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COVER STORY – How Sloan built cars and value at General Motors.

Having established techniques of control in the particular areas of appropriations, cash, inventory, and production, the general question remained: How could we exercise permanent control over the whole corporation in a way consistent with the decentralised scheme of organisation? We never ceased to attack this paradox; indeed we could not avoid a solution of it without yielding both the actual decentralised structure of our business and our philosophy of approach to it. I have dealt in other chapters with the organisation aspect of the question as it was developed in theory and practice in General Motors in the early 1920s. But that alone was not enough. It was on the financial side that the last necessary key to decentralisation with co-ordinated control was found. That key, in principle, was the concept that, if we had the means to review and judge the effectiveness of operations, we could safely leave the prosecution of those operations to the men in charge of them. The means as it turned out was a method of financial control which converted the broad principle of return on investment into one of the important working instruments for measuring the operations of the divisions. The basic elements of financial control in General Motors are cost, price, volume, and rate of return on investment. A word on rate of return as a strategic principle of business. I am not going to say that rate of return is a magic wand for every occasion in business. There are times when you have to spend money just to stay in business, regardless of the visible rate of return. Competition is the final price determinant and competitive prices may result in profits which force you to accept a rate of return less than you hoped for, or for that matter to accept temporary losses. And, in times of inflation, the rate-of-return concept comes up against the problem of assets undervalued in terms of replacement. Nevertheless, no other financial principle with which I am acquainted serves better than rate of return as an objective aid to business judgment. This principle had governed the thinking of the Finance Committee of General Motors since 1917, as it had governed the thinking of the du Pont people and certain other businessmen in the United States before that time. I do not know the origin of the principle itself. Even the least sophisticated investor measures his profits from stocks, bonds, or savings accounts in terms of what he puts into them. So, too, I imagine, every businessman evaluates profits in terms of his total investment. It is a rule of the game, so to speak. There are other measures for the running of a business; for example, profit on sales, and penetration of the market, but they do not supersede return on investment. However, the question is not simply one of maximising the rate of return for a specific short period of time. Mr. Brown’s thought on this was that the fundamental consideration was an average return over a long period of time. Under his concept General Motors’ economic objective was to produce not necessarily the highest attainable rate of return on the capital employed, but the highest return consistent with attainable volume in the market. The long-term rate of return was to be the highest expectation consistent with a sound growth of the business, or what we called “the economic return attainable.” Mr. Brown put it this way: “A monopolistic industry, or an individual business under peculiar circumstances, might maintain high prices and enjoy a limited volume with very high rate of return on capital, indefinitely, at the sacrifice of wholesome expansion. Reduction of price might broaden the scope of demand, and afford an enlargement of volume highly beneficial, even though the rate of return on capital might be lower. The limiting considerations are the economic cost of capital, the ability to increase supply, and the extent to which demand will be stimulated by price reduction. “Thus it is apparent that the object of management is not necessarily the highest attainable rate of return on capital, but rather the highest return consistent with attainable volume, care being exercised to assure profit with each increment of volume that will at least equal the economic cost of additional capital required. Therefore the fundamental consideration is the economic cost of capital to the individual business.” (“Pricing Policy in Relation to Financial Control,” Management and Administration, February 1924.) When Donaldson Brown came to General Motors he brought with him a financial yardstick. It was a method of crystallising facts bearing on the efficiency of management in the various phases of the business, such as inventory control, plans for capital investment in relation to expected demands on production, cost control, and the like. In other words, Mr. Brown developed the concept of return on investment in such a way that it could be used to measure the effectiveness of each division’s operation as well as to evaluate broad investment decisions. His concept can be expressed in the form of an equation for computing return on investment, and it is still one of the measures used by the du Pont Company and General Motors to evaluate divisional performance. This book, however, is not the place for such technicalities as formal equations. I shall touch only on general concepts of financial control. Rate of return, of course, is affected by all the factors in the business; hence if one can see how these factors individually bear upon a rate of return, one has a penetrating look into the business. To obtain this insight, Mr. Brown defined return on investment as a function of the profit margin and the rate of turnover of invested capital. (Multiplying one by the other equals the per cent of return on investment.) If this seems obscure, pass over it and note only that you can get an increase in return on investment by increasing the rate of turnover of capital in relation to sales as well as by increasing profit margins. Each of these two elements – profit margin and rate of turnover of capital – Mr. Brown broke into its detailed components, a case, you might say, of aggregating and deaggregating figures to bring about a recognition of the structure of profit and loss in operations. Essentially it was a matter of making things visible. The unique thing was that it made possible the creation, based on experience, of detailed standards or yardsticks for working-capital and fixed-capital requirements and for the various elements of costs. To get standards for commercial expense and manufacturing expense, Mr. Brown used past performance modified by plans for the future. The yardsticks thus established were compared with actual performance. The heart of the financial-control principle lies in such comparisons. Mr. Brown was able to set up tables showing, for example, how the sizes of the inventory and working capital were affecting the turnover of capital in the different divisions, or to what extent selling expenses were a drag on profits. To make this concept work, each division manager was required to submit monthly reports of his total operating results. The data from these reports were put on standard forms by the central financial office in such a way as to provide the standard basis for measuring divisional performance in terms of return on investment. Each division manager received this form, which spelled out the facts for his division. For a number of years this gave each division its rank in the corporation on a rate-of-return scale. The divisional return-on-investment reports were constantly studied by the top executives. If the indicated results were not satisfactory, I or some other general executive would confer with the division managers about the corrective action to be taken. When, as chief operating officer, I visited the divisions, I carried a little black book in which was typed in a systematic way both historical and forecast information about each division of the corporation, including, for the car divisions, their competitive position. The figures did not give automatic answers to problems. They simply exposed the facts with which to judge whether the divisions were operating in line with expectations as reflected in prior performance or in their budgets. The early return-on-investment form, which with some modifications is still used in General Motors, was the first step in educating our operating personnel in the meaning and importance of rate of return as a standard of performance. It provided executives with a quantitative basis for sound decision making, and thereby laid the foundation for what was to be one of General Motors’ most important characteristics, namely, its effort to achieve open-minded communication and objective consideration of facts. In the beginning many limitations in our method were evident. The reports, for example, were not usable for evaluation and comparison until they were set up on a uniform and consistent basis. Uniformity is essential to financial control, since without it comparisons are difficult if not impossible. One of the immediate tasks, therefore, was to strengthen the accounting organisation, both centrally and within the divisions, and to institute standard accounting practices throughout the organisation. The classification of accounts throughout the corporation was standardised on 1 January, 1921. A standard accounting manual, specifying a uniform set of procedures, became effective throughout the corporation on January 1, 1923. To co-ordinate financial organisations of the divisions and the central Financial Staff, we reaffirmed in 1921 the principle of dual responsibility for the divisional comptrollers, which had been introduced in 1919 to make those comptrollers responsible not only to their divisional general managers, but to the corporation comptroller as well. From My Years with General Motors by Alfred Sloan. Copyright (C) 1963 by Alfred P Sloan Jr. Used by permission of Doubleday, a division of Random House Inc. Sloan had to manage the conflicting requirements of Chevrolet, Buick, Pontiac and so on. This is the eternal battle between empowering managers and exercising financial control. “If you decentralise into independent units, how are you sure that the independent units aren’t going to start fighting their own corner?” says Roger Mills. “What you have to do is say, ‘What’s the role of headquarters?’ Decentralisation is still a big issue.” “Cycle time would probably be added to this list today,” says Mills. “You compete on being the fastest to get a new model out.” More importantly, perhaps, Sloan has identified what we would today call the key value-drivers for the business. After all, says Mills, “The other side of financial control is the up-side.” By the way, the use of ROI would probably have been quite a novel concept in the 1920s. “Time” is a concept that starts to appear here – in particular, the notion that business decisions taken today have an impact on tomorrow. “What he’s saying is that it’s the long-term that really counts,” says Mills. “In EVA (economic value added) terms, that means you’d accept a negative EVA in the short-term in the hope that it leads to higher EVAs in the future.” Various managers joined GM from du Pont, including Donaldson Brown who, in effect, was GM’s FD and the architect of much of GM’s value creation strategy. It was, in fact, quite a leap to make a connection between performance measurement as it relates to stocks and bonds, and performance measurement as it relates to business and management. Note, too, that Sloan refers to “total investment”, not “return on assets” which may have been written down by the accountants. “He’s got it here,” says Mills. “This is the bit that everybody so easily loses sight of: the name of the game is about being good at your business. Having a valuation trick is not going to do anything for you if you have a lousy business.” Here is the first – and vital – mention of a benchmark, threshold rate of return: the cost of capital. This reference, which appears in a footnote in the original text, is the underlying principle behind shareholder value creation metrics in that it turns a relative measure (return on investment) into an absolute measure (residual income or EVA or whatever). “This is standard EVA stuff,” says Mills. “and it’s effectively saying that it’s the margin you’ve got to look at.” It might seem more normal to the modern eye to calculate ROI simply by dividing the return by the capital. Brown did it by taking the profit margin (profit/sales) and multiplying it by turnover of assets – also known as asset utilisation – (sales/capital) to get ROI (profit/capital). Hence it shows more clearly, perhaps that ROI can be affected by improving profit margins or making better use of capital by increasing sales and throughput. But having earlier flagged up the importance of “economic cost of capital” – the opportunity cost, in other words – there is no mention here of it being used as a performance threshold. These nine words probably sum up what financial management is all about. “The more you read this the more it sounds like Weinstock at GEC,” Mills says. Wouldn’t Mr Brown have loved a spreadsheet! “Of course, this is exactly what you do with a valuation model: you pick out the key value drivers to see what has an impact on the business,” says Mills. “But he didn’t have the technology to do it.” Here’s the one flaw – and one which many businesses today still stumble over. Such a ranking puts the emphasis on maximising the rate of return when, in fact, what is needed is to maximise the cash return after deducting the cost of capital. Otherwise, businesses may decline to make certain value creating investments, those that exceed the cost of capital but which would lower the overall ROI. And comparing yourself with your peer group isn’t good enough, either. “For years, if you did this in Germany, you’d have been comparing yourself to companies that were destroying shareholder value,” says Mills. Many businesses fail to “roll out” their shareholder value programme properly, neglecting to cascade it through the organisation. Sloan makes no such mistake. But it will be many years before there’s real work done to address the imperfections of accounting: capitalising rather than expensing R&D, for example. Reader offer: Roger Mills is the author of The Dynamics of Shareholder Value: The principles and practice of strategic value analysis (published in association with Pricewaterhouse-Coopers). Financial Director readers may order a copy at a specially discounted price of just £20 (p&p free), reduced from £29. Send your order to: John Robertson at Mars Business Associates, 62 Kingsmead, Lechlade, Glos GL7 3BW or e-mail

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