What Drives ROIC?  129 This version of ROIC simply translates the typical formula of net operating profit after taxes (NOPAT) divided by invested capital into a per unit calcu- lation: price per unit, cost per unit, and invested capital per unit.1 To earn a higher ROIC, a company needs a competitive advantage that enables it to charge a price premium or produce its products more efficiently (at lower cost, lower capital per unit, or both). A company’s competitive advantage depends on its chosen strategy and the industry in which it operates. The strategy model that underlies our thinking about what drives com- petitive advantage and ROIC is the structure-conduct-performance (SCP) framework. According to this framework, the structure of an industry influ- ences the conduct of the competitors, which in turn drives the performance of the companies in the industry. Originally developed in the 1930s by Edward Mason, this framework was not widely influential in business until Michael Porter published Competitive Strategy (Free Press, 1980), applying the model to company strategy. While there have been extensions and variations of the SCP model, such as the resource-based approach,2 Porter’s framework is probably still the most widely used for thinking about strategy. According to Porter, the intensity of competition in an industry is deter- mined by five forces: the threat of new entry, pressure from substitute products, the bargaining power of buyers, that of suppliers, and the degree of rivalry among existing competitors. Companies need to choose strategies that build competitive advantages to mitigate or change the pressure of these forces and achieve superior profitability. Because the five forces differ by industry, and because companies within the same industry can pursue different strategies, there can be significant variation in ROIC across and within industries. Exhibit 8.1 underlines the importance of industry structure to ROIC. It compares the median return on invested capital over more than 20 years in two sectors: branded consumer goods and extraction industries (such as min- ing and oil and gas). Consumer goods have earned consistently higher ROICs than extraction companies. In addition, the returns of extraction-based com- panies have been highly volatile. The reason for this difference in the industries’ performances lies mainly in differences between their competitive structures. In the branded-consumer- goods industry, companies such as Nestlé, Procter & Gamble, and Unilever developed long-lasting brands with high consumer loyalty that made it dif- ficult for new competitors to gain a foothold. Building on these advantages, these companies were able to increase their returns on capital from around 20 percent in the mid-1990s to roughly 30 percent two decades later, despite challenges to traditional brands from new market entrants. One example is 1 We introduce units to encourage discussion regarding price, cost, and volume. The formula, however, is not specific to manufacturing. Units can represent the number of hours billed, patients seen, transactions processed, and so on. 2  See, for example, J. Barney, “Resource-Based Theories of Competitive Advantage: A Ten-Year Retrospective on the Resource-Based View,” Journal of Management 27 (2001): 643–650. 130  Return on Invested Capital the competition faced by Procter & Gamble’s Gillette shaving business from challengers such as Harry’s and Dollar Shave Club.3 In extraction industries, one company’s products are the same as another’s (iron ore is iron ore, with minor quality differences), so prices are the same across the industry at any point in time. In addition, the companies use the same capital-intensive processes to extract their products. As a result, the me- dian company in the industry doesn’t have a competitive advantage, and re- turns are low, averaging only 9 percent during this 20-year period. It is worth noting that imbalances in supply and demand can lead to cycles in product price and ROIC, as was the case with a long run-up in commodity prices in the years leading up to 2005. In the end, though, competition leads to low ROIC on average. Industry structure is by no means the only determinant of ROIC, as the significant variation among companies within industries shows. Consider the global automotive industry, which has been plagued by overcapacity for years. Still, the industry’s low returns do not deter new entrants, whether from different geographies (such as South Korean automakers’ entry into the U.S. and European markets) or due to the emergence of new technologies (such as electric-vehicle producers, including Tesla). Add in the difficulties that some manufacturers encounter in trying to close unionized plants, and it’s easy to see how overcapacity keeps returns across the sector low. Only a few manu- facturers, such as BMW, can parlay their premium brands and higher qual- ity into higher prices and superior returns on capital compared with other EXHIBIT 8.1  Company Profitability: Industry Matters Industry median ROIC excluding goodwill, % 15 10 5 0 20 30 25 35 2000 1995 2005 2010 2015 Branded consumer goods Extraction Source: Corporate Performance Analytics by McKinsey. 3 Unilever acquired Dollar Shave Club in 2016.