Think of return on capital employed (ROCE) as the Clark Kent of financial ratios. Most investors dont take a second look at a companys ROCE, but savvy investors know that, like Kents alter ego, ROCE has a lot of muscle. In fact, ROCE can help investors see through growth forecasts, and it can often serve as a reliable measure of corporate performance. In this article we’ll reveal the true nature of ROCE and how to calculate and analyze it. Read on to find out how this often overlooked ratio can be a superhero when it comes to calculating the efficiency and profitability of a company’s capital investments.

Defining ROCE

Put simply, ROCE reflects a companys ability to earn a return on all of the capital that the company employs. ROCE is calculated by determining what percentage of a company’s utilized capital it made in pre-tax profits, before borrowing costs. To calculate ROCE, you determine what percentage of a company’s invested capital it made in pre-tax profit before borrowing costs. The ratio looks like this:

= Profit Before Interest and Taxation / Capital Employed

Starbucks an example of vertical integration

Fatima Patova’s insight:

After my brief stint into the world of McDonalds, I decided to learn about what I thought was another franchise, but a more modern one:Starbucks. Turns out I was mistaken and it is not a franchise at all. Instead, the company is immensely vertically integrated for one purpose alone, maintaining perfect quality throughout the value-chain. At least that’s what its founder, Howard Schultz, claims in his book ‘Pour Your Heart Into It.’ I agree that when you have a globally orientated company, with both suppliers all around the world and coffee-shops now too, and you are selling a premium product, that this is a good strategy.

How did Starbucks get this way? Its organisational structure is ingrained in the strange history of the company. It originally started as a roaster and retailer of coffee-beans, when Schultz joined the company as a young salesman. He later left it to pursue his real passion, setting up coffee-shops, and a few years later returned to buy Starbucks the company, including the name. Had he not succeeded, his strategy of expansion may well have been very different.

In business, you’ll often come across the concept of transaction costs, or the make-or-buy decision. Transaction cost theory stipulates that you should keep the things in-house that constitute your core-competencies, and outsource those that do not. In other words, make it yourself versus buy it externally. In the case of Starbucks, the core-competencies is quality coffee which sells at premium prices. To them, it is vital to own the components and have the people that create this quality.

Being vertically integrated is both rewarding and risky. One the negative side, you have a lot of dependancies and there is a great risk of stagnancy in a dynamic market-place. The more people you have working for you and the more business-units you have to manage, the higher the complexity level and the more layers are necessary in a command-structure. Therefore everything happens much slower and is also much more expensive.

The best way to circumvent that is to focus on your core-values and the bottom-line. If your core-value is high quality coffee, you can also charge higher prices for it, off-setting some of the costs of vertical integration. But similarly, it pays off to slim down the complexity, make the process of creating your product as (cost-)efficient as possible.

And by controlling the value-chain, you can essentially control the experience, maintain the level of quality much better than if you are dependant on external partners. This is especially an issue in the world of coffee, where you would frequently deal with suppliers in developing nations with varying standards of quality. Starbucks does not grow its own coffee, but it does keep its buyers awfully close to those that do. Similarly, other industries like IT or retail face similar concerns. Do we hire programmers elsewhere or train them ourselves?

So why doesn’t a company like McDonalds integrate vertically? On a virtual level, you could say they do. They have created McDonalds university, which offers training to franchisees, in order to share the same values throughout the company-name. They keep their R&D in-house, but share the results throughout the virtual chain. They advertise on a national and regional level. And they maintain good relationships with suppliers to buywhat they call premium-products at far-less-than premium prices.

As the last sentence suggests, that is perhaps where the difference lies. The core-value of McDonalds is not the same as that of Starbucks. The first started with offering hamburgers for $ 0.15, now around $1; the latter offered premium beans and later coffee for $3.50. This is again a superficial observation, but higher prices translate into a higher budget for quality. Just like Apple maintains high margins for it’s hardware, vs. other PC-makers, it can offer a higher quality of design and customer service than most of its competitors. Similarly, Starbucks can focus on training the best people, buying the best equipment, run innovative marketing campaigns and strategies. And it can afford to be vertically integrated.