When Businesses Need Little or No Capital  477 EXHIBIT 24.9  TradeCo: ROIC and NOPAT Margin % 0 200 400 600 1,000 1,200 1,400 1,600 14 ROIC NOPAT/revenues 800 0 4 7 11 2016 2018 2019 2020 2015 ROIC not meaningful 2017 ROIC not meaningful NOPAT/revenues in 2020. Yet value creation declined, as the change in economic profit for the same period shows. The change in ROIC was driven by a decline in working capital. Earnings declined simultaneously and pushed down value creation. Not all businesses with low capital are inherently capital light. Indeed, some capital-intensive businesses have adopted capital-light models by out- sourcing their most capital-intensive processes—typically manufacturing and distribution. The high-tech electronics sector provides examples of this ap- proach, including Apple, Fujitsu, Hewlett-Packard, and Sony. In the apparel sector, companies such as Nike have outsourced their manufacturing. ROICs for businesses that have aggressively outsourced parts of their busi- ness chain can be very high and volatile. In addition, the capital reduction that comes with outsourcing can lead to confusion when ROIC is used to assess whether outsourcing creates any value to begin with. After outsourcing, many businesses end up with much higher ROICs. In some cases, managers even refer to the higher ROIC as one of the main benefits of outsourcing. But the ROIC increase does not necessarily mean that the company has created value for its shareholders. Consider the companies InhouseCo and ContractCo in Exhibit 24.10. The companies are identical, with one exception: ContractCo has outsourced all of its production to a third party. It has no net PP&E and no depreciation charges, but it has higher operating costs compared with InhouseCo. Al- though ContractCo’s earnings are lower than InhouseCo’s, its ROIC is more than five times larger because it no longer needs PP&E. But ContractCo is not creating more value in its business than InhouseCo. In fact, as the measure of economic profit indicates, the two companies’ value creation is identical. In this example, ContractCo has separated out its capital-intensive and low- ROIC production activities from its other activities without creating value. The ROIC for ContractCo goes up simply because it retains only the high- ROIC activities. But that does not say anything about the value creation from 478  Measuring Performance in Capital-Light Businesses outsourcing.9 Managers should therefore not make decisions to outsource merely on the grounds that it raises ROIC. These decisions need to be sup- ported by an analysis of economic profit or, equivalently, a DCF valuation. Economic Profit as a Key Value Metric Although there is no objective way to determine a cutoff point, we believe that ROICs above 50 percent need to be handled with caution when used as a mea- sure of value creation. Special caution is required in businesses where high capital turnover, rather than high earnings margins, drives such ROIC levels. In such cases, economic profit is a more solid performance measure that is always in line with value creation. (For more details on economic profit, see Chapter 3.) It can be defined in either of the following two equivalent ways: Economic Profit ROIC WACC Invested Capital = − ( ) ×  (24.1) Economic Profit NOPAT Capital Charge = −  (24.2) In Equation 24.2, the capital charge equals WACC times invested capital. EXHIBIT 24.10  Impact of Production Outsourcing on ROIC $ million InhouseCo ContractCo NOPAT Revenues 100.0 100.0 Operating costs (85.0) (94.5) Depreciation (3.8) – Operating taxes (3.9) (1.9) NOPAT 7.3 3.6 Invested capital Net working capital 5.0 5.0 Net PP&E 50.0 – Invested capital 55.0 5.0 Key value drivers, % NOPAT/revenues 7.3 3.6 Invested capital/revenues 55.0 5.0 ROIC 13.3 71.2 Economic profit NOPAT 7.3 3.6 Capital charge1 (4.1) (0.4) Economic profit 3.2 3.2 1 Cost of capital equals 7.5%. 9 Of course, outsourcing in this example could still create real value if it enables ContractCo to realize higher growth because it needs less capital for its business.