Many companies only deliver industry average returns, or even lower. They have no strategic competitiveness in creating value. As a result, they only get as much profit as their competitors get.
You might ask: what is the average return? Why does that matter?
In this article, we focus on average returns associated with the concept of competitive advantage, not those related to investment in the capital market.
What are average returns
Returns refer to profits relative to invested capital. That is the average return on capital invested in a company. We calculate it by dividing profit by capital invested. Net income is a common numerator, although some people prefer to use other profit measures such as net operating profit after tax (NOPAT). Meanwhile, invested capital consists of equity and interest-bearing debt (both long-term and short-term).
ROIC usually varies between industries. It depends on the intensity of competition within an industry. According to Michael Porter, five factors influence the level of competition, and ultimately ROIC, namely:
- Barriers to entry and exit
- Threat of substitution
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry in the industry
Why it is important
The size of the average return is an indicator of whether a company has a competitive advantage or not. In the long run, the ability to get returns above the average shows the company has a competitive advantage. Conversely, lower than average returns might have an impact on business failure, or even bankruptcy, because investors withdraw their investments.
Capital investment is an essential source of funding for companies. With it, the company can expand production facilities or new markets. The cost of funds becomes more expensive when investors doubt the company because it only produces an average return.
Therefore, it is crucial to building a competitive advantage. The company does it by combining two things, namely:
Both form core competencies, which are valuable, rare, and difficult or expensive for competitors to duplicate. Companies can use their competencies to develop competitive strategies in the market. Two options that companies can choose as a competitive strategy are:
- Cost leadership: emphasizing a lower cost structure than the industry average
- Differentiation: prioritizing superior products so that companies can charge premium prices.
The company uses both in two different target markets: broad markets and niche markets. The broad market offers a large number of potential customers, but; that also means a lot of competitors. Whereas, in niche markets, companies focus on the specific needs of customers.
How to calculate the average returns
To make the illustration easier, let’s take a case example. For example, suppose the ROIC of the five companies in the food industry over the past decade is as follows: 12%, 13%, 10%, 8%, and 7%.
To calculate the average ROIC in the industry, we add up each ROIC and then divide it by the number of companies. That yields an average of 10%.
From this data, we see that two companies produce returns above the average. Both of them are likely to have competitive advantages, and of course, to conclude with certainty, we need to explore their performance further.