I find respectable discussions on the content of key issues of our life especially rewarding. Here is an issue my friend Alejandro Fernandez had during his presentation at the 2022 TOCICO Conference.
The topic was The Measurement Nightmare Solved with Throughput Economics Approach. The idea is to judge the added value of a new move or idea, opening the door to evaluate the contribution of the new move to the Goal of the organization.
One of the financial measurements that can be used is the return-on-investment of the new move. Here is the formula stated by Alejandro:
Sanjeev Gupta and Filippo Pescara, two well-known TOC experts, claimed that the above formula is incorrect. The situation of presenting live could be too pressing to fully understand the criticism and its validity. Moreover, one of the most common, but also trickiest problems is when a specific expression can be interpreted in two very different ways. I believe this is the situation here.
Let us use an example:
Imagine a restaurant chain with four restaurants spread over the city. The owner is contemplating adding a fifth branch. He believes that such a restaurant, at a location far away from the others, would add mainly new customers, who are aware of the reputation of the chain, but highly prefer the new location.
- The new restaurant requires a net investment of $500K.
- The additional operating expenses of the chain would go up by $1.2M a year.
- The evaluation of overall Throughput (revenues minus the truly-variable-costs, like the purchased food) comes to 1.5M a year.
- This means the chain of restaurants will gain, due to the additional branch, net-profit, before tax, of (1.5M – $1.2M) = $300K a year.
- The ROI of the investment in the new restaurant is $300 / $500 = 60%.
But here is the clarity issue: The ROI of 60% is only for the new restaurant – it is NOT the ROI of the chain and it is obvious that the total ROI is NOT going up by 60%! To calculate the new ROI for the whole chain we need to consider the new total throughput of all five restaurants minus the operating expenses of all the restaurants, then dividing it by the total of the current investment plus the new one.
The point here is: what do you understand from the expression: Delta-ROI?
Is it the change in ROI for the whole organization? Or is it the ROI of just the new move?
The above formula refers to the later interpretation!
Comment: The full Throughput Economics method involves TWO series of calculations, one is based on conservative assessments of the additional Throughput and additional Operating Expenses, and one is based on optimistic assessments. To understand the reason for going through the calculations twice, see Alejandro’s whole presentation, or read the book: Throughput Economics, by Henry Camp, Rocco Surace, and me.
Please, come up with your reservations to continue the open discussion.