The focus on short term profits is destroying the possibility of long term growth

Interesting:

Christensen retells the story of how Dell [DELL] progressively lopped off low-value segments of its PC operation to the Taiwan-based firm ASUSTek [LSE: ASKD]—the motherboard, the assembly of the computer, the management of the supply chain and finally the design of the computer. In each case Dell accepted the proposal because in each case its profitability improved: its costs declined and its revenues stayed the same. At the end of the process, however, Dell was little more than a brand, while ASUSTeK can—and does—now offer a cheaper, better computer to Best Buy at lower cost.

Christensen also describes the impact of foreign outsourcing on many other companies, including the steel companies, the automakers, the oil companies, the pharmaceuticals, and now even software development. These firms are steadily becoming primarily marketing agencies and brands: they are lopping off the expertise that is needed to make anything anymore. In the process, major segments of the US economy have been lost, in some cases, forever.

Business school thinking is driving this
Why is this happening? According to Christensen, the phenomenon is being

“driven by the pursuit of profit. That’s the causal mechanism for these things… The problem lies with the business schools which are at fault. What we’ve done in America is to define profitability in terms of percentages. So if you can get the percentage up, it feels like we are more profitable. It causes us to do things to manipulate the percentage. I’ll give you a few examples.

There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Because if you ever use your money for something that doesn’t pay off for years, the IRR is so crummy that people who focus on IRR focus their capital on shorter and shorter term wins.
There’s another one called RONA—rate of return on net assets. It causes you to reduce the denominator—assets—as Dell did, because the fewer the assets, the higher the RONA.
“We measure profitability by these ratios. Why do we do it? The finance people have preached this almost like a gospel to the rest of us is that if you describe profitability by a ratio so that you can compare profitability in different industries. It ‘neutralizes’ the measures so that you can apply them across sectors to every firm.”

The thinking is systematically taught in business and followed by Wall Street analysts. Christensen even suggests that in slavishly following such thinking, Wall Street analysts have outsourced their brains.

“They still think they are in charge, but they aren’t. They have outsourced their brains without realizing it. Which is a sad thing.”

The case of the semi-conductor industry
How is this working out across the economy? In the semi-conductor industry, for instance, there are almost no companies left in America that fabricate their own products besides Intel [INTC]. Most of them have become “fab-less” semiconductor companies. These companies are even proud of being “fab-less” because their profit as a percent of assets is much higher than at Intel. So they outsource the fabrication of the semi-conductors to Taiwan and China.

Christensen notes that when he visits these these factories, they have nothing to do with cheap labor. It’s very sophisticated manufacturing, even though it’s (not yet) design technology. The plants cost around 10 billion dollars to build.

Christensen recalls an interesting talk he had with the Morris Chang the chairman and founder of one of the firms, TSMC [TSM], who said:

“You Americans measure profitability by a ratio. There’s a problem with that. No banks accept deposits denominated in ratios. The way we measure profitability is in ‘tons of money’. You use the return on assets ratio if cash is scarce. But if there is actually a lot of cash, then that is causing you to economize on something that is abundant.”

Christensen agrees. He believes that the pursuit of profit, as calculated by the ratios like IRR and ROA, is killing innovation and our economy. It is the fundamental thinking drives that decisions that he believes are “just plain wrong”.