RI favours big divisions and needs a defensible asset base (gross book value, no write-down gaming), and a capital charge set centrally so managers cannot negotiate their own hurdle.
2. Assess the true profitability of the largest customer, and recommend what Calder should do.
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Cost-to-serve analysis
| $000 | |
|---|---|
| Revenue | 9,400 |
| Gross margin at 18% | 1,692 |
| Expedited freight | (620) |
| Special packaging | (350) |
| Volume rebates | (480) |
| Returns | (210) |
| Dedicated account manager | (150) |
| Account margin | −118 |
| Working-capital cost: 9,400 × 8% × (78−45)/365 | (68) |
| Economic profit of the account | (186) |
At 16% of revenue, the account consumes roughly $9.4m of sales and $2.0m of receivables while destroying about $186k a year. The gross margin percentage conceals this because none of the cost-to-serve items sit in standard cost of sales.
Recommendation - renegotiate, do not simply exit
- Price the service back in: convert expedited freight and special packaging to a paid service tier, and replace the off-invoice rebate with a volume-linked structure that only pays on profitable volume. Even recovering freight alone turns the account to roughly −$0 - before any volume benefit.
- Terms: 78 days against 45 is a $850k interest-free loan. Move to the standard 45 days with a 2%/30-day settlement option, or price the extension at 8%.
- Segment the account: the returns and rushed orders may come from a subset of its SKUs. Exit those, keep the rest.
- Exit test: if the customer refuses any movement, quantify the avoidable fixed cost and the capacity released before walking away - the $9.4m of revenue is not margin, but the plant may not be able to replace it quickly.
Bring the analysis to the customer as a joint profitability review; a 16% customer usually wants to keep supply, and a documented cost-to-serve conversation is more effective than a price rise from nowhere.
3. How should the bonus plan be redesigned so that both of these behaviours disappear, and what new distortions would you have to guard against?
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Design principles
- Measure value, not ratio. Replace divisional ROI as the bonus driver with a profit measure after a capital charge - RI/EVA - so that every project earning above 10% adds to the bonus. The automation project then pays the manager $0.2m more, which is the firm's own answer.
- Mix the scorecard. Pair the financial measure with the drivers the strategy actually needs: on-time delivery, throughput on the constraint, cost-to-serve by customer, and cash conversion (DSO). Revenue alone is not a measure of anything.
- Weight and threshold sensibly. A single hard 15% cliff invites exactly this behaviour - a manager near the cliff will defer a good project or pull a sale forward for a few basis points. Use a smooth curve with no cliff, a capped payout, and a multi-year element (say 40% deferred over three years) so decisions cannot be optimised within a bonus year.
- Put account profitability in the data. The account manager's plan should show fully-loaded cost-to-serve for the top ten accounts each month; what is not measured cannot be managed.
- Governance on the inputs. The capital charge rate, the asset base definition and the allocation of shared costs are set by group finance, not by the division, and are audited.
New distortions to guard against
- Asset gaming: writing down or leasing assets to shrink the base. Answer: consistent gross-book-value convention and a review of sale-and-leaseback activity.
- Short-term cost cutting: deferring maintenance or R&D to lift RI. Answer: scorecard metrics on reliability and pipeline, and multi-year vesting.
- Under-investment in growth: a high capital charge can chill genuinely risky projects. Answer: risk-adjusted hurdle rates by project class, and a separate strategic-investment pool excluded from the annual bonus calculation.
- Cost-to-serve allocation: a customer profitability measure can start internal disputes over allocated overhead. Answer: separate directly attributable costs (freight, packaging, rebates) from allocated ones; managers act on the former.