When Reliance Electric acquired our nice, privately held, mid-sized business they paid a significant premium. They were a strategic buyer. They wanted an introduction to some of the horizontal markets where we strong. Congratulations. The seller got a bigger multiple of earnings. We got RONA.
RONA is short for Return on Net Assets. Based on Generally Accepted Accounting Principles the total purchase price of an acquisition of this nature is allocated to assets of the business based on the individual fair market value of the assets acquired. Overnight, depreciated assets suddenly became valuable once again as the premium in purchase price was spread over these assets in what amounted to a “write up.” This might be considered normal accounting mumbo jumbo except that one of B. Chuck Ames metrics required to fulfill the Basic Commitments outlined in the first part of this series. RONA.
Ames expected at least 18% return on net assets employed. The write up in assets moved the bar for our performance hurdle to a new, some would say, unfair level. What was fair about the metric was it allowed Reliance to earn back the premium it paid for the companies it acquired. And, it was also a very clear performance expectation for the managers of the company. We all knew exactly what was expected.
The metrics Ames incorporated to insure the ability to fulfill Our Basic Commitments to our shareholders and our employees included:
- Sustained rate of growth in earnings per share 4 to 5 points above the going rate of interest.
- Improved quality or stability of earnings so that in periods on economic decline earnings would not fall below the level of any prior period.
- 7% Return on Sales after tax.
- Increase earnings contribution by 15% per year.
- And, of course, 18% RONA.
Ames was very specific about operating units that did not achieve these profit goals. The unit was regarded as a “drain on, rather than a contributor” to the corporation. He made it clear to everyone that this drain could not be tolerated. There was no commitment to a plant, product or market that did not at least offer the prospect of hitting the performance targets. Further, it was the manager’s responsibility to make realistic assessments of a business unit and decide to get out of it if it wasn’t going to make its “fair contribution.”
Interestingly, Ames was quick to debunk “the allure of volume” argument. He wrote that return on capital and absolute earnings can be improved by walking away from marginal business, even if it meant shrinking the overall size of the business. His metrics were about making money.
Selected metrics, of course, will vary by company. They need to be relevant to the goals of the organization. The suggestion would be to pick three or four that apply to the individual situation and use them as guideposts for judging performance. The focus these metrics according to Ames would be on earnings.
The next installment of Basic Management Concepts will describe the Growth Strategy Ames devised for Reliance Electric. Once again, all the content of this article is based on the work of B. Charles Ames as outlined in his management manifesto titled Basic Management Concepts dated January 14, 1974.
B. Chuck Ames and his wife Jay currently manage the Ames Family Foundation. They divide their time between a home in Vero Beach, Florida and a second home in a suburb of Cleveland.