There is a short-sighted methodology for calculating the Internal Rate of Return (IRR) on an investment. It causes some investors to focus on smaller and smaller wins. If something doesn’t pay off for years, the IRR is so unattractive that the addled investor will focus capital on shorter and shorter term wins.
The other myopic view is called RONA. It is the rate of return on net assets. It sometimes causes companies to reduce the denominator through a reduction of assets. The “thinking” is: The fewer the assets, the higher the RONA.
Profitability is often measured by these ratios. The financial services industry has sought to simplify its practices through describing profitability by a ratio so that it can be compared across different industries. It effectively ‘neutralizes’ the measures so that they may be applied across sectors to every firm.
“You Americans measure profitability by a ratio. There’s a problem with that. No banks accept deposits denominated in ratios. The way we measure profitability is in ‘tons of money’. You use the return on assets ratio if cash is scarce. But if there is actually a lot of cash, then that is causing you to economize on something that is abundant.” — Morris Chang (Chairman and Founder of TSM)
The calculation of the IRR and RONA, based on a narrow view of costs and benefits, discounts long-term implications that include:
- The cost of the knowledge that is being lost, possibly forever.
- The cost of being unable to innovate in future, because critical knowledge has been lost.
- The consequent cost of business being captured by emerging competitors that can make a better product at lower cost.
- The missed opportunity of profits that could be made from innovations based on knowledge that was given away.