Alfred P. Sloan on ROIC

My Years With General Motors: Concept of the Organization

“I did establish in United Motors a unity of business purpose through the principle of return on investment. By placing each division on its own profit-making basis, I gave the general office a common measure to efficiency with which to judge the contribution of each division to the whole. In this connection I devised a system of standard accounting which Albert Bradley, long-time chief financial officer of General Motors, later was kind enough to say was pretty good for a layman.

In the great expansion in General Motors between 1918 and 1920, I had been struck by the disparity between substance and form: plenty of substance and little form. I became convinced that the corporation could not continue to grow and survive unless it was better organized, and it was apparent that no one was giving that subject the attention it needed.

An example, close to home for me: When the United Motors group was brought into the General Motors Corporation in late 1918, I found that if I followed the prevailing practice of intercorporate relations I would no longer be able to determine the rate of return on investment for these accessory divisions individually or as a group. This would necessarily mean that I would lose some degree of managerial control over my area of operations. At that time, material within General Motors was passing from one operating division to another at cost, or at cost plus som predetermined percentage. My divisions in the United Motors Corporation had sold both to outside customers and to their allied divisions at the market price. I knew that I operated a profit-making group, and I wished to continue to be able to demonstrate this performance to the general management, rather than to have my operating results in interdivisional business swallowed up in in the extra bookkeeping profits of some other division. It was a case of keeping the information clear.

It was not, however, a matter of interest to me only with respect to my divisions, since as a member of the Executive Committee, I was kind of general executive and so had begun to think from the corporate viewpoint. The important thing was that no one knew how much was being contributed—plus or minus—by each division to the common good of the corporation. And since, therefore, no one knew, or could prove, where the efficiencies and inefficiencies lay, there was no objective basis for the allocation of new investment. This was one of the difficulties with the expansion to compete for investment funds, but it was irrational for the general officers of the corporation not to know where to place the money to best advantage. In the absence of objectivity it was not surprising that there was a lack of real agreement among the general officers. Furthermore, some of them had no broad outlook, and used their membership on the Executive Committee mainly to advance the interests of their respective divisions.

I had taken up the question of interdivisional relations with Mr. Durant before I entered General Motors and my views on it were well enough known for me to be appointed chairman of a committee ‘to formulate rules and regulations pertaining to interdivisional business’ on December 31, 1918. I completed the report by the following summer and presented it to the Executive Committee on December 6, 1919. I select here a few of its first principles, which, though they are an accepted part of management doctrine today, were not so well known by then. I think they are still worth attention.

I stated the basic argument as follows:

The profit resulting from any business considered abstractly, is no real measure of that particular business. An operation making $100,000.00 per year may be a very profitable business justifying expansion and the use of all the additional capital that it can profitably employ. On the other hand, a business making $10,000,000 a year may be a very unprofitable one, not only not justifying further expansion but even justifying liquidation unless more profitable return can be obtained. It is not, therefore, a matter of the amount of profit but of the relation of that profit to the real worth of invested capital within the business. Unless that principle is fully recognized in any plan that may be adopted, illogical and unsound results and statistics are unavoidable…

There seems to me still to be no question about that. It is as I see it the strategic aim of a business to earn a return on capital, and if in any particular case the return in the long run is not satisfactory, the deficiency should be corrected or the activity abandoned for a more favorable one.

For sales to outside customers, I recognized in the report that the market would determine the actual price, and if this yielded a desirable return, the business in question might justify expansion. For exclusively interdivisional transactions I recommended that the starting point should be cost plus some predetermined rate of return, but only as a guide. To avoid the possibility of protecting a supplying division which might be a high-cost producer, I recommended a number of steps involving analysis of the operation and comparison with outside competitive production where possible. The point I wish to make here relates not to techniquewhich other people know better than I dobut to the general principle of rate of return as the measure of the worth of a business. That idea was fundamental in my thinking about management problems.

On the influence of rate of return on decentralization and the relation of the part to the whole, I made several points of which the following seem to me to be of interest.

As to its bearing on organization:

… [It] Increases the morale of the organization by placing each operation on its own foundation, making it feel that it is part of the Corporation, assuming its own responsibility and contributing its share to the final result.

As to its bearing on financial control:

… [It] Develops statistics correctly reflecting the relation between the net return and the invested capital of each operating divisionthe true measure of efficiencyirrespective of the number of other divisions contributing thereto and the capital employed within such divisions.

As to its bearing on strategic investment:

… [It] Enables the corporation to direct the placing of additional capital where it will result in the greatest benefit to the Corporation as a whole.

So far as I know, this was the first written statement of the broad principles of financial control in General Motors.”

Excerpt above taken from the book My Years With General Motors, written by Alfred P. Sloan.

See here for more information about Alfred P. Sloan over at Wikipedia.

See here for General Motor’s own company history and heritage.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

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