46 IRE TRANSACTIONS ON ENGINEERING MANAGEM1ENTJYtne

Measurement and Control of Economic Activitiesfron the Standpoint of Profitability*

JOHN C. FISHERt

Summary-It is possible to go a long way toward optimizing the would have dropped. The following procedure has muchprofitability of a complex enterprise by: 1) getting each local man- to recommenid it:agement team to commit itself in advance regarding the activitiesit believes to be marginal, then measuring the profitability of themarginal activities; 2) comparing the performance of company 1) Require the manager of a componenit to state whatcomponents with that of outside independent agencies; and 3) de- projects or other activities he would curtail if hissigning compensation schemes that properly reward efforts aimed budget were cut (but do not actually cut the budget).at achieving long- and short-term goals. Call these activities the marginal activities. Call the

residue the core activities.rT1 OP management cannot scrutinize each project that 2) Then subsequently and separatelv measure the

might be undertaken in a company. Executives do profitability of the marginal activities and of thenot have the time, and they may not have the core activities. (It has been pointed out that the

specialized knowledge required. Instead, they must set up after-tax flow of cash associated with a businesspolicies and procedures that lead the various operating enterprise, when discounted at about 6 per cent tocomponents of the business to undertake, in their own any reference date, gives a quantitative measure ofinterests, as nearly as possible the optimum combination the value of the enterprise at that time.' The dis-of activities. It is not easy to set up such procedures, or to counted cash-flow method is equally valid for measur-evaluate the performance of a component so that the local ing the profitability of the marginal activities or ofmanagement can be properly rewarded. Yet something any other identifiable portion of the enterprise.)can be said about a few of the principles involved.

There are two distinctly different questions that the The above measurement procedure tells somethingmanagement of a decnentralized company mav as,-k itselfm g n f d nld m y ys about the competence of the local management, anid morewith respect to each of the company's componenits. The abotut the marginal profitability of the component. If thefirst relates to the efficiency of a component in carrying return on funds invested in the marginal activities turnsout the task assigned to it: is the componient doing a out to be greater than the return on the core activities,competent job, or is it sliding along in mediocrity or less? the judgment of the local managers is demonstrated toThe second relates to the investment of funds in each be poor. Either they were unable to identify their profit-component. Given a component of whatever efficiency it able activities, or they have tried to pad their marginalmay have,managed aswellorbadlyasit maybe managed: return] by including some good projects in the marginalhow much should its budget be increased or decreased to group. Either way, their judgment was poor, and is sooptimize its profitability? It is possible, in principle, to revealed in the final measurement.answer both of these questions, and it is most convenient Assuming that the local managers have honestly putto consder the secondqueastion first. their least profitable activities into the marginal category,The problem of allocating money to a component o a as subse(uently revealed by the lower-measured return

business is that of determining the marginal returlon on money invested in this set of activities, it then is afunds invested in that component, not the average return simple matter to expand or contract their budget to ap-thereon. Ftor example, a component may be enormously proach maximuim profitability. The ideal toward whichprofitable, yet may deserve a smaller budget because it is one should strive is to achieve a marginal equivalent returnwast.ing a portion of its funds in unprofitable sidelines. It somewhere near 6 per cenit. If, upon measurement, theis difficult to determine marginal profitability simply by equivalent return on the marginal projects turns out to beasking a component what it would do if it were given sigvficantly less than 6 per cent, it is clear that a smallermnore mlfoney, because the local management is tempted to budget is called for. If prior policy has been to anllow thatdistort its estimates in the direction of higher profitability, component to retain half of its earnings, a. new policy ofIt is better to ask the component what it wvould do if it aloigi orti 0prceto t annsmgtbwere given less money, anld then to measure the profit- tried. If a fewv years of subsequent measurement showrsability of the items the component's management says it

' J. C. Fisher, "vA profitability criterion for measulrement and* Manuscript received by t.he PGEMI, MIarch 19, 1959.decisiSon-making," JRE TRANS. ON ENGINEERING 1MANAGEMENT, tot General Elec. Res. Lab., Schenectady, N. Y. be published.

1959 Fisher: Economic Activities and Profitability 47

this percentage still to be too high, it can be cut again. writing, it should be decided by lot whether the projectOn the other hand, if the equivalent return on the marginal is to be done by the engineering development activitygroup turns out to be appreciably above 6 per cent, it will itself or by an outside independent firm. (A good way forbe profitable to increase the budget. In extreme cases it selecting about one project out of eight is to flip threewill be necessary not only to allow a component to re- coins. If three heads turn up, farm out the project; other-invest all its earnings, but to supplement these earnings wise, keep it in the home organization.) It may be unfairwith those of other less-rapidly expanding components. to judge an engineerinig development activity on the

This method is not inew in principle. It has, however, results of a single comparison project, particularly wheretvo necessary ingredients that are not often employed the chance of technical success is not too high. For thiseveni separately. The first is to get local maniagement to reason, a half-dozen or so projects might be farmed outcommit itself in advance as to its marginal activities. (If over a period of a year or two before a reasonably fairthe local managers have the advantage of hindsight, they comparison could be made. It then would be interestingmay be tempted to manufacture a statement that makes to compare the two groups' average performance alongthem look good.) The second is actually to measure the the followiing lines:profitability of the marginal activities. Together these 1) Which group had the lower project cost in compari-two ingredients make possible a large degree of control. . . ~~~~~~~~~sonwilth the forecast coist?over the profitability of a comnplex enterprise, and go a

short~' evluating h 2) Which group did the Job more quickly in comparisonshort way toward evaluating the performanee of the local with the forecast time?management groups.

Determinatio ofthe efficiencyofacompayc3) Which group had the greater technical success inDetermination~~~of th.fiinyoacmaycmo comparison wi-th the forecast probability of success?nentt is a little more difficult in practice, but equally simple chmgrou gnrtthe largerbdiscou vue

4) Which group generated the larger discounted valuein concept. If top management wishes to establish the with its successful projects in comparison with therelative efficiency of a component, it must compare thecomponent's performance with that of a comparable in- forecast value?dependent organization. When the componenit under study It is easy to see that significanit differences in performance,is a complete business engaged in manufacture and sales, should they be revealed by comparisons of this sort,the appropriate independent organizations for comparison would go a long way towaard establishing the relativeare the component's competitors, some of which will be competence and effectiveness of the two groups.small companies whose profits are a matter of record. Not only is it possible to measure the marginal perform-For the comparison to be valid, component and competi- ance of a group, and to compare its efficieney with outsidetor should have similar goals and should be in a similar groups; it is also possible to design compensation schemesstage of development. that encourage local managemnent to do the profitable

Unfortunately, wheni a business shows tup poorly in thing with minimum supervision. The idea here is tocomparison with its competitors, there often is no clue compensate the managers of a business in such a wayto the trouble. Marketing, manufacturing, engineering, that their income increases when they aet to increase aheor any of several other business functions could be at value of theircomponent to the owners, and theirinceomefault. There is need therefore, for means of omparison decreases when they act in the contrary way. A managerthat can be applied to a component that is not a complete has two competing aspects to his job. He must conductbusiness, but is an engineering activity, a research activity, his business so that it is currently profitable, and he musta marketing activity, or other specialized portion of a conduct it so that it will be profitable in the future. Forcomplete business. its future profitability he must build facilities, train people,One might think that a comparison could be effected and invest in development and research, whenever the

by assigning the same task to the component and to an anticipated return on these investments merits the asso-outside agency, giving each the same budget and seeing ciated reduction in current profit. If a local manager haswhich produees the most profitable result. However, there a short-sighted attitude with respect to these matters, hisis every likelihood that the management of the component, compensation scheme may be at fault.in order to look good in the eomparison, will shift a In order that a manager's compensation encourage himconsiderable amount of effort to the comparisoni project to balance the short- and lon-g-term requirements of histo the detriment of the rest of the business. To avoid component, it must contain the following two elements:problems of this sort, it is convenient againi to requirethe component nunder study to commit itself in advance. 1) Compensation that is related as directly as possibleFor example, an engineering-development activity to the current profits of that company component

might be required to forecast the profitability of each over which the recipient now has some measure ofproject it contemplates undertaking. Such forecaUsts could control. (This portion encourages current profit-include estimates of the cost of the developmenlt, the ability and would encourage future profitability iflength of time required, the probability of technical suc- the man were to hold the same Job for a long time.)cess, the discounted value of the project if successful, and 2) Compensation that is related to the current profitsperhaps other items. After each forecast is submitted in of the component over which the recipient had con-

48 IRE TRANSACTIONS ON ENGINTEERINGMANAGEMEN1T June

trol a number of years before. (This portion encour- ment tends to agree with top management at budget time.ages future profitability, as a man knows he will These few examples are intended to illustrate some ofshare in the future success of a componient even the opportunities open to top management for measuringthough he may be transferred to another job.) and influencing both the marginal profitability and the

efficiency of individual business components. They stressA practical way of achieving this type of compensation the necessity of requiring a component to commit itselfmight be to pay some form of incentive compensation, in advance, and the necessity of subsequent quantitativebased upon current profitability, in more or less equal measurement.portions, to the present incumbent in a position and tothe man who held the job several years before. The op- ACKNOWLEDGMENTtimum division of funds and the optimum delay time for I am indebted to J. K. Bragg, Jr., and F. L. VerSnydersuch a scheme should be arranged so that local manage- for valuable criticism.