How Incorrect Profitability Metrics and Lack of Disruptive Innovation are Crippling the Economy

“By certain synthetic measures of profitability, some economists calculate that we have been coming out of a recession for a couple of years now; and they worry that America is likely to dive back down for a second downturn,” says Clayton Christensen, expert on innovation, Professor of Business Administration at the Harvard Business School and founder of Innosight Institute.  Why aren’t companies hiring?  The answer can be found in how we measure profitability, which Christensen believes to be flawed at its core.  “These measures are like having managers inhale nitrous oxide (laughing gas). They feel like all is well – even though their companies often are truly in distress. In reality we have never come out from the 2008 recession.”

Christensen explains how profitability models mislead managers.  “RONA (Return On Net Assets), for example, has a numerator and a denominator. You can increase that ratio by creating more profit or by getting assets off the balance sheet. The more you outsource, the fewer the assets and the higher your RONA becomes. But then they realize there’s nothing left of their company – they’ve divested everything in the company that creates true profit, even as they pursued ‘profitability,’” he says.

Even though RONA is a valuable equation for companies, it can trick a company into outsourcing too much work, which results in hiring fewer people, owing more money and ultimately being less profitable.  This hurts job seekers and the economy.  Compare this to how a start-up company initially measures profitability.

“Generally when a company is starting out, it measures growth by the number of employees, revenues, market share and net profits,” says Christensen. “At some point, as these fundamentals hit a plateau, many companies adopt new key indicators of ‘health’ – anything that can produce a bar chart in the company’s annual report that shows improvement – measures like RONA (in reality, they’ve often outsourced things to get assets off the balance sheet); gross margins (they’re being driven out of the mainstream market by disruptive competitors); or revenues per worker (it masquerades as a measure of productivity, when in reality you just had a big lay-off). Such indicators convey that the company is going up, when in reality it is not.”

What are other causes of fewer jobs in the marketplace?  Christensen believes it is also due to how venture capitalists fund businesses:  “Venture capitalists have largely stopped funding disruptive innovation. As a consequence, we haven’t had the engine of employment like we’ve had in the past. We measure the economy with the wrong metrics, and then employment rates do not improve because we aren’t creating new disruptive opportunities.”

The concept of capital formerly connoted things like permanence and building. Now, much of capital is “migratory capital.” The minute it is put into a company it wants to get out. If the capitalists can get more capital out of the company than they put into it, and if they can get it out fast, it increases their IRR (internal rate of return) – another synthetic shot of laughing gas. It causes venture investors to invest primarily in projects that can quickly be sold to a larger company. Investing to create companies that create what Christensen calls “new-market disruptions” – companies that make products or services that are so much more affordable and accessible that many more people can own and use a product than in the past – are increasingly rare. The reason: it typically takes 5-10 years until such disruptive companies are ready to go public – and it kills the IRR. As a result, the economy is awash in migratory capital that is trolling around the economy for companies in which they can quickly get more money out of the company than they put into it. And the economy is in a drought of company-building capital.

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