Operation Management IIM PGPMX 2018 - 20

Assignment

On

Return on Invested Capital

(ROIC)

A Restaurant Case Study

with Excel Working Model

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)
Operation Management IIM PGPMX 2018 - 20

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

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)
Operation Management IIM PGPMX 2018 - 20

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

Fixed Cost
Return
Revenue
Flow Rate

Variable Cost
ROIC
Flow Rate
Revenue
Price
Invested Capital
Invested Capital

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)
Operation Management IIM PGPMX 2018 - 20

In the above variables

 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 a working model of this ROIC tree in excel and found that ROIC comes
out to be 3.24%. Taking it further, we have created different scenarios whereby
improving certain parameters, we can improve the ROIC of this restaurant.

The variables to work upon are

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.

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)
Operation Management IIM PGPMX 2018 - 20

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%

16
No of Hours
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.

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)
Operation Management IIM PGPMX 2018 - 20

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 few variables we can change the ROIC. This
provides a link between the operations of a company and its financial performance.
These operational variables are key drivers of a company's financial performance.
Value creation takes place in the operations of a company and so, to increase the
economic value of a company, a detailed analysis of operations is a must.

Jointly Submitted by:

Dr. Sunil Patil (Roll no: 22) Vinod Kumar Singh (Roll no: 25)